The First & Most Important Rule of Investing
The first rule of investment is to not lose money. Here are 3 connected ideas to understand the rule thoroughly.
In this lesson, we will look at the single most important rule when it comes to Investing as well as Trading.
“The first rule of investment is don’t lose money. And the second rule of investment is don’t forget the first rule. And that’s all the rules there are.” - Warren Buffett
The above quote by Mr. Buffett might look simple and obvious. Of course, no one wants to lose money. But, why is Mr.Buffett stating the obvious? It is important to dig deeper.
If you look at the statement very closely, Mr Buffet did not say “The first rule of investment is to make money”. He said, “Don’t lose money”. There is a big difference. He emphasizes focusing more on the downside rather than the upside.
When I started investing and trading in 2011, I focused more on how much return (upside) I could make on an investment/trade rather than the possible loss that could follow (downside). It took many years for me to realize that to make more money it is more important to focus on the downside. Not just that. The ability to understand, quantify and manage the downside not only keeps you in the game but also puts you in an advantageous position over time.
Mr. Buffet’s statement conveys 3 key ideas through the first rule - “Don’t lose money”.
If you lose your capital, you are out of the game. Survive first.
Losses and Gains are Asymmetrical.
Losses hurt & interrupt Compounding.
If you understand the 3 key ideas above, you will save yourself a lot of time and money. Let us understand these ideas in greater detail.
1. Survive First
"To succeed you must first survive." - Warren Buffett
“I learned that if I can simply survive in the market, just like surviving in the war, and not lose money, eventually I will make something.” Walter Schloss
“Our job is to survive.” Jim Simons
So, What should you do to survive?
Control Risk & Preserve Capital.
What is Risk?
Risk is permanent loss of capital or purchasing power.
Risk is not knowing what you are doing.
Risk is not having a plan and being under-prepared.
We can control and minimize risk as much as we can but it is not possible to eliminate risk. There are certain risks that we cannot foresee. We will cover more on Risk and Control mechanisms in a separate lesson.
2. Losses and Gains are Asymmetrical
This is a case of simple math that is often overlooked. Let me ask you a question.
If you lose 50% on an investment, you need to find another investment that could return 100% to get back your initial capital. If you lose 60% it gets even more difficult. The more you lose, the more difficult it is to get back what you lost. That is illustrated by the chart below.
Here is a take on this key idea by some great Investors.
“I think it’s more important to avoid losers than it is to pick winners. I think that if you look at what happens when you lose a great deal of your capital, making it back in terms of compounding is difficult. It’s the oldest story in the world. If you lose 50% on an investment you need to make 100% on the next one to get back to breakeven, and that’s a difficult equation.” - Terry Smith
“A key investment principle is that big losses are not compensated for by big gains, so they should just be avoided at all costs. For example, if I have alternating gains and losses of 50%, I will lose a lot of money, because a 50% loss will require a 100% gain to recover from.” - Ray Dalio
“If we as investors fixate and overdose on downside protection, the upside, in many cases, takes care of itself. If you can put floors on the downside, then you’ve got a huge advantage.” Mohnish Pabrai
3. Losses hurt and interrupt Compounding
To illustrate the 3rd key idea, let us take the example of two Investors, Ram and Shyam. Ram invests in Fixed Income Instruments/Fixed Deposits and is happy with a fixed return of 8% every year. Shyam is doing active investing and was able to beat the returns of Ram in the first 9 years by 2% points. But in the 10th year, Shyam faces a loss of 9%.
Assume both of them started with the same capital on the same day. Can you guess who made more money at the end of Year 10? Please select an option below.
Here is the result.
Consistent Ram has performed slightly better than Shyam. This shows that the room for error is less. Just one year of negative returns is enough to bring Shyam down relatively. Ram has increased his capital by 2.2 times whereas Shyam has increased it by 2.1 times. Ram has made slightly more money with significantly less time and effort. The consistency of 8% compounded returns of a Fixed Income/Fixed Deposit Investor is highly underrated.
If you are managing your investments, you need to always keep the following statement in mind.
"The number one job of the money manager is not to make a lot of money, it's not to beat the market, it's not to be in the top quartile, the number one job is not to lose money, and it's to control risk." - Howard Marks
I hope I have been able to provide a context to “Don’t Lose Money” which is Rule 1 and the 3 key ideas connected to it. There are other rules, principles and models that you need to keep in mind while playing the game. We will explore them as we progress.
Let us close this lesson with one of my favourite quotes from the movie Rocky. It kind of summarises this topic.