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First Principles: Avoid Investing Mistakes

by Matt Jones, CPA
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I recently shared my worst investment ever, how I rushed into a stock I didn’t understand and violated my “First Principles” listed below. These Principles are some of the rules I follow for investing. You’re welcome to adopt, adapt or argue them. 

What are First Principles?

Farnham Street does an excellent job of explaining this concept. Essentially, First Principles are the building blocks of knowledge that you believe with certainty and use to make difficult decisions. When you’re facing a new situation you can rely on these to begin your decision-making process.

“Good Judgment depends mostly on experience and experience usually comes from poor judgment.”

– Anonymous

Experience is often helpful in this regard (touching a hot stove will burn your hand), but can limit creativity (we’ve always done it this way). Starting with your First Principles allows you the wisdom gained from experience without the limitations gained from mistakes. 

MJ.$ Principles for Investing

So far, I’ve come up with three principles for investing. These fit my investing style of long-term gains. Your principles may differ based on your goals, timeline and risk tolerance. This is not investing advice, but rather thinking advice. These are meant to grow and change over time. 

Don’t invest more than 0.5-1.0% of Net Worth into a single investment. 

This principle is simple: diversify investments. Build a financial base before focusing on investing by saving and getting debt under control. After that, with very few exceptions, spread your investments broadly. Diversifying will smooth out investment returns during broad financial crises and individual industry/company issues. 

Exceptions include employer stock options and ventures in which you have an active role in the success of the investment (i.e. a small business or rental property) or a unique advantage creating unequal upside return relative to downside risk. A portfolio of stock investments would not count as one investment (i.e. a 401K as a whole may be more than 1% of Net Worth, but each stock held in it should not exceed the 1% limit). 

Limited Number of Investments 

Make a smaller number of highly calculated investments for the long-term. Imagine only making a limited number of investments in a lifetime. Take the time to weigh all potential outcomes; analyze the opportunity cost; aim for limited downside with unlimited upside potential. This is obviously the principle I neglected with my worst investment ever

I could improve your financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches – representing all of the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.”

– Warren Buffett

Timing Equals Uncertainty

Attempting to time the market in the short-term is a bad strategy. Even a professional actively trading in the stock market is likely to make mistakes. Frequent transactions result in higher taxes and transaction costs. Focus on the long-term and plan to hold investments for a very long time. In the long run, a well-diversified portfolio of investments tends to rise in value. 

My first college accounting professor showed us a chart of his investment in Dell through the 1990s. You might be expecting me to say that he lost everything in the stock bubble. Even worse: He sold too soon, reaping a gain but missing on the rally that made Dell one of the best investments of the era. He made hundreds of dollars instead of holding on and making hundreds of thousands of dollars. There’s more risk of getting out too early than getting stuck holding the bag.

“The net result was that those who invested at Dell’s IPO saw their initial investment multiply dramatically. Those who bought 100 shares for a total of $850 saw their investment grow to 9,600 shares worth $43 each, or more than $412,000.”  

Source: Caplinger, Dan. “Dell Stock Split History: How the Tech Giant Made Early Shareholders Millionaires.” Nasdaq, 2018

You’ll never know when to get out of an investment. It’s painful to wonder whether a stock will go up, whether a stock has peaked or will continue to increase, whether now is the time to sell or if you’ll miss out on the real increase. This creates an unnecessary and disproportionate amount of anxiety. 

Looking at any investment and checking these principles should help me avoid obvious mistakes, particularly helping me avoid repeating mistakes. But it also allows me to learn from others’ mistakes. Isn’t that the goal?

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