Ten Investing Rules That Sum It All Up

Investing Rules #1 — Don’t invest in what you don’t understand.

When stock prices go down, where does the money go? If you don’t possess a complete understanding of the answer to that question, you do not know enough about stocks to invest in them.

Investing Rules

It’s not enough to kinda sorta understand an asset class in which you are invested. You must truly understand how that investment choice works if you are to have the confidence needed to stick with it through hard times.

Investing Rules #2 — Maxims and rules of thumb have limited value.

The purpose of maxims and rules of thumb is to present a simplified take on reality. There’s value in that. The human mind can only take in so much information at once. Maxims and rules of thumb help us to recognize important realities by focusing on the truth being conveyed while leaving out the detail.

Maxims and rules of thumb rarely express complete truths. Please be wary. Listen to maxims and rules of thumb. Do no come to accept them as gospel truths. Do not employ them in circumstances in which their core insight does not apply.

Investing Rules #3 — The 80/20 rule applies.

Most people are reluctant to try to learn about investing because it sounds complicated. There are indeed aspects of the investing project that are complicated. You don’t need to know about that stuff. If you come to possess a sure grasp of the basics, you will know more than 80 percent of investors. It does not take much work to learn the basics. Putting in 20 percent of the time that it would take you to know everything there is to know about investing will put you ahead of 80 percent of investors.

Investing Rules #4 — Investing takes place in the real world.

All of us know a good deal about how to buy stuff as the result of our experiences in a place we fondly refer to as “The Real World.” Many of us disregard many of the lessons we have learned when we enter InvestoWorld because “experts” tell us that the rules are different in InvestoWorld. No. InvestoWorld is part of The Real World. Investing strategies that do not pass The Common-Sense Test should be disregarded, no matter how many Big-Shot Experts endorse them.

Investing Rules #5 — Some investing realities are counter-intuitive.

InvestoWorld is part of The Real World. It doesn’t follow that every investing reality is immediately obvious to us. All investing realities are understandable. There are cases in which it takes a little bit of thought to come to an understanding of an investing reality.

Do investors who take on more risk obtain higher returns? The Common-Sense Rule at first might suggest to us that this should be so.

It’s not so, at least not always. If investors were always entirely rational, they would insist on being compensated for taking on risk. In the real world, investors are not always entirely rational. Investors sometimes choose asset classes that carry high levels of risk but that offer low long-term expected returns.

Rules of Investing

There is no real conflict with The Common-Sense Rule here. Don’t people sometimes make bad choices in dating or in their eating habits or in the clothes they wear? We’re humans, not robots. Emotions are a factor. That’s so with investing too. Adopting a common-sense take does not mean denying that emotions affect human decision-making.

Investing Rules #6 — There is no One True Way.

Is there one type of house that is better than all the others? Is there one type of spouse that is better than all the others? Is there one type of mouse that is better than all the others?

These are stupid questions.

There is no one investing approach that is better than all the others.

There might be one that today is best for you. Your circumstances might change. You might need to mix in some strategies used by those following other approaches. Start thinking that the approach you use today is the one that is always best for everyone and you lose access to the insights being developed by the millions of people following other approaches. Dumb.

Investing Rules #7 — The bottom line is not obtaining a good return.

The bottom line is living a good life. The purpose of investing is to supply you with the income stream you need to help you live a good life.

Getting mixed up on the core goal of investing can lead to all sorts of confusion and trouble.

Returns are quantifiable. The “good life” concept is not. We are all drawn at times to seek assurances that we have made good decisions by reducing things down to their quantifiable elements. If your friend obtained a better return than you, it may be because he took on a level of risk not appropriate for you. The fact that your return is smaller does not show that your choice was bad.

Assessing investment strategies by comparing the returns they have provided over short time-periods is like assessing potential marriage partners by comparing their “vital statistics.” Super-dumb.

Investing Rules #8 — Long-term investing is something entirely different.

What Works in Investing

“Buy-and-hold” has become a popular catch-phrase. Most of today’s investors think of themselves as long-term buy-and-hold investors.

The reality is that we are still in the early days of coming to understand what it means to be a true long-term buy-and-hold investor. We call ourselves long-term investors. But we assess strategies by looking to short-term results (results for time-periods of less than 10 years).

Long-term investing works. There is a lot more to it than most people realize.

Investing Rules #9 — It’s not just about retirement.

We don’t save only to retire. We don’t invest only to retire.

Stocks today (this article was posted in January 2007) offer a poor value proposition over a 10-year time-period. Stocks today offer a good value proposition over a 30-year time-period. Does it follow that, if you are 35 and do not expect to retire until you turn 65, you should be invested mostly in stocks? I say “no.”

Your accumulated savings will do a lot of good things for you between now and the day you retire. It might help you buy a bigger house. It might help you start your own business. It might protect you from worry about a recession or a corporate restructuring.

You should consider the value propositions of the various asset classes at all of the time-periods that matter to your hopes of achieving your most important life goals.

Investing Rules #10 — The experts cannot do it all for you.

What It Takes to Be a Good Investor

When you have problems with the electricity in your house, you call in someone who knows how to fix that sort of problem. You call in an expert.

When your daughter asks you for advice on which college to attend, you consult experts, but you add to the mix your own particular take, which is rooted in an understanding of your daughter that only you possess.

Investing is in part a math project. The experts can help with that aspect of the project. There are lots of good books available.

Investing is primarily a Life Planning project. That part you have to do yourself. There is some material available today on how to do this, but not nearly enough. I am in the process of writing a book that will explore this aspect of the investing project in depth. For now, it is important that you not be swept up by the focus on calculation that is present in much of the investing literature into thinking that investing is primarily a math project. The math is important but secondary.

Those are the investing rules. For those who live in a house. For those who are in love with a spouse. And for those who share living space with a mouse.

Eight Investing Questions You Need Answered Before Putting Money Down

#1 of 8 Investing Questions You Need Answered — When Stocks Prices Go Down, Where Does the Money Go?

The money disappears. It goes “poof!”

Investing Questions

Many middle-class investors do not understand this. They understand that money used to purchase lottery tickets can go “poof!” But putting money into stocks isn’t gambling. It’s, it’s, it’s — investing!

Right?

That’s sort of right and sort of not right. Stock prices are to a large extent determined by economic realities. The thing you own when you own a share of stock is a share of a corporate enterprise. A corporate enterprise is comprised of patents and machinery and property and goodwill and things like that. Those sorts of things have real value. Your ownership of things like that can never go “poof!”

It’s not only economic realities that determine stock prices, however. Stock prices are also determined by investing emotions. When investors become excited about stocks, they bid prices up to fantastic levels. When their emotions return to earth, they bid prices back down to the levels suggested by the things of real economic value owned by the underlying corporate enterprises, or sometimes even lower.

If you buy stocks at reasonable prices, you are not gambling because your money is being used to acquire a share in things of real economic value. If you buy stocks at times when prices are what they are today (this article was posted in September 2007), half of your money is being used to acquire a share in things of real economic value and half of your money is being used to acquire cotton candy that can be blown away with a change in the wind. Buying stocks today is half investing and half gambling.

The bad news is that half of the value of a stock purchase made today really can go “poof!” The good news is that only half of the value of a stock purchase made today can go “poof!” Once prices drop by 50 percent, all of your remaining money will be going to the purchase of a share in a real economic enterprise and you can be realistically assured of obtaining a strong long-term return on that portion of the money you invested.

#2 of 8 Investing Questions You Need Answered — What Do People Mean When They Say That Stocks Always Do Well in the Long Run?

They mean that, if you are willing to wait 30 years, you are almost sure to obtain a good return on your stock investment.

Please take a look at The Stock-Return Predictor (see tab at left). At today’s prices, the most likely 10-year annualized real return is less than 1 percent. You can beat that by putting your money in certificates of deposit. Go out 30 years, however, and the most likely 10-year annualized real return for a purchase of the S&P index is over 5 percent. That’s a highly appealing return.

Many investing “experts” engage in trickery by suggesting that it is always a good idea to invest in stocks “for the long run.” Few middle-class investors can afford to wait 30 years to see their stock investments beat the returns that they could have obtained by investing in far safer asset classes. Most would be better off lowering their stock allocations at times of extremely high prices and then increasing them again when prices came down and stocks again offered a compelling long-term value proposition.

It is not in a strict sense untrue to say that stocks do well “in the long run,” however. After the passage of 30 years, stocks really do always do well (or at least it can be said that U.S. stocks always have ). The trickery is in the suggestion that the odds favor stocks purchased at today’s prices doing well at the end of 5 years or 10 years or 15 years or 20 years. Purchasing stocks today with the thought that they might do well over those sorts of time-periods (which most of us think of as “the long run”) is a long-shot bet.

#3 of 8 Investing Questions You Need Answered — Why Doesn’t the Price You Pay for Stocks Affect the Value Proposition Obtained from Them?

Don't Understand Investing

There is no asset you can buy for which the price paid does not matter. The price paid matters when purchasing bananas. The price paid matters when purchasing cars. The price paid matters when purchasing houses.

So why doesn’t the price paid matter when purchasing stocks?

It does. There is a lot of trickery engaged in on this question too.

”Experts” are able to make arguments seeming to show that price doesn’t matter when purchasing stocks by focusing on short-term results. It is the emotions of investors that are the primary factor in determining stock prices in the short term. Emotions are unpredictable. Even though stocks are a poor buy today, it is possible that investor emotions will send stock prices far higher over the next year or two or three.

In the long run, though, it is the economic realities that are the primary factor in setting stock prices. When you purchase stocks at reasonable prices, you can be virtually assured that you will obtain a strong return in the long term (10 years or more). When you purchase stocks at the prices that apply today, you can be virtually assured that you will not obtain a strong return in the long run.

Prices matter when buying stocks, just as they matter when buying any other asset available for sale on Planet Earth. There is no need to abandon your common sense when deciding on an investment strategy.

#4 of 8 Investing Questions You Need Answered — Why Is Buy-and-Hold Such a Powerful a Strategy?

Many of today’s “experts” endorse the idea of adopting a buy-and-hold strategy without understanding why buy-and-hold is so powerful. It is essential that the investor seeking to pull off a buy-and-hold approach successfully understand why buy-and-hold works.

Buy-and-hold works because using a buy-and-hold strategy causes the investor to focus on the right things — the economic realities that determine long-term results, not the emotional cotton candy that determines short-term results. The media is focused on the cotton candy. 80 percent of what you read about investing tells you about what happened yesterday or what is happening today or what some people think is going to happen tomorrow. None of that junk helps you become an effective investor. It is not just a waste of time. It is dangerous to your hopes of obtaining a good return on your investment dollars.

It’s dangerous because it gets you interested in the gambling aspects of the investing experience. No one knows what is going to happen in the short term because the short term is determined by investor emotions. You need to tune that stuff out. The power of buy-and-hold is that it turns your focus to the long-term and it is in the long-term that purchasing stocks stops being gambling and becomes investing.

Most middle-class investors are today in a transition phase from being short-term gamblers to being long-term investors. We have learned in recent years that we should be focused on the long-term and that we should follow buy-and-hold strategies. However, few “experts” provide us the tools needed to focus on the long-term in a meaningful way. To focus on the long term, you need tools like The Stock-Return Predictor, tools that give you the information needed to form reasonable assessments of how your stock investment is likely to perform over the long term.

The good thing about buy-and-hold is that it takes your mind away from the short-term nonsense that is the focus of most media coverage of investing issues. The bad thing about what most “experts” tell us about buy-and-hold today is that it tunes out the long-term realities too. When prices fall as they are likely to fall in coming years, middle-class investors are going to be shocked and the shock is going to cause most to abandon their buy-and-hold strategies. Effective buy-and-hold strategies are valuation-informed buy-and-hold strategies.

How Investing Works The power of buy-and-hold is that it encourages a tuning out of the short-term nonsense. There is no power in avoiding knowledge of the long-term economic realities too. That aspect of the conventional approach to buy-and-hold is an unfortunate consequence of the fact that buy-and-hold was developed during the longest and strongest bull market in the history of the U.S. market.

#5 of 8 Investing Questions You Need Answered — Why Doesn’t Timing Work?

Most middle-class investors “know” that timing doesn’t work. Few know why.

If you don’t know the answer to the “Why?” question, you don’t really understand how timing relates to stock investing. You need to understand this before putting money at risk investing in stocks.

Timing doesn’t work because in the short-term it is investor emotions that determine stock prices. Say that you take note that stocks are absurdly overpriced. Does it follow that you can predict where prices are headed and thereby take advantage of your insight? It does not. Stock prices are determined by emotions. Emotions are not rational. There is nothing to stop absurdly high prices from heading to even more absurdly high levels. Timing doesn’t work because of the way stock prices are determined.

It is in the short term only that stock prices are determined by emotion. In the long term, stock prices are determined by the economic realities. In the long-term, stock prices are to a large extent predictable. In the long-term, timing works.

A good way of testing whether an investing “expert” knows what he or she is talking about is asking him or her why timing does not work. If all that the expert can say is “well, it just doesn’t,” it is fair to conclude that this particular expert is merely repeating what he heard from someone else and lacks a strong personal understanding of how stock investing works. You need to be wary of any advice offered by such an “expert.”

#6 of 8 Investing Questions You Need Answered — What Makes Someone a True Investing Expert?

It’s not popularity. It’s not managing lots of money. It’s not going to school to take courses with the word “investing” in the title and obtaining passing grades.

The same media that focuses its attention on the causes of the day-to-day price swings also blows the call as to what sorts of qualifications are needed to make someone an investing “expert.” The media looks at obvious credentials such as whether the person studied investing, whether he manages lots of money, and whether her views are frequently quoted. It is fair to say that these things are positive signs, but possession of these sorts of credentials are not sufficient to make someone a true investing expert.

The key to investing success is focusing on the long run. Those managing large amounts of money often cannot focus on the long run. The strategies that work in the long run are often the opposite of those that work in the short term. Fund managers posting poor short-term results are likely to lose their jobs. Those managing large sums are often compromised. The price paid for following effective long-term strategies is too high for them to do what their understanding of how stocks work tells them to do.

And those who speak openly about how stocks are likely to perform in the long term are rarely popular. Dallas Morning News Columnist Scott Burns gave the game away when he noted in a column from July 2005 that the reason why few reporters have told their readers about the Retire Early Community’s safe withdrawal rate findings of recent years is that: “It is information most don’t want to hear.” Investing “experts” and investing journalists don’t see it as their job to tell you what you need to hear. They see it as their job to tell you what you want to hear. There’s a difference.

Why Is Investing So Confusing?

The true “experts” are those who can provide you with clear and understandable and sensible answers to the eight questions listed in this article. These questions are basic. Anyone purporting to be an investing expert who cannot address them effectively is most likely trying to sell you something. Investor beware.

#7 of 8 Investing Questions You Need Answered — Why Are Most Middle-Class Investors So Confused About How Stock Investing Really Works?

Most middle-class investors are busy people. They have money they need to invest and the time they can put into the project of figuring out what they need to do is limited. They turn to shortcut methods for figuring out what to do that work in most other life endeavors but that produce poor long-term results in the investing field.

If you were trying to pick a restaurant and didn’t have much time to do research, you might just conclude that a busy restaurant probably serves good food. Otherwise, why would it be so busy? It doesn’t work that way with investing. Stocks become popular by going up in price. When stocks are high priced, they offer a poor long-term value proposition. The Stock Restaurant is a place that cycles from being a wonderful place to eat to being a horrible place to eat, and the times when it is most wonderful are the times when there are no lines.

Middle-class investors are not dumb and middle–class investors are not greedy. Middle-class investors are busy. Their time crunch causes them to accept explanations of how stock investing works that in a surface sense are plausible but which do not stand up to scrutiny. My advice to middle-class investors is to drill down on the basics. Insist on clear answers to the questions listed in this article. Do not put one penny at risk until you possess a sure enough grasp of the stock investing fundamentals to see what games are being played and to know how best to protect yourself from them.

Understanding the fundamentals does not take long. You can get by without knowing lots of detailed and technical stuff about how stock investing works. Not knowing the fundamentals can get you killed. You owe it to yourself to work the questions listed in this article until you are absolutely clear on them.

#8 of 8 Investing Questions You Need Answered — At What Price Level Do Stocks Represent a Good Buy?

If you don’t know the answer to this one, you are buying blind.

Stock prices fall 10 percent. You know what happens, don’t you? Some “expert” writes a column saying that now might be a good time to buy.

Dumb.

Investing Answers

I would take that description up a notch and refer to it as “pathetically dumb” if it were not for the fact that so many fall for it. Bad advice that hurts lots of people is certainly dumb but perhaps not pathetically so. The advice described above is powerfully dumb (and I saw Jonathan Clements at The Wall Street Journal put it forward only a few weeks ago).

Would you fall for the claim that an absurd price that is a little less absurd that one than one applied earlier is a good deal if a fellow trying to sell you a car tried to persuade you of it? If you were looking for a car with a fair market value of $20,000 and you went to a dealer who quoted a price of $40,000, you would walk out. What if he called you the next week to tell you the good news that he was now willing to take 10 percent off and let you have the car for $36,000?

People who call themselves investing “experts” pull this one all the time. Stocks are today selling at a price double their fair value. A 10 percent price drop isn’t going to improve the long-term value proposition enough to make stocks an appealing buy. Again, please spend some time with The Stock-Return Predictor to learn what you need to know to know when stocks will be worth buying again.

It’s a nice thing for the stock-selling industry that most of us know so little about how to identify when stocks offer a strong long-term value proposition and when they do not. It’s not such a nice thing for us middle-class investors. Insist on clear answers to these eight questions before putting money on the table. Don’t take every investing expert to be your friend.

Investing for Dummies — The Six “Must Know” Rules

It would take you a long time to learn all there is to know about investing. Fortunately, there are six Investing for Dummies rules that tell you 80 percent of what you need to know.

The first Investing for Dummies rule is — Stocks Rock!

Investing for Dummies I’ve gained a reputation in the Financial Freedom Community as a “bear” because I was the one who developed the Valuation-Informed Indexing approach to investing, an approach that takes advantage of the fact that stocks provide a far stronger value proposition at times of moderate valuations than they do at times of high valuations. That doesn’t make me a bear. That just makes me a guy who likes to obtain the highest possible value from each dollar he earns, both when spending money and when investing it.

The reality is that I love stocks, and for good reason. Stocks have done more to help middle-class workers win financial freedom than any other asset class. The same historical stock-return data that taught me the importance of paying attention to valuations also taught me that stocks offer a mouth-watering 30-year return regardless of valuations.

We are today (this article was written in June 2006) at valuation levels nearly double the moderate level. Stock returns are not likely to be too exciting for the next 10 or 20 years. So I don’t think it would be wise to put too high a percentage of your portfolio in this asset class at this particular time. But the most likely 30-year annualized real return for a stock purchase made today is 5.3 percent. Show me another asset class that can match that without requiring a good bit more work than it takes to invest in a stock index fund.

There are all sorts of asset classes that offer strong value propositions in the right circumstances. The middle-class worker seeking Investing for Dummy advice, though, should be considering placing at least a portion of his assets in stocks even when valuations are high, and more than that when they drop to moderate or low levels, from which the long-term returns are juicier.

The second Investing for Dummies rule is — You Don’t Need to Beat the Market.

John Bogle started a revolution in investing when he put forward the idea of investing in index funds rather than individual stocks or non-index mutual funds. Invest in an index, and you won’t beat the market, but you will match it. Given the appealing returns available to those who keep valuations in mind when deciding what percentage of their assets to put into stocks, there’s no need to beat the market. Matching the market by investing in index funds is good enough for most middle-class workers to achieve their financial freedom goals.

I’m not an indexing purist. I believe that you could get better returns from picking individual stocks or non-index mutual funds than you likely will get from index investing. The risks would be greater, though. And it would take a lot more time and research to invest successfully that way. If you are seeking Investing for Dummy advice, index funds are probably the way to go.

The third Investing for Dummies rule is — Emotions Trump Numbers.

Most conventional investing advice is numbers-oriented. There’s great value to be obtained from studying the numbers. As I noted above, I learned what I needed to know to develop the Valuation-Informed Indexing approach by virtue of research done into what the historical stock-return data says about how stocks perform starting from various valuation levels. If you have lots of time to devote to the project, you can learn all sorts of things about how to invest successfully by looking at research papers and articles and the historical stock-return data itself.

Keep It Simple

If you are seeking Investing for Dummies advice, though, you don’t want to get yourself tied up spending too much time with the numbers. You need to focus on the fundamentals. The most important things you need to know about stock investing are the ways in which it affects your emotions. When people say that stocks are risky, what they mean is that their prices are volatile. The reason why price volatility translates into risk is that it causes people to lose the ability to think clearly about their investing strategies.

If you are new to stock investing, please start out slowly. Stocks really are risky. There really are dangers to investing in this asset class. If you find yourself getting too enthusiastic, pull back. The most important trick is keeping your emotions in check at all times. Successful stock investing doesn’t come from being smarter than the other guy (or gal). It comes from being more emotionally balanced than the other guy (or gal).

The fourth Investing for Dummies rule is — Buy-and-Hold is Harder Than It Looks.

Just about everyone who advocates stock investing today advocates long-term buy-and-hold investing. There is a magic to buy-and-hold as powerful as the magic of compounding returns tapped into by those who save when they are young. The magic is — the unpredictability of stock returns (and thus the risk of stock investing) diminishes as you hold your stocks for longer time-periods. Hold your stocks for only one year, and you may do very, very well or very, very poorly. Hold your stocks for 30 years, and you are almost certain to do at least reasonably well.

Word had gotten out that buy-and-hold investors are successful investors. So just about all stock investors today describe themselves as buy-and-hold investors. Don’t believe it. The buy-and-hold concept only became popular during the most recent bull market, which was the longest and strongest bull market in the history of the U.S. market. If things go in the next bear market as they have in earlier bear markets, many of those now talking the buy-and-hold talk will find themselves not able to manage the buy-and-hold walk.

How can you learn whether you are a true buy-and-hold investor or not? Again, proceed with caution with your stock investing project. Do learn about this exciting asset class. Do put some of your money into it. Not too much, though. Learn about the pitfalls of stock investing before you take a chance on the sorts of stock allocations that could cost you a significant percentage of your life savings. Move forward, but move forward slowly. And focus your efforts on discovering how successful investors practice buy-and-hold not just on paper but in the real world too.

The fifth Investing for Dummies rule is — Valuations Matter.

There are lots of investing advisors who will tell you what I told you above, that stocks offer a mouth-watering long-term return. There are not too many who will be entirely straight with you about the other side of the story, that those who purchase stocks at times of high valuations can suffer bone-crushing losses that can remain in place for long periods of time. There’s a good chance that stocks will provide a negative real return for the next 10 years. If experiencing a loss on your investment causes you to sell your stocks, forget about those juicy returns that go to those who stick with their stock purchases for 30 years.

How Investing Works

Valuations matter. At times of low valuations, the returns provided by stocks are nothing short of amazing. At times of moderate valuations, the returns provided by stocks are plenty exciting. At times of high valuations (like today), stocks are an iffy value proposition over 10-year and 20-year time-periods. Consider keeping a portion of your portfolio in a safer asset class, such as Treasury Inflation-Protected Securities (TIPS) or IBonds. Then, when valuations drop and the value proposition offered by stocks improves, you can up your stock allocation to take advantage of the “sale.”

The sixth Investing for Dummies rule is — Timing Works.

It’s conventional wisdom today that “timing doesn’t work.” That’s a half-truth. There is indeed a good bit of evidence showing that short-term timing — jumping in and out of stocks because you think you know how they are going to perform over the next year or so — is unlikely to provide a good return. Long-term timing is an entirely different animal, however.

Long-term timing is reducing your stock allocation when prices go to extremely high levels and increasing your stock allocation when prices go to extremely low levels. There is a good bit of evidence in the historical stock-return data that long-term timing does work. And common sense supports the idea. All other assets we purchase provide a better value proposition when we obtain them at low prices than they do when we obtain them at high prices. Why should stocks be so different?

Avoid short-term timing. That’s not a game for the typical middle-class investor. Do consider lowering your stock allocation a bit at times of high valuations, though, and increasing it a bit at times of low valuations. A recent article in the Financial Analysts Journal by Cliff Asness (“Rubble Logic: What Did We Learn from the Great Stock Market Bubble?”) explains why long-term timing makes so much sense — Link to article on Investing for Dummies Rule #6.