The Easy Way to Follow Warren Buffett’s ‘Golden Rule’

May 28, 2021

Legendary billionaire Warren Buffett is famous for his folksy and straightforward advice on investing.

But he’s probably best known for one comment in particular.

During a 1985 interview on PBS, the host asked Buffett about the “rules” of successful investing. Here’s what he said:

“The first rule of investment is don’t lose… The second rule of investment is don’t forget the first rule. And that’s all the rules there are.”

Buffett was referring to the critical importance of risk management. He believes investors should focus on minimizing losses before they even think about maximizing gains.

Here at TradeSmith, we couldn’t agree more.

In fact, as I mentioned last week, our entire approach to investing is founded on three critical risk-management principles:

  1. Have a clearly defined exit strategy for every position you own.
  2. Don’t risk too much of your money in any single position.
  3. Spread your risk across a reasonable number of assets and positions.

We covered the first principle back in February. (If you missed it, you can catch up here and here.) And we covered the second one last week.

So today, I’d like to talk about the third. This one pertains to what professional investors call “asset allocation.”

This principle is probably the simplest and easiest to understand of the three. You can sum it up with the phrase, “Don’t put all your eggs in one basket.” But plenty of folks still get it wrong.

The most common mistake I see new investors make is putting too much of their hard-earned money in one asset class. And typically, that asset class is stocks.

Now, most folks know it would be dangerous to put all their money in just one or two stocks. So, they usually spread their money across several different stocks instead.

But the reality is, no matter how many different stocks an investor owns, if all of their money is in stocks, they’re almost certainly taking much more risk than they realize.

When the broad stock market suffers its next multiyear bear market — and make no mistake, it’s simply a matter of time before it does — those folks are likely to lose a big chunk of their savings, even if they’re using trailing stops and proper position sizing.

The same idea applies to any other asset class as well.

Bottom line: If you keep all of your “eggs” in one asset “basket,” sooner or later, you’re going to suffer a significant loss.

Instead, successful investors make sure to spread their risk around several major asset classes, including:

Let’s quickly go through each of them.

Cash

Cash includes paper currency and any money you have in bank, brokerage, or money market accounts. But it can also include “cash equivalents” like short-term U.S. Treasury bills.

Cash isn’t sexy, but it gives you “optionality.” It’s the only asset that you can easily use to take advantage of opportunities in other assets.

Warren Buffett agrees. He’s often referred to cash as a “call option” on any other asset, with no strike price and no expiration date.

For this reason, I believe every investor should always hold at least a little cash. Depending on personal or market circumstances, this might range from 5% to 50% of your portfolio.

For example, if you’re following a “buy-and-hold” approach, you’ll generally want to hold more cash, both as a buffer and to take advantage of market corrections. You’ll likely also want to hold more cash when one or more asset classes are expensive (like today) and less when assets are relatively cheap.

On the other hand, if you’re following our TradeSmith approach, which will automatically raise additional cash when your trailing stops are triggered, you can generally get away with holding less cash.

The only exception to this rule is if you don’t already have a “rainy day” fund with at least six to 12 months of living expenses in cash. In that case, you should make saving your top priority.

Bonds

Bonds are what’s known as “fixed-income securities.” You can think of them as a loan you make to a government or company.

In return for your initial investment (or “principal”), the issuer agrees to pay you interest on a regular schedule for a fixed amount of time. When that time ends, the issuer is also legally obligated to pay back your principal.

As I explained in our series on the “All Seasons” portfolio, U.S. Treasury bonds have been an easy way to boost the returns and lower the overall volatility of a diversified portfolio over the last 90 years or so.

Of course, with interest rates near historic lows and inflation threatening to move higher for the first time in decades, bonds may not perform as well in the years ahead. But I’m not ready to dismiss them entirely.

If you’re a buy-and-hold investor, I would still recommend owning some bonds to help offset the volatility of your stocks. Again, how much will depend on your circumstances, but somewhere between 10% and 40% (the bond allocation in the popular “60/40” portfolio many advisors recommend) probably makes sense for most folks.

However, I will point out that Treasury bonds are currently in the TradeSmith Health Indicator Red Zone. So, if you’re following our approach, there’s no reason to own them until they return to the Green Zone.

Stocks

I assume most Money Talks readers are familiar with stocks. They represent fractional ownership in individual businesses, and they’re historically one of the best ways to build wealth over the long term.

However, they are historically much more volatile than most other assets. That means it’s even more important not to put too much of your portfolio in stocks alone. Depending on your circumstances and risk profile, allocating somewhere between 30% and 60% of your total portfolio to stocks is reasonable.

But because stocks represent ownership in different businesses with different risk profiles, you’ll also want to be sure to spread your “stock risk” among several stocks as well.

At TradeSmith, our research suggests owning somewhere between 10 and 50 stocks is about right. Owning fewer than 10 stocks will expose you to significant stock-specific risk. And owning more than 50 tends to lead to lower long-term returns.

Owning 15 to 20 stocks is the “sweet spot” for most investors. It’s reasonably concentrated to allow you to outperform the market over time. But it’s still diversified enough to avoid the stock-specific risk I just mentioned.

If you’re a buy-and-hold investor, you’d be wise to stick to the stocks of great businesses that are likely to do well over the long run.

If you’re following our Health Indicator system, you have more flexibility to invest in less-proven or more-speculative stocks without taking excessive risks. But you’ll still generally do better if you stick primarily to high-quality stocks.

Real Estate

Owning real estate can be another great way to diversify your assets. However, I can tell you from experience that most folks should stick to the basics here. Riskier strategies like “house flipping” defeat the purpose of diversification and can get you into serious trouble.

The simplest way to own real estate is through your primary residence. Owning income-producing rental properties is another great option for folks with more capital.

Commodities

Commodities are probably the most misunderstood of the major asset classes. That’s because their prices are influenced by several different — and often divergent — factors.

One is technology. Over time, humans have become more and more efficient at finding and producing commodities. As a result, most become more abundant over time, leading to falling prices in the long run.

Another is inflation. Commodities are “hard assets” used in virtually every industry. That makes their prices highly responsive to changes in the money supply.

And, of course, like all assets, commodities are influenced by supply and demand. Prices go up when supplies fall or demand rises, and they go down when supplies rise or demand falls.

Together these factors make commodities incredibly cyclical. They tend to go through huge “booms” and “busts” more often than most other assets.

That means it’s generally a bad idea to buy and hold commodities for the long term.

This isn’t an issue for TradeSmith subscribers. But if you’re a buy-and-hold investor, your best bet is to own commodities only when the fundamentals are in your favor (during the “booms”), or to limit them to a relatively small percentage of your overall portfolio.

In either case, unless you’re comfortable trading in the futures markets, I’d recommend sticking to a diversified, lower-cost exchange-traded fund (“ETF”). I mentioned one of these — the Aberdeen Standard Bloomberg All Commodity Longer Dated Strategy K-1 Free ETF (BCD) — in my “All Seasons” portfolio series last month.

Precious metals

Technically, gold and silver are commodities, too. However, their relative scarcity and long history as money warrant a separate allocation.

I like to think of gold and silver as a kind of “insurance” against government shenanigans. And with virtually every major government flooding the world with unprecedented stimulus today, I believe it’s more important than ever for every investor to own some.

In general, I recommend most folks keep somewhere between 5% and 10% of their total portfolio in gold and a little silver. But again, those who are following our TradeSmith approach may prefer to own this “insurance” only when it’s in the Green or Yellow Zones.

Finally, I would recommend owning at least part of this position in the form of physical gold and silver bullion stored in a secure location. But popular ETFs like the SPDR Gold Shares ETF (GLD), iShares Gold Trust (IAU), or iShares Silver Trust (SLV) are suitable options as well.

You might also consider a physically-backed ETF like the Sprott Physical Gold Trust (PHYS) or Sprott Physical Silver Trust (PSLV).

Bitcoin and Crypto Assets

Finally, no discussion of asset allocation these days would be complete without addressing crypto assets and Bitcoin in particular.

I shared my thoughts on cryptos in detail in a Money Talks series earlier this year, so I won’t rehash them all here. (If you missed it, you can read it here: Part 1, Part 2, Part 3, and Part 4.)

In short, Bitcoin could ultimately be an even better store of value and inflation hedge than gold itself. So, I think it deserves a spot in any well-diversified portfolio today.

However, it still doesn’t have anywhere near the same long-term, proven track record as precious metals, so I don’t recommend risking too much. Somewhere between 1% to 5% of a total portfolio probably makes sense for most investors.

Of course, these are just general guidelines. Depending on your financial situation, you may choose to allocate differently.

The important thing is to spread your risk among several different assets to avoid risking too much of your money in any one of them.

It’s a simple idea. But when used alongside trailing stops and proper position sizing, it’s an incredibly powerful way to improve your long-term investing success.