How Can You Invest Like Charlie Munger?
Charlie Munger is one of the best investors of all time. He worked as the vice-chairman of Berkshire Hathaway. He is a very good friend of Warren Buffet and responsible for an important part of Buffet’s success.
How do I know it? Listen to what Buffet said about Charlie Munger: “The best 30-second mind in the world”. They worked over five decades to build half a trillion-dollar business.
Like Buffett, Charlie Munger has never written a book. However, he has shared his expertise in numerous speeches around the world. He recommended investors reading a lot and constantly learning new things. Because readers are thinkers, and without thinking not much possible to achieve.
Charlie Munger invested with principles based on his own rules. He used checklists to make consistent investment decisions while being right in most of them. He believes the only way of being a successful investor having a good organization. The organization of rules, emotions, and most importantly the money.
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Here are some of Munger’s investment principles;
- Risk – Every investment evaluation should begin with risk measurement.
- Incorporate an appropriate margin of safety.
- Stay away from people with shady attitudes.
- Insist on proper compensation for risk assumed.
- Beware of inflation and interest rate exposure.
- Avoid permanent loss of capital.
- Independence – Only in fairy tales are emperors told they are naked.
- Objective and rational attitudes require independent thinking.
- Only the correctness of your analysis and judgment matters and not whether others agree or disagree with you.
- Going with the flow will only make you average.
- Preparation – The only way to win is to keep working and hoping to have a few insights.
- Develop yourself through voracious reading, cultivate curiosity, and aspire to be wiser every day.
- The only more important will than the will to win is the will to prepare.
- Develop fluency in mental models from academic disciplines.
- If you want to get smart, you have to keep asking the question, “Why?”.
- Intellectual humility – Admitting your ignorance is the dawning of wisdom.
- Stay within your clearly-defined circle of competence.
- Identify and verify negative or false evidence.
- Avoid false certainties and precisions.
- Never fool yourself, have in mind that you are the easiest person to fool.
- Rigorous analysis – The use of scientific methods and effective checklists can minimize errors and omissions.
- Be able to differentiate between value and price, progress and activity, wealth and size.
- It’s always better to remember the obvious than the esoteric.
- Be a business analyst, not a market, macroeconomic, or security analyst.
- Consider the overall risks and benefits and always look at a potential second order and higher-level impacts.
- Think in reverse always – forward and backward.
- Allocation – An investor’s primary job is to allocate capital properly
- Remember that the best use is always measured by the next best use (opportunity cost)
- Good ideas are rare – when the opportunity avails itself, bet heavily (allocation)
- Do not fall in love with an investment – be dependent and alert on situations and opportunities
- Patience – Refrain from the normal human tendency to act.
- Don’t interrupt when its unnecessary; “Compound interest is the eighth wonder of the world.” (Einstein)
- Avoid unnecessary transactional taxes and frictional costs; never act for action.
- Be alert for the arrival of luck.
- Enjoy the process along with the proceeds because you live in the process.
- Decisiveness – When the right time comes, act with decisiveness and conviction.
- Be fearful when others are greedy and greedy when others are fearful.
- Opportunity does not come often; seize it when it comes.
- Opportunity is only for the prepared mind; that’s the game.
- Change – Live with change and accept complexities that cannot be eliminated.
- Recognize the true nature of the world around you and adapt to it, don’t expect it to adapt to you.
- Always challenge your “best-loved ideas” and be willing to amend them.
- Recognize reality even when you don’t like it, especially when you don’t like it.
- Focus – Don’t complicate things; remember what you set out to do.
- Remember that reputation and integrity are your most valuable assets and can vanish at any time.
- Guard yourself against arrogance and boredom.
- Don’t overlook the obvious by being too concerned with the details.
- Don’t rule out unneeded information; “A small leak can sink a ship.”
- Face your big troubles, don’t hide them.
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Munger’s Mental Models
Munger spent his life studying the very best ideas of different disciplines. He didn’t succeed by chance. He instead took persistent action while growing himself with better thought processes.
He believes we can’t know everything about the world. We even don’t need to do so. But learning principles from different approaches helps us creating our mental models.
Mental models are important in every field of knowledge. For better thinking and decision making, Munger posits that one must have a Latticework of mental models to absorb a large number of ideas.
This simply means stacking information from different areas of knowledge like psychology, mathematics, economics, history, etc., in your head to enable you to know a bit about everything so much that the whole is greater than the sum of the parts.
Mental models shape the way you think and understand the world. It helps you simplify complexities and make better decisions. Munger believes that if you understand 80 to 90 of these models, you’ll know just about enough to figure the world out.
Munger, in a speech in the 1990s, talks about “A Lesson on Elementary, Worldly Wisdom as It Relates to Investment Management and Business.” He talked about how learning the basic models of numerous disciplines is the way to be ahead in the business world and life in general.
Munger also highlighted the psychology of human misjudgment as an aspect of the mental model in another speech. He discusses the human brain and its role in making irrational decisions.
In his words, “Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang them back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form.
You’ve got to have models in your head. And you’ve got to array your experience both vicarious and direct on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You’ve got to hang experience on a latticework of models in your head”.
Learning these mental models does not just happen; it comes from a constant and wide reading of just about anything within and outside your niche. Take time to explore a topic outside your niche every day and learn a few things about them to enhance your knowledge and versatility. Reading about Architecture can give you some understanding of how to design your own house.
Another key point is taking notes of whatever you read and saving them for reference. Doing this more often increases your capacity and knowledge.
This is a lifelong process that can be very rewarding. There are a few processes to developing these mental models. These processes of thinking, when practiced, can open your mind to gain a better understanding of mental models.
His Thinking Processes
Charlie Munger encourages five main thinking patterns that have set him apart in his career:
This mental model comes from a German mathematician, Carl Gustav Jacobi. It is a powerful tool to improve your thinking because it teaches you to try to solve problems by looking at them backward. Gustav always urged his students to always invert.
Munger himself believes that every problem can not be solved forward. Instead, he advises thinking about those things you want to avoid happening and figuring out how to avoid them. This is basically flipping the problem and trying to solve it from behind.
2- Circle of Competence
Munger widely uses the circle of competence in analyzing investments. This thinking tool states that you don’t need to be an expert in everything to succeed, but by sticking to the things within your competence. Once you know what you understand, you can tell where you have the edge over others. Understanding and sticking to your circle of competence improves decision making.
3- First Principles Thinking
This type of thinking is often called reasoning from first principles. It involves separating underlying facts from assumptions based on them, leaving the essentials as what remains. If you know the first principles of something, then you can build the rest of your knowledge around it to unleash new possibilities.
4- The Matthew Effect
This mental model can be said to have its origins from the Bible, where it was stated that to those that have, more would be given, and those that do not have will have the little they have taken from them. This is the “Principle of Cumulative Advantage.”
What you have available gives you more advantage to acquire more, like the saying that goes, “The rich get richer, the poor get poorer.”
Munger advises that this principle can be applied to the business world when you, instead of focusing on your competition and how to dominate them, look for an advantage you have and make it bigger.
5- Probabilistic Thinking
This method of thinking tries to estimate the chances of any specific outcome coming to pass, using some logic and math tools. This tool is great for improving the accuracy of decisions and identifying the most likely outcomes from complex factors.
These models are a few that helps shape and form our thinking processes and patterns when studying other disciplines. Every field has its own models or general set of knowledge that is important for you to know in order to make better sense of the world.
Munger’s Advice to Investors
Munger’s counsel for investors is fourfold:
1- Treat a stock share as a proportional ownership of the business.
Munger believes that understanding a company’s business plays a vital role in understanding its values. That’s why the underlying business of a company is the only thing that matters when investing in any stock.
Munger does not dwell on top-down factors, monetary policy, consumer confidence, and market sentiment indicators. Instead, he looks at brand loyalty, network effects, low-cost production, etc., as some of the factors that can determine a company’s success or failure.
According to Munger, you should always “be motivated when you’re buying and selling securities by reference to intrinsic value instead of price momentum.”
2- Buy at a significant discount to intrinsic value to create a margin of safety.
The margin of safety shows the difference between the intrinsic value and the current market price. This concept rises above all other things in the mind of an investor. The margin of safety is a crucial factor in investment and, as such, will never become obsolete.
For every business Munger and Buffett purchase on behalf of Berkshire Hathaway and its shareholders, they always strive to pay a price below that of the company’s intrinsic value. And by requiring a margin of safety, they tilt the odds of success even more in their favor.
As Munger puts it, “No matter how wonderful a business is, it’s not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.”
3- Be rational, objective, and dispassionate.
Rationality is the essential quality of a successful investor. Humans are prone to making wrong decisions due to psychological and emotional biases. Munger says Rationality is the cure for such errors. Much like the margin of safety, the idea of being objective and dispassionate will never be outdated.
4- The Idea of excessive diversification is madness.
Munger believes investors can make more profit by investing only in their best ideas. In as much as diversification is good for investments, if investors put in the time and work to understand their investments, they can make good profits from it, instead of diversifying always.
Munger’s approach to investment and doctrine of the mental models as key to making a better life and investment decisions has made him a standout success in the field of investment. His methods have enabled him to grow wealth over the years, acting only when an opportunity comes and taking decisive actions. His style takes a lot of patience and systematic processes, but over time has proven to be very effective and rewarding.