The Little Book of Safe Money

1. Understand and obey the Three Commandments of investing

All the rest is commentary.

First Commandment: "Thou shalt take no risk that thou needst not take." Always question whether a risk is necessary and if safer alternatives exist to achieve your goals. This commandment encourages careful consideration before taking on any investment risk.

Second Commandment: "Thou shalt take no risk that is not most certain to reward thee for taking it." Ensure that the risks you take have a high likelihood of being rewarded. This involves examining historical evidence and understanding potential losses during periods of underperformance.

Third Commandment: "Thou shalt put no money at risk that thou canst not afford to lose." Analyze how much you can lose and how you will recover if your investment fails. This commandment emphasizes the importance of not risking more than you can handle financially or emotionally.

2. Diversify your portfolio, but remember you are the biggest egg

Your human capital is vulnerable to two kinds of risks: general and specific.

Human capital is your biggest asset. Your future earning potential is likely worth more than your home, retirement account, or stock portfolio combined. Protect this asset by diversifying your investments away from your primary source of income.

General risks to human capital:

• Location risk: Economic decline in your country or region
• Inflation risk: Erosion of purchasing power over time
• Alteration risk: Inability to change your work situation

Specific risks to human capital:

• Company-specific risks: Overreliance on a single employer or industry
• Market-specific risks: Vulnerability to changes in particular markets

To hedge these risks:

• Avoid overinvesting in your employer's stock
• Consider investing in sectors that may do well when your industry suffers
• Hold Treasury Inflation-Protected Securities (TIPS) to guard against inflation

3. Don't chase yield or reach for returns in fixed income

Don't reach for yield.

Higher yield often means higher risk. When investing in bonds or other fixed-income securities, remember that unusually high yields are usually a sign of increased risk. Chasing yield can lead to significant losses if the underlying investments fail to perform.

Key points to remember:

• Total return (income plus or minus change in value) matters more than yield alone
• Be wary of bond funds with high expenses, as they may take on extra risk to boost yields
• Favor low-cost bond index funds for most fixed-income investments

Avoid falling for promises of "higher yield at low risk." These claims often mask hidden risks or unsustainable investment strategies. Instead, focus on building a diversified portfolio of high-quality, low-cost bond investments that align with your risk tolerance and investment goals.

4. Stocks are not risk-free in the long run; focus on business value

Stock prices change every few seconds during the trading day. But the value of a business changes, at most, a few times a year.

Long-term stock returns are not guaranteed. Despite popular belief, stocks can underperform other assets over long periods and are not risk-free even if held for decades. Historical data suggesting otherwise may be incomplete or misleading.

Instead of relying on past performance or market trends, focus on:

• Understanding the underlying business value of stocks you own
• Assessing the company's ability to generate cash and grow over time
• Evaluating management quality and competitive advantages

Remember Benjamin Graham's principles:

1. Focus on business value, not stock price
2. Understand Mr. Market's mood swings
3. Maintain a margin of safety in your investments

By concentrating on these fundamentals, you can make more informed investment decisions and avoid the pitfalls of assuming stocks will always outperform in the long run.

5. Beware of financial products with catchy acronyms (WACronyms)

If you can't say it, you shouldn't own it.

Wall Street Acronyms (WACronyms) often mask complexity and risk. Financial institutions frequently use catchy abbreviations to make complex or risky products seem more appealing and familiar to investors. This marketing tactic exploits the psychological tendency to favor easily processed information.

Examples of potentially risky WACronyms:

• CMOs (Collateralized Mortgage Obligations)
• HLTs (Highly Leveraged Transactions)
• SPACs (Special Purpose Acquisition Companies)
• SPARQS (Stock Participation Accreting Redemption Quarterly Pay Securities)

When encountering a WACronym:

1. Ask what the acronym stands for
2. Research the underlying investment thoroughly
3. If you can't understand or explain it, don't invest in it

Remember: A catchy name doesn't make an investment safe or suitable for your portfolio. Always prioritize understanding the investment's structure, risks, and potential returns over its marketing appeal.

6. Recognize and combat your unconscious investing biases

None of us is perfectly rational. We all make mental mistakes.

Unconscious biases can lead to poor investment decisions. Our minds are subject to various psychological quirks that can influence our judgment without our awareness. Recognizing these biases is the first step in combating their effects on our investment choices.

Common unconscious biases in investing:

• Anchoring: Relying too heavily on one piece of information (e.g., a stock's recent price)
• Framing: Being influenced by how information is presented
• Familiarity bias: Favoring investments that seem more familiar
• Halo effect: Letting positive impressions in one area influence overall judgment
• Prediction addiction: Overconfidence in our ability to forecast market movements

To combat these biases:

1. Track your forecasts and compare them to actual outcomes
2. Reframe information by inverting data or changing perspective
3. Analyze investments objectively, without names or identifying details
4. Remember that you are prone to the same biases you recognize in others

By acknowledging and actively working to counteract these biases, you can make more rational and potentially more profitable investment decisions.

7. Choose a financial adviser carefully and do your own due diligence

Just like a romantic relationship, a financial relationship will endure only if it is founded on mutual trust.

A good financial adviser can be invaluable, but choose wisely. The right adviser can help navigate complex financial regulations, optimize your investments, and provide valuable perspective. However, it's crucial to find someone who aligns with your goals and values.

Key steps in selecting a financial adviser:

1. Determine what services you need (e.g., comprehensive planning, investment management)
2. Check credentials and disciplinary history
3. Interview multiple candidates and ask probing questions
4. Understand their investment philosophy and approach to risk management
5. Clarify fee structures and potential conflicts of interest

Questions to ask potential advisers:

• What made you want to become a financial adviser?
• How do you manage risk?
• What's the worst mistake you've made with a client?
• How do you get compensated?

Remember: Even with a trusted adviser, always do your own due diligence and maintain an active role in your financial decision-making.

8. Protect yourself from investment fraud and scams

If it sounds too good to be true, it definitely is.

Fraudsters target both sophisticated and unsophisticated investors. Con artists use various psychological tactics to separate people from their money, often playing on greed, trust, and the desire for quick wealth.

Red flags of potential investment scams:

• Promises of unusually high or guaranteed returns
• Pressure to make quick decisions
• Claims of "insider" information or "secret" strategies
• Requests for personal financial information
• Use of vague or overly complex explanations

Protect yourself by:

1. Never investing based solely on a friend's or family member's recommendation
2. Always doing thorough research before investing
3. Being wary of investments that sound too good to be true
4. Never sending money or providing financial information to strangers
5. Sleeping on investment decisions rather than acting immediately

Remember: Legitimate investments don't need high-pressure sales tactics or guarantees of extraordinary returns. If something seems suspicious, trust your instincts and investigate further.

9. Save more and make your money go further with simple strategies

Pennies saved today turn into dollars down the road-the surest and safest way of all to increase your wealth.

Small changes in spending habits can lead to significant savings. By becoming more mindful of your expenses and implementing simple cost-cutting strategies, you can increase your savings rate and build wealth more effectively.

Strategies to save money and reduce expenses:

• Drive more efficiently to save on fuel costs
• Adjust your thermostat to save on energy bills
• Brown-bag your lunch instead of eating out
• Use the library for free entertainment
• Shop smarter at the grocery store
• Manage credit card debt wisely

Focus on both reducing unnecessary expenses and finding better value for necessary purchases. Remember that every dollar saved is a dollar that can be invested and grown over time. By cultivating a habit of thrift and mindful spending, you can achieve your financial goals more quickly and securely.

10. Investors often earn less than their investments due to poor timing

Investments don't make or lose money. Investors do.

Poor timing and emotional decision-making can significantly reduce returns. Many investors buy high and sell low, driven by greed during market rallies and fear during downturns. This behavior explains why individual investors often earn less than the stated returns of their investments.

Factors contributing to this performance gap:

• Chasing past performance by investing in hot funds or sectors
• Panic selling during market downturns
• Failing to rebalance portfolios regularly
• Overtrading based on short-term market movements

To improve your chances of capturing investment returns:

1. Develop a long-term investment strategy and stick to it
2. Automate regular investments to avoid timing the market
3. Rebalance your portfolio periodically to maintain your target asset allocation
4. Avoid making emotional decisions based on short-term market movements
5. Consider using low-cost index funds to reduce the temptation to trade actively

By focusing on disciplined, long-term investing rather than trying to time the market, you can potentially earn returns closer to those of your underlying investments and build wealth more effectively over time.

Last updated: November 19, 2024