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When we lose money, we count the dollars we actually lost. Not Warren Buffet. His loss is what those dollars could have been. For him losing money is a gross violation of his underlying aim, which is to “watch money grow”.

Preservation of capital is an investment rule propounded by many but practiced by few.

When asking investors how it would feel to make preservation of capital, most report a sense of paralysis or a feeling that you can’t do anything because you might lose your money.

Here is a graph how most investors think about investing and risks. The conventional thinking goes like this – in order to make a 1000 dollars I need to risk to lose the 1000 dollars I already have.

Here is another graph showing the thinking behind the best investors of the world.

There are a couple of reason why the graph for the best investors in the world looks a lot better to anyone even remotely acquainted with the principles of risk versus potential profit. The second graph illustrates a proportionally smaller amount of risk with better profit.

Here is why the second graph is the right way to think about risk and reward.

1) While investing money the most you can lose is all of it but the most you can win is unlimited. If you bought the stock of Microsoft in the early 80’s you would have made more than 100 times the money you put in on your investment.

2) The second reason for this graph to look like it does is even more important. Because of the compound interest every dollar that you make on your investmet further increases the amount that you are going to make. For instance if you manage to buy a stock with a dividend yield of 10% then after the first year your 100 dollars would be 110, after the second year 121, after the third year 133,1 and so on. As you can see the first year you made 10 dollars, the second year 11 dollars and on the third year 12 dollars and 10 cents. When you have a stock that keeps rising 10% a year that doesn’t pay any dividends it is essentially the same thing – the first year your stock price will rise 10 dollars, the second year 11 dollars and the third year 12 dollars and 10 cents.

The investors that consider the second graph to tell the truth are more often focused on the investment process. They don’t view each investment to be a discrete, individual event because they know that even if you only invest for a relatively short term and make 10 per cent on your investment – it will give you 10% more to invest the next time.

Thanks to the compound interest you will potentially make more money with every passing year. Thus the longer your investment period the lower is the risk to lose all your money compared to what you can make.

The ideas from this post are derived from the book „The Winning Investment Habits of Warren Buffet & George Soros”.