Any student of investing has seen lists of rules or slogans. "Buy low, sell high." "Cut your losses but let your profits run." "Better safe than sorry." Sometimes all the rules get pretty confusing. Some rules sound quite sensible, until you find other rules that seem to say just the opposite. For instance, "get expert advice" is a common rule. But you'll also read or hear "make your own decisions" and "don't follow the crowd." Many investment writers and money managers will advise you to "invest for the long-term and be patient." Others will say you should "be ready to move quickly" or "timing is everything" What's a conscientious investor to do?

Brief, pithy rules are easy to remember. They seem to package the wisdom of the ages into a few simple words. The trouble is that often (like too many politicians), they reduce complex dilemmas into simplistic slogans.

I like to save lists of investment rules and this month we'll look at some I've collected. These rules are gathered from some of my good friends in the business like Bill Donoghue, Sheldon Jacobs, Gerald Perritt and from others I don't personally know like John Templeton and Harry Browne. We'll commend some, we'll pan others and we'll comment on many. This exercise has been fun and thought-provoking for me and I hope it is for you, too. But I think Gen. Douglas MacArthur is worth quoting here: "Rules are mostly made to be broken and are too often for the lazy to hide behind." So if you turn my comments into new rules for yourself, you'll miss the real value here. Use this discussion as a starting point to think about what rules you follow and why they make sense for you.

"Any fool can make a rule."
--Henry David Thoreau

In six short words, Thoreau manages to insult everybody who ever tried to reduce smart investing to a set of rules. I'm sure I am included. So with that out of the way, let's start at the beginning, at least as "the beginning" is defined by a legendary investor. Here's one of Sir John Templeton's "16 Rules for Successful Investing."

RULE: Begin with a prayer.
COMMENT: One day last month, Paul Harvey's News and Comment disclosed the prayer that is heard more than any other by priests and pastors at chapels in Las Vegas: "God, make me a winner." I don't know if the people who say that prayer have better-than-average success in Las Vegas, but I sort of doubt it. However, if all else fails, what have you got to lose?

It's easy to poke fun at the rules laid down by other people. But the rules we make for ourselves and the laws that are set by society let us live together. They help us make order out of chaos and give people a sense of stability and direction. They make life easier. Because I have my own set of rules to live by, I don't have to wake up every morning and figure out life starting from scratch. Most of the rules you'll find about investing are aimed at protecting people from mistakes that were made or observed by whoever made up the rule.

RULE: Don't take any more risk than necessary in order to get where you want to go.
COMMENT: There's a sound rule if ever I heard one, but sometimes it's a little hard to follow. "Risk" comes in many flavors, and how are you supposed to know how much risk is "necessary" to accomplish something? I think this rule is most useful if you define the kinds of risk you are taking and exactly what your investment goals are. Too few investors do that.

RULE: Invest early, and invest often.
COMMENT: This is a good rule. If your parents had invested $1 in your name on the day you were born and added $1 every day thereafter until you were old enough to take on this modest burden yourself, and if you had continued investing $1 a day and managed to earn 12 percent on your money, you would have $7 million at age 65.

Almost nobody follows that regimen. But the numbers speak to the magic of compound interest over long periods of time. I would add only one word at the start of the rule so that it would read: "Invest, invest early, and invest often." The most fundamental rule is to invest rather than spend. Even if all you can spare is incredibly small, do it and do it regularly. Even if you do it poorly and violate all the rules along the way, DO IT. Eventually you'll make better decisions.

RULE: Make common stocks the core of your investments.
COMMENT: For many people, that's the right approach. Stocks give you growth, especially over long periods of time. This rule applies to retirement savings and to other investments that won't be needed. But don't follow this rule slavishly. Stocks don't do everything right. They often don't provide much income (and the ones that do usually provide inferior growth). Stocks are volatile and if you have to sell them in the middle of a bear market, you can be very sorry you bought them in the first place. (One of the arguments in favor of market timing!)

RULE: Reduce your risks by holding your investments for the long-term.
COMMENT: That's what you hear from most traditional investment advisors, and mostly I agree with it. However, hanging on to an investment does not reduce your risk of losing money. A bear market is still a bear market and it can devastate investors financially and emotionally. I would say stay committed to stock funds for the long-term, but reduce your risk by using market timing to protect yourself from bear markets.

RULE: Avoid "zero-sum games" (where there's a loser for every winner) like options, futures and gambling.
COMMENT: Sounds good, but it's too simplistic. Options and futures can sometimes add spark to a portfolio without adding undue risk. I say you should understand the differences between investing, speculating and gambling. You're INVESTING when there is a high probability that you will make gains and some probability you will lose money. (Example: Investing in a well-managed diversified growth stock no-load mutual fund.) You're SPECULATING when there's a probability for large gains, but also for large losses. (Example: Buying shares in a company that has a new drug in development that is believed will cure AIDS.) You're GAMBLING when you'll either win big or lose it all, immediately. This is called betting the farm, and sometimes you can lose more than the farm. (Example: Borrowing money to go to Las Vegas to use a system you've developed to beat the odds at the blackjack table.)

RULE: Invest only in what you understand.
COMMENT: This is a rule that, if followed, would help investors avoid untold grief, both emotionally and financially. If you can't understand something, you can't understand the risks you are taking. Many people in the investment business thrive by selling complex investments that offer high hopes to investors and high commissions to sellers. The high commissions almost always pay off. But all too often the high hopes turn out to be little more than hope. Following this rule may force you to pass up state-of-the-art investments that your friends brag about, or about which you might read. But if you stick with the basics (stocks, bonds, mutual funds, T-bills and even certificates of deposit) you'll pay far less in commissions and you'll be able to understand what's happening to your investments. And when things go wrong, you'll at least have some idea why.

RULE: Don't hire an investment manager you can't fire or don't sign any no-cut contracts.
COMMENT: This is one of my own rules. Sure, you can invest for the long-term, but don't lock yourself into something and throw away the key unless you are very sure that's what you want to do. Most of us have experience with limited partnerships that offered great promise but for unexpected reasons didn't work out. And when they didn't work out we couldn't get out-they turned into no-cut contracts. I know an investor who sank a modest amount into a limited partnership, thinking his small investment was essentially "play money." But the partnership became extremely successful and a decade later when the investor was doing some estate planning he discovered that his partnership interest had grown so much that it was about half of his entire net worth. Only then did he dust off the partnership agreement he had signed and he found that the partnership does not guarantee to give him any money back until 2029-when this investor would be 113 years old. The success was nice, but this huge, illiquid partnership interest could leave his heirs with a large estate tax problem.

RULE: Avoid commission-based financial advisors.
COMMENT: I agree entirely. When you hire an advisor who is compensated IF you buy a financial product, the advisor's interests conflict with your interests. Imagine an advisor whose honest conclusion is that what you have is just fine and there's no need to do anything different. By suggesting that you sit tight, the advisor is acting against his or her own financial interests. If the advisor acts in his own interest in order to generate income for himself, he may work against your interests. There's more. When the size of an advisor's commission depends on WHAT product you buy (and this is almost always the case), the conflict of interest is much sharper. That's because it is usually in your best interest to buy simple products with low to moderate levels of risk. But usually, the higher the complexity and the higher the risk level, the higher the commission. I'm not saying that all commission-based advisors are crooks, I'm simply suggesting you buy advice separately from financial products.

RULE: Keep your overhead costs of investing at a minimum.
COMMENT: Obviously you have to pay something for management and service, and it's worth your while to pay for good advice. But some financial services are much more expensive than others. Watch those pennies, because over time, with compound interest, they add up to many dollars.

Harry Browne, an investment author and advisor who often marches to the beat of a different drum, once outlined 10 rules for safe investing. Here are four:

H.B. RULE: Regard your profession as your main source of wealth. Don't expect your investments to make your fortune for you.
COMMENT: Very good advice. If investors rid themselves of unrealistic expectations, they'd avoid much of the grief that so often follows. But if you start investing prudently at an early age your investment can make a fortune for you.

H.B. RULE: Don't assume you can replace your capital if you lose it.
COMMENT: I sometimes think we do a disservice to young people by encouraging them to make risky investments. The premise is that young investors have plenty of time to compensate for their mistakes through future savings. All investors make mistakes. Savvy investors limit the size of their mistakes. They don't bet the farm on any one thing and they welcome small mistakes as learning opportunities. But Harry is right: no matter how much you learn from it, a mistake that loses your capital won't give it back.

H.B. RULE: Don't use leverage, for it is a two-edged sword. If you do use leverage, limit your liability.
COMMENT: Leverage, the use of borrowed money to magnify your gains when the market is going up, is a wonderful tool during bull markets. But it's a disaster in down markets. Limit your exposure by combining leverage with market timing.

H.B. RULE: Keep some of your assets outside the country.
COMMENT: We preach a variation of this rule by urging investors to have some of their portfolios in international equities and international bonds when appropriate. We think Harry means this rule more literally, as he has often recommended opening foreign bank accounts and other financial arrangements that are physically outside the U.S. While this may make some wealthy people feel more secure, investors who follow that route had better make sure they understand what they are doing in terms of foreign taxes, foreign regulations, currency fluctuations and especially the expenses they will incur following this rule.

After his 10 basic rules, Browne added this thought, with which I thoroughly agree: "One more thing. Enjoy yourself. Keep some part of your money for this purpose. Spend it in any way you like, without feeling guilty."

RULE: Speculate only with money you can afford to lose.
COMMENT: I would rewrite it slightly: Speculate only with money you are HAPPY to lose. Even better, just don't speculate. I buy a Lotto ticket from time to time, spending $1 to $5 a pop. This is not speculation, it's gambling and I am almost certain to lose. But my losses will be small. My rule for myself is that I invest many dollars, I gamble with a few dollars and I speculate with none. (See definitions above.) I learned long ago to avoid speculation. When you speculate, the stories behind the speculations are always so tempting that it is very easy to part with much more money than you really should.

Last year, Money magazine excerpted part of a book ("Bogle On Mutual Funds") by John Bogle, founder of the huge Vanguard group of no-load mutual funds. The article listed 12 rules that he suggests. Let's look at three of them:

J.B. RULE: Respect investing's eternal triangle of risk, return and costs.
COMMENT: Well said, John. Too many people ignore this subject until they lose their shirts. Bogle accurately points out that high costs can sharply erode the high returns which are rightfully expected by investors who take high risks. I agree with his advice to "think very carefully" about costs, returns and risks before you invest.

J.B. RULE: Diversify, diversify, diversify.
COMMENT: We buy this rule lock, stock and barrel. Numerous studies have concluded that 80 to 90 percent of your ultimate gains or losses come from market risk, the upward or downward movements in an entire market. Author Sheldon Jacobs suggests minimizing those risks by diversifying into several markets, by geography, type of security and type of issuer. I take his rule one step further and suggest you time each market segment to protect your investments from downward swings. That strategy is at the heart of most of the work we do. We use multiple mutual funds that invest in multiple types of securities issued in multiple countries and we use multiple timing systems to protect these investments from downturns.

However, this is an area where life isn't quite as simple as the rules make it sound. One very good rule urges you to stick to what you know and understand. And some seasoned investors (with strong stomachs) find they are more successful when they concentrate their assets to focus on what they know very well. Such concentration is outside my own comfort zone and I don't recommend it for my clients. But if you are an expert in some area, or your business gives you access to investment opportunities not available to others, this is a rule you may wish to ignore. My advice: do so only after you have followed "The Ultimate Rule" that you'll find at the very end of this newsletter.

J.B. RULE: Stay the course.
COMMENT: If you jump ship in the middle of the ocean, you're bound to get wet. This applies to market timing and dollar-cost-averaging, saving for retirement and saving for your kids' educations. Figure out your philosophy and strategy of investing. Figure out what return you need and what level of risk you need to achieve that return. Make your investments and then stick with them until you are convinced by the fundamentals that your strategy is wrong. In investing, those who win are those who stay the course.

RULE: Take advantage of all available tax-deferred investing opportunities.
COMMENT: This rule helps guide my personal investments and the advice I give to clients. Use your opportunities to invest money in 401(k) and other employee plans, in IRAs and Keogh accounts. Look for other opportunities to defer taxes and use them to let your income build up faster. However, know what you are doing. Know your tax bracket. Know how to compare the net you'll get from, for instance, taxable money funds vs. tax-free ones. Be wary of schemes that put tax-advantaged investments (such as deferred annuities) inside tax-advantaged packages (such as IRAs).

THE NEXT-TO-THE-LAST RULE: Follow the rules.
COMMENT: In general, that's good advice, especially if you have thought about the rules enough to make them your own and you're not just following somebody's instructions. Sometimes you will want to make an exception to a rule. Maybe that temptation will hit you often! Occasionally, making an exception may be the right thing to do. But I think you should do that only if you thoroughly understand (1) the reason for the rule in the first place, (2) the reason for making an exception this time and (3) the possible consequences of deviating from the rule.

"Exceptions only prove the rule."
--Lord Byron

"An exception disproves the rule."
--Sir Arthur Conan Doyle

THE ULTIMATE RULE

Finally, here's one of my favorite rules. It's the motto of an American frontiersman, Tennessee Congressman and folk hero who was featured on an extremely popular television series in the 1950s. This is the perfect all-purpose rule for investing and anything else. Although it's nearly impossible to follow, it is so fundamentally right-on-target that it's hard to resist:

"Be sure you're right. Then go ahead."
--Davy Crockett

 

 

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