Ask Money

Tips on picking stocks

Chris Farrell May 22, 2012

Question: I’m an individual self-taught investor who has just lost a LARGE sum of money investing in a company whose stock (of course) went immediately downhill after I bought it. Rather than becoming afraid of stocks, I am sure there is a lesson to be learned here. I’m just not sure what it is. What tips could you give for people who lose large amounts of money but want to keep investing? Brian, Miami, FL

Answer:  Nobel laureate Paul Samuelson says that John Maynard Keynes — himself an astute investor — once said, “Really, you should buy one stock at any one time. The best one going. And when it’s no longer that, replace it by the new best.” It’s reminiscent of comedian Will Rogers’ quip, “Buy stocks that are going up. After they have done that, sell them. If they ain’t going to go up, don’t have bought them.”

Ah, if only it were that easy. 

As you probably know, I’m a fan of investing in broad-based equity index mutual funds, bond index funds and comparable products. A major reason why the index fund strategy does well over time is you aren’t paying a steep fee for a high-priced professional manager and a team of analysts. Instead, you’ll do as well or as poorly as the underlying index, minus a low annual charge. Nobel laureate William Sharpe rightly called indexing “a dull, boring way to be a better investor than many of your friends.”

That said, picking stocks is fun. I wouldn’t put my standard of living in retirement, my children’s college education or my emergency savings at risk to my stock-picking prowess. Nevertheless, sometimes we want to make a slightly bigger bet on a stock or stocks. These are satellite investments to your core strategy. I would make these investments in taxable accounts, so that if you have to sell at a loss, you can share the financial pain with Uncle Sam. 

You’ll want to think about exposing your portfolio enough to your investment ideas enough so that you can enjoy a nice payoff if you’re right, yet not so much that your portfolio is at risk if your ideas — your stock picks — turn out to be duds. I’d keep it small at first and stay below 10 percent of your portfolio. It’s an approach that passes the prudence test — big enough to count, not large enough to be disastrous.  

The key to buying individual stocks is developing an investment philosophy, spending time researching companies and buying stocks you want to own for the long haul. You’ll want to spend time researching your choices at a data service like Morningstar. You’ll want to trade infrequently.

“To invest successfully does not require a stratospheric IQ, unusual business insights or inside information,” Warren Buffett sagely writes. “What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding the framework.” 

What kind of investment philosophy? There are many legitimate approaches to the market. The other day, for another project, I took off my bookshelf William Gross’ Everything You’ve Heard About Investing Is Wrong. Gross is the bond king, the investment guru at the mutual fund giant Pimco. The book has dated since it came out in 1997 (although with the benefit of hindsight, large parts of his analysis turned out remarkably well).

However, I liked his investment approach. What I would do is quickly go through the book, slowing down when he talks investing lessons and investing insight. For example, in Chapter Two: Long-Term Thinking for the Smart Investor, he urges investors to focus on a medium-term timeframe. “Forget about trading. Set your sights on a horizon and sail until you get there. My ideal location is three to five years because it eliminates the daily flow of emotion,” he writes. He draws a compelling distinction between trading, speculating and investing.

Gross also emphasizes an insight from Jesse Livermore, the famed early 20th-century speculator. “Throughout all my years of investing, I’ve found that the big money was never made in the buying and the selling,” wrote Livermore in Reminiscences of a Stock Operator. “The big money was made in the waiting.”

Another place to go to think through an investment philiosophy is Warren Buffett’s annual letter to the shareholders of the company he runs, Berkshire Hathaway. The letters are wonderful and he lays out plenty of wisdom for investors. My final recommendation is to register at the website of GMO, the Boston-based money manager. (It’s free.) Read the quarterly reports on investing by Jeremy Grantham, a brilliant — and literate — investor.

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