I can hear it now. If there are only 3 simple rules of investing, why are there so many other rules? Why would anyone want to make things more complicated? Even here at Cabot, we’ve written things like, “10 Basic Rules of Investing According to the Legends,” and “Benjamin Graham’s Seven Criteria for Picking Value Stocks.” What gives? Let’s go to the kitchen to find out.
To bake bread, you only need four ingredients: flour, water, yeast, and salt. If you want to add ingredients to that, you can get fancy and make a cheddar cheese bread, or a maple syrup bread, or a tasty loaf with fresh basil, garden tomatoes, garlic, and shredded cheese. Obviously, that’s a long way from the basic four ingredients. But for your everyday loaf, you can keep it simple.
However! You can’t just throw those four ingredients together any way you feel like. Too much water and not enough flour, and you’ll have a sticky mess. Too much yeast and your bread will collapse. Investing is a little like that. You can keep it nice and simple, and as long as you follow the “rules,” you’ll find it’s easier to achieve success.
The 3 simple rules of investing that every investor, new or experienced, needs to know
There are, of course, many approaches to investing. Just like baking, you can get as complicated as you want. You can look at technical analysis, or different ratios, or stick to dividend stocks, or just hand all your cash over to a broker and hope for the best (although we’re big proponents of investing on your own). You can follow rules that focus on growth investing, or short selling, or options trading.
When it comes down to it, though, there are only 3 simple rules of investing that you need to follow. And you’re going to laugh when you read them, because they are amazingly simple. The first two come from Warren Buffett. The third one is ours, as far as we know.
- Rule #1: Don’t lose money.
- Rule #2: Don’t forget rule #1.
- Rule #3: Make money.
Before you walk away thinking this is amazingly anticlimactic, think about these for a minute. Every rule that you can come up with around investing is based on these three. And even though they are simple, they aren’t so easy. These are the flour, water, yeast, and salt of your investment bread. Now let’s look at how they function in real life.
Following the rules and raking in the dough
The easiest way to make money in the stock market is to buy stocks when the market is going up. It’s always easier to swim with the tide or run with the wind at your back. Stock markets are no different. And when markets are going down, you should work extra hard to weed out your losers and move toward cash for the same reason. AKA, don’t lose money.
It’s also smart to cut your losses short. When a stock starts falling, the only theoretical limit is zero. And the longer you stick with it, the less capital you have to put to work. No matter how much it hurts, you have to admit that you made a mistake and sell the stock when it reaches your sell point. AKA, don’t forget rule #1.
The other thing we often recommend to investors is to do nothing. That’s perhaps the simplest of our 3 simple rules of investing, but it’s way harder than it sounds. You have to let your stocks go up in value, though. The power of compound growth can swell your account dramatically—if you are patient. Long-term investments make more money than short-term investments. So learn to develop staying power. Let your profits run and run and run. This is how you make big money in the market. Not by taking 10% and 20% profits but by thinking big—in terms of 100%, 200% and larger profits. AKA, make money.
One addendum to that is to add a modest number of shares to your winners from time to time, trying to do this during corrections in the stock, not after the stock has posted a major run-up. Called “averaging up,” this is a great way to reinforce your investments in your best stocks.
What do you think? Are there investing rules that you like to stick with? Share your ideas in the comments below.