FIVE ETERNAL RULES OF INVESTING

Five Eternal Rules

Five things that you must remember while investing in 2011

I will write about five things that you must remember while investing in 2011, but in keeping with the spirit of the times. Everything I tell you was just as relevant in 2010 or 2009, and will be just as relevant in 2012 and beyond. So here goes.

1. Don’t try to time the market. There’s something irresistibly obvious about the idea of trying to time the movement of stocks. After all, isn’t the old adage, ‘buy low, sell high’? This must be the most misunderstood advice that investors receive. It seemingly implies — in fact, it practically requires — investors to try and anticipate the highs and lows, and time their investments accordingly. It would be better if this was changed to ‘buy continuously, sell whenever you actually need the money’. In an economy that is generally trending upwards but which has volatile markets, this offers the best combination of high returns with low effort.

2. Figure out whether you are a trader or an investor, and stick to it. Investors and traders superficially appear to be the same thing, but the purpose and method is different. Investors put away their savings in investments, and look upon this as a way of getting something extra from their savings. Traders, on the other hand, are people who trade in investments. They expect investments to be their actual income. Investors are likely to salt away the money and use it only when they need it, but traders buy and sell based on their expectation of how the markets are doing. But as the equity markets do better, more and more investors try their hand at trading, convinced that this activity is just a variation of what they do anyway. It isn’t, and they discover it the hard way.

3. Don’t chase past performance. The worst way to invest is to mechanically choose the investment that has been doing well in the immediate past without understanding the reasons. There is a saying that every complex problem in the world has a solution that is simple, easy to understand, and wrong. Doing ‘investment research’ by extrapolating the past into the future is an example of such a solution. Sure, there are many trends that will continue into the future, but many others won’t. Unfortunately, it is tempting to assume otherwise. In fact, given reversion to the mean, investments that have done better than their peers in the recent past are more likely to do worse in the immediate future. Investors ignore this at their own peril.

4. Have overall financial goals that your investments will serve. It is difficult to figure out which way to turn unless you know what your final destination is. A goal is something like ‘make a down payment for a bigger house in three years’, or ‘chuck my job and start a business in five years’. It could even be something like ‘make as much money as possible very quickly’. Each of these will lead you to choose very different investments. There are few investments that are appropriate for everyone in all situations. But most of the time, we follow a sort of a hunter-gatherer approach to choosing investments. We tend to reach out and grab whatever looks tempting at the moment. This approach results in investments that may not serve an investor’s purpose, even if they work out as expected.

5. Don’t trust anyone, especially the bigger outfits. Most financial advice is not trustworthy if it is being given by someone who earns from the resulting transaction. I know this sounds like a sweeping generalisation, but it’s largely true. There are exceptions, but mostly at the smaller end — the big institutionalised advice-givers optimise their advice for their own profitability. This is an inevitable result of their business model, so don’t fret about it. In personal finance, there is no substitute for educating yourself enough to be able to take your own decisions. If you depend on the seller’s advice, then you are basically going to be taken to the cleaners. This is not going to change, so better find your own way around it.