Each time we invest, we must be prepared to live with the consequences and hold ourselves accountable for the results. Therefore, it’s essential to invest with a set of principles that in no way guarantee success but help avoid many common pitfalls. The principles below are those we recommend for all investors and readers of Market Realist.
The Realist Principles
1. Long-term investing
There’s a clear correlation between the amount of trading by individual investors and their returns. For example, a team from UC Berkley reviewed brokerage accounts for over 65,000 U.S. households from 1996 to 1999. This study found that the one-fifth of investors with the longest-term investments outperformed the one-fifth of investors with the shortest-term investments by 71% annually. This research team summarized, “Our central message is that trading is hazardous to your wealth.”
2. No leverage
Borrowing money is a dangerous form of investing. It’s very easy to lose everything due to margin requirements. For example, taking 10:1 leverage with a margin call would involve losing 100% of your investment when the value of your investment decreases by more than 10%. For investors with leverage who wish to maintain a stable debt-to-equity ratio, the picture is also very troubling. When their portfolio value falls, investors must sell their positions to maintain the same ratio of debt to equity value. Therefore, using leverage often forces investors to make poor investment decisions by selling when the market is low, increasing overall portfolio risk.
3. No shortcuts
There are no shortcuts to investing. It takes hard work to produce results, and we won’t tell you otherwise. Many investment websites promise easy returns, but we know you’re smarter than that and recognize there’s no free lunch.
4. Don’t panic
The standard deviation for investing in the stock market, as measured by the S&P 500 index during the ten-year period from 2003 to 2012, is 20.3% annually. Therefore, investors shouldn’t be surprised when prices grow or fall rapidly. When the market hits a bottom, you can buy more at cheap prices. If the market grows, this means the value of your investments increased substantially. Whatever happens, have a plan and be careful not to overreact.
5. Keep it simple
Complexity can often introduce more risks. Avoid esoteric assets such as complex stock options, individual small-cap companies, leveraged funds, foreign currencies, and other complex investments. While they may sometimes be appropriate for professional investors, it’s often easier for individual investors to quickly lose their money on these schemes.
6. Don’t invest in securities you don’t understand
Even if you’re investing in a large-cap company or major ETF (exchange-traded fund), be sure to adequately research the investment until you feel confident making a decision. We try our best to point out the key factors affecting valuations of investments; however, we aren’t built to be a standalone source of information to help you form investment decisions. Try to read Market Realist research and analysis in addition to researching other investment sources and exercising your own independent judgement.
7. Don’t copycat invest—do what’s right for you
Various investment strategies involve replicating the trades of famous investors or hedge funds. However, it’s not always possible to know whether the investor’s also betting against (or hedging against) the same company. Furthermore, the investor may have acquired the security at a lower price or have a reason for buying that’s unique to their investment strategy.
8. Be conservative
Making money is much more difficult than losing it. For example, assume you make ten investments for $10,000 each. Nine of these return 10%, and the tenth loses 100%. Then you have actually lost $1,000 plus trading fees and your time. The sting of one bad bet can wipe out all your earnings. As famous investor Warren Buffett once said, ”Rule No.1 is never lose money. Rule No.2 is never forget rule number one.”
9. Avoid fees
Fees can have an unexpectedly huge impact on overall investment performance. For example, a $100,000 investment over ten years with a 6% annual return and 2% annual fee would generate a $46,000 profit. With no annual fee, the same investment would generate a $79,000 profit. That $33,000 difference is enough for a new car. For time horizons longer than ten years, the effect is much greater. Fees to avoid include unnecessary trading costs, management fees, and front-load fees.
10. Passive investing generally outperforms active management
Active investing, such as through mutual funds, involves higher fees and generally worse performance. The average total return (after fees and dividends) for the period from 2005 to 2012 for U.S. actively managed mutual funds was only 2.47%. During the same period, the total return for ETFs was 40.59%. By focusing on passive investing, we believe investors are likely to fare better than they would with active mutual fund investments.
11. Think for yourself
The most selling activity tends to occur when the stock market falls, and the most buying activity tends to occur when the market prices increase. Herd mentality is often described as anthropologic and natural in all of us. However, to be successful, investors we must resist the urge and make decisions about the direction of the markets based on data, not feelings or what other people say.
12. Don’t be overconfident
Skepticism is a healthy trait for an investor. When we convince ourselves that we’re right, we can be close-minded to contradictory information that might not support our conclusions (this is known as selection bias). While confidence is important to becoming successful and following a consistent investment strategy, it’s important to always be willing to consider relevant primary data with an open mind as it becomes available.
Finally, we urge you to heed the words of Ray Dalio, famous investor and founder of Bridgewater, one of the world’s most successful hedge funds: “Hyperrealism is the best way to choose and achieve one’s dreams… Success is achieved by people who deeply understand reality and know how to use it to get what they want.” The purpose of Market Realist is to help investors deeply understand reality, and we urge you to heed our investment principles in exploiting market truths.