Saturday, March 20, 2010

Improving Stock Selection -- Use a Simple Checklist

It is said that we should "learn from our mistakes." This truism applies to all aspects of our lives, including our investing decisions. Although it is difficult to objectively analyze our investing mistakes, it is important to do so periodically with the intention of determining where we went wrong so that we are able to identify and implement appropriate corrective actions. The remainder of this article describes the Covered Calls Advisor's recent experience in this regard.

The single most important decision-making process for most investors (including us covered calls investors) is stock selection. The Covered Calls Advisor recently decided to identify those stocks purchased and subsequently sold during the past six months that had underperformed the Russell 3000 broad market benchmark. A quick analysis determined that of the 30 equities during this period, nineteen outperformed the benchmark and eleven underperformed. Of these eleven, five were especially weak selections in that their underperformance was more than 5% below that of the benchmark for the comparable time period.

These five worst performers became the focus for further analysis since they were definitely considered stock selection "mistakes." If the decision-making process used in each instance was analyzed objectively, would it be possible to pinpoint errors made and thus have an opportunity to "learn from these mistakes"? Fortunately, it soon became very apparent that the answer to this question was a definite "Yes".

The Covered Calls Advisor uses several sources of information and analytical methods to determine whether a particular company qualifies as a worthwhile investment. But in recent months, this advisor often failed to research the selected companies as fully as desired prior to their purchase. In other words, shortcuts were taken. This realization was particularly disconcerting since "discipline" is one of the five key characteristics specified in a prior article on this blog titled "Investing Pyramid of Success" (See "link ").

So how could the necessary discipline be defined to ensure that all necessary research methods in analyzing a potential stock investment would be consistently followed? The answer came from an unlikely source, a book titled "The Checklist Manifesto" (See "link"). The author, Dr. Atul Gawande, demonstrates how ordinary checklists have been used to significantly improve complex decision-making processes in diverse disciplines such as medicine, aerospace, and investing. The author explains how behavioral researchers have determined that there are two primary difficulties in complex decision-making:
(1) "the fallibility of human memory and attention, especially when it comes to mundane, routine matters that are easily overlooked under the strain of more pressing events"; and (2) "people can lull themselves into skipping steps even when they remember them."

To combat these difficulties, "checklists seem to provide protection against such failures. They remind us of the minimum necessary steps and make them explicit. They not only offer the possibility of verification but also instill a kind of discipline of higher performance." Checklists "catch mental flaws inherent in all of us -- flaws of memory and attention and thoroughness."

The two decision-making difficulties described above are an accurate reflection of this advisor's own difficulties. Putting the desired research steps into a checklist would certainly be a simple, effective tool to establish a more disciplined stock selection process. So, a step-by-step "Stock Selection Checklist" was developed and is as follows:

The first two items on this checklist are presented other Covered Calls Advisor articles (see See Stock Selection post; and See Buy Alerts spreadsheet embedded within this post). While the other items are important for obtaining a comprehensive understanding of a particular company's investment potential, more detailed descriptions of these steps will not be provided at this time.

The specific items on the checklist are unique to the approach used by the Covered Calls Advisor. As a reader of this article, you are likely to use very different steps in your own analysis, and that is fine. But hopefully, you will now consider developing your own "Stock Selection Checklist" that itemizes the essential steps in your own investment decision-making process. Completing every step on the checklist prior to making a final investment decision is definitely a time-consuming process -- but it's worth it. Remember: Good stock selection is Job #1 for covered calls investors, and an essential quality for successful investing is discipline. An ordinary checklist provides a nice, simple framework for a consistent analytical approach and helps us to decrease the likelihood of making errors of omission. In short, using a checklist will provide the discipline necessary to reduce our stock selection mistakes and to improve our overall investing results.

Your comments or questions regarding the items on this checklist or anything else related to this article are certainly welcomed. Please click on the "comments" link below or email me at the address shown in the upper-right sidebar.

Regards and Godspeed to All,