The following is a guest post by Larry Swedroe, co-author of “ Your Complete Guide to a Successful, Secure Retirement “. If you’d like to contribute a guest post to Money Q&A, check out our guest posting guidelines.
Warren Buffett famously once said, “Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.”
Temperament trumps intellect because having the right temperament allows you to ignore the “noise” of the market and be a patient, disciplined investor, adhering to your well-thought-out financial plan through the inevitable bad times — times when even good strategies deliver poor outcomes.
7 Rules for Successful Investing
My almost 25 years of experience as a financial advisor has taught me that there are seven keys to being a successful investor. They are:
1. Understand the nature of risks before investing.
When investment strategies are delivering positive returns, it’s easy to stay the course. However, your ability to withstand the psychological stress that negative returns (or even relative underperformance) produce is inversely related to your level of understanding of the nature of an investment’s risks.
You must understand both what could cause returns to come in below expectations, and also how the risks of each investment correlate with the risks of other investments in your portfolio (that is, whether correlations tend to rise or fall when your other portfolio assets are doing poorly).
2. Know your investment history.
To paraphrase a noted Spanish philosopher, those who don’t know their investment history are condemned to repeat it. Before investing, you should not only have an estimate of an asset’s expected future returns (based on valuations and historical evidence, not opinions) but also knowledge of the returns’ historical volatility.
You should also know how often an investment’s returns have been negative over five-, 10- and 20-year periods. For example, you should expect that U.S. stocks will underperform riskless one-month Treasuries in about 10% of future 10-year periods. Being prepared for such periods should help keep you from panic-selling.
3. Ignore all guru forecasts.
Legendary investor Benjamin Graham observed: “If I have noticed anything over these sixty years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.” Evidence on the lack of economic and market forecasting ability led Graham to draw his conclusion.
It’s also what led Jonathan Clements, writing at the time for The Wall Street Journal, to offer this advice: “What to do when the market goes down? Read the opinions of the investment gurus who are quoted in the WSJ. And, as you read, laugh. We all know that the pundits can’t predict short-term market movements. Yet there they are, desperately trying to sound intelligent when they really haven’t got a clue.”
4. Don’t take more risk than you have the ability, willingness or need to take.
Most battles are won in the preparation stage, not on the field. If you assume more risk than you have either the ability, willingness or need to take, you increase the odds that the inevitable next bear market will cause you to lose your head while more disciplined investors are keeping theirs.
Losing your head leads to the stomach taking over decision-making. The result likely will be that your well-developed financial plan will end up in the trash heap of emotions.
5. Understand that even good strategies can have bad outcomes.
“Fooled by Randomness” author Nassim Nicholas Taleb noted: “One cannot judge a performance in any given field by the results but by the costs of the alternative (i.e. if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly, the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”
6. Minimize the frequency with which you check your portfolio’s value.
Nobel Prize winner in economics Richard Thaler found that we tend to feel the pain of a loss twice as much as we feel joy from an equal-sized gain. This creates a problem for investors who frequently check their portfolio values.
On the other hand, the less you watch and/or read the financial media, and the less you pay attention to economic and market forecasts, the more successful investor you are likely to be!
7. Keep a diary.
Write down every time you are convinced that the market is going to go up or down. After a few years, you will realize that your insights, unfortunately, are actually worth nothing.
Larry Swedroe is the co-author of Your Complete Guide to a Successful, Secure Retirement . He serves as the director of research for Buckingham Strategic Wealth and The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.