On Investing Guidelines

Making the rounds last week on the financial blogs is Richard Bernstein's "10 Guidelines Learned in 20 Years". Bernstein was a global investment strategist with Merrill Lynch for the last 20 years.

As a rule based technician or quantitative strategist, I like guidelines. Guidelines are like signposts pointing the way to profits in the markets. I have my own list of guidelines, and I thought I would comment on some of Mr. Bernstein's that are so near and dear to me.

Mr. Bernstein's Guideline #2
"Most stock market indicators have never actually been tested. Most don’t work."

Hallelujah!! I have been saying this for several year now. But what is really amazing is not that most indicators don't work but investors continue to use them anyway.

I have given this a lot of thought as to why investors behave so irrationally. One, they haven't done their homework. Furthermore, it is really difficult to find something that "works" and if you do find something you are comfortable with, it will probably only work some of the time. Two, there is comfort in being part of the consensus. MACD, RSI, etc and all the other dribble is just that - dribble and nonsense. I wish it was so easy. But I think there is more to the consensus issue. To me, consensus also means mediocre and many market participants are mediocre, yet mediocre is great if you are managing tens of millions of dollars. Fund payment structures ensure that you don't have to be great to make money, but you do have to be exceptional to make your clients money. Many money managers have a vested interest in protecting their own interest. So if they do everything just like everybody else and fail, then they can blame the system. This was a refrain often heard in 2008 as "no one saw this coming".

Mr. Bernstein's Guideline #3
"Most investors’ time horizons are much too short. Statistics indicate that day trading is largely based on luck."

I don't know much about day trading, but I would agree that investors want to be investors but they tend to act like traders. And what happens? They too easily trade themselves out of strong trends. Investors should focus on longer term monthly charts and those markets making secular moves. Having the secular winds at your back can cover up a lot of mistakes.

Mr. Bernstein's Guideline #5
"Diversification doesn’t depend on the number of asset classes in a portfolio. Rather, it depends on the correlations between the asset classes in a portfolio."

Agreed! Finding assets classes to invest in that don't correlate is the difficult part. Asset allocation and diversification are very important and having non-correlated assets might even be more important.

Mr. Bernstein's Guideline #9
"Investors should research financial history as much as possible."

If investors did, then we wouldn't have to worry about Guideline #2. But they don't, so a lot of investors use tools ill suited for the job. Oh well. Of course, there will always be the person who says, "Yeah, that worked in the past. How do you know that it will continue to work in the present?" Well, you don't know. But I would counter that if you don't know what worked in the past, then you definitely won't know what works in the future. Do the work and you will be rewarded.