Warren Buffett has two important rules: “Rule one: never lose money. Rule number two: never forget the first rule. At first glance, his words seem trivial. Everyone already knows that you should never lose money, it’s obvious.
But what is really behind these rules?
One of the most important functions of investing is to preserve capital. Some investors forget this, focusing only on profits. Risk management is a set of rules that allows you to minimize possible losses and be prepared for unforeseen circumstances.
It is not possible to avoid losses completely, even Buffett loses his capital due to market volatility. But everyone can reduce the risk.
What can any investor do?
- Reduce risk: if you allocate 1-2% of your portfolio to a risky trade, even in the worst-case scenario you will lose 1-2% rather than your entire portfolio.
- Diversify your investments: don’t invest too much in one asset. For example, don’t keep all of your assets in one stabelcoin (the fall of UST showed how important this is). Don’t keep too many altcoins in your portfolio, neglecting BTC (altcoins fall faster than Bitcoin)
- Have a safety cushion and reserve: the crypto market constantly gives you new opportunities, and the reserve will allow you to use them. And a safety cushion will help in unforeseen situations. There is no need to rush for fear of not making enough profit.
Risk management is not limited to these examples
There are no universal rules, it all depends on strategy and activity. For example, traders use Stop-Loss orders, partially or completely fix profit at certain levels, use indicators to assess risks and so on.
Often people lose a lot of money because of FOMO. For example, an investor buys some altcoin and expects it to fly to the “moon”. Because of his inflated expectations, he invests too much in the deal for fear of missing out on profits. The growth doesn’t happen and he loses most of his capital.
Bottom line: Buffett’s rule calls for rational thinking and sound risk management. Even a few simple actions can significantly reduce losses.