No one likes to lose, particularly when it comes to money. But losses are a part of the stock market, and even the best investors experience losses. In fact, Warren Buffett has lost more than we'll ever make.
Still, he's a winning investor. That's because Buffett generates the right kind of losses. It sounds strange, I know. Here are his secrets:
Rule No. 1: Don't lose money.
Rule No. 2: Don't forget Rule No. 1.
The worst kind of losses
Read the first rule carefully. It says don't lose money. To me, this rule is not about short-term price volatility. It's about avoiding situations where we're likely to have a permanent loss of capital.
Let me give you an example of a situation that is totally un-Foolish. Professors Joseph Engelberg, Caroline Sasseville, and Jared Williams of Northwestern University wrote a paper called "Is the Market Mad?" (download at the bottom). Here are the key findings:
- On average, the quartile of small-cap stocks (those with market caps of less than $1.6 billion) recommended as a "buy" on Mad Money lose 6.6% over a 12-day period. Those losses can add up fast.
- From the authors: "The uninformed traders [buy] despite the fact that these stocks became overpriced overnight and earn negative cumulative abnormal returns over the next two weeks." (Emphasis added.)
The interesting thing about the data is that it includes a wide range of picks, from high-risers like energy-drink maker Hansen Natural
The lesson has nothing to do with Mad Money (it's an entertaining show) or its individual recommendations. The lesson: Be informed. Buffett earned his billions by taking the time to be an informed investor, not violating the spirit of Rule No. 1 and impulsively trading into stocks that could very well go down and stay down.
Unpleasant but acceptable losses
It's tough to sell stocks. At Inside Value, we try to sell them when they are overvalued. But it's a judgment call as to what's overvalued. As a result, sometimes we experience losses from stocks that rise only to fall back a bit. Those losses sting but are bearable.
In a recent interview, Charlie Rose pressed Buffett about why he didn't sell his shares of Coca-Cola
Totally acceptable losses
Buffett has estimated he's cost Berkshire Hathaway shareholders about $10 billion by not investing in Wal-Mart
While not buying a stock and watching it go up can be a bitter pill to swallow, you don't violate Rule No. 1. Sure, there's an opportunity cost, but there's no real loss of capital. Those "losses" are totally acceptable.
The Foolish bottom line
The Inside Value team is just like you: We don't like to lose money. And here's how we work to make the most of value's winning ways.
1. Be informed.
2. Sell when a stock is overvalued.
3. Buy when the opportunity is there.
Former recommendation Omnicare is a perfect example. Lead analyst Philip Durell was informed, bought when he saw the opportunity, and sold when he felt it was overvalued, resulting in a 104% gain. And it's all documented at the Inside Value website.
If you'd like to see what we're recommending today, click here to join Inside Value free for 30 days. There is no obligation to subscribe.
David Meier is a member of the Motley Fool Inside Value team and does not own shares in any of the companies mentioned. Coca-Cola and Wal-Mart are Inside Value recommendations. Openwave Systems is a Rule Breakers recommendation. The Motley Fool has adisclosure policy.