Today, I want to zoom in on one of Warren Buffett's most famous quotes:
Rule #1: Don’t lose money.
Rule #2: Never forget rule #1.
Buffett is one of the richest people on Earth and arguably the greatest investor of all time. To me, his importance lies in the wealth of knowledge he’s shared about investing over more than 55 years through his writings and interviews. Below is one of the many stories about him.
When Warren was still just a young boy (11 years old), he bought three shares of Cities Service Preferred stock for himself and his sister Doris. The shares cost $38.25 each at the time. Shortly after his purchase, the stock crashed nearly 30%, dropping to $27 per share.
Every day on the way to school, Doris made sure to rub it in that the value of her stock was falling. Eleven-year-old Warren felt terribly guilty.
Ultimately, the loss turned out to be temporary (and only on paper) because the stock recovered to $40. But Warren still refers to this event as one of the most important lessons of his life.
One of the lessons Cities Service taught him is that when you make a mistake with someone else’s money, chances are they’ll be upset with you. That’s a responsibility Buffett didn’t want to take on until he was confident he could succeed.
Buffett learned this lesson when he was only 11 years old. As the writer of SMART Capital, I completely understand his perspective. You are even more cautious when dealing with someone else’s money.
Unfortunately, this mindset is often absent in today’s financial world. Many advisors and fund managers treat other people’s money as if it were “play money.”
Buffett is the complete opposite. He treats other people’s money the same way he treats his own and has always remained conservative in his approach. Investing is a marathon, not a sprint, and once you start losing money, you’ll never make it to the finish line.
Besides having a strong emotional aversion to losing money (whether my own or others’), there’s also a cold, hard mathematical reality we always need to keep in mind.
If you lose 50% on a stock, that stock needs to double in value just to get back to where you started. That’s a steep hole to climb out of. So, be extra cautious.
To make this clear, I’ve included a table showing how much a stock must rise to recover from a loss:
A 100% loss is something you can never recover from! So, don’t think, “Oh well, the loss is already so big, I’ll just let it sit.” Recover—even small amounts—because it’s better late than never.
Everyone knows the basic rule of investing: buy low, sell high. But often, people do the opposite. No one sets out with the intention of losing money, of course. Humans are naturally risk-averse. Yet, too often, we’re guided by our biases and emotions, and the things we end up doing contradict our intentions.
In short, never forget Warren Buffett’s rules. And if you find yourself facing a loss that seems permanent, make sure to cut your losses in time—because the longer you wait, the harder it will be to recover.
What’s important here is “permanent loss.” Price fluctuations in themselves are not a big deal, but if the company is structurally worse off and genuinely losing value, that’s what we call a permanent loss. You need to accept that loss as quickly as possible.