It sounds contrary, but understanding how you lose money is what will make you a successful investor. Because you will lose money.
There are three ways of thinking when it comes to losers. Two of them will help you retire to a life of leisure; the other will help you retire to a life of dog food.
1. Big losses, bigger winners
One of the successful strategies is to accept occasional large losses as a cost of finding that one stock that goes to the moon. Such a strategy can be very effective, since a single winner can overcome multiple losers. If you'd picked up Hansen Natural (Nasdaq: HANS ) back in 2003 at a split-adjusted $0.50 and held on until now, then you made 100 times your money. It really doesn't matter if you lost 80% of your investment in four other picks -- that one great gain makes up for all of your losses.
Ditto for Dell (Nasdaq: DELL ) or Cisco Systems (Nasdaq: CSCO ) in the early 1990s. If you'd bought a reasonable position in either stock, you'd be set for retirement. The strategy works because when you lose, you can "only" lose 100% of your investment. If you win, well, the rewards are nearly limitless.
2. Small losses, constant winners
The second strategy that investors use is to minimize losses at every turn. This is based on Warren Buffett's first rule of investing: "Never lose money." This approach works because of two mathematical properties. The first is the asymmetry of losses and gains. If you lose 50% of your investment, you actually need it to double to break even. If you lose 80%, you need to quintuple your remaining cash just to break even!
The second mathematical property that makes this strategy attractive is compounding. Most of the big money in the stock market is made through long-term compounding -- the interest on your investment earning yet more interest. But if you lose money, then you interrupt its compounding. You don't just lose the principle. You also lose everything you would have made on the money you lost.
Together, these two show that losing money at all can crush returns. Thus, some investors try extremely hard never to lose money.
Value investors like Buffett buy with a margin of safety -- purchasing stocks for less than they're worth. Such bargains can appear during bouts of temporarily bad news, such as when Berkshire Hathaway bought USG (NYSE: USG ) during fears of asbestos liability, or when American Express (NYSE: AXP ) suffered through the "Salad Oil" scandal. Or, they can arise simply because the market isn't giving the company full credit for its competitive position and potential growth, as we saw in Berkshire's recent purchases of Wal-Mart (NYSE: WMT ) and Anheuser-Busch (NYSE: BUD ) . In either case, the belief is that since the stocks are undervalued, they're unlikely to become even more undervalued and, in fact, are likely to bounce back to more reasonable prices.
3. Big losses, small winners
A strategy you should avoid is one of big losses and small winners. Novice investors often inadvertently adopt such an approach by selling their winners early to lock in gains and letting losses ride in the hopes of eventually breaking even. It's easy to fall into this trap. When a stock goes up 20%, it's natural to think "Hey, 20% is pretty good. I'd better sell this stock before I lose my gain." Then, when a stock goes down, this investor may say, "It just needs a bit longer; then it will bounce." In combination, such reasoning results in a bunch of small winners and large losers, and it will frequently underperform.
The best strategy
Either the "big losses, bigger winners" or the "small losses, constant winners" strategies can help you beat the market. Fool co-founder David Gardner and his team at Motley Fool Rule Breakers follow the first strategy. We at Motley Fool Inside Value service have adopted the second. Both strategies -- and newsletter services -- are beating the market.
If you're wondering which strategy is right for you, ask yourself this question: Does volatility keep you interested in your portfolio, or would you prefer a less volatile path with more consistent profits?
If it's big gains and volatility you're after, tryRule Breakers for free. If consistent profits sound more to your liking, grab a free pass to Inside Value. Or try both. There is never an obligation to subscribe.
Fool contributor Richard Gibbons has tried all three strategies and likes the winning ones more. He owns call options on Cisco but does not have a position in any other security discussed in this article. Wal-Mart, Dell, and Anheuser-Busch are Inside Value recommendations. Dell is also a Stock Advisor pick. The Motley Fool has a disclosure policy.