In the latest of series for Master Investor, Frederik Vanhaverbeke, author of Excess Returns: A comparative study of the methods of the world’s greatest investors, looks at how some of the world’s greatest investors are so successful.
To me, it’s obvious that the winner has to bet very selectively. It’s been obvious to me since very early in life. I don’t know why it’s not obvious to very many other people.
Another top investor that is repeatedly referred to in my book Excess Returns: a Comparative Study of the Methods of the World’s Greatest Investors is Charlie Munger. Munger is best known for being the right-hand man of Warren Buffett in Berkshire Hathaway. Less known is that before joining forces with Buffett he managed an investment partnership of his own.
Between 1962 and 1975 he achieved in this partnership an annual compound return of 19.8%, beating the S&P 500 (including dividends) by almost 15% a year!
In the early years of their collaboration Charlie Munger and Warren Buffett were not completely on the same page with respect to the investment approach. While Buffett admired the quantitative deep-value approach of Benjamin Graham, Munger felt no connection whatsoever with that – in his opinion, quaint – type of investing. Later on Charlie Munger managed to convince Buffett, also under the influence of Philip Fisher, to pay more attention to the qualitative aspects of businesses (i.e., the company’s competitive position, its management, etc.).
Throughout his career Munger has always been outspoken about what he deems essential for success in the market.
He frequently railed against the efficient market hypothesis and against individual investors who are focused on the short-term, who pay attention to market forecasters, who complicate the valuation process, and so on. He stresses instead that success derives from patience, a long term view, high selectivity in the choice of stocks one owns, independence (i.e., not relying on input from analysts, brokers, strategists, etc.), hard work (to perform serious due diligence, to obtain unique insights and to discover excellent investment ideas before others), and consistency (rather than complexity) in the way one values businesses.
He illustrates this with the fact that a lot of Berkshire Hathaway’s success can be attributed to the strong performance of no more than about fifteen top performing companies that were analyzed thoroughly, that were found through hard work, that were purchased at compelling prices, and that were held for a long time.
Similar to other top investors, Munger also pays a lot of attention to the factor of human psychology in investing.
Way before behavioral finance became an established academic discipline Munger discussed the impact of cognitive biases on investment decisions. He advises investors to defend themselves against biases like the home bias (i.e., the bias to prefer stocks close to home over other stocks), the sympathy bias (e.g., the bias to feel sympathy for certain stocks merely due to some accidental similarities with something you like), and the consistency bias (i.e., the tendency to stick with one’s decision even in the face of disconfirming evidence) by regularly trying to destroy one’s own “best-loved and hardest won ideas.”
Playing devil’s advocate with one’s most cherished ideas fosters a mindset where the investor looks at his or her holdings with a detached view. It also prevents investors from buying minor ideas, or from replacing an excellent stock with an inferior one.
Munger also believes that people who cannot stomach an occasional drop of 50% of their stock portfolio with resignation have no business in the stock market.
Here is his final warning to everyone who treads the stock market lacking tolerance for losses:
“if you can’t stand making a serious loss in stocks you will get the results that you deserve.”
It is fair to say that Warren Buffett owes part of his current investment style to the wisdom of Charles Munger. In our next article we will look into another mentor of Buffett: Philip Fisher.