Quest for Alpha: The Next 10 Rules for Being a Successful Investor

Last Updated Feb 9, 2011 9:57 AM EST

(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 10 Rules for Being a Successful Investor and The Final 10 Rules for Being a Successful Investor.)
  • The only thing worse than having to pay taxes is not having to pay them. The "too many eggs in one basket" problem often results from holding a large amount of stock with a low cost basis. Large fortunes have been lost because of the refusal to pay taxes.
  • The safest port in a sea of uncertainty is diversiï¬?cation. Portfolios should include appropriate allocations to the asset classes of large and small, value and growth, real estate, international developed markets, emerging markets, commodities, and high-quality bonds.
  • Diversiï¬?cation is always working; sometimes you'll like the results, and sometimes you won't. Diversiï¬?cation in the same asset class reduces risk without reducing expected returns. However, once you diversify beyond popular indices (such as the S&P 500), you will be faced with periods when a popular benchmark index outperforms your portfolio. The noise of the media will test your ability to adhere to your strategy. Remember, a strategy is either right or wrong before the fact.
  • The prices of all equity and risky bond assets (such as high-yield bonds and emerging-market bonds) tend to fall during ï¬?nancial crises. Your plan must account for this.
  • Identifying a mispriced security is the necessary condition for out­performing the market; the sufï¬?cient condition is being able to exploit any mispricing after the expenses of the effort. The "his­tory books" are ï¬?lled with investors that tried to exploit "mispricings," only to ï¬?nd that trading (and other) costs exceeded any beneï¬?ts.
  • Equity investing is a positive-sum game; expenses make outper­forming the market a negative-sum game. Risk-averse investors don't play negative-sum games. And most investors, prob­ably including you, are risk averse. Use only low-cost, tax ­efï¬?cient, and passively managed investments.
  • Owning individual stocks and sector funds is more akin to specu­lating, not investing. The market compensates investors for risks that cannot be diversiï¬?ed away, like the risk of investing in stocks versus bonds. Investors shouldn't expect compensation for diversiï¬?able risk - the unique risks related to owning one stock, or sector or country fund. Prudent investors only accept risk for which they are com­pensated with higher expected returns.
  • Take your risks with equities. The role of bonds is to provide the anchor to the portfolio, reducing overall portfolio risk to the appropriate level.
  • Before acting on seemingly valuable information, ask yourself why you believe that information is not already incorporated into prices. Only incremental insight has value. Capturing incremental insight is difï¬?cult because there are so many smart, highly motivated analysts doing the same research. If you hear recommendations on CNBC or from your broker or read them in Barron's, the market already knows the information it is based on. It has no value.
  • The four most dangerous investment words are "This time it's dif­ferent." Getting caught up in the mania of the "new thing" is why "the surest way to create a small fortune is to start out with a large one" is a cliché.
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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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.