The bull market is aging and a potentially damaging trade war is ramping up. With investment risks in mind, we have written a lot recently about investing without losing money, what criteria to choose investments, safe investments for retirement, and the risks of offshore investing. A recurring theme has been the importance of not losing money when investing. One does not need to look any farther than a Warren Buffett quote to understand the importance of this subject. The Oracle of Omaha said that the first rule of investing in not to lose money and the second rule is not to forget the first rule! When the market is going up, why is it important to think about not losing money? It is all in the arithmetic.
Importance of Not Losing Money When Investing: The Arithmetic
If you have an investment that routinely appreciates at 10% a year, you should be happy. Let’s assume that this is a stock that does not pay dividends. The value per share just goes up 10% year after year. If you started with $10,000, where does that get you at the end of each year?
Exponential growth of a sound investment
- Year 1: $11,000
- Year 2: $12,100
- Year 3: $13,310
- Year 4: $14,641
- Year 5: $16,105.10
- Year 10: $25,937.42
This is a nice return on investment. But, what if, rather than a 10% gain every year, there are some losses thrown into the picture? What kind of rate of return do you need the next year to make up for one year losses of 10%, 20%, 30%, 40% or 50%?
Rate of return needed in one year to make up for losses in the preceding year
- Loss = 10%, required return the next year = 11.11%
- Loss = 20%, required return the next year = 25%
- Loss = 30%, required return the next year = 42.86%
- Loss = 40%, required return the next year = 66.67%
- Loss = 50%, required return the next year = 100%
The obvious point of this little arithmetic exercise is that if you lose money on an investment, you have less money to work with. Thus, you need a higher return on investment to get your original investment back. And that simply assumes that you are back to ground zero. Forget about that original year after year exponential growth! Buffett is a smart guy, but to understand his advice, you only need to do the arithmetic.
Importance of Not Losing Money When Investing: What Are Your Options?
If you had simply put your money in CD’s at the local bank in the days leading up to the 2008 stock market crash you would not have lost any money. But, if you had left your money in CD’s you would have experienced a period of historic low interest rates. The ideal solution would have been to pull your cash out of risky stocks when the market looked suspect and then re-invest when the market bottomed out. But, how would you know?
Intrinsic Stock Value
Perfect market timing is impossible. But, there are general principles that help an investor decide “when to hold em and when to fold em” to quote Kenny Rogers and The Gambler. An approach invented by Benjamin Graham is called intrinsic stock value.
The dictionary definition of intrinsic stock value is its fundamental value. It is obtained by adding up predicted future income of a stock and subtracting current price. It can also be seen as actual value of an equity versus its book value or market value. The concept of fundamental analysis of equities evolved from this concept. Using fundamental analysis the intrinsic value of a stock is the expected company cash flow discounted to current dollars. It is a discounted cash flow valuation.
Successful long term investors do not bet on the stock market. They only invest in a company when they understand its business model and when they can reliably predict that the business model will create profits into the indefinite future. There were successful long term investors who simply got out of the stock market in the run-up to the 2008 crash. And, there were those who simply stayed in the market and rode the subsequent bull market to increasing gains over the years. The key to their approach is understanding how the company makes money and how its approach will continue to work, or not, over the years.