Warren Buffett has made billions for himself and shareholders of Berkshire Hathaway
If you listen to investors, they'll often talk about the risk-reward ratio of an investment. Seriously, who thinks about the risks of an investment before they envision the REWARD$? For example, the market is entranced with the lure of Molycorp and rare earth metals. The opportunity is seemingly huge, which has investors hooked, yet there are scores of things that could go wrong. Another example is YRC Worldwide, which has been crushed by the market as it flirts with bankruptcy, but become a favorite among penny-stock investors for its potential to hit the jackpot should things work out.
If you focus on the risk first and not losing money, the upside will take care of itself. By loss, I mean a permanent loss of money -- not just a few-months decline in share price. In the short term, stock prices will fluctuate. In the long term, a stock's price will follow the performance of the business. You should thus focus your efforts on making money over the long run by investing in strong businesses, with excellent managements, when the businesses are undervalued.
The key is to find companies that meet all three of these criteria. If you get the first two right and the last part wrong, it will cost you. There is no denying Baidu
From December 2007 to November 2008, Google dropped 63% from its high of $714. We're not here to guess how high investors will bid up a stock. To win in the long run, you need to figure out how you might lose money and buy at a price that protects you from things not going as planned. To do this, we look to the single most valuable concept in all of investing.
The 3 most important words in investing
Margin of safety.
It's simple. Imagine you calculate a stock's intrinsic value at $20 a share, and the current market price is $17 a share. While the stock might appear to be trading for less than it's worth, that's a narrow margin of safety. As a rule of thumb, many value investors look for a 50% margin of safety to protect them from their assumptions being wrong. However, in some cases they may require a smaller margin of safety.
The quality of the business, strength of the balance sheet, and future growth opportunities all affect the margin of safety. For example, Philip Morris
Most investors don't keep tabs on their companies' fundamental values. That's a mistake. You need to follow companies over time, read past the headlines, and wait to invest till a stock is undervalued. If you do so, you're in a much better position to spot potential trouble early. Better yet, you'll improve your odds of investing in home run stocks at great prices that provide the market's best returns. We can help you keep tabs on your companies with MyWatchlist.com, our free, personalized stock-tracking service. Not only will you get valuable updates on companies you are interested in, but you also get immediate access to a new special report, "6 Stocks to Watch From David and Tom Gardner." Click here to get started.
Dan Dzombak believes "don't lose money" are the second three most important words in investing. He is also positive a contraction counts as one word. His musings and articles he finds interesting can be found on his Twitter account: @DanDzombak. He owns shares of Philip Morris.
Berkshire Hathaway is a Motley Fool Inside Value pick. Baidu is a Motley Fool Rule Breakers recommendation. Berkshire Hathaway is a Motley Fool Stock Advisor selection. Philip Morris International is a Motley Fool Global Gains pick. The Fool owns shares of Berkshire Hathaway and Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.