"Rule No. 1: Never Lose Money. Rule No. 2: Never Forget Rule No. 1."
Perhaps Warren Buffett (Trades, Portfolio)’s most famous saying is the one regarding never lose money. It is so widely quoted that I think it’s safe to say every single value investor knows it by heart. However, as a practical matter, we are faced with the dilemma that the only sure way that an investor can strictly follow Rule No.1 and Rule No.2 is to never invest in anything. Given the circumstances, should we disregard Mr. Buffett’s rules then? Or should we construe it another way?
Like many other famous quotes from Mr. Buffett, this one requires some further processing. Different investors may interpret this quote differently, but my interpretation is something like this – Rule No.1: Always remember margin of safety, which means you should at least pay as much attention, if not more, to the downside as to the upside. Said differently, take care of the downside, and the upside will take care of itself.
You may immediately realize that my interpretation is not perfect, and it is also obvious. But I believe, in practice, discipline is often lost in hindsight as most investment theses are focused on the upside. Mr.Buffett is simply reminding us to act rational when our brains release a good amount of dopamine when we think about potential gains, even though they may end up being mirages.
Let’s take a look at Mr.Buffett’s investment history to get a further understanding. First of all, Mr. Buffett never stopped investing in order not to lose money so we know he is not talking about not losing money from inactivity. Secondly, he has lost money in the past and in the present (a current example involves Tesco). Does this mean he doesn’t even follow his own rules? Therefore, Mr.Buffett is not saying that we will never lose money if we follow the rules. Neither is he saying that we should simply stop investing in order not to lose money.
Again, let’s take another step back and think about how Mr. Buffett practiced this Rule No.1. For example, both Coca-Cola (KO, Financial) and Heinz were wonderful businesses for more than 100 years before he pulled the trigger, and I would bet a lot of money that, during the time when those two great companies are publicly traded, there are many times when you can buy them at fair prices. Similar conclusion can be made to his purchase of American Express (AXP, Financial) and Walt Disney Company (DIS, Financial). Also Walter Schloss once told the story of how Mr.Buffett bought the shares of American Broadcasting Company. The link is here.
My speculation based on my observation is the following –Â the way Mr. Buffett practiced Rule No. 1 is by buying businesses at the worst-case price, which often coincides with a temporary catastrophic event. In theory, this makes perfect sense because theoretically if the lowest possible price for something is 50 cents, and you bought it for 50 cents or lower, you should never lose money. In practice, you could be wrong in whether 50 cents is the true worst case or not, and this is especially so in cigar butts. With quality business with decent predictability, the 50 cents is more certain. My guess is that Mr.Buffett has calculated the worst case for a reservoir of great businesses and in the infrequent cases where a great business actually hits the worst case, he is ready to react. By buying businesses at the worst case price and staying inactive during the rest of the time, Mr. Buffett has minimized his chance of losing real money.
Of course there are times when Mr. Buffett paid more than the worst case of great businesses, but I would bet most of the best 10 or 20 investments of his investment career are buying businesses at close to worst-case prices. And this, to me, is the real implication of Rule No.1.
