Amending Buffett's Investing Rules: Don't Fear Short-Term Fluctuations

Includes: DIA, QQQ, SPY
by: Mariusz Skonieczny

If you have ever read books about Warren Buffett, you are likely to be familiar with his two rules:

  • Rule #1: Never Lose Money
  • Rule #2: Never Forget Rule Number One

However, these rules can be confusing, especially to beginning investors. Recently, I received an e-mail from a beginning value investor who bought a particular stock for $7.50 per share and saw it go down to slightly below $5.00 per share. He was worried because his first goal in investing was not to lose money, and he was concerned because it was down 30 percent.

More experienced value investors are aware that when Buffett said not to lose money, he was referring to a long-term and permanent loss of capital, and not to short-term fluctuations. As stated above, Buffett’s rules can make new investors unnecessarily fearful about short-term declines. I think that the following rules may be better suited for new investors:

  • Rule #1: Never Expect to Make Money In The First 12 Months After Purchasing An Investment
  • Rule #2: Never Forget Rule Number One

As value investors, we are trying to purchase $1.00 bills for $0.50 or less. Why would anyone want to sell something worth $1.00 for $0.50? Usually, it is because the seller believes that the price will go down in the near future. Many investors would sell for $0.50 if they believed that the next day they could only get $0.45. It wouldn’t matter to them that in three years they could get $2.00 for it. So as value investors, when you buy something for less than what it is worth, you are able to do it because the market dislikes the company for one reason or another. Your purchase of the stock will not cause the market to have a change of heart just because you are special. Let’s remind ourselves of another important quote from Buffett:

  • A stock doesn’t know you own it.

When I buy stock in any company, I automatically assume the price will go down immediately after I purchase it. And many times, it does decline. It often takes two to three years for an investment thesis to play out. During the first 12 months, almost anything can happen to the stock price as it is mainly driven by short-term speculators who care little about the underlying business. If you cannot tolerate losing money within the first year or maybe even longer in order to see positive returns in the end, then investing might not be for you.

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