ASX Education: Ten Investment RulesI have been writing the Marcus Today newsletter for over twenty years and read something called "Farrell's Rules" over thirty years ago. There is an article about 'Farrell's Ten Rules' below which you might find interesting, but as I read them, I realise they are a bit old, and I'm sure we can do better. Everybody has their system, conscious and unconscious. Given a stock code, we all tend to go through the same routine, through habit rather than brains, and the more experienced we get, the less we change that routine. But as Einstein supposedly said " “The definition of insanity is doing the same thing over and over again, but expecting different results.” If your 'system' worked, and if my system worked, you wouldn't be reading the Marcus Today newsletter, and I wouldn't be writing it, we would all be on a yacht in the Caribbean surrounded by fluffy white towels and caviar. But we aren't. As investors who are only interested in our own outcome (selfish but true) we really owe it to ourselves to constantly improve what we do, to get better, to progress, to be the best we can be, and the only way to do that is not to be so arrogant as to pretend we know what we are doing already, and keep doing it, but to allow ourselves, force ourselves even, to think outside the square, to have an open mind, to learn, to develop (y)our own investment rules. Let's get you started. FARRELL'S RULES OF INVESTING Bob Farrell was the chief stock market analyst at Merrill Lynch from the late 60s until 1992, a period that included booms and busts as always. He was a technical analysis pioneer, and amazingly, thanks to his results saw Merrill Lynch adopt and promote technical analysis at a time when Benjamin Graham's Intelligent Investor had the finance industry doing fundamental analysis and not much else. Over the years, Farrell developed his now-famous Ten Rules – ten rules about investing – here they are: FARRELL’S TEN RULES (Source Money Web – Felicity Duncan)
- Markets tend to return to the mean over time – Markets go up, and markets come down, but they never stay in one place. Farrell’s first rule is a reminder of the fact that markets never go up and up endlessly, nor do they fall forever. Whatever direction they’re headed, they are ultimately keyed to their long-term average return. Sometimes returns will be in excess of the long-term average, sometimes below, but the long-term average grounds the returns that investors can realistically expect. Investors that understand this are less likely to panic sell or buy into bubbles.
- Excesses in one direction will lead to an opposite excess in the other direction – Markets will overshoot. Sometimes, they will run higher than earnings and dividends justify, and when that happens, they will likely go on to overshoot on the downside, dipping below the levels justified by earnings and dividends. This is an extension of rule one, and understanding these two rules will help insulate you from the urge to follow the herd up and down.
- There are no new eras – excesses are never permanent – This is an important rule. It seems that every few years, we are given a reason why things are different this time. Emerging markets will go up forever because they have huge growth potential. New technologies make the old rules obsolete, and tech stocks won’t follow the rules of other stocks. Farrell’s rule reminds us that it is never different.
- Exponential rising and falling markets usually go further than you think, but they do not correct by going sideways – When you see the market rising sharply, you know it’s headed for a top, and vice-versa. But the trend can extend far longer than reason would allow – it’s like the old saying, markets can remain irrational longer than you can remain solvent. Trying to time the rises and falls is very difficult, and more a matter of luck than skill. Further, when the correction comes, it’s never a gentle sideways process; corrections are usually as brutal as the excesses that precede them.
- The public buys the most at the top and the least at the bottom – Retail investors tend to pile into the market as it approaches its top and to bail out and stop buying as it approaches the bottom, thanks to those old favourites, fear and greed. Sadly, this is the worst possible investing strategy. However, it is a good indicator – when your parking attendant starts giving you stock advice and talking about his share picks, you know the market is close to its top.
- Fear and greed are stronger than long-term resolve – This is a corollary of rule 5 – on average, our emotions tend to be stronger than our logical selves. When the market is rising, even the smartest investor will start to feel the urge to buy, buy, buy! Similarly, when the market is falling, even the most iron-willed types will feel the need to divest completely. It takes a lot to buy when others are fearful, and sell when they’re greedy.
- Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chips – This is an interesting rule. The idea is that when a market rally is led by just a handful of big blue-chips, it is not a sign of real, deep market strength. Ideally, you want to see a broad-based rally with small- and mid-cap stocks participating in the rise. Rallies driven by a few big companies tend to fizzle out quickly.
- Bear markets have three stages: sharp down, reflexive rebound and a drawn-out fundamental downtrend – Bear markets often display a characteristic pattern. First, there’s a sudden, sharp fall. Then, there’s a rebound, and some of the losses are erased. Then, the market enters a sustained downturn that often overshoots (see rules 1 and 2).
- When all the experts and forecasts agree – something else is going to happen – This is more a warning about groupthink than a hard-and-fast rule. Essentially, what Farrell is saying is that when everyone is, say, punting a particular stock, you should bring an especially critical eye to bear, and vice-versa. When a stock is unloved and criticised, there may be a buying opportunity, and when everyone loves a stock, it might be a good moment to sell.
- Bull markets are more fun than bear markets – This is true for everyone – investors, analysts, journalists, and regulators. People always want the good times to continue, so when you’re two years into a bull market, it’s extra hard to find anyone who wants to rain on the parade.
- You will never overtake by following everyone else. You have to think for yourself. Do things differently. Do things a different way or forever stay in the pack.
- The one with the most information wins. Most of us can't be bothered to go the extra step, but it can only help. Refer to the One Stock Portfolio article – if you had to sell your whole super fund and were only allowed to buy one stock, how much work would you do before buying it. Now, why aren't you doing that with every stock?
- The only thing that moves the share price is the unknown. Assume that everything that is known, published, is already in the share price. So you will not make money looking at consensus forecasts, yields and PEs. Its the Catch 22 of the stock market. You have to guess the unknown. Its the unknown that makes a stock the best or worst performing stock next year.
- Don't be blinkered. You cannot trade a stock on fundamental analysis. The Intelligent Investor is not the golden bullet; a lot of people believe it is. Sure, knowing the quality and reliability of a company, if it is going to endure, is a key piece of information but a price is made up of value and sentiment not value alone, and sentiment can dominate for long periods. Use both fundamental and technical tools, any tools that help the cause, don't be blinkered.
- Stocks do trend. As much as the "you can't time the market" ostriches with their heads in the sand want it to be true that you can't time the market, so they can just buy something (or advise you to buy something) and do nothing (or provide no more advice) ever again, they are wrong. You can time the market, and you have to – we are over ten years after the GFC, and we are still not back to the pre-GFC level. Time is money. Don't time the market, and you can lose over ten years of returns in 18 months. If you can't time the market, you might as well give up now.
- Investment and trading is not about certainty its about probability. Research, analysis, technical analysis, any analysis you do before buying a stock can only, at best, narrow the probabilities of getting the price direction right, but it can go wrong the next day. Understand that, and you will rid yourself of pride, prejudice and denial. You have to entertain the idea that you could be wrong and be prepared to do something about it if you are. Not pretend you know.
- One good idea a year is a good year. If you buy ten stocks, at the end of a year, one will have gone to nothing. Three will do nothing. Three will be up with the market; one will be up 50%. One will double. And one will be a ten bagger (goes up 10x). It is the ten-bagger that creates all the performance. You have to be on the look out for the 'great' stocks, not just the good stocks everyone knows about.
- Be Spock. Emotion is a killer. It undermines every logical assessment of a stock. If you 'love' or 'hate' stocks, you have lost your objectivity. If you care about whether you have lost or made money, you are missing the point. The only thing that matters is what the share price is likely to do tomorrow, next week, next month, next year. The price you paid for it is utterly irrelevant.
- Its a game of odds. You will buy the wrong stock. You will fluke a great stock. Expect errors do not define yourself by it. Your job is to do better than luck alone and with time and experience, you will.
- If it's not fun, intellectual, social, a hobby…give it away. If you come at the stock market out of necessity, begrudgingly, if you don't love it, don't do it. Far better you let someone passionate, experienced and resourced do it for you. One letter a year telling you how your investments went, at the cost of less than 2%, is better than endless days and weekends trying to do it yourself. For less than 2% you can get all your evenings and weekends back. It's not worth it if you even spend one weekend spent being shitty with your family because Wall St fell over on Friday night. (I know…so speaks the fund manager…let me do it for you!)
- Take revenge on fees. Each time you pay a road toll as a TCL shareholder, grin. Each time you pay a bank fee or hear others complaining about the profitability of the banks, grin.
- If you are a CSL shareholder, give as much blood to CSL as you can and let them on-sell it for a huge profit.
- Sell. It probably won’t get better.
- Keep procrastinating, until its worthless.
- Trust a gut instinct, but don’t trust it.
- If it sounds too good to be true, someone has their hand in your back pocket.
- Don’t beat your self up when you get it wrong. Many more intelligent people have been caught holding hand grenades.
- Sharks patrol these waters.
- Be Remington. Like the company so much you want to buy it.
- Don’t invest in companies with dodgy names. Listed Investment Company Henry Morgan (HML). Pirate investors. Really, what was I thinking!
- Don't listen to tips that start with "I know someone…."
- Place trades at the end of the day, after the market closes when you are calm and thoughtful.
- If you gamble for fun, not money, expect to pay a "pleasure tax."
- ,Verbal debt is the same as financial debt, it has to be repaid, AND with interest. If management is telling you the future is bright, it has to turn out better than bright.
- Quality is better than quantity. The more stocks you own, the closer you will come to average. Who wants to be average?
- Investing requires time and passion. Don’t confuse wanting to be wealthy with passion and don’t confuse checking your portfolio regularly with time.
- Accounting is the language of investing. Many investors speak the words but fail to understand the language.
- Don’t just look for the positives in a company, also look at the reasons it might fail.
- Don't just focus on famous stocks. If it's famous, who is left to get excited about it?
- Think before you trade. If you trade four times a day at $19.99, it's going to cost you $20,000 a year. If your starting capital was $100,000, then you just gave away a 20% return and will have to make 25% trading just to beat a bond.
- If it sounds like a con, looks like a con but you can’t see the con. It’s a con. There's a wonderful Damon Runyan quote about the gambler Sky Masterson who was told, "Someday a guy will show you an unopened deck of cards and bet you that the Queen of hearts won't spit cider in your ear. Don't take that bet, because as soon as you do, you'll end up with an earful of cider."
- Marry the right person. It’s the most significant financial decision of your life.
- Every time you buy a share, you are trying to predict the future. That’s why the stock market isn’t easy.
- Limit the number of stocks to 10 or 12. More than 20 stocks? – buy the index or hand it to the professionals.
- Build the portfolio on a stock by stock basis – you have to wake up excited about each stock, not "the portfolio".
- Focus on Australian companies with a history of reliable overseas earnings, and you won't go far wrong.
- Assess the Directors’ qualifications, their holdings in the company, and how much they are paying themselves and the senior management.
- Buy on a rising share price and sell on a falling price.
- Average up but never average down.
- Strategists, economists and analysts are victims of “group think”. “Group think” is already in the price. No edge there.
- Dividends are not the be all and end all. Capital growth is far more important, volatile and risky. Total return is the only measure.
- Hot stocks become cold stocks, whilst warm stocks tend to stay warm.
- Don’t borrow to invest in shares.
- Don't invest in anything that relies on nature to grow and succeed. There are enough variables in the market already without taking on nature. Avoid all agriculture, cropping and aquaculture. Businesses that supply them and process and distribute their products are ok, but growing the stuff rarely pays back the capital invested.
- Having a professional manage your money is a good feeling when they succeed.
- The Big 4 Banks should be the foundation of your portfolio because they aren’t going away anytime soon.
- Sleep well at night with your investments, if you can’t then buy bonds and term deposits.
- Markets are strongest when they are broad and weakest when they narrow to a handful of big companies.
- Stop listening to the popular crowd. The best ideas come from the unpopular crowd.
And here are ten more rules for the punters amongst you:
Rule 1 – It's all about maths. You want to find a horse at 4 to 1 (20% probability of winning) that will pay 6:1. If you bet $10 on that horse five times, it should win once, giving you a return of $ 70 on your $ 50 outlay.
Rule 2 – you need to maximise your chances. Even though Rule 1 suggests that you only need to bet five times (on that horse) you need to go as often as possible to even out the randomness and kinks.
Rule 3 – Maths is more important than the name. For this exercise, every horse that meets a mathematical parameter is the same horse. This helps you follow rule 2.
Rule 4 – Rookies are optimists; pros are pessimists. If you look at horses lined up for a race and you assess their reasons for winning, you are an idiot. They all have reasons for winning the race. That's why the owners have paid the entry fee. You need to look for the reasons why each horse WON'T win. The horse with the fewest reasons isn't (necessarily) the winner, but it is (or should be) the favourite. This helps you identify your value horses (Rule 1)
Rule 5 – Read from the bottom up. Australian horses are listed from the highest weight down. This means that the best horses have the lowest number saddlecloth and are the first listed in the race. If you look at those horses first, you can be seduced and miss the better value, lighter-weight horse lurking near the bottom of the list.
Rule 6 – Read the bookies board. Every race will have a series of odds that add up to a total value number. If the bookies are taking zero cut off the top, then the total probabilities will add up to 100%. This never happens. Depending on where you are, the value will be somewhere between 115% (pretty good value) and 140% (strictly for amusement – expect to lose). How do you calculate? Simply take the win price and divide into 100. So a $2 win (for a $1 bet) implies 50% value. A $6 win price means 16% value. Add every horse in the field and see what it gets you. This is why you never bet on golf tournaments.
Rule 7 – Understand stupidity. Once the Pokies and Casino came to Victoria, the "stupid money" left the race track and went down the slots. If you can find a popular gambling endeavour where skill is rewarded, but also rare, that's where you want to be.
Rule 8 – (Poker corollary to Rule 7). At every card game, there is a sucker who has been invited to lose their money, which will then be "allocated" by the good players. Everyone knows who the sucker is. If you don't know who it is, it's you.
Rule 9 – Maths respects power. The basic principle of rule 1 is too obvious to be a viable long term solution. If there are discrepancies in the win price paid for a horse from one market to another (say the off-course totalisator versus the on-course bookmakers) the value will be snapped up and disappear. But the more complex the bet, the more multiplication adds to your value, and the harder it is for the mug punter to skim off all of the value.
Rule 10 – Start small and simple. Start with the dogs. Eight dogs maximum, quinellas with simpler arithmetic. And small bets.