13 Essential Rules for Investing

Posted by Donald Latumahina 7 Comments

I just finished reading The Bogleheads’ Guide to Investing, and it is the best personal finance book I read this year. The book is very practical with tons of useful tips. It’s also witty which makes it fun to read. It’s philosophy of investing is long term with buy-and-hold strategy, and it proves the effectiveness of this strategy with numerous studies.

Here I’d like to share with you 13 investing rules I summarized from the book. I believe they are essential for successful investing. Here they are:

1. Choose a sound financial lifestyle

This is the first thing you should do before investing. There are three steps you need to take:

  1. Graduate from the paycheck mentality to the net worth mentality.
    People with paycheck mentality spend to the max based on their net incomes. Their financial lifestyle is all about earning to spend. On the other hand, people with net worth mentality focus on building net worth over the long term.
  2. Pay off credit card and high-interest debts
    Paying your high-interest debts is the highest, risk-free, tax-free return on your money that you can possibly earn.
  3. Establish an emergency fund
    For most people, six months living expenses is adequate.

2. Start early and invest regularly

Saving is the key to wealth, so there is no substitute for frugality. And, due to the power of compounding, starting early makes a huge difference.

3. Know what you are buying

Know more about the various investment choices available to you, such as stocks, bonds, and mutual funds. Don’t invest in things you don’t understand.

4. Keep it simple

Simple investing strategy almost always beats the complicated ones. Index investing takes very little investment knowledge, practically no time or effort – and outperforms about 80 percent of all investors.

Instead of hiring an expert, or spending a lot of time trying to decide which stocks or actively managed funds are likely to be top performers, just invest in index funds and forget about it.

However, not all index funds are created equal. Many of them will also charge you high sales commission and high yearly management fee. Do not buy those. Only consider investing in no-load funds with annual expense ratios of 0.5 percent or less, the cheaper the better.

5. Diversify your portfolio

When it comes to investing, the old saying, “Don’t put all your eggs in one basket,” definitely applies. In order to diversify your portfolio, you should try to find investments that don’t always move in the same direction at the same time. A good mix for this is stocks and bonds.

6. Decide your asset allocation

You should decide what a suitable stock/bond/cash allocation for your personal long-term asset allocation plan is. This is the most important portfolio decision you will make.

Investments in stocks, bonds, and cash have proven to be a successful combination of securities for portfolio construction. At times, you will read about other more exotic securities (such as hedge funds, unit trusts, option, and commodity futures). It is advised to simply forget about them.

7. Minimize your investment costs

The shortest route to top quartile performance is to be in the bottom quartile of expenses.
Jack Bogle

Costs matter, so it’s critical that you keep your investment costs as low as possible. It is recommended to avoid all load funds and favor low-cost index funds.

8. Invest in the most tax-efficient way possible

For all long-term investors, there is only one objective – maximum total return after taxes.
John Templeton

Tax can be your biggest expense, so it’s important to be tax-efficient. One of the easiest and most effective ways to cut mutual fund taxes significantly is to hold mutual funds for more than 12 months.

9. Avoid performance chasing and market timing

I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.
Warren Buffett

Using past performance to pick tomorrow’s winning mutual funds is such a bad idea that the government requires a statement similar to this: “Past performance is no guarantee of future performance.” And market timing (a strategy based on predicting short-term price changes in securities) is something which is virtually impossible to do.

The logical alternative to performance chasing and market timing is structuring a long-term asset allocation plan and then staying the course.

10. Track your progress and rebalance when necessary

Rebalancing is the simple act of bringing your portfolio back to your target asset allocation. Rebalancing controls risk and may reward you with higher returns.

Rebalancing forces us to sell high and buy low. We’re selling the outperforming asset class or segment and buying the underperforming asset class or segment. That’s exactly what smart investors want to do.

11. Tune out the “noise”

Most sales and advertising pitches from brokerage houses and money managers are variations of one single message: “Invest with us because we know how to beat the market.” Far more often than not, this promise is fictitious at best and financially disastrous at worst.

Here is a simple guideline: all forecasting is noise. Believing that “It’s different this time” can cause severe financial damage to your portfolio.

12. Master your emotions

When it’s time to make investing decisions, check your emotions at the door. Things such as blindly following the crowd, trying too hard, or acting on a hot tip will almost always leave you poorer.

Forget the popular but misguided notion that investing is supposed to be fun and exciting. If you seek excitement in investing, you’re going to lose money. Get excited about earning and saving money, but be very dispassionate when it comes to investing.

13. Protect your assets by being well-insured

To be a successful investor requires being a good risk manager. Managing risk means having a plan to cover the downside. That’s what insurance is all about – damage control to prevent the unforeseen from smashing your nest egg.

You need to consider the following type of insurance: life insurance, health care, disability, property, auto, liability, and long-term care.

Three key rules for being properly insured:

  1. Only insure against the big catastrophes and disasters that you can’t afford to pay for out of pocket.
  2. Carry the largest possible deductibles you can afford.
  3. Only buy coverage from the best-rated insurance companies.

Note:
I hope you find these rules useful. I completely agree with all of them, including the “controversial” rule of “tuning out the noise”. A few months ago I read the book Fooled by Randomness which takes different approach but arrives at the same conclusion.


Categories: Finance

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  • http://myinvestingblog.com hank

    I just stumbledupon the site and can’t agree more with the philosophy – I haven’t read the book yet, but I’ll put it on the list – and your site is now in the ol’ bookmarks – nicely done!

  • http://www.lifeoptimizer.org Donald Latumahina

    Thanks, Hank! The philosophy is simple but sound. That’s why I like it and feel obliged to share it here.

  • http://lawrencecheok.com Lawrence Cheok | A Long Long Road

    Hi Donald,

    great article on simple investing strategy. Unknowingly, this is something that I have been practicising for the last couple of years, and I must say the average returns have been fairly good (>20%) :)

    Your first point rings with me. It all starts with having the right financial mindset which I have stated in my post

    why schools should teach personal finance.

    There’s no point in investing, if whatever you have invested and gained are all unwisely spend over consumer spending.

    .

  • http://www.lifeoptimizer.org Donald Latumahina

    Lawrence,
    It’s good that you have been practicing it for years! Many people waste a lot of time on the wrong path and lose the power of compounding as a result. As you said, having the right mindset from the beginning is essential.

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