The rules of prudent investing

While we search for the answers to the complex problem of how to live a longer life, there are simple solutions that can have a dramatic impact. For example, it would be hard to find better advice on living longer than do not smoke, drink alcohol in moderation, eat a hearty breakfast and a balanced diet, get at least a half hour of aerobic exercise three to four times a week, and buckle up before driving. The idea that complex problems can have simple solutions is not limited to the question of living a longer life.

Do not take more risk than you have the ability, willingness, or need to take. Plans fail because investors take excessive risks. The risks unexpectedly show up, and investors with 30 year horizons can turn into investors with 30-day horizons. That leads to the abandonment of plans. When developing your plan, consider your horizon, stability of income, ability to tolerate losses, and the required rate of return.

Never invest in any security unless you fully understand the nature of all the risks. If you cannot explain the risks to your friends, you should not invest. Fortunes have been lost because people did not understand the nature of the risks they were taking.

The more complex the investment, the faster you should run away. Complex products are designed to be sold, not bought. You can be sure the complexity is designed in favor of the issuer, not the investor. Investment bankers don’t play Santa Claus providing you with higher returns because they like you.

Risk and return are not necessarily related; risk and expected return are related. If there were no risk, there would not be higher expected returns.

If the security has a high yield, you can be sure the risks are high, even if you cannot see them. The high yield is like the shiny apple with which the evil queen entices Snow White. Investors should never confuse yield with expected return. Snow White could not see the poison inside the apple. Similarly, investment risks may be hidden, but you can be sure they are there.

A well-thought-out plan is the necessary condition for successful investing; the sufficient condition is having the discipline to stay the course, rebalance, and tax-loss harvest as needed. Unfortunately, most investors have no written plan. And emotions such as greed and envy in bull markets and fear and panic in bear markets, can cause even well-thought-out plans to be trashed.

Having a well-thought-out investment plan is the necessary condition for achieving your financial goals. Integrating the investment plan into a well-thought-out estate, tax and risk management (insurance of all kinds) plan is the sufficient condition. The best investment plans can fail due to events unrelated to financial markets. For example, the breadwinner dies without sufficient life insurance, there is an accident and there is insufficient liability coverage, or disability or long-term-care insurance is needed but is not in place.

Do not treat the highly improbable as impossible, nor the highly likely as certain. Investors assume that if their horizon is long enough, there is little to no risk. The result is that they take too much risk. Taking too much risk causes investors with long horizons to become short-term investors. Stocks are risky no matter the horizon. And remember, just because something has not happened doesn’t mean it cannot or will not.

The consequences of decisions should dominate the probability of outcomes. We buy insurance against low-probability events (such as death) when the consequences of not having the insurance can be too great to accept. Similarly, investors should insure their portfolios (by having an appropriate amount of high-quality fixed income investments) against low-probability events when the consequences of not doing so can be too great to contemplate.

The strategy to get rich is entirely different from the strategy to stay rich. One gets rich by taking risks (or inheriting it). One stays rich by minimizing risks, diversifying, and not spending too much.

The only thing worse than having to pay taxes is not having to pay them. The “too many eggs in one basket” problem often results from holding a large amount of stock with a low-cost basis. Large fortunes have been lost because of the refusal to pay taxes.

The safest port in a sea of uncertainty is diversification. Portfolios should include appropriate allocations to the asset classes of large and small, value and growth, real estate, international developed markets, emerging markets, commodities, and high-quality bonds.

Diversification is always working; sometimes you’ll like the results, and sometimes you won’t. Diversification in the same asset class reduces risk without reducing expected returns. However, once you diversify beyond popular indices (such as the S&P 500), you will be faced with periods when a popular benchmark index outperforms your portfolio. The noise of the media will test your ability to adhere to your strategy. Remember, a strategy is either right or wrong before the fact.

The prices of all equity and risky bond assets (such as high-yield bonds and emerging-market bonds) tend to fall during financial crises. Your plan must account for this.

Identifying a mispriced security is the necessary condition for out-performing the market; the sufficient condition is being able to exploit any mispricing after the expenses of the effort. The “history books” are filled with investors that tried to exploit “mispricings,” only to find that trading (and other) costs exceeded any benefits.

Equity investing is a positive-sum game; expenses make outperforming the market a negative-sum game. Risk-averse investors don’t play negative-sum games. And most investors, probably including you, are risk averse. Use only low-cost, tax efficient, and passively managed investments.

Owning individual stocks and sector funds is more akin to speculating, not investing. The market compensates investors for risks that cannot be diversifed away, like the risk of investing in stocks versus bonds. Investors shouldn’t expect compensation for diversifiable risk – the unique risks related to owning one stock, or sector or country fund. Prudent investors only accept risk for which they are compensated with higher expected returns.

Take your risks with equities. The role of bonds is to provide the anchor to the portfolio, reducing overall portfolio risk to the appropriate level.

Before acting on seemingly valuable information, ask yourself why you believe that information is not already incorporated into prices. Only incremental insight has value. Capturing incremental insight is difficult because there are so many smart, highly motivated analysts doing the same research. If you hear recommendations on CNBC or from your broker or read them in Barron’s, the market already knows the information it is based on. It has no value.

The four most dangerous investment words are “This time it’s different.” Getting caught up in the mania of the “new thing” is why “the surest way to create a small fortune is to start out with a large one” is a cliché.

The market can stay irrational longer than you can remain solvent. Bubbles do occur. However, investors should never attempt to short them because, while bubbles eventually burst, they can grow larger and last longer than investor resources.

If it sounds too good to be true, it is. When money meets experience, the experience gets the money and the money gets the experience. The only free lunch in investing is diversification.

Never work with a commission-based adviser. Commissions create the potential for biased advice.

Work only with advisers who will give a fiduciary standard of care. That is the best way to be sure the advice provided is in your best interest. There is no reason not to insist on a fiduciary standard.

Separate the services of financial adviser, money manager, custodian, and trustee. This minimizes the risk of fraud.

Since we live in a world of cloudy crystal balls, a strategy is either right or wrong before we know the outcome. In general, lucky fools do not have any idea they are lucky. Even well-thought-out plans can fail because risks that were accepted occur. And risks that were avoided because the consequences of their materializing would be too great to accept may not occur.

Hope is not an investment strategy. Base your decisions on the evidence from peer-reviewed academic journals.

Keep a diary of your predictions about the market. After a while, you will conclude that you should not act on your “insights.”

There is nothing new in investing, just the investment history you don’t know. The knowledge of financial history will enable you to anticipate risks and incorporate them into your plan.

Good advice does not have to be expensive; but bad advice always costs you dearly, no matter how little you pay for it. Smart people don’t choose the cheapest doctor or the cheapest CPA. Costs matter; but it is the value added relative to the cost of the advice that ultimately matters.

There are four more rules for investors to be able to succeed on their own:

An interest in investing. It’s no different from cooking, gardening, or parenting. If you don’t enjoy it, you’ll do a lousy job. Most people enjoy finance about as much as Carmela Soprano enjoys her husband’s concept of marital fidelity.

The horsepower to do the math. As Scott Burns explained to me years ago, fractions are a stretch for 90% of the population. The Discounted Dividend Model, or at least the Gordon Equation? Geometric versus arithmetic return? Standard deviation? Correlation, for God’s sake? Fuggedaboudit!

The knowledge base—Fama, French, Malkiel, Thaler, Bogle, Shiller—all seven decades of evidence-based finance back to Cowles. Plus, the “database” itself—a working knowledge of financial history, from the South Sea Bubble to Yahoo!

The emotional discipline to execute faithfully, come hell, high water, or Bob Prechter. Mr. Bogle makes it sound almost easy: “Stay the course.” Alas, it is not.

For those who cannot, a financial adviser will do:

When interviewing a potential financial adviser, you should need them to make the following 11 commitments to you. Doing so will give you the greatest chance of avoiding conflicts of interest and the greatest chance of achieving your financial goals.

  1. The firm should be able to show that its guiding principle is to give investment adviser services that are in the client’s best interests.
  2. The firm follows a fiduciary standard of care. A fiduciary standard is often considered the highest legal duty that one party can have to another. This differs from the suitability standard present in many brokerage firms. That standard requires only that a product or service be suitable; it does not have to be in the investor’s best interest.
  3. The firm serves as a fee-only adviser — avoiding the conflicts that commission-based compensation can create. With commission-based compensation, it can be difficult to know if the investment or product recommended by the adviser is the one that is best for you or the one that generates greater compensation for the adviser.
  4. All potential conflicts are fully disclosed.
  5. Advice is based on the latest academic research, not on opinions.
  6. The firm is client-centric — advisers focus on delivering sound advice and targeted solutions. The only requirement they have in offering particular solutions is whether the client’s best interests will be served. The firm is focused on providing advice, not products.
  7. Advisers deliver a high level of personal attention and develop strong personal relationships, and because no one can be an expert on all subjects, clients benefit from a team of professionals to help them make sound financial decisions.
  8. Advisers invest their personal assets (including the firm’s profit-sharing/retirement plan) based on the same set of investment principles and in the same or comparable securities they recommend to their clients.
  9. They develop investment plans that are integrated with estate, tax, and risk management (insurance) plans. The overall plans are tailored to each client’s unique personal situation.
  10. Their advice is goal oriented — evaluating each decision not in isolation but in terms of its impact on the likelihood of success of the overall plan.
  11. Comprehensive wealth management services are provided by individuals with Certified Financial Planner (CFP), Personal Financial Specialist (PFS), or other comparable designations.

adapted  from The Quest for Alpha- The Holy Grail of Investing  by Larry  E. Swedroe

For more stuff written by Larry  Swedroe, read his articles here.

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