Rules of Investing

Barry Ritholtz has a great list of investing rules, originally posted in two parts with descriptions in the Washington Post here and here. He recently reposted the consolidated list on his blog, The Big Picture, and it’s too good not to share. Every investor has their own process and decision-making rule set (or at least should), and while there’s no one approach that’s right, there are plenty that are wrong.

Barry’s rules, at least in my opinion, are effective guides to help avid common mistakes and pitfalls. They’re broad enough that I think they’re applicable to investment activities ranging from managing a personal 401k or IRA all the way up to running a hedge fund or advisory firm. At the risk of upsetting his attorneys*, here’s the list:

1. Cut your losers short, and let your winners run.
2. Avoid predictions and forecasts
3. Understand crowd behavior.
4. Think like a contrarian (but don’t always act like a contrarian).
5. Asset allocation is crucial.
6. Decide if you are an active or passive investor.
7. Understand your own psychological make up.
8. Admit when you are wrong.
9. Understand the cycles of the financial world.
10. Be intellectually curious.
11. Reduce investing friction.
12. There is no free lunch.

The most common question people ask me about investing is whether I think the market will go up or down over a certain period of time. My answer is always that I have no basis to know, and anybody who says they do is either lying or breaking the law (or both). Barry’s rule #2 sounds simple, but it might be the most important one to me. There’s a big difference between making thoughtful investment decisions based on an understanding the current market environment, and basing investment hypotheses on some (misguided) belief that you have a unique ability to predict the future. Sometimes speculators get lucky, but over the long-run it seems that speculating is generally not a very successful strategy.

*I once quoted a post from Barry’s blog (with proper citations and references) and got a slightly threatening, but lighthearted email telling me that I was violating their intellectual property rights, and that I should take the post down and never do such a thing again. To me, quoting someone else’s blog is usually a nice gesture. We’ll see what happens this time.