The recent turmoil in the markets (combined with an abundance of spare time) has spurred many people to finally take the leap and begin investing in stocks. That includes a number of friends who, having suffered me drone on about investing for years, were pretty sore that I then refused to recommend them individual stocks.
This is a practice I started a few years ago. Rather than provide individual stock tips, I’ll happily mention a few different companies that I’m interested in at the moment and suggest they do a little research themselves. Alternatively, if someone comes to me with a stock they are thinking about investing in, I’ll ask them to pitch the stock to me before I give my own opinion. I can then advise them on their research rather than the actual stock itself. Perhaps I’ll be able to point out that they’ve made an assumption that isn’t necessarily correct, or that they haven’t considered something that could alter the company’s competitive position.
This is incredibly important, in my opinion, to developing good investing behavior. It all comes back to one of our Golden Rules — Buy What You Believe In. I don’t believe anyone can be a good investor without understanding and believing in the companies that they own.
Every day, the market opens, and some stocks go up and some stocks go down. Some days, stocks go up or down a lot. Despite what you may read on certain internet message boards, no stock just goes up day after day. Even looking at a company like MasterCard — its long term chart would suggest that it pretty much always goes up. However, there have been some bad days along the way.
How is an investor ever going to make an informed decision on the movement of a stock if they don’t understand the business? If you don’t understand a business, how are you going to know if the stock going down is a short-term problem or a serious issue that could impact the future of the business? The selloff could be a potential buying opportunity or it could be a warning to get out while you can. But how would you know that without understanding the business?
I was recently asked about my opinion on pharmaceutical stocks. My response was the same one I always give: “I don’t invest in them because I don’t understand them, and unless you have some expertise in the area, neither should you”. The response back was pretty intense. A flurry of people messaged in saying that they had invested in X pharmaceutical stock at $5 per share and then sold it $20 per share, or some variation of that.
One of the most dangerous aspects of the stock market is that whenever you invest, you’ll either make money or lose money. When you lose money, a good investor will analyze what went wrong and hopefully learn a lesson. However, when you make money, most people think they must have done something right. That’s not necessarily the case. You could, for example, close your eyes and drive through a busy intersection. Not being involved in some horrible car crash wouldn’t make that a good decision. This is exactly the mentality of those who invest in companies they don’t understand and make money. For how else could they rationalize their decision?
It’s entirely the same thing with giving people individual stock tips. If they lose money, they blame you. If they make money, they think they’re a brilliant investor for asking you in the first place.