A while back I clarified what Warren Buffett really meant when he said:
You should invest in a business that even a fool can run, because one day a fool will.
Now, it’s time to clarify another one of his famous, and often misunderstood quotes which goes like this:
There are only two rules in investing. Rule # 1: Never Lose Money. Rule # 2: Never Forget Rule # 1
Here’s what I think Mr. Buffett really means with those words.
- 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 — even when the gun has a million chambers in it with a bullet in just one chamber. 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.
- However, 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.
The thoughts behind this post were triggered because of a tweet by Mr. Samir Arora on twitter for which I thank him.