I'm going to post up the 6 vital principles that come to us from great Rule #1 investors starting with Ben Graham then Warren Buffett then on to today's greats like David Einhorn and Mohnish Pabrai. These principles are timeless but have been stated in one form or another publicly for at least 80 years and yet still to this day few investors follow them. Its hard to understand why that is; these are not fair-weather or bull-market principles. These principles have worked to generate serious alpha returns through the Great Depression, WWII, Korean War, Vietnam and the Great Society inflation, the end of the gold standard, the great bull from 1980 to 2000 and through two huge bubbles that crashed the market in the last decade. These are principles to invest by. Learn them well and violate them at your own risk. Here is the first one:
1. RATIONAL: Stay Rational
Easier said than done when you are investing real money. Money you can't afford to lose tends to be 'hot' or emotional. Pro gamblers try to avoid sitting down with more than they can afford to lose but anyone investing all of their own hard-earned money is always sitting down with more than they can afford to lose. Fear of losing more than you can afford to lose tends to make the mind go irrational. You start guessing. You can't tell the difference between a good idea and a bad idea.
Investing decisions are not life and death decisions (unless you've embezzled $100 million or so) but still, remaining rational in the face of intense emotions is an art that is learned in the trenches. They don't teach this at business school because they can't generate real emotions in a classroom setting.
Staying rational is an art that the best investors in the world have learned. They have the ability to separate their emotions, block them off and operate on pure reason. If A, then B. If B, then C. Therefore, if A, then C. Using our rational mind is a huge advantage in a marketplace that dominated from time to time by irrationality covered over with Modern Portfolio Theory. MPT says that the market is a roulette wheel which never remembers the last spin, all professional investors are solidly rational and, therefore, price is value.
I'll write more about irrationality in the future but for now suffice it to say that were it not for the occasional irrationality of otherwise brilliant fund managers sheltered and comforted by MPT, we'd all of us be out of luck trying to beat the market. Fortunately, its in the nature of the beast for a fund manager to do irrational things; principally to sell something at a significant discount to its actual value.
A corallary of 'Rationality' is that price is not value. Price is only what you pay. Value is what you get no matter what you paid for it. Pay too much and you'll never have excess alpha returns. But buying value on sale requires an intelligent human to do the irrational thing and sell it when its on sale. The good news for us is that fund managers rarely hold stocks for longer than 3 months. If a company is having an issue that may take longer than a few months to solve, an issue that calls their near-term future earnings into question, fund managers will begin to sell. Uncertainty is anathema to the Big Guys. Hampered as they are by size to react to unforeseen events and by their Ivy League MPT education, we can forgive them their hair-trigger launch for the exits, particularly since their loss is our gain if we stay rational.
This is the key to Rule #1 type investing. In a nutshell, we buy fear and we can't unless someone is afraid. That someone is a fund manager who in the face of any uncertainty begins to sway like a too-tall tree in a too-big wind. We little guys just have to remember that "A is A". Its obvious. Well-educated fund managers all studied this tautology in their survey philosophy courses. But fund managers forget that "A is A" if they aren't in the classroom and the tautology is structured as "value is value". If the future earnings are reasonably intact despite the problem, value is still value and it most certainly isn't the same thing as price, no matter what the siren call of Modern Portfolio Theory is whispering in the fund manager's ear.
Next time principle #2.
Now go play.