The first rule of investing is, you do not lose money. It’s the single most important concept that new investors struggle with, and it’s the concept that Benjamin Graham used at the start of his seminal book The Intelligent Investor. Graham starts Chapter 1 by defining the difference between investors and speculators: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
Since speculation isn’t safe, it shouldn’t be considered a form of investing. It’s more akin to gambling, and it’s responsible for phenomenal losses in stocks, bonds, derivatives and black jack.
To belabor the point: your principal is the most important thing in your portfolio. Let’s say you invested your principal ($10,000) in a “hot” stock. If that stock loses 50 percent of its value, your principal is now $5,000. To get back to $10,000, you’re going to have to generate returns of 100 percent!
Point taken, but what’s the simplest way to protect your portfolio against losses? In short, by diversifying. Graham recommends a mixture of stocks and bonds, with no one asset class falling below 25 percent of your holdings. For example, if you’re holding 25 percent of your principal in bonds, the other 75 percent should be in stocks. This scenario would only occur if you reasoned that stocks were undervalued. If stocks appear overvalued, your position would be reversed: 25 percent in stocks and 75 percent in bonds.
Ok. Great. That makes sense, but what sort of stocks should I buy? Again, using Graham as a guide, you should only buy stocks when they’re cheap relative to the underlying value in the company. Since no one can predict where the market will be in the coming days, one of the best strategies for protecting your principal when picking stocks is by “dollar-cost averaging.”
When you dollar-cost average, you start accumulating shares of a particular company on a regular basis; i.e. you’re buying shares of Google (NASDAQ:GOOG), every second Monday no matter what the cost. This helps minimize the risk that you’ll be caught in the day-to-day whims of the market by averaging your purchase price over time.
Safe isn’t necessarily sexy, but it’s about the only way you’ll be able to sleep at night. Graham knew that, and he did his best to share his experience with others. We’d be wise to listen up.