Saturday 29 October 2011

10 Rules of Financial Safety

Harry Browne was a US personal finance commentator and advisor. He is particularly well-known for his 'permanent portfolio' concept (although this is not a model I agree with totally!). One of his famous observations is: “The best kept secret in the investing world: Almost nothing turns out as expected.”

He came up with  his 16 Rules of Financial Safety, which incorporate a lot of common sense. A couple of these are not directly relevant to a DIY Income Investor, so I'll try to boil these down to just 10 rules [my few additions are in square brackets].

These rules are based on the text quoted on the Crawling Road blog, which links to a 'permanent portfolio forum' - worth a look, particularly for US visitors!

Rule #1: Your career [usually] provides your wealth

You most likely will make far more money from your business or profession than from your investments. Only very rarely does someone make a large fortune from investments.

Your investments can make your future more secure and your retirement more prosperous. But they can’t take you from rags to riches. So don’t take risks with complicated schemes in the hope of multiplying your capital quickly. Your investment plan should be aimed, first and foremost, at preserving what you have—preserving it from investment loss, government intervention [such as tax], or mismanagement.

Rule #2: Don’t assume you can replace your wealth

The fact that you earned what you have doesn’t mean that you could earn it again if you lost it. Markets and opportunities change, technology changes, laws change. Conditions today may be considerably different from what they were when you built the estate you have now. And as time passes, increasing regulation makes it harder and harder to amass a fortune.

So treat what you have as though you could never earn it again. Don’t take chances with your wealth on the assumption that you could always get it back.

Rule #3: Recognize the difference between investing and speculating

When you invest, you accept the return the markets are paying investors in general. When you speculate, you attempt to beat that return — to do better than other investors are doing — through astute timing, forecasting, or stock selection, and with the implied belief that you’re smarter than most other investors.

There’s nothing wrong with speculating — provided you do it with money you can afford to lose. But the money that’s precious to you shouldn’t be risked on a bet that you can outperform other investors.

Rule #4: No one can predict the future

Events in the investment markets result from the decisions of millions of different people. Investor advisors have no more ability to predict the future actions of human beings than psychics and fortune-tellers do. And so events never unfold as we were so sure they would.

No one can reliably tell you what stocks will do next year, whether we’ll have more inflation, or how the economy will perform.

Rule #5: No one can move you in and out of investments consistently with precise and profitable timing

Investment advisors can be very valuable. A good advisor can help you understand how to do the things you know you need to do. He can help call your attention to risks you may have overlooked. And he can make you aware of new alternatives.

But no one can guarantee to have you always in the right place at the right time. And worse, attempts to do so can sometimes be fatal to your portfolio.

Rule #6: Don’t use leverage

When someone goes completely broke, it’s almost always because he/she used borrowed money. In many cases, the individual was already quite rich, but he wanted to pyramid his fortune with borrowed money.

Using margin accounts or mortgages (for other than your home) puts you at risk to lose more than your original investment. If you handle all your investments on a cash basis, it’s virtually impossible to lose everything—no matter what might happen in the world—especially if you follow the other rules given here.

Rule #7: Don’t let anyone make your decisions

Many people lost their fortunes because they gave someone (a financial advisor or attorney) the authority to make their decisions and handle their money. The advisor may have taken too many chances, been dishonest, or simply incompetent. But, most of all, no advisor can be expected to treat your money with the same respect you do.

You don’t need a money manager. Investing is complicated and difficult to understand only if you’re trying to beat the market. You can preserve what you have with only a minimum understanding of investing. You can set up a worry-proof portfolio for yourself in one day — and then you need only one day a year to monitor it. Allowing the smartest person in the world to make your decisions for you isn’t nearly as safe as setting up a safe portfolio for yourself.

Above all, never give anyone signature authority over money that’s precious to you. If you should put money into an account for someone else to manage, it must be money you can afford to lose.

Rule #8: Don’t ever do anything you don’t understand

Don’t undertake any investment, speculation, or investment program that you don’t understand. If you do, you may later discover risks you weren’t aware of. Or your losses might turn out to be greater than the amount you invested.

It’s better to leave your money in Treasury bills  [gilts for UK investors] than to take chances with investments you don’t fully comprehend. It doesn’t matter that your brother-in-law, your best friend, or your favorite investment advisor understands some money-making scheme. It isn’t his money at risk. If you don’t understand it, don’t do it.

Rule #9: Expect surprises and diversify

Every investment has its time in the sun — and its moment of shame. Precious metals ruled the roost in the 1970s while stocks and bonds were in disgrace. But then gold and silver became the losers of the 1980s and 1990s, while stocks and bonds multiplied their value. No one investment is good for all times. Even Treasury bills  [i.e. gilts in the UK] can lose real value during times of inflation.

And you can’t rely on any single institution to protect your wealth for you. Old-line banks have failed and pension funds have folded. The company you think will keep your wealth safe might not be there when you’re ready to withdraw your life savings.

We live in an uncertain world, and surprises are the norm. You shouldn’t risk the chance that a single surprise will wipe out a large part of your holdings.The portfolio should assure that your wealth will survive any event — including an event that would be devastating to any individual element within the portfolio. In other words, your portfolio should protect you no matter what the future brings.

Rule #10: Whenever you’re in doubt about a course of action, it is always better to err on the side of safety

If you pass up an opportunity to increase your fortune, another one will be along soon enough. But if you lose your life savings just once, you might never get a chance to replace it.

I'm sure there are a few more 'rules' that you could think of - but I think those above make a good start!

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

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