Warren Buffett has made billions for himself and shareholders of Berkshire Hathaway following the one rule of investing: Don't lose money.
While it may seem simple, it's actually the hardest part of investing. Most investors make a key mistake that loses them money year after year.
If you read along, I'll fill you in on the mistake that costs investors billions and reveal the three most important words in investing.
The mistake
If you listen to investors, they'll often talk about the risk-reward ratio of an investment.
Seriously, who thinks about the risks of an investment before they envision the REWARD$? For example, the market is entranced with the lure of finding the next Fortescue Metals (ASX: FMG), the next truly massive iron ore player.
As investors who bought Fortescue shares at a few cents 5 or so years ago will attest, the rewards are seemingly huge, which has investors hooked.
Yet, for all the iron ore hopefuls out there, it's likely most will be total failures as investments. That's the nature of the game in mining exploration – the odds are stacked against you.
If you focus on the risk first and not losing money, the upside will take care of itself.
By loss, I mean a permanent loss of money — not just a few-months decline in share price. In the short term, share prices will fluctuate.
Making money made simple
In the long term, a company's share price will follow the performance of the business. You should thus focus your efforts on making money over the long run by investing in strong businesses, with excellent managements, when the businesses are undervalued.
The key is to find companies that meet all three of these criteria. If you get the first two right and the last part wrong, it will cost you.
Look at Woolworths (ASX: WOW), for example. In 2007 investors seemingly believed the sky was the limit with the Woolies' share price. As a result, investors began to think that buying Woolworths at any price was a good investment, regardless of any margin of safety Only time will tell, but it looks like they may have been mistaken.
From December 2007 to today, Woolworths shares have dropped 25% from their peak of close to $35 to trade at around $26 today.
We're not here to guess how high investors will bid up a company's share price. To win in the long run, you need to figure out how you might lose money and buy at a price that protects you from things not going as planned. To do this, we look to the single most valuable concept in all of investing.
The 3 most important words in investing
Margin of safety.
It's simple. Imagine you calculate a company's intrinsic value at $10 a share, and the current market price is $7 a share.
While the shares might appear to be trading for less than it's worth, that's a narrow margin of safety. As a rule of thumb, many value investors look for a 50% margin of safety to protect them from their assumptions being wrong.
However, in some cases they may require a smaller margin of safety. The quality of the business, strength of the balance sheet, and future growth opportunities all affect the margin of safety.
A company with strong brands, global diversification, and growing at a reasonable rate would need a lower margin of safety than a highly indebted company operating in a very competitive sector. Put simply, the chance of permanent loss of capital in the latter company is significantly higher.
Improve your odds
Most investors don't keep tabs on their companies' fundamental values. That's a mistake.
You need to follow companies over time, read past the headlines, and wait to invest till a company is undervalued. If you do so, you're in a much better position to spot potential trouble early.
Better yet, you'll improve your odds of investing in home run shares at great prices that provide the market's best returns.
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This article, written by Dan Dzombak, was originally published on Fool.com. Bruce Jackson, who owns shares in Berkshire Hathaway and Woolworths, has updated it. The Motley Fool has an important disclosure policy.
