Pay attention, and you'll hear a lot of talk about psychology and economics in the area of investing.
You have to pay close attention, however, or you'll get the wrong idea. You'll start thinking psychology means market sentiment, that economics means predicting which way the market is going. It doesn't and you can't. Most of that can be waved away, like bad air.
Rather, there are elements of psychology and economics with meaning for investors, not as forecasting tools, but as arbiters of our decision-making process. My experience as an investor tells me I need three sets of skills to make buy and sell decisions:
First, I need an investing center. I need to know where I'm headed and what vehicle is suited to get me there. Am I a buy-and-hold guy or a trader? Second, I need to be able to read financial statements. Accounting is the language of business, finance the language of money. (I've covered both topics in Rule Maker columns over the last six months.) If you can't speak either, at all, start thinking seriously about index funds -- not just one, but a diversified group.
The Rule Maker strategy -- with its focus on profitable, cash-rich companies -- tries to supply a few of the tools investors need in the first two skill sets. It gives the investor an investing center focused on dominant, established companies, as well as screening criteria aimed at getting investors to focus on profitability, efficiency, liquidity, and solvency.
What's missing, I think, is the third layer of skills, a category that recognizes the difference between knowledge and execution. In other words, decision-making. Applying what we've learned to stock-picking, and sticking with it, is tougher than writing about it. It's the difference between drawing up a play on the sidelines and sinking the basket under pressure.
Economics and psychology, especially the middle ground the two perhaps are reaching in the field of behavioral finance, can teach us a lot about this third skill set. Both fields look to uncover how and why we make decisions. Nothing is more central to investing, a fast-moving world with imperfect information, than having a method to arrive at sound decisions.
In the Rule Maker, just as in every investor's portfolio, we've got to be able to police our decision-making or we'll end up with a bag full of JDS Uniphase (Nasdaq: JDSU) and Yahoo! (Nasdaq: YHOO), stocks too young to qualify as Rule Makers, yet which ended up in the portfolio.
This is the area Berkshire Hathaway's (NYSE: BRK.A) vice chairman Charlie Munger honed in on as the weakest link, not just in the investment process, but in the decision-making process overall. How can we keep from being overwhelmed by a bias, for failing to understand how much we lean towards overconfidence, for anchoring expectations to irrelevant numbers, for holding onto losing investments beyond the point of reason? Munger is interested in the subject of rational decision-making. How do we accomplish this and spread the word?
There's no easy answer, but a couple of books provide a great sketch of the problem: Influence: The Psychology of Persuasion, and Why Smart People Make Big Money Mistakes. Also, Latticework, Robert Hagstrom's new book (which I haven't read yet), takes a fuller look at Munger's solution to the decision-making problem. It involves developing knowledge across a variety of disciplines, from mathematics to psychology, to add depth and flexibility to our decision-making.
Let's be frank: Munger and Hagstrom aren't offering stock picks. This is to the good. We aren't offering stock picks in the Rule Maker, either. We can't say it enough: Take what you learn here and apply it to your own decision-making process. Throw out what doesn't make sense; smash what doesn't work for you.
Over the coming months, we're going to take what we've learned and cross two streams: First we're going to sweep for new Rule Maker candidates in new industries, such as consumer products. Each Rule Maker writer will tackle an industry, run through the basics, and hunt for new candidates. Second, once per week, we're going to pick an existing Rule Maker and give it a good workover, starting with Intel (Nasdaq: INTC). We want to know the same things you do. Is the company still dominant? Do we think it will continue?
Finally, the Rule Maker team has decided to put this month's $500 investment in financial services company American Express (NYSE: AXP). We believe the company will grow more profitable as it increases the number of customers who carry its charge and credit cards, and as it cross-sells financial advisory services to a growing card base. The credit card business is consolidating, only a few companies have the skills to make money in it, and Amex is the only top-tier player with a premium brand.
We'll make the investment in the next five business days. Also, we're leaving last month's $500 in a money market fund while we wait for a richer opportunity. When the chance arises, we want to be able to move with more than our standard $500 investment.
Have a great day.
Like you, Rich McCaffery makes hundreds of decisions each and every day. The Motley Fool is investors writing for investors.
