Do this, and you’ll already be a better-than-average investor

This post is not about index funds.

This might be the last time I remind you: If you haven’t done it already, fill out my reader survey for a chance to win one of two $10 gift cards to Amazon.com. I’ll e-mail the winners after the deadline (11:59 PM on 4/26/2010). Good luck!

Yeah, from time to time, I get sick of reading about index funds, too.

One of the early indications I’ve gotten from the reader survey is that you guys are interested in learning more about investing. I get that. Most basic personal finance topics—like spending less than you earn, paying yourself first, and building an emergency fund—are pretty, well, basic. Once you make it past that personal finance 101 stuff, investing is the first real black box you’ll face.

The first natural reaction to facing something seemingly big and confusing is to not invest. As has been detailed in every personal finance blog you’ve ever visited, that’s a mistake. The second, less natural but understandable, reaction is to invest in mutual funds. That’s the best solution for the overwhelming majority of people (but you’ve also read that in every personal finance blog you’ve ever visited.)

But just for the sake of education, this post is about investing in individual stocks. What makes somebody like Warren Buffett the best investor on Earth and what makes somebody like the E*Trade baby so miserable at it?

The answer: When you buy a stock, you’re buying a company. Treat it that way, and you’ll succeed like Buffett. Treat it like something else, and you’ll trade like the baby.

Maybe that’s something you already knew, but let’s spell out how that changes the whole stock buying paradigm.

You don’t buy a company sight unseen.

Let’s say your brother owns a Quiznos franchise (my favorite sub, by the way). He wants to expand the store and needs an investment from you to make that happen.

Sure, he’s your brother, but you’re going to want to see some financials right? You’re going to want to see his profit and loss statements. You’ll want to see how much he owes in loans and how much extra his plans will cost him. You might even want to sit in on the store for a few days to meet some customers and see how smoothly it runs.

What you won’t do is ask for a price-to-earnings ratio, or some other basic ratio, and call it a day. Just imagine that, your brother says “A $10,000 investment will buy you $1,000 dollars per year of earnings. That’s a P/E of only 10!” A P/E of 10?! That’s all I need to know. Sign me up!

But somehow, when we buy a stock, which is a small portion of a company after all, we think a couple hours of research will be enough. Or we trust the “Buy” rating from 8 out of 10 analysts. That’s just silly.

You don’t buy a company for any price.

And then if your brother said, “So, I’ll sell you half the business for a million dollars!”, would you say “Well, I like my brother and his company so much that I’ll buy no matter the price”? No. And yet, that’s what happened during the dot-com bubble and then during the real estate bubble.

I say this, even though economists have found that the biggest determinant of stocks’ short-term direction is momentum. If a stock price just rose by a penny, it’s more likely that it will rise by another penny than fall a penny. This is despite the P/E ratio, price-to-book ratio, or any other value metric you want to take a look at. And it’s also why those crazy candlestick readers, who pay almost no attention to fundamentals, are successful enough that they keep playing.

I also say this, even though I think that average savers, who invest regularly for retirement, should simply put their money into index funds and not pay much attention to valuation. I’ve written before the reasons why I think regular investors should be careful relying on a value strategy.

But when it comes to investing in individual companies, the game changes a bit. While the market as a whole is mostly efficient most of the time, the prices of individual stocks are much more prone to wild swings.

You don’t buy a company and sell it the next day.

There’s a clever commercial out right now in which a guy buys something at a yard sale and immediately tries to sell it back to the owner. I can’t remember what company it’s for so I can’t post it here (any help?). The point of the commercial is to show how crazy it is to trade companies frequently.

Imagine that the stock market opened only once a year. On that day, everyone could sell their stocks to each other, but for the other 364 days of the year, you were stuck with the companies you owned. How would that change the way you invested?

Warren Buffett often writes in his shareholder letters that his favorite holding period is forever. He doesn’t buy a company hoping that its share price will appreciate. He buys one hoping to make money off its earnings (i.e. dividends).

Let’s pretend Apple signed a contract with God, promising that it would never over its company’s lifetime pay a dividend to shareholders. Instead, all of that money would stay with the company and go into research and development, accelerating Apple’s growth. Because of that, Apple became the fastest growing consumer tech company ever.

Now, knowing that Apple will never pay a dividend, what price would you pay for its shares? $0, right? Because what good is a company if it can’t pay its earnings to you?

So if you try your hand at individual stock investing, make this your mantra: “I’m buying companies. I’m in it for the long haul. And I will make money off my companies’ earnings.” You’ll already be several steps ahead of most investors.

Tagged as: buy and hold, Investing, stock market