By Jason Zweig | 7:24 pm Dec 13, 2013
Image Credit: Christophe Vorlet
With U.S. stocks up 27% this year, many investors might already be struggling to avoid getting greedy and making careless mistakes.
By building a checklist — a standardized set of questions you must answer before you commit to any investment decision — you can reduce the risk of making costly errors. The best way to do that is by looking at your past mistakes. That’s true no matter how you invest, even if you don’t buy individual stocks at all.
The idea, still surprisingly underused in the investment business, is adapted from hospitals and the airline industry. An itemized list of procedures and how to follow them, the surgeon Atul Gawande has written, can “hold the odds of doing harm low enough for the odds of doing good to prevail.”
Checklists help fix one of the biggest flaws in the way investors make decisions: inconsistency.
How much you pay for a stock matters. But so do the quality of the company’s management, how much debt it has, who its customers and competitors are, how easily it can raise prices, and many other variables.
So which factors should you emphasize the most? Many investors, including professional money managers, just go with what feels right at the time.
As the Nobel Prize-winning psychologist Daniel Kahneman’s book “Thinking, Fast and Slow” puts it, “Humans are incorrigibly inconsistent in making summary judgments of complex information.” (Disclosure: I helped Prof. Kahneman write the book but don’t receive royalties from it.)
Decades’ worth of psychological studies show that people are extremely good at figuring out which information they need for a decision — but do a poor job of using that evidence methodically over time. You are likely to draw divergent conclusions from identical data on different occasions, even when nothing fundamental has changed, because of variations in context, alterations in your mood, shifting demands on your attention and memory, and so forth.
No wonder John Mihaljevic, editor of the Manual of Ideas, a website for value investors, says wryly that he uses checklists to combat his tendency to make “the same type of mistake again and again.”
Structuring your decisions this way, says Michael Shearn, author of the book “The Investment Checklist,” forces you to take “a holistic view” of a stock or other asset. That should reduce your odds of being flummoxed by the unexpected.
“When we look to make an investment, the greed part of the brain is turned on,” says Mohnish Pabrai, managing partner of Pabrai Investment Funds in Irvine, Calif., a group of private portfolios with assets of approximately $700 million. “A checklist is like a circuit breaker that helps prevent the brain from being able to flip that switch.”
To build his list, Mr. Pabrai studied his mistakes and those of great investors like Warren Buffett. Anyone “can build a customized checklist based on your own history of your own failures,” he says. Mr. Pabrai advises investors to review their past decisions that lost money.
“Rub your nose in your own failures,” he urges. “Avoiding the mistakes you’ve made in the past will take your error rate way down in the future.”
Mr. Pabrai says he believes that the flubs made by great investors fall into five groups: valuation, or how cheap an investment is; leverage, or risks associated with borrowing; management and ownership; “moats,” or how well-fortified business are against competition; and personal biases.
First he does all his other research; then he works through the checklist to make sure he didn’t miss anything.
Among the questions on Mr. Pabrai’s list: How good is management at allocating capital? Is cash flow overstated because of an unsustainable recent boom? Does the company appeal to me because of personal preferences that might be clouding my judgment?
Guy Spier, managing partner of Aquamarine Capital, a Zurich-based investment firm that manages $160 million, uses his checklist to determine, among other things, how a company makes its customers and suppliers better off. That, he says, helps him figure out how likely the company is to be able to fend off competitors.
Your list, of course, should include only questions you know how to answer; they need only be relevant to your past mistakes and to your current and prospective investments.
Mr. Spier emphasizes that you don’t have to be a stock picker to benefit from a checklist. “Even if all you own is mutual funds or municipal bonds, look at the places where you’ve made mistakes and where you can understand the mistakes of others,” he says. “Use that to understand where you don’t want to go in your own investing world.”
Ponder what you should have asked to avoid those problems to begin with. Those are the questions to add to your checklist.