1. Cut your losers short, and let your winners run.
2. Avoid predictions and forecasts
3. Understand crowd behavior.
4. Think like a contrarian.
5. Asset allocation is crucial.
6. Decide if you are an active or passive investor.
Let’s move on to part two:
7. Understand your own psychological make up. Most investors think they are competing against other traders, big institutions, hedge funds etc. In fact, they are their own most dangerous opponent.
Why is that? It is because of the way we are wired. We fall prey to all sorts of cognitive errors. We are overconfident in our abilities to pick stocks, time the market, know when to sell. We suffer from confirmation bias, seeking out that which agrees with us and ignoring facts that challenge our views. We vacillate between emotional extremes of fear and greed. We are surprisingly risk-averse, and at precisely the wrong times. The recency effect has us overemphasizing recent data points while ignoring long-term trends.
Our own cognitive and psychological errors often lead us down the wrong path. You can counter these foibles only if you are aware of them.
8. Admit when you are wrong. One of the biggest problems many investors have is admitting they made a bad investment. Men, suffering as they do from testosterone poisoning, are especially bad at this. Whether it’s ego or just stubbornness, too many people seem to hold on to their losers for way too long. Pride can be a very expensive sin.
The most effective approach is to admit your error, fix the mistake, then move on.
Think of investing as more akin to batting in baseball than to being a lawyer, accountant or doctor. If you are a .333 hitter – if you get a hit one out of three times at bat – you are an all-star ball player. A doctor who loses two-thirds of his patients or an accountant who has 66 percent of his clients audited are both doing something terribly wrong.
We have a saying in my office called “strong opinions weakly held.” We may have a high degree of confidence in a particular investing theme – say, emerging markets dividends or municipal bonds – but as soon as we have proof we are wrong, we reverse the position, sell the holding and move on.
I believe in admitting errors and, in fact, each year I publish a list of mea culpas – describing my worst investing errors. I explain what I did wrong and what I learned from it. It may be human to make mistakes, but it is foolish to make the same ones over and over. Try making some new mistakes instead.