When you invest your savings, you are taking on risks. This is an unavoidable fact for investors. Even if your entire portfolio is United States treasury bonds, you are still taking on some level of risk, no matter how small. The hope is that any potential rewards in the form of wealth creation outweigh these risks.

This is why it is important to implement risk management techniques when building an investing portfolio. Legendary investor Warren Buffett sums it up succinctly with this famous quote:

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

Warren Buffett

We’ll explore what Buffett truly means by this quote and how you can use it to build a rock-solid investment portfolio. In bull markets, many people focus on the potential rewards an investment can provide. But what people should focus equally—perhaps even more—on is avoiding losses.

In this post, we will cover:

• The goal of risk management in investing
• How to diversify your investment portfolio to avoid permanent losses
• What you don’t do matters more in risk management

The goal of risk management in investing

At first glance, Buffett’s quote on losing money may sound obvious. Of course, none of us want to see stocks go down, right? However, Buffett’s quote is not about the temporary fall of stock prices. Even the greatest investors like Buffett can’t avoid buying stocks that fall in the short term, sometimes for many years. This is something you should expect to happen, at least from time to time.

What he does mean is risking permanent loss of capital. For an individual investor, this is your portfolio falling to zero – or at least close to it – with no chance of recovery. This can come through stocks you own filing for bankruptcy or by taking on too much leverage and risk in your own portfolio (which we’ll cover in the last section).

Let’s take an extreme example to hammer home the point.

An investor that returns 20% per year for 50 years can turn $100,000 into over $900 million. These are incredible returns. At this point, the investor has built a life-changing amount of wealth from just a small (ish) pile of savings. But if that same investor takes on too much risk and causes their portfolio to go to zero, they will permanently lose all this money. They must start over again, no matter how strong their past returns were.

Remember, any number multiplied by zero equals zero. No matter how good your historical performance is, if you make one mistake that permanently destroys all the value in your portfolio, all those past gains are erased.

So, the overarching goal of risk management is to avoid permanent losses. But what strategies do you actually implement to minimize the effects and/or avoid the risk of permanent losses? One word should rise above all else for beginning investors: diversification.

How to diversify your investment portfolio to minimize and avoid permanent losses

The easiest way to manage the risk of permanent capital loss is to properly diversify your portfolio.

There are a lot of ways to diversify. Some simple, some extremely complicated. For beginners, I would focus on three methods of basic diversification:

1. Diversifying across different stocks
2. Diversifying across different sectors
3. Diversifying across different asset classes

Method 1: Stocks

Diversifying across stocks is easy to understand. On average, each individual business has a decent chance of going bankrupt. If your entire portfolio is in one stock, and that company files for bankruptcy, you have just permanently destroyed all your capital. Buying one stock—or even just three to four stocks—is poor risk management.

The good news is it only takes 10 – 12 stocks to diversify a portfolio fully. Many investors might want to own more than this, with a typical portfolio of 20 – 25 stocks.

But don’t go around thinking the more stocks you own, the better. At around 25 stocks, an equal-weighted portfolio sees no diversification benefits from owning more companies. At some point, an investor should just own an index fund and forget buying individual stocks. If you own 100 stocks, you’ll get the same returns as index funds with much more work.

Method 2: Sectors

Method two is diversifying across different sectors. On average, 10 – 12 stocks will get you proper amounts of diversification. But if those stocks are all in one sector, you might not actually be diversified. A portfolio filled with unprofitable biotechnology stocks is not diversified.

Conversely, a portfolio exposed to many different sectors across the economy will give you much better diversification and risk management. This is something I see individual investors underrate. It is not that you just need to own at least 10 – 12 stocks, but 10 -12 stocks that aren’t exposed to the same economic factors.

Method 3: Asset Classes

Investors can further diversify beyond stocks by expanding their portfolios to different asset classes. These can include bonds, high-yield savings accounts, real estate, or commodities. If you clear the minimum investment size, you could even get fancy and buy private equity or venture capital investments.

Example of Good Diversification

A classic example of diversification across asset classes is the 60/40 portfolio. This is a portfolio made up of 60% stocks and 40% bonds. The portfolio is often rebalanced back to its starting exposure, typically quarterly or annually. This is because stocks may outperform bonds (or vice versa) for a time and cause the portfolio to deviate from its 60/40 exposure.

Why is rebalancing important? It allows an investor to trim their exposure in a systematic fashion to the asset class that has recently outperformed and add exposure to the asset class that has underperformed.

The historical performance has been quite strong. 60/40 portfolios have returned close to the long-term performance of index funds with less harsh drawdowns due to rebalancing and exposure to fixed income (another term for bonds). This can further improve an investor’s risk management strategy and is popular for investors nearing or in retirement.

To sum up, proper diversification comes from having your eggs in more than one basket, but not too many. You should own many different stocks (whether through individual purchases or index funds), not be overexposed to one sector, and possibly consider other asset classes.

What you don’t do matters more in risk management

Asset diversification is excellent. However, an investor can get in trouble and permanently lose capital in other ways. These mainly come from decisions made outside of asset allocation and are sadly all too common in modern financial markets.

Two common culprits can lead to permanent capital losses, or what some may call “blowing up” a portfolio and sending its value to zero: margin trading and options trading.

The risks of margin trading

Buying stocks on margin just means taking out loans to buy assets. Some brokerages will lend to investors so they have more capital to purchase stocks.

Buying stocks on margin offers tremendous upside but creates unnecessary downside risks. For one, you have to pay interest on the loans back to the brokerage, which can drag returns down.

More importantly, buying stocks on margin means you have a risk of permanent loss of capital even if the stocks you own don’t go to zero. Your brokerage won’t let the value of your portfolio run well below your capital level, as that would be poor risk management for them.

Without getting into the details in this article, when the value of your portfolio falls below the actual capital (or cash you deposited into your brokerage), your broker will implement a “margin call” and require you to deposit more cash into your account. If you don’t have the cash, the broker will take ownership of these assets from you as collateral in a default bank loan.

Buying stocks on margin dramatically increases your risk of permanently destroying the value of your portfolio and should never be implemented, especially among beginning investors.

The risks of options trading

The second culprit of poor risk management is using stock options to try and juice portfolio returns. Options are a way to not only bet on the direction of a stock but at exactly what price it will trade at a specific future date.

Again, we don’t have time to explain how options work in this article. But given their current popularity and the amount of money lost using them, it is essential to reiterate how dangerous they can be.

For example, if you buy a stock up 10% a year from now, you will have gained 10% for your portfolio. Simple. But if you bought an option on the same stock betting that the price will be at least 20% higher one year from now, the value of that option contract would be worth zero. A permanent loss of capital, and one that keeps happening time and time again in modern markets.

Never buy stocks on margin and never use options to avoid blowing up and permanently losing capital. It’s that easy.

I would also add cryptocurrencies to this list. I understand that some people are fervent proponents of digital currencies, but they have no backing of cash flows underlying the asset. We have seen cryptocurrencies go to zero repeatedly, with many buyers getting tricked and/or defrauded. These investors took unnecessary risks and exposed themselves to permanent capital losses for no reason.

No one is immune to risks in financial markets. It is just as important – if not more so – to avoid the downside and find stocks you think will go up. Never forget Buffett’s rule #1 when it comes to investing and implement proper risk management strategies when building your portfolio.