I have been investing since my sophomore year of college. I was pretty excited when I opened my first brokerage account with Scottrade and funded it with a large sum of $1,000! The first two stocks I purchased were Berkshire Hathaway and Apple. Since then I’ve learned some pretty important investing rules.

To help out, I’m sharing some investing rules I’ve learned over the years. But before discussing that let’s first look at why it’s important to understand behavioral finance.

Are People Naturally Bad Investors?

Last week I discussed some of the pros and cons of passive and active investing. I came to the conclusion that passive investing is a much easier strategy for most people because it’s less stressful, less time consuming, and easier to execute than active investing.

In reality, passive and active investing are both more difficult than people realize. And it has nothing to do with how smart you are. Nope. It all comes down to behavioral finance and emotions. Throughout my years, I’ve learned that it is very easy to let emotions dictate your actions.

Peter Lynch is one of the most successful mutual fund managers of all time. During his legendary tenure, the Fidelity Magellan fund returned 29.3% returns per year between 1977 and 1990 (more than double the S&P 500)!

However, according to Lynch himself, at least half of all investors in the fund lost money!

That is a crazy pill to swallow! How do you lose money when you’re investing with the greatest mutual fund manager of all time?

Well it all comes down to behaviorial finance. A lot of people piled money into the fund when performance was good. And they dropped it like a rock when things weren’t doing so well.

The intersection between finance and psychology is very interesting to me. Over time I’ve learned some pretty important rules of investing. Hopefully they help you avoid losses or make you money. Here are my tips for both passive and active investors:

1. Always do your own homework

Never invest any money into a company because of a recommendation, even from a close friend. You should personally vet all potential investments. This means reading through all of the filings, creating your own models, talking to industry participants, and really understanding the business. If you don’t have the time to do all of the above, it’s perfectly fine to invest in an index fund.

A lot of investors try hit home run investments and buy really risky companies where they don’t fully understand the business. As Warren Buffett always says: Stay Within Your Circle Of Competence. As long as you invest in companies you understand, you’ll do fine in the long run.

I see a lot of beginning investors shoot for every high risk high reward opportunity that lands on their desk. It’s okay to pass on an investment. There will always be another great opportunity.

2. The market is a classroom and loss is the professor

Understand that the stock market is eternally a classroom and we are all students. Unfortunately, loss is the teacher. Do not be afraid to lose money early in your investment career. In my opinion, it is best to lose money when you’re younger and don’t have any obligations (like kids, mortgages, etc.).

Losses are a great teaching tool because you tend to remember your losers better than your winners. I remember all my losses and why I think the investments never worked out. Many great investors lost a ton of money early in their career and they were better off because of it.

3. Trust but verify

I know this is very difficult, but always keep this in mind: NEVER blindly accept what management tells you.

I’ve been in this business long enough to know that they rarely tell investors when business is bad. I mean how many CEOs have publicly said: “You know, our business is in secular decline and I think that you should think twice before investing in our business because you might lose money”.

The answer is none! Unfortunately, most management teams are more interested in keeping their jobs and collecting their checks. Don’t fall for the management hype.

4. Let your winners ride and cut your losers

Investing is like tending to your garden. Some of your plants will grow faster than others and some will hold back the rest of the group. One mistake I often see is holding onto losers in hope they bounce back.

Let’s say you owned a stock that is down 20%. A lot of investors would never sell the stock for a loss even though the fundamentals might have turned the wrong way and the thesis was wrong. The two reasons they all cite is: (1) I’m down so much so I can’t sell for a loss and (2) it’ll bounce back.

But here’s the thing! You’ve already lost money! A paper loss should be considered a cash loss! Sometimes I even see people sell their winners to buy more of their losers. When I started investing, I made the same mistake. After all… I loved the stock at $50, so I must love it a $40 right? Well, it must be an even bigger bargain at $30, right?

At the end of every year, I look at every single investment made during the past year. I’ve done this for the past 7 years and I’ve found one common theme: I’ve made the most money averaging up on my winners. 

In fact, I’ve lost money 70% of the time when I averaged down on my losers. As cliche as it sounds, it is my firm belief that you should cut your losers and let your winners ride.

5. Never let FOMO dictate your actions

I see a lot of investors who invest in companies because they “don’t want to miss out.” This company could be the next Apple or Google!

Basically, it’s the fear of missing out (FOMO). I have fallen for this trap a few times. I would invest in certain companies because I was afraid of missing out on big returns if they took off. More often than not I lost money chasing returns on those investments.

Never chase returns and never be afraid to miss out in potential investments. There will always be another great opportunity.

6. Volatility is your friend

There’s a funny saying in the finance world. It goes something like this: investors don’t care about volatility as long as it is upward volatility. However, the moment downward volatility comes along, everyone freaks out.

In many mathematical finance models, volatility is defined as risk. As a student of the markets, I could not disagree more. Market volatility or a stock volatility does not mean it is more risky!

In fact, I would go so far to call volatility a godsend. Volatility represents opportunity!

The U.S. has been in a bull market for the past 7 years. Since the lows of 2009, the S&P 500 increased over 230%! However, it has not been a smooth ride up the entire time.

Over the past six years, the S&P 500 experienced four corrections:

• 04/23/10 – 07/20/10 (70 days): -16.0%
• 04/29/11 – 10/03/11 (157 days): -19.4%
• 05/21/15 – 08/25/15 (96 days): -12.4%
• 11/03/15 – 02/11/16 (100 days): -13.3%

Volatility is my longtime friend. I love it. Volatility is amazing because it allows you to purchase shares at a discounted price.

As Warren Buffett once said, the stock market is a wealth transfer machine. Over the long-term, money transfers from the ill-informed to the well-informed. Volatility should be embraced with open arms.

7. It is okay to hold cash

Sometimes it is okay (and even smart) to hold cash. You don’t have to be fully 100% invested in the market all the time. If there are no good investment opportunities, then you shouldn’t put money in sub-par investments. Having a little cash around is a great way to take advantage of market corrections whenever they occur.

8. Trading on margin can be dangerous

Trading on margin basically means you are borrowing to purchase investments. Most brokerages will provide you margin depending on the equity in your account.

Many investors trade on margin to create higher returns. In reality, they are digging their own grave.

Margin is a double edged sword. Your returns can be much higher, but your losses are also proportionately higher. Let’s see how margin can really hurt you.

Say you buy a stock for $10,000 funded by $5,000 in equity and $5,000 on margin. If the value of the index/stock falls to $8,000, your margin debt remains the same at $5,000, but the value of your equity falls to $3,000.

Even though the stock fell 20%, you’ve lost 40% in equity! In times of market volatility, your equity can drop below threshold levels and you’ll get a margin call.

Be careful when using margin for investing purposes. It is extremely dangerous and you could lose a ton of money.

Conclusion

If I learned anything over the years it is that while investing may sound easy (buy low sell high), it is far from a walk in the park. However, investing is necessary if you want to save for retirement and combat the impacts of inflation. Hopefully these investing rules/tips will help you in your financial journey!

Readers, do you have any other tips you’d be willing to share? I’d love to hear them!