A lot of people trade stocks like they’re renting them. They impulsively buy whatever names are popular or catch their eye.
That works OK in a raging bull market, when everything is moving up.
What I’m going to explain to you today is the simplest and best way I know to improve the long-term durability and performance of your investment portfolio.
And it’s especially important to think about now, after nine years of relative complacency during this bull market.
The key is learning how to stop “renting” your stocks – and start owning them…
Before you buy your next stock, I want you to ask yourself three questions…
- Do I know this company’s business model well enough to describe it to a 10-year-old?
- Am I comfortable putting at least 20% of my entire net worth into this stock?
- Am I comfortable holding this stock for at least 10 years?
If you can answer yes to all three questions, congratulations… You have identified a wonderful long-term investment.
Now, to be clear, I am not recommending that you actually put 20% of your worth into your next stock purchase. Nor am I saying you must hold it for a decade.
But I am suggesting you use these heightened thresholds to add incremental discipline to your investment decisions. Your capital is precious. It demands higher standards.
More important, employing this rigor will mean you’re investing in stocks the way that buyers of private businesses invest. Think about it… Owning requires more due diligence than renting. And that’s a great thing.
When you rent something like an apartment or a car, you’re more likely to act on impulse and throw some money at something that catches your eye… After all, you’re only committed for a short time.
But if you’re buying that house or car… you’re likely to take a little more time to make sure it’s something you’ll be happy owning for a long time.
When you apply this to your investing, your portfolio will begin to fill up with businesses you understand. You’ll own more businesses with high-quality operating models. And you’ll sleep better at night knowing you own businesses with franchises that will endure for the long haul... regardless of what happens to the market or the overall economy.
In short, you are on your way to becoming a “whole-business investor.”
Let’s look at those three questions again, one by one…
1. Do I know this company’s business model well enough to describe it to a 10-year-old?
This question forces you to truly “do the work” to understand what you’re buying. How does this company actually make money? Who are its customers and competitors?
To be able to clearly and succinctly describe a business to a 10-year-old, you must really know it inside and out. This deeper level of understanding will enable you to make better decisions in times of heightened market panic or greed.
2. Am I comfortable putting at least 20% of my entire net worth into this stock?
To answer “yes” to this question, you need to be convinced that the investment represents an exceptional opportunity. You must be sure you’re buying a high-quality business.
Maybe it’s capital-efficient, with excellent returns on investment. Maybe it possesses one-of-a-kind assets, pricing power, moats, or an extreme “margin of safety” in the form of a low stock valuation relative to its asset value. Whatever the case, you know this business is worth owning in size. And that knowledge will help you drown out any market fear or noise.
3. Am I comfortable holding this stock for at least 10 years?
Legendary “whole business” investor Warren Buffett is a master at putting things in succinct, clear language. So I’ll let him describe it…
If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.
That’s it. Earnings growth over the long run is the single best predictor of share-price growth. Fill your portfolio with businesses you feel confident will be bigger and better in the years to come, and push flash-in-the-pan companies off your radar.
The combined effect of answering “yes” to these three questions will eliminate marginal ideas from your portfolio. You will stop renting stocks and start owning them. You will become the quintessential whole-business investor – a public-equity shareholder with a private-equity mindset.
You will own the best and forget the rest. And your portfolio will be all the better for it.
Source: Daily Wealth