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Warren Buffett: Know When to Cut Your Losses

Despite being one of the greatest investors of all time, Warren Buffett (Trades, Portfolio) has made his fair share of mistakes. Investors can't expect to be right 100% of the time - in fact, you'd be lucky to be right 60% of the time.

A core aspect of value investing is finding cheap businesses that are unloved by the market, but at the same time, you have to respect the fact that you will often be wrong. The trick is to know when to throw in the towel on a business or investment. Here's what Buffett had to say on the issue in an interview with Fortune.

Bad economics trumps good management

Buffett stated that one of the biggest warning signs to an investor is when a business deteriorates even when it is run by competent people:

"When you really know you have a bad business is when you have a good manager and bad results. When you get bad results with a bad manager you still have to examine the question of whether you can get better results with a better manager. When a management for a reputation for excellence encounters a business for a reputation for bad economics, it's the reputation of the business that remains intact - and I've proved that many times!"

He then talked about a deal he did in the early 1990s buying a shoe company called Dexter Shoes. This turned out to be a disastrous business decision because even though the company was profitable and well-run before being acquired by Berkshire, it could not survive the fact that clothes manufacturing as an industry was leaving the United States. The bad macroeconomics overwhelmed the good management of the company.

By his own admission, Buffett usually cuts his losses later rather than sooner. He pointed to his experience acquiring the original Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) textile business as evidence of his desire to turn around a struggling business rather than throwing in the towel early. Now, while it is certainly true that Buffett stuck with his textile businesses for longer than he probably should have, recent events have shown that he has no qualms about cutting a position that he no longer believes in.

During the most recent Berkshire annual investor conference, Buffett disclosed that he and his team had sold Berkshire's stakes in the four biggest U.S. airlines - United (NASDAQ:UAL), Delta (NYSE:DAL), Southwest (NYSE:LUV) and American (NASDAQ:AAL), due to deteriorating macroeconomics. I think this is a good example of how Buffett's folksy public attitude of "buy and hold forever" is somewhat at odds with his keen business sense and willingness to protect himself against losses by selling out early. In fact, as I wrote in a previous gurufocus article, this is a trait that great investors shares with great traders.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.