There are many investment ‘rules of thumb’ out there, and there are plenty that make a lot of sense, especially those attributed to the likes of Warren Buffett, Benjamin Graham, Peter Lynch, and the other greats.
But there are some that are outright nonsense, or at the very least badly misunderstood. Here are three that I think we’re all better off ignoring:
Run your winners and cut your losers
When shares are on very high valuations, isn’t that actually a good time to consider selling and taking your profit? Or when they’re falling, isn’t that actually a great time to buy?
If you’d topped up on bank shares shortly after the Brexit vote sent them plummeting, you’d be doing well now — but this rule would have had you selling them when they were at the cheapest they’d been for years.
And it would have you firmly sticking to every stock market boom that’s come along. Would it make sense to stay on the latest growth share bandwagon when P/E valuations are reaching 50, 60, 70 or more? Very occasionally yes, but almost always no — and this rule tells you not to sell shares when they’re at their highest prices.
Whether you are running a profit or a loss is utterly irrelevant when to comes to deciding whether to sell. The only things that count are the price now, the fundamental valuation now, and the company’s future prospects now.
Buy what you know
This is one that’s often recommended, but often misunderstood to investors’ huge costs — because there are caveats that are often overlooked.
The rule does not mean “buy what you know, even if what you know is worthless junk“, or “buy what you know, even if it’s massively overvalued“. I’ve worked in software development, and I was dismayed to find my techie colleagues piling into the dotcom bubble because it was what they knew — and getting badly burned.
I even met one guy who’d sold his high-tech company, getting a good price partly because of tech-company madness, but who then invested the bulk of the cash in the stock market, in what he knew… in late 1999.
No, this rule needs to be turned around to say “don’t buy what you don’t understand“. Just because you know about something doesn’t mean you’re any good at valuing shares, and that’s far more important than knowledge of any specific industry.
You can’t beat the market
People, amazingly, still trot this one out. It implies that in 1999 and 2000 you couldn’t have beaten the market by simply not buying tech stocks. And that in the financial crash you couldn’t have beaten the market by buying cheap banking and insurance shares while most investors were selling. In fact, many did beat the market by doing exactly those things.
And it flatly contradicts an approach that Warren Buffett has been very successful with, that of going against the market when the market is wrong.
The rule is based on the Efficient Markets Hypothesis, which says that all information is known to everyone at the same time, so you can’t get in ahead of the crowd and win. But the critical flaw with that is that it assumes everyone will act equally rationally, and that rational analysis can only ever produce one unanimous outcome.
And that’s utter garbage.