When one of the most successful investors in the world has a piece of investment advice, everyone should take note. Warren Buffet has given two simple rules for successful investing that you’ll want to follow if you’re hoping to achieve above average returns. This article will explore those rules and what exactly they mean.
Warren buffet is one of the most successful investors in the world. He is currently the third richest person on the planet with an estimated net worth of $100.3 billion (as of 2021). That figure could grow substantially with any new investments he makes, as it tends to do year after year.
If you want to invest like Warren Buffet (and who doesn’t), he famously said that he has two rules he follows for maximizing returns.
Warren Buffet’s two rules for investing:
1. Never lose money.
2. Never forget rule #1.
That sounds simple enough, right? Just don’t lose money. unfortunately, that’s much easier said than done. Most investors are subject to directional market forces that can cause downturns just as easily as growth. Warren Buffet has a great point with these two rules though. If you can simply insulate yourself from losses, you’ll significantly outperform the market. That’s something that, for the most part, Mr. Buffet has managed to do, so let’s explore how.
If you’re not yet convinced about the necessity of avoiding losses, take a look at the chart below.
The chart is pretty simple, but the implications are staggering. If you lose 25% of portfolio value, you’ll need a 33% gain just to get back to even! Consider the possibility of larger losses – a 75% loss in value takes a whopping 300% gain to recover from. That’s extremely difficult to achieve, so many investors will lose money.
So, how do you minimize downside risk in investments?
There are a handful of things that investors can do to avoid losses and mitigate downside risk.
1. Beware of a market that looks like it’s in a bubble.
If it looks like a bubble and acts like a bubble, it’s probably a bubble. Bubbles are the term for inflated asset values beyond what can be deemed rational. For example the housing market in 2008 was insanely hot, and people started speculating that housing prices were inflated. However, almost no one actually beleived that housing prices could suffer massive drops in value as housing had always traditionally appreciated. Indeed, history has shown that this was a bubble that was driven by irresponsible lending practices. Too much availability of capital drove a massive increase in demand, which in turn caused prices to significantly increase. When the capital availability dried up, and the extremely low amount of equity that many people had in their homes was exposed, the bubble popped and home prices took a massive hit. This looks obvious in hindsight, but some of the best investors in the world lost billions in this catastrophe.
It can take massive willpower to avoid a hot market when others are making huge gains. However, when a bubble pops, you can be left holding the bag as investors flee from the asset. You should always assume that you’re at an information disadvantage and trade conservatively as a result. It’s almost impossible to account for all the ways that another investor could have more information about the value of an asset, so it’s best to rely on fundamentals and trade in assets that have clear, defensible value. If you see a massive inflation of value over a short amount of time, be very weary as you consider whether to invest.
2. Don’t assume that the market has done your due diligence for you.
Economists love to talk about market dynamics as if they’re perfectly explainable. That’s not true today, and never has been in the past. If it were, economists would be the richest people in the world, and they’re clearly not. When evaluating an investment, you must do your own due diligence. The market is very imperfect at pricing risk, and often misses the full extent of potential upside. When looking at an asset, consider the short and long term risks and opportunities relative to your investment time horizon. Consider how much you’re willing to lose, and what you stand to gain.
Almost every trader who pics stocks loses money over time. That’s true of even some of the best hedge fund managers, and stock brokers. The stock market has historically been a shallow slope up and to the right. That’s also true of housing prices, and some other assets. Cryptocurrency is young, but it has been steeply up and to the right, with the exception of a few notable market corrections. If you’re investing in fundamentals with a clear time horizon in mind, you’re less likely to get caught up in the short term gains and losses that drive virtually 100% of day traders to lose money. 3. Choose essentials over speculative technology.
While Warren Buffet has been broadly derided for his extremely cautious and conservative investment style, no one can argue that it hasn’t worked. He consistently chooses companies that are stable, predictable, and that have quiet, capable leaders. That means that he has missed out on huge technology successes like Tesla, and Facebook. However, it also means that he’s avoided the massive losses that some speculative technology businesses have suffered. So, this plays directly into Warren Buffets rule number 1 – never lose money.
Mr. Buffet has chosen to invest in Coca Cola, railroads, oil companies, and cell phone providers. These are ultra-stable, predictable companies that had solid growth ahead when he invested. These simple (and boring) bets have yielded billions in profits for both the companies, and Berkshire Hathaway. While some may think these investments are boring, you can’t argue with results. The stocks that everyone will use year after year, are attractive therefore.
4. Buy companies you believe in, even if the market doesn’t.
This is something that Warren Buffet has managed to do consistently. He’s a value investor – that is, he buys companies that have intrinsic, rather than speculative value. The stocks have significant revenue and are trading at reasonable valuations. Mr. Buffet once said “It’s Far Better to Buy a Wonderful Company at a Fair Price Than a Fair Company at a Wonderful Price.” So, look for the wonderful company and make sure you’re paying a fair price. Bargain hunting can get you into trouble as you invest in lower quality companies with shakier foundations.
5. Let your winners ride.
It can be extremely tempting to cash in on gains after a stock moves higher. History has shown though, that its a much better idea to let your winners ride. The phenomenon you’re observing as a stock increases, is the market realizing that the company is a winner, just like you did. If the stock price has gone up then, and you still believe in the company and it’s products, why would you exit? Warren Buffet famously stated: “Our Favorite Holding Period Is Forever.” He’s investing in companies that he beleives in for the extremely long term, and he’s enjoying the fruits of that appreciation long after most would have gotten greedy and realized their gains by selling the stock.
Ask any investor and they’ll tell you that as they’ve matured, they’ve learned to let their winners ride.
10 Facts about Warren Buffet that you need to know:
- Warren Buffet is one of the most successful investors in the world. He has a net worth of approximately $100.3 billion as of 2021.
- Berkshire Hathaway started as two separate cotton mills in the 19th century. Warren Buffet purchased the combined (and struggling) company in 1965.
- Warren Buffet lives in a very modest home in Omaha, Nebraska. It’s worth about $250,000 today, and he purchased it in 1958 for $31,500.
- Berkshire Hathaway has only paid a dividend once in its history. In 1967, they paid a dividend equal to 10 cents per share. Instead, Berkshire Hathaway prefers to reinvest their profits.
- Warren Buffet is one of the only people in the world that has a McDonalds Gold Card. This card entitles Mr. Buffet to free meals for life at McDonalds restaurants.
- Warren Buffet eats extremely poorly. Perhaps as evidenced by his McDonalds Gold card, he frequents fast food restaurants, eats junk food regularly, and drinks multiple cans of Coca Cola every day.
- Mr. Buffet has pledged to give away 99% of his wealth. He’s made massive philanthropic gifts to charities such as the Bill and Melinda Gates Foundation.
- Warren Buffet spends 80% of his days reading, and has been known to get through 600 to 1000 pages per day. He considers his job to be accumulating information and then trying to figure out if there’s anything to act on as a result.
- Warren Buffet’s first job was delivering newspapers for the Washington Post. He estimates that he delivered 500,000 newspapers as a child.
- Berkshire Hathaway shares have increased in value by more than 2.7 million percent from 1965 to 2019. That’s a compounded annual gain of 20.3%.