June 19, 2013

Investment Rules

Investment, trading and understanding markets and economy is an absolute necessity in the modern world if you are to build your nest egg and have a nice retirement to look forward to.

Successful investment requires one to overcome strong natural biases and emotions to avoid losing it all. Here are some collected words of wisdom from various sources as a public note to myself, to help me keep these things in mind. These rules are easy to write, read and parrot to your fellow traders and investors, but when your own money is at play, extremely hard to adhere to.

  1. Never risk more than 1% of your capital in a single investment. Risk/reward ratio per investment should be at least 1:3. You’re going to have bad investments – everyone does. The trick is to cut your losers quickly and let your winners run far – one good trade should be able to pay for many bad trades. Another way to think about this is – if you have two or three good trades, and that’s all you did that year, you’d be up 5-6% on yearly basis – that’s not bad! Your first goal is to beat inflation – that’s the break-even point. Anything beyond that is a bonus.

  2. Never ever add to a losing position or cost-average down. Put another way, don’t throw good money after bad money. The temptation is huge, but face the reality – what you expected isn’t happening. Wait for the trade to confirm itself and direction before considering adding to it, but also remember not to exceed the 1% risk limit.

  3. Diversify as much as possible. There is a natural tendency to favor certain asset classes or industries – but this also consolidates your risk. Three banking sector stocks or three precious metal positions count combined against the 1% rule – because they are closely related, they’re likely to move similarly – and before you know it you’ve overcommitted yourself. Here’s a few ideas for diversification: cash, stocks, bonds, physical gold and silver, friends startup, fine art, stake in a mango farm, antiques, wine, real estate, land, stamps, coins. Don’t forget to also diversify geographically – in the modern world there is no reason to limit your investments to a single country or even continent.

  4. Don’t short rocket ships and don’t catch falling knives – the market can remain irrational longer than you can remain solvent. It’s OK to be contrarian, but wait for the new trend to be established and confirmed. There is always time to get in once that happens.

    One of the most common misconceptions about investment is to buy low and sell high. Nothing could be further from the truth. No, the idea is to buy high and sell higher. This is what is meant by waiting for a trend to be established. Every asset price fluctuates – over-reaching and correcting – driven by greed and fear. When an asset is regularly making higher highs and higher lows (during corrections), it is said to be trending in a bull market – that is when you want to buy. Buying the dips is equivalent to guessing bottoms and catching knives – but buying just as the asset is breaking into a new high – that’s riding the wave. The risks of trying to buy the dip are far greater than those of riding a wave going in your direction.

    This also brings the topic of STOPs and specifically TRAILING STOPS. STOP is a price point you have previously selected that is your exit point from that trade (see the 1% rule). As the trade goes in your way, adjust your exit point first to break-even so you don’t let your winning trades become losers – and then keep the stop following the wave upwards. So if you bought at $10 with STOP at $9, as the price moves to $12, you set your stop at $10, as the price continues to $15, you have your stop at $13 and so forth until, say, the price hits $20 (your stop at $18) and then retraces back to $17.5 – you should be out of the trade now with a nice $8 profit.

    But I could have sold at $20 and made another $2!” you say. No. Don’t try to guess – follow what the market is doing; if you sold at $20 and the price continued to go to $40, you’d be fairly unhappy.

    In brief, ride established trends, enter at breaks to new highs (or lows if shorting a bear trend), don’t try to guess bottoms or tops, and ride your winning trades with trailing stops as far as they’ll go – irrational market is awesome if you’re on the right side of the trade to benefit from it.

  5. Do not look to get rich fast – slow and steady wins the race. Trading too big trying to take shortcuts only gets you wiped out. If you want to gamble, you’ll have better odds at the casino. Remember, all markets that can be rigged, are, by those in position to do so – and it’s the gamblers that get slaughtered.