Brain Food for Investors

One of the more frequent questions I get from investors is some variation on, "I want to pick stocks myself. Where should I start?" Usually, the questioner is focused on what I think of as small stuff: whether this book or that book is a better guide to investing, whether one investing "system" is better than another, or whether they should use a stop-loss every time they buy a stock.

Unfortunately, this is the wrong question for anyone who thinks investing may be their avocation, because investors who are able to generate superior long-term returns don’t worry about stop losses or investing systems. Instead, they build a broad set of mental skills, which is why I think the right question for anyone trying to improve their stock-picking skills is, "How should I think?"

So, if you're starting out as an investor, or you've been looking for ways to improve your stock-picking acumen, try strengthening your mental muscles.

Read shareholder letters. I'm always struck by how few investors do this. When many of the world's best investing practitioners write regular lessons on how they do what they do, it's almost shameful to not take advantage of the information. In how many other fields do the best minds lay out their thinking for all to see? A few hours reading shareholder letters is, in my mind, more valuable than a week's worth of consuming financial media. Why not go straight to the source, after all? (We've provided links to many of our favorite shareholder letters on Morningstar.com.)

Read annual reports. Lots of them. Warren Buffett often talks about the "mental database" of companies that he draws upon in making investment decisions, and building that database is critical for any serious investor. There's simply no substitute for being familiar with a wide swath of companies--the more you know, the more easily you can draw connections between them, separate the good from the bad, and understand the value chain in an industry. Who buys and sells what to whom, and which player captures the bulk of the profits?

Also, since a key attribute of successful investing is patience (i.e. waiting until a wonderful company is trading at an attractive price), the more wonderful companies you find, the better the odds that one you know will eventually trade at a price you like.

Read financial history. Like many things, financial markets tend to move in cycles, and history often does repeat itself in slightly altered guise. At the recent Morningstar Investment Conference, Jeremy Grantham said that he "hero-worshipped financial history," and even if your views aren’t as bearish as his, knowing the scams and opportunities that the market has offered up in the past will help you recognize them when they recur in the future. I don't think anyone can read about the popularity of the Nifty Fifty stocks prior to the bear market of 1973-1974 and not be struck by the similarities of that market trend to the great Internet bubble or the emerging-markets mania of the early 1990s.

John Kenneth Galbraith's A Short History of Financial Euphoria is a fine place to start, while Edward Chancellor's Devil Take the Hindmost offers more detail for history buffs and stock geeks. Whichever book you choose--and there are many more to choose from--you can't invest well without being armed with the knowledge of what the market has done in the past. The players may change, but the cycle of fear and greed is the same today as it was centuries ago, because the players are still human.

Read about behavorial finance. People are wired in odd ways that cause us to make decisions far out of whack with what we rationally "should" do. Unless you know what these flaws are, you can’t consciously avoid them, nor can you take advantage of them when they cause assets to be mispriced by other investors. Buffett has famously said that, "Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing."

My colleague Brian Lund has written an excellent introduction to why investors can often be their own worst enemy, and I'd recommend the unfortunately named Why Smart People Make Big Money Mistakes as a good primer. Of course, Roger Lowenstein's When Genius Failed is a classic example of how overconfidence in one's abilities can lead to investing disaster. It's a must-read.

And speaking of must-reads….

Shameless Plug
Morningstar's first full-length book on stock investing is out. Look for it in your favorite bookstore, or you can order it here. It's titled The Five Rules for Successful Stock Investing, and it was written by yours truly in conjunction with Morningstar's stock analyst staff. The first half of the book covers the basics of fundamental analysis: a discussion about developing an investment philosophy, a mercifully short introduction to reading financial statements, a primer on valuation, and a guide to evaluating company management and assessing economic moats. The second half is a series of chapters on each sector of the market--from hardware to health care to banking--that explains industry jargon and helps you analyze complicated companies.