There are an infinite number of reasons you might decide to invest in a certain company. But Berkshire Hathaway CEO Warren Buffett says there's one you should always avoid: Buying a stock merely because you think it's going to increase in price.
That's because even the best investors aren't able to predict how the market will perform.
Instead, you should invest in companies that you both understand and believe will offer long-term value, according to Buffett.
No matter how much or how little you're buying, you should be able to get your reasoning down on paper without relying on outside resources, Buffett told Becky Quick on CNBC's "Squawk Box" on Monday.
"Everybody when they buy a stock should be able to take a yellow pad" and write down exactly why they plan to invest in that particular company, Buffett said.
He also doesn't think investors should worry about how the stock will perform in the near term. If you want to predict what the stock price is going to do, "you can have a separate piece of paper," he said. Rather, Buffett recommends focusing on businesses that will hold their value over time. As he told CNBC in 2018, "nobody buys a farm based on whether they think it's going to rain next year."
"You're buying businesses," Buffett told Quick on Monday. Because people can "make decisions every second with stocks," as opposed to investing in a physical entity like stores or farms, "they think an investment in stocks is different than an investment in a business. But it isn't."
Buffett follows three general rules when deciding which companies to invest in: "First, they must earn good returns on the net tangible capital required in their operation. Second, they must be run by able and honest managers. Finally, they must be available at a sensible price," he wrote in his 2019 annual letter to Berkshire shareholders.
That said, any individual stock can over- or underperform, and past returns do not predict future results. Beginner investors are encouraged to look into low-cost index funds instead, which are much less risky.
The rate of return for each index fund is determined by the performance of the companies that are in the fund, which can balance each other out. Say you buy an index that contains only two companies. If one company goes up by 3%, but another goes down by 2%, you're still up by 1%.
Buffett is a fan, too: "Consistently buy an S&P 500 low-cost index fund," he told CNBC's "On The Money" in 2017. "I think it's the thing that makes the most sense practically all of the time."