How to Protect Your Investments from Yourself

Last Updated Nov 19, 2009 1:54 PM EST

When it comes to investing, the three enemies that pose the biggest threat to our success are killer markets, professionals that claim to help us, and ourselves. Wall Street Journal columnist, Jason Zweig, shows us how to conquer these enemies in his new book, The Little Book of Safe Money (Wiley 2010).
No other financial author I'm aware of has spent more time collecting the research of the human mind on matters of money. Zweig takes this voluminous research and condenses it into a short, fascinating, and practical book that is also fun to read.

He starts off with three commandments of investing:

"Thou shalt take no risk that thou needst not take." If you are taking risk, make sure of two things - it's to meet an objective, and there are not alternative investments that meet that objective with less risk.

"Thou shalt take no risk that is not most certain to reward thee for taking it." What this commandment is actually saying is a little different than it sounds. It means there needs to be strong evidence that you will receive a reward. It does not refer to investments that are riding a hot streak, such as gold. Having recently been hot does not qualify as evidence under this commandment.

"Thou shalt put no money at risk that thou canst not afford to lose." Put simply, if you've met your financial goal and have a low need to take risk, don't take it.

Sinners in our midst
In early 2008, many investors violated all three commandments betting on a sixth year in a row of market gains. They not only bet on the market, they bet on the front runners of the moment, and we all know how that turned out.

Earlier this year, chastened investors were looking for safer harbors for their money. Yet as the recent stock market bull has raised its horns, people are already sinning again. In fact, Zweig told me that even he was shocked at just how short investor's memories appear to be.

When to buy stocks
Zweig notes that history doesn't tell us when to buy stocks, but psychology and price does. In essence, we should do the opposite of what our instincts tell us to do. When things look great, returns are likely to decline. And when the clouds of gloom start to form, and you're hearing predictions like "capitalism is dead," it's probably a good time to buy stocks. Neither Zweig nor I are market timers, but rebalancing fits this piece of advice pretty well.

A hedge against a market plunge?
Zweig notes that sophisticated investors are like "jumbo shrimp," an oxymoron. They pour money into hedge funds without much due diligence, blindly believing their money is safe and that the returns have bested the stock market. He walks us through the data that is available to illustrate that the return of the average hedge fund may be overstated by as much an eight percent annually.

A new world
If I had a dime for every time someone has told me that the smart money is invested in emerging markets, I'd be sitting on a Mt. Everest size pile of dimes. Following up on his column in The Wall Street Journal, Zweig refers to research that shows the fastest growing economies tend to yield lower stock market returns than those of slower growing economies.

The analogy that I use to explain this is that beaten up value stocks tend to outperform the hot growth stocks, over long periods of time. Primarily because the expectations are so high for growth stocks that it's hard for those companies to deliver. It's much easier for a value stock to beat the low market expectations. The same is true for the stock markets of various countries.

Words of warning
How do we know when we are about to break one of the three investing commandments? Here Zweig gives us a cheat sheet on the key warning signs, such as:

Can't lose.

Limited-time offer.

Guaranteed.

Don't you want to be rich?

Low risk, high return.

You have to hurry.

My take
This book is a well written, fascinating page turner that I read in one sitting with a big bag of microwave popcorn. Yet, I don't just recommend a book because it was thoroughly enjoyable. The main reason to read this book is that it can put you on the path toward reaching financial freedom. But it's up to you and whether you'd rather spend your retirement years pursuing your interests, or spend them asking strangers if they'd like their value meal supersized.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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