The Long and the Short of It - Finance and Investment for Normally Intelligent People Who Are Not in

1. Become Your Own Investment Manager

You cannot, unfortunately, trust people who offer financial advice.

Self-reliance in investing. The financial services industry is rife with conflicts of interest and high fees that erode returns. By becoming your own investment manager, you can avoid these pitfalls and make decisions that truly align with your goals. This doesn't mean you need to become an expert in every aspect of finance, but rather that you should:

• Educate yourself on basic investment principles
• Develop a clear understanding of your financial goals and risk tolerance
• Learn to use online platforms for low-cost investing
• Regularly review and adjust your portfolio

By taking control of your investments, you'll save on fees and ensure that your strategy truly reflects your needs and objectives.

2. Understand Market Efficiency and Its Limitations

Markets are 80 per cent efficient, but the profits from investment are mostly to be found in the 20 per cent that is not.

The Efficient Market Hypothesis (EMH) paradox. While markets are generally efficient at incorporating available information into prices, they are not perfectly so. This creates opportunities for intelligent investors. Key points to remember:

• Short-term price movements often reflect noise rather than fundamental value
• Market efficiency varies across different sectors and asset classes
• Opportunities arise from behavioral biases and institutional constraints

Understanding both the efficiency and inefficiency of markets allows investors to focus their efforts on areas where they can potentially gain an edge, while avoiding futile attempts to outsmart the market in highly efficient segments.

3. Focus on Fundamental Value, Not Market Sentiment

An asset is worth the higher of its fundamental value and its market price.

Value-driven investing. Instead of trying to predict short-term price movements, intelligent investors should focus on understanding the true value of assets. This involves:

• Analyzing a company's competitive advantages and cash flows
• Considering the long-term prospects of industries and economies
• Being patient and willing to hold assets that may be temporarily out of favor

By concentrating on fundamental value, investors can avoid getting caught up in market hype or panic. This approach also provides a framework for making rational decisions about when to buy, hold, or sell assets based on their relationship to intrinsic value rather than fleeting market sentiments.

4. Diversify Intelligently to Manage Risk

You do not need to hold many different securities if the returns from those you do hold are uncorrelated with each other.

Effective diversification. True diversification is about more than just holding a large number of assets; it's about owning assets whose returns are driven by different factors. To diversify intelligently:

• Look beyond traditional asset classes to find truly uncorrelated investments
• Consider geographic diversification, including emerging markets
• Include assets that may perform well in different economic scenarios (e.g., inflation, deflation)
• Regularly rebalance your portfolio to maintain desired allocations

By focusing on correlation rather than simply quantity, investors can build portfolios that are more resilient to various market conditions and economic shocks.

5. Adopt a Contrarian Mindset

Be contrarian. Your aim is to avoid following in the rear of the crowd, and to be travelling in a different – even the opposite – direction.

Think independently. The power of conventional thinking in financial markets often leads to mispricing of assets. By adopting a contrarian approach, investors can:

• Identify overlooked opportunities in unfashionable sectors
• Avoid overpriced "hot" investments
• Capitalize on market overreactions to news and events

Being contrarian doesn't mean blindly opposing popular opinion, but rather thinking critically about market consensus and being willing to act when your analysis differs from the crowd. This approach requires emotional discipline and confidence in your own research and judgment.

6. Pay Less in Fees and Trade Infrequently

Only one thing eats up investment returns faster than fees and commissions, and that is frequent trading.

Minimize costs. The compounding effect of fees and trading costs can significantly erode investment returns over time. To combat this:

• Use low-cost index funds or ETFs for core portfolio holdings
• Avoid high-fee actively managed funds unless they have a proven track record of outperformance
• Implement a buy-and-hold strategy to minimize trading costs and taxes
• Be skeptical of complex financial products with hidden fees

By focusing on cost control, investors can keep more of their returns and benefit from the power of long-term compounding.

7. Think Probabilistically and Embrace Uncertainty

If you don't practise SEU, you will be Dutch-booked – sold products that will be financially rewarding for the promoter but not for you.

Probabilistic reasoning. Successful investing requires thinking in terms of probabilities rather than certainties. This involves:

• Assessing the likelihood of various outcomes rather than seeking definitive predictions
• Understanding the concept of expected value in decision-making
• Recognizing the difference between risk (known unknowns) and uncertainty (unknown unknowns)
• Being comfortable with the idea that good decisions can sometimes lead to bad outcomes due to chance

By embracing probabilistic thinking, investors can make more rational decisions and avoid common pitfalls like overconfidence or paralysis in the face of uncertainty.

8. Beware of Financial Innovation and Complex Products

Why do I want to buy what they want to sell?

Simplicity and transparency. Many financial innovations and complex products are designed to benefit their creators rather than investors. To protect yourself:

• Be skeptical of "revolutionary" financial products or strategies
• Avoid investments you don't fully understand
• Question why someone is offering you a seemingly attractive deal
• Stick to simple, transparent investments for the core of your portfolio

By favoring simplicity and transparency, investors can avoid many of the pitfalls and hidden risks associated with complex financial products.

9. Set Realistic Goals and Maintain a Long-Term Perspective

The prudent spending rate should be a little less than your target rate, converted into a real post-tax rate of return, and should be revised from time to time in line with experience.

Long-term focus. Successful investing requires setting realistic goals and maintaining a long-term perspective. This involves:

• Defining clear, achievable financial objectives
• Understanding the power of compounding over time
• Avoiding overreaction to short-term market movements
• Regularly reviewing and adjusting your strategy as needed

By focusing on the long term and setting realistic expectations, investors can avoid the stress and mistakes associated with short-term thinking and unrealistic goals. This approach also allows for the power of compounding to work in your favor over extended periods.

Last updated: October 11, 2024