How to Avoid Losses in Your Investments

American billionaire investor Warren Buffett is famous for not wanting to lose money when he invests. He hates losing, so much so that he’s quoted as saying, “Rule number 1 in investing is: Don’t Lose Money. Rule number 2 is: Don’t Forget Rule No.1”.

Now, this does not mean that he expects to be on the winning end all the time in his investments. That just can’t happen – people make mistakes, lots of it, even Buffett. The key takeaway though, is that Buffett tries to assess the possible downside-risks and losses with every investment he makes, often aiming for minimal downside.

This brings to mind the idea that knowing what not to buy, is as important – or maybe even more important – than knowing what to buy. If we can know where to avoid the losses, we can protect our gains. Or, as long-time Buffett sidekick Charlie Munger says, “Tell me where I’m going to die, that is, so I don’t go there.”

While that’s obviously not achievable in life (we’re all going to kick the bucket sometime down the road), there are easier ways to avoid ‘death-spots’ in investing.

A business that’s a chronic loss-maker is not going to be worth much of a dime in the long-run. Try asking your favourite char kway teow stall owner if he’ll still be there stir-frying that culinary delight every night if the stall was bleeding cash all the time.

In the same vein, as shareholders, we’re part-owners of a business. And, if the business can’t make money, we’re not going to be able to profit either. It’s really as simple as that.

In Singapore, companies listed on our stock exchanges are required to give notice if it has chalked up three years of consecutive losses. This “NOTICE OF 3 CONSECUTIVE YEARS’ LOSSES” can be found on the SGX website here.

There were four companies serving the notice in the months of May and June; information technology provider Stratech Systems (SGX: S73); pharmaceutical firm Transcu Group (SGX: E15), which specialises in drug delivery systems; investment holding firm Japser Investments Limited (SGX: FQ7), with interests in the oil and gas industry; and manufacturer of precision-moulding parts, China Kunda Technology Holdings (SGX: GU5).

For five years ending 3 June 2013, the Straits Times Index (SGX: ^STI) had gained less than 5%.  Investors who invested in the index five years ago would not have been too happy.

But, that’s nothing compared to what investors in those four companies experienced. The results range from an almost complete wipe-out for Transcu’s shares, to a more than 50% loss in Stratech System, as seen from the graph below.

how to avoid losses

Source: Yahoo Finance

These companies were either making chronic losses or seeing rapidly shrinking profits prior to June 2008. In fact, Stratech had chalked up consecutive years of losses from 2004 to 2007. It really wouldn’t be that hard to side-step that potential land-mine as the three-year-notice could have delivered an early warning.

Over the long-run, its businesses that generate growing profits and cash flow that can slowly make shareholders rich. Buffett’s number one rule is to not lose money. Perhaps that’s a rule we can use to apply to companies we want in our portfolio – these companies shouldn’t be losing money too.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.