Fundamental investing rules: independent investment advice
Posted by Don Martin on Sat, Feb 26, 2011 @ 05:08 PM
My fundamental rules of investing:
1. Avoid leverage whether it is using a margin loan, options, futures, etc. This avoids risk of loss due to expiration of options, risk of tracking error in futures due to backwardation-contango, risk of panic sales to meet margin calls (especially during a "Flash Crash").
2. Avoid excessive risk and / or high volatility investment because during a crash it will require a lot of appreciation to make up for the loss and you may panic and sell out during the dip.
3. Avoid investing in things that have no traditional stream of income because an income stream is the key to using credible valuation tools. This means avoiding commodities, rare art, bare land, etc. This helps to keep you from buying tech bubble stocks with no earnings or opaque companies that lack clear financial statements.
4. Be contrarian. Use independent investment advice. The way to get alpha is by having a creative, contrarian insight, not by following the herd.
5. Use risk-adjusted investment measurements (Sharpe and Information ratios) just as you should also use inflation adjusted and tax-adjusted investment measurements. See my post.
6. Never overpay for an investment; use income based methods like Shiller PE10 and try to buy only at a discount so as to have a margin of safety. This means boycotting, rather "market timing" an overpriced investment. Be tough and stubbornly refuse to buy until conditions are right. Don't be afraid to hold a lot of cash for a long time in order to fulfill your mission, even if interest rates are artificially low.
7. Treat potential investments like a ticket that you can only punch once every one or two years (imagine only 25 trades in a lifetime allowed). You must wait patiently with possibly high levels of cash or bonds until a carefully chosen opportunity becomes available.
8. If an investment is opaque, illiquid, hard to value, has significant tracking error, has bad spreads then you must assess a high risk premium hurdle rate for that during your decision making process. This probably means the forecasted profit won't be enough to overcome the hurdle rate discount, so be glad you were warned and don't buy it. If you are not adequately compensated for excess risk caused by these problems then it is better to accept the more modest rate of return from more traditional securities investments that have greater transparency.
9. Bonds are a tool and tools should be used for the purpose for which they are intended to avoid injury. Bonds are intended to be a reasonable stable store of value during a stock crash, so avoid "B" paper bonds because they act like a risky equity during a crash, precisely when you needed them to act like an "A" paper bond. If you desire the hoped for returns of junk bonds then instead you should simply buy poor quality small cap stocks and hope for a bull market.