It's become an investing cliche.
Warren Buffett's two rules for investing:
- Never lose money.
- 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 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 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 (Nasdaq: AMZN). Not only has he built Amazon.com into an Internet retail powerhouse, but he was also one of the initial investors in Google, 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 BP (NYSE: BP), refiner Sunoco (NYSE: SUN) and alternative energy player Suntech Power (NYSE: STP) 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.
It takes a good amount of time to wrap your head around the balance sheet of small commercial bank like Bank of the Ozarks (Nasdaq: OZRK). A little more for a big commercial bank like PNC (NYSE: PNC). And more time than most have to figure out Bank of America (NYSE: BAC), complete with its Countrywide and Merrill Lynch complexities.
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, 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.
This article was originally published Jan. 28, 2010. It has been updated.
Berkshire Hathaway and Intel are Motley Fool Inside Value recommendations. Google and Suntech Power are Motley Fool Rule Breakers picks. Amazon.com and Berkshire Hathaway are Motley Fool Stock Advisor recommendations. Motley Fool Options has recommended a buy calls position on Intel. The Fool owns shares of Berkshire Hathaway.
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.
