How to Never Lose Money

It's become an investing cliche.

Warren Buffett's two rules for investing:

  1. Never lose money.
  2. Never forget rule No. 1.

I've personally heard that advice so many times, it's begun to sound as inane as "Buy low, sell high." Just as no one goes into an investment trying to buy high and then sell low, no one intends to lose money. But like most clichés, especially those originated by Buffett, there's a great lesson here -- if you can parse the words correctly.

The moment of illumination
I finally understood exactly what Buffett meant by "never lose money" when I heard about the home run opportunity he passed up in 1968.

Back then, he served as a trustee of Grinnell College alongside a man named Bob Noyce. You may know Noyce better as one of the co-founders of Intel (Nasdaq: INTC  ) .

Believe it or not, Buffett had the opportunity to get in on Intel on the ground floor. It would have been one of the greatest investments on his packed list of great investments.

But he passed it up.

Why? He knew it lay outside his circle of competence (another well-worn Buffettism).

In his words: "We will not go into businesses where technology which is way over my head is crucial to the investment decision."

Buffett's spurning of the Intel motherlode reminds us that if never losing money is our goal, we have to avoid some individual investments that have tremendous market-beating potential.

It sounds counterintuitive, but it's true. Just because an investment works out in our favor doesn't mean there was skill involved. To truly follow Buffett's lead, we need to invest in companies about which we have above-market knowledge.

A tech example that worked out
But just in case you think I'm picking on tech stocks, I'll share a counterpoint. A contrast to Buffett is someone like Jeff Bezos, the founder of Amazon.com. Not only has he built Amazon.com into an Internet retail powerhouse, but he was also one of the initial investors in Google (Nasdaq: GOOG  ) , getting in at about a nickel a share. Wow.

Two things to note here: First, tech companies are within Bezos' circle of competence. Second, he has more of an entrepreneur's risk tolerance than does Buffett. Rather than "never lose money," it's more "make up for any losses with the killings you make on your winners."

To be clear, the "circle of competence" lesson applies not only to technology companies, but also to all industries.

For example, in the energy space, an educated choice among Big Oil titan Exxon (NYSE: XOM  ) and alternative energy player First Solar (Nasdaq: FSLR  ) requires knowledge of global supply constraints, a projection of consumer demand, insight into the technologies employed, and a feel for government regulations and subsidies. All this does not include digging into the companies themselves, which is complex enough.

General Electric (NYSE: GE  ) showed us how complicated a company can get. The losses at GE's financial arm are painful proof that not knowing can cost you big money as an investor.

More of what it takes
But following Buffett's "never lose money" credo takes more than just sticking within industries you know more about than the next guy. Just because an Exxon or a General Electric is within your circle of competence, and you've determined that its business model is superior, doesn't mean you should invest in it.

Nope, you need a margin of safety as well. In other words, the price must be right.

That sounds obvious, but it never sinks in for many investors. Just because a company is poised for success doesn't mean investors will profit from the success. At some point, even the best businesses are too expensive for investment purposes.

To use a non-stock example, an art investor would gladly buy a Van Gogh for $10,000. But he'd be a small-f fool to buy one at $10 billion.

Even Buffett loses money
Here's a secret: Every investor loses money at some point. Even Buffett. Remember that his company's name, Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) , hearkens back to the ill-fated textile mills that helped solidify his philosophy.

His admonition to never lose money is less a rule, and more a way of thinking. It's a reminder not to stretch for the siren song of too-good-to-be-true returns. This requires:

  • Staying within your circle of competence.
  • Opportunistically buying in at a good price.

Our team at Motley Fool Inside Value seeks to follow Buffett's philosophy as they search for the stocks that provide upside with a minimum of risk. Like Buffett himself, they've had some losers along the way, but since inception in 2004, they've beaten the market by an average of 7 percentage points per pick. If you'd like to see the stocks they've unearthed so far, I invite you to join them free for 30 days. Click here to start. You can cancel at any time.

Berkshire Hathaway, Intel, and Wal-Mart Stores are Motley Fool Inside Value selections. Google and First Solar are Motley Fool Rule Breakers recommendations. Amazon.com and Berkshire Hathaway are Motley Fool Stock Advisor selections. Procter & Gamble is a Motley Fool Income Investor pick. Motley Fool Options has recommended buying calls on Intel. The Fool owns shares of Berkshire Hathaway and Procter & Gamble.

Anand Chokkavelu owns shares of Berkshire Hathaway. He enjoyed the Man in the Yellow Hat's book, How to Never Lose Monkey. The Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (25)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 29, 2010, at 8:23 AM, lotontech wrote:

    I began my book on this subject by making the simple observation that...

    "If your investment falls by 50% you'll need a 100% rise just to get you back where you started."

    There are also a few metaphors that spring to mind, like the fact that sporting games (tennis, golf, etc.) are often won not by the player who hits the best shots but by the player who hits the least number of bad shots.

    So never forget:

    DON'T LOSE MONEY!

    But how you achieve this feat is where I differ from the author of this article. IMO it's all about the clever placement and trailing of your Stop Orders.

  • Report this Comment On January 29, 2010, at 9:30 PM, TMFEditorsDesk wrote:

    @Iotontech,

    I prefer vetting a company thoroughly before buying and then riding out price dips if they occur. In fact, I think about adding more shares on dips.

    Now, I am always open to re-evaluating if my investing thesis is blown, but a mechanical stop loss order doesn't help matters.

    - Anand Chokkavelu (TMFBomb)

  • Report this Comment On February 01, 2010, at 5:07 PM, TMFEditorsDesk wrote:

    A quick side note: Although Buffett didn't buy Intel, Grinnell College did.

    Can you imagine being a small liberal arts college in Iowa with Bob Noyce and Warren Buffett in your corner? It eventually results in an endowment of over $1 billion (as of June 30, 2009) for an enrollment of under 2,000 students.

    -Anand (TMFBomb)

  • Report this Comment On February 04, 2010, at 11:48 PM, crca99 wrote:

    Hey, thanks for the side notes on Grinnell College.

  • Report this Comment On February 05, 2010, at 12:20 PM, TMFEditorsDesk wrote:

    @crca99,

    np. Are you a graduate of Grinnell?

    -Anand (TMFBomb)

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