Buffett’s Only Two Rules For Investing…

Printer Friendly Printer Friendly April 8, 2020
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1”

– Warren Buffett

When I first started driving, my mom and dad would always remind me not to drive too fast. They would always tell me that the traveling time is not much different when driving 55-70 mph and that speeding up really is not worth it especially if an accident happens.

Now that I am older and a bit wiser, I realized my parent’s advice is also applicable when it comes to trading. In the long run, it is not in our best interest take short-term risky trades especially for stocks that we are not interested in owning 5-10+ years from now.

Why might you ask?

  • Making risky investments can create stress. So much that it may physically affect us. We may lose sleep, not eat, be in a bad mood or depressed, etc.
  • We may make great returns but at the same time, when we make mistakes, the stakes can equally be as high. Many of us know that the feeling of making great returns doesn’t compare to the same feeling when you lose the same amount.
  • Investing is something that we are doing for the long-term. History has repeatedly shown us that no matter which technique is used, in the end, the compounded return is around 20% per year. Thus, making quick money with high risks vs. investing carefully, in the long, run will generate you similar results (and save on trading commissions).

I have created a downloadable excel sheet with the results displayed below to illustrate why making only a few big losses might actually significantly decrease returns. Below are three hypothetical situations here:

1) A low-risk investment strategy generating 20% per year will take your $1,000 of seed capital and grow it to $38,3337.60 after 20 years.

2) A moderate-risk investment strategy will return 30% per year. However, there will be losing years. I modeled for a 15% loss every 4 years (3 years profit and the 4th year will be at a loss). Starting with $1,000 with turn to $22,711.45 in 20 years.

3) A high-risk investment strategy will generate 50% profit each time of profit however it will also make a 50% loss. I modeled for a 50% loss every 4 years (3 years profit and the 4th year will be at a loss). Starting with $1,000 with turn to $13,684.18 in 20 years.

Year 20% Return
Low Risk
30% Return
Moderate Risk
50% Return
High Risk
0 $1,000.00 $1,000.00 $1,000.00
1 $1,200.00 $1,300.00 $1,500.00
2 $1,440.00 $1,690.00 $2,250.00
3 $1,728.00 $2,197.00 $3,375.00
4 $2,073.60 $1,867.45 $1,687.50
5 $2,488.32 $2,427.69 $2,531.25
6 $2,985.98 $3,155.99 $3,796.88
7 $3,583.18 $4,102.79 $5,695.31
8 $4,299.82 $3,487.37 $2,847.66
9 $5,159.78 $4,533.58 $4,271.48
10 $6,191.74 $5,893.65 $6,407.23
11 $7,430.08 $7,661.75 $9,610.84
12 $8,916.10 $6,512.49 $4,805.42
13 $10,699.32 $8,466.23 $7,208.13
14 $12,839.18 $11,006.11 $10,812.19
15 $15,407.02 $14,307.94 $16,218.29
16 $18,488.43 $12,161.75 $8,109.15
17 $22,186.11 $15,810.27 $12,163.72
18 $26,623.33 $20,553.35 $18,245.58
19 $31,948.00 $26,719.36 $27,368.37
20 $38,337.60 $22,711.45 $13,684.18

As the table depicts that even though a high-return investment strategy yields amazing results it is also a double edge sword, every time you take a loss, it is also equally significant. In the long run, the strategy that generates the least return provides better results with much less stress, time spent on trading, and commissions.

This article sums up the simple investment rules that Warren Buffett suggests: “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1” – Warren Buffett

If we don’t take big losses, then we will be able to make consistent compounded returns and accomplish our investment goals.




Comments

Nice article. However, very hypothetical in nature. How can we make an annual 20% return? Buffet’s mentor Benjamin Graham said that an 8% YoY market return is expected. Therefore, shouldn’t we expect more like 15% at most?

This analysis is somewhat silly.
A 20% return is outstanding, but more importantly the 2 other methods describe also yield a very good return:
30% IRR = 16.9% which is better than 99% of money managers
50% IRR = 14% which is better than, well most money managers by far.

You would be trouncing the S&P500 with ease.

Bottom line: if you can make 30%, 50% and take the losses as describe (sleep ok, etc), then definitely go for those methods!!! You would be considered a star in any rankings, and be a rich person too.

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