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• Invest in what you know. Your chances of being right about a particular stock’s price future improve as your knowledge of its business, its industry, and its management increases. Since you can’t know enough about everything, develop expertise by narrowing your scope. Identify several industries that interest you and learn as much as you can about them: how they create customers, how they develop products, how they maximize profits.
• Be suspicious of stock stories. The stock brokerage and information businesses work on the basis of drama. Create a great story about a start-up company with a revolutionary technology headed by a genius billionaire, and you’ve got a proven formula for sales. Brokers, stock analysts, and investment gurus all make their livings by discovering, packaging, and presenting such stories. A good story works by evoking emotion. Emotion overrules logic. With your logic put aside, you allow yourself to make investments you will probably regret later.
• Be conservative with each investment. However well you know the business, never invest more than you can afford to lose. My personal limit is 1 percent of my investable wealth. That means that
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if you have an investment portfolio of a million dollars, you should never put more than $10,000 in any single investment.
• Have a Plan B. When I invest in small businesses, I always have a Plan B. A Plan B is what I do if the business doesn’t work out like I think it will. A good Plan B should limit your losses. When it comes to stocks, Steve does the same thing with stop-loss orders. “When a stock hits an established stop-loss,” he told me, “it’s a signal to me that the market knows something about it that I don’t. I’m not smarter than the market. So when I get a chance to get out with most of my investment intact, I am happy to get out.”
How I Look at Stock Selection Strategies
Steve’s approach to investing reflects his conservative nature and the recognition that the market is too big, complex, and alive to treat it like some finite, comprehensible, mechanical contraption.
That’s the way I feel about the world of business generally. Although I have developed some expertise in certain specific sectors (information publishing, consumer health products, etc.) and certain business skills (direct marketing, back-end sales, etc.), I recognize that if I stray even a little bit from these areas of expertise and invest in something somewhat new and different, the chances of being successful are very small.
I didn’t always feel that way. When I began my career in the information publishing industry, I had enormous enthusiasm for every new idea I ran into. Whenever someone would suggest a new book, audiocassette series, or periodical, I was all ears. If it had—or seemed to have—a big potential and a great story (see my previous comments on stories), I’d usually fall in love with it. Over the course of the next few days, weeks, or months, I’d do everything I could to give birth to this next great brainchild.
I was fortunate to have at that time the counsel of a partner/boss who understood reality a bit better than I did. He was able to douse many of my hottest ideas by asking me simply, “Do you believe in it enough to put in half of the capital?”
“Well,” I thought, “you own the business. That should be your job.” But I was wrong. And I learned the hard way how wrong I was. Because every three or four times I was crazed on some great new idea, he let me test it in the marketplace. And three out of four times
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(my track record might have been even worse . . . it’s too painful to remember), the idea bombed and our business—the business he owned and was funding—lost money because of me.
I am prone to guilt, so this laissez-faire approach to teaching me about start-ups had a much greater effect on me than his challenges or his counseling. (“Michael,” I remember him saying a hundred times, “you have to decide if you are fish or fowl. You can’t be in every business that looks interesting. Choose one area and focus on it.”)
To make a long, embarrassing personal history short, in the period of time that I worked under his mentorship, I changed from being a very quick and enthusiastic backer of new moneymaking ideas to a very skeptical and conservative investor.
The fact is, most new business ideas fail, and many, if not most, old businesses slow down and eventually die. If this is true in the world of the businesses I know, shouldn’t it be true of the stock market that represents them?
When Investing in Business, Take the Short Odds
And that’s an important point.
As I explained, my early experience as a promoter of hot new ideas has taught me the danger in good stories. The better they sound, the more skeptical I’ve learned to become. As an investor in small businesses, I’d much rather put my money into something with reasonable but probable prospects, as opposed to something that has fantastic but only possible prospects. Twenty-five years of investing experience has taught me that I’m not that good at spotting winners.