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Investing's #1 Rule: Don't Risk What You Have for Something You Don’t Need

Value investor with a deep passion for understanding and a desire to improve results over time.

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What to Risk

Any investor's journey is fraught with the vicissitudes of life, as Charlie Munger would surely describe them. As a result, we value investors are taught to insist on a margin of safety any time we buy a stock. This is sensible! After all, while a business's future prospects might look predictable and positive, all sorts of shenanigans from Mr. Market can take place, and there can be other factors you just can't see at the moment of purchase that can surprise you in the future, and sometimes the surprise isn't altogether positive.

Buffett's rule number one is identical to his second rule for investors: don't lose money. While admittedly a little bit trite, this advice is undeniably effective for you if you can pull it off, but there's something you should understand before putting any money at risk, and that's precisely what you should be risking in the first place.

The Allure of the Risk Curve

The what to invest is the most important question, and Buffett once again comes through with another of his uncannily appropriate quotes:

"Rational people don’t risk what they have and need for what they don’t have and don’t need.”

Buffett's folksy wisdom has a way of penetrating the noise and cutting straight to the heart of the matter with stock investing. In this case, the Oracle of Omaha cautions against chasing returns by going further out on the risk curve. As you tend to get hypnotized by the upside, you often forget to take care of the downside.

As Howard Marks is fond of saying in his memos, if you take care of the downside, the upside tends to take care of itself. This is intuitive since the market tends to move up and to the right over enough time, but if you're reaching for return that isn't there, you are very likely to end up violating rule number one . . . and this can lead to losing something you can't afford to lose.

How to Do It

Start with a proper three-scenario valuation model, like I've described here. Once you've come up with a rough idea of a bull (best), bear (worst), and base case scenarios, the general idea is to multiply the probabilities, with a final number indicating whether the stock is a buy or not. If this number is higher than the stock price, it's worth remembering that it's not yet a buy, since you still have to subtract your margin of safety in order to take into account those vicissitudes Uncle Charlie was talking about earlier.

This number is incredibly useful, and it's a great indicator of whether something is investable right now, but it's not quite time to dive in just yet. Instead, it's even more important to conjure Buffett once again and to take a closer look at your bear case scenario. If you have a stock that looks like an asymmetric upside, with a fantastic bull case and a reasonable base case, even with a very high probability of those scenarios coming to fruition, you still need to avoid losing something you simply can't afford to lose, and that's where a lot of people get this wrong.

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The Mother of All Cautionary Tales

Consider the classic 1929 crash, where infamous amounts of margin calls caused untold numbers of investors to be wiped out completely, with their entire portfolios liquidated to pay what they owed and their bank balances soon to follow. Clearly, investing rewards risk, and you have to take some, but the important thing is to ensure that you're not risking what you can't afford to lose, even if it's unlikely to happen.

The crash in the stock market didn't cause the Great Depression, but it did make life a lot worse for a lot of people, and it contributed to the overall feelings of malaise at the time. Even worse, millions of people violated investing's true rule number one: don't risk something you have for something you don't need. As more and more money was borrowed on the assumption that stocks would always go up, people became more and more comfortable with putting more and more collateral up, even things they really couldn't afford to lose.

Fast forward to 2007 and 2008, and you see almost the exact same picture, but with institutions replacing individuals and mortgage-backed securities replacing individual stocks.

Playing Russian Roulette

Imagine sitting around a table with some other desperate wretches. There's a gun on the table—one of those old-timey revolvers, where you load the bullets into the appropriate chamber—with one bullet loaded, spun randomly so that nobody knows whether it will fire a lethal bullet during any given trigger pull. Each person in turn who plays Russian roulette points the gun at their temple, then pulls the trigger. If the gun doesn't go off, they get to keep a million dollars per turn they play. Now, ask yourself: would you play this game? What if the stakes were $10 million?

Now, the stock market probably (hopefully) won't literally kill you if you make a mistake, and this is by no means designed to scare you away from buying stocks. Put another way, I'm not exactly a spreader of FUD. Nevertheless, it pays to look before you leap, and the thing to look at here is whether you could afford a fully realized bear case scenario.

The simplest way to put this is that you don't want to play Russian roulette with your wealth, and certainly not with a portion of your wealth that you can't afford to lose. Instead, use diversification to minimize having too many eggs in one particular basket, and make sure your investments aren't all overly correlated so that if there's a crash, you're not wiped out all at once.

Ask Yourself This

As you mature along your stock investing path, you'll probably start thinking about more abstract, holistic concepts like portfolio allocation. Avoiding too much concentration on one stock can be catastrophic, and you can prevent a lot of roulette-like risk by simply avoiding having too many eggs in one basket. Still, it's far better to ask yourself the following question every time you make a single stock purchase:

If things go really wrong here, will I be okay?

If your answer is "no", then don't buy the stock. You don't have to be "The Abominable No-Man" like Charlie Munger, but saying "no" to putting to risk things you can't afford to lose is an important first step, and eliminating possible investments can be just as valuable as finding great bargains.

This content is accurate and true to the best of the author’s knowledge and is not meant to substitute for formal and individualized advice from a qualified professional.

© 2021 Andrew Smith

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