Golden Rules of Investing

Ok, enough of the big picture, let’s talk about how to make money with money.

As much as I want to launch straight into a how to get rich quick scheme, we’re going to have to zoom wayyyy out and take in the whole of the available financial markets.

Before we launch into the techy stuff though, I want to present to you:

THE GOLDEN RULES

These rules are those that I’ve landed on after a lot of financial education, trial and error and experience. There are the occasional exceptions to some of them, but these will be very unusual, to the extent we can basically ignore them. For my money, you should treat these rules as the gospel accordion to Art, I do.

There more your investments are returning, the more risk you’re taking on. No exceptions, no ifs, no buts.

“But Art, I bought Amazon shares and made a 30% return, Amazon is a great company, they were always going to go up! Its basically free money”. First, well done. Second, you’re wrong. Amazon shares have done very well over the past few years, with performance driven by strong results, high growth and, recently, the COVID pandemic. However, if you’d bought the shares at any point during any of those years then you were buying into what the market already expected. Amazon’s price to equity (P/E) ratio, which measures the profitability per share has been above 74x for the last two years (and actually for the last 10). The long run average for the US market is about 16x (in general a lower multiple here is better; you’re buying more earnings (“E”) for a lower price (“P”)).

This means a massive amount of growth is already expected by the market to justify such a high price. You’re buying into this story. The risk here isn’t that Amazon stops being a great company, the risk is that people stop thinking it’s the greatest company. Or even that they start thinking it’s a merely good company. If the market started believing that maybe Amazon should only be worth twice the long-term average P/E (32x), Amazon’s share price would fall by 66%. This is a risk. There are no high returns without risk. Period.

The only proviso to add here is that diversification can raise your return while lowering your risks (which is amazing!). We’ll look at that in another post where we look at designing a diversified portfolio.

Your emotions are your enemy.

“But Art, that sounds extreme. Surely as long as I control my emotions most of the time, they can work for me as much as against me.” In investing, emotions, particularly uncontrolled ones, will cost you very, very dearly. You’ve maybe heard that the market runs on greed (pushes prices up) and fear (pushes prices down). This is broadly true, every time stock prices plummet 20% over a week, its rare that any massively new information has been presented. Rather, people stop ignoring the information that is already there that doesn’t agree with their preferred world view at the time. We’re really good at this. When that awful prick at work who’s consistently annoyed that crap out of you for a year randomly buys you a coffee, you’re pretty unlikely to suddenly think “wow, maybe they’re actually a great guy/girl!”. Rather, you’ll wonder “they’re trying to butter me up for something/the must feel guilty for being so awful/they’re trying to look good to the boss”. We make evidence fit into whatever our emotions tell us we believe at the time.

In markets this is very dangerous. Selling when everyone else is selling because the newspapers are screaming that stocks will fall even further; you’re selling at the worst possible time (selling when stocks are cheap). Equally, when you buy when stocks are already shooting up, you’re buying at the worst possible time (buying when stocks are expensive). If you can learn to buy when stocks are falling and sell when stocks are rising (or, at minimum, just sit and do nothing at both times), your returns will be increased hugely.

You can’t really trust your mind either.

“Seriously Art, first I can’t trust my emotions and now I can’t trust my mind? This is getting ridiculous. Are you going to start advocating I pick investments by throwing a dart and a wall of company names?”

Not quite! Naturally, you do need to use your mind and financial knowledge to pick investments. However, your mind plays tricks on you. These tricks are called “behavioural biases” in finance/psychology. I find them fascinating and you’ll find they apply to all sorts of stuff. Once you start noticing them they pop up in many of our daily choices and interactions. That example I gave above? Anchoring bias. That co-worker has acted like a prick. Now, new data (the coffee) is discounted because you’re anchored to the original decision (he/she is a prick).

Want another example? You’re looking at two jumpers, both by good brands which you like and are identical in every way. You literally couldn’t choose between them if they were put next to each other. Both are £50 but one is reduced from £150. Which do you want? You want the reduced one right? What a steal, £100 off! Anchoring bias. They’re the same! What if the reduced one was £55? Still prefer it slightly? Even worse, you’re £5 down for zero gain!

There’s a whole load of behavioural biases to look at, but I’ll cover them in separate posts. Suffice to say, watch out for your brain its conspiring to against you!

Investing in individual stocks or managed funds can be fun and rewarding, but in the long you’ll almost always be better off buying into a passively managed fund.

“But Art, I always hear about funds that have done super well, or a stock that’s risen massively. Passive funds seem to do alright but never that well.” You’re 100% correct imaginary reader who asks questions to help me prove my point. I’ll be getting into the passive vs active debate in another post, but here I’ll boil it down to a cliff notes version. Effectively, some managers claim to earn excess returns and, given the expectation is that they’ll get you more bang for your buck, they charge you higher fees to park your money with them. The big problem is that a huge number of them don’t hold up their end of the bargain. In fact, because they charge fees, as often as not, you’ll end up earning less return overcall! So not only are you paying them to manage your money badly (95% of actively managed US equity funds have earned less than the US index over the past 5 years) but you’re paying significantly more for that privilege!

If these active managers whose sole job is to choose good stocks (and who have access to research, support and lots of well-paid time) fail to make investments which make more than the index, what chance do a regular guy/girl playing the markets have! Unfortunately the answer is not much of a chance over the long term. I’m not telling you not to try, but I’m saying its probably worth leaving the majority of your money to sit in a (or a selection of) passive fund(s).

If you’re asking, “what the hell is a passive fund!?”, I’ve got you! That’s covered in another post.   

It’s often better to do nothing than to do something.

“But Art, surely I should reposition my portfolio to news, or try to make sure I’m positioned well for booms or crashes?” If you can do this, go ahead! If you’re like the 99% of us who are utterly crap at predicting the market (except in hindsight of course, where half of us are convinced we would have got it right, “if only…”) then its not worth trying. Because of the biases and emotional issues discussed in the other rules, the urge to do something if often one worth resisting. The only true way for investing to earn you good money is through time. Messing around with your assets will just raise trading costs and open you up to making silly knee jerk decisions. Your money doesn’t do its best work when its boss (you!) is leaning over its shoulder asking: “why do you think that?”, “are you sure that number is correct?” etc. Leave it alone! Much like you, your money will work better for you without micro-management.

So there are my golden rules. There’s a hell of a lot more to talk about when it comes to investing, but we’ve set the stage. Ready to dive into the nitty gritty details? Let’s do it.