Paul Morigi
Co-authored by Treading Softly
Depending on your walk of life, you may come across different names that epitomize success in their field. A handful will achieve so much success that they become easily recognizable to people who are on the outside. You might not be into sports, maybe you never flipped to ESPN once in your life, but you almost certainly recognize the names: Wayne Gretzky, Michael Jordan, Muhammad Ali, and Serena Williams. I’ve never watched an entire soccer game in my life, but I know of David Beckham.
For many who are outside of the investing sphere, you ask them for the name of a legendary investor, the first name that they’re going to mention is probably Warren Buffett. This is due to not only his great success, but also his influence and impact, which have extended beyond the realm of investing alone. Many novice investors or new retirees taking control of their portfolios will stumble across some of Buffett’s famous rules. These rules originate from an interview where he lists two of his investment rules.
The first rule is: don’t lose money,
The second rule is: don’t forget rule no. 1.
Sadly, so many investors completely misunderstand what these two rules mean, and they miss out on his explanation of them, which continues in the video interview that he did.
When he’s asked about some of the most important characteristics of an investment or portfolio manager, the first thing Buffett tells you is that you don’t have to be smart to be an investor. He says it doesn’t take a great IQ to be a great portfolio manager, which is good because most of us have middle-of-the-road IQs. We all have our strengths and weaknesses. You might be a genius at crafting something with your hands but be flummoxed by spreadsheets. That does not mean that you’re going to be a bad manager of your portfolio.
What he highlights is that it’s more about the emotional stability of the person. They need to be emotionally stable, not one who’s highly reactionary, and who doesn’t rely on the crowd to either love them or hate them to feel successful. They have to have a level of stability to be able to invest in the facts.
Interestingly, Warren Buffett is a man who lost billions upon billions of dollars in the great financial crisis and during the COVID-19 crash. Yet he’s the one who’s out there espousing the rule that you don’t lose money.
Don’t Lose Money
The concept of his first rule applies more to the mindset you make going into an investment than the actual outcome on the other side.
Even though Buffett has been sitting on multibillion-dollar losses at various periods of time, he continues to remind investors that they should never lose money. The idea here is that no investor walks up to their portfolio and their life-long savings, and plans on gambling it away on the market. Yet many investors, as they go along investing, start to lose sight of this goal.
An investor should always do their homework and research and understand the investment that they’re going to make before they make it. The rationale for this is that if the market thinks your investment is of less value than when you bought it, you can still hold it or even add to it. This is exactly what Buffett has done multiple times in the past. His investments during the great financial crisis saw extremely depressed prices, and he was sitting on massive losses, yet he continued to provide capital to banks like Bank of America. So why did he do this? Well, it applies to additional rules that Buffett has espoused over time. Even as he’s added additional layers to his philosophy over the years, his first rule of never lose money applies to a mindset, not to an outcome.
Building From The Foundation
Buffett continued to expand on his ideology by explaining to people that they need to pick businesses and not just random stock tickers. You’re buying into the ownership of a company, and you need to understand what that company does and be able to understand that there’s going to be ups and downs for every single company you own. You’re not just buying vague tickers on a screen. You’re not gambling on which ticker will be popular tomorrow. You’re investing in a business that does something to generate a profit. It either does that well, or it doesn’t, regardless of popular opinion.
Another aspect that he explains is that it’s better to buy a wonderful company at a fair price than a fair company at a wonderful price. What you’re willing to pay does not always equal to what you are receiving. You can buy an overpriced Prada pair of sneakers, or you can buy a New Balance pair of sneakers that have the same internals – you paid a very different price. The value that you received is the same regardless of the price you paid.
Understand that you’re buying companies and not just tickers. You want to buy wonderful companies, ones that have good quality fundamentals, which means that you’re able to accept that the market will not always value those companies efficiently. In 2013, Buffett wrote this in a letter to shareholders, comparing one of his investments in farmland to stocks:
“There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate. It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.”
He went on to write:
“During the extraordinary financial panic that occurred late in 2008, I never gave a thought to selling my farm or New York real estate, even though a severe recession was clearly brewing. And, if I had owned 100% of a solid business with good long-term prospects, it would have been foolish for me to even consider dumping it. So why would I have sold my stocks that were small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they were certain to do well.”
Its price may go up and down, but if you don’t sell when it dips, you’re not losing money. Invest in businesses that you believe are good and will produce good profits, and don’t worry about what prices your neighbors are shouting.
A lot of times, investors start throwing these rules out at a company that has declined in price in a stock market. They sell even if the company remains stable and strong. They’re doing the opposite of what Buffett recommends by throwing out his rule or misapplying it. It’s sad to see. It’s always appropriate to reassess your investments frequently to determine if they are still good companies, but when you conclude that they are, you should be content to hold.
Buffett has explained that his favorite holding time is forever, and you can’t hold forever if you can’t stomach volatility and temporary unrealized losses.
Conclusion
I respect that Buffett doesn’t like to pay a dividend with his company, Berkshire Hathaway. He’s never paid a single one, yet he loves to collect companies that pay dividends. He owns banks, shares of Apple (AAPL), and he owns entire insurance companies that pay profit into his mother ship. He’s like you and me. He likes to get paid, but he doesn’t necessarily like to pay out.
As income investors, we can learn a lot from the philosophy that Buffett espouses. That’s the wonderful thing about Warren Buffett. You do not have to mirror him exactly. You don’t need to move to Omaha. You don’t need to start drinking cherry coke, and you don’t have to buy everything that he buys. Ironically, Warren Buffett doesn’t encourage people to do those behaviors, but what he does encourage them to do is understand that his rules come back to a mindset.
When I developed my Income Method, I was developing a philosophy of how to approach the market, not strict rules on which companies to buy. I looked at and digested Buffett’s rules. His plan that you should never go into the market to lose money, his goal to buy good businesses and not just tickers on a screen, and his favorite holding time should be forever. This means that if you’re going to be holding forever, you have to accept that volatility will come. You will have periods of large unrealized losses and large unrealized gains.
I adapted the base that Buffett espouses to fit my goals. For example, since my goal is to generate income, I demand that every company I invest in pays me. I added some additional portfolio management rules to ensure that I’m taking risks that are acceptable to me – investing in at least 40 different holdings with small allocation sizes. But at its core, I’m buying parts of businesses that I believe are strong and prepared to hold through the noise of the market for as long as the company remains a good business. Most importantly, I approach the market with a plan that will make money in the long run.
When it comes to retirement, you need income. If you want to hold something forever, you can’t be selling pieces of it to pay your living expenses. Instead, you need a portfolio of companies that pay you strong dividends so that way you can hold them forever and continue to be paid for your ownership.
There are many different ways to make the stock market work for you. The important thing is that every investment you make should be made with intention. Whether you are inspired by Buffett’s method or my method, or create one of your own, you should “never lose money” in the same sense that the sports stars above never lost a game. Have a plan you can execute, avoid gambling, and make the market work for you.
