Before I jump into today's article about improving your investing decisions, I'd like to announce a contest designed to get some of you smart readers to share your small-company investment ideas. Here's how it works: Between now and September 14, send in a short essay (maximum 500 words) on your favorite small-cap investing idea to me at [email protected]. Make sure the subject line of your e-mail says "small-cap investing contest."
Your idea can be a growth stock, a value stock, or something in between. But it's got to be a great investment idea, and you have to make your case for why it's so great. I will announce the winners (as well as the stocks) in this column on September 25. In addition to being able to show off their prowess at the office water cooler that afternoon, the winners will get some very cool Fool prizes.
Now back to our regularly scheduled programming....
Back to the basics
Investing is one of those activities that can be deceptively simple. There are probably as many different investment approaches as there are investors, and there are, of course, an infinite number of factors, opinions, and analytical tools that one can use or ignore in making investment decisions.
But no matter what investment style and philosophy you follow, it may be helpful on occasion to take a step back from the information overload of the media and the cacophony of the market and remember that at its very essence, investing is about taking control. To my thinking, there are only four things about investing that you can control. Three of these control variables are concerned with buying. Only one of them has to do with selling. Before discussing further the ramifications of these four control elements for investors, let me first lay them out for you.
1. Which companies to buy
The first variable is the choice of which company to invest in. There are over 10,000 choices on the major U.S. exchanges, ranging from heavyweights like Coca-Cola (NYSE: KO) to struggling upstarts such as Amazon.com (Nasdaq: AMZN) and everything in between. Of course, one can also choose to buy baskets of companies -- rather than individual ones -- through index funds, mutual funds, or any of the other investment vehicles available out there. And of course, one can decide not to invest as well. Nevertheless, the first decision takes place when an investor decides on a company he or she wants to buy.
2. What price to pay
The second decision an investor makes is at what price he or she would be willing to buy that company. Note that if the answer is anything other than "the currently quoted price," you have no control over whether you will actually get to act on this decision. Nevertheless, you are in control. The company may never hit your predetermined price, in which case you may either decide to do nothing or to modify your price. If the company you've decided you want to buy hits the price that you've determined you are willing to pay, there is one final variable in the buying process.
3. How large a position to take
How much money should you allocate to this company at this price? Whether you are running a $100 million mutual fund, a $100,000 IRA, or a $10,000 portfolio in your Ameritrade or Datek account, this is a key decision. Whether you think of it in terms of dollar amounts ("I'll take a $500 flyer" or in percentage terms "I'm comfortable with 10% of my portfolio) you need to decide how much of a plunge to take.
Those are the three buy-side decision variables. Once you've decided upon the company, the price, and the amount, you've navigated 75 percent of the investing cycle. At this point, there is only one further action you can control.
4. Hold or sell at the current price
Whereas on the buy side you can choose to buy if your company hits a certain price, thus providing you with control (i.e., I will buy at Price X, I will not buy above Price X), the sell side is different. You already own the stock. Therefore, your control over the sell decision is limited to whether or not you will sell at the prevailing market price. Sure, you can set a theoretical price target by saying "I will sell when it goes up to $75." But the price may never get there, and if it doesn't, at some point you will be forced to make another decision: to continue holding in the hope that the stock will actually ever make it to the price target that you've set, or to sell at the current price. Therefore, once you own the stock, you really have only two choices: to hold it with the expectation that it will go up at some point, or to sell at the prevailing market price.
Now that we've identified the four decision factors that make up the full investing cycle, what can we gain from them? First of all, I'd guess that many investors are stronger in one or two particular areas, but may be undermining their success to some degree by being weak in another. Accordingly, I encourage you to do a postmortem analysis of some of your recent investment decisions.
Do you seem to be prone to investing in companies that appear to have promising prospects but then fizzle away, leaving you with little or none of your original investment? You may need to spend some time learning to identify high-quality companies. You may be a sucker for a good story, or quick to pull the trigger on a company with promising technology but not the best business prospects.
Maybe you pick strong companies that are among the leaders in their markets, but always seem to buy them at close to the 52-week high price. You may need to work on valuation issues, the dynamics of business cycles in a particular industry, or simply on being patient and waiting for your price.
If it appears that you aren't getting optimal returns because you invest too little in the companies that go up and too much in the companies that go down, you will probably find it helpful to spend more time thinking about how much of your portfolio to allocate to each new purchase.
Finally, if you are prone to selling due to fear or boredom, or if you find yourself holding stocks long after it has become apparent that your original investing thesis was flawed, you may need to spend time to create a sell strategy that you are comfortable with. Careful review of how you make decisions in each phase of the investing cycle should allow you to improve your overall investing results. I have found this "back to basics" approach to be very helpful in creating an investment process that I can trust. I hope you find it helpful as well.
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Zeke wrote this column after six months of intensive shock therapy with that psychologist from the TV series "The Sopranos." Or maybe that was one of his frequent hallucinations. Zeke doesn't own shares in Coca Cola or Amazon.com. The Motley Fool is investors writing for investors.
