“Rule #1: Never lose money. Rule #2: Never forget rule #1.” -Warren Buffett

Warren Buffett’s “Rule #1 and #2” hold special appeal to many investors. They seem to sum up so much good advice in just 11 words. And from a philosophical standpoint they do. But from a practical sense they can cause investors to set such a high bar for making investments that they are unable to fully invest their savings and end up not reaching their financial goals.

What Buffett’s rules help with is avoiding “sins of commission”. These are the mistakes we make when we take an action that goes wrong. Buying a stock that loses money is a sin of commission. Outside of investing, asking someone on a date who says no and leads you to be embarrassed is a sin of commission.

But “sins of omission” can be just as painful. Not investing in a great stock because it wasn’t perfect or because you were too busy learning every last detail of the stocks you already owned to find time to work on new ideas are sins of omission. So is not getting up the nerve to ask that attractive someone out on a date.

There is a sort of wicked tension between avoiding sins of commission and sins of omission when it comes to investing. Every smart and successful investor wishes they knew just a little bit more about the companies in their portfolio. On the other hand every smart and successful investor works hard to allocate more time to researching new ideas.

The problem with Buffett’s advice is that it ignores this tension and focuses investors exclusively on avoiding sins of commission.

In a recent post, Ben Carlson looked at how investors who stayed out of the market in the wake of the financial crisis now must achieve massive gains just to get back to zero. For all the times that you’ve heard about how you need to double your money to get back to even if you take a 50% losses, no one ever talks about the reverse. Similarly, in this 2014 presentation Robert Vinall looks at the dangers of Sins of Omission.

But Warren Buffett is a funny guy. While he’s a fountain of wisdom, many of his quotes are contradictory. While his “Rule #1 and #2” quote is one of his most famous, here is Buffett talking about his biggest mistakes at the 2004 Berkshire Hathaway shareholder meeting (according to notes taken by Whitney Tilson):

“The main mistakes we’ve made – some of them big time – are: 1) Ones when we didn’t invest at all, even when we understood it was cheap; and 2) Starting in on an investment and not maximizing it… We’re more likely to make mistakes of omission, not commission.”

So Rule #1 is “don’t make sins of commission” and yet Buffett admits it is sins of omission that have been his biggest mistakes. How do we reconcile this contradiction?

Warren Buffett is way to complex and sophisticated of a thinker to be summed up in a sound bite. But that’s what people have done with the Rule #1 and #2 quote. Life would be so easy if we could act on the basis of simplistic soundbites. But life, and investing, is far more complex. Yes, when investing we should always seek to protect our capital and be sure to focus on downside risks as much as upside potential. But also, we should recognize that not investing can be just as big of a mistake as making a bad investment. The issue for investors is not to try to avoid any and all mistakes. The goal is to compound your capital as much as possible over the long-term. Doing this well requires taking risks that might cause you to lose money, in direct violation of Buffett’s Rules. But it also requires protecting your capital and paying attention to the risk of loss as much as you pay attention to the opportunity for gains.

It is where Never Lose Money meets Mistakes of Omission that we find the interesting frictions and incongruities that lay at the center of successful investing.

The soundbite of the Rule #1 quote is, quite literally, a danger to reaching your long term investment goals. But in practice, Buffett has figured out how to reconcile the two opposing concepts of not losing money while also not being too afraid to act even in the face of uncertainty. It is this ability to reconcile opposing ideas that stands at the center of Buffett’s brilliance.

“The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.” -F. Scott Fitzgerald

 

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.