"Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1." – Warren Buffett (Trades, Portfolio)
Warren Buffett's first two rules of investing are perhaps the sage's best-known pieces of advice, but just because they are the most widely disseminated pieces of advice does not mean they are correctly followed or even properly understood by the clear majority of people reading them.
Most readers will read the rules and make the common mistake of looking at them from an optimistic viewpoint, which generally means they'll go out to try and make as much profit as possible in the shortest time, letting losses run to avoid taking a loss ultimately. If viewed from a pessimistic standpoint, however, these rules make much more sense.
What Buffett is saying is investors should try as hard as possible not to suffer a permanent capital loss. To put it another way investors should concentrate on those opportunities that are likely to generate profit with little to no risk of permanent capital impairment. Over the long term, even a small 1% to 2% capital impairment can cost you tens of thousands of dollars in returns. A permanent loss of 20% or more can cost you hundreds of thousands of dollars in return. By keeping an eye on the potential downside and investing only in those opportunities that offer lucrative returns with little risk, Buffett has been able to build the wealth he has today.
While the average investor will not be able to create Buffett-like wealth, you can significantly improve your investment performance by focusing on the potential downside, cutting losers early and managing risk/reward effectively.
Cutting losers
Cutting losers early and letting winners run is probably the hardest part of investing. It is especially hard for value investors, who will often find themselves buying in a downtrend and having to weather further declines before the stock begins to rise.
It can be hard watching a stock after investment but to be a successful value investor you have to be able to navigate these periods of turbulence and wait for the payoff although at the same time you need to be vigilant and cut those losing positions that may never recover.
Trying to walk this tightrope is not easy; it requires constant vigilance, but as over the long term value investing has been shown to outperform all other investing styles, the extra work required is worth the effort.
Put in the effort
Limiting portfolio losses should not be done automatically. By putting an automatic stop loss in place, you are essentially saying your fundamental research is useless at a certain price, which shouldn't be the case. Automatic stop losses make you a technical speculator, speculating on nothing but price alone. This is the opposite of value investing.
Instead of an automatic stop-loss policy, a better way to monitor losing positions is fundamental analysis based on price point triggers.
For example, say a position in your portfolio detracts 1% from overall portfolio performance. This decline is a trigger to reinvestigate the company, its prospects and fundamentals. If your new up-to-date research reaches a different conclusion than that of your initial research, it may be time to reconsider the position. By looking at the loss as a percentage of the overall portfolio, it helps you keep a more balanced perspective of profits and losses.
If a stock declines 40% over the course of a year, but it is just one of a basket of 100 stocks, the overall decrease (assuming all other shares do not change throughout the year) is 0.4%, hardly earth shattering in the grand scheme of things. What's more, by using an overall portfolio percentage decline figure your most concentrated positions get more attention while smaller more speculative (and volatile) positions will not continually trigger your price point review level.
How you decide to implement your own loss evaluation strategy is up to you, but if you keep in mind Buffett's first two rules, you're on the right track.
Disclosure: The author does not own any share mentioned.
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