/Rule Number One: Never Lose Money

Rule Number One: Never Lose Money

When in school, I used to participate in our annual 6-KM cross-country race. Just the idea of “running away from school” was exciting for me, and thus I participated every year. And every year, there was this classmate of mine, Anshul, who won the race, beating all of us by at least half a kilometer and more.

While I did not look much into the reason then why Anshul was consistently winning the race every year, I now know why it was so.

Here is the speed chart of me and most of my other friends vs Anshul running that 6-KM race –

You know the reason now, don’t you?

The reason why we lost and Anshul won every year was because we focused on high speed alone, while he focused on consistency at a decent speed. In other words, while we were the Shahid Afridis of those races, Anshul was Rahul Dravid…and that made all the difference in the end.

Speed Vs Consistency
“Speed has never killed anyone. Suddenly becoming stationary, that’s what gets you,” said Jeremy Clarson, an English broadcaster, journalist and writer who specialises in motoring.

Consider investing. Every bull market creates a lot of new investors with 40-50% 5-year CAGR under then belts. And these people inspire others into making such kind of killing from stocks. Some of these guys are really smart, while most are just a product of the bull market.

So, a lot of new investors, who like I did at my school race, get inspired by others making fast returns in quick time and start the investing game at high speeds. And thanks to the bull market and beginner’s luck, they do make some good returns in the first 2-3 years of their career.

The going looks very easy, and the future looks very bright for these investors. And this causes them to raise their bets, and try things like –

  1. Overpaying (not paying up, but overpaying) for high quality stocks because “the story remains exciting” and in the hope these stocks will continue to rise like they have done in the past (your long term returns are dependent on the price you pay for a business, and the probability of losing money by overpaying for stocks is high)
  2. Buying low-quality businesses with mediocre or low return on capital (mistake) that appear cheap, and holding on when these stocks fall so as to get their money back (bigger mistake), and averaging as these stocks fall further (even bigger mistake).
  3. Moving outside their circle of competence and buying businesses they don’t understand but just because a few others have recently made money in them (surprisingly, I suddenly see a lot of people wanting to learn about the pharma business now, seemingly because some of these stocks have done very well in the recent past).
  4. Changing their investment philosophy abruptly to go with the flavour of the season (like I see some people now seeking comfort in buying average or bad businesses that are trading cheaply because they have nothing to buy among good businesses that are trading expensive)
  5. Blindly cloning investors who have been successful in the recent past, ignoring that those cloned may have not seen more than one bad cycle and that some of them could be talking up their books

Here is a chart I would like to share on how most of these investors – who choose speed over consistency – fare when the race is run over a long distance (not 3-5 years but 15-20 years or more) –

This brings me back to the two basic rules of compounding –

  1. The longer you let it work, the bigger will be its effect – time, not rate of return, is the most important variable in the compounding formula; and
  2. If you lose big money even few times in your compounding journey, you will not receive its benefits, even in the long run.

So, like Clarson said, it’s not chasing the 25% CAGR speed that will kill you in the stock market, but the speed bumps you will meet along the way (losing big money, thanks to the mistake you may make in your need for high returns) that will get you.

Losing a 6-km race in school is still fine because the stakes are not high. But losing your wealth permanently can be disastrous because here your financial future is concerned. And once you trip over badly (due to the need for speed and the missteps it can lead you to take), it can be really difficult to come back into this game.

This, I believe, is why the most important words ever spoken in investing were – “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”

And to modify this a bit – “Never lose money. But if you still lose some money out of your mistakes, never lose the lesson.”

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