Sunday, 23 March 2014

Three "Crazy" Rules of Investing You'll Never Hear From Your Broker

In life, things rarely work out the way you'd expect. The "nice guy" hardly ever gets the girl. The smartest kid in the class never becomes rich and famous. Meanwhile, the problematic student with lousy grades in high school ends up in the U.S. Senate -- or beyond.

The investment world also has its share of "crazy" rules. I call them "crazy" because they highlight the way the investing world works in ways you would never expect.

Yet understanding these "crazy" rules, and how you can apply them, can spell the difference between making (and keeping) your investment profits -- or, at worst, spending an unpleasant stint in the poor house.

With that backdrop, here are my three "crazy" rules...

1. Don't Confuse Luck with Smarts

Old time traders put this view another way: "Never confuse brains with a bull market." The role of "luck" in investment success is more complicated than you think.

You probably believe that if you turn a $10,000 investment in a single stock into $1 million, it would be the best thing that could ever happen to you. But you'd be wrong.

After enjoying such remarkable success, you'd suddenly think that you'd "cracked the code" of the markets. The next time around, you'd have the confidence to bet your life savings on another "can't lose" investment.

And maybe you'd win this time, as well. So you do it again.

After all, you calculate that if you repeat your success only one more time, you'd have $100 million in the bank. But this time, you tell yourself that once this investment hits, you'd take all of your chips off of the table.

Sure enough, your luck runs out and your latest "can't lose" investment flops. And since you "bet the farm," you not only lost your shirt but you're also deeply in debt.

You wake up one morning to realize that you are worse off than when you started.

That's the problem with sudden wealth -- whether it comes from a big bet on a stock tip, buying a winning lottery ticket or becoming a highly paid pro-athlete.

Almost everyone who wins the lottery ends up poorer five years later than beforehand. You see formerly wealthy pro athletes declaring bankruptcy almost every week.

The lesson? Understand that if you have ever won a big investment bet, you were at least as lucky as you were smart.

Over the long term, there are no shortcuts. Making money on a consistent basis is a grind that is one part "insight" and nine parts "discipline".

2. Your Analysis Is Irrelevant to Your Investment Success

The philosopher Friedrich Nietzsche once observed that, "Any explanation is better than none."

I disagree. Sometimes, in the investment world, no explanation is really necessary -- or relevant.

Today, you suffer from information overload. You can access more information about the financial markets than ever before. Yet, I bet your investment returns have not improved.

Not only do we seem incapable of divining the future, we can't even seem to agree on what happened. Was the credit crunch a result of Greenspan's monetary policy? Bernanke's incompetence? Clinton's "affirmative action" mortgages for low-income borrowers? Or was it just a classic mania? We crave explanations because it gives us an illusion of control.

But it gets even worse. Even the "doom and gloomers " who got their analysis "right" in predicting the credit crunch weren't able to turn their insights into money for their clients. Analysts who promised to "crash-proof" their clients' portfolios ended up losing more money for their clients than if they had stuck with simple index funds.

That's because they weren't that right after all. Gold didn't hit $3,000 an ounce. The U.S. dollar didn't implode. Treasuries didn't collapse. And the U.S. stock market recovered.

The lesson? Successful investors are successful in the long term because they admit their mistakes.

As the world's greatest speculator George Soros said, "My system doesn't work by making valid predictions. It works by allowing me to recognize when I am wrong."

3. Your "Intelligence" is Your Biggest Handicap

Warren Buffett famously observed that it takes no more than average intelligence to become a successful investor.

I'd add something to that perspective. I'd say high intelligence is actually a handicap to successful investing.

Here's why. When you are smart, you are used to being 100% correct. You just can't accept the possibility of being wrong. So you stick to your guns, even when the market is telling you otherwise.

That's why overeducated Wall Street analysts make such lousy money managers and why hedge fund managers who flaunt their intelligence inevitably flounder.

Think about it this way. If high intelligence was the key to successful investing, top business school professors and economists would be the wealthiest guys on the planet. Instead, the Forbes 400 is populated by dropouts from places like Harvard (Bill Gates) and Stanford (the Google guys).

That's also why poker players make the best traders and investors. They play each hand as if it is dealt to them. If they get a bad hand, they fold. They play the investment game the same way.

Perhaps that's also why a former Dean of Harvard College, Henry Rosovsky, observed the following about Harvard students, "Our A students become professors. Our B students go to law school. Our C students rule the world."

Now you also understand why my Harvard law school classmate Barack Obama doesn't release his college and law school transcripts.

How You Can Apply These Three Crazy Rules

So, how can you use these "crazy" rules to improve your investment returns?

First, never bet too big on one idea. You may get lucky once. Maybe even twice. But your luck will eventually run out. And if you bet the farm, you are out of the investment game for good.

Second, don't delude yourself into thinking that you have special insight into the market. Bring that attitude to your investments, and you will have your head handed to you.

And it's not a question of "if" but "when".

Third, learn to think of your investments like a hand in a poker game. Up the ante when you are lucky enough to get a good hand. But also be prepared to fold -- and to fold often.

By following these rules, I have saved me from my own follies more than once.

They will do the same for you.

By Nicholas A. Vardy
Editor, The Global Guru
http://www.nicholasvardy.com

Quote for the day

“Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor.” - Warren Buffett