The single biggest investing mistake is losing money because you didn’t evaluate the possible downside of an investment. It is easy to see the possible upside in an investment even as a novice. That is why we begin investing. If we decide to invest in Apple, we can imagine all the great sales those new IPods or AirMac will achieve. Usually only seasoned investors see the possible downside. Before making any investment, it is important to make a reasonable assessment of the possible upside AND downside of any investments.
Investing is essentially taking risks with your money. Answer this question: would you rather invest in a stock with a guaranteed return of 10% a year, rather than a stock with a possible 100% upside and 50% downside? If stock X goes up 10% a year for the next 2 years, you will have a 21% profit. If stock Y goes up 100% next year, then down 50% the next, you will have 0% profit (same if it goes down 50% first, then up 100%) after 2 years. The mentality you want to have is that of a risk manager.
The reason that Warren Buffet has succeeded is because he concentrates on large companies that are undervalued and with a competitive advantage. By virtue of being undervalued (defined as trading at a low relative price to earnings ratio, or P/E), the investment will have limited downside. By virtue of having a competitive advantage (patents, large size and scale, brilliant management, brand name, etc), it has an upside.
Another strategy is to invest in large, out of favor companies. A current example would be Home Depot. It is trading at mutli-year lows because it is dependent on a robust housing sector for it’s profits. Because it is out of favor, and there is a lot of negative sentiment around the stock already, there is limited downside. In other words, everyone already knows that it is doing bad, and there are not a lot of people that want to buy it right now. It is likely that the investors who still own the stock are in it for the long term and will not sell on any minor bad news that comes out. On the other hand, any good news will probably bring in new buyers and raise the stock price.
Rule #1 of investing is don’t lose money. Rule #2 of investing is never forget Rule #1.