Imagine you want a car. What car should you pick? First, you have to know why you want a car right. You probably also have a few criteria like:

1. What’s my budget?
2. What type of car? i.e sedan, SUV, etc.
3. What’s my preference for make and model? 
4. Should I get brand new or second-hand?
5. Automatic or manual transmission? 

Why are these questions useful? They narrow down your search. Instead of going through hundreds of cars, you only have to focus on a few dozen that satisfy your criteria. You can quickly differentiate a good pick that satisfies all of your criteria from a bad one that meets a few or none of them. If for example, you want a car for your growing family, you immediately rule out getting a Ferrari because it doesn’t fit your criteria: a car that can accommodate your whole family. Ferrari is without a question a great car but a poor choice for your circumstances. Having a criteria is also powerful for picking stocks.

So you want to buy some stocks. Why do you want to invest? Duh, to make money and get rich. But that’s like saying I should get the fastest car in the world because I want to go from point A to point B. There are thousands of stocks out there that can make you rich so you still need a way to narrow that down to a manageable amount before you can do a deep dive on each of them. Therefore, the question is how much time do you have or willing to spend on researching stocks? If you invest in the market to grow wealth without having much interest in analyzing stocks, it’s probably best to pick broadly based index ETFs rather than individual stocks. 

This might sound obvious but it isn’t. It is not uncommon to see people with busy careers getting their hands in short-term trading. There’s nothing wrong with trading but combining a busy full-time job with trading, which by nature demands a lot of time because you’re timing the market, is not that different from turning a car with 500 horsepower into one with 100 horsepower. Distraction is the problem. 

It’s easy to get distracted when you don’t have investment criteria. You get excited at every stock recommendation because they all look like the next Amazon. You jump into hot stocks because they promise to triple revenue in 5 years. You got into cybersecurity and online payment stocks because of the online shift due to Covid; you got into blockchain stocks because of all the wonderful things going on there; you got into E-commerce stocks because of the ‘new normal’. There’s nothing wrong with these industries. It’s just that your portfolio will be all over the place. That usually means you get into things that you don’t understand what the risks are. You don’t have an edge if you don’t know the risk. That’s why trying to be everywhere often translates into poor returns. 

Volatility is another reason why most people who got into hot stocks have poor returns. Everyone knows you’ll be filthy rich had you invested in Amazon after the dot-com bust. But very few have the mental fortitude to stomach countless 30-50% drops in its share price over those 20 years. Most people sell out at the bottom not because the stock fundamentals deteriorate, but because the wild share price swing gave them sleepless nights. Therefore, having a criterion such as only invest in stocks with a durable competitive advantage helps you in two ways: avoid hype stocks (or so-called pump and dump stocks) and put more focus on the long-term fundamentals rather than the short-term price movement when investing in quality stocks like Amazon. Criteria bring clarity so you know what to do and what not to do in uncertain times. 

Criteria is also an antidote against envy. Most people lose money not because of a market downturn but because of doing things out of envy. It’s okay to get a hatchback or subcompact car if you are not confident on the road. What gets you into trouble is when you want an SUV because everyone else is driving one. You don’t have to follow others just because they made 5-10x more money than you. You’re not missing out on anything because finding investments that fit your criteria is the most effective way to achieve your financial goal. Everything else doesn’t matter. 

Your criteria are only as useful as your ability to stick to them. Therefore, having criteria that are simple and easy to follow so you can stick to it over the long-term is more important than what it is. Don’t underestimate the power of simplicity. Tom Gayner—who manages a $5 billion portfolio for Markel Corporation—has 50 words long criteria:

1. Profitable business that earns good return on capital without too much leverage.
2. Business run by people with equal measures of talent and integrity.
3. Business that has good reinvestment opportunities or good capital discipline i.e ability to do good acquisitions/pay dividends/share buyback.
4. Buy them at a fair price.

Lou Simpson’s criteria are just as simple. Lou managed GEICO’s investment portfolio from 1979 to 2010 with a track record of 20.3% p.a. His investment criteria (or philosophy) are similarly straightforward:

1. Think independently
2. Invest in high return businesses run for the shareholders
3. Pay only a reasonable price, even for excellent businesses
4. Invest for the long-term
5. Do not diversify excessively

What works for them might not work for you. Context is the key. Lou Simpson’s ‘Do not diversify excessively’ criteria worked well for him but is risky for someone who can’t tolerate high volatility or when it’s applied to poor quality stocks. Therefore, the best criteria are the ones that make the most sense to you; ones that align with your life circumstances. What makes the most sense also means you can stick to it during hard times. And that’s important because your criteria are only as useful as your ability to stick to them. 

One of the underrated aspects of criteria is that it improves decision quality. Every piece of news looks important if you don’t have criteria. You have the urge to form an opinion on most economic events when in fact 99% of those things are just a waste of time. If a stock you own announces a poor quarterly earnings result; falls 20% on the expectation of a rate hike; or receives an analyst downgrade, should you hold or sell the shares? That depends. These events are important for a trader but trivial to a long-term investor. Lou Simpson’s thought process would filter them out because they’re irrelevant to his criteria of owning excellent businesses for the long-term.

Put it differently, criteria help you to make one good decision that replaces 100 unnecessary decisions. Criteria act as a filter that eliminates a long chain of downstream decisions. You avoid wasting time on unimportant stuff, get overwhelmed by endless buy/hold/sell decisions, make less mistakes because you’re more focused, and have fewer but high quality calls. All of these translate into better investment returns.

So here’s an unconventional truth about the stock market: being a successful investor has more to do with figuring out what the hell are you doing in the market than knowing which stock is going to be the next Amazon.