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Warren Buffett, Rule No. 1

Warren Buffett may be one of the richest people in the world, but he has provided the general investing public with an equally vast wealth of knowledge through his 55+ years of writings and interviews. Every Wednesday I will be unearthing a different quote from the Oracle of Omaha and will describe the logic behind his common-sense madness.

When Warren Buffett was 11 years old, he bought three shares of Cities Service Preferred for himself and three shares for his sister Doris, for $38.25 each. Soon after, the price plummeted by nearly 30% to $27 per share. Doris reminded him every day on the way to school that her stock was going down and 11 year old Warren felt horribly responsible.

Although the loss was only temporary and on paper (the shares eventually recovered to $40), Warren has called this event one of the most important of his life.

One of the lessons Cities Service Preferred taught him was that if he made a mistake with other people’s money, somebody might get upset with him.  So he didn’t want that responsibility unless he was sure he could succeed.

Although Buffett learned this lesson when he was only eleven, this is quite a refreshing notion in today’s world where too many fund managers treat other people’s money (“OPM”) as play money, rather than as their own personal capital.

Buffett on the other hand views other people’s money just the same as he views his own and has consequently always remained fairly conservative in his approach. Investing is a marathon, not a sprint, and if you start losing money then you’ll never make it to the finish line.

Apart from an emotional aversion to losing money, Buffett also has strong mathematical support behind his loss-aversion: If a stock goes down by 50% then it will have to double for you to make your money back. That’s a big hole to climb out of, so Warren’s reminding you to watch where you step.

In the same way that everybody knows to “buy high and sell low,” nobody invests with the intent to lose money. In fact, human beings are naturally risk-averse. But all too often we are affected by biases and emotions, causing our actions to differ from our intent. Dumb investments lead to even dumber investments, often in an economic environment where financial soothsayers see no other path but up for the stock market.

We would do well to bring a healthy amount of skepticism, caution, and conservatism with us at these times, and to make sure we never forget Warren Buffett’s first two rules of investing.