Thursday, August 30, 2012

The 10 Essential Investment Rules - Prof. Davide Accomazzo



Article provided by Prof. Davide Accomazzo, Pepperdine University

At the end of 14 grueling weeks in my Portfolio Management class, I wrap it up with this 10 rule list. After all the fancy formulas and complex graphs we review in class, the art of investing comes down to common sense and risk management. After my many years in the trenches, managing money for investors from all over the world in multiple and very different markets, I can confidently say that these 10 rules are your lifeline.
  1. Understand the nature of expected returns. One of the keys to a long and successful investing career is to truly understand the nature of the expected returns; in other words WHY should this particular investment or strategy produce a positive return, what are the drivers of price formation, what is the investment thesis supporting our decision and are past circumstances going to have the same weight in the future?
  2. Fully understand the risk Understanding the reasons for expected returns is only half the story; you must also understand the risk associated with the investment. You must run a stress test and identify what contingencies could develop and how your investment would perform in those situations.  Do not rely on static historical correlations but adopt a correlation scenario approach where you allow for specific disruptions to occur.
  3. Analyze performance on a risk adjusted basis Looking at performance numbers in a vacuum is meaningless and yet incredibly common; you must always put performance into the context of risk; do not assume that higher performance numbers are the result of superior management; is it superior investment selection (or superior timing) or just leveraged beta?
  4. Risk management is the most important element of investing This is by far THE MOST IMPORTANT rule of all.  Finding investments is easy, entering trades is easy…controlling the risk is hard.  Never allow for a loss to be terminal to your account; always have an exit strategy BEFORE you enter the trade. A classic market truism says: "Good traders know how to make money, great traders know how to take a loss."
  5. Discipline overrides conviction Investing is a probability game; if you can be disciplined and follow a process based on rules 1 and 2 AND you constantly control the risk so that a loss will never take you out of the game, you will succeed in the art of investing.  Never be emotionally involved, never "marry" a position and…never take it personally when things don't work out. 
  6. Adapt your style to changing market conditions (market structure changes) Rule 6 may sound contradictory to rule 5 but in fact it is complementary.  You must be disciplined but you must also have a review process that alerts you when "structural" changes happen in the market which may require you to adapt.
  7. Opportunities are made up more easily than losses When in doubt…pass. Over 40 markets are open every day for business, opportunities abound. Losses are practically and emotionally tough to make back.
  8. Emotions are your worst enemy Treat investing/trading as a job; have a process, have risk management and if you are looking for a thrill go to Vegas or take on paragliding. Investing should be boring and not emotionally charged.
  9. Act independently of the crowd (but do not be a contrarian just for the sake of it) Being a sheep does not produce consistent superior returns in the investment universe. However, you must have a process to identify out of the box ideas and to identify peaks of complacency or fear among the crowd so that you can take the other side of the trade. In other words be creative but do not be a contrarian just for the sake of it.
  10. Perception is reality (Theory of Reflexivity) As Gordon Gekko eloquently said 25 years ago: perception is reality when investing. Remember that as an investor you are making a guess of what the average investors' guess is of an uncertain future outcome.