One of Warren Buffett’s most famous gospels is: “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”
The gospel has been the subject matter of great debate over the decades. According to some experts, the gospel is false and cannot be practiced in real life.
An expert has argued that Warren Buffett’s rule is wrong. After a detailed discussion, he concludes “It is disingenuous to pretend investors SHOULD not lose money, either temporarily or on individual positions within a portfolio. You WILL lose money. It comes with the territory. The objectives of investing are much more long-term than any individual year that may report a loss. Your objectives should apply to your portfolio total, not just one particular losing position.”
However, another leading expert has argued that the meaning behind those simple looking words is not as obvious as it looks but there is actually complex wisdom behind it. He explains that the essence of the advice is that “wrong entry points can prove costly. One should try and avoid big negatives, because you may end up working your entire life trying to recoup those losses.”
Samir Arora, the whiz-kid fund manager with Helios Capital, manages billions of dollars of investments. When he got stumped about the precise implications of the gospel, he reached out for help. Prof Sanjay Bakshi, the authority on value investing, rushed to counsel him about its true meaning:
— Sanjay Bakshi (@Sanjay__Bakshi) December 12, 2015
The Prof’s explanation is as follows:
“Never Lose Money
Buffett’s often quoted advice is often misunderstood. What does it mean? Here’s what I think it means.
✓ It means don’t get into a situation no matter how high the NPV, if it carries even a minuscule probability of financial ruin.
✓ It means don’t play Russian roulette. Or jump out of planes with parachutes which have a probability of opening up 99% of the time.
✓ It means don’t do trades that will make money most of the time but carry a small chance of blowing you up. Don’t do what LTCM did. Or many other funds which blew up suddenly after delivering excellent returns for a while.
✓ It doesn’t mean being loss averse. It’s perfectly OK to lose all your money in a few investment operations so long as they won’t cause ruin at the portfolio level.
✓ It means be that one should be risk averse (where risk is defined as probability of financial ruin) but not necessarily loss averse.”
It is noteworthy that on an earlier occasion, the Prof has explained the seminal difference between “risk aversion” and “loss aversion”. He explained that while investors should strive to avoid “risk”, they cannot and should not be averse to suffering a “loss” because “gain” and “loss” are an inherent part of investments. In fact, the Prof warned that an aversion towards loss would have the paradoxical effect of turning us into “reckless gamblers“. Even in the present explanation, the Prof has emphasized “It doesn’t mean being loss averse. It’s perfectly OK to lose all your money in a few investment operations so long as they won’t cause ruin at the portfolio level”.
The Prof’s explanation cleared the air for Samir Arora and he gracefully said “Thank You. Totally clear now.“