Never Lose Money – The Everlasting Truth about Investing
Warren Buffet, one of the most successful investors in history, has two very simple rules about investing:
- Never lose money.
- Never forget rule number one.
It probably isn’t quite that simple, but Buffet’s advice is very important to follow. One of the key things to know about investing is the downside of wherever you are considering placing your money. A clear understanding of the risks is much more important than knowing the potential gain. To have an idea of how important Buffet’s rules are, take for example a company with a stock price at $100/share, say the price drops to $50/share, it loses $50/share or 50% of its original price. Now in order to get back to $100/share, it would need to make a 100% gain on the current price of $50/share. So clearly it would need a lot more effort to recover.
With that said, every time you invest, it is important to know the margin of safety of the potential investment. The margin of safety is a key concept of Benjamin Graham’s value investing philosophy. It is defined as the difference between the intrinsic value of a company and its current share price. Basically, what you are doing is comparing the current price of a company to the present value of the sum of future profits earned by a company during its lifetime. The larger the spread between the two, the more margin of safety you have, or in other words, the more cushion you have to absorb the risk of a potential investment.
Having a margin of safety does two very important things for investors. First, buying at a discount preserves the principal. Essentially, if you are paying less for something that is worth more in value, you are reducing the risk that the amount of value received will fall below invested capital. Second, margin of safety reduces risk while at the same time maximizing reward. At first glance, this is contrary to the modern portfolio theory which centers around the idea of risk/return trade-off. But consider this: if you are paying $50 for something that is worth $100, your potential return is $50, now for the same item that is worth $100, and this time you pay only $40, your potential return is now $60. In other words, you are risking less for a higher return.
To put it together, if an investor consistently does a great amount of research to thoroughly understand the potential risks surrounding investments and rigorously follows the principals of value investing by getting large margins of safety and preserving capital, over time, the portfolio will generate a considerable return thanks to the power of compounding.
Finally, keep in mind that when you are not finding any opportunities that appeal to you, keep your money parked in cash and wait for an opportunity to come up is always a safe bet.
If you need help deciding which investments are the best choices for you, KCH can help. Do not hesitate to contact our office at 973-586-2360 or email us (firstname.lastname@example.org) should you have further questions or to set up a consultation.