The following is a guest post about Warren Buffett’s number 1 rule. If interested in submitting a guest post please read my guest post policy and then contact me.
Much of the investment world is focused on how to make money. Buy this amazing stock which will double or triple in 6 months! Follow this trading strategy for market beating returns! Short call options to increase your income!
And this is what people love to hear. Making money is exciting!
But Warren Buffett’s most important rule of investing has nothing to do with how to make money. His famous rule number one is NEVER LOSE MONEY (and his equally famous rule number two – never forget rule number one!).
Why is this such an important rule?
One of the reasons this rule is so important is that the more money you lose, the harder it is to make it back. If you lose 50% on your first investment, then your next one needs to double, just to get you back to where you started. And while you’re waiting to get back to where you started, you’re missing out on the magic of compound returns in the meantime.
This also means that if one of your goals is financial independence or early retirement, you’re going to have to work longer to earn that money you lost, as well as to make up for the compounding returns you’re missing out on.
Not only that, but losing money is rather painful for us in general. We humans seem wired to really dislike it, and avoid it any way we can. Whether it’s losing $10 from our wallet, an accident that costs us hundreds, an investing mistake in the thousands, or even losing half your life savings to a con artist – we usually feel some sort of pain each time.
And when we gain the same amount of money, the nice feeling we get doesn’t quite outweigh the pain of an equivalent loss. This is the well-established ‘loss aversion’ characteristic in most of us – we feel losses more painfully than the equivalent happiness experienced by a gain (it’s at least twice as bad to lose, according to some smart people who tried to work this out).
OK, makes a lot of sense. Definitely much easier not to lose money in the first place, and do your best to make what you have grow.
So how on earth do you go about actually following this advice? If we want to grow our money, never losing money is almost impossible, right? Isn’t this a little like learning how to ski, and saying ‘never fall over?’ Don’t all great entrepreneurs encourage us to fail, sometimes in a big way, and to get comfortable with failure as a path to success?
Never losing money in investing
Despite how uncompromising this rule sounds, all great investors have lost money before – often huge amounts. But the reason they’re great investors today is because they learned some hugely valuable lessons from them, and the pain of those mistakes has prevented them from doing it again.
So to answer the question of this post, avoiding big losses is the key. Losing some money is part of the reality of investing. There are no guarantees in investing. There is always uncertainty. And uncertainty spelt another way means ‘chance of losing money’.Or in the skiing context, this is more like ‘don’t tackle a super difficult run that is far beyond your ability, where if you do fall over, you might end up in hospital, or dead’.
But there are a few potential ways to avoid the big losses, and giving yourself the best chance of following Buffett’s golden rule, without having to learn from your own mistakes:
- Stick with what you know (Operate within your circle of competence). Try to avoid investing in biotech stocks or rare earths exploration companies, if you don’t really know anything about what they do. You’ll just make investing harder for yourself. Do what Warren Buffett himself does and stick to what you know – you can always work on expanding your circle of competence. Or to put it another way, stick to the ski slopes that you can handle, where it’s easy to pick yourself up and keep going after a little stumble.
- Consider using diversification to your advantage – don’t just diversify for the sake of diversification, by running out and buying hundreds of different shares that you don’t know anything about. But think about what impact it would have on you if one or two of your current investments were completely wiped out, and plan for it.
- Consider using ‘stop-loss’ orders when buying shares. This effectively means when you buy, deciding the maximum loss you’re prepared to take (for example, 10%), and preparing a sell order in advance for this scenario. The views among the investment world on using stop losses are mixed, but it really comes down to whether it suits you own specific plan and style.
- Develop the right mind set, habits and behaviours of a good investor. This is one of the biggest downfalls many of us have as investors. Getting greedy, fearful, impatient, overconfident – having the best plan and finding the best investments in the world won’t get you far if you struggle with some of these behaviours (just ask Ted).
- To support these great behaviours, develop your own criteria and checklist for your investments. Not only will you be in far better control of your investment decisions and results, but you’ll be able to learn what works and refine you plan over time, rather than endlessly chasing the next great idea / strategy / guru which won’t work in the long run. Having your own checklist or criteria also increases the chances of you sticking with what you know.
- And to be fully prepared in case you do find yourself facing some big losses in the future, plan for your own ‘worst case scenario’ in advance, and work out how you’ll not only survive this scenario, but possibly even remain happy and optimistic with your life. This could be as simple as only investing an amount that you’re prepared to lose completely (but that doesn’t mean try to lose it by taking big risks!).
If you follow some of these steps, you’ll go a long way to avoiding the big losses, and any little losses won’t bother you so much.
But if all else fails, and you do find yourself confronted with some huge, painful losses….
Big mistakes are usually an amazing opportunity to learn something. And these sorts of mistakes are great motivators of change, as you probably won’t forget them in a hurry.
So dust yourself off, face your mistakes square in the face and learn everything you can from them, and keep going, knowing that you’ve just taken a giant stride towards becoming a better investor.
At the end of the day, money is important for most of us, but it’s just a means to an end. Most of the really special things in life are free anyway, and the other things you really need don’t have to be so expensive. So remember to keep your perspective if, despite your very best efforts, you slip up on Buffett’s golden rule.
This article was written by Jason Murphy, creator of the Islands of Investing blog. He is continually striving to become a better investor, and aims to help others do the same. Islands of Investing’s goal is to provide a quiet place away from the constant noise of the investment world, to help people learn, be inspired, and focus on the important things – in investing and in life.