The world’s most successful investor didn’t get to where he is today without an in-depth knowledge of the way the market works.
According to him, the most important rule in the market is to not lose money. The second rule just reinforces the first.
In this rule you can find a timeless piece of market wisdom…
If you lose 10% in a stock (a fall from ₹100 to ₹90) then you need to make 11% profit (a gain from ₹90 to ₹100) to get back what you lost.
To recover a 20% loss, you need to make a 25% profit. To recover a 50% loss, you need to double your money.
As they say in motor racing, ‘To finish first, you have to first finish.’
So don’t lose money. But how do not lose money in the market?
Well, Buffett follows the timeless wisdom of his mentor, Benjamin Graham who taught him the importance of ‘margin of safety’.
This is what he said..
“The three most important words in investing are margin of safety.”
This is idea of buying stocks at a price lower than it’s intrinsic value. It is the cornerstone of value investing.
Here’s an article on how to find the intrinsic value of a stock.
By buying stocks at a discount to its intrinsic value, you will avoid filling up your portfolio with overvalued stocks.
Instead, your portfolio will have undervalued stocks which should provide good downside protection. These are usually called value stocks.
But to do this, you need to find what a business is worth, i.e. its intrinsic value.
In fact Buffett has said, the only two things you need to know about making money in stocks is how to value a business and how to think about stock prices.
But what about stocks in a market crash? Should you buy more? Sell? Or just hold on?
What does Buffett have to say?
Here’s a Buffett quote that is quite prescient…
“If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes”.
By this Buffett is saying, if you’re in the market for short term trading, then just stick to that. Don’t think of becoming an investor. A true investor is a long term investor.
Here’s another quote which is classic Buffett…
“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years”.
For more on this read Equitymaster’s article – 10 rules for successful long-term investing.
Market declines are inevitable. They will happen. Like the fall in the market now. So be prepared for them.
During these periods of decline, look for ways to capitalise on opportunities the market provides you. Invest in stocks of your favourite companies that are trading cheap.
“The years ahead will occasionally deliver major market declines — even panics — that will affect virtually all stocks. No one can tell you when these traumas will occur.”
And that’s absolutely correct. No one can predict market declines. We can learn from them. We can be prepared for them. We can take advantage of them.
Buffett uses market corrections like the one now to buy stocks aggressively. He sees them as ideal buying opportunities. You should too.
Stock markets swing wildly on news. They go up and down on sentiment. It’s important not to get caught up in the madness of the market. Instead, stick to your homework and always stay rational.
But what if you lose money?
Losing money in stock markets is natural. Everyone has to face losses sometimes. There’s no avoiding them. So you must know how to handle market losses.
One good way to do this is to clean up your portfolio. Hold on to only the fundamentally strong stocks and get rid of all the junk stocks.
Use the money raised by selling the poor quality stocks to buy more of the good quality ones.
This is what Buffett has to say…
“Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks”.
Don’t throw more money at stocks that are performing badly. If the company’s fundamentals are not looking up, then it’s best to sell and exit the stock.
This is a difficult decision to make. If will involve some pain of losing money in the short term.
But accepting this loss will prove to be a smart decision. You will not only avoid further losses but also make more profits in the future if you buy more fundamentally strong stocks.
You can use Equitymaster’s Stock Screener to find fundamentally strong stocks.
You can get started right away with our Warren Buffett Stocks Screener.
(This article is syndicated from Equitymaster.com)