Investment Rules That Everyone Should Follow

Saturday, September 1, 2012, 2:00 AM | Leave Comment

Making 30%+ yearly returns as an individual investor, Tony from A Young Investor writes about investing, the financial markets, and economics.

Starting out as an investor, no one gave me a list of “Rule #1, Rule #2, Rule #3….”, so I had to learn from my own mistakes and the mistakes of others. And make mistakes I did, but fortunately, I’ve managed to learn from my mistakes.

Many investors are stuck in the beginner stage because they can’t acknowledge the following fundamental truths:

Do Not Oversimplify Things

Many investors make the mistake of oversimplifying things – if the asset is cheap, than it’s a buy. If it’s expensive, then it’s a sell. However, what they don’t realize is that the words “cheap” and “expensive” are all relative terms. If a stock was trading at a P/E ratio of 40 – 1, then it must be cheap at a 30 – 1 ratio, as most investors believe. Not so! A cheap stock can get cheaper, and an expensive stock can get more expensive. In most cases, there are reasons why certain stocks are “cheap” and others are “expensive”.

For example, take Research In Motion, whose P/E ratio is at a meager 7 – 1. Investors who oversimplify things would take this low P/E as a sign to buy Research In Motion. But because they’re oversimplifying things, they’re missing a big part of the picture – RIM is dying and its market share is shrinking, which is why investors have driven RIM to such a low price – RIM might disappear in the future.

On the other hand, companies such as Google have “high” P/E ratios in the 25 – 1 range. Investors who oversimplify things will sell the company, but a shrewd investor will take a closer look. Since Google’s business is very steady, and has no competitors nearly as good, maybe GOOG will constitute a “buy” signal.

Disclaimer: I use Research In Motion and Google merely has examples for the sake of this post – I have no position in either of the stocks.

You See What You Want to See & Believe What You Want To Believe

This problem has existed since the beginning of humanity – we humans want to see what we like to see and tend to discard what we don’t want to see. In the world of investments, many investors make the same mistake. If they’re bearish, they’ll look at everything as a bearish signal and if they’re feeling bullish, they’ll look at everything as a bullish signal.

So how does one overcome this problem? Use a strict model. For example, my investment model classifies data into “Positive, Negative, and Neutral”. That way, my market opinion doesn’t make me blind to the other side – my model will automatically categorize information based upon cold, sound numbers. For example, if PMI hits a certain number, I’ll know if that’s a Positive, Negative, or Neutral sign.

Speaking of investment models, check out my post on Basic Investment Rules Part 1.

Timing is Critical

Many investors buy a stock when it’s cheap, thinking “if this doesn’t work out, I’ll hold it until it does work out”. Great! But don’t forget – you can be holding onto a money losing position for a long time, and time is something that no one has enough of. By holding onto a money losing position for a few years, you would have made more money putting the money into the bank, which gives an interest of 1% a year. Timing is everything, and this doesn’t just apply to investing. In the world of business, business ideas that are too early or too late will not become successes.

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