Remember Rule #1 – Don’t Lose Money

Sure, none of us want to lose money. That’s no fun! Making money and growing our investments is what we look to do. When you look at the math, its more important than we might think.

The world reknowned super investor Warren Buffet has even been paraphrased as indicating: Rule #1: Never Lose Money. Rule #2: Don’t forget Rule #1.

Sure, we have to take risks at times. It is a part of being an investor, and there is a risk/reward dimension that frames many of our choices with our finances. It even frames choices in our life too. But as a personal investor, its important to manage your portfolio with some simple math in mind.

And it really is quite simple, conceptually.

Here is a classic example:

Scenario 1: You have $100, but lose 10% in year one and gain 10% in year two. This means that after year one you have $90, and after year two you have $99.

Scenario 2: You have $100, but lose 20% in year one and gain 20% in year two. This means that after year one you have $80, and after year two you have $96.

Think about it.

When you look at both Scenario 1 and Scenario 2, its clear that once you lose money from a certain base amount, gaining the same percentage back on the new base won’t get you back to where you originally started. This is where losses in your portfolio – be it equity or real estate – can really wreak havoc with your overall financial situation. It might not be evident a the time, but it puts us behind the 8 ball, so to speak, when we lose money.

To further illustrate this, lets focus again on Scenario 2. With a 20% decline from $100, you’re then at $80. To get back to $100, you need to have a 25% increase in the following year. Again, showing that once you lose a certain percentage of money, you need to increase it at a higher percentage to get back to where you started. This can be  a challenge; a 5 percentage point difference is fairly significant, all things considered.

An additional point to consider when looking at Scenario 1 and Scenario 2: look at where you end up in Scenario 2 vs. the first Scenario. In Scenario 2, since the percentages were higher, you end up at a lower amount after year 2. Thus, the bigger the loss, the harder it is to recover.

The takeaway from this as it applies to our investments is to carefully manage risks. Losing money puts you on a slippery slope when it comes to getting back to your starting point.

A further takeaway from this concept, taking it further, is that money can be hard to come by. Keep your earning power by having marketable skills, and live within your means by embracing sensible frugality. This puts you in a position to recover in other ways if your portfolio takes a hit.

Comments

  1. says

    One thing that has been hard for us is that salaries stay the same (or are reduced), yet expenses like utilities and such are still growing. Employers know there aren’t many jobs out there, so they have ability to not offer raises. It will be interesting to see if people will be changing jobs in droves once the economy recovers.

    However, an area that I have seen as being cheaper is hotel prices. There was an 80 dollar price difference for the same hotel room year-over-year when we went to Washington DC. So, I guess there is a small silver lining in this economy, just not for the hotel industry!

    • thewisesquirrel says

      Everyday Tips – Thanks for the comment. Its become tougher across the board. Many expenses are going up, while things are getting more challenging for a lot of folks in terms of employment, I certainly agree.

      Change does bring some opportunity as well, like those hotel prices you mention. Supply and demand may cause issue in employment/salary, but its good that there are ways we can benefit too!

      Another is home purchasing for first time buyers. Even if home prices aren’t going back up anytime soon, homes can be purchased at a big discount from a few years back. For those that don’t have to sell in order to buy, that’s pretty good.

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