Friday, March 21, 2014

My Take on Harry Browne's 16 Rules of Financial Safety

Harry Browne (1933 - 2006) created 16 rules for aspiring investors to keep themselves safe in good or bad markets.  These rules were originally published on his website, and I have them listed in bold below with my own commentary beneath each respective rule.

1. Your career provides your wealth.

Most of the wealth in the world is created by businesses adding real value to society, not through people making superior investments.  That's not to say investing is useless or a zero-sum game.  The goal of the financial markets is to efficiently lend capital to businesses and/or people in need, whether in the form of stocks (ownership interest), bonds (debt), derivatives (contracts to help reduce financial risk), etc.

By progressing in your career and living below your means and wisely investing your savings, you can augment your net worth over time by lending your excess cash.  In many cases, that cash helps grow businesses and you earn a handsome return, a win-win for both and you'll likely end up wealthier than if you put that cash under the mattress or in the bank.  Unfortunately, not every dollar you invest will be returned to you (another term for this phenomenon is "risk".)  The rules below will hopefully reduce instances where this happens.

2. Don't assume you can replace your wealth.

People, markets, economies, and politics change over time.  Just because you made a fortune a few years ago doesn't mean you'll be able to make it again.  Take an extreme example, a young professional athlete who makes millions in his 20s.  Do you think he'll have the ability to replicate his early earnings in his 40s or 50s?  Don't assume that money lost in risky investments can always be made back!

3. Recognize the difference between investing and speculating.

When you speculate, you are taking a much higher risk than the average risk in the markets in hopes of a higher return.  You may come out ahead or you may lose all/most of your initial investment.  Many speculators have made a fortune but a large unlucky minority have seen their investment nearly wiped out.  It's OK to speculate and many fledgling companies in the past that are highly successful today would not have made it if nobody speculated on them, but please only speculate with money you can afford to lose!

4. No one can predict the future.

When you read CNBC, SeekingAlpha, the Wall Street Journal, or any other financial news source, you will run into many experts with a variety of views about the state of the markets and the economy in the future.  One might say we'll see a recession next year while another says the economy will expand even faster.  Clearly, they can't all be true as there is only one outcome for the future.

If an expert repeatedly predicts a recession, eventually he/she will get it right.  And when they get it right, they end up receiving a lot of publicity for their prediction with little regard for the failed predictions in the past.  Does that make this expert reliable?

Take a look at the news archives of financial columnists in the past; there's no dearth of predictions of where we will be today.  Some of them may have come true, but how many of them?  And look even further back in history.  How many of these experts were consistently right year after year?

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

In other words, nobody's perfect, not even the superstars.  Even Warren Buffett missed the Tech Bubble in the later 90s and early 2000s.  Much of the fluctuations in the markets, especially in the short term, are essentially random noise.

6. No trading system will work as well in the future as it did in the past.

Market conditions are constantly changing, and the future is rarely the same as the past.

7. Don't use leverage.

You may have heard some saying about how to invest and get rich with other people's money.  If prudently executed, it may work for real estate investments but not for stocks.  Unlike stocks, a mortgage lender cannot repossess your house if your mortgage falls underwater as long as you keep making the payments.  That's not the case with a margin loan from your broker to buy stocks.  You can lose more than your initial investment.

There's one circumstance when you may use a nominal amount of leverage.  If you save your money in a margin account and need some cash short-term, you can withdraw it from the account without selling any stocks by using margin.  (Say if your car breaks down and you need the cash for repairs...)  The margin interest will usually be lower than the amount in commissions and capital gains taxes you would have paid if you sold your stocks for emergency cash.  But don't margin more than 2 months of after-tax salary or 10% of your current account value, whichever is lower!

8. Don't let anyone make your decisions.

At least, don't let other make decisions with money you cannot afford to lose.

9. Don't ever do anything you don't understand.

Pretty common sense here: if you don't understand an investment, it's best to err on the side of safety.

10. Don't depend on any one investment, institution, or person for your safety.

Diversify your investments, both at the macro level (different asset classes like Stocks, Bonds, Commodities, etc.) and at the micro level (different stocks or use an index fund.)  Diversify among different brokerage firms if you have more than $250,000 in assets.  SIPC insurance in the US covers up to $250,000 in losses to your investment if your broker goes under (not if your investments lose value.)  MF Global's collapse is a clear lesson to diversify among your institutions.  Diversify your money managers as well if you choose that route with money you can afford to lose.

11. Create a bulletproof portfolio for protection.

You'll want to invest the majority of your wealth in a simple, balanced, and conservative portfolio that will reasonably hold up in any economic climate without major adjustments.  You need a solid plan that you can stick with in the worst of times instead of constant angst over which investments need to be sold or when to reenter the markets.  Harry Browne created an asset allocation known as the Permanent Portfolio to achieve steady and stable returns over the long run without the need to forecast future economic conditions.  More on the Permanent Portfolio in future posts...

12. Speculate only with money you can afford to lose.

This is pretty common sense..  only speculate if you don't mind losing your money.  Maybe create a separate brokerage account with money you can afford to lose and speculate to your heart's content with it.  Use it to chase the latest trends, bottom fish in a down market, try out emerging market stocks, etc.  Just make sure you don't use any leverage here .

13. Keep some assets outside the country in which you live.

If you live in a stable democracy, this may be less of a concern, but if corruption is rampant in your country's leadership, it may be prudent to hold offshore assets.

14. Beware of tax-avoidance schemes.

The only tax avoidance schemes you need are 401K's and IRAs, both of which are unofficially endorsed by the government as legitimate vehicles to avoid or defer taxes for the purpose of saving for retirement.  It's also not too difficult to invest your taxable accounts in a way that's tax efficient by avoiding the Wash Rule and only selling to take capital gains when absolutely necessary.  But with taxes already at historical lows (in the US), there is little incentive to seek out greater tax savings.  This could also backfire in ways:

  • You may end up spending a ton of time and money on lawyers and accountants and not even recoup your consultation fees.
  • If you're caught hiding money in an illegal tax shelter, you could face hefty fines and/or imprisonment.
  • Certain investments that provide tax advantages (i.e. muni bonds) may not be right for your situation.

15. Enjoy yourself with a budget for pleasure.

Most people have the opposite problem: spending too much money.  However, it's also possible that you're saving too much to live a healthy and fulfilling life.  Prioritize what's important to spend money on and cut back on the big ticket items if possible.

16. Whenever you're in doubt about a course of action, it is always better to err on the side of safety.

This goes for everything, even advice I'm giving you.  It's better to be safe than sorry if you don't understand it.

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