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By Barry Ritholtz, Published: September 28

Each year on the Big Picture, the blog I call home, I update my top trading rules and aphorisms. Its a collection I have gathered over the years of my favorite trader, analyst, economist and investor viewpoints on what and what not to do when it comes to investing in the capital markets. Whenever I publish a list like this, someone invariably asks: You have been at this for 20 years (and you seem to like numbered lists), what have you learned over that time? Fair enough. You could probably cobble together my guide from what Ive written for The Washington Post. Let me save you the trouble. Here is the first half of my dozen rules for investing. (Come back next time for the rest.) 1 Cut your losers short and let your winners run: Perhaps the best investing advice ever, its sophistication is belied by its apparent simplicity. Letting your winners run generates all sorts of desirable outcomes: It allows compounding to occur, gives you the benefit of time and keeps your transaction costs, fees and taxes low. Since this rule does not allow you to take a quick profit for no reason (other than having one), it also forces you to develop an actual exit strategy. Similarly, cutting your losers short forces you to be humble and intelligent. It rotates you away from the sectors and stocks that are not working. Best of all, you are forced to admit your own fallibility crucial for all investors. 2 Avoid predictions and forecasts: Humans are very bad at guessing what the future will bring. The academic literature overwhelmingly proves this. If you prefer anecdotal evidence, recall how many economists forecast the Great Recession (almost none), the initial reviews of the iPad (mostly panned) or even the iPhone (meh!). For your own investing, you should ignore other peoples forecasts. And you should avoid making any yourself. Why? Because when investors make forecasts they focus more on being right than making money. They unconsciously shift their portfolio toward their predictions rather than what is occurring in the markets. This is a recipe for disaster. Consider how many people completely missed the huge rally since the March 2009 lows, mostly because of forecasts of another crash. They were rooting for their prediction, instead of spotting the opportunity. 3 Understand crowd behavior: The investor who understands the behavior of crowds has an enormous advantage over one who doesnt. He understands that investing often involves figuring out where the crowd is going, even if its objectively wrong. Recall Keyness theoretical beauty contest, where players were not trying to pick who they thought was prettiest, but rather, select who they anticipated the crowd might pick. Investing isnt necessarily a process of picking the best asset class, sector or stock, but rather, selecting what the crowd is buying. Investors sometimes forget that, most of the time, the crowd is the market. (You can take advantage of this by, as Rule 6 suggests, becoming a index investor). The psychology of crowd behavior is such that higher prices attract more buyers and lower prices create sellers. Fear of missing a rally is a powerful element; fear of losses is even stronger. 4 Think like a contrarian: The crowd can be fickle, overly emotional or even irrational. The contrarian learns to recognize when the crowd turns into an unruly mob. When that happens, its time to stop betting with the group, and take the other side of the trade betting against the crowd. Most people accept conventional wisdom at face value, tend toward widely accepted social mores and are uncomfortable being a

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lone voice of dissent. There is an evolutionary reason for this: Humans are social animals, and we have evolved to cooperate with the members of our tribe and to work with the group. But there is a qualitative difference between what the majority of rational-thinking market participants are doing and the reflexive, panicked behavior of an unthinking mob. The true contrarian can tell the difference between a crowd and a mob, a market rally and a bubble. The tricky part is the timing. 5 Asset allocation is crucial: What is your relative weighting of stocks, bonds, real estate and commodities? In the popular finance media, this gets little attention. Yet all of the academic studies show that its the most important decision an investor makes. Its far more important than stock selection, yet thats all anyone seems to want to talk about. As we noted last summer, Stock picking is for fun. Asset allocation is for making money over the long haul. The worlds greatest stock picker would have gotten shellacked in 2008; the worlds worst stock picker made a ton of money in 2009. The weighting you select for various asset classes is a function of such factors as your age, income, risk tolerance and retirement needs. It is what serious investors focus on. 6 Are you an active or passive investor: For the equity portion of your allocation, you must answer a crucial question: Do you buy indexes and garner market-level returns, or do you pick stocks (or sectors) and time the market in an attempt to beat the indices? Those who try to beat the market have a tough road ahead: Each year, 80 percent of professional managers fail to beat their benchmark. Of the few who do, once you take fees and costs into consideration, less than 2 percent actually hit that bogey. If you want to beat the market, understand the long odds that are working against you. That is why for most investors, indexing is a much better bet. In conclusion, investors need to fully understand the challenges that face them: Capital markets are about making the best probabilistic decisions using imperfect information about an unknowable future. Sometimes you have an embarrassment of riches to select from; other times you are choosing the least-worst option. Either way, you will never have perfect information that allows you to bet on a sure thing. There is no magic elixir. Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of Bailout Nation and runs a finance blog, the Big Picture. You can follow him on Twitter: @Ritholtz. For previous Ritholtz columns, go to washingtonpost.com/business. The Washington Post Company

2012-09-29 12:27

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By Barry Ritholtz, Published: October 12

This week, were going to pick up with my rules for investing. These rules come from 20 years of experience or 20 years of learning from my own mistakes. My list is designed to help you understand what you face as an investor and avoid the sorts of errors that cost many investors a lot of money. Understanding the philosophy here will result in fewer losses, better performance and more restful nights. Because I didnt want to overwhelm you, I broke the list into two parts. Before we get to this weeks list, you can read the first part here. For those reading this in the newspaper, those six rules were: 1. Cut your losers short, and let your winners run. 2. Avoid predictions and forecasts 3. Understand crowd behavior. 4. Think like a contrarian. 5. Asset allocation is crucial. 6. Decide if you are an active or passive investor. Lets move on to part two: 7. Understand your own psychological make up. Most investors think they are competing against other traders, big institutions, hedge funds etc. In fact, they are their own most dangerous opponent. Why is that? It is because of the way we are wired. We fall prey to all sorts of cognitive errors. We are overconfident in our abilities to pick stocks, time the market, know when to sell. We suffer from confirmation bias, seeking out that which agrees with us and ignoring facts that challenge our views. We vacillate between emotional extremes of fear and greed. We are surprisingly risk-averse, and at precisely the wrong times. The recency effect has us overemphasizing recent data points while ignoring long-term trends. Our own cognitive and psychological errors often lead us down the wrong path. You can counter these foibles only if you are aware of them. 8. Admit when you are wrong. One of the biggest problems many investors have is admitting they made a bad investment. Men, suffering as they do from testosterone poisoning, are especially bad at this. Whether its ego or just stubbornness, too many people seem to hold on to their losers for way too long. Pride can be a very expensive sin. The most effective approach is to admit your error, fix the mistake, then move on. Think of investing as more akin to batting in baseball than to being a lawyer, accountant or doctor. If you are a .333 hitter if you get a hit one out of three times at bat you are an all-star ball player. A doctor who loses two-thirds of his patients or an accountant who has 66 percent of his clients audited are both doing something terribly wrong. We have a saying in my office called strong opinions weakly held. We may have a high degree of confidence in a particular investing theme say, emerging markets dividends or municipal bonds but as soon as we have proof we are wrong, we reverse the position, sell the holding and move on. I believe in admitting errors and, in fact, each year I publish a list of mea culpas describing my worst investing errors. I explain what I did wrong and what I learned from it. It may be human to make mistakes, but it is foolish to make the same ones over and over. Try making some new mistakes instead.

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9. Understand the cycles of the financial world. Another challenging thing to do in investing is to reverse your thinking, especially after a specific approach has been profitable for a long time. The longer the period of successful thinking, the more important and challenging the reversal will be. Pay attention to history, and you learn that events move in long, irregular cycles. We have the business cycle, which alternates between periods of expansion and contraction. Recessions happen, as do recoveries. Then there is the market cycle, where booms and busts occur regularly. Every bull market is followed by a bear; every bear market is followed by a bull. This can be difficult to remember when you are in throes of either one. It seemed in 1999 that almost no one could imagine that the manic price rises of the market would ever end. And in late 2008 and early 2009, it looked like the vicious market collapse would never end. But it did and it always does. This too shall pass is a proverb that humbled King Solomon. Understand what it means when you mistakenly believe something will never change. 10. Be intellectually curious. There is a tendency amongst investors to settle into a comfort zone. You develop a particular style, find an investing method you like and then think it will last forever. This is a recipe for slothful calcification. Heraclitus was a Greek philosopher whose doctrine of flux stated The only constant is change. This is especially true in investing. The many different inputs that drive market returns constantly change. At various times, it can be profits, the Fed, the economy, interest rates, technology, tax policy, etc. It is important that you constantly upgrade your skill set, while learning to be both adaptive and flexible. The best investors all have a healthy dose of intellectual curiosity. If everything else is changing, but you are not, then you are being left behind. 11. Reduce investing friction. Friction refers to all of the little costs that, when compounded over time, can add up to big dollars. In investing, friction refers to anything that is a drag on total returns outside of market performance. Think about the long-term effects of the fees, costs, expenses and taxes on your net, above and beyond how your investments did. Since 1974, the markets have returned about 10 percent a year. The average 401(k) retirement account earned about 3 percent annually over that period. There are numerous reasons these portfolios radically underperformed the markets, but one of the primary reasons is the layers of excess fees and fund loads. Investors with lower costs tend to have better growth and retain more of their assets over the long haul. Keep your fees, costs expenses and taxes low. It is a guaranteed way to improve your returns. 12. There is no free lunch. This is the most fundamental rule in all of economics. It gets forgotten by too many investors. The temptation is to get something for nothing. You never get something for nothing. Consider: That hot stock tip? You want the upside without doing all of the tax research. High-yield junk bonds? Some people believe that an 8 percent yield when the 10-year Treasury is paying 1.62 percent does not come with an increased risk of default. They are mistaken. Sitting in way too much cash? It creates a false illusion of safety that will not keep up with inflation. No one on television is going to make you wealthy. There is no magic formula or silver bullet or secret hedge fund. The best investors generate long-term returns by making rational, unemotional decisions. They do their homework, spend time and effort learning the basics. They are unemotional, intelligent and patient. You can be as well. Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of Bailout Nation and runs a finance blog, the Big Picture. You can follow him on Twitter: @Ritholtz. For previous Ritholtz columns, go to washingtonpost.com/business. The Washington Post Company

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