Investing isn’t a precise science, it’s an unpredictable art, which means that sometimes we’ll have to deal with losses in our investment portfolio.
Even the world’s best investor, Warren Buffett, has made many mistakes over his career amounting to hundreds of millions in losses (although no single loss has even exceeded 1% of his investors’ capital).
Losing money is just part of investing. Your primary goal should ensure that when you do lose money, it doesn’t ruin years of hard work overnight. Here’s a few tips to help you avoid these catastrophic losses.
1. Skin in the game
I’ll only invest in companies where management has a significant stake. I believe this helps me avoid the worst corporate disasters because managers with money on the line are less likely to make serious costly mistakes that affect shareholders. Owner-operators are motivated to produce the best outcomes for investors.
2. Cash is king
In business, cash is king, and a company with lots of it and little debt is unlikely to go bankrupt. Unlike profit, which can be manipulated by management to present the best possible view of a firm’s finances, cash flow is harder to adjust favourably — it presents a more realistic view of a company’s finances.
3. Invest don’t speculate
My third tip is to invest and don’t speculate. Speculating is buying an asset because you believe its price will go up while investing is buying a stream of cash flows from an asset. Unlike investing, being a successful speculator involves a lot of luck, which is why speculating is often described as being a form of gambling.
4. Do your research
The most common reason why investors lose money is that they buy something they don’t understand.
Research is a critical part of the investment process, and it shouldn’t be overlooked. One of the reasons why Warren Buffett has been so successful is because of his rigorous due diligence process (when deciding when to buy Coca-Cola he reportedly read 100 years of the firm’s annual reports).
By spending so much time trying to understand each business he buys, Buffett can sleep easy knowing that he’s not going to wake up to any sudden surprises. If you want to want to avoid negative surprises as well, it might be best to follow his lead.
5. Invest for the long term
My fifth and final tip to avert catastrophic investment losses is to invest for the long term.
Trying to predict what stock prices will do in the short term is impossible. In fact, studies have shown that in the short term (up to five years) there’s a 50/50 chance stock prices will either be higher or lower (akin to flipping a coin).
However, over 10 or 20 years, the risk of loss rapidly deteriorates. According to my Foolish US colleagues, the risk of losing money in the market drops to just 12% after 10 years, and 0% after 20 years. This is the best evidence I’ve seen that shows investing for the long term is the best way to protect yourself against losing money in the stock market.
