"The first rule of investment is don't lose. And the second rule of investment is don't forget the first rule. And that's all the rules there are. (...) If you buy things for far below what they're worth and you buy a group of them, you basically don't lose money," Warren Buffett (Trades, Portfolio) explained in an interview.
It sounds very simple. Very basic. Surely that can't be all there is to become an investor as successful as Buffett. Well, no, it is not. However, it is an excellent starting point.
After all, the Oracle of Omaha's number one rule of never losing money is the foundation on which he built his entire investment strategy and legendary track record. Let's explore why this concept is so critical by looking at insights from three of history's most celebrated investors - Buffett, Charlie Munger (Trades, Portfolio) and Peter Lynch. Each of them emphasized the importance of never losing money.
Buffett's rules of investing
"Rule number one: Never lose money. Rule number two: Never forget rule number one."
This oft-quoted Buffett maxim perfectly summarizes his conservative approach to investing. Before even thinking about making money, focus first and foremost on not losing it.
Buffett built his entire investment philosophy around avoiding losses. When asked about the key to his success, Buffett responded: "I'm pretty good at staying away from things I don't understand."
In other words, never invest in businesses you don't thoroughly comprehend. Stay within your circle of competence to avoid losing money in unfamiliar territory.
He also insists on a margin of safety when making investments. Rather than pay full price for a stock, the guru buys companies at significant discounts to intrinsic value.
This built-in margin of safety helps avoid the potential for permanent loss. Even if the investment doesn't pan out as expected, the downside is limited when you buy an asset at a price that's far below what it's worth.
Munger on avoiding loss
Buffett's longtime business partner and vice chairman of Berkshire Hathaway Inc. (BRK.A, Financial)(BRK.B, Financial), Munger, shares his obsession with avoiding loss.
"All intelligent investing is value investing - acquiring more than you are paying for. You must value the business in order to value the stock," Munger has said. Focusing on value protects against overpaying.
Like Buffett, Munger emphasizes staying within your circle of competence. "You have to figure out where you've got an edge. And you've got to play within your own circle of competence."
This optimizes decision-making and minimizes the potential for loss. Why invest in businesses you do not understand? Stick to companies you have knowledge about to stack the odds in your favor.
Munger also disdains unnecessary financial risks that could lead to loss. When asked about his investing goals early on, he responded: "I did not intend to get rich. I just wanted to get independent." Avoiding risky bets enabled him to achieve the steady gains that brought independence.
Lynch: Cutting flowers and watering weeds
Lynch, a legendary mutual fund manager, delivered market-crushing annualized returns of 29% at Fidelity Magellan for 13 years. How? In large part by following a common sense approach focused on avoiding loss.
He warned against the all too common mistake of holding onto losers while selling winners. He said this is "like cutting the flowers and watering the weeds."
When a stock declines in value, it clouds people's judgment. They rationalize holding the position, not wanting to "crystallize" the loss by selling. This causes bigger losses.
Instead, Lynch preached watering flowers (letting winners run) and pulling weeds (selling losers). Interestingly enough, he admits that Buffett himself taught him to accept his mistakes and grow from them. And chief among those mistakes, he "always sold stocks too early." So let your winners run to maximize gains and weed out your losers before they do more damage.
He also advised against bottom fishing in stocks because they seem cheap. Just because a stock has declined does not guarantee it cannot fall further. "It can't go any lower" is not a reliable investing approach. The downside for a company can always be 100%, no matter how much the stock has already dropped.
Lynch made his Fidelity investors wealthy by sticking to companies he researched thoroughly and selling ones that did not perform fundamentally. Avoiding losers was crucial. Clearly, he took Buffett's lesson to heart.
Why this rule matters
At first glance, the simplicity of "never lose money" might elicit skepticism. After all, stocks fluctuate. No investor buys at the absolute bottom or sells at the peak. Some losses are inevitable, right?
While market volatility is an inescapable reality, concentrating on avoiding unnecessary losses is vital for several key reasons.
First, losses hit harder than the equivalent gain feels good. Behavioral finance research confirms that pain from a 30% loss feels twice as bad psychologically as the pleasure of a 30% gain. Digging out of holes is much more challenging due to this asymmetry.
Second, avoiding losses is the key to compounding wealth. Losses destroy compound gains. Your portfolio value compounds most when asset values steadily rise rather than suffer significant periodic downdrafts. Never losing money enables compounding.
And third, loss aversion causes suboptimal investor behavior. People hate incurring losses far more than they enjoy gains. This leads to hanging onto losers and selling winners quickly. Combatting innate biases is critical.
By focusing first and foremost on not losing money, investors set themselves up for sustained gains that compound wealth over time. It is a simple concept but challenging to execute in practice. Our psychology often works against this principle.
Applying this rule as an individual investor
So how can individual investors apply Buffett, Munger and Lynch's wisdom about avoiding losses in their own portfolios? Here are key ways to put this principle into practice:
- Stick to companies within your circle of competence. Never invest on speculation or tips alone. Understand the business thoroughly first.
- Maintain a long investing time horizon. Short-term volatility is smoothed out over five to 10-year periods or longer. Think like a business owner rather than a stock trader.
- Build a margin of safety into investments. Do not pay full price. Demand a discount to mitigate the downside.
- Cut losses quickly without hesitation or guilt. Let winners run higher over time. Do not sell successful investments early.
- Tune out market noise and stay disciplined. Do not panic and sell during temporary market declines. Stick to the long-term plan.
Put simply, when in doubt, do not invest. If you cannot research a company enough to gain confidence in its future prospects, stay away. Never speculate. Never chase hot trends or tips. Mastering emotional discipline and patience will go a long way.
Embracing the fundamental principle of never losing money
"Never lose money" is deceptively simple advice, but this compelling concept has profound investing implications.
Buffett, Munger and Lynch all recognized that avoiding losses is the ultimate key to compounding wealth over time. Their laser focus on not losing money became the foundation of their investing success.
Rather than chase big gains, they concentrated first on not losing capital. They tuned out market swings and remained focused on long-term fundamentals. Most importantly, they overcame innate psychological biases that lead most investors astray.
Achieving market-beating returns requires many investing skills. But the ability to avoid unnecessary losses while letting winners ride is arguably the most vital trait of all. Master this basic principle like the legends, and you will be well on your way to investment success.
