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October 1, 2012

6 rules of investing

NEW YORK — Each year on the Big Picture, the blog I call home, I update my top trading rules and aphorisms. It's a collection I have gathered over the years of my favorite trader, analyst, economist and investor viewpoints on what — and what not — to do when it comes to investing in the capital markets.

Whenever I publish a list like this, someone invariably asks: "You have been at this for 20 years, what have you learned over that time?"

Fair enough. You could probably cobble together my guide from what I've written for The Washington Post. Let me save you the trouble. Here is the first half of my dozen rules for investing.

1. Cut your losers short and let your winners run: Perhaps the best investing advice ever, its sophistication is belied by its apparent simplicity.

Letting your winners run generates all sorts of desirable outcomes: It allows compounding to occur, gives you the benefit of time and keeps your transaction costs, fees and taxes low. Since this rule does not allow you to take a quick profit for no reason, it also forces you to develop an actual exit strategy.

Similarly, 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.

2. Avoid predictions and forecasts: Humans are very bad at guessing what the future will bring. The academic literature overwhelmingly proves this.

If you prefer anecdotal evidence, recall how many economists forecast the Great Recession (almost none), the initial reviews of the iPad (mostly panned) or even the iPhone (meh!).

For your own investing, you should ignore other people's forecasts. And you should avoid making any yourself. Why? Because when investors make forecasts they focus more on being right than making money. They unconsciously shift their portfolio toward their predictions rather than what is occurring in the markets. This is a recipe for disaster. Consider how many people completely missed the huge rally since the March 2009 lows, mostly because of forecasts of another crash.

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