April, 2011

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Our Third Rule of Investing

As many of you may know, Warren Buffet’s first rule of investing is- Don’t lose money! His second rule of investing is- Don’t forget the first rule! This is terrific advice save for one small detail. The detail is that we have never met anyone smart enough to follow these two simple rules. We have never met Mr. Buffet, but we are quite sure that he has not been able to follow these two rules without a few lapses during the past decade.

 

The third rule of investing is really the only one you need because- you can actually follow it!  Lose money as infrequently as possible and limit the amount of each loss!!

This gives you a plan for investing that you can execute (unlike the far more well known edicts of Mr. Buffet). The process needed to follow this rule will be challenging but you can do it. To lose money as infrequently as possible is to only enter into investments which have a reasonable expectation of being profitable. Buying a tech stock in late 1999  with a price-to-earning ratio of 400 was just not a reasonable concept. Could you have doubled your money as the P/E ration zoomed to 800? Of course, but this was not a likely or reasonable outcome. This investment was more likely to lose money than to make money and should have been avoided. If you did foolishly make this trade (an infrequent loss we hope!), what was your process to keep your loss small? If you allowed your tech stock to fall 90% in value (as most investors did!), you clearly had no process in place that was designed to limit the scope of your losses.

 

So, make it a mantra and figure out how you are implementing it-

Lose money as infrequently as possible and limit the amount of each loss!!