"What was I thinking when I bought that pig?"How many times have you asked yourself that question? Don't worry, you're not alone. It's an all-too-common lament among individual investors, whose portfolios are often littered with these losers. Almost as bad as the financial hit is the nagging related question, "How could I have ever been so stupid?" Today, we address that issue. Included in our discussion are two basic tools that will help you look back and understand your own thought process, and the analytical steps you took -- or failed to take -- before buying that sow. More importantly, this process can help before you buy the next pig.
The Best Constantly ImproveDeveloping a way to both evaluate and improve your performance is one of the most important skills any investor can have. Yet far too few individuals have a mechanism by which they can review their stock picks, evaluate their trade management and assess their market calls. This is a pity. Constantly reviewing your trading, recognizing what went wrong -- and right -- and adjusting your methods on the basis of what you learn is one of the simplest ways anyone can improve their skill set. Reviewing strategy for weak spots and making incremental improvements is especially important for the
The Trading DiaryOne of the best ways to evaluate your stock purchases, as well as their subsequent market performance, is to keep a trading diary. The key idea is to do more than merely track your returns. Dozens of Web sites can do that for you, as does your monthly brokerage statement. Our goal is much more comprehensive. We want you to create a paper (pixel?) trail, memorializing your thought process prior to your purchases. More importantly, you need a way to evaluate -- after the trade -- what you could have done better.
Keeping a trading diary will help you accomplish these things: It will force you to maintain your
pre-purchase checklist . It will also make you articulate why you made certain purchases. That often turns out to be important in the evaluation process later on, when trying to determine just why you bought that pig. Having a clear idea of why you own a specific name will put you in a better position to see your entire investing picture. It gives you insight into your own performance. On an individual stock level, you may discover what tactical errors you may be making. Are you being too impatient? Are your stop losses too tight? Or are you letting stocks get too far away from you before you finally cut them loose? Technical traders might find that they are getting sucked into a false breakout; value investors might be buying cheap stocks that keep getting even cheaper. The diary is also a good way to avoid repeating the same errors. I much prefer to discover new and different errors (and do so all the time!). I don't mind the occasional error -- if I can learn something from it -- but I try never to repeat the same mistake twice. Lastly, and perhaps most importantly, your trading diary will help you improve your overall strategic performance. Doing a post-mortem on your trades will help you adjust your strategy and philosophy. Are you over-trading? Are your positions too large? Perhaps you are bucking the major trend. Regardless, a good trading diary will help you understand exactly what you are doing right and wrong.
Words and NumbersLet's get into the nitty-gritty of your trading diary. There are two aspects to this. The first consists of documenting each individual position before purchase; this is simply another part of your pre-purchase research, and it will help you in your review process. The second aspect is analyzing your investing performance afterward, something we will get into in more detail in a later column. (For a preview, check out this link.)
The pre-purchase diary should be a simple one-pager; You should have down, in one place, all of the specific info you accumulated before making the purchase decision. More than mere info, however: These are the key data points you use to make your purchase decision. It can be on paper or in your computer; you can even blog it if you like. But the important thing is to go through the exercise of gathering all the data prior to making your actual purchase. This attached Word doc is general, so it can be easily adapted to your own investing style. It includes elements of fundamentals (price-to-earnings, price-to-cash flow, catalysts, etc.); technical analysis (trend, volume, moving averages, etc.); and trade management (stop-loss, risk/reward ratio, holding period). If you do quantitative screening of any sort, this is also the place where you would describe the parameters. Your trading diary is also the place where you write out what your "purchase thesis" is. It may be as simple as "This is an undervalued stock" or "I like the technical breakout." It could be "I think this new iPod thingie is going to be a big hit for Apple ( AAPL)." Lastly, I rank my potential trades on a scale of 1 to 10. I want to see if my own gut-level expectations for a position turn out to be accurate. Am I better off only buying 8s, 9s and the very rare 10s? Should I own a broader basket of stocks? The ranking process helps me understand my own analytical abilities. You should play with the trading diary -- add to it, personalize it, make it your own. If anyone feels they have significantly improved on it, please send it in an email. I will share it with the readers in a next column.