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.
If you follow the financial media, you will regularly hear comments such as, “I’m cautiously optimistic on stocks here”. What this particular prognosticator is doing is trying to hedge his bet so that he will be able to claim success on the prediction later on, no matter what the outcome. If stocks do well, he’ll proclaim, “I told you to be bullish!” On the other hand, if stocks do poorly, he’ll say, “My caution has been warranted”. It’s all just public relations spin and everyone plays along, but it doesn’t help investors make good decisions if no one accepts accountability for their recommendations. Modus Advisors doesn’t play these games. Our goal is to serve our clients as well as we can, not to generate hype in the media. But we do believe in caution. And we believe in optimism. The difference between Modus Advisors and most financial commentators is that we accept both of these things as permanent conditions for any investment strategy. Why be cautious? During the past few months, we’ve seen social unrest close to home with the hot button topic of union rights in Wisconsin and other states. We’ve seen violent uprisings in various Middle East countries that toppled governments and sent oil prices sharply higher. We’ve seen a massive earthquake and devastating tsunami hit Japan. We exercise caution because there is always risk, much of it unforeseen and even in cases where something is predictable, the timing is usually highly uncertain. Why be optimistic? Quite frankly, for all of the problems we face today, the U.S. and the rest of the world has been through worse, but the global economy continued to grow over time and investors have generally fared well as long as they were committed to a long-term strategy. Substantial dislocations such as two World Wars, a huge number of smaller wars and conflicts, the Great Depression, dozens of recessions, inflationary bouts, financial crises, etc…none of these have stopped the trend towards increasing prosperity in the world.
You probably don’t know much about Peter Thiel. He’s made huge sums of money as a co-founder of PayPal and early investor in Facebook. His investment fund bet on skyrocketing oil prices in 2007-2008 and foresaw the economic crisis that would come when the housing bubble collapsed. Okay, so now you know a little about Peter Thiel. Enough to know that he’s a pretty smart guy, maybe someone to pay more attention to in the future, maybe someone you’d like to invest your money with. Right?
Case #1: On January 10, 2011, a small consumer goods company stock jumped +8.1% on trading volume more than 40 times its average in recent weeks. There wasn’t a single bit of company or industry news that caused this stock to move so dramatically. It was, in fact, caused by a typo and some clearly unsophisticated investors. The prior Friday, CNBC Mad Money’s host Jim Cramer made a recommendation for a completely unrelated stock while on the air. Summaries of Cramer’s show are then typed up and posted to cnbc.com. During this transcription, cnbc.com mistakenly attributed the incorrect stock symbol to Cramer’s pick. Come Monday morning, a sizeable number of investors who saw the cnbc.com article were ready to snap up shares, but they didn’t bother to do even the most basic research on the company (e.g., verify that the stock symbol actually belonged to the recommended company). Cramer said “Buy!”, so they were going to buy. Unfortunately, they were buying the wrong stock. Case #2: Todd Sullivan manages an investment partnership, but also provides stock research to investors through an online subscription service. Mid-day on January 14, 2011, he emailed an alert to his subscribers that he had sold half of his position in a stock that had quadrupled in price since he first bought it. He told subscribers that he still thought the company had a good outlook, but he felt it prudent to take some of his big gain off the table. You can probably guess what many of his subscribers did next. Yes, they dumped their stock as fast as they could. Other investors unaware of the sell alert likely panicked, assuming that there was some bad news out on the company, and sold right along with them. At the end of the day, the stock was down -14%. While each of these cases came about for different reasons, there are a few notable similarities. First, there are a lot of investors who will trade urgently and without thinking just because they heard that someone else was doing the same. Second, big changes in price can occur due to trigger events that have nothing to do with what is occurring at the actual company. Markets can be crazy. In these examples, they went crazy one stock at a time. In other periods, the entire market can seem crazy, with hair-trigger traders filled with emotion. We need to accept that this happens and understand that it is no reason to run from the market. What matters are not these daily gyrations, but the long-term opportunities that the markets provide to grow your wealth. Let the other guys make the silly mistakes while you stay focused on your ultimate goals.