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Quest for Alpha: 10 Rules for Being a Successful Investor

(The following comes from the appendix Rules of Prudent Investing in Larry's most recent book, The Quest for Alpha, which presents compelling evidence on the failure of individual investors, mutual funds, pension plans, venture capital and hedge funds in their efforts to outperform the market. For the remaining list of rules, see the posts The Next 10 Rules for Being a Successful Investor and The Final 10 Rules for Being a Successful Investor.)
While we search for the answers to the complex problem of how to live a longer life, there are simple solutions that can have a dramatic impact. For example, it would be hard to �nd better advice on living longer than do not smoke, drink alcohol in moderation, eat a hearty breakfast and a balanced diet, get at least a half hour of aerobic exercise three to four times a week, and buckle up before driving. The idea that complex problems can have simple solutions is not limited to the question of living a longer life.

I have spent over 35 years managing �nancial risks for two leading �nancial institutions as well as advising individuals and multinational corporations on the management of �nan­cial risks. Based on those experiences, I have compiled a list of rules that will give you the greatest chance of achieving your �nancial goals.

  • Do not take more risk than you have the ability, willingness, or need to take. Plans fail because investors take excessive risks. The risks unexpectedly show up, and investors with 30 ­year horizons can turn into investors with 30-day horizons. That leads to the abandonment of plans. When developing your plan, consider your horizon, stability of income, abil­ity to tolerate losses, and the required rate of return.
  • Never invest in any security unless you fully understand the nature of all of the risks. If you cannot explain the risks to your friends, you should not invest. Fortunes have been lost because people did not understand the nature of the risks they were taking.
  • The more complex the investment, the faster you should run away. Complex products are designed to be sold, not bought. You can be sure the complexity is designed in favor of the issuer, not the investor. Investment bankers don't play Santa Claus providing you with higher returns because they like you.
  • Risk and return are not necessarily related; risk and expected return are related. If there were no risk, there would not be higher expected returns.
  • If the security has a high yield, you can be sure the risks are high, even if you cannot see them. The high yield is like the shiny apple with which the evil queen entices Snow White. Investors should never confuse yield with expected return. Snow White could not see the poison inside the apple. Similarly, investment risks may be hidden, but you can be sure they are there.
  • A well-thought-out plan is the necessary condition for success­ful investing; the sufï¬?cient condition is having the discipline to stay the course, rebalance, and tax-loss harvest as needed. Unfortunately, most investors have no written plan. And emotions such as greed and envy in bull markets and fear and panic in bear markets, can cause even well-thought ­out plans to be trashed.
  • Having a well-thought-out investment plan is the necessary condi­tion for achieving your ï¬?nancial goals. Integrating the investment plan into a well-thought-out estate, tax and risk management (insurance of all kinds) plan is the sufï¬?cient condition. The best investment plans can fail due to events unrelated to ï¬?nan­cial markets. For example, the breadwinner dies without sufï¬?cient life insurance, there is an accident and there is insufï¬?cient liability coverage, or disability or long-term ­care insurance is needed but is not in place.
  • Do not treat the highly improbable as impossible, nor the highly likely as certain. Investors assume that if their horizon is long enough, there is little to no risk. The result is that they take too much risk. Taking too much risk causes inves­tors with long horizons to become short-term investors. Stocks are risky no matter the horizon. And remember, just because something has not happened doesn't mean it cannot or will not.
  • The consequences of decisions should dominate the probability of outcomes. We buy insurance against low-probability events (such as death) when the consequences of not having the insurance can be too great to accept. Similarly, investors should insure their portfolios (by having an appropriate amount of high-quality ï¬?xed income investments) against low-probability events when the consequences of not doing so can be too great to contemplate.
  • The strategy to get rich is entirely different than the strategy to stay rich. One gets rich by taking risks (or inheriting it). One stays rich by minimizing risks, diversifying, and not spending too much.
Tomorrow, we'll continue our look at the rules investors should follow, including what's worse than having to pay taxes.

Excerpted with permission of the publisher John Wiley & Sons, Inc. from The Quest for Alpha: The Holy Grail of Investing. Copyright 2011 by Larry Swedroe. This book and e-book is available at bookstores, through Amazon and Barnes & Noble and from the Wiley Web site.
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