Sunday, 29 August 2010

Charlie Munger's 10 Rules for Investment Success

  Those of you lucky enough to attend a Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) annual shareholder meeting have undoubtedly heard Charlie Munger say, "I have nothing to add."
In reality, the guy has quite a bit to add. Thankfully for us, Munger is almost as forthcoming with his investment thoughts as his pal Warren Buffett. In his must-read book, Poor Charlie's Almanac, Munger puts forth a 10-step checklist that even the most inexperienced investors could benefit from.
 
1. Measure risk All investment evaluations should begin by measuring risk, especially reputational.
It's crucially important to understand that from time to time, your investments won't turn out the way you wanted. To protect your portfolio, don't set yourself up for complete failure in the first place. Giving yourself a large margin of safety, avoiding people of questionable character, and only taking on risk when you can be sure you'll be satisfactorily rewarded are all steps in the right direction. Companies like Chipotle (NYSE: CMG) might have perfectly bright futures, but when their shares are priced for perfection, they might nonetheless prove too risky for savvy investors.
 
2. Be independent Only in fairy tales are emperors told they're naked.
With stockbrokers often rewarded for activity, not successful investments, it's critically important to make sure you believe that what you're doing is right. Chasing others' opinions may seem logical, but investors like Munger and Buffett often succeed by going against the grain. Big Berkshire investments such as Coca-Cola (NYSE: KO), and more recently Petrochina (NYSE: PTR), were largely ignored by the masses when they were first made.
 
3. Prepare ahead The only way to win is to work, work, work, and hope to have a few insights.
It shouldn't surprise you that the best investments aren't the ones we typically read about in the paper. The diamonds in the rough are out there, but finding them requires effort. Buffett reads thousands of annual reports to cultivate ideas -- even if he only comes up with a few candidates each year. Munger advocates a constant curiosity for nearly everything in life. If you never stop asking the "whys" in what you do, you won't have trouble staying motivated.
 
4. Have intellectual humility Acknowledging what you don't know is the dawning of wisdom.
Perhaps most crucially to Berkshire's success, its leaders never stray away from their comfort zones. In investing, a clear idea of what the business will look like in the future counts most. If you struggle to comprehend what the business does today, you might as well be throwing darts. While companies like Google (Nasdaq: GOOG) and Boston Scientific (NYSE: BSX) are certainly titans in their own right today, they might look drastically different in five to 10 years.

5. Analyze rigorously Use effective checklists to minimize errors and omissions.
The numbers don't lie. When researching investments, Buffett and Munger like to try to estimate the security's worth before they even look at its price. They are businessmen, not stock-market junkies. They focus their brainpower on the value of businesses, not convoluted economic forecasts or intricate market-timing techniques. Munger is incredibly brilliant, but the analytical rigor of his investment decisions is based around simplicity, not complexity.

6. Allocate assets wisely Proper allocation of capital is an investor's No. 1 job.
In the early days of Munger's investment partnership, he held very few securities. When good ideas came, he poured significant capital into them; otherwise, he simply enjoyed the California sun. The amount of money employed in each of your investments should relate directly to its attractiveness. When you find a great investment, don't be afraid to bet big on it. 

7. Have patience Resist the natural human bias to act.
Munger said it best himself: "Half of Warren's time is sitting on his ass and reading; the other half is spent talking on the phone or in person to a highly gifted person that he trusts and trust him." While it can be tempting to jump in and out of the market, true fortunes are made from big commitments in quality companies, held indefinitely. When you're done with that, find a hobby. Spending all day watching stock tickers won't do you much good. 

8. Be decisive When proper circumstances present themselves, act with decisiveness and conviction.
This also goes back to not following the herd. When others are jubilant, you should be scared, and vice versa. Don't let others' emotions sway you; the market masses should help you find opportunities in their absence, not guide you down their own path to mediocrity. 

9. Be ready for change Accept unremovable complexity.
Investing success requires us to accept inevitable changes. Munger and Buffett hated railroads for decades, but as the times changed, they threw their old thoughts out the door and invested billions. The world around us won't always conform to our preferences and prejudices, and sometimes our best ideas will prove incorrect. If you aren't willing to roll with a changing market, you may find yourself fighting a lost cause.

10. Stay focused Keep it simple and remember what you set out to do.
In chasing little, unimportant things, we often overlook huge and critical factors. But by keeping it simple, we can fixate on what really matters: buying good companies at a good price, and holding them until they're fully priced.
Charlie Munger often gets overshadowed by his more famous partner, but don't assume that's any reflection of Munger's own genius. He's undoubtedly been a guiding light for Buffett himself, and by any count, he should go down as one of the greatest investors of all time.

For related Munger-esque Foolishness:
http://www.fool.com/investing/general/2007/12/13/charlie-mungers-10-rules-for-investment-success.aspx

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