Sunday 15 September 2013

Why Warren Buffet's Rule No. 1 Is Not "Always Make Money"

Everybody knows that Warren Buffet's famous Rule No. 1 is "Never lose money" and Rule No. 2 is "Never forget Rule No. 1". However, why is it that his Rule No. 1 is not "Always make money" but "Never lose money"? By right, if you aim to always make money, won't the outcome be the same as never lose money?

Since Warren Buffet is heavily influenced by the teachings of Benjamin Graham, we have to bring in Benjamin Graham's concept of "margin of safety" (MOS) in this discussion. Imagine that the intrinsic value of a stock is $1, if the stock trades at $0.90, it would have a MOS of 10%.

Let's now consider 2 investors, one who subscribes to "Never Lose Money" (LNM) and another who subscribes to "Always Make Money" (AMM). Other than this investment principle, let's assume that both investors have the same investment characteristics, e.g. same amount of capital, same rules in selling, etc.. Given this investment principle, the AMM investor will always go for an investment so long as it has, say, a 10% MOS. On the other hand, the NLM investor will never go for an investment unless it has say, a 40% MOS. 

In terms of investment opportunities, there will be more investments with 10% MOS compared to those with 40% MOS. The AMM investor will be more busy investing compared to the NLM investor. However, the AMM investor will quickly find that he has a shortage of capital to take advantage of all the investment opportunities (with 10% MOS) while the NLM investor will always have sufficient capital for an investment opportunity (with 40% MOS).

Assuming that the stock realises its potential and rises to its intrinsic value, the AMM investor's profit margin will be 11.1% ($0.90 to $1). On the other hand, the NLM investor's profit margin will be 66.7% ($0.60 to $1). On profit margin alone, one profitable trade of the NLM investor is equivalent to six profitable trades of the AMM investor. If we include trading costs, the difference in profit margins will be even greater. Now, let's not forget that the AMM investor have spread his capital thinly across many investments with 10% MOS while the NLM investor can only concentrate on a few investments with 40% MOS. The capital outlay on the stock by the NLM investor will be several times that of the AMM investor. In total, the NLM investor's absolute profit will be many times that of the AMM investor. Having said that, it should be noted that it will take a much longer time for a stock to rise from $0.60 to $1 than from $0.90 to $1.

Assuming that the stock continues to be undervalued and trades around $0.80, the AMM investor would suffer a loss while the NLM investor would not be invested yet.

Finally, assuming that the stock is a value trap and falls to say, $0.40. The loss margin of the AMM investor will be 55.5% ($0.90 to $0.40) while that of the NLM investor will be 33.3% ($0.60 to $0.40). Factoring the larger capital outlay, the NLM investor would probably lose more money compared to the AMM investor. However, to watch a stock falls from $0.90 to $0.40 will be a much larger psychological blow to the AMM investor. This psychological blow may have a greater impact to the AMM investor's investment philosophy. He might lose patience with the stock and sell it off. More seriously, he might even lose faith with the concept of value investing which has proven to work so many times.

In conclusion, the rule of "Never lose money" will lead to less frequent losses, less frequent but much larger gains, and less emotional distress and more faith with a proven investment philosophy. It's no wonder that Warren Buffet's Rule No. 1 is "Never lose money" and not "Always make money". It's just 3 words, but a lot of intelligence packed into it.

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