Monday, June 2, 2014

Buffets first rule and how I apply it to investing

Warren Buffett is famous for saying; "The first rule of investing is don't lose money; the second rule is don't forget Rule No. 1."  It sounds pretty simple but for many individuals it is the number one reason they are not successful in their investing. I have talked with many people and it is not uncommon for them to lament that they have watched stock XYZ go down in price by 90% and yet they do not sell. They tell me that in retrospect they should have sold but that they thought they would wait until the price got back to where they bought it so they could at least get out even. Some people have entire portfolios littered with these type of companies. This answer tells me something about this person and their psychology. First of all they do not understand math nor do they understand themselves. I have a hard and fast rule and that is no matter what if a security I am holding drops by 25% I sell it no questions asked (this applies to investments, speculations are a different animal). Here is the reason; assume I have a stock that I bought for $100 and it drops 25% to $75 dollars. Even though I experienced a 25% drop I now need a 33% gain to get back to even. If the $100 stock dropped to $50 I now need a whopping 100% gain to get back to even and it just gets worse the further it drops. I think the most inexperienced investor would understand that 100% gains are not that common.

Another area I want to touch is psychology. People allow their emotions to get involved in their investment decisions. I can understand this as we are dealing with money. Hopes, dreams, and peoples plans are rolled up in these decisions. It is difficult to admit when we are wrong or when our timing is way off. This can be doubly troubling if we are dealing with retirement money, kids college money, or the down payment for a house. However letting a stock decrease 90% and then not selling in the hopes that it will increase 1000% in order to get back to even is not rational. We do not want to be wrong nor do we want our bad decision to be confirmed by selling the stock for a massive loss. However doing nothing is also a decision and one that will lead to more bad decisions and does nothing to help us get to our financial goals. Here is a good article on prospect theory and why people hold losing positions.

Here is a good rule to follow when investing; never commit more than 5% to any one position. Then limit your loss to 25% no ands, ifs, or buts. If you have a $100,000 portfolio and you risk $5000 on stock XYZ and it immediately declines by 25% sell it. You will have a loss of $1250 or 1.25% of your total capital. Assuming the fundamentals of the company are still good you can always re-enter the position after you have analyzed why it it fell or after the market stabilizes if it is a bear market or crash situation. Believe me I have made the same mistakes and had to learn these lessons the hard way and it cost me a bunch of time and lost opportunity. However it is never to late to change your way of doing things and investing with hard and fast rules will save you grief and make you a better investor.

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