Rule 1. Never lose money (Warren Buffett’s first rule). You’re going to lose money. What makes the difference is how you react. Do you lose your cool and compound your losses? Or do you react in a disciplined, focused manner and learn from your mistakes? If you spend all your time trying to avoid losing money, you’ll never make any in the first place.
Rule 2. Never buy high, never sell low. Never say never. Try to buy low and sell high but make room for exceptions. Establish a system that will give you sell signals when a better opportunity arrives. Following that system can mean selling low. And sometimes coming late to the table—after the price has already risen—is better than missing the meal altogether.
Rule 3. Set a goal for every trade. Don’t do this, please. Investing requires flexibility. Sell your positions only when a better opportunity arises—or when you need the money for something more important.
Rule 4. Never add to a losing position. If you buy a diamond ring and then the price goes down, what do you do—sell the ring or buy another? If stock in a good company is getting cheaper, especially if it’s for a dumb reason, buy more.
Rule 5. You can’t beat the market, so invest in index funds. You can indeed beat the market if you invest wisely and put in the time and effort to develop a good system. Proponents of the Efficient Market Hypothesis say that people who beat the market consistently must be doing so by chance. Frederik Vanhaverbeke, in his book Excess Returns, puts that argument to rest. He names 67 investors and traders who made annual compound returns of more than 15% over periods of at least ten years. He writes:
It was not home runs and leverage that drove these returns. Virtually all of these returns were achieved through diversified portfolios with significant turnover across periods ranging from 10 to almost 60 years. . . . The most striking example of consistency is Edward Thorp, who posted gains in 227 of the 230 months that he ran an investment partnership between 1969 and 1988. Assuming the probability of a positive gain in any particular month is about 0.6 (as has been the case historically), the probability that someone can achieve this level of consistency or better [purely by chance] is 6 × 10–46. This is only a few orders of magnitude higher than the probability that one would find a single specific atom by looking in a random place on earth. It is therefore safe to say that Thorp was not just lucky.
Rule 6. Keep it simple, stupid. Well, if you’re stupid, I guess you have to keep it simple. I hope you’re not. Companies and their stocks are not simple creatures, and treating them as if they are is a big mistake. Acknowledge complexity and approach investing accordingly.
Rule 7. Don’t try to outperform the market. Yes, that’s actually a rule suggested by a writer for lifehack.org in an article entitled “Eight Investing Rules You Need to Follow to Make You Rich.” She comments, “This is one of my favorite investing rules.” I wonder if she tells her kids not to try to get A’s.
Rule 8. Back up your fundamental analysis with technical analysis. Buying a stock is like buying a used car. The most important thing is to look under the hood. The least important thing is to compare the price you’re paying with the fifty-day simple moving average.
Rule 9. Keep your winners and sell your losers. It’s usually more profitable to do it the other way around because of mean reversion. Let’s say you buy $10,000 each of two stocks on the same day and a month later one has risen 20% and the other has fallen 20%. The loser is more likely to rise over the next month than the winner (I tested this, using both the Russell 3000 and the S&P 1500 since 1999, on Portfolio123). Sell the $2,000 you made on the winner and invest it in the loser.
Rule 10: If prices are rising, go long; if prices are falling, go short. Prices may be rising or falling today, but you have no idea what they’ll do tomorrow. They turn on a dime. If you short the market when prices are falling you’ll be missing out on your best opportunities when prices start to rise, as well as risking a lot more than you would by just holding what you have.
Rule 11. Always keep a significant portion of your money in cash. And miss out on compounding? If you’re convinced that a) there are no good stocks to buy right now; b) the market is about to crash; or c) you don’t want to miss an opportunity if a stock you’re watching unexpectedly falls in price, then go ahead and keep some cash in a safe place. But don’t make it a habit. Park your money in investments with a margin of safety instead. And remember, if you need cash, you can always quickly sell your least favored stock.
Rule 12: The trend is your friend. The trend is actually your enemy. Never follow trends—in life or investing. It’s the surest way to lose money. Stock prices revert to the mean. Buck the trend as much as you can.
Break these rules. And when you’ve finished, find some more to break.
But there’s one rule you should never break:
Rule 13: Make your own rules. Make absolutely sure they work. And then stick to them, making only minor modifications, through thick and thin.
My ten largest holdings right now: VHI, ALSK, AVDL, CRNT, SMMT, CVV, ELMD, AMSWA, GSL, KMDA.
CAGR since 1/1/2016: 48%.
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