What is the key to a lifetime of successful investing? People have all sorts of answers to that question, but I think that Warren Buffet’s answer is the best:
An investor needs to do very few things right as long as he or she avoids big mistakes.
Speculating on a bunch of unproven companies can certainly lead to enormous gains if they make it big, but it can also lead to some truly staggering losses. Imagine two hypothetical investors. Investor A speculates and has some very good years and some very bad years. For three years in a row his portfolio is up 50%, but then in the fourth year he loses 70% to a series of big mistakes. This cycle repeats itself over Investor A’s investing lifetime, about 40 years. Investor B, on the other hand, manages a 5% return each and every year for the full 40 years. Which investor does better in the end?
Given that 75% of the time Investor A manages a 50% return it would seem at first that he should blow away Investor B. But not so.
Because Investor A continually makes big mistakes his successes are almost completely canceled out. When you lose 50% of your portfolio you need a 100% gain just to get back to even, and this fact is working hard against Investor A. Investor B, on the other hand, never found the next big thing because he wasn’t looking. Instead, he was consistent and avoided making the same mistakes which Investor A made. And at the end of 40 years time he was much better off for it.
How to avoid big mistakes
Warren Buffett talks a lot about moats, and for good reason. A moat is some kind of durable competitive advantage which allows a company to achieve above-average returns on capital in the long-term. Buying stock in companies with moats is generally a good idea, although overpaying for them can certainly lead to sub-par results. But they rarely lead to the horrifying results achieved by Investor A. And by the time they do it has typically been clear for a while that the moat has vanished.
Buying stock in companies that have no discernible competitive advantage can be fraught with danger. It can certainly lead to huge gains if the company is successful, but it can lead to huge losses as well. Take Groupon Inc (NASDAQ:GRPN), for example. The company partners with businesses to offer coupons for discounts on products and services, and was the first of the “daily deal” sites to gain prominence. Groupon Inc (NASDAQ:GRPN) IPO’d in 2011 at $20 per share, valuing the company at $15 billion at the time. The company had yet to turn a profit, but revenue was growing fast.