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Billionaire Warren Buffett’s top rule for investors is dead simple – don’t lose money. But how can anyone follow this in a stock market where share prices can go down as well as up?
Nobody can prevent a stock going down. Fortunately though, this isn’t what Buffett means when it comes to avoiding losses – it’s something else entirely.
The stock market
There are two ways to think about buying shares. One is in terms of owning a stock that can move up and down in price and the other is about being part of the underlying business.
This is the difference between trading and investing. Fundamentally, traders buy shares because they think price is going to go higher – usually in the near future. Investors, by contrast, buy shares because they think the underlying business is going to produce a lot of cash. And this usually takes longer.
That’s not to say traders ignore what the underlying business is doing. A lot of the time, their reason for thinking a stock’s going up is because the company’s earnings are likely to grow.
Equally, investors don’t have to be entirely disinterested in share prices. Buffett’s said before that earnings growth in Coca-Cola has resulted in the stock going higher over time.
In each case though, it’s a means to an end. For traders, the business matters because it affects the share price and for investors – such as Buffett – it’s the other way around.
How to avoid losing money?
Buffett’s advice means investors should therefore be wary of companies that might lose money over time. And there are lots of ways of doing this. One that investors need to be wary of is attempting to grow through acquisitions. This can result in permanent losses, but there are some things investors can do to minimise this risk.
A good example is Judges Scientific (LSE:JDG) – a stock I own in my portfolio. The company’s grown significantly by adding other scientific instrument firms to its existing network.
This kind of business comes with a danger of the kind of losses Buffett says to avoid. Paying too much for a company means spending out cash that can be lost if the deal doesn’t pay off.
Judges Scientific though, has a couple of ways of limiting this risk. It focuses on acquisition targets that fit within its core specialism and are relatively small compared to its own size.
That helps reduce the risk of making a bad deal. And it’s why the company’s managed to grow is revenues at 12% a year on average over the last five years.
Being a good investor
Avoiding losses is Buffett’s first rule of investing. And the way Judges Scientific plans its acquisitions is a good model for how investors should think about their own investments.
Focusing on its core competence helps limit the risk of making a mistake. In the same way, investors in general should concentrate on businesses they can understand. Equally, focusing on small targets reduces the impact on the firm as a whole if things do go wrong. And this is exactly why ordinary investors should look to build a diversified portfolio.
That’s why I hold the stock. And it’s also why it’s on my list to keep buying.
This story originally appeared on Motley Fool
