Rules based investing has become increasingly popular in recent years. By sticking to a pre-defined set of criteria and rules, investors aim to remove emotions and behavioral biases from the investing process. However, the success of rules based investing depends greatly on selecting sound principles as the foundation and executing the rules properly. There are several principles that underpin successful rules based strategies, including diversification, risk management, discipline, etc. Investors also need to pay attention to portfolio construction, rebalancing, and managing risks and trading costs. Simply following the rules mechanically without understanding the rationale can backfire. With the right principles, thoughtful design and skilled execution, rules based investing can be an effective approach for many investors.
Successful rules based investing requires sound principles as the foundation
The starting point for implementing a rules based investing strategy is having principles that lead to long-term success. Some key principles include diversification across asset classes, portfolio rebalancing, disciplined buying and selling, risk management, low costs, etc. Diversification improves risk-adjusted returns by reducing volatility and drawdowns. Rebalancing forces investors to ‘buy low and sell high’ to maintain target asset allocations. Pre-defined buying and selling rules instill discipline and avoid emotional decision making. Risk management techniques such as stop losses preserve capital during market turmoil. Minimizing fees and trading costs improves net returns. A rules based strategy built on these time-tested principles gives it the best chance for long-term prosperity.
Careful portfolio construction and execution of the rules are critical
In addition to sound underlying principles, making rules based investing work in practice requires thoughtful design choices in portfolio construction and disciplined execution of the rules. Portfolio design elements like asset allocation, diversification, position sizing and leverage determine risk and return profiles. Rules need to be detailed enough to guide different market environments but not overly complex. Rebalancing cadence, stop loss percentages, buying and selling triggers should optimize costs, taxes and risk-adjusted returns. Closely tracking trading costs like commissions and slippage and managing risks are key. Having systems and processes that remove emotions and rigorously follow the rules during bull and bear markets separates success from failure. Rules are only effective when followed consistently in practice.
Blindly following rules without understanding their purpose can undermine performance
While rules based strategies offer many benefits, investors should not follow rules blindly without understanding their underlying purpose. For example, stop losses aim to limit downside but can also lead to selling at inopportune times. Frequent rebalancing generates transaction costs and taxes. Some rules require customization for an investor’s specific circumstances. Tweaks to improve strategy performance should align with core principles not just past return chasing. An investor blindly following rules they don’t fully comprehend is prone to abandoning them at the worst times. Understanding why the rules exist leads to conviction during periods of underperformance and their long-term success.
Rules based investing can simplify investing for many investors if executed properly
Rules based investing has clear benefits in terms of systematizing the investing process and removing emotional decision making. This approach can simplify investing for novices. The strategy can be delineated clearly on paper and followed rigorously. Investors know what to expect and can judge progress based on a predefined benchmark. However, investors need to ensure they choose sound foundational principles and execute the rules in a disciplined fashion. Skilled formulation and implementation of the strategy coupled with patience and commitment to stick to the rules through ups and downs lead to success.
When built on robust principles and executed with discipline, rules based investing strategies can simplify the investing process and potentially improve returns for investors. However, investors should ensure they understand the rationale behind the rules instead of just blindly following them.