One thing that constantly amazes me is how many people look for the next earth-shattering technology when the really outstanding investors became rich by merely following a few simple rules. Take Charlie Munger, Warren Buffett's business partner, for example. He explains his success by saying, "We try to profit more from always remembering the obvious than grasping the esoteric. It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent."
This is an important concept -- you don't have to be able to play chess blindfolded to achieve incredible returns. Simply follow the well-known strategies of great investors. Your challenge is to apply the rules and avoid making stupid mistakes.
Three simple rules
Long term, the best strategy is to read as much as you can about investing, figure out what works, and create your own rules. But you can start by asking yourself three simple questions before buying any stock.
- How does the company make money?
- What factors make this company likely (or unlikely) to fend off competition and prosper?
- What is this company worth?
If you don't have satisfactory answers to any one of these questions, you run the risk of stupidity. You're either investing in a poor company or don't know enough about the company to be reasonably confident you're making an excellent investment.
Why grasp the obvious?
So what's to gain from not being stupid? Piles of money, of course! Your portfolio will benefit when you identify the bargains and avoid the swill. Consider the five-year returns of the following stocks:
| Company | 5-Year Return |
|---|---|
|
Apple |
548% |
|
Pulte Homes |
319% |
|
Humana |
328% |
|
Sunrise
Senior Living |
231% |
|
Nortel Networks |
-91% |
|
Eastman Kodak |
-36% |
|
Cisco Systems |
-43% |
| S&P 500 | -6% |
Five years ago, Apple was one of the most innovative companies, with one of the strongest brands, and it was trading at less than double the cash on its balance sheet. It was marginally unprofitable that year, but only barely. It was cheap. I thought then about buying it. But I never did. That was stupid.
Pulte, Humana, and Sunrise were similarly cheap five years ago. All held dominant positions in their niches. All had price-to-earnings (P/E) ratios in the single digits or low double digits. All were impressively undervalued. All had phenomenal subsequent returns.
Nortel, Kodak, and Cisco nicely illustrate the other side of the coin: Losing money is a major downside of not following the rules. Even in 2001, Nortel's flaws were rather conspicuous -- the company hadn't been profitable for four years. Kodak was a good brand but was clearly failing to protect its niche from invading digital cameras. Cisco was perhaps the easiest mistake to make. It was the top company in a growing industry with astronomical competitive advantages. But it was trading at an even more astronomical price.
Next steps
In all these cases, following three sensible rules would have significantly benefited your portfolio. If you want some assistance in not being stupid, or want to read about our best non-stupid investment ideas, we're happy to oblige. After all, at Motley Fool Inside Value, we don't seek to impress you with our stunning intelligence, only to consistently identify outstanding investments. To check it out free for 30 days, click here.
Fool contributor Richard Gibbons actually does play chess blindfolded, but only against stupid players. He owns LEAP calls on Cisco and used to own Sunrise, but he does not have a position in any of the other companies discussed in this article. The Fool has a disclosure policy.
