This classic Bill Mann investing article was originally published Jan. 5, 2005. Some information has been updated.
The Buffettoids among us will recognize the title instantly. "Rule One: Never Lose Money. Rule Two: Never Forget Rule One."
The thing is, only among the braggarts of the anonymous snakepits that can be message boards and the liars who run penny stock promotion schemes (and the two are not necessarily unrelated) will you find people who actually claim to have never lost money on an investment. Every dip, every rise, somehow these folks were in front of. Every big run-up they somehow were in front of -- magically getting out at the top.
It's like some sort of evil version of Lake Wobegon, where it's not so much that all of the kids are better than average, but more that every one of 'em makes perfect decisions all the time, and are rewarded instantly for them.
And if you believe these keyboard and predictive-dialer heroes for one second, please call me first: I have some prized oceanfront Arkansas property that you might find too tasty to pass up.
In fact, Warren Buffett himself has failed mightily to live up to Rule One at times. Berkshire Hathaway
So why on earth would Buffett be able to say "don't lose money" with a straight face? Is it because his winners have so substantially outstripped his losers? Is it just a victor's boast?
No, not even close. What Buffett is talking about here is a state of mind. This is a guy who is a billionaire many times over, and yet if he were to see a nickel in a parking lot he'd bend over and pick it up.
Here's an interesting side note: Let's say that Warren Buffett picked up a nickel and invested it in Berkshire Hathaway when he took it over in 1965. Today, that nickel would be worth more than $130. How many nickels would it take to pick up and put to work for you before that particular payoff got to be really enticing? This is why those folks who pooh-pooh Buffett's unbelievable investing record are just wrong, wrong, wrong when they say, "Well, Buffett has access to all this inside information." He was Warren Buffett, unknown Midwestern investor, long before he was "WARREN BUFFETT, ORACLE OF OMAHA." And before he became known as a superinvestor, he had to, well, superinvest, by turning nickels into dollars many times over.
"Never lose money" is a philosophy for investing. It means something simple: There's no such thing as "play money." You don't go out and speculate on a total flyer. You remain disciplined, whether your account is up or down. No casino attitude. There's no such thing as the house's money. It's ALL your money, and it's all to be protected.
Think of an investing dollar this way: If you are 30, and you have an investing dollar and throw it away, you're not only losing the dollar, but you are permanently destroying all of its future value to you. True, you're not Warren Buffett -- each nickel becoming $130 over 40 years is, for most people, extremely unlikely.
But on the other hand, if you earn an average of 10% per year on that dollar, in 40 years that same dollar would be worth a little shy of $50. Rule One: Never lose money.
So that means take no risks, right? Not in the slightest. In 2004, Pepsico offered a contestant the chance to win a billion dollars. The odds were fairly slim, but the game wasn't rigged. There was a non-zero chance that Pepsi would have to pay a billion dollars to some extraordinarily lucky contestant. So Pepsi did the reasonable thing: It insured itself against the loss, and the company that carried that insurance was Berkshire Hathaway. Berkshire took the risk for two reasons: First, it could afford to make the payout, and second, the amount Pepsico paid for the insurance was well in excess of the expected payout beforehand.
It works like this: chance of paying out is, say 1 in 10,000. So the value of that chance, pre-event, is $1 billion divided by 10,000, or $100,000. So if Berkshire charged Pepsi $300,000 for the insurance, then the net expected gain to Berkshire was $200,000.
Clearly, though, there was a risk of being wrong, or being right and having the correct analysis of risk factors, one of which jumps up and bites you anyway. When you invest, you are by necessity taking a risk on future events, chief among them the company's ability to generate free cash flows at a sufficient level in the future to validate your buying at the current price. Look at the moonshot companies from 2004: Sirius,XM Satellite Radio
Sometimes, many times, an increase in risk will mean that an investor will suffer huge, staggering losses. Having the proper mind-set for investing means that you do not have any deep-seated need to have your decisions consistently reaffirmed, nor for you contrarian-minded folks out there does it mean that you must always be against the grain, or that you must at least be in agreement with the right kind of people. Think Bill Miller at Legg Mason Value Trust always agrees with Buffett? I'd bet a share of Amazon.com
Rest assured: Even if you couldn't for the life of you see what Miller saw in Amazon, or in Tyco
Do you know where the risks are for the companies you own? A huge number of stocks shot up like rockets in the last two months of 2004. If you hold Sirius, do you have any idea what level of subscribership is baked into current share price? What about this company makes you believe that it will not just meet this amount (justifying today's price), but exceed it (justifying holding the stock for still higher prices)?
Don't put yourself at risk of losing money needlessly by failing to have some idea of this for every company you own. If you do not, your investing results will be based largely on blind luck. And sometimes blind luck isn't very lucky at all.
Want some instruction? Check out these articles:
XM Satellite Radio and Taser are Rule Breakers recommendations. Berkshire Hathaway and Tyco are Inside Value picks. Overstock is a former Hidden Gems and Rule Breakers pick. Amazon is a Stock Advisor selection. Try out these or any of our other Foolish newsletters for yourself, free for 30 days.
Bill Mann holds shares of Berkshire Hathaway. He uses his risk-assessment skills in helping Tom Gardner co-pilot the Motley Fool Hidden Gems small-cap newsletter service. The Fool has a disclosure policy.