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…Investing is about managing risks that will substantially reduce your ability to “stay in the game long enough” to “win” so how do you navigate volatile markets and stay within the “probabilities” of outcomes when emotions run high? [This article presents]…ten basic investing rules that have historically kept investors out of trouble over the long term. These are not unique by any means but rather a list of investment rules that, in some shape or form, have been uttered by every great investor in history.
What follows is an edited ([ ]) and abridged (…) version of an original article from realinvestmentadvice.com to provide the reader with a faster and easier read.
Investing Rule #1: You Are A “Saver” – Not An Investor
…If you ask most people if they would bet their retirement savings on a hand of poker in Vegas, they would tell you “no.” When asked why, they will say they don’t have the skill to be successful at winning at poker. However, daily, these same individuals will buy shares of a company in which they have no knowledge of operations, revenue, profitability, or future viability simply because someone on television told them to do so.
Keeping the right frame of mind about the “risk” that is undertaken in a portfolio can help stem the tide of loss when things inevitably go wrong. Like any professional gambler – the secret to long-term success was best sung by Kenny Rogers; “You gotta know when to hold’em…know when to fold’em.”
Investing Rule #2: Don’t Forget The Income
An investment is an asset or item that will generate appreciation OR income in the future. Little diversification is left between asset classes in today’s highly correlated world. Markets rise and fall in unison as high-frequency trading and monetary flows push related asset classes in a singular direction. This is why including other asset classes, like fixed income, which provides a return of capital function with an income stream, can reduce portfolio volatility. Lower volatility portfolios will consistently outperform over the long term by reducing the emotional mistakes caused by large portfolio swings.
Investing Rule #3: You Can’t “Buy Low” If You Don’t “Sell High”
Most investors do fairly well at “buying” but stink at “selling.” The reason is purely emotional, driven primarily by “greed” and “fear.” Like pruning and weeding a garden, a solid discipline of regularly taking profits, selling laggards, and rebalancing the allocation leads to a healthier portfolio over time…
Investing Rule #4: Patience And Discipline Are What Wins
Most individuals will tell you they are “long-term investors.” However, as Dalbar studies have repeatedly shown, investors are driven more by emotions than not. The problem is that while individuals have the best of intentions of investing long-term, they ultimately allow “greed” to force them to chase last year’s hot performers. However, this has generally resulted in severe underperformance in the subsequent year as individuals sell at a loss and then repeat the process [and] this is why truly great investors stick to their discipline in good times and bad. Over the long term – sticking to what you know and understand will perform better than continually jumping from the “frying pan into the fire.”
Investing Rule #5: Don’t Forget Rule No. 1
As any good poker player knows, you are out of the game once you run out of chips. This is why knowing both “when” and “how much” to bet is critical to winning the game. The problem for most investors is that they are consistently betting “all in, all of the time” as, over time, the “fear” of missing out in a rising market leads to excessive risk buildup in portfolios. It also leads to a violation of the simple rule of “sell high”…
Investing Rule #6: Your Most Irreplaceable Commodity Is “Time.”
Since the turn of the century, investors have theoretically recovered from two massive bear market corrections. After 15 years, investors finally returned to where they were in 2000. Such is a hollow victory when considering that 15 years to prepare for retirement are gone. Permanently.
For investors, getting back to even is not an investment strategy. We are all “savers” with a limited amount of time to save money for our retirement. Those retirement plans were vaporized if we were 15 years from retirement in 2000. Could such an environment happen again? Absolutely. It is ultimately a function of valuations. Will it happen? No one knows.
Do not discount the value of “time” in your investment strategy.
Investing Rule #7: Don’t Mistake A “Cyclical Trend” As An “Infinite Direction.”
An old Wall Street axiom says the “trend is your friend.” Unfortunately, investors repeatedly extrapolate the current trend into infinity. In 2007, the markets were expected to continue to grow as investors piled into the market top. In late 2008, individuals were convinced that the market was going to zero. Extremes are never the case. The same occurred at the bottom of the market in March 2020.
It is important to remember that the “trend is your friend.” That is, as long as you pay attention to it and respect its direction. Get on the wrong side of the trend; it can become your worst enemy.
Investing Rule #8: Success Breeds Over-Confidence
…When the markets are rising, most individuals’ success breeds confidence. The longer the market rises, the more individuals attribute their success to their own skills. The reality is that a rising market covers the multitude of investment mistakes individuals make by taking on excessive risk, poor asset selection, or weak management skills. These errors are always revealed by the forthcoming correction.
Investing Rule #9: Being A Contrarian Is Tough, Lonely & Generally Right.
Howard Marks once wrote that:
“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’)
Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”
Historically, making the best investments occurs when going against the herd. Selling to the “greedy” and buying from the “fearful” are extremely difficult things to do without a very strong investment discipline, management protocol, and intestinal fortitude. For most investors, the reality is they are inundated by “media chatter.” That “noise” keeps them from making logical and intelligent investment decisions regarding their money, which, unfortunately, leads to bad outcomes.
Investing Rule #10: Comparison Is Your Worst Investment Enemy
The best thing you can do for your portfolio is to stop benchmarking against a random market index. That index has nothing to do with your goals, risk tolerance, or time horizon. Comparison in the financial arena is the main reason clients have trouble patiently sitting on their hands, letting whatever process they are comfortable with work for them. Unfortunately, some comparison along the way causes investors to lose their focus… The only benchmark that matters is the required annual return to obtain your future retirement goal. If that rate is 4%, then trying to obtain 6% more than doubles the risk you have to take to achieve that return. The end result of taking on more risk than necessary will cause you to deviate from your goals when something inevitably goes wrong.
It’s All In The Risk
Robert Rubin, former Secretary of the Treasury, changed the way I thought about risk when he wrote:
“As I think back over the years, I have been guided by four principles for decision making.
- First, the only certainty is that there is no certainty.
- Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecast. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty.
- Second, every decision, as a consequence, is a matter of weighing probabilities.
- If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.
- Third, despite uncertainty we must decide and we must act.
- Lastly, we need to judge decisions not only on the results, but on how they were made.”
It should be obvious that an honest assessment of uncertainty leads to better decisions, but the benefits of Rubin’s approach go beyond that.
- Although it may seem contradictory, embracing uncertainty reduces risk while denial increases it.
- Another benefit of “acknowledged uncertainty” is it keeps you honest.
A healthy respect for uncertainty and a focus on probabilities drives you never to be satisfied with your conclusions. It keeps you moving forward to:
- seek more information,
- question conventional thinking,
- continually refine your judgments,
- and understand that certainty and likelihood can make all the difference.
The reality is that we can’t control outcomes; the most we can do is influence the probability of certain outcomes, which is why the day-to-day management of risks and investing based on probabilities rather than possibilities is important not only to capital preservation but to investment success over time.