Follow the rules

The basic rules of sensible investing are widely known. The problem is that they are treated as guidelines, rather than laws.

We come across people who talk about the investment decisions they have made. Nowadays, a lot of mutual fund investors are aware of all the basic good practices of investing. But curiously, their actual investment portfolios are often exercises in applying the 'exception that proves the rule' explanation to these good practices. For example, one should never invest in an equity fund in one go. The way to invest in equity funds is to do so through an SIP, so that the cost is averaged over a period. The advantages of doing so are enormous. They are also well-known and easily understood.

Even so, the portfolios of people who know this are full of exceptions, all for a supposedly good reason.

1.'I got this chunk of money and someone told me about this great investment so I put it all in this one time.'

 2.'I know sector funds should be avoided but right now, it's obvious that infrastructure is going to do well so I invested a large sum in infra funds',

3. 'Equity is volatile so I'm making this ten-year investment in an FD'.

These are typical examples and are repeated in a lot of portfolios with minor variations. They are all of the exceptions to the rule category, and the investor in most cases has self-consciously decided to violate the investment rule that they know to be correct. They did so because they convinced themselves (perhaps with some help from a salesperson) that under their current circumstances it was okay to make an exception to the general rule.

Most of us, most of the time, take the rules of investing to be general guidelines or well-meaning advice which can be violated whenever we are tempted to make an exception. There is  a NASA document that is quite relevant to this despite being about software development. Called 'The Power of Ten', it was written some years ago by Gerard Holzmann, a computer scientist who has worked for NASA. The document lays down ten rules of developing safety-critical software. However, what is more relevant to us is the what Holzmann tells us about what he discovered while researching the paper.

He found that if rules are to be followed, they must be treated as laws, not as guidelines. Most organisations have dozens or even hundreds of guidelines but in practice, their employees become experts at justifying exceptions to these rules. Instead, he found that it was better to have a few rules that were never to be violated. There should be no process to examine whether exceptions were justifiable. Even if an exception was justifiable in a particular case, in the larger picture, never allowing an exception resulted in a much better final outcome. This happened because by sacrificing a few justifiable exceptions, a large number of frivolous ones can be eliminated without wasting any effort over evaluating them.

Of course, for investors there is no one to enforce these rules rigidly so it ultimately boils down to self-discipline. Still, it can be useful to understand the logic that goes into this advice. There may well be situations where it will turn out that violating the basic rules of good investing could have led to better returns. However, these exceptions are few and far between, and in any case can only be detected with certainty in hindsight. Therefore, it makes sense to take the guidelines as sacrosanct, and never fall for the old exception that proves the rule story.