Imagine I buy two shares one after the other. One goes down 50%. I sell it, then use the proceeds to buy a different share, which goes up 50%. How much of my original money do I have left? The answer is 75%. That is the power of falling share prices. It would be the same the other way around too – if my first share went up 50% and I reinvested the proceeds in a share that fell 50%, I would have 75% of my original money left over.
That may seem odd. One share rose by the same amount as the other fell. But the movements did not cancel each other out. That is a critical lesson for investors.
Warren Buffett on losing money
The famous and very successful investor and Berkshire Hathaway chairman Warren Buffett says that the first rule of investing is never to lose money and the second rule is never to forget the first rule.
That sounds so blindingly obvious I think many people do not even realise what a powerful piece of investing wisdom it really is. As my example above shows, two investments that move equal amounts in opposite directions do not simply cancel each other out.
Falling share prices and losing money
But another part of Buffett’s investing approach is also helpful here. He imagines the stock market as a person called Mr. Market. Every day, Mr. Market offers to buy your shares at a certain price, or sell you more shares at that price.
The brilliance of this Mr. Market analogy is that it underlines how voluntary selling shares is. If I do not want to sell my shares, I do not have to (in most situations, although, sometimes a takeover bid may be different). So falling share prices can mean my portfolio is worth less on paper. But I have not actually lost money unless I sell shares at that level.
Sometimes, it may make sense to do so. If a share price is falling because a business’s fundamental prospects have changed, it might be less painful for me as an investor to sell my holding and swallow the loss. But in many cases, if I still believe in the investment case for the business, I will keep the shares as part of my long-term investing philosophy. Until I sell, falling share prices are only a paper loss.
Thinking about how to buy shares
That helps explain why I look at the possible downside of shares I could buy, not just the potential upside.
Of course I am looking to invest in companies that can do well and make me money. Falling share prices could offer me an opportunity to buy them more cheaply than before. But even more important than that to building long-term wealth is avoiding companies that will cause me to lose a lot of the money I invest. That may sound obvious, but it is a lynchpin of Buffett’s approach to investing.
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Christopher Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.