I’ve a confession to make. I’ve never really been a fan of super-investor Warren Buffett’s two rules.
You know the ones to which I’m referring, of course. Rule #1: never lose money. Rule #2: never forget Rule #1.
Oh, I applaud the sentiment, alright. It’s just that I’m not a fan of the way that it’s expressed. You can’t ‘never lose money’. Sometimes shares head south for totally unforeseen reasons — natural disasters on the other side of the world, wars, or financial meltdowns.
In short, even though Buffett is loved and admired for his homespun folksy investing wisdom, those two rules are a little too homespun and folksy for me.
Translated: exercise due caution
What Buffett is really saying, of course, is don’t take unnecessary or avoidable risks. Have a strategy, and make carefully considered fact-driven decisions, rather than piling into get-rich-quick stocks because everyone else is doing it.
Put like that, I agree. That’s what I try to do.
But much the same sentiment, in my view, has been better expressed by another stellar — although lower-profile — investor: Charley Ellis, who I once had the pleasure of interviewing.
The Loser’s Game, by Charles D. Ellis (as Charley is more formally known, in case you want to look it up), was published in 1975, in the Financial Analysts Journal. It’s been cited and read countless times since then. On the internet, you won’t have any difficulty finding it, or finding articles about it.
Professionals vs. amateurs
Ellis’s insight was a powerful one, and came from his love of tennis. Professional tennis players, he realised, win games by actively making winning strokes. Amateur tennis players, on the other hand, win games by making fewer mistakes than their opponent.
As he puts it:
“Professionals win points, amateurs lose points. Professional tennis players stroke the ball with strong, well-aimed shots, through long and often exciting rallies, until one player is able to drive the ball just beyond the reach of his opponent.
Amateur tennis is almost entirely different… the ball is fairly often hit into the net or out of bounds, and double faults at service are not uncommon. The amateur duffer seldom beats his opponent, but he beats himself all the time. The victor… gets a higher score because his opponent is losing even more points.”
Yes, but tell me what to do!
Call me picky, but I’ve a slight problem with The Loser’s Game, too. And it’s the same thing as with Buffett’s two rules — even with those rules rephrased, as above.
And it’s this: as aspirations, they’re great. Take fewer needless risks. Make fewer needless mistakes. Great: I get it.
But which risks? Which mistakes? They don’t really tell you.
Well, I’ve got views on that. Mistakes that I see people making, needless risks that I see people running.
So here goes… and in keeping with the spirit of Buffett’s original rules, I’ve expressed these seven observations as ‘rules’, too.
7 rules for investing success
1. Don’t blindly chase yield. The key word there is ‘blindly’. High yields are great, as long as you know why they’re high. Has the share price recently tanked, for instance? In short, what you’re looking for are sustainable yields, not just high yields.
2. Don’t fall for an attractively low P/E ratio. Who doesn’t enjoy an entry point at a low price-to-earnings ratio? But again, it’s important to know why the P/E is low. Is it just an out-of-favour sector? Or something darker? If in doubt, steer clear.
3. Don’t think that historic yields are more reliable than forecast yields. In fact, the reverse is more likely to be true. Yes, they’re forecast yields, so will likely be slightly wrong. But they’re very unlikely be out in a major way — for example, by failing to show the impact of a recent dividend cut or dividend suspension. Historic yields are easily fooled by these.
4. Don’t buy a stock just because it is cheap by historic standards. Remember: a share price that has fallen by 99% is a share price that fell 98% — and then halved.
5: If you don’t understand the business model, don’t buy the shares. Need I say more? Where do the revenues come from? Where do the profits come from? And where does the cash come from? It’s important to understand this.
6. When researching a stock, always read the first few pages of the latest annual report. Always. It’s a quick and handy primer on what you’re buying into, but the page you’re really looking for is the one with all those five-year charts. Study them.
7. Collective investments — investment trusts, funds, and trackers — provide cheap, quick, and effective diversification. Yes, there’s a management charge — but it’s typically much less than what you’d pay trying to build the same diversification yourself.
Be a winner, not a loser
So there we have it. Actionable insights — and, I hope, a little more useful than simply an exhortation to ‘don’t lose money’.
Remember: Charley Ellis’s losers are the people who don’t do this stuff. So put yourself among the winners, not the losers.
