Ritholtz’s rules of investing (part II)

Ritholtz’s rules of investing (part II)
Barry Ritholtz
October 12 2012

This week, we’re going to pick up with my rules for investing. These rules come from 20 years of experience – or 20 years of learning from my own mistakes. My list is designed to help you understand what you face as an investor and avoid the sorts of errors that cost many investors a lot of money. Understanding the philosophy here will result in fewer losses, better performance and more restful nights.

Because I didn’t want to overwhelm you, I broke the list into two parts. Before we get to this week’s list, you can read the first part here. For those reading this in the newspaper, those six rules were:

1. Cut your losers short, and let your winners run.

2. Avoid predictions and forecasts

3. Understand crowd behavior.

4. Think like a contrarian.

5. Asset allocation is crucial.

6. Decide if you are an active or passive investor.

Let’s move on to part two:

7. Understand your own psychological make up. Most investors think they are competing against other traders, big institutions, hedge funds etc. In fact, they 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. You can counter these foibles only if you are aware of them.

8. Admit when you are wrong. One of the biggest problems many investors have is admitting they made a bad investment. Men, suffering as they do from testosterone poisoning, are especially bad at this. Whether it’s ego or just stubbornness, too many people seem to hold on to their losers for way too long. Pride can be a very expensive sin.

The most effective approach is to admit your error, fix the mistake, then move on.

Think of investing as more akin to batting in baseball than to being a lawyer, accountant or doctor. If you are a .333 hitter – if you get a hit one out of three times at bat – you are an all-star ball player. A doctor who loses two-thirds of his patients or an accountant who has 66 percent of his clients audited are both doing something terribly wrong.

We have a saying in my office called “strong opinions weakly held.” We may have a high degree of confidence in a particular investing theme – say, emerging markets dividends or municipal bonds – but as soon as we have proof we are wrong, we reverse the position, sell the holding and move on.

I believe in admitting errors and, in fact, each year I publish a list of mea culpas – describing my worst investing errors. I explain what I did wrong and what I learned from it. It may be human to make mistakes, but it is foolish to make the same ones over and over. Try making some new mistakes instead.

9. Understand the cycles of the financial world. Another challenging thing to do in investing is to reverse your thinking, especially after a specific approach has been profitable for a long time. The longer the period of successful thinking, the more important – and challenging – the reversal will be.

Pay attention to history, and you learn that events move in long, irregular cycles. We have the business cycle, which alternates between periods of expansion and contraction. Recessions happen, as do recoveries.

Then there is the market cycle, where booms and busts occur regularly. Every bull market is followed by a bear; every bear market is followed by a bull. This can be difficult to remember when you are in throes of either one. It seemed in 1999 that almost no one could imagine that the manic price rises of the market would ever end.

And in late 2008 and early 2009, it looked like the vicious market collapse would never end. But it did – and it always does.

“This too shall pass” is a proverb that humbled King Solomon. Understand what it means when you mistakenly believe something will never change.

10. Be intellectually curious. There is a tendency amongst investors to settle into a comfort zone. You develop a particular style, find an investing method you like – and then think it will last forever. This is a recipe for slothful calcification.

Heraclitus was a Greek philosopher whose doctrine of flux stated “The only constant is change.” This is especially true in investing. The many different inputs that drive market returns constantly change. At various times, it can be profits, the Fed, the economy, interest rates, technology, tax policy, etc. 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.

11. Reduce investing friction. Friction refers to all of the little costs that, when compounded over time, can add up to big dollars. 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.

Since 1974, the markets have returned about 10 percent a year. The average 401(k) retirement account earned about 3 percent annually over that period. There are numerous reasons these portfolios radically underperformed the markets, but one of the primary reasons is the layers of excess fees and fund loads.

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.

12. 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. Consider:

That hot stock tip? You want the upside without doing all of the tax research.

High-yield junk bonds? Some people believe that an 8 percent yield when the 10-year Treasury is paying 1.62 percent does not come with an increased risk of default. They are mistaken.

Sitting in way too much cash? It creates a false illusion of safety that will not keep up with inflation.

No one on television is going to make you wealthy. There is no magic formula or silver bullet or secret hedge fund.

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.

~~~

Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. You can follow him on Twitter: @Ritholtz. For previous Ritholtz columns, go to washingtonpost.com/business.