It is easy to drown in the flood of information available in the financial markets. There's always one more report to read, one more press release to peruse or one more chart to interpret. In such an environment, it's easy to get pulled off course; information intended to help you, can actually make it difficult to maintain a consistent investment process.
Unfortunately, the market rewards disciplined investing and often quickly punishes emotional, distracted or disorganized approaches. What's more, it's easy to forget discipline when things are going especially well or especially bad. And then there's just human nature – humans are fallible creatures and even the best find it difficult to remember or replicate what worked three or four years ago.
Accordingly, investors should seek out ways to stay disciplined and methodical when it comes to researching new ideas, maintaining an existing portfolio and exiting positions. One of the best ways to achieve this is the use of checklists. Just as airline and military pilots have used checklists for decades to eliminate avoidable accidents and produce better results, so too can investors use checklists to develop better and more consistent investment behaviors.
The Advantages of Checklists
Words like "disciplined" and "methodical" are going to show up a few times in this article, and for good reason. A methodical and disciplined approach means that investors are considering the full range of the possibilities and risks, practicing careful due diligence and performing the detailed research that often accompanies long-term investment success. To that end, step-by-step checklists help foster, support and reinforce that step-by-step approach.
Checklists also help investors avoid lazy mistakes or short-cuts. Many investors, particularly value investors, claim that there is a wealth of information in the details and footnotes of filings like 10-Ks. That's true, but the fact remains that investors often forget to go through every step and read all of that material. They certainly may mean well, and they may even think they have done it, but it's all too easy to forget in a hectic and busy time. In other words, a checklist ensures than an investor always does what he or she intends to do.
Checklists are also advantageous in that they leave a decision-making trail that can be modified and corrected with time. If an investment didn't work out, the investor can often see what went wrong and that may point to a necessary change in the process. Perhaps that investor ignored large insider sales or perhaps the investor failed to investigate what new products were coming out from rivals. Whatever the case may be, it can be a new item to add to the list. Just as airlines are constantly updating pilot checklists on the basis of experience (good and bad), so too should investors.
On the flip side, investors may also learn that they are being too strict or demanding; investors who see too many stocks succeed outside of their standards may need to revisit and revise those standards. If an investor can identify what works in the market, they can compare the qualities and characteristics of those stocks to the standards demanded by their checklists and see if they match appropriately.
Emotions are often the enemy of successful investors, and checklists can help sap the emotion from investment decisions. If nothing else, the methodical process of going through a checklist introduces a bit of tedium to offset those emotions and can allow a cooler head to prevail. The routine and ritual of going through a checklist can help preserve gains or avoid chasing bad ideas by not allowing investors to get carried away with momentum or hot stories.
The Disadvantages of Checklists
While checklists are useful tools and this is a pro-checklist article, fairness demands that some of the downsides and disadvantages of checklists be presented as well.
For starters, checklists can feed a "paralysis by analysis" - the idea that there's always just one more piece of information to find before an investment decision can be made. This is especially true in cases where checklists have become too long or too thorough over time.
Checklists may also provide a false sense of security. Checklists are a consummate example of "garbage in, garbage out" and if investors build checklists on the basis of trivial or incorrect views of the market, the resulting investment performance will be lacking.
Lastly, checklists can be emotionally painful. It can ding the ego or pride to realize that you cannot do it all and need to rely on refreshers. Likewise, some investors love the rush that comes with investing on whim and emotion, and checklists can feel like straightjackets. Moreover, checklists eliminate some of the excuses that investors may like to use to explain losses – a consistent and methodical approach doesn't really allow for investors blaming "shorts," hedge funds or other fictional evil-doers for their losses.
Steps to Build a More Useful Checklist
As there are so many different valid investment strategies out there, it is beyond the scope of a single article to offer the range of appropriate checklist permutations. Instead, there are some more general philosophies and approaches that can help investors create usable checklists for their own particular approach.
Above all, it is important to identify the key steps in the process and the key opportunities for a serious error. A fundamentals-based value investor, for instance, has to consider those financial footnotes, but likely has little reason to worry about chart patterns. Relying on technical analysis, though, may have to include a number of confirming or contradictory signals before coming to a final decision on a stock, while not worrying much (if at all) about the details of the company's off-balance sheet financing.
Checklists must also be brief. These are reminders and guides, not how-to manuals. Anything beyond a single page is likely to be too unwieldy to be practical, and investors are well-advised to create separate lists for separate tasks (like buying, evaluating current holdings and selling).
Physically using the checklist also seems to make a difference; printing it out and actually checking boxes seems to feed a different psychological process than just referring to a list on a screen. This, after all, is the major difference between a real checklist and the "mental checklist" that most investors claim to use. The investor has to make sure that their process demands that they go through each step and leaves a record of doing so.
Last and not least, checklists need to be consistently evaluated and revised. When something goes wrong, identify the cause and evaluate the checklist to see if it needs revision. When something goes right, the same rules apply. Not all mistakes are preventable, but it is important to identify those that are and make sure they do not reoccur.
The Bottom Line
Checklists are tools, not panaceas. If an investor can identify the aspects of an investment that indicate a possibility to outperform the market, it behooves them to make sure that they carefully evaluate every potential investment for those aspects and stay away from investments that do not have them. There is nothing sexy about checklists and most investors will find them to be tedious at first. As time goes on, though, and potential mistakes are avoided in lieu of real winners, diligent checklist-users are likely to find that this is a relatively simple and cheap means of boosting returns.