Warren Buffett: “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1”
This is probably the most important rule in investing. But I think it is also misunderstood. The two words that cause confusion are ‘lose‘ and ‘money‘. Here is what I think Buffett really meant with these two words.
‘Money‘ is not the absolute dollar amount. It is the value of your dollars adjusted for their purchasing power over the investment horizon. Buffett explains it beautifully in another place when he says “Unfortunately, earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner. For only gains in purchasing power represent real earnings on investment. If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won’t eat richer“. It is easy to say that this is simply the inflation-adjusted real return but this statement brings about two new problems. First, each person’s inflation rate is different depending on their individual basket of consumption…and this basket can also vary over time. The official rate of inflation (and it doesn’t matter which official authority one uses) may be benchmarked to a different basket of goods. Secondly, as most governments are incentivized to show lower inflation, I will not be surprised at subtle changes in the way official inflation is measured that understates real inflation. I use two heuristics to come up with an acceptable baseline rate of inflation to measure my personal investment performance. First, I use the official US CPI but adjust it up by 4% as some studies have shown that the adjustments to CPI methodologies over time understate the true inflation by 3-4%. Second, I take a minimum rate of 5% as I believe that my expenses are going up by atleast that much every year. So to actually become richer through investing, I need to beat 5% every year at a minimum. This gives me a heuristic of myCPI = min (5%, official US CPI + 4%). At the end of each year, I can use this to benchmark my investment performance. Note that I am better off overestimating my inflation rate than underestimating it. By overestimating it, I will be richer than I think which is not the worst mistake in the world.
‘Lose‘, I think, is also a misunderstood word. If I bought a stock for $100 today and it went down to $95 tomorrow, did I lose $5 on that investment? The correct answer is – not necessarily. The stock price is only relevant if I choose to act on it. If the fundamental value of the company is unchanged, the fluctuation in its stock price is irrelevant. If you have good reason to believe that the stock price is worth much more than $100, then either ignore Mr. Market’s mood swings or use it to your advantage by buying more. However, this is not a justification to naively double down on a losing investment. If you don’t have a good estimation of the company valuation, doubling down on a losing investment is a great way to throw good money after bad. The valuation estimate need not be a point value. If I think a company’s stock is worth somewhere between $120 and $200 and Mr.Market is giving me an opportunity to buy it for $100, even that wide range of estimates is good enough. You also need to have the capability of holding the stock through Mr.Market’s volatile mood swings. If not, you may end up selling up at an inopportune time and crystallizing your losses. Thus ‘lose‘ should be interpreted as a permanent impairment of capital.
So, to sum up, the first and the most important rule of investing can be awkwardly rephrased as ‘don’t impair your purchasing power permanently’. I have to admit that the original phrase sounds much more elegant as long as it is understood correctly.