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With rising interest rates, stagnant inflation, and staggering bank runs, the markets have indeed wobbled a bit. Whenever the fear of panic is in the air, it’s best to go back to the basics. Focus on what we can control. Prepare for the occasion.
Below is a list of key investment principles I have collected so far. I hope to keep adding as I gain a better understanding of the world.
Key investment principles
Defense won the championship. Financial security means spending less than you earn. Have realistic lifestyle expectations to create incredible resilience to life’s ups and downs. Don’t expect outsized returns or delinquent income to bail out unnecessary spending.
Stocks are not squiggly lines. They represent the ownership of businesses.
Owning productive assets is the most consistent way to maintain and increase your global purchasing power. Real business, providing real goods and services that build human material progress, will always be a source of wealth.
Investing is wisest when it is conducted in a business fashion.
Buy at the right price to get the most reliable margin of safety. The catch is, there will be long stretches where you may feel left out and have little to buy when prices are high. Maintain vigilance; Opportunities always return eventually.
Everything in the market is in cycles. Never forget, or your reminder will be costly. Human fear and greed drive these cycles.
You might say “Cash is trash!” will hear As many times as you’ll hear “cash is king!” Ignore these extreme declarations. Cash represents a call option to purchase a future trade price.
The market can be exciting, but your investments should be boring. Enthusiasm is an expensive request of any portfolio.
An asset is the sum of the cash flows returned to its owner until the judgment day, discounted at the fair rate. Don’t let short-term low rates lower your internal hurdle rate.
A “win-win” mentality for all constituents (customers, suppliers, employees, regulators, the communities in which they operate, owners) represents the only way for corporate survival. If a company betrays any of those parties, eventually there will be defection and the consequences will put the company at risk.
Most public companies fail at “win-win” relationships and are therefore unfit for long-term ownership.
Beware of agency costs and institutional imperatives. A lot of the apparent irrationality you see can be explained by poorly aligned incentives and “but everyone else was doing it…”.
Stay within the circle of your ability. If you are asking if something is in your circle, then it is not.
Sometimes assets like apartments (based on cash flow), sometimes like Rembrandts (what the other person is willing to pay).
Bonds are sensitive to changes in interest rates. The longer the period, the greater the impact on rates. Bonds are also subject to credit risk. Return of principal is as important as return of principal.
Most of the time, the stock market is reasonably efficient. However there are times when it is completely disconnected from reality. Therefore, it is important to remember that the market does not tell you what your property is worth. It only provides the recent price, and the implied expectations of the crowd about the future. It’s your job to estimate what assets are worth based on business potential.
Markets are looking ahead. This enables them to make incredible, seemingly illogical movements, especially in the short term. Keep a healthy emotional distance. Panic is contagious.
Buying with the intention of selling to someone later at a higher price is speculation. This strategy may appear to work for a while, but eventually you will run out of big fools. Avoid these zero-sum situations.
Any dominant string multiplied by zero still equals zero. Follow “Buffett’s Rule #1: Don’t Lose Money” whenever possible. Never interrupt the power of compounding unnecessarily.
There are five “deep risks” that lead to permanent loss of wealth.
- Severe and prolonged inflation.
- Severe deflation from the economic recession.
- Expropriation through taxation and nationalization.
- Destruction by acts of God.
- Business failure.
| Note: Quoted price movements are not listed above. |
Short term is the human condition. Looking at a 5+ year time horizon there is less competition. But don’t discount the difficulty of being alone while focusing on that long term.
Technology is amazing, but in the long run, everything is a toaster. Capitalism is relentless in stealing producer surplus and turning it into consumer surplus.
There is a constant struggle between overconfidence of significant location concentration and watering down the portfolio with too much diversification. Do your best to find the sweet spot.
Regression to the mean is a force of nature. On rare occasions, it really is different this time. But it usually doesn’t pay to bet that way.
The selling criteria are strict, but here are four possible reasons to sell:
- The facts no longer support your thesis. Or your initial thesis was just plain wrong.
- Price moves forward compared to the outcome of the trade that future returns have already been drawn forward.
- The position in the portfolio has become so large that you cannot sleep well at night.
- A more attractive opportunity is worthy of capital.
Macroeconomics falls into the “very hard” pile. Yes, it is vitally important, but it is unpredictable to depend on the decision maker.
Markets and economies are complex adaptive systems, more akin to forests than washing machines. Contingent behavior exists on the edge of chaos and is practically impossible to predict. There are nonlinearities, tipping points, sand-pile effects. Something that doesn’t seem sustainable can last longer than you think, and then collapse suddenly.
You never know when an avalanche will go. But you can usually avoid standing under a large pile of snow.
Markets and economics do not fit “normal” Gaussian distribution curves. The tails are thick, meaning there are many surprises hidden that are very predictable. Once-in-a-thousand-year events occur regularly. So a conservative position with the aim of flexibility is the winning approach.
More simply said, choose flexibility over customization. Survival is the highest goal.
Complexity is the enemy. Avoiding obvious stupidity is easier than striving for genius.
Journaling offers an antidote to all kinds of behavioral biases. Suppresses bias behind crystallizing your ideas.
Patience is the only sustainable competitive advantage. Whoever has the longest timeline wins.
Always conduct your affairs so that you can play out your hand. This means never taking advantage of “obvious” opportunities even if you have to pass them up. You may eventually be right, but the road to get there may take you out of the game.
“The secret is to win as slowly as possible,” said race car driver Niki Lauda.
A “man overboard” plan is in place. You will be tested. Use procedures to keep your head when others are losing theirs. “This too shall pass” is sage advice.
No style of investment management is always in fashion. Lose with equanimity, stay humble when you win.
Small, cheap, quality, and speed are promising statistical factors that moderate human behavior. They have a long history of working better than average, but they don’t work all the time. Simple models routinely beat experts.
Absolute returns are followed by relative returns. Don’t reach for yield.
No position should be so great that you cannot sleep well at night.
Take someone’s word for it. Trust, but prove.
Once you reach 120 IQ, your EQ becomes very important. Temperance wins the investing game. Proper habits, environment, process, structure, mindset and biological inputs can maximize your temperament.
Think more than you count. Higher mathematics is never required.
There is no specific scoring for degree of difficulty in the investment world. Clearing 1-foot bars can yield excellent returns.
There is always something to do, but your buying and selling activity should be very infrequent. If it’s a no-brainer, take a pass.
Jason Zweig’s Seven Qualities of Great Investors
- curiosity
- Skepticism
- freedom
- modesty
- discipline
- Patience
- Courage
A quick housekeeping item
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As always, we are grateful for such great partners in this wealth building journey.
Jake
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Editor’s note: The summary bullets for this article were chosen by Search Alpha editors.