Rule #1 of Investing: DON’T LOSE MONEY

Rule #2 of Investing: SEE RULE #1

-- Warren Buffett

Warren Buffett will be forever known as one of the greatest investing geniuses of all time. Most traders and investors are in sheer awe of his accomplishments and do not even try to emulate his approach to the markets on the assumption that Mr. Buffett’s strategy is simply too wise and complex to understand. But when you look at his track record more closely, you realize that his success has as much to do with controlling risk as it does with reaping reward. In fact, there are many years when Mr. Buffett underperforms the market earning less that the DJIA or the S&P. Yet in the long run he winds way ahead of the average investor. How does he do it? In the years when the market declines heavily, Mr. Buffett generally loses very little money. For example in 2001 and 2002 when the broader averages were down by double digits each year, Mr. Buffett’s Berkshire Hathaway’s portfolio lost only a few percentage points. In the subsequent run-up, everyone else had to make up their loses before they got back to even while Mr. Buffett continued to compound his profits.

In trading, the turtle really does beat the hare. Unless you able to print double digit returns for many years in a row, controlling your loses is much more important than maximizing your gains. Suppose you have two investors. The first investor generates 20% each year for three year running and then he hits a drawdown of 40%. The second investor makes only 5% each year and then in the fourth year he loses 5%. Who has more money at the end? That’s right the second investor with his paltry 5% returns actually outperforms the first investor who has the stellar hedge fund like numbers. It all reminds me of an old Smith Barney television ad with John Houseman growling into the camera as he utters, "It isn’t how much you eaaaaaaarn, it’s how much you keep!"

As FX traders, this is a lesson that we can all take from Mr. Buffett. While the majority of currency traders focus only on how much they can possibly make letting their greed run wild, we should instead pay much more attention to how much we can lose. That’s why I always believe that the single best decision a trader can make is to radically lower the leverage on the account. I myself trade only on 3:1 leverage and try to never exceed more than 10:1 at any given time. This approach by no means will guarantee you success, but it will provide you with a much greater margin for error and allow you more time to survive the market’s inevitable volatility.

One other strategy that few traders practice is the art of minimizing your loss. Whenever we make a trade, we find ourselves in one of two scenarios. We are either ahead on the position or we are behind. When most traders get seriously behind on the trade, they generally have only one thought, "God please let the trade get back to even and I’ll never do that again!" But trading gods are not that generous, they rarely provide you with a second opportunity to escape without a loss. However, the markets by their very nature often do retrace part of their move and often offer you a chance to exit the trade on a countertrend rally. That’s why when we are seriously behind on a trade, the question we should be asking ourselves isn’t how am I going to make money from this? Rather it should be how am I going to minimize my losses on this loser trade? In that way, each and everyone one of us can be a little like Warren Buffett.

Boris Schlossberg serves as director of currency research at GFT, and runs bktraderfx.com.