On the Importance of Investment Checklists

Checklists are surprisingly effective at dramatically improving performance, even when those involved are highly trained, smart people. The benefits of improving outcomes are particularly evident when a complex task is involved, however, the benefits can also be dramatic when simple tasks are performed.

The New Yorker ran an article in December of 2007 by Atul Gawande called “The Checklist” that forcefully makes the case for the efficacy of checklists. Take, for example, something as straightforward as preventing infection when a line is inserted into patients at a hospital I.C.U. In 2001, John Hopkins adopted the following checklist to reduce infection: (1) wash hands with soap, (2) clean the patient’s skin with chlorhexidine antiseptic, (3) put sterile drapes over the entire patient, (4) wear a sterile mask, hat, gown, and gloves, and (5) put a sterile dressing over the catheter site once the line is in. It was observed that in more than a third of the patients, at least one step was skipped.

After nurses were empowered to raise the issue if a step was skipped, the rate of infection over the subsequent year dropped from 11% to 0. After fifteen months, it was determined that following this simple checklist was responsible for saving eight lives and generating savings of $2 million. The article gives several other equally compelling examples of how checklists have made a profound positive difference in both medicine and aviation.

In a talk at the Columbia Business School, value investor Monish Pabrai spoke about checklists. He argued that they work because, “Our brains are designed to take short-cuts and arrive at answers quickly. When you see the lion, you run. You don’t process your options, you just run. We are also a mix of rationality and emotions. When we notice a great business, we read up on it, run through a number of concerns/questions and arrive at a decision – not as effective as checklist.” That’s why great investors like Charlie Munger recommend the use of checklists.

Here’s what noted short seller Joe Feshbach had to say about checklists in the book The Art of Short Selling by Kathryn F. Staley. “Money managers make the same mistake over and over – that’s part of the whole reactive process. We’ve developed a check list of good short criteria and a training manual based on successful and unsuccessful actions.” (page 31) I would argue that most investors make recurring mistakes.

Even great investors make mistakes. For example, Buffett has said that he made a mistake not selling Coke when its valuation reached stratospheric levels during the Internet bubble. Perhaps he was unduly influenced by his being on record numerous times as saying he would hold positions like Coke forever. This is known as confirmation bias: the tendency to act in conformity with past statements or commitments.

Charlie Munger purchased Cort during the Internet bubble based on its strong earnings. What he missed was that those earnings were the result of unsustainable tailwinds from the Internet boom. Pabrai thinks we should learn from this mistake and add the following to our own investment checklist, “Are the revenues and cash flows of the business sustainable or overstated / understated due to boom or bust conditions?”

So where do you start if you want to make an effective investment checklist? A good place is your past mistakes. Look at where you’ve lost money in the past and convert the lessons learned into rules you can put on your checklist. Also, as you come across wise investment counsel – such as only buy a stock in a business you understand – add it to your list. Buffett strongly suggests that we all make a written statement of why we’re buying a given stock and why it’s undervalued. Add the written thesis of why a stock is undervalued to your checklist.

I think a good checklist can also save a lot of time. Nobody has time to look at everything. Using a few good checklist questions when searching for prospective investments such as “Can I lose my investment?”, “Is there a sufficient margin of safety?” and “Is the idea within my circle of competence?” can act as a kind of investment triage by quickly filtering out investments that are non-starters. Such a practice can potentially also save you a lot of money.


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