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Macro Economics
Don't Play Russian Roulette

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By washcomp
November 17, 2009

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I was listening to a dude from the Fairholme Fund this morning and a couple of things he said struck a chord. Taken in parallel to Warren Buffet's interview a couple of nights ago on Charles Rose and thrown into a blender with my own twisted way of looking at investing, I've come up with a few maxims of investing. We all know the be fearful when others are greedy and greedy when others are fearful, etc., but the following stuff (in my opinion) is equally important:

1) Most of us avoid playing Russian Roulette. The odds may be in our favor, but if we lose there's no chance to recover. In a similar vein, do not make bets in an investment to the extent that, no matter how unlikely the event is, there could be an event which would inflict unacceptable damage.

2) Do not assume because you are correct that the market will pay any attention to you. Success is measured by the money you make, not the ability be certain that your convictions are right and the market is insane.

3) Your core equity investments should be in companies which have the ability to continue to grow and are protected by a wide moat. These may be global or domestic. For long term investments you should limit yourself to the top two or three companies in a sector. Quality is always in style.

4) You should not start with the possible good things that could happen to a company or investment, but should first concentrate on all the bad things which could disappoint you and filter out choices which could, if things break incorrectly, could damage your interests to an unacceptable level.

5) Evaluate your diversification from the standpoint of what factors correlate. If you hold foreign currency, gold and oil at this point in time for example, you are going to have roughly correlated behavior as they respond to the US dollar. If we get a sudden increase in interest rates, both stocks and bonds are likely to decrease (and the dollar rise). Think hard about correlations and relationships. You may find that you are not as diversified as you think.

Do NOT allow all (or even a large portion) of your eggs to be in the same basket. While the basket can make you lots of money, if things break wrong, it can deal you a knockout punch.

6) Protect capital. If you lose your table stakes you are out of the game. Don't lose money. If you must lose money, make sure that it is a small enough proportion of your assets that, while an annoyance, it is not in any way debilitating.

7) Making money is a good thing. When an investment appreciates, do not hesitate to take part or all of your profits and try to find something of better value to replace it. No one ever lost money by taking a profit. Always have a sales price in mind. What goes up, frequently goes down (and you haven't really made money until you've converted an investment to cash).

Do not be frightened of paying taxes. Strive to, when you grow up, pay a million dollars in income tax in a year. We may never achieve this goal, but at least you'll have a set of goal posts in your sights. Should you reach this arbitrary goal (in the absence of inflation), be happy, rather than sad, when you sign the check :-)

8) Always be aware of your risk profile and limit your risk to a level acceptable to you. The equity market is inherently riskier than many other asset groups, but all of them (under various circumstances) can be dangerous to your financial health. Pay attention and make sure to minimize your losses.

9) While there are specific reasons to own mutual funds, be aware that you may be paying a substantial portion of your potential profit as fees and your returns will frequently not be worth the simplicity they offer.

10) Individual bonds protect principle held to their maturity, in general, better than stocks. Before their maturity, their NAV value fluctuations (under certain circumstances) can be as volatile as stocks. Bond funds, due to their lack of maturity do not provide the eventual protection of capital offered by bonds.

11) Investing is not a game, hobby or substitute for Las Vegas. Investing (or trading) is using real money in what should be a well planned out strategy to safely protect and hopefully grow its value.

Jeff