How to be a good investor in the stock market

How to be a Good Investor in the Stock Market

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Becoming a good investor in the stock market means having self-awareness of your capabilities, sound investing principles and a good understanding of your own behavior. Essentially, having the ability to concentrate on a few ideas, to be right about the business and to not get disturbed by other people’s opinion. Furthermore, having the discipline to do research and having the determination to make an investing decision is crucial.

In this article we will see the importance of learning from other investors and reading. Additionally, insights of Warren Buffett’s partnership will be shared and we will see that he basically outperformed by concentrating his capital in a few ideas with a high expectations of outperforming the Dow Jones. This is something you can still see today when analyzing the Berkshire Hathaway portfolio.

I’d like to share that much of my knowledge comes from reading. I discovered some great books that can help you to become a better investor and to improve your mindset. Please check my overview page where I have summarized these for you: https://www.financeandinvestingfacts.com/best-investing-books/
Please note that I’m using affiliate links in this article to Amazon at no additional cost to you. Thank you!

How can I become a good stock investor in the stock market?

Your behavior, being honest to yourself and understanding businesses is most important if you’d like to be a good investor in the stock market. Ask yourself: can you stand a loss? See the book “Damn right” about Charlie Munger (Vice Chairman of Birkshire Hathaway). Investing will certainty bring periods of losses which is something you need to be prepared for. Furthermore, understanding which companies you can evaluate is crucial (circle of competence). This comes largely down to understanding the moat and business model. This allows you to understand how the business earns its money now (what drives the results) and then figure out if this can occur in the future.

Understanding your own investment is crucial to ensure that you stand behind your reasoning during market declines and to be immune to other opinions. Obviously, you do have to check your own facts and reasoning over time to see if the business and management keep aligned with your way of thinking. Deterioration of the business model and/or bad management actions can very well lead to justified selling actions.  

In summary, the first steps are testing and analyzing your own behavior and evaluating if you are capable of selecting businesses. Understand what the investing principles are and whether you should start with index funds, stocks or a combination. Personally, I would start reading and learning a lot and I would buy a very good business and an index funds with a small portion of your net worth.

Set a goal and make your own decisions

When a man does not know what harbor he is making for, no wind is the right wind

Seneca

Set a goal you want to work towards and have a strategy to reach the goal. Otherwise you keep on wondering. This will increase your efficiency. This could be simply investing and not losing money and growing your wealth above inflation. 

I always find one quote of Charlie Munger very useful:

There’s an apocryphal story about Mozart. A 14-year-old came to him and said, “I want to learn to be a great composer.” And Mozart said, “You’re too young.” The young man replied, “But I’m 14 years old and you were only eight or nine when you started composing.” To which Mozart replied, “Yes, but I wasn’t running around asking other people how to do it.”

Charlie Munger

In essence, this means that you should just do it and make the decision yourself to start investing. Over time you will compound knowledge and you will find out what works and what doesn’t work. Only your own decisions and reasoning can ensure that you follow your own way of thinking.

How to define a good investor?

Personally, I define “a good investor” by doing better than the S&P 500 average measured by 3-5 year periods. Achieving average is simple, buy the S&P 500 index and have patience (which is not easy). The noise that the investor has to process each day makes this harder than it should be in theory. Great investing success (i.e. beating the index) can be achieved most successfully by concentrating in outstanding businesses. Obviously, being a good investor to you could mean investing in sound dividend stocks or simply buying and regularly investing in the S&P 500.

Have a long-term horizon and focus on compounding over time 

A good investor needs to be able to find a good idea and have the courage and conviction to invest when others might say it’s a bad idea. You can prove your point in 5 years if the business indeed produced a lot of free cash flow. Until then, you need to believe in yourself and concentrate on the facts and have patience.  

The right temperament and discipline in investing is key. Letting yourself become the victim of the mood of Mr. Market and the general current opinion is devastating for your investment success. I believe that behavior is the largest explanation for why people have poor investing results.  

A fair warning: the techniques of Warren Buffett described here by analyzing his investing from the 1950’s up to now involve focus investing. That is concentrating in the best stocks with the highest chances of making a high return and a very low probability of losing. This requires extensive research, knowledge and determination. As always, please see my index funds (ETF) article as this is the best advice to most investors.

Compounding over time is a huge advantage of long-term investing

Short term predictions are often wrong because the economy is unpredictable. But something sensible can be said about stable businesses with a moat. At least, with great certainty we can say something about their competitive position. E.g. about Procter and Gamble and Coca-Cola. It is likely that we will still eat and drink in 10 years and that these companies still are the dominant players.

They will still have a large market share that these companies can defend. So, keep it simple and understandable for yourself. The most predictable future cash flow estimations can be made for stable industries and companies.  

Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to do make much different than a 6% return even if you buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.  So the trick is getting into better businesses.

Charlie Munger – USC Business School in 1994 entitled ‘A Lesson on Elementary Worldly Wisdom’

In sum, pick a terrific business and just sit on your ass as Charlie would say. It’s better to pay a bit more for a good company than to try to get a mediocre company cheap. The compounded growth of a company over time can make up for a high purchasing price. 

Keep on learning and use your time efficiently by using filters 

You’re reading should not be random. There is simply too much information, so you need to use filters to digest the right information that’s understandable to you. A useful filter could be:

  • Do I understand the business?
  • Does the business have a above average return on capital?
  • Is there a stable and growing free cash flow without excessive debt?

Pretty much, this boils down to the investing principles of Warren Buffett that we’ll touch upon later in this article. Make a list of potential interesting businesses and read about them and write down some important metrics. E.g. return on capital, debt, free cash flow, incremental capital deployment and returns on incremental capital and turnover ratios and margins for instance. Try to determine what the business would be worth to you. What’s a good price? This depends on how well the capital can be deployed to generate free cash flow over time.

Focus on a view things

View your portfolio in terms of opportunity costs (choice 1 versus choice 2) and think about the question: will a buy or sell improve the portfolio? Only buy your top 1-2 percent choices that you understand and are better than the rest.

Focusing on stable stalward companies is a smart thing for beginning and experienced investors. A good advice is to avoid big mistakes. Don’t start with a business without a stable earnings record and without a moat. Look at what the top buys are of respected investors to get some guidelines. Buffett used to do this when he was younger. Study the mistakes of others (e.g. IBM of Buffett or the airlines) and try to avoid it.

You only have to be right on a very, very few things in your lifetime as long as you never make any big mistakes… An investor needs to do very few things right as long as he or she avoids big mistakes

Warren Buffett

The 2020 shareholders meeting of Berkshire Hathaway

The 2020 meeting of Berkshire Hathaway was full of the same principles required for being a good stock investor in the stock market. Buffett repeated that you should hold stocks long-term and be prepared mentally and psychologically for large drops in the short run. The stocks can go down 50 percent or more, that’s one of the reasons you don’t want to buy stocks on margin. You can get cleaned out even though the business might do well long-term.

Two highlighted insights and time stamps of the 2020 Berkshire Hathaway shareholders meeting:

  • 3:15h: only buy stocks if you want to hold it long-term. Make your own decisions about the business (the best investors don’t ask others but make their own choices with confidence). Otherwise you get influenced by the next person and you might sell too soon. Think about a farm that you hold or real estate that does not get a quote each minute. Behavior and understanding what you buy and its earning power over time.   
  • 5:11h: don’t pay 12 percent or more on credit cards or anyone. Easiest win. Very hard to loan at 12 percent plus and then make a save investment that’s returning more.  

Acknowledge it when your wrong about your investment!

Warren Buffett gave the example of selling the airline businesses. Buffett said during the annual meeting that the business model of airliners is severely hampered by the current crisis. He is uncertain if:

  • People will start flying again in the same quantities
  • If the airlines can pay back the 10-12-billion-dollar debt
  • The likelihood of having too many planes which will lower the margins

The chances of a positive investment outcome have shifted from a positive to a negative expected return. Or the risk of a severe loss is higher than let’s say approximately 5 percent in the mind of Buffett. So, the likelihood of loss has gone up and the probability of success has gone down.

Go to bed smarter than when you woke up 

We read a lot. I don’t know anyone who’s wise who doesn’t read a lot. But that’s not enough: You have to have a temperament to grab ideas and do sensible things. Most people don’t grab the right ideas or don’t know what to do with them.

Charlie Munger

Read a lot and ask yourself “why” continuously and try to come up with answers. Search for answers by using the wisdom of success and failure of other people

A superb book to understand the questions “why” is Guns, Germs and Steel by Jared Diamond. That mindset of asking why is useful in business as well. Bill Gates is also a fan of this book. Personally, I too believe that this book is  marvelous to train your brain and to learn more about human history.  It basically tells that the history of people differs due to geography (location) and not due to biological differences. See also this short video on CNBC of Munger talking about this book (he read it twice).

Learn from successful people 

As said before, it’s important to learn from the mistakes of others. Also, learn by reading biographies of people you look up to. Especially from their mistakes.

Larry Page and Sergey Brin say in their 2004 Founders’ IPO Letter that: “Much of this was inspired by Warren Buffett’s essays in his annual reports and his “An Owner’s Manual” to Berkshire Hathaway shareholders.” I can’t repeat it enough: try to read as much as you can about Warren Buffett letters and his interviews; watch a lot of YouTube videos as well.

Quotes of famous and successful investors about the good businesses all have a similar trend. Look at the times they are talking about free cash flows, moats, compounding and returns on capital. 

Bill Ackman is another interesting investor and there’s a recent interesting podcast that you can listen to on YouTube. Pay attention to what he reads, life philosophy, working attitude and investing framework for example. Bill Ackman is very focused on simple and predictable long-term free cash flow generating businesses. His thinking is influenced by Warren Buffett. He names the WSJ, FT, NYT, Economist, Fortune, Grant’s interest rate observer, Twitter, and Bloomberg. Most importantly is understanding a business. What makes a business a mediocre or a great one? 

Not everyone in the stock market can outperform

Another simple yet essential point is that 10 percent of the investors are in the top 10 percent in terms of stock market performance. Hence, 10 percent is also in the bottom 10 percent of the stock market. The top 10 percent are most likely the people who bet big on a few good ideas which increases the chance of success. The worst thing that can happen is landing in the bottom 10 percent. Sticking to the S&P 500 index fund can guarantee an average result without. Which could be your best option depending on your capabilities and nature.  

A great stock investor according to Charlie Munger 

A good investor in the stock market will do a few things right according to Charlie Munger. The secret for doing better than average is given by Munger at 3:10 “we tried to do less… we never had the illusion we could understand everything. It’s so simple but almost no one understands and applies it. 3 stocks and I outperform everyone.” Charlie Munger bought a few stocks and almost never trades. But the stocks are very good and are able to reinvest earnings each year against high returns.  

We did less, we never thought we could know everything: we have a few things where we are right. This is a very different way to approach things. His stocks are: Berkshire Hathaway, Costco, Daily Journal and Li Lu’s Asian Fund (outperforming by almost never having a transaction).

Inactivity is how an investor makes money and activity is how Wall Street makes money according to Buffett. Additionally, I’d like to quote Keynes: “…it is in our innate urge to activity which makes the wheels go round…” (chapter 12 of The General Theory of Employment, Interest & Money). 

Compare this line of thinking with the richest people

Buffett only had a few good ideas in any year that offered a high chance of outperforming the market and were understandable. He measures his new potential ideas to the existing portfolio.  

Why are Jeff Bezos, Bill Gates and Warren Buffett so rich? Largely due to the stocks they hold in one business. Of course, these businesses are very good and they over- and underperformed the index during certain periods in time. But they always thought as owners and believed in the power of their business.  

“The less you trade the more you keep” is applicable to this line of thinking. Additionally, I remember that Warren Buffett says that great portfolio management can be done by not doing anything for months. 

A good investor has a standard for measurement 

So if you are evaluating others (or yourself!) in the investment field, think out some standards – apply them – interpret them. If you do not feel our standard (a minimum of a three-year test versus the Dow) is an applicable one, you should not be in the Partnership. If you do feel it is applicable, you should be able to take the minus years with equanimity in the visceral regions as well as the cerebral regions -as long as we are surpassing the results of the Dow. 

Warren Buffett, partnership letters

Another benchmark is your largest stock position. You should always look at your own stock portfolio first to determine if a new buy will improve the portfolio. This can be due to a larger discount to the cash flows that a business will produce.

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.

Warren Buffet, 1992 letter to shareholders

Buffett outperformed the Dow Jones and investment companies 1957-1968 

How to be a good investor in the stock market - Buffett Partnership versus the competition
Table published by Warren Buffett in his partnership letters

The power of a focus portfolio (the secret to why Warren Buffett did so well) 

Buffett had the measurement stick (Dow Jones) in mind when he added a new position (or sold one).  

It’s all about probabilities, the chance that the investment will outperform the Dow Jones standard with 10 percentage points and the probability that you will do worse. The Dow Jones is the yardstick to measure your performance against. It can also be seen as a hurdle rate to determine the minimum required return of an investment. Warren Buffett concentrates if the likeliness of success is  very high and the chances of loss very low. I’d like to quote especially two parts of his partnership letter of 1966.

We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations. Frankly, there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects the range of all possible relative performances, including negative ones, adjusted for the probability of each – no yawning, please) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage.

Warren Buffett, partnership letters

Probability theory and logic leads to concentrating in investing

The previous quote and the next one are in my opinion brilliant and rather unknown insights in the mind of Warren Buffett that he still applies.

We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation of performance is at least ten percentage points per annum superior to the Dow. How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?” This depends to a great degree on the wideness of the spread between the mathematical expectation of number one versus number eight.” It also depends upon the probability that number one could turn in a really poor relative performance. The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable. The greater the number of selections, the less will be the average year-to-year variation in actual versus expected results. Also, the lower will be the expected results, assuming different choices have different expectations of performance. 

Warren Buffett, partnership letters

Concentrating in outstanding businesses is necessary

Importantly, Buffett also states in his letter of January 1966: “We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.”  

Examples of stocks (which Buffett does not name in the letters) are American Express and Disney made him a lot of money. Remember, it’s harder to outperform if you buy more stocks. First, the more stocks you buy the more similar your portfolio will become to the index. Second, there are simply not that many stocks at one time that you understand and can outperform the index.

This requires an investing attitude that is unique 

Concentration can (and often does) lead to more volatility. Simply stated, this means I am willing to concentrate quite heavily in what I believe to be the best investment opportunities recognizing very well that this may cause an occasional very sour year – one somewhat more sour, probably, than if I had diversified more. 

Warren Buffett

Diversification is a protection against ignorance. Putting more money in your idea 30 or 35 instead of your first idea of attractiveness strikes Charlie and Buffett as madness. But if you don’t want that anything happens to you compared to the market, then buy the S&P 500 Index. This is a very smart and sensible investing strategy for 99.5% of the people! Knowing if you’re the 0.5% who is willing and able to analyze businesses and to hold them for years is a crucial question you need to answer!

Warren Buffett Exposes Hedgefunds

Warren Buffett discusses in this video how the S&P 500 beats hedge funds and that the group who does nothing has to better than people who do a lot. Activity here means fees and trading which costs money. 

Furthermore, Buffett tells that he would rather have 3 wonderful businesses for his family than 50 mediocre business. This is due to the competitive advantage and the certainty that you can have in the ability to generate enough cash. This is less risky according to Buffett because the likelihood that you will lose money is very small. Remember, there is no second Coca-Cola or Amazon. Although Pepsi did a remarkable job back in the days to increase its brand power…  

“A really wonderful business is very well protected against the vicissitudes of the economy over time and the competition. I mean, we’re talking about businesses that are resistant to effective competition. And three of those will be better than 100 average businesses. And they’ll be safer, incidentally. There is less risk in owning three easy-to-identify, wonderful businesses than there is in owning 50 well-known, big businesses.

Warren Buffett

Dominant companies determine their future (e.g. big tech stocks) 

This is title I remember well from the book Security Analysis 5th edition (1988; not written by Graham & Dodd anymore). It means that companies with a moat will do very well over time. This is one of the most important investment lessons.

The 1996 Annual Meeting shows an interesting quote about investing and business schools. Charlie Munger: “If you believe what Warren says, then you teach the whole course (investing) in a week” Warren Buffett: and the high priests (Wall Street) wouldn’t have any edge over the lay people and that never sells well.” This reminds me of the old days where a few people where able to read Latin and made things quite comfortable for themselves at the cost of the rest. Luckily, we have better access to information these days (e.g. Google)!  

What to learn about investing in business school according to Buffett 

Essentially, Buffett says that you only need to know how to value a business and how to think about markets (see the book above). Accounting is needed to understand the language of a business. My advice to readers who want to improve is to start learning about accounting and ratio analysis. Know the difference between costs, expenses, expenditures. What is capital intensive, opex, capex etc. Know the difference between accrual and cash based accounting. A good book is Financial Statements step by step Ittelson and Financial Shenanigans. Also the letters of Warren Buffett teach you a lot about accounting.

Obviously, a lot of reading and learning is required before one is able to correctly analyse businesses. So, start working your way through SEC fillings (annual and quarterly reports, presentations and earning calls).

Furthermore, have a framework/strategy for analyzing a business

Let’s repeat the one of Warren Buffett:

  1. Do you understand the business (how do and will they earn money)?
  2. Long-term expectations of the business (i.e. does it have a moat and a high return on capital)?
  3. Good Management (can they allocate capital well and are they shareholder oriented)?
  4. A fair buying price (use a discounted cash flow analysis and think about the compounding possibilities of the company)

Furthermore, always remember that the market is there to serve you and not to instruct you (Benjamin Graham) and that investing requires emotional stability.

Understanding accounting is crucial as it is the language of the business. Impossible to correctly value a business and access its quality without accounting knowledge. Recommend book: financial statements step by step Ittelson  

Obviously, the businesses that you select need to be very well protected by a moat against the competition.  

Amazon, Facebook, Apple and Microsoft versus SP 500 and NASDAQ 100
https://finance.yahoo.com 5 year comparison of S&P 500, NASDAQ, Microsoft, Apple, Amazon and Facebook

Apple, Amazon, Google, Facebook and Microsoft have something in common. A moat, high incremental returns on capital (financed primarily by the cash flows) and increasing free cash flows.  

Patience and determination of Warren Buffett

We probably have had only five or six situations in the nine-year history of the Partnership where we have exceeded 25%. Any such situations are going to have to promise very significantly superior performance relative to the Dow compared to other opportunities available at the time. They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal (anything can happen on a short-term quotational basis which partially explains the greater risk of widened year-to-year variation in results). 

Warren Buffett

And more recently: Warren Buffett on banks (43:30 min): businesses I understand, like price relative to future prospects. In 10 years earn more and high probability that I’m right. Not best investment, but pretty sure that I won’t be disappointed.  

The principles of Keynes (source) align with those of Buffett

Keynes was an economist and investor of the Chest Fund and developed the following investment principles: 

1. A careful selection of a few investments having regard to their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time. 

“2. A steadfast holding of these fairly large units through thick and thin, perhaps for several years, until either they have fulfilled their promise or it is evident that they were purchased on a mistake. 

“3. A balanced investment position, i.e, a variety of risks in spite of individual holdings being large, and if possible opposed risks.

John M. Keynes

Essentially, Keynes says that concentrating in understandable and high quality businesses is the right strategy. And only a few are available at one given point in time to the investor. Philip Fisher had a similar way of thinking as mentioned in previous articles.

But I’d rather think of myself as being 100% Ben Graham and 100% Phil Fisher. And they really don’t contradict each other. Its just that they had a vastly different emphasis.

Berkshire Hathaway Meeting 1995

Benjamin Graham last thoughts about stock investing

The risk of paying too high a price for good-quality stocks – while a real one – is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Benjamin Graham

Graham said in one of his last interviews that you don’t need superior talent to do well in investing. What is needed is reasonable good intelligence, sound principles and (most importantly) firmness of character. “Don’t be led astray by Wall Street’s fashions, its illusions, and its constant chase for the fast dollar.”  Sticking to your principles and having the ability to make individual decisions is key to become successful in life, investing and in business. That doesn’t mean that you shouldn’t listen to others. But you should be very careful to select to whom you’re willing to listing and in the end have the ability to make an individual decision and sticking to it.  

Mastercard shows a very favorable free cash flow pattern
A good quality stock example: Free cash flow of Mastercard 2007-2020 (source Macrotrends)

Do what works and keep doing it

According to Munger, the fundamental algorithm of life is: repeat what works (2010 shareholder meeting Berkshire Hathaway).

Try to see what some of your favorite investors are doing and analyze the companies yourself. Understand your own nature: be honest and acknowledge mistakes, learn from these, learn from mistakes from others and understand why it happened. Understand behavior of people and that people can act irrational and can panic. It’s a huge advantage if you can keep it together. Remember that most people cannot stand the deviation from the market index (i.e. volatility). This is crucial to figure out for yourself before starting! 

Keep on learning and reading. It’s astonishing how much CEO’s and billionaires read. People like Warren Buffett have also learned from others and by reading. This allows you to build an edge over the ‘average’ investor. Remember, the best investment is an investment in yourself. Knowledge will compound over time, as will your investment results! Be ready to lose and learn in the short-term and profit in the long-run.

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