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 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. 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."
A circle of competence example
To be clear, the "circle of competence" lesson applies not only to technology companies, but also to all industries.
Let's take the health-care space as an example.
Consider UnitedHealth Group
If your focus is pharmaceutical companies like Merck
As for players in other parts of the industry, like medical-device provider Medtronic
Medtronic will be hit with a new 2.3% medical device excise tax, though wider health insurance availability should help to boost sales. In an industry in which scale is the name of the game, Community Health Systems' 120 hospitals provide it tremendous leverage against insurers that smaller hospital owners may not have. Of course, insurers are very large, too. Express Scripts, which tries to save customers money with its industry-leading generic fill rate, could be part of the solution to rising health-care costs. But then again, wider generic use could simply narrow its cost advantage.
We can all have our opinions on the prognosis for the health-care sector, but these are very complicated issues, so including health-care companies within our circle of competence is another thing entirely.
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, 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 it searches for the stocks that provide upside with a minimum of risk. Like Buffett himself, the team has had some losers along the way, but since the service's inception in 2004, it has beaten the market by an average of 7 percentage points per pick. If you'd like to see the stocks unearthed so far, I invite you to join 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.
Anand Chokkavelu owns shares of Berkshire Hathaway. He enjoyed the Man in the Yellow Hat's book, How to Never Lose Monkey. Berkshire Hathaway, Intel, and UnitedHealth Group are Motley Fool Inside Valuerecommendations. Google is a Motley Fool Rule Breakers pick. Amazon.com, Berkshire Hathaway and UnitedHealth Group are Motley Fool Stock Advisor recommendations. The Fool has created a covered strangle position on Intel. The Fool owns shares of and has written puts on Medtronic. Motley Fool Options has recommended a buy calls position on Intel. The Fool owns shares of Berkshire Hathaway and UnitedHealth Group, and it has a disclosure policy.