Saturday, October 14, 2006
Fundamental law in investing
The Buffettians among us will instantly recognize these rules. Firstly, never lose money. Secondly, never forget rule one.
So why has he been able to say "never lose money" with such a straight face? Is it because his winners have so substantially outstripped his losers? Is it just to boast his ego? None of those.What he is talking about is a state of mind. This is a guy who is a billionaire many times over, and yet if he were to see a nickel in a parking lot he'd bend over and pick it up.
Let's say that Warren Buffett picked up a nickel and invested it in Berkshire Hathaway when he took it over in 1965. Today, that nickel would be worth more than $130. How many nickels would it take to pick up and put to work for you before that particular payoff got to be really enticing? This is why those folks who pooh-pooh Buffett's unbelievable investing record are just wrong, wrong, wrong when they say, "Well, Buffett has access to all this inside information." In 1965, no one gave a damn who he was, he was juat plain Warren Buffett, unknown Midwestern investor, long before he was "WARREN BUFFETT, ORACLE OF OMAHA." And before he became known as a superinvestor, he had to, well, superinvest, by turning nickels into dollars many times over.
"Never lose money" is simply a philosophy for investing. It means something simple: There's no such thing as "play money." You don't go out and speculate on a total flyer. You remain disciplined, whether your account is up or down. No casino-like attitude. There's no such thing as the house's money. It's ALL your money, and it's all to be protected.
Think of an investing dollar this way: If you are 30, and you have an investing dollar and throw it away, you're not only losing the dollar, but you are permanently destroying all of its future value to you. True, you're not Warren Buffett -- each nickel becoming $130 over 40 years is, for most people, extremely unlikely. But it is likely it can become $50 or $20 some 40 years later. When you destroy, thrown away or spend a dollar today, you are also destroying all the future cash flow or intrinsic value that the dollar can produce.
So that means take no risks, right? Not in the slightest. In 2004, Pepsico offered a contestant the chance to win a billion dollars. The odds were fairly slim, but the game wasn't rigged. There was a non-zero chance that Pepsi would have to pay a billion dollars to some extraordinarily lucky contestant. So Pepsi did the reasonable thing: It insured itself against the loss, and the company that carried that insurance was Berkshire Hathaway. Berkshire took the risk for two reasons: First, it could afford to make the payout, and second, the amount Pepsico paid for the insurance was well in excess of the expected payout beforehand. It works like this: chance of paying out is, say 1 in 10,000. So the value of that chance, pre-event, is $1 billion divided by 10,000, or $100,000. So if Berkshire charged Pepsi $300,000 for the insurance, then the net expected gain to Berkshire was $200,000.
It is also important to know where are the risks the company you hold. Don't put yourself at risk of losing money needlessly by failing to have some idea of this for every company you own. If you do not, your investing results will be based largely on blind luck. And sometimes blind luck isn't very lucky at all.