If I was back at the start of my investing career and had £1,000 to invest, I’d focus on preserving capital first. It’s the most important thing of all. Much more important than thinking about how big my gains from investing could be.
One of the often-quoted utterances of Warren Buffett— the well-known and super-successful US investor – is: “Rule number 1: Never lose money. Rule No. 2: Never forget rule number 1.” He’s not talking about the day-to-day fluctuations of share prices that could cause a temporary red figure in your share account. You’ll never iron out that kind of volatility. But he’s talking about a permanent loss of capital brought on by plunging share prices that never recover. You’ve got to try to avoid those situations, which generally means avoiding risky investments such as over-priced shares or dodgy underlying businesses.
The shocking truth about losses
US-based investor and trader Mark Minervini – who has himself made several million dollars from the stock market – did a good job of explaining why it’s so important not to lose your money. In his book, Trade Like Stock Market Wizard, he explained that if you lose 5% of your money, you will have to make a gain of 5.26% to get back to breakeven. Indeed, the mathematics show us that you have to make a bigger gain than the size of your loss to recover your money.
But it gets worse. The size of the gain you’ll need to get back to breakeven rises on a scale as the loss deepens. For example, if you lose 50% of your money, you need a 100% gain to get back to breakeven. Shocking! If you’d made that gain without first losing half you’d have doubled your money, and all for the same ‘effort’.
Let’s imagine, in one final illustration, that you’d invested your £1,000 into shares of one of the big London-listed banks back in 2007, such as Royal Bank of Scotland or Lloyds Banking Group. Both firms saw their shares plunge more than 90% over the following year or two, so your £1,000 would have shrunk to below £100. With a 90% loss, you need to make a 900% gain to get back to breakeven – shareholders in those banks since 2007 are still waiting for their money to fully recover. Yet a 900% gain without first losing any would have turned your £1,000 into £10,000.
Spreading the risk
That’s why it’s so important not to lose money. One way you can do that with your £1,000 is to avoid putting it all into the shares of just one company. Single-company risk can be lurking even in places you might least expect. Back in 2007, Lloyds and Royal Bank of Scotland were great big FTSE 100 names that many investors trusted — big mistake!
I’d invest my first £1,000 in a collective investment vehicle backed by many underlying shares, which would provide me with diversification and minimise risks to my capital from any single underlying business. I could go for a managed fund. But the running charges are often quite high and there’s plenty of evidence that, as a group, fund managers don’t tend to outperform the returns from the general stock market. So I’d go for a low-cost, passive index tracker fund, such as one that follows the FTSE 100 index.
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Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.