Warren Buffett once famously said that his number one rule in investing is to never lose money. And yet, as I had pointed out in a previous blog post, his own company Berkshire Hathaway’s shares had dropped by 50% more than once. How would he reconcile those drops with his number one rule? The answer lies in the way he looks at those drops. To him, those market driven events that makes Berkshire stock price fall sharply are temporary in nature. He doesn’t lose money due to them. Why? Because he wouldn’t sell his stake when the share price falls. At another time, he also said this:
You shouldn’t own common stocks if a 50% decrease in their value in a short period of time would cause you acute distress.
My goal is the same as Buffett’s. I try not to lose money when investing. In that spirit, in this blog post, I will list some ways I could lose money in my investing. And how I try to minimize that risk.
Just as Buffett has taught us, losing money is not the same thing as having investments go down below their costs. So long as those investments eventually recover. We long-term investors don’t lose money because we invest in the stock market. We lose money only when we liquidate our positions below cost. And even then, only when we do it enough times such that our cumulative losses exceed our gains from other profitable investments.
This last point is worth pondering over. Occasional losses don’t matter much. I make mistakes and take loss when I sell a failing position. I don’t feel good when that happens, but I try to keep the bigger picture in mind. Do I have more winners than losers? Do my gains from winners outweigh losses from my mistakes? If yes, then I am on the right track.
Here are some other ways I could lose money:
- I could lose money if I panic and sell out when the stock market is down—thus converting my paper loss into real loss.
This sounds trivial and yet it is by far the most common reason for investors’ underperformance. Dalbar reports that nearly half the underperformance of mutual fund investors comes from their own behavior: panic selling, exuberant buying, and market timing.
As for me, I don’t try to time the market. I also keep myself grounded by reading the stock market history. I prefer to think about my portfolio’s value as a possible range, rather than one single number.
- I could lose money if I over-invest my savings into stocks.
By overinvesting, I mean put too much into stocks in the hopes of making it big. It is especially relevant today since the market has done well in the last decade. Greed and fear of missing out is on people’s minds. What would happen when stocks go down and I need some of my savings back to spend on near-term needs? Nah, I’d rather not be in that situation.
How to avoid overinvesting? I do it by following a portfolio allocation that keep some liquid and otherwise principal-protected positions in it. Today, I have about 12% of my portfolio in these safe investments. See my portfolio update from last month here.
- I could lose money if I buy stocks on margin.
This investor behavior also stems from greed and FOMO. Buying on margin is essentially to take on leverage (in other words, debt) to goose future returns. However, unlike other common debts that individuals take (such as a home mortgage or credit card debt), margin loans can be called early by a stockbroker. When stocks fall—which happens often—my securities would also fall in value and since they’d be the collateral for any margin loan, I’d either have to pump more cash into my brokerage account or sell some stocks to reduce the loan size. Neither action would be desirable for a long-term investor like me.
How do I avoid this risk? Simple, I just never buy stocks with a margin loan. Nor with any other kind of loan. I buy stocks with free and clear cash i.e. my own savings. I am not looking to supercharge my investing returns. I wrote a post two years ago (Don’t be dismissive of low returns) on how 10-15% annual returns could make us lot of money if we are patient and disciplined.
- I could lose money if I ever grow tired of waiting for stocks to recover from a fall.
This could happen in a bear market. Indeed, I know a few fellow investors who did just that during the long drawn out recovery from the 2008 crash. Between 2011 and 2012 as the market staged partial comebacks and drop backs, it tested investors’ patience. By the middle of 2012 as stocks had finally stumbled to a level they were last seen in 2008, some investors were ready to fold. After all, it had taken more than three years to recover from the previous bear market and they weren’t about to risk another.
I study market history. I know how long a typical bear market last. I am prepared mentally for extended downturns. Even when faced with near back-to-back bear markets (2000 and 2008), it was very profitable to hold on to stocks, and, even better, buy more. I did both and came out fine.
Here’s the good news though. All these risks are avoidable and under our control. I can’t lose money if I do either of the following two things:
- I can’t lose if I invest a reasonable portion of my savings in a broad stock market index fund. And stay disciplined and patient throughout the investing period.
History proves it. Consider the chart from this post. Over any ten-year period in the U.S. stock market, an investor got almost no downside (worst-case loss of 1%) with potential upside as high as 19% annualized. Over a twenty-year period, our odds improve even further. Worst-case return since 1950 has been no less than positive 7%, in that case. See my two-decade long investing journey in a 401(K) here.
- I can’t lose if I invest in high-quality businesses that can withstand economic turmoil. These businesses navigate through a recession and come out even stronger on the other side.
This is what I do in my portfolio today. I invest in good businesses and let them compound my savings. I loan my money to people running these businesses. In essence, they work for me. So when they make money, I make money.