Editor's note: New investors rushed into the markets after the pandemic bottom. Making money seemed easy... But the "get rich quick" mentality quickly led to losses. In this article – which we've updated from its last appearance in DailyWealth on February 11, 2022 – our colleague Dan Ferris explains how pro investors avoid dangerous buys... and why a selective strategy is your best defense today.
Buying what's popular is not a mistake – when you're buying almost anything other than stocks...
You buy a Ford F-150 pickup truck or a Samsung smartphone because its popularity is a sign of its quality and consistency.
But in financial markets, "following the herd" only looks wise – until its utter foolishness is revealed.
In recent years, we've seen exactly how that happens. Just consider the poster child of the pandemic boom: the ARK Innovation Fund (ARKK)...
As Simon Lack of SL Advisors pointed out in a blog post last year: "ARKK's Investors Have In Aggregate Lost Money."
Lack does the math to show what any experienced stock market participant knows... More investors join a manic bull run at the top than at any other time.
The situation with ARKK is no different. The fund focuses on disruptive tech innovators. That made it a magnet for foolish investors who were ready to pile in at exactly the wrong moment. As Lack wrote...
Because inflows to ARKK followed strong performance, as is usually the case, it turns out that the cumulative on ARKK is negative. peaked last February at just under $12 and has been in steep decline ever since. At the beginning of this year it crossed into negative territory. The average dollar invested in ARKK has lost money.
One more time... The average dollar invested in ARKK has lost money, even though the fund soared as much as quadruple digits to its peak. And remember, that loss doesn't include its slide over the past year.
It happened for a simple reason: Most of the money came in at the top.
As I often note, fools do in the end what the wise do in the beginning. And it sure seems like every fool in the world fell in love with stocks in 2021...
But here's the thing the herd doesn't realize. After they've bet (not invested) every spare penny they have, there's nobody left to buy. And that's exactly how we got here. The stock market boom went bust... turning 2022 into the worst year for the market since 2008.
So, as investors grapple with the bear market that began last year, this seems like a good time to discuss one simple way to avoid being a fool...
Seasoned professional investors tend to agree that avoiding doing stupid things is more important than doing something smart.
The core of every successful investment strategy is avoiding risk. Otherwise, the strategy will eventually take on a risk it shouldn't and lose all the profit it made – just like all the fools who bought into the housing bubble before the financial crisis... and ARKK at its top in 2021.
We all know this... or we should. But how many investors believe it?
Tell me truthfully – when Warren Buffett says there are two rules to investing and Rule No. 1 is "Don't Lose Money" and Rule No. 2 is "See Rule No. 1"... do you really believe him? He's looking to make money, not merely avoiding losing it... right?
The two-rule adage is one of the all-time great investment truisms. However, it involves more than Buffett's folksy Midwestern wisdom suggests.
What follows might earn me the title of Captain Obvious... but I would prefer that to Captain Obfuscator.
The two-rule adage really means something like, "You can't make money in the market without placing your capital at risk. But you need to know the difference between a risk worth taking and one not worth taking, and there are a lot more risks you shouldn't take than you should take."
That's the obvious part. Now, here's where it gets a little more complicated...
"Learning to identify the good risks is more about avoiding the bad ones than most people realize... To be successful, you have to do a lot of work that results in not taking any action. Also, a catastrophic loss can wipe out years of compounding and must be avoided."
Doing a lot of work that leads to taking no action is an especially big problem for most investors. People want action. They want to buy and sell every day... And they want to make a lot of money and feel great about it all the time.
But investing doesn't work that way...
Investing is a creative endeavor. And creative endeavors often mean doing work that doesn't generate any concrete result. (Just as an example, famed architect Frank Lloyd Wright designed more than 1,000 structures in his life – but only about half of them were ever built.)
Most people find this seeming lack of action uncomfortable. So people overtrade their accounts and lose too much money taking bad risks... rather than avoiding the bad risk by putting in a lot of work just to "do nothing."
Here's what I mean. When it comes to researching stocks, you'd be lucky to find that 40% of all the stocks you look at are worth owning for the long term. If you're truly embracing Buffett's two-rule adage, it's probably less than 4%.
The actual percentage isn't what's most important. What matters most is understanding that it's desirable and healthy not to want to buy most stocks most of the time...
That's particularly true for those stocks being snatched up in a speculative frenzy.
Those are the money-losing propositions that the two-rule adage counsels investors to avoid.
When you no longer jump at risks that aren't worth taking, you give yourself the time to find the worthwhile opportunities. Today, we're heading into a time where this matters a great deal...
Just like we saw in 2020, many investors entered finance for the first time during the dot-com boom. They jumped in at the top. Then, when that boom became the dot-com bust, the ones who succeeded had to learn the difference between being smart... and being in a frothy bull market.
Wise investors today will learn to be selective. Meanwhile, as always, the fools can't find a risk they don't like...
Make sure you're not one of them.
Editor's note: A specific group of investments is poised to soar, regardless of what the stock market does next. It's all thanks to a rare market cycle... one that only comes around every couple of decades. But you must be selective to profit from it. That's why Dan recently teamed up with an industry legend to unveil a new playbook for this precise moment in time... Get the details here.
These days, with the dawn of platforms like Robinhood, it's easier than ever to start investing for the first time. But you need to keep your "tuition" cost small – and avoid key mistakes... Learn more here: How to Avoid Losing Grandma's Life Savings.
"I've come to realize that having a longer time horizon is an edge in today's financial markets," Mike Barrett writes. If you treat your investment portfolio like a farmer treats his crops, you'll learn the patience to be selective – and many other surprising lessons, too... Read more here.