If you were to ask me what I believe is the greatest piece of advice Warren Buffett (Trades, Portfolio) has ever given, I would say it is his two rules of investing:
"Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1."
There is much more to this simple statement than first meets the eye.
It simply sums up Buffett's key goal of making sure he never suffers a permanent capital impairment -- something the dean of value investing, Benjamin Graham, first taught him many decades ago.
Follow the rules
It is very easy to say that to be a good investor, you need to make sure you do not lose money. But actually putting this into practice and building your investment strategy around the primary goal of never suffering a permanent capital impairment is more complex.
What Buffett is referring to is making sure that every single investment you consider has zero chance of total loss and has a high probability of generating a positive long-term return. This means staying away from high-risk, high-reward stocks and favoring high-quality companies that are already profitable and have a long runway for growth in front of them.
Following this strategy has undoubtedly cost Buffett some money, but it has probably saved him much more. Not chasing opportunities that look fantastic at first, but later turned out to be costly, has saved him time, money and effort.
It is very easy for people to overcomplicate investing. Many investors are looking for a simple and straightforward strategy to follow so they don't have to put in any effort. But the simple fact of the matter is you don't need to be a genius to be successful. You just need to follow a few simple rules to protect your capital and make sure you avoid the market's worst stocks.
Focus on risk, not reward
Buffett's first two rules of investing are a great place to start if you want to construct an investment strategy. You don't need any complicated algorithm or degree in financial engineering to understand that suffering a permanent capital impairment is bad and should be avoided at all costs.
To put it another way, you want to focus on risk before you focus on returns. This is something renowned investor Seth Klarman (Trades, Portfolio) spoke about in 2009 at The Ben Graham Center for Value Investing at the Richard Ivey School of Business in Ontario. He said the first of three pillars of his investment strategy is:
"You want to focus on risk before you focus on returns. … A lot of it is focusing on multiple scenarios, what can go wrong? How much can you lose?"
Value investing is all about minimizing risk by investing in companies at attractive prices. Controlling risk is central to the investment process of both Klarman and Buffett, who are arguably the best value investors alive today.
So if there's one thing we can learn from these two skilled investors, it is that we should always focus on risk first, considering what can go wrong, before we start to work out the potential for profit. It might be more exciting to chase high-growth tech stocks that have the potential to shoot for the moon without considering the downside, but more often than not, these high-risk, high-reward opportunities only cost investors money.
If you are happy to waste your money chasing these opportunities, with the hopes of one day striking it rich, that is up to you. But the slow and steady approach of finding high-quality businesses with a near-zero risk of losing 100% of your capital seems much more appealing and relaxing.
Read more here:
