Psychology of money

What is the difference between a 10% loss for Warren Buffett and an ordinary investor

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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”.

Posted in Books, Future value of money, Investment principles, Natural law of money, Philosophy, Uncategorized, Warren Buffet | No Comments »

Winning Investment Habit No 1 – KEEP WHAT YOU HAVE. Preserve your capital

Rule No. 1: Never lose money.
Rule No. 2: Never forget Rule No. 1

Warren Buffet

„Survive first and make money afterward.”

George Soros

„If you don’t bet, you can’t win. If you lose all your chips, you can’t bet”

Larry Hite

What’s the difference between a Winning Investor and a Loosing Investor?

The winning investor – Believes that his first priority is always the preservation of capital, which is the most important cornerstone of his investment strategy.

The loosing investor – Has only one investment aim – „to make a lot of money”. As a result he often fails to keep the money he already has.

Did you know that if you have a stock that drops 20% then you would need it to grow 25% in order to get back to the same price level before the price drop. (Example: If you start with 100 dollars and lose 20% you will end up with 80 dollars. In order to go from 80$ to 100$ you need a gain of 25%).

If you lose 50% of 100 dollars you will end up with 50 dollars. But in order to get from that 50 dollars back to 100$ you need to double the 50 bucks. This means you need a growth of 100% .

It might not seem like a big deal – 50 dollars to lose is nothing catastrophic. But consider the same on a larger scale.

Let’s say that you have a pension fund that holds 1 million dollars. Because of problems in the subprime market your fund loses half of its value – now you only have 500 000 dollars left. What do you think how much time would it take to get back to the initial 1 million?

Well no one can tell for sure but the only thing that is known for sure is that it will take a lot more effort (and time) to get the money back.

Here is a chart that on the left give you the initial loss in % and on the right it shows how much you need to make afterwards in order to get the initial sum back.

This is exactly why Preservation of capital is ALWAYS the number 1 priority of any half decent investor. If you have a loss of 1 per cent you need a growth of more than 1 per cent to get the money back. The more you lose the bigger the gap between what you lost and how much you need to make to get it back will grow.

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

Posted in Books, Future value of money, Investment principles, Natural law of money, Saving money, Uncategorized, Warren Buffet | 1 Comment »

The natural law of money

Each and every one of us has seen the natural law of money at work.

It is so simple that most of us are familiar with the law in a subconscious level but almost never think about it consciously.

So what is this law you ask?

It is simple. The natural law of money is as follows:

The more money you have the faster you will get to the point that you don’t have any money at all. The less money you have the slower you will get to the point that you don’t have any money.

In other words - the more money you have the faster you will spend it.

This is a universal law but it only works in the middle of the scale - it will cease to work when you don’t have any money at all or if you are a wealthy multi billionaire.

So, the natural law of money says that the more money you have the faster you will get rid of it?
How can this be you ask? It is common knowledge that in order to make money you need to have money in the first place - aren’t these 2 statements contradicting?

Well, not really - the natural law of money only works if you are not thinking about how to make more money. If you start to think about how to keep your money - or better yet - how to grow your money then the natural law of money stops working.

If you start thinking about how not to spend your money your chances of multiplying what you have grow exponentially.

Posted in Cutting costs, Goals, Natural law of money, Saving money, getting started | 3 Comments »