Tuesday, September 15, 2009

Never Lose Money

The following is a guest post by Manish Chauhan. Please note that the opinions expressed in this article do not necessarily correspond with those of Barel Karsan.

Manish is the blogger behind Jagoinvestor, a site dedicated to Financial Planning and Money Engineering. In this post, he will talk about an important rule investors in the stock market must remember.

Warren Buffett's Rule

Warren Buffett says there are two rules in stock market:

Rule 1 : Never Lose Money
Rule 2 : Never forget Rule 1


Most investors have heard this and read it numerous times, but have thought "how can one never lose, and how can that be the single most important rule in stock market?"

The real meaning of these two rules lies behind those words and if we dig deep behind them, we will understand the real value of those rules. Let me decode it for you here; read it with full concentration, as these two rules are really worth everything in stock market.

What Warren Buffett really means when he says "Never Lose"


No one in this world can only win, one has to sometimes lose and this is also true in the stock market. No one can ever trade or invest in such a way that he/she never loses. What Warren Buffett actually means by "never lose" is that every time we lose , it has to be an insignificant loss i.e. the quantum of loss has to be so limited or small that it's not going to affect us psychologically. If we make a profit of 100 every time we win, and lose 20 or 30 every time we lose, we are actually not losing if you aggregate the trades.

If you win 100 and lose 20, you are actually winning 40 for every trade in a series of 2 trades. But if you are letting your losses mount and never controlling them, then you are really losing and then those losses can impact you in big way.

What he means when he says "Never Forget Rule Number 1"

By this he wants to emphasise how important controlling losses is. Here's another one liner of his: in the stock market and in life, you don't need to do lot of things right as long as you are not doing lot of things wrong. So as long as you remember that controlling your losses is the most important rule, you otherwise just need to be an average investor and the power of compounding will take care of the rest.

So in the end, I would summarize these rules again and what you should actually read:
Rule 1 : Never Lose Money (Control your losses and cut them soon enough so that you don't feel them)

Rule 2 : Never forget Rule 1 (Controlling your losses is the top priority you should have. The rest will take care of itself.)
Let's look at an example. There are two investors, Ajay and Robert, that both make 1000 trades over the course of their lives: 500 losing trades and 500 winning trades.

Ajay makes a profit of 6% on winning trades and a 3% loss on losing trades. He has $11.9 billion dollars at the end.

On the other hand, Robert concentrates more on controlling his losses. As a result, he is able to control his losses to just 1% per losing trade, and also makes 5% on winning trades . At the end of his career, he would have $25 billion.

Conclusion

It's only controlling losses which made Robert more money than Ajay. Remember this: you need to concentrate on "not messing it up" rather than making it "rock".

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4 comments:

Jonathan Goldberg said...

It really depends on your investment style. One can argue that if you invest like Buffett then you have a very high conviction of the value of every stock you own. If this is the case then short term market fluctuations to the downside should not faze you and you would hold your position. You can learn more about this style of investing on my blog - but last thing you want to do is buy low conviction stocks and sell them on the downside... many small losses only add up to one giant loss.

Manish Chauhan said...

@Jonathan

First I would like to clear that this article scope is limited to "trading" and not "value investing" .. Even thought Warren Buffet is a value investor and not a trader , his ideas can be extended to "trading" , I am a trader my self .

I agree with your points btw, on value investing .

Manish

Sunil said...

Incidentally I started blogging recently and agree that cutting losses is important. You can check out my personal experience on this at www.investologic.wordpress.com.

If we focus on companies that are not running under losses and the PE is not exhorbitantly high, market volatility takes care of the rest. One needs to be disciplined in cutting losses and overall returns will be highly positive even with a 50% success ratio.

bullionsInvestor said...
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