A graduate of Harvard Law School, Charlie Munger was given some solid advice by Warren Buffett, who said that law was ?ne as a hobby, but he could do better.
A few years later, Munger left his law firm and started investing. Today he works with Buffett as vice chairman of Berkshire Hathaway. His net worth is about $1.3 billion. He guided Buffett from a pure Graham style of investing, which looked only at the financials of a company, to focus more on the quality of the business. Buffett gives him the credit for much of the enormous success of Berkshire Hathaway and always refers to Munger as “my partner.”
Munger is a worthwhile model for how value investing can work. First, he limits his investments to businesses with a sustainable competitive advantage, then he buys them at a fair price, and finally, he believes that a portfolio of three companies is plenty of diversification. When Munger ran his own partnership from 1962 to 1975, the partnership returned a compound annual return of 13.7 percent, after fees, versus 5.0 percent for the Dow Jones Industrial Average.
[drizzle]During that time, a $100,000 investment in the partnership would have grown to $530,745, versus $188,565 if it had been invested in the Dow Jones Industrial Average. He was content to invest a lot of capital in very few holdings and hold those positions for a long time. His extreme patience combined with extreme decisiveness paid off handsomely.
Unlike Buffett, Munger keeps a very low profile and is rarely quoted in the media. The last Berkshire Hathaway shareholders meeting in May 2008 drew over 31,000 people to hear words of wisdom from both Buffett and Munger. But when Munger held his annual shareholder meeting just a few days later (he is the Chairman of Wesco Financial Corporation, 80 percent owned by Berkshire Hathaway) and answered questions, there were only 500 or so shareholders in attendance. Munger is not one that enjoys the limelight.
Over the past 20 years, Munger has given several memorable speeches at places such as the University of Southern California, Stanford Law School, and, most recently, the California Institute of Technology. While Buffett outlines his investing approach in off-the-cuff remarks and shareholder letters, Munger has said he has no interest in being so detailed with the public.
In those speeches Munger doesn’t really give investment advice. Instead he offers something more valuable: lessons on the importance of elementary worldly wisdom. He says that this is the starting point to being a good investor.
Munger says that you can’t be a great stock picker if you don’t have an elementary, worldly wisdom. By remembering isolated facts and figures without hanging them on “a latticework of theory, you don’t have them in a usable form.” By having only one model, or one way of viewing problems, you conform to the old saying “to the man with only a hammer, every problem looks like a nail.” The models also need to come from different disciplines such as math, science, literature, and physics. You don’t need to know many models; a small number of them will do most of the heavy lifting.
The models to know in math come from basic arithmetic. Knowing how to figure out compound interest and basic algebra (solving for x) is a good place to start. Decision tree theory is a very useful tool for helping you choose among several courses of action. Munger says that it is nothing more than high school algebra applied to real-life problems.
Decisions are all about probabilities: identifying relevant variables and attaching probabilities to each of them. Munger says that one of the major advantages that Warren Buffett has is that he automatically thinks in terms of decision trees.
Munger goes on to show how psychological models are extremely important in the financial world. But what is most surprising is that economic textbooks have barely a word on the influence psychology has on markets. He mentions several models, such as social proof, a need to view a behavior as correct only after seeing how others react, and availability misweighing tendency, a concept that says an idea or fact is not worth more simply because it is easily available. Just knowing how to recognize when this situation arise will give you a big leg up over everyone else.
Munger also mentions models in natural science and shows how the ecosystem model can offer insight. The ecosystem, a community of plants and microorganisms that are linked to one another and interact with the physical environment, is much like similar businesses in certain industries. Many species of animals and plants live in niches and not only survive but thrive; so too niche companies.
Putting It in Practice
Acquiring knowledge in many different disciplines has practical applications in the investing world. There are many excellent investors who started off in fields far removed from finance. Many credit their success to the fact that they had these mental models while most of Wall Street was viewing events as a man with hammer seeing every problem as a nail.
You probably won’t put all these mental models into practice when making each investment decision. The main thing to remember is to have this latticework of knowledge in place for when the situation arises. Here are a few examples of applying the mental models mentioned above in real-life situations.
It’s been said that when Albert Einstein was asked what he thought was the greatest discovery made by mankind, he replied “compound interest.” He even went on to call it the eighth wonder of the world.
In 1962 when Buffett was 33 years old and running his partnerships, he used the following example to impress upon his partners the power of compounding. If Queen Isabella invested $30,000 at a 4 percent annual compound rate of return instead and rejected Columbus’ request for funds to reach the Indies by sailing west, her heirs would have over $2 trillion. If we update that example by 40-plus years, the sum would now be closer to $10 trillion. Queen Isabella rejected Columbus’ request three times; imagine where Spain might be if she had rejected him one more time!
Being able to appreciate the power of compounding might make you resist making investments with the potential for huge payoffs at the risk of total loss. A shorthand way to calculate the period required to double your original investment by an expected growth rate is the rule of 72. If you wanted to know how many years it would take to double your investment with a compounded rate of 9 percent, divide 72 by the rate. In this example it would take you 8 years (72/9 percent = 8 years). I use this model almost daily when projecting the price I need to pay in today’s dollars to earn a 15 percent return (72/15= 4.8 years) on my investment (simple algebra, solving for x). I don’t purchase a company unless I can make 15 percent or double my investment in five year or less.
I then use a decision tree to weight the probabilities of certain events happening over the next five years