Why is Not Losing Money so Important? (Not the reason you think)

​For anyone who has followed Warren Buffet’s investing philosophy his perhaps most oft quoted statement is:

The first rule of investing is don’t lose money.  The second is never forget rule #1

Since Warren Buffet is based on personal wealth the world’s best investor it might be a good idea to listen to what he has to say, we’ll explore it in detail over several other posts but for now let’s start by asking the question, why is this so important?

Why is it so important not to lose money?

On the surface there are lots of reasons, you’ve worked hard for your money you might as well take advantage of it, losing it would be like going to work for free and there are few people who would want to do that.  But you have to remember Warren Buffet wore shoes with holes in them and declined expensive wine because he’d rather have the money to invest.  In other words he’s coming at it from the perspective of maximizing your investment, which in turn will maximize your ability to live whatever life it is you choose.

So from the perspective of investing why is it so important not to lose money?

To understand the answer to that question we need to do some simple math.  If you lose 10% of your investment, in other words say you had $100k to invest and you lose 10%, you’re now down to $90k, what rate of return do you need to get to bring you back to $100k?  Most people will guess 10%, after all, a 10% gain should cancel out a 10% loss right?  WRONG!

10% of $90k is only $9k, so you’re $1000 short even though you go the same rate of return as you lost (not to mention the lost time where your money could have been earning money for you).  You actually need 11.12% to bring you back up to that $100k mark you started at.

A 10% example isn’t that dramatic after all we can tell ourselves getting an 11.12% return is reasonable.  But let’s look at a 20% loss.  So your $100k is now worth $80k.  What rate of return do you need to get back to where you started?  Answer 25%!  In other words by taking a 20% loss you increased the return you need to get by 25% over and above what you lost to begin with.

What about if we took a 50% loss?  Our $100k invested is now worth $50k?  Here you need to DOUBLE your money just to get back to where you started.

You need a 100% return to recover from a 50% loss!

Keeping in mind Warren Buffet, the world’s best investor averages a 20% return per year how likely is it to recover from a significant loss?  Not very.  Over the last number of years only 0.6% of mutual funds have beat the S&P 500, which from 1950 to 2009 including both dividends and price increases has averaged 11%/yr.  If you could beat the market by enough to recover your lost money wouldn’t you be doing it daily anyway?

In other words the math shows us losses hurt us more than equivalent gains help us.

Bottom line is losing money, especially large amounts, set us back so far that it’s almost impossible to make up the difference.  Don’t lose money!

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