16 Golden Rules to Invest Well

The late Walter Schloss is probably the least well-known investor in my personal list of investing heroes.

He started working for the great investing sage Benjamin Graham in 1946 and picked up the art of investing over time. In 1955, Schloss left Graham and started managing other people’s money on his own.

What followed was more than four decades of investing excellence. From 1956 to 2000, Schloss’s U.S.-based fund had achieved a compound annual return of 15.3% – every $1,000 entrusted to Schloss in 1956 would have turned into $525,000 by 2000!

For some perspective, the broader U.S. stock market would have grown $1,000 in 1956 into ‘only’ $111,000 by 2000.

Schloss is such a fascinating character to me because of the way he invested. He did not rely on fancy math, complex valuation models, or arcane market-forecasting techniques. All he did was to find stocks that were selling at a lower price than his appraisal of their intrinsic business values (this appraisal is largely based on a stock’s asset values). His office was also Spartan (it’s a rented closet space), and his ‘investing team’ consisted of a grand total of two – himself and his son, Edwin, who joined the business in the 1970s.

In 1994, Schloss had penned a short memo titled (link opens PDF) Factors needed to make money in the stock market. The memo contained 16 factors which Schloss had relied on while investing. Here are those 16 golden rules along with my comments.

Rules No.1 to 12: Click here.

Rule No. 13: “Try not to let your emotions affect your judgement. Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.”

This is unfortunate because fear and greed are probably the biggest psychological drivers of stock prices over the short-term, meaning to say that it’s likely that many investors are affected by these emotions even though they’re the worst to have.

Greed can push stocks up to unsustainable levels (as we saw during the October 2013 penny stock debacle in Singapore) while fear can lead to stocks selling for absurdly low valuations. The Great Financial Crisis of 2007-09 was a time when the market overdosed on fear and you can see in the table below how some of the blue chips in Singapore were valued at low PEs in that episode that were patently ridiculous:

Company Lowest PE ratio during financial crisis
SIA Engineering Company Ltd (SGX: S59) 6.5
DBS Group Holdings Ltd (SGX: D05) 4.6
Jardine Cycle & Carriage Ltd (SGX: C07) 4.4

Source: S&P Capital IQ

From the date of their lowest valuations to today, SIA Engineering, DBS, and Jardine C&C have seen their stock price jump by 154%, 172%, and 255% respectively. If you can recognise when fear and greed are rampant and act in a contrarian fashion (be warned though: It’s something extremely hard to do), you may well be on your way to becoming a great investor.

Rule No. 14: “Remember the [sic] work compounding. For example, if you can make 12% a year and reinvest the money back, you will double your money in 6 years, taxes excluded. Remember the rule of 72. Your rate of return into 72 will tell you the number of years to double your money.”

Rule No. 15: “Prefer stocks over bonds. Bonds will limit your gains and inflation will reduce your purchasing power.”

Bonds can be useful and can serve important roles in your portfolio if you’re more concerned with getting a fixed source of income while taking on lower risk of losing your capital. Stocks on the other hand represent partial ownership of a business. When you own stocks, you get to participate in a business’s growth (and all the associated risks that comes with ownership) – you don’t get that with bonds.

Know what you’re getting yourself into when you choose stocks over bonds or vice versa.

Rule No. 16: “Be careful of leverage. It can go against you.”

Leverage can be a wonderful thing when the tide’s with you. But when the tide turns, leverage can kill. Even the smartest of investors can get crushed from the use of borrowed money to invest. Below are two of my favourite examples on the matter.

The hedge fund Long-Term Capital Management was chocked full of bona fide geniuses (there were many PhD holders working in the fund along with two Nobel Prize winners, Robert Merton and Myron Scholes ). But the fund collapsed within four years of its founding and had to be bailed out by the New York Federal Reserve. It’s not hard to see why the fund had failed: It was leveraged to the hilt (it had borrowed up to $100 for every dollar it had).

A story involving Warren Buffett and Charlie Munger is another instructive example. The two are a world-famous investing duo today. But earlier in their careers, they were actually part of a trio with Rick Guerin. According to Buffett, Guerin was as smart an investor as both him and Munger. Sadly, Guerin was in a hurry to get rich and so invested with leverage.

The U.S. stock market got hit savagely in the bear market of 1973-1974 (stocks fell by almost half from peak to trough in that episode). Guerin, in order to meet margin calls, was forced to sell his Berkshire Hathaway stock to Buffett at less than US$40 apiece. Each Berkshire stock’s trading for around US$200,000 today.

And, that was pretty much the end of Guerin’s investing career. Don’t make the same mistake.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Berkshire Hathaway.