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Investor Psychology

Investing Rules That Still Work

To be successful, focus on human behavior, says a top strategist.

Sam Stovall is chief strategist at Standard & Poor's. His book, The Seven Rules of Wall Street, was published by McGraw-Hill in February.

What are the seven rules?
1. Let winners ride, but cut losers short.
2. As goes January, so goes the year.
3. Sell in May and then walk away.
4. There's no free lunch on Wall Street.
5. There's always a bull market someplace.
6. Don't get mad, get even.
7. Don't fight the Fed.

Can you really distill the complexities of investing into seven simple rules?
Some people think you need calculators to come up with the right answers. But investing is driven by human behavior. That's what the rules are about. Portfolios based on these rules of thumb have beaten the market over time. I put them together because I wanted to stop myself from becoming my own worst enemy. I'm emotional, indecisive, impatient, risk-averse and lazy. As Dirty Harry says in Magnum Force, "A man's got to know his limitations." But I'm also an opportunist. I observe human behavior and benefit from that.

Give us an example.
Okay. Which is the best portfolio, one with last year's worst-performing stocks or best-performing stocks? Most would say to go with last year's losers -- buy low, sell high. But 40 years of history says you do better by buying last year's winning industry groups. From a behavioral standpoint it makes sense. Many investors will dump the dogs once they break even, limiting appreciation. This year may be the exception. Coming out of a bear market, stocks that are priced to go out of business but don't may do well when the market comes back.

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Explain "don't get mad, get even."
The SP 500 is weighted by market capitalization, meaning the larger the company, the greater the impact. With the SP equal-weighted 500 index, every stock is equal. A portfolio based on that index, which you can construct using exchange-traded funds, gives you the safety of holding stocks of larger companies, but with the higher returns of mid-cap and small-cap indexes.

Do you have a favorite rule?
They all have pluses or minuses. If you take a buy-and-hold approach, set up a "let your winners ride" portfolio and adjust it once a year. If that feels like driving a Ferrari behind a school bus, set up a portfolio based on "there's always a bull market someplace." You can tweak it regularly.