Every investor will have specific benchmarks and strategies. But too often, they are quick to choose an investment target -- such as earning 15% a year -- before they define an investing process.
One appropriate process to reach your goals is:
- Examine only companies and industries that you understand well.
- Focus on fundamental valuation (earnings, debt levels, return on equity).
- Invest with a time horizon of several years for each investment.
Investing with such a simple and effective framework will help you prevent significant losses. That should always be your primary goal -- not chasing astronomical gains. Remember Warren Buffett's famous advice: "Rule No. 1: Don't lose money. Rule No. 2: Never forget rule No. 1."
Loss avoidance is the No. 1 goal
Your first consideration should be the degree of loss in any investment, whether it's Berkshire Hathaway (NYSE:BRK-A, BRK-B), Google (NASDAQ:GOOG), or Countrywide Financial (NYSE:CFC). Ranked from lowest risk of loss to highest (in my opinion), let's take a quick peek at these companies:
- Berkshire is a well-run business with tons of cash run by a successful investor. These three factors suggest that it will do well over time without significant loss.
- Google is also an excellent business with a pristine balance sheet. Unlike Berkshire, it's vulnerable to attack from the likes of Microsoft (NASDAQ:MSFT) and a host of other tech outfits. On top of that, at the current price, investors are vulnerable, too -- to loss of capital.
- Countrywide looks like a stereotypical value investment, with a 2008 expected price to earnings (P/E) ratio of five and a price-to-book (P/B) ratio of 0.40. But it could face serious credit issues that might leave your investment and the valuation worthless.
Easy to say, but not easy to do
I'm not suggesting that you should not incur any degree of risk in your investment selections. Loss avoidance is one more tool in your investing process that, over time, shields your portfolio from substantial loss of principal.
No investor wants to lose money. But we humans have always been intrigued by the possibility of a free lunch, and we let our speculative urges take over. Only with a clear and disciplined approach focused on avoiding catastrophic mistakes will you be able to ensure that your investments do well over a sustained period.
When your approach is sound, you need not worry about what happens next month or next quarter. When your approach is disciplined, you aren't tempted to buy a Baidu (NASDAQ:BIDU) at $300 a share, even if it does go to $400 in a few months. Instead, you realize that with a P/E of about 150 and a P/B of more than 40, buying that stock would be speculating, not investing.
Choosing to avoid losses is the most important part of an investment strategy, but not the only one. You must also be aware of unexpected events and their ramifications. In his 2006 annual report, Buffett stated that to work at Berkshire, a chief investment officer would need to be "genetically programmed to recognize and avoid serious risks, including those never before encountered."
Avoid targets and stick to your process
Picking a number for a desired investment return doesn't help you achieve it; in fact, it could be disastrous. Those targets lead investors to focus on upside potential rather than downside risk. The higher the price you pay for stocks, the lower your returns are.
Contrary to popular notion, the number of hours you spend analyzing a stock does not factor into your investment returns. Sticking to a consistent and disciplined approach does.
Too much activity is costly. Don't let the daily whimsies of Mr. Market guide your process -- except when you can take advantage of bargain opportunities.
Need more help in defining your process? Check out this Foolishness:
