Warren Buffet’s first rule of investing is “Don’t Lose Money” and his second rule is “Don’t forget Rule #1.” Far be it for me to question the wisdom of one of the more successful investors of his generation, but I question how practical this rule is for retail investors like you and me. The missing context in the “invest like Buffet” school of thought (which I whole heartedly agree with) is that Buffet runs a large insurance business and invests the proceeds of insurance policies for a living. I would actually be appalled if someone with that breadth of business experience and acumen did not experience above average investment returns. One other factor we tend to over-look about Buffet: he’s playing with a lot of other people’s money (granted, some of the money is his as well). You tend to sleep better at night if you didn’t lose house money. Having said that, this does not diminish Buffet’s stellar track record; many others have used other people’s money and fared far worse (mutual fund managers line up to the right please…).

For the rest of us not blessed with Buffet’s midas touch, I wonder whether this ideal investing rule could not be expressed more effectively. Perhaps for us mere investing mortals, our first rule of investing should be: “invest only what you can afford to lose.” Let me explain.

One of the more recent trends in the personal finance world is the application of psychology and behavioral studies to investing. Coined “neuroeconomics” by some, scientists have attempted to determine why we do the things that we do. For those who have been in sales most of their life, I am sure that some of the findings may come as no shock; people are motivated by negative emotions like fear, anxiety and worry more than positive emotions like happiness. Think of anyone who’s ever sold you insurance. They don’t sell you on the fact your estate will be resolved satisfactorily. They sell you on visions (nightmares?) of car crashes, orphaned children, planes going down- the 1 in a million occurrences that provoke negative emotions. In the investing world, most average investors are motivated by fear and loss. Think of the average investor- they fear loss so much they sell while the market is dropping assuming they are fleeing to safety (while losing money in the process).

A friend passed along this article on why people do foolish things with money. I focused particularly on this passage: “Regret falls under a psychological effect known as loss aversion. Research shows that before we risk an investment, we need to feel assured that the potential gain is twice what the possible loss might be because a loss feels twice as bad as a gain feels good. That’s weird and irrational, but it’s the way it is.” (emphasis is my own)

But Buffet’s rule doesn’t address the other side of the emotional equation: the compulsiveness and loss of control that occurs when we get an adrenaline rush of winning. Gamblers speak about this; you get on a winning streak and you lose your mind. You think you can’t lose. But the house always wins and gamblers end up dead broke believing the next hand is the “big one.” It is what creates bubbles and “irrational exuberance”; we become emotional junkies and shut off the analytical side of the brain trying to get the next high. I called this my “penny stock” phase. It sounds better than my “stupid phase.”

Buffet’s rule focuses on avoiding loss but “invest only what you can afford to lose” addresses our emotional duality: a remainder that we should always have enough even after our losses not to enter into a blind panic and to avoid getting “high” on chasing profits and keep pouring money into investments that we think will never go down (i.e. don’t gamble the house on a stock).

We are seeing both sides of the equation now. Think of the euphoria, as recent as 12 months ago, of people who made large leveraged investments into real estate thinking it would never go down. “They don’t make land anymore.” True, but how many $500,000 houses in distant suburbs does America really need? Now we are on the opposite end of the scale- the world will end tomorrow. Sell Google stock- its worthless! Buy gold bullion, you’ll need wagons of money to buy bread soon!

Investors don’t become average by buying the wrong investment. Investment become average by obeying the wrong emotions.

Thoughts?

If you are interested in neuroeconomics, the book du jour is Your Money and Your Brian by Jason Zweig who is the Malcolm Gladwell of his genre. My Money Blog wrote a great review of the book.

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