Image source: Getty Images
Billionaire Warren Buffett’s top rule for investors is simple – don’t lose money. But how can one follow this in the stock market when stock prices go up and down?
No one can prevent the stock from falling. Fortunately, though, this isn’t what Buffett is talking about when it comes to avoiding losses – it’s something else entirely.
The stock market
There are two ways to think about buying stocks. One is about owning a stock that can go up and down in value and the other is about being part of the underlying business.
This is the difference between trading and investing. Basically, traders buy stocks because they think the price will go up – usually in the near future. Investors, in contrast, buy stocks because they think the underlying business will generate more income. And this usually takes a long time.
That doesn’t mean salespeople are ignoring what the subsidiary is doing. Most of the time, their reason for thinking that the stock is going up is because the company’s earnings are likely to increase.
Equally, investors need not be indifferent to stock prices. Buffett said before that income growth Coca-Cola caused the stock to rise over time.
However, in each case, it is a means to an end. For traders, the business is important because it affects the share price and for investors – like Buffett – it is the other way around.
How can you avoid losing money?
Buffett’s advice means that investors should be wary of companies that may lose money in the long run. And there are many ways to do this. Another thing investors should be wary of is trying to grow by buying. This can lead to permanent losses, but there are other things investors can do to reduce this risk.
A good example is this Science Judges (LSE:JDG) – a stock I hold in my portfolio. The company has grown significantly by adding other scientific instruments plants to its existing network.
This type of business comes with the risk of the kind of loss that Buffett says should be avoided. Paying the company more means spending money that could be lost if the deal doesn’t pay off.
Judges Scientific, has several ways to limit this risk. It focuses on equity acquisition targets within its core expertise and is small relative to its size.
That helps reduce the risk of making a bad deal. And that’s why the company has been able to grow 12% profit per year on average for 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 investments.
Focusing on its core competency helps reduce the risk of making a mistake. In the same way, investors in general should focus on businesses they can understand. Equally, focusing on smaller targets reduces the impact on the company as a whole if things go wrong. And that’s why average investors should look to build a diversified portfolio.
That’s why I hold the stock. And that’s why it’s on my list to keep shopping.
