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Rationality and the Importance of Keeping a Stock Book

April 04, 2007
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Dr. John Price

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Two of the biggest blocks to successful investing are irrational thinking and not learning from the past. When in a bear market, people act as if it will go on for ever. The same applies to a bull market. Biases such as these fall into the category of heuristic simplification

Another major bias is when people have a few successes, they immediately attribute them to their prowess as an investor, rather than to luck. This is called a self-attribution bias.

But whatever their names, what is important is not to get caught by them,

One of the most effective ways of achieving this is to start a stock book. Putting it simply, a stock book is a place where you write down the reasons why you are buying or selling a particular stock (or doing nothing). It is also a place where you can keep clippings of articles about companies that you are watching and printouts from the internet of relevant press releases, announcements and reports.

It can be as simple or as complex as you like. What works well for me is a ring binder with sections for the different companies. Apart from printouts mentioned above, I also use plastic pockets to include clippings of newspaper and magazine articles.

Others have used Google Notebook, an add-in provided by Google. It allows you to click on any page on the web and save it to a notebook.

When I start to get interested in a particular stock, I go to my stock book to see if there is any material on the company. I often find that I had an interest in the company four or five years ago. When I look at this old material I may see that the company had made various forward looking statements and so I can gauge whether or not they have lived up to them. I can also read comments I may have made on the company — its strengths and weaknesses, its future prospects and challenges, and so on.

Another important way for using your stock book relates to buying stocks. Before you buy, write down the main reasons why you are doing this. What is it that you particularly like about the company? What is its market position or niche? What do you think will take place in the future?

Take your time to write down your thoughts in these types of areas.  There are two main benefits for doing this. The first is that it sharpens your thinking about why you are taking a particular action. You are more likely to buy for rational reasons. If not, at least you will know that you are not being rational.

The second reason is that it helps to improve your skill in making decisions in following years. Often we buy a stock for reasons that are vague and only partially thought through. The problem with this is that, even if the investment is successful, it is no help for making the next decision, or any others after that. The best you can deduce from it is that you were lucky once and perhaps you will be lucky again.

You may be satisfied with this approach when you are investing comparatively small amounts of money. But I like to think that no matter where you are now on the wealth scale, it won”t be long before you are investing significant amounts of money. When that happens, lackadaisical methods will no longer be enough.

Putting it simply, you may be prepared to invest $1,000 on a hunch, but few people would be willing to do the same with $100,000 or more.

Another advantage is that if we are clear why we bought a stock, we can test in later years if our reasoning was sound. If the price went up, it reinforces our reasoning. If it did not go up, then we can look back at our logic and perhaps locate steps where we went wrong. This may help us to avoid the same mistake in the future.

Warren Buffett is a great supporter of being clear why you bought a particular stock at a particular time.

Recently a group of students paid a visit to the “Sage of Omaha”. In response to one of the questions, Buffett replied:

My partner Charlie Munger and Tony Nicely at Geico are always rational. 160 IQs can say stupid things that sound good. People do silly things, whether they have 120 IQ or 160. You can always improve your rational thought. Rationality is the only thing that helps you. One thing that could help would be to write down the reason you are buying a stock before your purchase. Write down “I am buying Microsoft for $300 billion because…” Force yourself to write this down. It clarifies your mind and discipline. This exercise makes you more rational.

Note that Buffett talks about buying all of Microsoft. This fits in with his strategy of acting as if you are going to buy the whole company. Once he puts a price on the entire company, then he can put a price on individual shares.

Peter Lynch, the record-breaking former manager of the Fidelity Magellan Fund also recommends that investors are always very clear about why they make their purchases. In One Up On Wall Street he wrote:

Before buying a stock I like to be able to give a two-minute monologue that covers the reasons I”m interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path. The two-minute monologue can be muttered under your breath or repeated out loud to colleagues who happen to be standing within earshot. Once you”re able to tell the story of a stock to your family, your friends, or the dog (and I don”t mean “a guy on the bus says Caesars World is a takeover”), and so that even a child could understand it, then you have a proper grasp of the situation.

With few exceptions, people are not rational. Neither do they learn from history. With a stock book you have a chance of getting ahead of the game by overcoming both of these habits.

 

About the author:

Dr. John Price
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 4.7/5 (9 votes)

Comments

budlab
Budlab - 7 years ago
I think that Dr. Price's software is one of several good tools that help us filter out mediocre companies. Another approach is Q&A flight simulator training.

I pose a question this way: Do the Flight Simulators at FlightSafety help to make our pilots better and us safer?

Yes. The Checklist System has been talked about with praise by Charlie Munger. So, I contend that an automated system of Question & Answer can also help the average investor get better about learning and following the sound principles of Buffett, Munger, and Graham. In some ways, that is also the method that the students of Graham were exposed to.



That is the method that the Archbot A.I. Open Source Software Project provides. Q&A with a Buffett-like Avatar. We need more volunteers to make the simulator's brainfile bigger and stronger. Buddy "A.I." Buffett

http://groups.msn.com/BerkshireHathawayShareholders/general.msnw?action=get_message&mview=0&ID_Message=31457

and [www.pr.com]








billytickets
Billytickets - 7 years ago
excellent post. Personally I don't believe in "small positions"( don't think others are wrong just not my thing) My 5 filters eliminate all but 50-100 stocks and "valuation" determines which one if any i will put my money in. This method is great for Large or Small purchases. When i made a 500$ ticket or memorbalia investment I still make my"list".Here is my"latest".peace

Well obviously i like JNJ for the next 12 months. Jim cramer and a close friend of mine who works for company BOTH became Bearish in the last 2 months or so. BILLYTICKETS LAW STATE: When 2 people who should be VERY BULLISH BECOME BEARISH THE TIDE IS READY TO REVERSE.

I look for the "worst" scenario vs the"best" and see if the risk is worth the reward

JNJ has not been under 55 dollars at the end of amonth since October of 2004 which is almost 3 years ago.Since then the dividend has increased 55% and the net income has increased 35% and the stock pricehas increased less than 12%



Jnj gets more than 65% of their revenues from outside the US and will benefit from a weaker dollar

AVG PE has been 23.67 over the past 10 years. with alow of 16.6 and ahigh of 31.6.with earnings forecasted for between 3.51 and 4.05 in 2007 you see the range is at the lowest 58.266 and the highest at 127.98.Certainly you can see that the you are buying the stock at the low part of its projected range

ROE has been between 24.3 and 30.1% in the past 10 years

Dividend Yield has been between 1.2 and 2.3% with an average of 1.6 over the past 10 years. JNJ dividend with NO raise is 1.66$ for 2007 .Expected historical range should be 72.173-138 at year end. Again you can see that you are buying the stock CHEAP

The stock also have a "floor" because WEB has put in 3 billion ( half in 1st quarter of 2007) and has another 30 billion avaialable "if needed" The company has an approved 10 billion dollar buy back already in place

Lets look at valueline rating on safety the stock has had its highest rating for almost 17 years now,Price stability and Eranings predictibility rating is also a perfect a 100

This company incraesed their net income 29.4% in the past 2 years and last years "bad year" they increased it from 10.4 to ONLY 11 billion. And their earnings predicbility again is 100 which is as good as it gets.

Because Billytickets is CRAZY he has put EVERY dollar AVAILABLE for investment in 2007 into this stock at price between 60-62 dollars. With WEB and his 30+ billion cache of CASH ready to buy on ANY dips and JNJ 's 5 billion dollar buyback in place .SHORT SELLERS will soon "GROW TIRED" and have to search for "weaker prey". This stock's AVERAGE PE over teh past 10 years is 23.67 and has spent only 1 year UNDER 18. At 18 times 2006's earnings of 3.76 the stock should be at 67.68 a 9.1% premium over Todays stock price .Add in the 2.7% dividend and you have a 11.8% return based on a 18 PE and LAST YEARS earnings.Ask your self one question before buying

Is it reasonable that acompany with 11 billion dollars of PROFIT a ROE of between 24-30% and the with MANY solid BRAND NAMES and VARIED STREAMS OF INCOME and a company buy back and the GREATEST INVESTOR withl 30+ BILLION behind him should grow its income over the next 5 years?

kfh227
Kfh227 premium member - 7 years ago
I don't keep a book, but I am starting to second guess my strategy of selling companies that cut their dividend. So far, I sold off MRK and CAG at losses.

There is a problem I think with what I do. I only buy quality. And when a quality company cuts the dividend, it's probably in order to enhance profitability going forward. Not as a sign of fear from the BOD and the execs as I previously maintained.
billytickets
Billytickets - 7 years ago
The "problem" is NEVER being quality. In my latest article Munger said that Berkshire's 103 billion dollar empire was mostly the result of 10 decisions.

In my article does PE matter. Mrk is one of the 11 dow stocks that has a ROE of 25% or more.In my"study" for it MRk was purchased at 47.10 in 2002 and 2003 43.8 in 2004 and 35.4 in 2005( which was its high,it could have been purchased"better") and 37.95 in 2006.Despite the poor enviornment forBig pharma stocks those purchases yielded you about 8% annually in that time frame.Obviously if you average down More in the last few years that would have improved your investment even better. The stock as is PFE and JNJ are all 3"undervalued" IMO.

Always BUY quality.peace
musto
Musto - 7 years ago
It's hard to be rational sometimes.

Yesterday, AXP went up by 5%, and I feel sad and irrational.

I'd been eyeing to buy it around 58, and of course

the stock doesn't know or doesn't care about that.

I could have bought it around 59 change last week and still

would have been a good buy.

I think I need counselling.

ccyork
Ccyork - 7 years ago
musto Wrote:

-------------------------------------------------------

> It's hard to be rational sometimes.

>

> Yesterday, AXP went up by 5%, and I feel sad and

> irrational.

> I'd been eyeing to buy it around 58, and of

> course

> the stock doesn't know or doesn't care about

> that.

> I could have bought it around 59 change last week

> and still

> would have been a good buy.

>

> I think I need counselling.

>

>


cheer up, musto! i felt the same way about AXP...and AEO, too.

maybe they will come back down, maybe not

but you don't have to swing at every pitch. mr market keeps tossing them every day. choose the best one

interesting chapter I read in "Reminiscences of a Stock Operator" today. the protagonist was working with a very limited capital base and he knew he had to wait for the right price

he waited six long weeks for his price target before buying. believe me, for him, this was a L O N G time to wait. he made a killing when he finally bought the stock. he could have made much more if he had bought earlier, but it would have been a much riskier deal

wait for the fat pitch

-- ccyork

PS...of course Phil Fisher would say "don't fuss over nickels and dimes...if it's a good company, buy the stock" 8-)

musto
Musto - 7 years ago
Thanks.

I'm already feeling better.

That's what I like about this website, full of people more rational than myself.

billytickets
Billytickets - 7 years ago
Musto you have 90% in JNJ and BRK-B TRUST me you are doing GREAT.

My one piece of advice :Stay out of YOUR own way and wait for the "fun to begin"

Your approach is very Buffettlikeand i gave you props in my last article. YOU have a 99% chance that yourportfolio will be higher in 1,2 or 4 years. DONT CHANGE A THING my friend.

Many think I am disturbed and "crazy" and that is true but iam not poor or "wrong".So far anyhow.lol peace my friend
musto
Musto - 7 years ago
thanks billy,

I can count on you to set me straight.

I wasn't planning to touch those two holdings.

I intend to keep them forever(well almost).

I had some extra cash on the side that was burning my pocket.

I figured AXP is a great place to put that cash into good use.

American Express is in the middle of a great transformation. They were

making money too easily so they got into all kinds of low return businesses.

Now, they're getting rid of them.

They spun-off Ameriprise, they're shopping the American Express Bank, etc.

Looking forward the ROEs are going to be rising through the roof.

When you're researching AXP, don't look at the past, but look to the

future.

And the future is looking bright.

By the way, you're not crazy. It's fun to have you around.

Besides, I learn a lot from you.

billytickets
Billytickets - 7 years ago
Likewise my friend. You and I are kindred spirits we enjoy"debate" but yet we seem less distracted than most. I enjoy the amount of intelligence and people who are really knowledgable and have great desire to be "constantly on the lookout".

Iam the most"strange" because I trust few companies only feel "sure" about "fewer" But once i buy them I keep them unless they become grossly "overpriced" ( which has never happened)

I really take the punch card thing "serious" and am by far the most opinionated person in this forum( and possibly in the free world) . My portfolio hit its all time high today and my "equity" ( yes i use margin) is up 50% since jan 1,2006( loading up last year on BRK_B was nice).More importantly my dividend yield on "cost" of my portfolio even with BRK-B is now just shy of 7% annually. Thanks for "inspiring me" my friend

armeetofo
Armeetofo - 7 years ago
musto

do not look at price frustrations, look at the buying price range, you will feel better,

JNJ, i bought it 6 and 11/2004, 7/2005, 6/2007 and 7/2007 due to my buying range is $49 to $70.

hope it will help.

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