Warren Buffett's two rules for investing have become a cliche:
1. Never lose money.
2. Never forget rule No. 1.
I've heard that advice so many times, it has begun to sound as inane as "Buy low, sell high." No one goes into an investment trying to buy high and then sell low, and no one intends to lose money. But like most cliches, 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.
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 mother lode 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 circle of competence example
To be clear, it is possible to have a circle of competence in technology. It's just not generally Buffett's forte. And the "circle of competence" lesson applies not only to technology companies, but also to all industries.
Let's take the discount brokerage industry as an example.
The big three discount brokers -- E*TRADE
However, their success has bred competition from smaller players including optionsXpress
To invest in the industry, you should have a good handle on terminology like "DARTs" -- daily average revenue trades; since they charge so little for trades, they need to make up the difference in volume. As E*TRADE's problems with its subprime investments have shown, you should also be able to figure out what's going on on their balance sheets. And you'll need to be able to roughly forecast where the industry is headed -- with the increased competition and trades becoming commoditized, there will be tremendous pressure to lower trading prices.
Without this type of knowledge, the discount brokerage industry can't truly be within your circle of competence.
More of what it takes
But following Buffett's "never lose money" credo takes more than just sticking with industries you know more about than the next guy. Just because a company 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
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.
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