You may have heard billionaire Warren Buffett’s investment rules before.

Rule #1: Never lose money.
Rule #2: Never forget Rule #1.

Buffett’s strategy sure has worked for him over time, although in truth there are no guarantees that you can avoid losing money in risky investments such as stocks. Even Buffett has made some mistakes.

We admit to not being as smart as Buffett, so when we establish our own investment rules, we want to start with something that seems obvious, but is routinely ignored.

MODUS ADVISORS RULE # 1: DON’T DO ANYTHING DUMB!

I know what you’re thinking, “Of course. Who would do things that they know are dumb?” The unfortunate answer is that many investors, amateur and professional, make dumb mistakes. The problem is that they usually don’t think about it until after something goes wrong.

At Modus Advisors, we don’t like nasty surprises, so we spend time up front thinking about what can go wrong with any investment or strategy. It doesn’t ensure that nothing bad can happen, but it creates a rational framework for future decision-making. Here are a few examples of the dumb things you shouldn’t do and why it can become a problem.

1.    Don’t try to time the markets! Many investors try this every day and the appeal is clear. If only you could always be invested in something that’s going up and stay out of things that are going down, you could be fabulously rich in a relatively short period of time. But hoping for it and accomplishing it are two different matters. Good luck finding anyone who has actually succeeded in timing the markets over many years. The only certainty you have by trying this is that you’ll put a lot of time into it, pay more in transaction fees, possibly pay more in taxes (assuming you make any money, of course), and most likely raise your stress level. A few lucky ones will end up making more money, but most will fail.

As an alternative, you are likely to earn profits over time even if you are just a passive participant in the stock and bond markets due to economic growth throughout the years.

2.    Don’t believe that you know something that the market doesn’t know! This is a common problem for amateur investors. Comments such as, “I should buy this stock because the company is growing really fast” is a typical example. The problem is that every other investor following that company knows that the company is growing fast, too. And they’ve already factored it into the price that they’re willing to pay for the stock. So just knowing things about a company gives you no advantage in a competitive financial market. You either need to know something that other investors don’t know (excluding insider information, which is illegal to trade on) or you need to see that other investors are misinterpreting the available facts. Better analysis may lead to better performance, but realize that you are trying to outsmart millions of other investors and analysts that have their money or their jobs on the line and thus are highly motivated to understand everything you do and more.

3.    Don’t buy investments that you don’t understand! No matter what type of investment you make, you need to know how it works and what it is you are buying. For example, if you buy an individual stock, are you doing it just because you like the company’s products or have you actually done exhaustive research on the risks and opportunities the company faces? If you didn’t do the research, how will you know what to do with the stock later on? What usually happens is that if the stock goes up, you feel good about it and might sell it for a gain someday, but if the stock goes down a lot, you don’t know what to do. Now you have to decide how bad the news is, but since you don’t really understand the company’s operations, you can’t figure out the likely impact. Since you are just now realizing that you don’t understand the stock, you will be compelled by your emotions to sell the stock to avoid the possibility of further losses. Unfortunately, that means you’re also locking in current losses. This is not a good way to invest in stocks!

Look at it this way: it’s really smart to make sure that you don’t do anything dumb. Mistakes are unavoidable - you won’t make money on every investment – but your approach matters a lot. Most people focus heavily on the pros of an investment and pay little attention to the cons. When we analyze investments, though, we work first to rule out, and then rule in. In other words, identify the problems first and make sure we aren’t going to do anything dumb. By doing that, it makes it that much easier to do something smart. As one of our favorite portfolio managers says, “If we can limit the downside, the upside tends to take care of itself”.