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How to become financially independent 12: laws of Investment Part Two

Continuation from yesterday’s blog …

4. Be contrarian

John Maynard Keynes said that “the central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merit, the investment is inevitably too dear and therefore unattractive.” It sounds easy when stated like that, but to go against the herd is to go against human nature, to the extent that it can almost physically hurt.

Adhering to a value approach will tend to lead you to be a contrarian naturally, as you will be buying when others are selling and assets are cheap, and selling when others are buying and assets are expensive.

Humans are prone to herd because it is always warmer and safer in the middle of the herd. Indeed, our brains are wired to make us social animals. We feel the pain of social exclusion in the same parts of the brain where we feel real physical pain. So being a contrarian is a little bit like having your arm broken on a regular basis.

5. Risk is the permanent loss of capital, never a number 

Using beta as a proxy for risk may be mathematically elegant, but risk is not volatility. Quoting Keynes again: “It is largely the fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”
We should regard risk as the probability of a permanent loss of capital, and that loss can come from three sources:

  • Valuation risk — paying too much for an asset.
  • Fundamental risk — underlying problems with the asset that you’re buying. Also known as value traps.
  • Financing risk — leverage.
6. Be leery of leverage 

“Leverage is a dangerous beast,” Montier says. “It can’t ever turn a bad investment good, but it can turn a good investment bad. Simply piling leverage onto an investment with a small return doesn’t transform it into a good idea.”

Much of what is termed “financial innovation” is nothing more than thinly veiled leverage, and he believes we should view it with skepticism.

7. Never invest in something you don’t understand 

This seems to be just good old, plain common sense. If something seems too good to be true, it probably is. The financial industry has perfected the art of turning the simple into the complex, and in doing so managed to extract fees for itself! If you can’t see through the investment concept and get to the heart of the process, then you probably shouldn’t be investing in it. In his opinion, if you can’t understand it, you shouldn’t be investing in it.

I hope these seven immutable laws help you to avoid some of the worst mistakes, which, when made, tend to lead investors down the path of the permanent impairment of capital. Invest only in things that you fully understand and believe in and take investment advice only from people who are financially successful from taking their own advice. Play it safe. 

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