I think it is easier to figure out what not to buy than what to buy. If we can weed out the stocks to avoid, we’ll be a step closer to figure out what to buy. What are some stocks you should avoid? Generally, hot stocks that everyone is talking about. Some are ‘momentum’ stocks where the share price has gone into the stratosphere over a short-period without any solid reason. Some are promising startups growing revenue at a very high rate but barely profitable. Buying these stocks doesn’t necessarily mean you’ll lose money; Amazon.com was such a stock back in the early 2000s with a promising future but no profit. It just means the odds are not in your favor. Do it long enough, the chance of losing money is almost certain.¹
And here’s another problem. When we ask “What should I buy?”, what we’re really asking is “what stocks are going to make me lots of money” rather than “what stocks can I buy that if something goes wrong, I won’t lose much” And it is better to approach the stock market from a ‘how can I not lose money’ mindset because of the compound effect.²
There are two ways to lose money in the market. One comes from the stock itself. You overpaid for a stock, you invest in stocks with poor economics; a turnaround story that failed, value traps, etc. Another comes from you. You can lose money holding onto a long-term winner.³ How? Overconfidence, FOMO, poor self-control, highly suggestible, and all sorts of psychological biases.
What’s the common pattern across these psychological biases? You don’t know what you’re buying. When you don’t know what you’re buying, it is easy to get overconfident (Dunning-Kruger effect). When the price of a stock you’re not familiar with goes up, you get into the FOMO mentality. You have a lack of self-control and become easily suggestible. And when the price comes down, you panic because you’ve no idea what to do. Fear comes from the unknown. When you panic, you follow the crowd because you think the crowd knows more than you so you buy high and sell low.
That’s something to avoid. Only buy things you understand or familiar with. However, ‘understand’ is a flimsy word. We often think we know something when we don’t know we don’t know. A simple heuristic: if you can’t explain the business behind a stock in a way that a 5 years old kid would understand, then you shouldn’t buy it. And do that by writing it down on a piece of paper. You should get a good sense of whether you know what you’re buying using this heuristic.
So what should you buy? Buy the things you understand. Buying stocks you understand naturally puts you in a direction that helps you avoid stocks you shouldn’t buy in the first place. If you’re new to the stock market, you might think this is hard because you aren’t familiar with any stock at all. You actually do. It is in the things you use every day. The knowledge and insights you’ve accumulated from your daily interaction with all sorts of products and services is your biggest advantage in the stock market.
What is your daily routine? What kind of products or services do you use every day? Where do you spend the most money? What subscription services do you use? Are you price-insensitive towards certain things? Either because the cost is only a fraction of your total expenses and/or there’s simply no alternative? Is there anything that changes your behavior? A brand that you always go for that should it become unavailable, you’ll never go for the alternative? Or what products/services that will give you massive pain if it disappears tomorrow?
You should be able to come up with at least dozens of ideas from these questions. This isn’t to say you should invest in a stock just because you like its products or service. But it is a good starting point. If you love certain products, chances are others do too. And this isn’t restricted to yourself; be attentive to your surroundings. Does your partner have brands that he/she always goes for? Any quirky habit or preference that is considered as ‘irrational’ is always a great place for inquiry. Are there any critical products that your company uses? How about your kids? Do they have any preferences?
Warren Buffett once said the five most dangerous words in business is “everyone else is doing it”. I think that’s also true in investing. Just because everyone else owns some of the most popular stocks out there doesn’t mean you should own them or that owning them is a guarantee that you’ll make money simply because everyone owns them or that they’re popular. Rather, investing is about owning things that you believe in after thorough research.
- Amazon.com is possibly the only online retailer out of hundreds that have survived and thrived over the past 20 years. So how do you know which one out of those will be the one back in the 2000s? This question applies to today’s promising industries from cannabis, self-driving tech, 3D printing, fake meat, electric cars, etc.
- It takes more than a dollar to gain back a lost dollar. Losing money in the market is like driving a car in the 1st gear; you’ve little opportunity to compound (or snowball) your wealth.
- I once saw a guy who earns a single-digit return investing in Amazon by jumping in and out over 4-5 years when he could have made 400% sitting there and doing nothing.