June 27, 2012 7 Comments

Obey Your Rules!

Without a written set of rules or an investment model to follow, you will think “hey, this looks cheap, let’s buy it” or “I think it’s getting overpriced, time to sell.” But how do you know that the price won’t get cheaper, or that the price won’t go higher? You don’t. You’re simply “guesttimating”. Without a concrete set of rules to follow, you’ll become self-indulgent and buy in a bubble or sell in a market crash.

Fortunately, an investment model will force you to think logically, put the market into a matter of odds and, paradoxically, save yourself from yourself. “According to my model, exactly what is the probability that the price will go down and that the price will go up?” Based on that specific probability, you can make a logical and sound investment.

Never Invest In XYZ Just Because Someone Else Is

Not wanting to think for themselves, most investors just want to copy others and act on tips, which are fast tickets to the poorhouse.

The “These 10 stocks will double your money overnight and make you rich rich RICH and!” emails are targeted at exactly the right audience: the average person doesn’t want to think for himself. To quote Reminisces of a Stock Operator “The average investor spends less time thinking about where to place his life savings than he does buying a piece of furniture. He just wants to be told what to invest in, and moreso, how much money he can make from the investments.”

Out of a 100 tips, most will burn a whole in the tip receiver’s pocket because the tip giver is probably just as clueless as he is. In other cases, the tip giver realizes that he cannot make money from investing in his tips but CAN make money by selling them to less fortunate investors! Look at Jim Cramer. Nobody has consistently beaten the market via Cramer’s tips, but you can bet he makes millions a year from Mad Money!

In other situations, investors who don’t want to lose money from get-rich-quick tips copy the investments of other successful investors, traders, or hedge funds.

The thinking goes like this: “If Bridgewater or GMO Capital is investing in XYZ on the long side, why shouldn’t I just tag along and make some easy money?”

With a critical flaw in his belief, the imitator assumes that he can enter and exit the investment at the same time as the successful investor does. This is definitely not true.

For example, an investment by Bridgewater (a highly successful hedge fund) was (as usual) publicly disclosed via its Quarterly Report, after which the imitator entered the same investment but at a DIFFERENT PRICE. Herein lay the problem.

A)    Because Bridgewater entered the investment at $20 and the imitator entered the investment 2 ½ months later at $28, he did not make the 40% return that Bridgewater did.

B)     Having sold out at the top of a trend, Bridgewater left the imitator with a huge loss while thinking that Bridgewater still held its position, which it didn’t.

The above scenario is far too common: tag-alongs cannot buy or sell at the same price as the investment their following.

Always do your own homework and never completely rely on a third party because even if you make some money by imitating others, one day you will lose everything.

But serious investors copy professionals for none of the above reasons. When an investor’s market view conflicts with that of a successful investor whom he really trusts, he will often scrap his initial conviction and do what the successful investor is doing. If you’re one of these people, avoid this trap!

In the event of such a conflict, it’s best to have no position at all. Simply following the successful investor can be disastrous, because this might be the 1 out of 5 times that he’s wrong. But going blindly ahead with your market view can also be disastrous, because the successful investor has a long, successful track record.

Never Invest On Your Gut Feeling

I found that successful investors have different views on the importance of gut feeling. Some say that “my gut feeling has saved me multiple times in the past”, and others proclaim that “trusting your gut feeling will be your doom.” Here’s what I think.

“Gut feeling” can be divided into two things: subconscious thinking, and irrational human behaviour. As for subconscious thinking, the human brain, constantly sorting ideas and “files” into a logical order, is like a computer.  This happens when an investor works long days and cannot stop thinking about the market. Sometimes, the brain will come to a conclusion in the back of the brain. (For example, one investor had a dream about silver spiking, and sure enough, silver began an upwards trend the next day.) HOWEVER, such subconscious thinking rarely happens, and when it does, only to investors who have been in the markets for many years/decades.

On the other hand, gut feelings are root of irrational human behaviour. It’s natural human behaviour to sell when everyone else is selling and buy when everyone else is buying (which is where the term crowd psychology  stems from). Hence, your “gut feeling” is really what makes you feel good at the moment (e.g. buying at the top of hysteria).

The ultimate question is, should you trust your gut feeling? To me, the answer is a resounding no. Only when you have years of successful investment experience can you begin to trust your gut instinct, or else, you’re just indulging your irrational human instincts.