The Three Golden Rules of Investing

John Price, Ph.D.
www.sherlockinvesting.com

Perhaps you have recently been walking in the forest. Or maybe you went on a picnic. Or even went swimming in a river¾ all wonderful, refreshing activities. In each case, however, you have to know what you are doing. Otherwise you could walk into a patch of poison ivy, get swept by the current, or even get seriously injured.

The same applies to the marketplace. If you treat it in a casual way without proper planning and preparation, you could get hurt. Financially, not physically. Of course, the marketplace is not something natural like a forest or an ocean. Quite the opposite—it is an extreme example of something structured by humans. Nevertheless, there is an important similarity. It is so huge and complex, with so many facets and nuances that, just like nature, no single individual can fully understand it.

When it comes to walking in a forest or swimming in a river, we have grown up with simple rules such as ‘stay on the path’ or ‘don’t swim beyond your depth.’ As we become more experienced, we may strike off into the trees or swim across a river. Even here, there are rules or principles, and it is these that I want to examine to see if they can help us in the marketplace.

First of all you need to know your capabilities. For example, how far can you walk—or swim? You don’t start on 20 mile hike if you have never walked more that a mile or two. So my first golden rule is:

First Golden Rule of Investing: Know who you are before you start investing in assets that have risk—don’t use the marketplace to find out.

Some questions you can ask yourself include: Do I like to work things out for myself or do I prefer to rely on other people? Do I like getting information by talking to people or by reading? What type of information do I prefer, technical or expository? What is my risk tolerance? How would I feel if stock I bought for $20 went to $10 overnight? What if it stayed there for a week? a month? a year?

Coming back to walking and swimming, you don’t want to find yourself halfway across a one-mile lake and then start asking yourself why are you there. Yet the same thing happens repeatedly with investors. They buy a particular stock but don’t have any clear reason for doing so. Their brother-in-law said it was a sure thing. Or they read something in the Wall Street Journal. Or the stock had a low p/e ratio, or a high return on equity. In the right context, each one of these might be a perfectly good reason for making a purchase. However, frequently it is the case that people buy a stock because of a vague combination of a whole lot of reasons such as these. Then, when the market conditions change, they have no framework for deciding what to do next because they are not sure why they made the purchase in the first place.

When you know why you bought Intel, for example, you will have a stronger basis for knowing what to do when its price goes up, or down, or even stays the same. For instance, if Intel starts to go down in price and you bought it as a momentum play, then you will probably want to sell as quickly as possible. But if you bought it as an undervalued stock, and if the fundamentals have not changed, then you might want to buy more.

This brings me to my second golden rule.

Second Golden Rule of Investing: Know why you are buying a particular stock—don’t wait until its price goes up or down to think about it.

In my investment workshops I teach people how to analyze companies and then make a two-minute presentation to the whole group on their suitability as a stock purchase. This helps them to focus on substantial issues regarding these companies and gives a sound basis for making a buy/pass decision. They are also encouraged to maintain a stock book in which they list the pros and cons of each stock they are interested in.

Warren Buffett said that when he looked back over his investments in his early partnerships, the larger investments always did better than his smaller ones. He attributed this to a "threshold of examination and criticism and knowledge that has to be overcome or reached in making a big decision that you can get sloppy about on small decisions."

Finally, we know that to enjoy nature we shouldn’t be in a rush. This is also very true with the marketplace. So my final golden rule is:

Third Golden Rule of Investing: Take your time—you are investing for the rest of your life.

Buffett said recently that he doesn’t get paid for activity, just for being right. "As to how long we’ll wait," he continued, "we’ll wait indefinitely." No one makes you buy a stock. If you know what type of investor you are, and why you would buy a particular stock, then you will be better able to determine a reasonable price to pay for it. Then you can quietly wait until Mr. Market offers it to you at your price. Wishing you happy and successful investing!

You can get more information about the above topic, and a list of proposed topics, on my web site www.sherlockinvesting.com.