Rules of Investing


Avoid predictions and forecasts: Humans are very bad at guessing what the future will bring. For your own investing, you should ignore other people’s forecasts. And you should avoid making any yourself. No one on television is going to make you wealthy. There is no magic formula or silver bullet or secret hedge fund.

Admit when you are wrong: One of the biggest problems many investors have is admitting they made a bad investment. Whether it’s ego or just stubbornness, too many people seem to hold on to their losers for way too long. Cutting your losers short forces you to be humble and intelligent. It rotates you away from the sectors and stocks that are not working. Best of all, you are forced to admit your own fallibility — crucial for all investors.

Understand crowd behavior: The psychology of crowd behavior is such that higher prices attract more buyers — and lower prices create sellers. Fear of missing a rally is a powerful element; fear of losses is even stronger.

Asset allocation is crucial: What is your relative weighting of stocks, bonds, real estate and gold? All of the academic studies show that it’s the most important decision an investor makes. It’s far more important than stock / fund selection. The weighting you select for various asset classes is a function of such factors as your age, income, risk tolerance and retirement needs. It is what serious investors focus on.  Stock / Fund picking is for fun. Asset allocation is for making money over the long haul.

Understand your own psychological make up: Most investors are their own most dangerous opponent. Why is that? It is because of the way we are wired. We fall prey to all sorts of cognitive errors. We are overconfident in our abilities to pick stocks, time the market, know when to sell. We suffer from confirmation bias, seeking out that which agrees with us and ignoring facts that challenge our views. We vacillate between emotional extremes of fear and greed. We are surprisingly risk-averse, and at precisely the wrong times. The recency effect has us overemphasizing recent data points while ignoring long-term trends. Our own cognitive and psychological errors often lead us down the wrong path. We have difficulty conceptualizing long arcs of time. We selectively perceive what agrees with our pre-existing expectations and ignore things that disagree with our existing beliefs. We tend to forget our losers and overemphasize our winners. You can counter these foibles only if you are aware of them.

Confusing past performance with future potential: This warning is routinely ignored by investors. Consider this,when Value Research or Morningstar gives a mutual fund a five-star rating, the fund attracts lots of new investors and fresh rupees. The primary factor in the rating is (can you believe it?) past performance. This despite a Morningstar study that found that five-star funds mostly underperform.

Be intellectually curious: There is a tendency amongst investors to settle into a comfort zone. It is important that you constantly upgrade your skill set, while learning to be both adaptive and flexible. The best investors all have a healthy dose of intellectual curiosity. If everything else is changing, but you are not, then you are being left behind.

Reduce investing friction: Friction refers to all of the little costs that, when compounded over time, can add up to big money. In investing, friction refers to anything that is a drag on total returns outside of market performance. Think about the long-term effects of the fees, costs, expenses and taxes on your net, above and beyond how your investments did. Investors with lower costs tend to have better growth and retain more of their assets over the long haul. Keep your fees, costs expenses and taxes low. It is a guaranteed way to improve your returns.

There is no free lunch: This is the most fundamental rule in all of economics. It gets forgotten by too many investors. The temptation is to get something for nothing. You never get something for nothing. Sitting in way too much cash? It creates a false illusion of safety that will not keep up with inflation.

The best investors generate long-term returns by making rational, unemotional decisions. They do their homework, spend time and effort learning the basics. They are unemotional, intelligent and patient. You can be as well.



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