The 5 Laws of the Market We All Have to Follow

by Jay Pestrichelli on December 9th, 2013

Our book is called,  Buy and Hedge: The 5 Iron Rules for Investing Over the Long Term, and as the title suggests there are 5 Rules we tell you to follow to create a hedged and sustainable long term portfolio. But what is often forgotten are the laws of the markets the inform the creation of the rules. We call these the Immutable Laws of Investing. 

Immutable means unchanged through time, unalterable, or ageless. You get the picture.  Think of these as laws of physics or relativity. No matter how hard a wide receiver tries, he is still subject to gravity and kinetic energy equations when he tries to leap over a safety for the game winning touchdown.
 
Regardless of whether you’re Goldman Sachs or the college kid placing his trade, these are laws all investors/traders must deal with. They are more than the rules of the game…these are immutable and do not change. So pay attention because you already know them:
 1-Capital lost is capital that cannot grow
2-Risk is what you buy, return is what you hope for
3-Emotion is the enemy
4-Volatility is Kryptonite
5-The Taxman cometh
 
As we get to the end of a great year in equities, it’s a good time to remind ourselves of these laws.  I don’t want to go through them in too much detail (you can get that from the book), but here is a quick overview of each one and how they apply to us today:

#1 Capital lost is capital that cannot grow: This law reminds us that compounding is the greatest force of the universe, but equally damaging is the growth needed to overcome losses. Mathematically, a 10% loss needs 11% to get back to even or a 20% loss requires a 25% gain to break even. Paper losses are still losses and have to conform to this law.  Limiting losses is important for everyone because the greater the loss, the more growth needed to offset it.
 
#2 Risk is what you buy, return is what you hope for:  This law reminds us that when we trade or invest, we are taking risk. Understand that before rubbing your hands together like Dr. Evil and counting your potential gains. The input is always risk and output is the return. Risk is the only thing YOU can control. You rarely have the ability to effect the performance of the stock you buy. Even the legendary activist investor Carl Ichan, knows he can’t control the outcome of the stocks he buy. Sure his tweets may effect a stock for a little, but he also prides himself on managing his risk and exposure to all of his investments. Watch his buying and selling activity and you’ll see that even he doesn’t put all his eggs in one basket. His basket is diversified. Click here for a report on his holdings.
 
#3 Emotion is the enemy: This one doesn’t need much explanation, except to be careful to understand how much emotion is driving your investing decisions as opposed to your trading and investing rules. For those of you that have ever said, “This market just feels overbought” you need to check yourself. Get data to substantiate your claims and figure out it if is relevant or not. Has anyone ever said, "I wish I had been more emotional when I made that investment?"

One of my favorite sayings is a quote by John Maynard Keynes, “Markets can remain irrational longer than you can remain solvent”. Put another way, what you think is irrational just isn’t and will break you if you hold on to what you think vs. how you act. click Click Here for a list of Keynesian quotes.

#4 Volatility is Kryptonite: Translating the Superman speak to economics this means that volatility in a portfolio erodes returns. While volatility can be exciting and can mean large gains, it also means the drawdowns are dramatic. One of our first posts ever illustrates the mathematical validity of this claim. Check it out here…for old times sake
 
#5 The Taxman Cometh: At this time of year we’ve got to think about taxes and how only AFTER-TAX returns matter. So be sure to have your 2014 account and investing strategy set up to maximize returns after tax, not just pre-tax. Hedging creates regular tax events so use them to your advantage when you can.
 
While hedging is the strategy of choice for us, it may not be what you do with  all your investments. But regardless of how you choose to invest, these 5 laws are to be remembered because the do govern your results. Ignore them at your financial peril. 


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