Archives For Basic Investment Rules

Most Frequent Market Biase

November 4, 2012 — 1 Comment
  1. Confirmation bias – hearing what we want to hear.
  2. Overly optimistic – majority of humans are optimists. Like Andy Grove (Intel CEO) said, only the paranoid and skeptic survive.
  3. Dislike of losses – people hate losing. Period. And when the majority of people face a loss, they become paralyzed – a good investor would never do such a thing.
  4. Crowd mentality – humans have a tendency to follow the crowd. Never do that, especially in a bear market when only contrarian investors make money.
  5. Recent memory – the average person’s memory is short lived. This is very fatal in the markets.

Too many investors and traders fail because they focus on an all or nothing, 1 trade-become-rich strategy. Instead, what they should be doing is choose the trades when the odds are in your favour, swing your bat, and if that doesn’t work, move on.

A good friend of mine, let’s call him Mark, was kind enough to let me publish his trading rules here.

The basic rules are essentially the same, no matter what kind of an investor you are. Here’s his list of rules.

Do Not Speculate

Too many people jump into the markets as if they were at a casino in Las Vegas or Macau. They get in and out of the markets every time the market moves up a few points or down a few, without really knowing what to do. If you do this, you’ll be no better than the majority of gamblers at Luxor (for those of you who don’t know, Luxor is a pyramid-shaped casino in Vegas) – losers.

As long as you invest with sound judgement and don’t speculate, the markets will be more like a game of chess than a slot machine. The difference? Strategy and dedication makes all the difference.

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Suppose you had 2 scenarios:

Scenario A: 1 investment, $100,000, probability of being profitable is 68%, will have a 30% profit.

Scenario B: 100 investments, total $100,000, average probability of being profitable is 68%, will have an average 30% profit.

Now you have 2 choices: you either can choose Scenario A or Scenario B to invest in. Which one would you choose?

I’d choose Scenario B. By divserfiying among 100 investments that have the same (on average) probability & profitability as that of 1 investment (mentioned in Scenario A), you’re:

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Never Invest In Individual Stocks

Influenced by internal and macro (external) factors, a stock’s price can be tugged in opposite directions. With multiple factors to consider, an investor will have difficulty predicting which will triumph over the other and what the future price will be.

Because financial reports don’t reveal all the internal details about a company, it is nearly impossible for an outsider to comprehend growth prospects and management strength. Given the “unclassified” information that management selected, you’ll be blindly investing in individual stocks.

Also, there’s a risk that the stock you bought will go bankrupt. Because this does not apply to entire indexes as they can never fall to zero, you can average in and hold until you make money.

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There’s Nothing Wrong With Cash

With a negative implication, the words “100% cash” imply that an investor is idly doing nothing and making absolutely no money on his capital. On the contrary, there’s nothing wrong with having no position.

Feeling that he must have a position at all times at all times, the poor investor will become impatient, make poor investment decisions, and lose money. On the other hand, a good investor will wait patiently for a wildly profitable, first class investment and commit everything he’s got once opportunity presents itself.

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Obey Your Rules!

Without a written set of rules or an investment model to follow, you will think “hey, this looks cheap, let’s buy it” or “I think it’s getting overpriced, time to sell.” But how do you know that the price won’t get cheaper, or that the price won’t go higher? You don’t. You’re simply “guesttimating”. Without a concrete set of rules to follow, you’ll become self-indulgent and buy in a bubble or sell in a market crash.

Fortunately, an investment model will force you to think logically, put the market into a matter of odds and, paradoxically, save yourself from yourself. “According to my model, exactly what is the probability that the price will go down and that the price will go up?” Based on that specific probability, you can make a logical and sound investment.

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