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What If?.....Eight Important Lessons I have learned as an investor

"The future's uncertain and the end is always near." Many are investing as if the second part of this old Doors song lyric is true, but the first part is false. Last week, as the market bottomed, I read a lot of posts from investors, including some who are professionals, chanting the same mantra, they knew with 100% certainty what the S&P was going to do later this year, proclaiming that it would fall below 600, and it was the time to go short.

If one took data of the S&P index for the past 100 years and calculated the statistical probability of the S&P falling below 600 this year in the 99% confidential interval, the probability would be far less than 0.1% (yes I do have the mathematical pedigree to make such a calculation and claim). Yet, I read many posts proclaiming that they KNOW this going to happen (and when), and are investing as if it is a given, with 100% certainty.

It the zealous belief in such extraordinary events occurring that that brings me to recall several lessons I have learned from my years investing. Here are eight key lessons I have learned from many years as an active investor.

1. The greatest lesson I have learned to ask myself "What if I am wrong?"   I do not know the future, I am but a mere mortal. Therefore, I have plans in place for the times something other than I expected occurs, and I have procedures that assume I am going to wrong frequently, perhaps even half the time. The market can be a great humbler.

Several have posted or stated unequivocally in the past few days that the S&P is going lose half it's value in six months, and when the top and bottom will occur. Think of how absurd this sounds outside the walls of an insane asylum. You don't even know what you're going to have for dinner tonight. Investing as if you can predict and time a calamity is riddled with traps that rarely lead to successful outcomes. What you can do is your due diligence as an investor, invest within your risk tolerance, and acknowledge the reality that there will plenty of times your selections will be wrong.

2. The herd is almost always wrong.  It is only in stock market that people like buy at higher prices and love to sell at lower prices. It is the herd mentality, people are sheep. Let's call them "sheople". It is by definition that highs occur when there is a preponderance of buyers and lows when there is an abundance of sellers.

There are hundreds of stocks the investing public was in love with less than three months ago that couldn't be given away at 20-30% less last week. I noted a few days ago that the price of MSFT stock had dropped 27% in ten weeks. Did the underlying fundamentals of Microsoft change by 27% in ten weeks? Of course not. What changed was investor sentiment.

3. Arrogance is the enemy of the investor.  One day this past week, I was told by a passionate investor that it was the bottom of the market, and there would never be as low a point ever again in the markets or as good a buying opportunity. On the same day, another posted that the S&P was going to drop below 600 before the end of this year. Both were absolute in their knowledge, and dismissive that any other scenario could possibly occur.

Thinking you possess the knowledge of the future, such as when a stock or index will hit a top or bottom, is more than arrogant, it borders on delusional, one step removed from spotting Elvis or thinking Hitler is living in your basement. Furthermore, there are unexpected geopolitical events or natural disasters that can have an impact on the financial markets. What is important is to have a discipline and methodology. For example, I step into positions, which I will describe next.

4. Develop a system and constantly tweak and improve it as you gain experience.  Suppose I want to accumulate shares of a certain issue. I do not buy the entire position in one transaction. I break my allotment into three or four chunks. I take an initial position. If the price moves lower, and I have done my review and still want to obtain more, I pick up another chunk. In other words, I cost average into, and then out of, positions. Sometimes I do this on a weighted basis. Why do this?...because I KNOW there are times I will be wrong, and I accept that the probability that I will be able to buy or sell an absolute bottom or top is nil. Remember, I am just a mere mortal. I may not make as big a gain as if I had gone hog wild and caught the bottom and the top, but the cost of my mistakes will be significantly reduced, as well as my anxiety, and I am not trying to pick absolute tops and bottoms, but adjusting my cost basis in a logical, disciplined manner. What I have learned, is that the system employed in managing a portfolio is more important than the individual stocks selected.

The most important metric is investor sentiment. One of the mistakes I made earlier as an investor was thinking that sentiment would net out neutral. It does not, investor sentiment nets out to be positive more often than negative, the mean over time is slightly more bullish than neutral.

When I become more bearish, it does not mean I am expecting the market to drop 40% or 50%. It means I am adjusting my allocations because I want to have some dry powder to work with for what I anticipate will be more favorable pricing at a future time.

5. Experience does matter.  As an active investor since the 1980s, I have had my shares of gains and losses. My returns do not erode as time progresses, they tend to improve as I gain more experience. Although the losses and bad trades are painful when they occur, they are valuable learning experiences. Living through multiple bull and bear markets provides an investor with a sense of the cyclicality of the markets.

It is my observation that less experienced investors will tend to believe they have superior predictive powers. A few months ago, I spoke with another Investment Advisor and expressed my concern that the markets may be ripe for correction. He rebuked me rather firmly, proclaiming that the market would continue to rally much further. He was quite a bit younger than me. He also made claims of extraordinary returns, including during the market crash in 2008. While I was concerned that a correction may be approaching in the aftermath of large rally, he KNEW that wasn't the case.

The single biggest mistake I ever made was shorting when the environment was bearish. You see, I was certain that a certain market sector was going to crash. Besides, everyone else was saying it was going to.

6. A stock does not know you own it.  I recently read a post from someone who stated that since another individual (he either didn't like or disagreed with) was buying a certain stock, he had just shorted it. A week later the stock was almost 20% higher. Within a few weeks, the stock was 30% higher than where he shorted it. No problem, he just deleted the post boasting about shorting the stock. Hopefully, it is obvious why this is not a reason to enter such a transaction.

When a position goes against you, the stock or the company is not taking an action against you, it does not know who owns the stock.

7. Set your expectations realistically.  A potential client once approached me and expressed that his expected returns would be 100% per year. If your "plan" is to achieve unrealistically high results, you are more likely to make irrational transactions, take on excessive risk, and wind up slaughtered. Compare your returns with yields on fixed income, market indices, and other broad measures of performance, and set your expectations to be in accordance.

8. Investing as if an outlier event is imminent is foolhardy.  If you invest in a stock because you read on someone's facebook page (in between the LOL's and hee-hees) that it was going to double tomorrow, or you are convinced there is going to be a 25% market decline next week, you are expecting that events which happen very infrequently are going to happen right then, and you can time the occurrence of such. Good luck with that.

The media constantly presents, and the Internet is full of posters, making bold titillating predictions designed to attract audience that have little chance of occurring. What gets more clicks, "Boring Week Ahead Expected in the Market", or "Expert Predicts 1929 Style Crash to Happen This Tuesday"? Take these extraordinary predictions for what they are, entertainment value.

These are not the only lessons I have learned as investor, they are eight important ones that come to mind at this time. This post is somewhat a work in progress, as I intend to edit it further in the future. It was initially written on July 7, 2010.