We flip through the TV channels but there’s nothing to watch. We walk down the cereal aisle and end up not buying any cereal (we buy donuts instead). And don’t even get me started on trying to figure out which coffee pot to buy because they all start looking the same.
That my friends is the paradox of choice. Dare I say we have too many options available to us for almost any product? It can paralyze the mind with indecision. Data overload and analysis paralysis is a real thing.
Well, when we turn our attention to trying to decide which stocks to buy we are faced with the same problem. Thousands are available in many different countries. I’ll be the first to admit that I struggled with this when I first started growing my taxable account.
Even since I started this blog 2 years ago, my process has evolved and gotten more refined. I learned that having a strategy and a process is my way of dealing with the paradox of choice. The evolution of my Master Stock List is the result of my strategy of dealing with so many choices.
Honestly, it’s why my stock buying process is fairly simple as I explained in Walla! It’s That Easy. Similar to that article, we’ll provide some concepts and I’ll do my best to explain how I developed my list (though it evolved). Seriously, if you follow some basic guidelines the number of stocks does narrow significantly.
Some Basic Decision Concepts
This entire blog could be used to just explore the basic concepts of building a stock portfolio. It’s a hard, complex task that needs to be made as simple and basic as possible. These are not all-inclusive decision concepts but they will at least get you thinking.
Know What You Own
I’ve written often about this but it really narrows the list and keeps things simple. I know Q-tips, Band-Aids, and Coke. I have Aetna as my health insurance and I go into CVS stores all the time. I’m not a smoker but I know of cigarettes and that oil is important to make my car run.
Warren Buffett’s has some good advice when deciding on a possible investment:
“If you need a computer or a calculator to decide whether to invest, then don’t do it – invest in something that shouts at you – if it is not obvious, walk away . . . If you don’t know the business, the financials won’t help at all.”
Warren Buffett
You’ve experienced enough things in your life so you shouldn’t have to buy something you don’t know about. That old saying of “Stranger Danger” our parents told us as kids can apply to stock buying too.
Long-Term Perspective
The saying of “buy low and sell high” should be more like “buy low and hold forever.” When looking at an investment, you should be thinking about holding it for 20-30 years and not 20-30 days.
The perspective that holding something forever really changes your thought process on what to buy. You start wondering if your stock will even be around for 20-30 years. And with that, the concept of quality becomes a significant part of the thought process.
Loss Aversion
Loss aversion isn’t just about losing real hard earned money. It can also mean that you are getting anxious about being left out of a rising market. You might also feel like joining everyone else and trying to become a Tesla millionaire.
If there is one thing I’m continuing to learn is that patience in my stock buying process is CRITICAL. I really love the concept of:
“Assiduity – the ability to sit on your ass and do nothing until a great opportunity presents itself.”
Buffett and Munger
Buffett and Munger prefer investments where they are certain of a good result rather than being “hopeful” of a great one. And a good result can also mean never losing money. That’s their #1 Rule.
Stupid Mistakes
As one that has made his share of stupid mistakes, I think this deserves a spot on any list of decision concepts. I’ve written not once, not twice, but three times on the subject. Sadly, one might say I’m on expert on the topic.
I really like the comment Charlie Munger made on the subject:
“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.”
Charlie Munger
When you make a stupid decision, it usually means you lost money. So, it’s important to consider this in your decision-making process; try to be consistently not stupid.
This isn’t like a football team that’s winning 35-7 and they suddenly try not to lose. Trying not to lose is different than remembering not to make stupid mistakes. Investing in stocks means you must take risks but not stupid risks.
Decision Process: Slow or Fast?
I was giving one of my employees their annual review the other day and we touched on this subject. They are smart and logical most of the time. It’s when they get emotional that things go sideways. Emotion is the enemy of rational decision-making.
When making investment decisions, slow, controlled, rules-based and analytical thinking is preferred. This is the process I used when creating my Master Stock List. The list provides guardrails to keep me from investing into a stock with emotion. It was built with a lot of slow decision-making. Staying calm and rational is the objective.
“The voice of reason is inaudible to irrational people.”
Mardy Grothe, Psychologist
And even though I know that I want to invest in Coca-Cola and Johnson & Johnson, I can still get emotional in buying those at the wrong price. I’ve implemented a rules-based process of choosing my price points. Plus, I love to build positions over time and “let the game come to me.”
Intuitive-thinking has no business being part of deciding what and when to buy. I’m all ears and willing to listen to anyone who can convince me that emotion has a place in investing.
Building A List Of Potential Stocks
I have built a process and my Master Stock List is the outcome of that process. As of today, I’ve got 53 stocks on the list. There have been more and there have been less … it’s ALWAYS evolving. Interestingly, I’ve not changed the list all that much recently which can mean that I’m comfortable with the list.
There are many stock screeners (I like Finviz.com) but the factors I used were all quality based. The whole experience is to narrow the list down using criteria that identifies quality stocks that meet my objectives. Descriptors like:
- Dividend paying companies with yields above 3% (or 4% or 5%)
- Dividend payout ratios under 70% (the lower the better)
- Market capitalization above $10 billion
- Stock price above $25
- Positive net profit margins
- Debt/Equity under 1
- Beta under 1
These aren’t all inclusive descriptions but you get the idea. Whatever you consider descriptions of value use those but be flexible. Your list will evolve and shrink until you have found potential stocks to buy. Eventually, it will be necessary to start doing further investigations into each company.
Another important factor I used was determining how much of each to have in my portfolio. Quality was the biggest factor. I want my positions to survive many different type of economic environments. So, I found Consumer Defensive to be a sector that dominated my list. I identified 4 stocks (3 in the Consumer Defensive sector) that I’m comfortable being my largest positions:
- Coca-Cola (KO)
- Procter & Gamble (PG)
- Nestle (NSRGY)
- Johnson & Johnson (JNJ)
These are my Big 4 targets and can take up to 6% each of my investment portfolio. In other words, these 4 stocks can be worth up to 24% of my total portfolio value. I’ve got another group that can be worth up to 4% and another list of those at up to 2% of my total portfolio. Again, quality and a few other factors helped make the determination.
It took me a while to get to this point and I had to be patient and not just buy any stock that looked cheap. Seriously, I had an itchy trigger finger to buy something. It’s hard to just sit on your cash but that is best until you know what you want to buy. Be patient my friends.
Quality, But At What Price?
When you know what to buy then you’ve got to figure out when to buy (pricing). This section won’t be focused on technical or quantitative analysis, though these can help. Similar to figuring out what to buy, it’s about having a rational process that helps you know when to buy.
From a high-level perspective, I’m focused on two types of buying:
- Position Building
- Market Corrections
First, Position building means I need to know the general ballpark price I’m willing to pay for a company. A combination of factors can help in your process. Once I know my target then I build a position over time.
One month I might have Coca-Cola in my price range and the next month I might be adding to Philip Morris. This is similar to putting money into a mutual fund every month and dollar cost averaging. Because stock prices fluctuate, it allows me to only purchase stocks that are below my price targets. Some months I don’t buy anything so my cash builds up until something comes below my buy target.
Second, I like to have cash around (easier said than done) for the occasional moments when there’s a market correction. When this occurs, I focus completely on the highest of quality stocks that usually have premium prices.
For example, in February 2020, Johnson & Johnson was priced at around $155 but during the COVID crash it dropped down to $110. This all happened in one month. Within 3-4 weeks, the stock was back up to $155. Because the highest quality, sleep well at night stocks are normally priced at premium prices, I love buying them during their momentary drops.
Summary
This is an extremely complex topic so keeping it simple to write and read is important. No math involved today.
Having a plan and a process, whatever it might be, is the important ingredient to building your stock portfolio. Peter Lynch always said nothing above 5th grade math is needed when it comes to buying stocks.
Weeding through the thousands of stocks can seem overwhelming so it’s important to know what you are buying. Build your own process but keep it simple (and stick to it).
Normally, when people lose money on stocks it’s because they made a stupid mistake. All this means is they got too smart for their own good and ventured outside of their process (or didn’t have a process).
And just because you are smart (perhaps even very smart) doesn’t mean you are rational. I’ve seen the smartest people I know make the stupidest mistakes. Build a plan and stick to it.
Keep challenging your process and system … continue to learn and evolve so the model/system gets better and works best for YOU! My advice, start by focusing on buying only the highest quality of companies. This gives you time to develop your process.
Good luck and thanks for reading!
Mr. TLR