Investors should ask numerous questions about an investment before buying and weigh the answers while accepting that the answers will often contradict.Brian Jackson/Getty Images/iStockphoto
Last week, Rob Carrick published "It's time for everyone to check out dividend stocks". On the same day, I wrote a post arguing that investors should reduce holdings of dividend stocks because of rising interest rates.
On the surface this looks like a contentious debate. It's not, and more importantly the incident highlights one of the most under-appreciated and important topics in investing: asking the right questions.
In Rob's case, he was answering the question "are dividend stocks highly attractive based on yields relative to government bonds and compared to their historical valuations?" His argument that they are is almost undeniable.
In my case, I noted the relationship between bond yields and utility and real estate stocks. Throughout market history, real estate and utilities underperform when rates rise. The implications were that the risks involved in holding these income-generating sectors was rising along with yields, and that it might be the case that their prices will fall no matter how attractive they look if yields keep climbing. The question I was answering was "are bond yields creating enough investment risk that reducing holdings is a prudent move?" I argued they were.
I suggest that neither of us were wrong, we were just answering different questions. Future performance for REITs and utilities will determine which of these questions was the right one to ask.
The right questions will vary for different types of investors. Warren Buffett's first two rules of investing, "never lose money" and "never forget rule #1", make it relatively easy to speculate on what questions he asks. Something like "Have I limited the risk of losing capital in every single way I can?" is likely for the world's most famous investor. That's why he buys stocks at valuation discount, and favours long term financial histories showing consistent, stable profit growth. It also explains why Berkshire Hathaway buys companies with strong "competitive moats" that protect against loss of market share.
Ideally, investors should ask numerous questions about an investment before buying and weigh the answers while accepting that the answers will often contradict. There is a risk of "paralysis by analysis," over-thinking the problem to the point where making a decision is impossible, but that's not the worst thing in the world. No investor can expect to profit from every new market trend, even if commission-generating brokers are happy to let them try.
Asking numerous questions from a variety of perspectives will help prevent mistakes and, as Mr. Buffett's long time business partner Charlie Munger famously said, avoiding mistakes is more important than missing a trade.
"It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent."
Scott Barlow