Warren Buffett’s Top 2 Rules of Investing

 
 

Warren Buffet, the “Oracle of Omaha’s” most famous words have been repeated over and over by many wannabe astute investors.

Rule No.1: Never lose money.

Rule No.2: Never forget rule No.1.

Many investors and even wealth managers seem very confused by these words. Too many investors think that a drop in the value of an investment means they’ve lost money and they are breaching the Oracle’s rules. Technically it does, but that isn’t the intent of the infamous quote.

Two Questions

What Buffett is famous for is a compound annual rate of return over the past 50 odd years of about 20% and making mountains of money for long-term shareholders. Two questions for you: do you want those returns, and do you have the courage it takes to get them? There is a bit of baggage that comes along with those returns, they are not a free ride. The baggage is RISK. Crazy you say. How could anything that has generated about 20% a year for 50 plus years be risky?

The reality is that Berkshire Hathaway stock (BRK.A) has had multiple 20+ percent drops in value from one calendar year to the next. The worst was in 1974, falling 48.7%. In the global financial crisis of 2008, BRK.A dropped 31.8%. In fact, about 22% of the time BRK.A has a losing year. Tell someone when their investment loses 20 plus percent that they don’t have a risky investment.

Bad Investor?

Ironically, there will be lots of investors who have lost money with Mr. Buffett. Does that make him a bad investor? The facts are irrefutable that it doesn’t. What it speaks to is fear and greed and how we deal with risk and the variability of returns as humans. Many will be lured in by any number of investments that have a great long-term history of performance, then be freighted beyond their limits when the first storm clouds show up.

This isn’t to mock investors who can’t live with the reality that it ALWAYS takes some level of risk to generate greater than average returns. I personally think a lot of fault lies with the investment industry. The race to attract your dollars needs to have a pitch. And the best pitch scares the you-know-what out of you so you take action.

Risk Profiling

A risk profile analysis is often used in the financial industry for theoretically determining how you should invest, and then directing you to a suitable strategy that matches your risk profile. Many of these profiling questionnaires ask how much you would be prepared to lose to potentially generate a higher return. The wording is much like Buffet’s #1 Rule. We can easily read into the question and Buffet’s rule, don’t lose money. Buffet knows that you lose money when you lock in the losses by selling. But this is not what his rule states, nor is this what the risk profiling is telling you. The risk profiling is not there to educate you, but to determine your state of mind at the time you fill it out. It assumes or really doesn’t care about your level of understanding of what it takes to help you succeed financially. Why would it do this you ask?

If a firm gets you to answer a series of yes or no answers it is protecting itself. If you are profiled as a conservative investor and are ultimately unhappy with the lack of performance, then you have no one to blame but yourself. It is far easier to let you pigeon hole yourself as an investor than to actually educate you. Plus, it is an excuse to put you in a “Managed” product that could have higher fees associated with it. There are also some pluses I’m told, I’m still looking for them.

Risk and Return

Clearly staying the course with Buffet has made many people very wealthy, even after losses close to 50%. Imagine the success investors would have if they were taught how to truly evaluate risk and return? Where they could appreciate the ultimate value in staying the course and making intelligent vs. emotional decisions about very successful investment strategies. Don’t think for a minute I’m advocating throwing caution to the wind and going crazy buying random high-risk investments. I’m talking about following proven strategies that have prospered repeatedly even after taking arguably severe beatings.   

I do my best to educate both myself and investors to understand that the real risk with investing can be avoiding risk. Ask yourself why GICs are so popular with everyday folks, even though for many the returns, net of inflation is negative? For some reason, it is ok to take this risk on, and ensuring you have to save more and for longer to meet your goals? But heaven forbid we understand the true risks when it comes to investing. 

I agree 100% with Buffett, but not in the way far too many misinterpret him. Wealth management is often described to me by sales agents in the financial industry as “we are here to protect your wealth, not grow it.” I read this as more of an excuse to keep people ignorant of the facts. 

A great read is Buffett’s biography, but for a quick primer on Buffet check out this link. Oh, and when I looked at the holdings in BRK.A, there were no GICs.