Investing in the Public Markets – Rules to Live by

I am an oil trader and financier; a business which has been a huge economic beneficiary of the sustained increases in oil prices, drilling, refining and related processes. As such, the amount of wealth created in energy-related investments has been enormous and, not surprisingly, a vast majority of individuals have overweighed portfolios in energy with the expectations that “oil prices can only go up.” Of course, this sentiment is certainly understandable when you look at the performance of the energy sector versus the S&P 500 since the turn of the century. (Annualized return, capital appreciation only: S&P 500 3.24% vs. Energy 17.71%)

Not surprisingly, the recent plunge in oil prices, and related energy stocks, has sent investors scurrying for cover. Previous “complacency” has turned to outright “panic” as portfolios, and retirement plans, have been crushed by plunging asset prices.

Strongly rising asset prices, and in this case commodity prices, have driven investor exuberance in the sector leading many to ignore deteriorating fundamentals, excessive leverage, and other financial diseases. However, when prices deteriorate rapidly, investment mistakes are quickly revealed.

It is important to remember that we are not investors. We are speculators placing bets on the direction of the price of an electronic share. More importantly, we are speculating, more commonly known as gambling, with our “savings.” We are told by Wall Street that we “must” invest into the financial markets to keep those hard-earned savings adjusted for inflation over time. Unfortunately, due to repeated investment mistakes, the average individual has failed in achieving this goal.

With this in mind, I would like to share with you some time-tested rules about “risk” that have repeatedly separated successful investors from everyone else hoping you will learn a thing or two.

1. Managing Risk. Great investors focus on “risk management” because “risk” is not a function of how much money you will make, but how much you will lose when you are wrong. In investing, or gambling, you can only play as long as you have capital. If you lose too much capital while taking on excessive risk, you can no longer play the game. As Warren Buffett keeps saying: “Be greedy when others are fearful and fearful when others are greedy”. One of the best times to invest is indeed when uncertainty is the greatest and fear is the highest. You don’t though get rewarded for taking risk; you get rewarded for buying cheap assets. And if the assets you bought got pushed up in price simply because they were risky, then you are not going to be rewarded for taking a risk; you are going to be punished for it. At the end of the day, it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong. Being right and making money is great when markets are rising. However, rising markets tend to mask investment risk that is quickly revealed during market declines. If you fail to manage the risk in your portfolio, and give up all of your previous gains and then some, then you lose the investment game.

2. Understanding cyclicality. The realization that nothing lasts forever is critically important to long term investing. In order to “buy low,” one must have first “sold high.” Understanding that all things are cyclical suggests that after long price increases, investments become more prone to declines than further advances.

3. Nothing good or bad goes on forever. The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment. Always remember: Nothing good or bad goes on forever. The mistake that investors repeatedly make is thinking “this time is different.” The reality is that despite Central Bank interventions, or other artificial inputs, business and economic cycles cannot be repealed. Ultimately, what goes up, must and will come down. Wall Street wants you to be fully invested “all the time” because that is how they generate fees. However, as an investor, it is crucially important to remember that “price is what you pay and value is what you get”. Cheap is when an asset is selling for less than its intrinsic value. “Cheap” is not a low price per share. Most of the time when a stock has a very low price, it is priced there for a reason. However, a very high priced stock CAN be cheap. Price per share is only part of the valuation determination, not the measure of value itself. Eventually, great companies will trade at an attractive price. Until then, wait.

4. It is all about behavior. Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose. Investor behavior is the biggest risk in investing. “Greed and fear” dominate the investment cycle of investors which leads ultimately to “buying high and selling low.”

5. And emotions. The speculator’s deadly enemies are: ignorance, greed, fear and hope. All the statute books in the world and all the rule books on all the Exchanges of the earth cannot eliminate these from the human animal. Allowing emotions to rule your investment strategy is, and always has been, a recipe for disaster. All great investors follow a strict diet of discipline, strategy, and risk management. In fact, the biggest investing errors come not from factors that are informational or analytical, but from those that are psychological. The biggest driver of long-term investment returns is indeed the minimization of psychological investment mistakes. As Baron Rothschild once stated: “Buy when there is blood in the streets.” This simply means that when investors are “panic selling,” you want to be the one that they are selling to at deeply discounted prices. The opposite is also true. As Howard Marks opined: “The absolute best buying opportunities come when asset holders are forced to sell.” As an investor, it is simply your job to step away from your “emotions” for a moment and look objectively at the market around you. Is it currently dominated by “greed” or “fear?” Your long-term returns will depend greatly not only on how you answer that question, but to manage the inherent risk.

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