Saturday, August 8, 2009

Buffet's Two Rules of Investing

Once we understand how to think about the market using Ben Graham's Mr. Market analogy, the next important lesson, I believe, is to remember Warren Buffet's two rules of investing.
1) Never lose money.
2) Do not forget the first rule.

To appreciate these rules better, I am quoting from Chapter 5 of the book "Margin Of Safety". This book is rare and out-of-print. It is written by another legendary value investor, Seth Klarman. So here is what is says:

Avoiding loss should be the the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather "don't lose money" means that over several years an investment portfolio should not be exposed to appreciable loss of capital.

While no one wishes to incur losses, you couldn't prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of free lunch can be compelling, especially when others have already seemingly partaken. It can be hard to concentrate on losses when others are greedily reaching for gains and your broker is on the phone offering shares in the latest "hot" initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome.

Greedy, short-term oriented investors may lose sight of a sound mathematical reason for avoiding loss: the effects of compounding even moderate returns over many years are compelling, if not downright mind boggling. Table below shows the delightful effects of compounding even small amounts. Shown below is the compounded value of $1000 invested at different rates or return and for varying durations.

Rate5 years10 years20 years30 years

As the table illustrates, perserverance at even relatively moderate rates of return is of utmost importance in compounding your net worth. A corollary to the importance of compounding is that it is very difficult to recover from even one large loss which could literally destroy all at once the beneficial effects of many years of investment success. In other words, an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains with considerable risk of principal. An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.

There is an understandable, albeit uneconomic, appeal to the latter pattern of returns, however. The second investor will outperform the former nine years out of ten, gaining considerable psychic income from this apparently superior performance. If both investors are money management professionals, the latter may also have a happier clientele (90 percent of the time, they will be doing better) and thus a more successful company. This may help to explain why risk avoidance (and hence value investing) is not the primary focus of most institutional investors.

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