One of the more damaging pieces of advice to the average investor is Warren Buffet’s famous investment rule:
“Rule No. 1: Never lose Money. Rule No. 2: Never forget Rule No. 1”
While this folksy wisdom has a great ring to it, it can be easily taken out of context. I think what Buffet is trying to say is not to gamble with your money and be prudent in your decision making. Many investors read this rule and believe that they should literally attempt to not lose money when they invest. Over the past 20 years, Buffet’s own company, Berkshire Hathaway, has had 6 losing years, with one of them erasing approximately 1/3 of his shareholder’s value. That means over the last 30 years, he has broken his own rule 30% of the time!
Investing involves risks. Those risks aren’t just theoretical. Historically, the stock market goes down around 1 out of every 3 years. For those who are trying to follow Buffet’s rule, how are they going to deal with this simple fact? Unfortunately, we tend to see it manifest itself in market timing, the act of trying to get in and out of the market at the right times. No one we know of has been able to do this consistently enough where you could attribute their performance to skill versus just plain luck. Buffet himself eschews the practice of market timing. He once wrote that his, “favorite holding period is forever”.
Those investors who want to follow Buffet’s rule have three strategies they can lean on to help them implement this idea of not losing money:
- Time period– over one year periods, the stock market has negative returns about 30% of the time. Conversely, there has never been a 20 year period in the S&P 500 where returns have been negative. The longer time you have, the lower the probability of losing money.
- Diversification– when you buy one or two companies, the risk of loss is high. In fact, we wrote about this in a prior post. Since 1983, 39% of all publicly traded stocks have lost money. You must spread out your bets to ensure you don’t pick one or two losers that can cause permanent losses.
- Discipline– there will be bad times. Probably the easiest way to violate Buffet’s rule is to sell your investments AFTER a loss. Having the discipline to stick with your investment strategy after a difficult period is a key factor in avoiding permanent losses.
I think amending Buffet’s rule would be immensely helpful. Here is how I would word it:
“Rule No. 1: Don’t lose money, permanently. Rule No. 2: Never forget Rule No. 2”
By implementing the three strategies we’ve listed above you have a much better chance of following that rule.