Wednesday, August 09, 2006

Removing variation improves investing results

Do you ever wonder why Toyota, Honda, Subaru, etc. vehicles have both remarkable reliability, AND so very few recalls?

Well, one reason is that that the Japanese-based manufacturers strive to reduce variation in their product build-outs. That means that, for instance, Toyota workers world-wide, are taught - for instance - to tighten a certain bolt with their left hand. The ordinary assembly worker is given months of training to ensure exactly that happens. Therefore, when a problem arises, it is much easier to find the source: variation has been driven out of the system.

This was something that was stressed by Dr. W. Edwards Deming(, the so-called "American who taught the Japanese about quality."

This is also something that can be done to improve investing results as well. To get better at investing, we have to take the time to create (or borrow) some systems, some analysis, before we buy a security. This may start out as simply as writing down a very few basics on a piece of ordinary fullscap about the investment.

This would include some valuation metrics (PE and growth ratios, for instance), some of the underlying business metrics (e.g. balance sheet info, etc.), and also what your expectations are regarding the potential of the stock, both on the upside and downside. Don't forget to list the what you see as the positives, and also the negatives. This allows you to consider things that could derail your rosy forecasts, and hopefully get a better picture of reality.

In my small and microcap blog, I do this in a narrative fashion, that works well for me. But I have also tried to institute these things as a system, by using a standard template for each stock I analyze. This, hopefully, allows me to drive some variation out of my investing system.

Of course, the final step is to review actual results against both a reasonable benchmark (an appropriate market index), and also against your initial projections. This should also help to develop "profound knowledge", something Dr. Deming promoted strongly.


The Confused Capitalist

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