The Jutia Group blog recently suggested the One Question You Need to Ask Before Buying Any Stock Now. That that question a stock trader should ask themselves is:
“Would I start this business today?”
Now before I go any further, it must be noted that Jutia is definitely investment oriented. In fact, they refer to trading as “basically buying a piece of paper and hoping to sell it at a higher price”. At its most simple level, trading stocks is exactly that, but there’s no need to get snarky about it :-). After all, most investors also hope their bits of paper can eventually be sold at a higher price.
Anyway, the reason Jutia suggests asking this question is to keep away from trying to identify what’s hot and avoid attempting to bottom pick. From an investment perspective, I agree with the sentiment of the question, I’m just not sure if it’s the right one.
The reason I say that is because the question puts most prospective investors in a situation they just aren’t equipped to handle. Realistically, are the vast majority of investors capable of really sitting down and assessing all of the various issues involved in starting and running a business? That’s something which takes a lot of specialized knowledge. I’d argue that even big-time investment manager aren’t equipped to answer that question for all the stocks they hold in their portfolios.
Even if we water the analysis down to something more realistic – meaning a standard top-down view of a company starting with a look at the economy, then the sector – there’ still a time frame issue. There are some businesses for which the answer would be affirmative in the near term (a few years – something addressing a specific need or development in the economy) but for which the answer would be negative in the longer-term – or vice versa. Thus the risk to the question is that an investor could find themselves caught up in one of those fads which the question is meant to avoid.
With all that in mind, I think maybe a better question is:
Am I excited about this stock?
Emotionality about an investment is usually a real warning sign. It’s an indication that you might be getting caught up in a story stock. Those are sexy companies with hot new products (or just product ideas), in high profile industries everyone is talking about. They have a way of getting hold of you and leading you to toss out your risk management rules and ignore all the warning and negative signs you’d otherwise spot.
I’m not saying an investor can’t occasionally put money in something exciting. They do sometimes pay off very nicely. It’s just that proper portfolio allocation has to be part of it all.
The long time horizon for investing does tend to keep the emotionality out of things. It’s much easier to think rationally and soberly when your pay-out time frame is expected to be measured in years. The shorter-term is where emotion often plays the bigger part, which is why investors need to pay attention to their excitement levels (and their feeling of potentially missing out). That’s the time when – as in the late 1990s – investors turn into traders. I’m all for trading, of course, but not when you’re supposed to be investing (and think you’re doing so).