Three Rules for Investing

A “trader” would be primarily concerned with which direction the stock market was heading, while an “investor” would concentrate on selecting stocks with the best chance of outperforming the market overall. In other words, the investor was always long, while the trader might be long or short.

Market Wizards

Whether you consider yourself a “trader” or “investor”, these are three rules you should consider.

Rule #1: Define your risk

Before entering a trade, know where you’ll get out if you’re wrong.

Know the exact price level that if reached, you’ll close out the position. By following this rule religiously in every trade, you wont lose more than you define.

If you don’t define your risk, and a trade goes against you, at what point do you get out? How much of a loss do you endure if you don’t know how much you are willing to risk?

Hope is not a strategy. Define your risk.

Rule #2: Buy at the right price

Price matters. You can’t time the market, but you can wait for the right price to buy a stock.

Bill Ackman emphasized this point during his appearance on the Lex Fridman podcast.

We can’t earn the kinds of returns we want to earn for our investors by paying a really high price. Price matters a lot. You can buy the best business in the world, but if you overpay, you are not going to earn particularly attractive returns. We get involved in cases where a great business has made a big mistake or has lost its way, but is recoverable. We buy from shareholders who are disappointed or lost confidence and are selling at a low price relative to what it’s worth.

Bill Ackman on Lex Fridman Podcast

What’s the right price?

That’s defined by your process. Maybe a combination of fundamental analysis, technical analysis, and a definition of risk.

Rule #3: Be patient

In order to buy at the right price, you have to be patient. You exhibit patience by doing nothing.

One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do. Most people—not that I’m better than most people—always have to be playing; they always have to be doing something. They make a big play and say, “Boy, am I smart, I just tripled my money.” Then they rush out and have to do something else with that money. They can’t just sit there and wait for something new to develop.

James B. Rogers, Jr. in Market Wizards

Trade as little as possible. That is why I don’t think of myself as a trader. I think of myself as someone who waits for something to come along. I wait for a situation that is like the proverbial “shooting fish in a barrel.”

James B. Rogers, Jr. in Market Wizards

When you execute a patient trade that works out, pay attention to that “shooting fish in a barrel” feeling.

Recognize how the setup felt after you endured and waited for the right moment to get in. That trade may feel “easy” and “obvious”. Pay attention to that feeling, and recognize that in the majority of cases that feeling is not there. It’s during those cases in particular that you should exhibit patience by doing nothing.