Warren Buffett: How to Stop Losing Money When Investing

The first role in investment is don't lose, and the second rule of investment is don't forget the first rule. And that's all the rules there are. I mean that if you buy things for far below what they're worth, and you buy a group of them, you basically don't lose money.

This video is sponsored by the investment research app Quarter. One of Warren Buffett's best quotes is that there are only two rules when it comes to investing: Rule number one: never lose money. Rule number two: never forget rule number one. A big part of Warren Buffett's success is that over his very long career, he has avoided losing large amounts of money. This boils down to just a few simple concepts: only investing in companies you understand, buying stocks in great businesses, and only buying stocks for less than their true value.

In this video, we are going to go through these concepts in depth. Make sure to stick around to the end of the video because you can begin applying these concepts to your own investing today. Also, make sure to hit the like button real quick because a ton of work goes into making these videos, and you liking these videos helps me stay motivated to continue making content for you guys. You all are great, and let's get into the video!

Only investing in companies you understand relates to a concept popularized by Warren Buffett that is called a circle of competence. Imagine that there is a circle: any company that falls inside of the circle, you understand and are able to value that business. Any company that falls outside of the circle, you don't have a deep enough understanding of the business and the industry to invest successfully.

Buffett says one of the most important keys to successful investing is being able to clearly define your circle of competence and make sure you stick to investing only in companies that are inside that circle. Keep in mind everyone's circle of competence is different because people have different levels of understanding of certain businesses and industries.

Let's say someone is a general manager of a restaurant and as a result has a deep understanding of the restaurant industry and the companies that operate within the industry. Stocks such as McDonald's, Chipotle, Domino's, Darden Restaurants, Starbucks, Wendy's, Restaurant Brands International, and Papa John's all may very well fall within this person's circle of competence.

While high-tech stocks such as Nvidia, Tesla, Amazon, Facebook, and Snapchat would probably be outside of this person's circle of competence. Or in another example, let's say someone works in digital advertising and social media marketing because they frequently work with large social media companies and have an in-depth understanding of the business and industry. Stocks such as Facebook, Spotify, Alphabet (parent company of Google and YouTube), Snapchat, and Pinterest may very well fall within their circle of competence.

While old-school classical industrial companies like General Electric, 3M, Honeywell, and the railroad Union Pacific would likely fall outside of the borders of their circle of competence. Or if you work in the retail industry and have a deep understanding of that industry, companies such as Walmart, Target, Costco, Kohl's, and Lululemon could be within your circle of competence. Or maybe automakers like General Motors, Ford, Volkswagen, Honda, and Toyota would fall outside of your circle of competence.

Notice how each of the three different people in these examples had different companies that fall within their circles of competence based upon what industries they had a deep knowledge of and expertise in. Buffett frequently said that when it comes to investing, it's not how large your circle of competence is; it's more important that you only stick to investing in the companies within that circle. Most investors get themselves into trouble when they get overconfident and try to invest in companies that are outside their circle of competence. That's how investors can lose a lot of money.

It's obviously very important to develop a deep understanding of companies and industries so that they can be included in your circle of competence. The best way to do that is by researching a company, and today's sponsor of this video makes that research process as easy as possible. The investment research app Quarter is what I use in my own investment research process. They make learning about a company, its future growth plans, and the main questions Wall Street analysts are asking the company incredibly easy.

The best part of it is that the app is completely free to download and use. Make sure to click the link in my description to download the app today. Another important thing to consider to help avoid losing money is to invest in great businesses.

Now, this is a great thing that gets thrown around a lot — investing — but what exactly makes a business great? Let's listen to what Warren Buffett has to say on this topic: "The ideal business is one that earns very high returns on capital and could keep using lots of capital at those high returns. I mean that becomes a compounding machine. So if you have your choice, if you could put 100 million dollars into a business that earns 20 percent on that capital, say 20 million, ideally it would be able to earn 20 on 120 million the following year and 144 million the following year and so on. That you could keep redeploying capital at these same returns over time."

One way you can evaluate businesses based on the criteria Buffett just described is by a financial metric referred to as return on equity, or ROE for short. ROE is calculated by taking a company's profit (referred to as its net income) and dividing it by shareholders equity. Return on equity is expressed as a percentage, and generally speaking, the higher the number, the better.

Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. Use one of Warren Buffett's biggest investments, Apple, to demonstrate this concept. Apple's return on equity is a staggering 144 percent. This is especially impressive when you consider that the computer and smartphone industry has an average return on equity of around 21.

This shows that Apple is able to produce significantly higher returns than that of its competitors in the same industry. This high return on equity also helps explain the huge run-up in the value of Apple stock over the years and why Apple is considered one of the best, if not the best business on the planet.

Now, even if a certain business is within your circle of competence and is a great business, that doesn't necessarily mean it's a great investment. Not even the best business in the world is worth an infinite price. The key to not losing money when investing is the concept of margin of safety. This simply means that you as an investor are getting more than what you paid for. This is arguably the most important concept in all of investing.

In fact, legendary value investor Seth Klarman wrote an entire book on the subject, interestingly enough titled Margin of Safety. If you want to learn more about that book, check out the summary video I made on it here. Think of margin of safety using buying a house as an example. Let's say you're able to get a deal when you buy a house in the scenic state of California for eight hundred thousand dollars. Its true value is one million dollars in this example. This means your margin of safety in this house purchase is two hundred thousand dollars. This is calculated simply by taking the true value of the house and subtracting out what you paid for it.

To show how important a margin of safety is when it comes to not losing money when investing, let's imagine that the property market in your area falls by 10 percent, bringing the true value of your purchased house down to nine hundred thousand dollars. Because you paid eight hundred thousand dollars for this property, you still have an asset that is worth more than what you paid for it. Take the nine hundred thousand dollar value of the property and subtract out the eight hundred thousand dollars you paid. You still have a positive one hundred thousand dollar margin of safety.

However, let's say you pay the full value of one million dollars for this house that is also worth one million dollars. Since you paid the full market rate, your margin of safety is zero. Let's say that the same ten percent fall on the real estate market happens; things aren't looking too good for you. You now take the nine hundred thousand dollar true value of the house and subtract out the one million dollars that you paid. That gets you a value of negative one hundred thousand dollars.

Now do you see why the concept of margin of safety is important when investing and how it keeps you from losing money? Let's apply this same concept when it comes to investing in stocks, which are just little pieces of businesses. It doesn't matter whether you are investing in Apple, Coca-Cola, or Tesla; the process of calculating a company's true value or its intrinsic value and the margin of safety is the same.

In order to determine the margin of safety, you first have to calculate the intrinsic value of a stock. Let's see how that is done by using Coca-Cola stock as an example. The intrinsic value of any stock is based on two things: the cash that the stock will produce over its lifetime and the rate at which you will discount that cash back to the present day. This is surprisingly a pretty simple concept and will all make sense after you see an example.

Let's say Coca-Cola will generate three dollars per share in cash the first full year we own this stock. In this example, that would be the year 2022. We then assume that the annual per-share cash flow will grow by 12 percent per year over the next 10 years that we own the stock. This means that the three dollars per share in cash flow in year one will grow to Coca-Cola producing eight dollars and thirty-two cents a year in cash flow at the end of year 10.

Additionally, in this example, we assume that at the end of year 10, we can sell the stock for 10 times that year's per-share cash flow. So we take the eight dollars and thirty-two cents of free cash flow in year 10 and multiply it by 10 to get around eighty-three dollars and twenty cents. This means the total cash we will receive at the end of year 10 is ninety-one dollars and fifty-one cents. This is simply the dollars and thirty-two cents the stock generated in cash flow plus the eighty-three dollars and twenty cents we sold the stock for.

So now that we have our estimates for how much cash the stock will produce for us while we own the stock, we are now able to discount those numbers back to today. We do this because cash we receive in future years is not as valuable as cash we receive today. This is why I've given a choice between me giving you one thousand dollars today or one thousand dollars a year from today, you would pick the one thousand dollars right now.

In order for you to choose to receive the cash a year from now instead of today, you would need to receive more money to make it worth your while to wait that extra time. In this example, we are going to use 8 percent as our discount rate. So after discounting these cash flows by 8 percent, we get an intrinsic value of seventy-one dollars and forty-three cents.

So is this how much we should pay for the business? Not necessarily. This is where the concept of margin of safety comes into play when investing. We want to buy the stock at less than our estimation of the stock's intrinsic value. The difference between this intrinsic value and what we paid for the stock represents our margin of safety.

The margin of safety helps protect us as investors from losing money in case our estimate of intrinsic value is wrong. Let's say that instead of that 12 percent growth rate we talked about, we were wrong in our estimates and the actual growth rate turns out to be only 10 percent. In this scenario, the intrinsic value of the stock is now only sixty-two dollars and ninety-eight cents. But notice that this is still more than what we paid for this stock. See why margin of safety is so important?

It helps protect us as investors from losing money in case the company isn't as successful in the future as we originally planned. The larger the margin of safety, the more money you can make in an investment if things turn out the way you planned. And arguably, even more importantly, the protection you have from losing money if things don't turn out as good as you thought they would.

Remember Buffett's words from the beginning of this video: there are only two rules in investing. The first rule is never lose money; the second rule is never forget rule number one. Make sure to like this video and subscribe to the channel if you aren't already, because it is my goal to make you a better investor by studying the world's greatest investors. Talk to you soon!