This is our next lesson regarding investments. It will be about the Golden Rules, or The Commandments Of Investor. Do not treat this list as just nice-to-know stuff: all these rules are written not in ink, but in sweat, blood and tears of many-many investors. Moreover, one of these rules is extremely important for us as for fundamental investors – I will stress it out later on in this lesson. Off we go!
We will start from briefly listing the Rules. Here they are:
- Be ready for losses;
- If you can’t afford to lose this money, refrain from investing it;
- Nobody can predict financial future;
- Invest only in what you understand;
- Ideally, you should invest in the companies which can be managed by a complete moron;
- Don’t be too agressive: most companies in your portfolio should give you stable income;
- Don’t have too many companies in your portfolio: you must be able to pay attention to each of them;
- Diversify if not confident enough.
Investing or business without losses is an oxymoron or Utopia. Nobody can always win in investments world. I can’t remember who said that, but the quote illustrates this fact:
Each entrepreneur at home has a sack, tied up with a red band. This sack contains the shares of companies he owned and which went to wall.
I have a collection of stocks like that too. Even though I don’t have them in flesh – they are all physically were at my brokerage accounts – but I have a list of my investments failures with important conclusions beside each one. I call it my Cemetery of Idiot’s Dreams. Second Cup, Real Goods Solar, GII.UN – to name a few. They either a result of over-excitement and reckless speculations or trace their roots into the times, when I knew too little about fundamental investing. Anyway, I will conclude this part with the words of an old and wise Jewish saying:
Thank you, Lord, that you took just the money!
The rule “Don’t be too aggressive” also reads as “Avoid too risky companies”. How to measure the risk? In a way it is already statistically measured by such ratio as Beta. Beta measures volatility of the particular stock in comparison to the market. Beta = 1 means that it behaves exactly as the whole market; Beta = 10 means that this stock will react by 10% change in return to 1% of corresponding market change. So, another reading of the same rule: avoid companies with too high Beta. And, of course, if you speculate and you are aware of what you are doing, this rule is not applicable.
Once again, most of the companies in your portfolio should give you stable not-risky income.
Problem #7: Take a couple of companies – first to pop into your mind. Please find out their Betas.
Again, another very Captain-Obvious rule: if cannot afford to loose this money, do not even think of investing it! This an extreme edition of more general principle:
Your investment vehicle must correspond to your goals and time horizon.
An example: you need to buy a car in 2 years. It would be a very risky move to invest the money into stocks or mutual funds in this case: if the market goes down, your investment will shrink accordingly, and, if it happens, because of short time span, the market will highly unlikely recuperate by the time you need the money. Some may say: “Yeah, but I will invest into blue chips only!” That’s good, but the market risk affects them as well. Of course, they will probably be less impacted by any crisis and will recover very soon, but all this requires time (and since you need a car in 2 years, you may not want to wait, say, 4 years).
We will talk about diversification in more details later. Just couple of recommendations here.
First – companies in your portfolio should belong to ideally absolutely different sectors and industries (the less interconnected they are – the better).
Second – statistics says that the portfolio of 20 companies is almost same good as the whole market index. Provided, of course, that they belong to not-very-interconnected sectors and industries.
Third – 20 companies in the portfolio is already too many for a newbie and non-professional. 10-12 is already enough for a quite good diversification, but much easier to maintain.
Nobody in the financial world can predict the future, including interest rates, stock quotes, oil and commodities prices, market dynamics, frenzies and crises, future values of volatility index and so on. Nobody, including fund managers, journalists and financial experts etc. So, please adjust your expectations accordingly! Don’t get me wrong, you will be able to make educated decisions, relying onto fundamental analysis and common sense, and they will be accurate to certain extent. But nobody can guarantee you anything, so, don’t trust “gurus”.
This doesn’t mean that you need to be a doctor to invest into pharmaceuticals or a programmer to invest into IT etc. This rule should read: Know the nature of business! An extreme edition of this rule:
Never invest in any idea you can’t illustrate with a crayon. (Peter Lynch)
If someone offers you to buy a shop at the corner, you probably will ask a lot of questions (like what revenue it generates, how much is the rent etc), but the first question probably will be: “What does this shop sell?” But by some strange reason people forget to ask the same question about the companies when it comes to buying them at stock market. Never invest if you don’t understand the nature of business.
By the way, approximately 40-50% of my bad investments (see the Cemetery of Idiot’s Dreams above) in the past can be at least partially explained by not following this simple rule!
Do you remember that in the very beginning of this lesson I said that one of these rules is extremely important for us as for fundamental investors? This is exactly this one!
And now a fly in the ointment: this rule is easier said than done. Sometimes we think that we know what the companies are doing, but in fact we don’t. For example…
Problem #8: What is the main business of McDonald’s?
Problem #9: What is the main business of payroll companies? Say, ADP?
Another principle is best explained by Peter Lynch:
Owning stocks is like having children – don’t get involved with more than you can handle.
In our case to handle means at least to read annual reports and follow the major news which can affect the business of them.
This is the only nice-to-follow rule here. But it is important though. When you assess any business, it is very important not only to make sure that it has a durable competitive advantage, but also that this advantage doesn’t require too much of:
- research and development;
- capital expenditures;
- sophisticated management.
To illustrate this: X is a top-notch software company with durable competitive advantage and perfect management. Company Y is a tobacco company. Y also has a durable competitive advantage. All else being equal, which of them is more moron-resistant in terms of management? Look at X, with its short lifespan of the products, tons of research and development and a cut-throat competition from other rivals – it must be very management-sensitive as opposed to Y.
Ideally, you should invest in the companies which can be managed by a complete moron…
By the way, I like the continuation of this phrase: because sooner or later any of them can get a CEO who is not as bright as a bulb!
The last but not the least – Test yourself at Golden Rules of Investor Quiz if you have digested this article successfully.