3 Investing Principles to Live By

Updated: Jul 19, 2020

1) Really understand your risk tolerance and the volatility of the space you are investing in. Investing in some small startup company vs investing in a large firm with lots of cash on hand and consistently repeatable revenue sources will deliver significantly different risk and return characteristics. Of course everyone wants the best return they can get but even the best investors are often unable to consistently beat the overall markets.

2) Diversify. If it is that difficult to consistently select the single best company to invest in, then it makes sense to invest in many different companies. Furthermore, diversification has the added benefit that it actually reduces your risk more than it reduces your return potential. We call this improving your risk-adjusted returns. Please do not get me wrong on this point; diversifying is not designed to increase your returns. It is designed to reduce your risk of large losses but still allow you to get the overall returns of the asset class you are investing in. In fact, this element of return to risk can be somewhat calculated using historical data from any combination of publicly traded stocks and is very useful in comparing different investment strategies.

3) Check your emotions at the door. Investing is not for the faint of heart and can really play with your emotions. You cannot let fear, greed or your ego interfere with a sound investment strategy. Let me tell you right now, that is not easy to do and even the best investors experience it to some degree and have made a bad decision because of it. First, let’s talk about greed. If something seems too good to be true it probably is. An investment that is paying 10%+ in dividends or interest, even if when looking at its chart you find that it has been doing so for quite a while and the price has stayed relatively flat, there is a reason why it is paying such a high yield. The reason is simply because it has to pay that much to get any investor interested at all in the first place. The return is compensating for some risk that you have to fully understand before you can decide to invest in it. It doesn't mean that it's a bad investment it just means that investors who really understand the business and the real risks involved will also be better prepared to know when to run for the door while you might still be left holding the bag. Fear, this includes both the fear of loss and FOMO. The fear of missing out is another emotion that has to be controlled to invest successfully. The first way to control this is to have a plan and make sure that the money that you are investing is not needed for quite some time down the road. The second thing to understand is that everything goes through cycles, especially the economy and the stock market. However, these cycles are impossible to predict. There are certain indicators that economists use to try to predict the economy but trust me, it is impossible to regularly get it right. This is proven by the statistics which show that the average investor underperforms the market over time because they get out and then back in at the wrong times. We call this trying to time the markets, which again just can’t be done consistently. Just follow the adage that “time in the market beats timing the market”. Or even better try to at least consider the advice from Warren Buffett, “be fearful when people are greedy and be greedy when people are fearful.” The last emotion I want to discuss here quickly is ego. There has been extensive study on what is known as Behavioral Finance, including research coming from the 2017 Nobel Prize winner Richard Thaler. Many of the topics within Behavioral Finance discuss in some manner how your ego can prevent you from making the proper investment decision at the right time. One example that I personally have suffered from is not admitting to myself that I was wrong. Allowing my ego to tell me that I was right when I decided to invest in a certain company and that I should continue to hold onto the position until my thesis is correct. The problem here is again that things change and even if my thesis was correct at the beginning I need to be aware along when things may have changed and always be willing to reevaluate. So, what I suggest is to always look at a position you have purchased and pretend that you do not own it already. Then ask yourself, based on the information that I know about this company right now would at I buy it at the price that it is currently trading at. If the answer is yes, hold onto it or buy more, if it is no then sell it and move on.

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