Bob Farrell’s Rules for Investing
There are many approaches to investing in the capital markets. At Coyle Financial Counsel, we prefer investment strategies that rely on fundamental analysis. These include both growth and value strategies. Growth managers seek to invest in companies with strong growth prospects. Value managers specialize in finding undervalued stocks of unloved or overlooked companies.
Managers who use fundamental analysis study a company’s financial data, among other things, to form an opinion on the firm’s capacity to generate cash flows in the future. They may use those cash flow estimates to produce an intrinsic or fair value for the company’s common stock, or they may use a relative value approach by looking at price-to-earnings ratios for similar firms. In either case, they want to find stocks that are reasonably valued (or undervalued) and avoid stocks that are overvalued.
A very different approach to investing believes that how security prices change over time actually contains useful information for investors and that fundamental analysis is futile. This approach is called technical analysis and their practitioners study various contrarian indicators and price charting patterns. They look for evidence that markets have overreacted to new information and often use trading rules to attempt to profit from these shifts in market sentiment.
Technical analysis relies, ultimately, on the findings of behavioral finance, which recognizes that there is a psychological element to investor decision making. Investors often let their emotions affect how they view money and investing. All investors, even investment professionals, can be subject to things like overconfidence or hindsight bias. Herd behavior can lead to bubbles in asset prices as everyone gets enamored with a stock and continuously bids up the price.
Bob Farrell is a well-known technical analyst who started his career with Merrill Lynch Pierce Fenner & Smith in 1957 and was a leading equity strategist there for the next 35 years. He developed and published Ten Rules of Investing from his many years of investment experience. While these “rules” tell us nothing about fundamental investing, they are nevertheless very insightful about how the collective investment decision making of all of us mere mortals can move markets or, alternatively, how we can be our own worst enemies when it comes to investing our hard-earned money.
Here are the first six of Bob’s Rules, along with a short descriptive comment from Bob:
- Markets tend to return to the mean over time
Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.
- Excesses in one direction will lead to an opposite excess in the other direction
Markets that overshoot on the upside will also overshoot on the downside, kind of like a pendulum. The further it swings to one side, the further it rebounds to the other side.
- There are no new eras — excesses are never permanent
There will always be some “new thing” that elicits speculative interest. In fact, over the last 500 years, we have seen speculative bubbles involving everything from Tulip Bulbs to Railways, Real Estate to Technology, Emerging Markets (5 times) to Automobiles and Commodities. It always starts the same and ends with the utterings of “This time it is different.”
- Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
The reality is that excesses…can indeed go much further than logic would dictate. However, these excesses…are never worked off simply by trading sideways. Corrections are always just as brutal as the advances were exhilarating.
- The public buys the most at the top and the least at the bottom
The average individual investor is most bullish at market tops and most bearish at market bottoms. This is due to investors’ emotional biases of “greed” when markets are rising and “fear” when markets are falling. Logic would dictate that the best time to invest is after a massive sell-off; unfortunately, this is exactly the opposite of what investors do.
- Fear and greed are stronger than long-term resolve
“Gains make us exuberant; they enhance well-being and promote optimism,” says Santa Clara University finance professor Meir Statman. His studies of investor behavior show that “Losses bring sadness, disgust, fear, regret. Fear increases the sense of risk and some react by shunning stocks.”
At Coyle Financial Counsel, we are well aware of how tempting it is for investors to fall prey to one or more of these behavioral biases, which can often sabotage long-term investment results if left unchecked. This is why it is so important to have a comprehensive financial plan in place, one that is also structured in such a way that your long-term financial objectives will not be subject to the Siren’s Song of emotional investing.
John Finley, CFA, serves as Chief Investment Officer for Coyle Financial Counsel and is responsible for overseeing the investment process. John’s prior experience includes managing institutional fixed-income portfolios for corporations, pension funds, non-profit organizations and foundations at several large, global asset managers. With more than 20 years of institutional investment experience, he is energized by helping individuals understand the role investing plays in meeting their long-term financial goals.
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