How to Never Lose Money

Warren Buffett has two famous rules for investing:

• Rule No. 1: Never lose money.
• Rule No. 2: Never forget rule No. 1.

Those rules sit at the heart of his tremendous investing success. While you may never displace Buffett on the list of the world's richest people, following his principles in your portfolio will certainly help you earn your share of wealth. To get from where you are to where you need to be, though, your first step is to figure out why those simple-sounding rules are so very important.

Why it matters
There are two main reasons why not losing your money is such an important part of investing success. The first is the simple fact that it takes a 100% gain to make up for a 50% loss. Even worse, the return you need to recover from a loss only gets nastier as the loss itself deepens.

Take, for instance, these former darling stocks of the late-1990s technology bubble:

For investors who held through the lows to recover what they thought they had near the peaks in any of these firms, they'd need to see returns somewhere between 910% and 79,186%. That's in spite of total losses between 90.1% and 99.9% of their all-time highs. Is it possible to see returns like that? Yes, in theory. Will it happen in a reasonable time frame? Not very likely.

The second reason why never losing money is so important is that if you take care of protecting against the downside of an investment, the upside will tend to take care of itself. Check out the returns of those very same companies since they bottomed out after the tech bubble burst:

While none of these companies has quite recovered its bubble glory, each has more than doubled off its lows. Same companies -- totally different returns. The key differences? When you bought the shares and the prices you paid for them.

How to profit
Of course, you're likely never going to buy exactly at a company's low point, nor will you likely sell precisely at its peak. Not even Warren Buffett himself can make that claim. The better you get at figuring out the difference between a low price and a high price, however, the better your chance of capturing much of that upside while avoiding the worst of the fall.

The key is valuation -- the cornerstone of any value investing strategy. Over time, the market tends to find the proper prices for companies' shares. As the high-tech bubble showed us, though, while the market is pretty good over time, on a daily basis, it can be way off base. To protect your money and thereby both reduce your downside risk and increase your upside potential, you first need to figure out what a company is really worth. Buy only if it's truly selling for well below its real worth. Sell only if it's selling well above that value. Everything in between is just noise in the system and the inherent fuzziness of predicting the future earnings that drive that valuation.

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At Motley Fool Inside Value, we understand both why Buffett's rules are so important and how to apply them to find superior investments. Every single selection in our market-beating portfolio was picked based on its attractive valuation. Just as that straightforward strategy has worked for Buffett for decades, it still works well for us today.

Join us today to get started building your own value-focused portfolio. You can view all of our picks and research, including our top five companies for new money, with a free 30-day trial. You just might find it to be the most important step you take at launching your successful investing career.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta did not own shares of any company mentioned in this article. The Fool has a disclosure policy.