Warren Buffett’s rules for investing

Warren Buffett has amusingly spelled out his two rules for investing many times in the past:
Rule #1: Don’t lose money
Rule #2: Don’t forget Rule #1

This may seem like a gross oversimplification, but it holds a kernel of truth I believe few grasp.

Those who’ve made a lot of money investing–whether in real estate, equities, bonds, commodities, whatever–have almost always done so because they didn’t lose very often, and when they did it was with small bets.

In my opinion, this stands in stark contrast with the belief that most people hold: that people who make a lot of money investing do it by gambling big and hitting the jackpot. They tend to think that great investors bet the farm on a wild toss of the coin and make out like bandits.

I’m certain some people have gotten rich that way, but they are a very small minority. The vast majority have done it by not losing their shirts on bad gambles.

Not losing money isn’t very sexy. It’s not like buying Cisco and watching it go up by 10 times. It’s the hard work of picking things you’re pretty certain will go up and almost 100% certain will not go down.

Instead of trying to catch shooting stars, not losing means finding a few things that, after a whole lot of research and study, look like they will provide good upside and have an extremely low likelihood of going down much, if at all over the long run.

Why is it that trying to catch shooting stars doesn’t work and not losing does? Because most attempts to catch a shooting star ends with a large if not total loss. Even if you manage to catch a shooting star once, the next time you play you are more likely to lose than win. Over time, this just doesn’t work.

Not losing slowly builds over time into a growing some of money. It doesn’t happen fast. It doesn’t look very sexy. But it works. If you aren’t losing, you just keep building up and up.

That’s what Mr. Buffett is trying to tell you.

Don’t swing from your heels at a wild pitch and hope you connect and knock it out of the park. Instead, wait for a pitch you are almost positive you can hit, and then get a base hit that allows you to move forward in the game. Over time, this will build into a win.

Swinging for the fences will provide a couple of exciting moments, but will lead to loss after loss over time. And, that’s not how to successfully invest.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Academic research on investing isn’t all bad

A great article by James Montier at Dresdner Kleinwort (“Modern Portfolio Practice: A view from the Ivory Tower”) provided some remarkable evidence of what makes for successful investing. The truly amazing thing is that his evidence came from academia, a field that generally insists that no one can beat the market except by luck.

What are the secrets revealed by extensive academic research? Be a stock picker, run a focus fund, do something different, know when to sell, keeps funds small, keep turnover/trading costs low, stick with your principles, and have some skin in the game. Now, I’ll expand on each of these.

Be a stock picker means focus on picking good investments instead of trying to mirror the market over the short term. Most money managers try to hug the market to avoid short term under-performance, but this lack of conviction leads them to always under-perform over the long run. The best investors focus on picking good investments, not on the mirroring the market or indexes.

Run a focus fund means concentrate on your best investing ideas instead of diversifying over too many investments. Too much diversification is a bad thing if you are trying to out-perform the market. Most investors don’t have the conviction or long term time frame to do this.

Do something different means think and act independently. If you’re focusing on what everyone else is doing and paying too much attention to short term results, you will get the same below average results as others. As Sir John Templeton put it succintly, “It is impossible to produce superior performance unless you do something different from the majority.”

Know when to sell means most investors focus too much on buying and not enough on selling. The investors with the best records follow rules for buying and selling and then adhere to that discipline religiously!

Keep funds small highlights the fact that the best money managers manage smaller amounts of money. As Warren Buffett puts it, “Size is the enemy of performance.” The marketing organizations that focus more on getting new clients than getting good returns are not a good deal.

Keep turnover/trading costs low seems simple enough. The average mutual fund manager buys and sells his whole portfolio every year (100% turnover) generating high trading costs and tax issues for taxable accounts. The best money managers trade infrequently to keep costs down and performance up.

Stick with your principles means don’t change your discipline just because it isn’t working right now. Most money managers and investors chase performance. That leads them to sell recent under-performers and buy recent out-performers right when the under-performers start to out-perform and the out-performers begin to under-perform. Sitting tight, even in a strategy that isn’t doing well in the short run, works better than changing discipline every time it’s not “working.”

Have some skin in the game means that managers with their own money at stake get better performance. Always ask a money manager where his money is. If he doesn’t have his own money in the same place he’s recommending you put your money, walk away quickly!

These rules may seem like common sense to you, but you can rest well and follow it more freely now that the rocket scientists in academia have blessed sound advice with their research.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.