That's a rule, not an exception

We've all heard the saying about the exception that proves the rule, perhaps to the point of weariness. Personally, this has always struck me as nonsensical. How can an exception possibly prove a rule? Logic dictates the opposite: the rule is inherently flawed if there's an exception. It's as simple as that. The phrase once held a different meaning, lost to time.

The problem is that this saying is often trotted out as a justification when people have accepted a principle in theory only to violate it. I often come across this in discussions about investment decisions. Nowadays, many mutual fund investors are well-versed in the best investing practices. The problem is that their actual investment portfolios often read like a catalogue of exceptions to these very practices, each justified by the infamous' exception that proves the rule' story.

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Consider a fundamental tenet of investing: one should never invest in an equity fund all at once. The prudent approach is to invest through SIPs, whose benefits are so widely understood that it's hardly worth discussing. Yet, the portfolios of investors who understand this principle are often riddled with exceptions, each accompanied by a supposedly sound justification.

You might hear explanations like, "I came into a lump sum, and someone tipped me off about this fantastic investment opportunity, so I put it all in at once." Or perhaps, "I know sector-specific funds are generally ill-advised, but it's clear that infrastructure is poised for growth, so I made this big investment in this great infra fund."

Another common refrain goes, "Given the volatility of equity markets, I've opted for a 10-year fixed deposit investment." These scenarios, with minor variations, repeat themselves across numerous portfolios. They all fall into the 'exception to the rule' category, with investors consciously choosing to deviate from investment principles they very well know are correct. They've convinced themselves, often with the help of a persuasive salesperson.

Most of us treat investment rules as general guidelines or well-intentioned advice that can be disregarded when we're tempted to make an exception. This mindset is wrong. An unlikely source provides an interesting perspective on this issue. While searching online for unrelated information, I stumbled upon a NASA document that, despite focusing on software development, offers relevant insights for investors. The document outlines 10 rules for developing safety-critical software, titled 'The Power of Ten' and authored by Gerard Holzmann, a NASA computer scientist. Holzmann's research findings leading up to the paper are particularly pertinent to our discussion.

Holzmann discovered that rules must be treated as laws, not guidelines, for them to be effective. Many organisations have numerous guidelines, but in practice, their employees become experts at justifying exceptions to them. Instead, Holzmann found that having fewer but inviolable rules yielded better results. He advocated for eliminating any process to evaluate whether exceptions were justifiable.

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Here's the most important thing you must appreciate: even if an exception might be warranted in a specific case, the overall outcome improved when exceptions were never allowed. This approach worked because sacrificing a few justifiable exceptions eliminated many frivolous ones without the need for case-by-case evaluation.

For individual investors, there's no external enforcer of these rules, so it ultimately comes down to self-discipline. Nevertheless, understanding the logic behind this advice can be invaluable. There may indeed be situations where deviating from the basic tenets of sound investing could have led to better returns. However, these exceptions are few and far between and can typically only be identified with certainty in hindsight. Therefore, it's much better to regard these guidelines as sacrosanct and resist the temptation to fall for the 'exception that proves the rule' narrative.

Overall, treating investment principles as inviolable laws rather than flexible guidelines will get you better results. Sometimes, you will miss out on something lucrative. Still, far more often, this will safeguard against making frequent exceptions based on short-term market conditions, clever salesmen, or your own biases.

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