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Four Real-World Investing Rules That Should Be Taught in Schools


When investing in the real world, textbooks and theory aren't much help.

MINYANVILLE ORIGINAL The idea that I've been on Planet Earth long enough to have actually learned meaningful life lessons from my own mistakes kind of makes me sick.

That applies across the board to family situations, career choices, my love life, and the topic of today's discussion: investing.

After over a dozen years of looking at the market on a more-or-less daily basis, and throwing a decent amount of money down the drain on idiotic trades, I've grasped some key realities about how money moves in the real world, far away from the textbooks and theory pushed at your average business school.

With that in mind, I'd like to present four investing rules I wish they had taught me back in school.

1. What You Know, Everyone Else Probably Knows, Too.

Investors have a tendency to overestimate the uniqueness of their ideas, even though they are usually inspired by widely-disseminated news and financial reports. Furthermore, the presence of social media outlets like Twitter and Facebook (FB) have drastically accelerated the speed at which investable information is distributed. That means that with few exceptions, everything gets priced into the market pronto.

So if you're thinking of running out to buy Amazon (AMZN) because it's eating Best Buy's (BBY) lunch, or shorting Facebook because of slowing revenue growth, slow down and take a deep breath.

It's important to understand the past and present. But to a certain extent, to be a successful investor, you'll have to predict the future -- a far bigger challenge than skimming through 10-Ks and listening to earnings calls. In other words, focus on examining not where fundamentals are, but where they may be going.

Remember, when a guy on TV tells you a stock is good because it's trading at X times earnings and has Y in cash on its balance sheet, he's simply repeating the bare minimum of what the market knows.

As wise men have said, "What the market knows is not worth knowing."

2. Timing Is Everything.

At Minyanville, when looking at the market, we believe it's important to understand not only "the what," but "the why."

However, the more I think about it, the more I'd argue that "the when" trumps both those considerations.

Let me tell you a story.

I once interviewed at a hedge fund that was making a major bet on its prediction that the housing bubble would implode.

Smart money, right?

However, that interview took place in early 2003, right before the Housing Index (^HGX) doubled.

Likewise, a lot of folks were short Netflix (NFLX) last year as it crashed and burned from that $304.79 high hit on July 13, 2011.

However, many a bear's butt was fried on the 73% rally the stock staged before it finally died out.

So when you have an investment thesis in your mind, ask yourself, "What makes now the right time to bet on this?"

Furthermore, if the S&P 500 (^GSPC) is skyrocketing, it is entirely likely that junky companies rally big-time.

Likewise, if the market's in meltdown mode, even the best of the best can get smashed.

Apple (AAPL) closed out 2007 at $198.08. But in 2008, even in the face of enormous earnings beats and the halo of the iPhone's unprecedented success, Apple finished the year at $85.35 -- a drop of 57%!

You may be smart, but remember: Sometimes Mr. Market just does not give a damn about what you think.

3. You May Be Suffering From Confirmation Bias.

The Oxford Dictionaries defines confirmation bias as "the tendency to interpret new evidence as confirmation of one's existing beliefs or theories."

Translated into financial terms, it means that if you're bullish on gold (GLD), you interpret everything you see as bullish for gold. In fact, you'll hunt around for more reasons to be bullish for gold.

I know the power of confirmation bias from a horrible experience with a former tech highflier called Rackable Systems, which changed its name to SGI (SGI) after it acquired Silicon Graphics in 2009.

Rackable Systems was essentially the Fusion-IO (FIO) of 2006. It was pulling in boatloads of money selling energy-efficient servers to major data-center operators like Microsoft (MSFT), Amazon, and Yahoo (YHOO).

And then -- let me point out that I had complete knowledge of this -- competitors like Hewlett-Packard (HPQ) decided they wanted to get a whole lot more of those data-center dollars.

Maybe I should have imagined what would happen if Rackable lost Microsoft (34% of revenues) or Yahoo (26% of revenues) as a customer, or at the very least, the margin pressures that could be introduced in a more competitive server environment.

However, I viewed the new competition as nothing less but a complete confirmation that Rackable was on the right track -- a massive barrel of stupidity that resulted in me watching Rackable crash from $56 to under $10.

It is impossible to stay perfectly objective when performing research.

However, you can stay one step ahead of your own bias by regularly asking the question, "Am I just telling myself what I want to hear?"

4. In Isolation, Valuation Ratios Are Useless.

Far too often, investors take an incredibly simplistic view of valuation ratios, automatically assuming that if something is "cheap," it's good, and if it's "expensive," it's bad.

However, oftentimes you'll see the cheap get cheaper and the expensive get more expensive.

For example, over the past few years, how many times have you heard that Research In Motion (RIMM) was cheap based upon a P/E ratio? And yet due to declining market share and earnings power, it's down 93% from its 2008 high, and down 26% this year alone.

On the other side of the equation, (CRM), the poster boy for supposedly "overvalued" stocks with its 100+ P/E, is up 37% in 2012.

A P/E ratio, like every other valuation ratio, is 100% meaningless in isolation.

Rather, it is far more important to examine how the "E" part of the equation is changing. (Or sales for EV/S ratios or EBITDA for EV/EBITDA ratios, etc.)

A company trading at five times earnings can look awfully expensive following a bad quarter that destroys future earnings expectations. That's how a stock like Nokia (NOK) can go from $10 to $5 to $2.50 in the blink of an eye.

It also works the other way around -- a high-priced momentum stock can suddenly look cheap if earnings come in ahead of expectations and forward estimates rise.

However, investors should note that the expensive momentum names that rally strongly when the market is up also tend to get hit hard when things go south.

Also read: 7 Lessons for Any Dividend Investor, 10 Products America Makes Best, and Up-and-Coming Retailers: Where Are They Now?

Twitter: @MichaelComeau

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