Kuta Beach

Kuta Beach

Sunday, 4 July 2010

Fundamental Rules of Investing

I've been investing for maybe four years now and I have been moderately successful, although one could argue that my moderate success is due to luck rather than skill. I do believe that investing is about 50 per cent skill and 50 per cent gambling. Good investing can be achieved if you research a particular asset before investing in it, but there will always be things that affect your investments that are unpredictable and out of your hands.

Based on my experience, I think there are three important rules of investing:
  1. diversify
  2. research
  3. think negative
  4. keep costs low (but don't overdo it).
Diversification is obvious. It pretty much states that you should not put all your eggs in one basket. That is, if you are buying assets for investment, spread your money out around multiple assets. If one or a few investments fail, you won't be hurt as badly. Many people think that simply owning 15 stocks or putting money into an index fund gives enough diversification, but in my opinion it is always better to overdiversify. The aim really is to buy everything, not only stocks from your local stock exchange but also foreign stocks, bonds, and even precious metals. The virtues of diversification are even in the bible. Ecclesiastes 11:2 states, "Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth." The world's richest man Warren Buffett states, "Diversification is a protection against ignorance." Since most of investing is done in ignorance (remember what I said about investing being 50% gambling) I recommend that you err on the side of caution and overdiversify rather than underdiversify.

Another important aspect of investing is research. When I quotes Warren Buffett earlier, I didn't quote him fully, so here is what Buffett said about diversification in full: "Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing." Warren Buffett recommends that your average small investors should diversify because they are ignorant. Warren Buffett does not diversify. His investments are highly concentrated among perhaps 20 or so companies. What makes Buffett such a great investor is his ability to research companies and forecast whether they are good or bad. This brings me to the next fundamental rule of investing, which is research. You must try to read about your investments as much as possible. You should try to keep up with business and political news to know the major trends and what is happening. In a Forbes interview, Warren Buffett spoke about how much emphasis he puts on reading and research: "I just read. I read all day. I mean, we put $500 million in PetroChina. All I did was read the annual report." To diversify our quotes, Ecclesiates 7:12 of the bible states the following: "Wisdom keeps a man from danger as much as money does." This rule is at odds with the first rule. If you research something and find that it is good, it is a good idea to invest more in it.

Another advice I recommend is to assume your investments are guilty until proven innocent, i.e. employ negative thinking. Many investors grow to love their investments and start to become very emotional about them. Many investors often talk about how great their investments are, how perfect it is, and so forth. If you find yourself having too much faith in a particular investment, it is necessary to attack it yourself in order to test it. For example, if you find yourself going very heavily into stocks, you need to ask yourself questions such as whether these stocks guaranteed to perform well in the long run or whether your investment really is safe or whether you are just gambling your money. It is human nature to have faith in something you have invested heavily in. A wife in love with her husband is naturally going to want to believe that he is faithful. The reason why we humans do this is because it is painful to think about the consequences of investment failure. But being blind to risk is extremely dangerous in investing. To conclude, it is best to diversify, but if after you research something you start to invest heavily in it, train your mind to critique the investment and only continue to invest in this asset if you are absolutely sure. Otherwise, diversify. When I recommended this rule of a friend at work, she told me that this rule violates a book she just read called The Secret. According to this book, in order to be successful you have to imagine that you are successful in your mind and then the law of attraction will make whatever you are thinking about happen in real life. This is absolutely stupid! Can you imagine a person in the late '90s borrowing millions of dollars from the bank and then investing all that money into Enron stocks and then visualising in her head Enron stocks going up. Enron stocks would collapse and she would lose all her money and have a mountain of debt that will enslave her for the rest of her life. Just because she visualised in her head that Enron stock prices went up does not make Enron stock prices go up. This is insane! Negative thinking is good risk management. All good companies do it. Donald Trump is also a negative thinker, having said the following: "It's been said that I believe in the power of positive thinking. In fact, I believe in the power of negative thinking. I happen to be very conservative in business. I always go into the deal anticipating the worst. If you plan for the worst--if you can live with the worst--the good will always take care of itself." In other words, negative thinking in business and invesment encourages prudent and conservative behavior whereas positive thinking encourages reckless cowboy behavior.

Another advice is to keep costs low. This means keeping an eye on investment fees. This rule is important but it's important not to overdo this because many expensive investments are expensive for a reason.

No comments: