TL;DR: Most investing mistakes are the result of unforced errors driven by greed and fear. To help avoid these errors, develop a set of investing rules to follow religiously. The rules I follow focus on capital preservation, by investing in a diversified set of assets I know well, with a long term view, using limited leverage. That’s the best way I know to buy value and avoid being a forced seller at the worst possible times.
It was March 2009. The stock market had been in free-fall for 12 months, and my ‘portfolio’ was in shambles. At the all time market lows, my net worth even dipped into negative territory with all the debt I had piled up buying stocks. The margin that had helped juice my returns over the preceding years was now working against me, turning me into a forced seller at the worst possible time. It was ugly.
Of course, what doesn’t kill you sometimes makes you stronger. In this case, there were two silver linings. First, I was still early in my career, so in retrospect I wasn’t dealing with a ton of money. Losing $100K in your 20’s is a lot easier to recover from than losing $10M in your 50’s. Better to make those sort of mistakes at a young age. Second, those losses were a painful (and expensive!) lesson that forced me to develop a much clearer set of investment rules to keep my future self out of trouble. Most investing mistakes can be chalked up to unforced errors driven by greed or fear, and while it’s impossible to turn off those emotions, one way to help combat these tendencies is to define your own set of investing rules, and make a commitment to live by them. Below are the rules I try to live by with every investment I make. Take these to heart and they might just save you a bundle someday as well!
Rule #1: Never lose money
Obvious, right? Sure sounds obvious, but unless you go into every investment with your #1 focus being capital preservation, you run a much higher risk of losing it all. Greed gets the best of us at the worst of times. Reaching for higher returns in a low return environment is a recipe for taking on too much risk. Simply put, you need to evaluate investments to make sure what you’re buying has durable, lasting value, and that it’s relatively immune to external shocks. You should be modeling out worst case scenarios and making sure those scenarios leave you relatively whole. This doesn’t mean you stuff your money under a mattress, but it does mean you think first about how you’ll get your invested money back.
Rule #2: Never forget rule #1
Yup. See #1.
Rule #3: Invest in what you know
The best way to ensure you never lose money is to invest in things you understand intuitively, implicitly, and on a visceral level. This means staying away from complex financial products (one reason I dislike most of what Wall Street offers up). The reason for this is obvious – things you really know well will be things that you can place a clear value on.
A strong sense of intrinsic value is the only way to withstand the psychological influences that affect behavior. Those who can’t value companies or securities have no business investing and limited prospects (other than luck) for investing successfully.
This will let you buy well, and sell well. Some of the categories I know well include:
- Familiar real estate markets – this can be your hometown, or a market you’ve become familiar with over time. In either case, the most important part is choosing a property type and sub-market to follow – track property listing and sales prices, and soon enough you’ll have a good idea for value
- Products I use on a daily basis – This could be a consumer product you use everyday (see Apple, Tesla, Facebook), or an enterprise company you use at work. I find this works particularly well for ‘enterprise’ companies, because those businesses are often easier to understand than consumer properties like Twitter. A good example is Salesforce – once I saw how much my company was spending on Salesforce, and how ‘sticky’ that spend was, I was pretty sure it was a winning company. With a little due diligence on the price and multiples, finding a good entry point was easy, and because I continue to use Salesforce every day, I have a front row seat to their progress and that of their competitors, so I will know if they’re getting stale and it might be time to sell
- Long term US & Global prosperity – For the rest of my assets, I throw them in diversified, low-fee index funds from Vanguard, which is another thing I understand reasonably well – the US and Global economy. Sure, I have no idea where things will go over the next year, but I have great faith in the US and Global economy. Every day, billions of people wake up striving to improve the companies they work for. On the whole, they will make great strides. That much I understand, so on the whole, I’m comfortable ‘going long USA’ and ‘going long the World’!
Rule #4: Know where you have an edge, play there
Related to rule #3, you want to invest in things where you have an edge over the average investor. It’s a competitive market out there, so don’t expect to outperform everyone, everywhere. Know where you have an advantage that will help you skew the odds in your favor. This advantage can be informational, it can be contacts or relationships you have, it can be a unique perspective or insight you have the rest of the world hasn’t caught on to yet. Look for those places where you have an edge, and play there. It will be much easier for you to find great opportunities.
Rule #5: You make your money when you buy
If you buy well, then a profitable sale will take care of itself. All you have to do is wait for the market to correct its view on things. Ideally, if you purchase a yielding investment, like real estate, you’ll also be getting paid in the interim period – so even if the market takes its time to catch up on price, you’re still getting paid. If you pay too much for something, you could end up waiting a lifetime for that elusive return. As Warren Buffett often quips, investing is like being at bat in baseball, except you can take as many pitches as you want. You don’t have to swing. Wait until you find an investment that fits your criteria, then pull the trigger. If the market isn’t serving up good deals, then hold onto your cash. Wait until the deal comes to you, don’t reach for something and end up overpaying.
Rule #6: Don’t reach for returns
You always need to know what kind of return environment you’re investing in. Is it a low return environment? Are yields low? Are asset prices inflated? In times when the markets have stretched valuations, and yields are low, there is a temptation to take on more risk in order to reach a higher absolute return. Buy those junk bonds. Invest in those high flying stocks. Reach for yield. It’s a mistake.
Bond investors call this process “reaching for yield” or “reaching for return.” It has classically consisted of investing in riskier credits as the yields on safer ones decline, in order to access the returns to which investors were accustomed before the market rose.
The 2007 housing crisis is a perfect example of this – the low interest rate environment of the early 2010’s led pension funds and others to pile into the tempting yields offered by securitized mortgage products, without actually doing their diligence on what they contained. It didn’t end well. Reaching for returns will have you dialing up risk at the worst possible time. When yields are low, and asset prices are high, prospective returns will be low – it’s at exactly this time that the risk of a correction is greatest, and you should be most conservative with your money. Therefore, know what sort of return environment you’re in, and invest accordingly. Accept the lower returns if that is what the market is offering. Don’t reach for yield, because that’s a sure way to get burned.
Rule #7: Have an investment horizon of forever
If you don’t want to own it for 10 years, don’t bother owning it for 10 minutes. Thinking in decade time horizons will force you to think about the quality of the assets you buy, not the momentum of the market. Looking for decade-long investments will also leverage your time well. If your capital keeps getting ‘cycled out’ every 6-12 months, you’ll be constantly working to find the next deal. Personally, I’d rather own an asset that will churn our 10-15% returns consistently over the next 20 years without me touching it, as opposed to an investment that requires me to find a new place for the money every six months. This is also good advice for taxable accounts – buying and selling assets generates capital gains which means taxes you will owe to the government that could be working for you instead!
Rule #8: Use leverage with care
Never buy stocks on margin. That’s getting greedy. If you read my preamble above, you’ll see the potential consequences of that sort of action – market declines trigger margin calls, which make you a forced seller at exactly the worst time to be selling. The only time I advocate using leverage for investment purposes is with real estate. The cheap cost of capital, long term fixed rates, investment yields, tax advantages, and relatively stable nature of real estate make it better suited for these purposes. But even in this case, be very careful how much leverage you apply. I only finance new properties up to 75% loan-to-value (LTV), even when I can get higher. My long term goals for real estate leverage is closer to 50-60% LTV across my portfolio. Yes, this reduces returns modestly, but it also reduces the risk of ‘blowing up’. Fortunately with real estate, you won’t get a ‘margin call’ if the market price of your property goes down, but if your rental rates fall off, you could run into a cash crunch and be forced to sell. Stress test all of the properties you buy. What happened to property prices from 2009-2012? What happened to rental rates? If rental rates drop 20% could you still make your mortgage payments? The key here is to avoid becoming one of those forced sellers (see below).
Rule #9: Never be a forced seller
The best opportunities to buy assets come along when people are being forced to sell. In 2009, the stock market was full of forced sellers as credit collapsed, prices dropped, and margin calls were made. From 2009-2012, landlords got crushed with rental price declines and vacancies. They were forced to sell their properties at steep discounts. You always want to be a buyer when others are being forced to sell (which is why it’s nice to always have some ‘dry powder’ on hand). What this also means is that you never want to be the forced seller.
Since buying from a forced seller is the best thing in our world, being a forced seller is the worst. That means it’s essential to arrange your affairs so you’ll be able to hold on—and not sell—at the worst of times.
This is why all the preceding rules are so important – buy quality assets you would be comfortable owning for decades, with only modest leverage that is manageable, should the worst case scenarios come true. Ideally you’ll be buying during the next market crash, but at the very least you need to be able to hold what you’ve got and weather the storm. Stress test your portfolio to make sure that’s the case.
Rule #10: Diversify, always
No matter how well you follow the rules above, there will be things you can’t predict. When you’re investing in multi-decade timescales, things change. Sometimes faster than we can ever imagine. A typical mortgage will last 30 years… 30 years ago was 1987. Personal computers were a novelty, the internet was barely a thing, cell phones were the size of shoe boxes, and you were lucky if your car had power windows. I expect the changes we’ll see over the next 30 years will be even more profound. Given that we live in an uncertain future, the only way to defend against this is to diversify your bets. A good rule I’ve heard thrown around is to limit your investment in any one asset to 1% of your net worth (excluding your home). This is a useful way to think about things – for example, if your net worth (excl. home) is $1M, then the largest position you would want to take in any single stock would be $10K. For the stock market this is a pretty good heuristic. For things like real estate, this is a little unrealistic, but the principle remains the same – don’t buy all your real estate in one market. Diversify across a few markets with different economic drivers and dynamics. Diversify across asset types – multifamily, commercial, self storage etc. This diversity will make it much harder for you to get wiped out in any given downside scenario.
So that’s it, 9 simple investment rules to live by. The hard part is living them daily. Nobody can guarantee a risk free, worry free set of investments, but if you hold yourself accountable to these rules, you’ll remove most of the major risks when investing, and if you take care of the downside, often the upside will take care of itself.
Good luck, and enjoy the journey!
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