The Rules of Wealth

1.    In every market, you control what matters most.

Over the last 20 years, the market has returned an average of 8.25% per annum, but the average investor has gotten just over 4% of that. The highs and lows of the market may be out of your hands, but how you choose to behave is within your power, and is just as important a driver of returns.

2.    Risk is the likelihood of permanent loss of capital.

Risk is not a paper loss. Risk is not underperforming your golf buddy. Risk is not even underperforming the benchmark. Real risk is the probability of you permanently losing your money. Viewed thusly, those with a long time horizon and diversified portfolios are taking on very little risk indeed.

3.    Start today. Start again tomorrow.

Compound interest is the secret to getting rich slowly. The way to maximize the power of compounding is to start today and stay consistent. If you hope to reach $2 million in retirement savings and start investing at age 22, you can hit your target by saving less than $6,000 a year. Wait until you turn 40 and things have gotten much tougher, requiring roughly $26,500 in savings per year.

4.    Trouble is opportunity.

We are all familiar with the Oracle of Omaha’s admonition to be “greedy when others are fearful and fearful when others are greedy," yet so few of us manage to successfully view a downturn as the opportunity it truly is. There is true joy (and riches) to be had in financial schadenfreude, so commit yourself to continue investing and even upping your savings when times are bad.

5.    Diversified does not mean never going down.

Diversification is not a panacea nor does it prevent your portfolio from falling, even dramatically at times. What it does is protect you from idiosyncratic risk and losing your shirt on a concentrated bet. Buying a car with an airbag is not a bad idea, even if you never get in a wreck. Diversifying your portfolio is similarly wise, even if the benefits may not always be apparent.

6.    Do less than you think you should.

In most endeavors, when you work harder and do more, you are better off. Investment management is just the opposite! The more you trade, the more financial news you watch and the more active you are, the more likely you are to underperform (and get eaten alive by fees in the process). Take heart – laziness pays!

7.    Get rich quick and get poor quick are sides of the same coin.

Though it’s not perfect or linear (sorry Modern Portfolio Theory!), there is a strong relationship between risk and reward. It’s true that penny stocks could quadruple your net worth over night, but it’s just as true that they could break your back. Defense wins championships in investing, as in football.

8.    Forecasting is for weather people.

Famed contrarian David Dreman found that from 1973 to 1993, of the 78,695 estimates he looked at, there was a 1 in 170 chance that analyst projections would fall within plus or minus 5% of the actual number. The smartest people in the world don’t bother with the crystal ball. Said JP Morgan of the market’s future trajectory, “It will fluctuate.”

9.    If it’s exciting, it’s probably a bad idea.

Nobel laureate Paul Samuelson said it best, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

10.   This time isn’t different (and neither are you).

Robert Shiller is fond of saying that “This time it’s different” is the most dangerous phrase in investing. While mania can carry a market for a time, the truth about what works long-term on Wall Street is pretty boring (think paying a fair price for a profitable company) and is unlikely to fundamentally change.

11.   Excess is never permanent.

John Neff astutely noted that, “Every trend goes on forever, until it ends.” It has been said that nature abhors a vacuum and an investment corollary is that markets abhor excess. While short term trends and emotionally fueled investors can push a stock up or down for a time, things tend to come back to Earth eventually. Betting that something will rise or fall in perpetuity is a risky bet.

12.   Your life is the best benchmark.  

Benchmarking to your own goals instead of a arbitrary external ones has myriad benefits. First off, it personalizes the whole endeavor and makes investing about doing what you love instead of outperforming others. Research also shows that goals-based investors are more likely to stay the course during tough times and even save at higher rates, since what they are chasing is so personally meaningful.

To learn about each of these rules in much greater detail, please check out The Laws of Wealth by Nocturne Capital founder Dr. Daniel Crosby. 

Five Things You Should Never Do in the Stock Market

  • Don’t lose your sense of history – The average intrayear drawdown over the past 35 years has been just over 14%. The market ended the year higher on 27 of those 35 years. A relatively placid six years has lulled investors into a false reality, but nothing that we have experienced this year is out of the ordinary by historical measures.
  • Don’t equate risk with volatility – Repeat after me, “volatility does not equal risk.” Risk is the likelihood that you will not have the money you need at the time you need it to live the life you want to live. Nothing more, nothing less. Paper losses are not “risk” and neither are the gyrations of a volatile market.
  • Don’t focus on the minute to minute – Despite the enormous wealth creating power of the market, looking at it too closely can be terrifying. A daily look at portfolio values means you see a loss 46.7% of the time, whereas a yearly look shows a loss a mere 27.6% of the time.Limited looking leads to increased feelings of security and improved decision-making.
  • Don’t forget how markets work – Do you know why stocks outperform other asset classes by about 5% on a volatility-adjusted basis? Because they can be scary at times, that’s why! Long term investors have been handsomely rewarded by equity markets, but those rewards come at the price of bravery during periods short-term uncertainty. The relationship between risk and reward is real; choose peace of mind or a shot at meaningful wealth-compounding because you can't have both. 
  • Don’t give in to action bias – At most times and in most situations, increased effort leads to improved outcomes. Want to lose weight? Start running! Want to learn a new skill set? Go back to school. Investing is that rare world where doing less actually gets you more. James O’Shaughnessy of “What Works on Wall Street” fame relates an illustrative story of a study done at Fidelity. When they surveyed their accounts to see which had done best, they uncovered something counterintuitive. The best-performing accounts were those that had been forgotten entirely.In the immortal words of Jack Bogle, “don’t do something, just stand there!”

Behavioral Finance is Dead, Long Live Behavioral Finance

Ancient Grecians believed in geocentricity, the idea that the Earth is the center of the Universe around which all others objects orbit. In classical antiquity, it was widely supposed that the body contained four humors, blood, black bile, yellow bile and phlegm, and that optimal health resulted from an appropriate balance of the four. Maternal Impressionists explained birth defects in children as resulting from negative thoughts from the mother during pregnancy. And phrenology, the practice of making inferences about someone’s character and personality from the shape and contour of their head, was for some time thought to be a legitimate science.

Much as we laugh at these pseudo-scientific anachronisms, I am confident that the time is not far distant that we will puzzle that we ever developed financial models that did not somehow seek to account for the behavior of market participants. In making such a provocative statement, I do not wish to pick on traditional financial models or necessarily to elevate what currently constitutes the burgeoning field of behavioral finance. Rather, I hope to illuminate the ways in which arriving at any sort of truth is an imperfect endeavor and discuss the way in which ideas that begin on the lunatic fringe can sometimes be welcomed into the fold of legitimate scientific inquiry.

Almost since its inception and increasingly with its popularization, proponents of behavioral finance have delighted in dismantling the efficient market machine, gleefully poking holes in this dogma with quirky anecdotes about investor irrationality. For their part, efficient market theorists have given as good as they’ve gotten, criticizing behavioral finance for its lack of theoretical underpinning and inability to consistently improve investment returns. But all of this rhetorical jousting (while fun!), misses the point fundamentally.

Rather than hoping for the death or preeminence of one faction or the other, we ought to be working to combine the findings of both camps in applied ways that positively impacts actual investors, something Dr. Greg Davies calls “behavioralizing finance.” Behavioral finance has a great deal to learn from efficient market theorists about building a comprehensive, rigorous framework of assumptions. Traditional finance could learn a thing or two from the behaviorists about being tentative, respecting the limits of knowledge and safeguarding others’ assets accordingly.

Behavioral finance was born in the ivory tower of academia, legitimized with Daniel Kahneman’s Nobel Prize, popularized by Dan Ariely, Richard Thaler and others who taught us to laugh at and recognize our own financial misbehavior. Oddly enough, the next step in the progression of behavioral finance is an anonymity of sorts, the kind that comes with widespread acceptance and integration. After all, heliocentrism is not an idea anymore, it’s the “way things are.”

My children are six and two and it is my hope that when they attend college there will be no behavioral finance courses offered at their universities. If there are, we will still be mired in the same intellectual turf wars that can keep great ideas from exploring their points of fusion rather than their surface dissimilarities. My hope instead is that they will learn about finance, a complicated, tentative, somewhat messy discipline that their professors approach with some mathematical precision, but would never dream of disconnecting from the people that give it life.