"Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1." — Warren Buffett (Trades, Portfolio)
Warren Buffett (Trades, Portfolio)’s rules Nos. 1 and 2 is perhaps one of the billionaire’s best-known quotes, but it would appear that many investors don’t understand the meaning behind the saying.
Every investor wants to make money. What would be the point of investing if you don’t earn a suitable return on your investment? However, in the rush to look for the stocks that may provide the greatest profit in the shortest possible time, investors often make a fundamental mistake.
Investing is all about balancing risk and reward. There is no point buying a stock when the downside is 100%, and the potential upside is also 100%. As you can’t be certain what the future holds for any particular company, this kind of investment has a 50-50 chance of wiping out your initial investment. Repeated over and over again, 10 investments with a 1-1 risk-reward ratio will not generate a long-term positive return. At best you’ll end up with the same level of capital you started with (assuming a 50-50 win-loss ratio) although it’s more than likely when all is said and done you will end up with less than your original commitment as commissions eat into the capital.
Buffett’s rules are all about skewing the risk reward ratio in the investor's favor.
You're not Warren Buffett
There is plenty of research out there supporting the conclusion that most investors cannot consistently pick winning investments. What’s more, any experienced day trader will tell you that you cannot control the direction of the markets. Therefore average investors should concentrate on trying to control the factors they can influence, such as trading costs, the stocks they buy and the holding period of equities.
The risk/reward of a particular investment is another factor investors can control, and this is where Buffett’s first two rules come into play. By selecting equities with a limited downside, investors can skew the risk-reward ratio in their favor.
Of course, markets are extremely unpredictable, and it is almost impossible to pick equities that won’t fall in value at some point in the future. That being said, it is relatively easy to pick equities that are unlikely to go to zero in the short, medium or even long term.
Buffett’s rules are about avoiding high-risk investments when you can lose 100% of your capital if things don’t go to plan. Now, granted the opportunities with the highest potential returns tend to come with the highest level of risk and in the rush to achieve the best returns in the shortest possible time investors quickly forget Buffett's rules.
Some investors may have had success in using the high-risk return strategy but for most investors, this is not a suitable course of action to follow and can be extremely damaging to long-term returns.
The numbers don't lie
Let us look at the figures. According to the U.S. market research group Dalbar, which publishes the Quantitative Analysis of Investor Behavior study, the Standard & Poor's has managed an annualized return of 11.6% over the past 30 years, far outstripping inflation, which has averaged 2.7%. Over the same period, the average investor has achieved a return of 3.79%, fixed-income fund investors gained 0.72%, and investors in asset allocation funds gained 1.76% per year. These figures are shocking as they show the average investor only achieved an average real annual return of 1.1% per annum over the past three decades. For the purpose of this article, however, we only need the returns figures.
Assuming you invested $10,000 in the S&P 500 30 years ago, today after growing at a rate of 11.6% per annum for three days that amount would be worth just over $241,000. But all it would take is one significant loss in the first or second year (when you’ve first started investing) to severely impact long-term returns.
Let's say you’re running a portfolio of 30 stocks, which are producing the same annual returns as the S&P 500. In year two, and one of the positions goes to zero, giving a 3.3% loss overall or $370 of the portfolio at the time. At the end of the three decades, your total portfolio value stands at $234,000 after this adjustment, a cost of $7,000.
Clearly, this back-of-the-envelope calculation does not reflect the whole picture; there are other things to consider here, but it does highlight a key point. A 20% loss in year two would leave you with only $198,000 at the end of the three-decade period, $43,000 less than value would have been if the investor had followed Buffett’s first two rules. Further losses of 40% and 60% in year 10 are reflected in the chart below.
The bottom line
Overall, it’s crucial that investors understand and implement the ideas behind Buffett’s first two rules of investing. A significant investment loss can hold back your returns for decades but by remembering Buffett's rules, you should be able to avoid this disastrous scenario.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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