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4 Useful Rules of Investing
To be followed meticulously
Rule number 1 - Every Dog has its day
Meaning of this proverb is that everyone will have good luck or success at some point in their lives. As you can observe, I have highlighted the words “at some point”. It implies that the timeline is uncertain. While it is sure that there will be good luck, when will this good luck or success embrace is the question. Similar phrase in the stock market is “Timing the market is difficult”. I am a staunch believer of this. I really dont know when the next bull market comes or when the share price of the company I invest in increases.
Only way to overcome this uncertainty in timeline is to buy time. We can buy time in 4 different ways.
1.) Personal Level:
We should only invest in the stock market the money that we don't need at least for next 10 years. Timeline of 10 years is because generally one economic recession and boom cycle comes every 5 to 10 years. Hence there are high chances of good luck or success embracing us in the stock market within a span of 10 years. By committing to invest at least for a time horizon of 10 years, we can overcome the time uncertainty to an extent.
Invest in companies which have high chances of survival.
We can use the Waterline principle instituted by Wilbert L Bill Gore to identify companies which have high chances of survival.
Gore compared the level of allowable risk to the waterline on a boat.
Risks above the waterline wouldn’t sink the boat. If a decision goes bad and produces a hole in the side of the boat above the waterline, you can fix the hole, learn from the experience, and carry on.
Risks that fell below the waterline, in contrast, can blow a hole that can sink the boat.
While the above principle is for risk tolerance in decision making, If we can re-imagine a company as a Boat. Then if say 90% of a boat is below the waterline, then it is very easy for a hole to hit below the waterline. Such companies are risky and have a very low chance of survival. On the other hand, if only 10% of a boat is below the waterline, then it is very difficult for a hole to hit below the waterline. Such companies have high chances of survival.
For example, Wonderla Holidays could easily overcome COVID-19 impact and generate lifetime high profits in Q1-2023 as it is like a boat which is only 10% below waterline. On the other hand, PVR is under process of being merged with Inox which might not have materialized if COVID-19 had not happened.
Companies with high levels of leverage and weak moat are like boats which are 90% below the waterline. We need to try to avoid investing in such companies and instead invest in companies which are like boats with less than 10% below the waterline. Such companies have negligible debt and strong moat.
Finding companies which are floating 90% above the waterline is job half done. We also need a captain who ensures that the company remains 90% above waterline in the future as well. That is why I like promoters or management who hate to take debt and who are also keen to take multiple small bets instead of one large bet. In other words, management of the companies should have similar risk tolerance.
Doing an SIP in companies ensures that our entry valuation is not at high levels. It gets averaged down through SIP as we enter the company at different time horizons.
Remember, every dog has its day. If all the above 4 points are meticulously followed, then there will come a day when the company we invested in gives us good returns.
Rule number 2: All eggs in one basket
We are taught not to invest all our savings in one investment vehicle and are often advised to diversify. This is because, if all eggs are put in one basket and if the basket falls, then all our eggs break in one go. To mitigate this risk, we often diversify.
What if we are forced to put all eggs in one basket? Then to mitigate the risk, we may cover the basket with bubble wrap. Put the contents in a carton box filled with grass. Write fragile on the box. Basically we try to take various precautions to ensure that the basket does not fall and eggs do not break even if the basket falls.
While diversification is a good tool to mitigate concentration risk, we should not become complacent while diversifying.
Even though we are diversifying, we should think as if we are putting all eggs in one basket while choosing each and every investment idea. To put it in another words, for every investment idea we choose to invest in, we need to ask ourselves, are we ready to bet our networth on the same?
Rule number 3: Not see the forest for the trees
Not see the forest for the trees means being unable to get a general undertanding of a situation because you are too worried about the details.
We need to filter out news we consume so that we can see forest for the trees. I keep asking myself the question “Will this news article be relevant even after 10 years?” to help me filter out all the noise prevailing in the media. This helps in focussing on the big picture and not getting worried about the minute details.
As a thought experiment, try to pick a 10 year old newspaper and read the same. You will realise how irrelevant the majority of the articles are.
Rule number 4: Fear of missing out - FOMO
We often face the mental pressure of missing out on an investment idea where others have invested and made good money out of the same. This phenomenon is called FOMO - Fear of missing out.
To avoid this situation, we need to understand the difference between error of omission and error commission.
Error of omission is where we missed out an investment idea and it pans out to have given very good returns.
Error of commission is where we invested in an idea and it turned out to be a dud.
Error of commission is more dangerous than error of omission. Its forgivable to commit an error of omission but not at all ok to commit an error of commission.
As Warren Buffet once said “Return of the money is more important than return on money”.
If we focus on the return of our money, then return on money will automatically follow. Hence, we can focus on avoiding the error of commission by making peace with the error of omission and overcoming the fear of missing out.