Charlie Munger and his Investment Philosophy

Who is Charlie Munger?

Charlie Munger is the vice-chairman of Berkshire Hathaway Corporation, chaired by Warren Buffett. He shares his hometown with the famous investor Warren Buffett. He was born in Omaha on 1 January 1924. As a kid, he worked at Buffett’s grandfather’s grocery store. He earned US $2 for ten hours of labour. Back then, the two best friends and business partners hadn’t met. Charlie wasn’t always into investing. He actually trained to be a meteorologist for the Second World War at Caltech. Later he attended Harvard Law School and eventually started his own law firm. The law firm provided counsel to investors and investment managers. This was his first step in the world of investing. Munger stopped practicing law in 1965. He joined Warren Buffett at Berkshire Hathaway after leaving his family practice. He eventually became the company’s Vice Chairman in 1978. Today, Charlie Munger is Warren Buffett’s right-hand man. Working and growing old together, he has been an important part of Buffet’s success. They worked together for over five decades to build more than half a trillion-dollar business. You might have read many articles about Warren Buffett and his investment strategies. However, Munger does not share the same spotlight despite being one of the most successful investors. One reason for this is the big difference in their net worth. Warren Buffett’s net worth is over US $110.4 billion while Munger’s net worth is only US $1.9 billion (2021). He doesn’t make it in the list of the world’s top-five wealthiest people. But Munger does a lot of philanthropy work. He gives away funds in gifts and donations to various universities to promote education. In 2004, Munger donated 500 shares of Berkshire Hathaway to Stanford. The shares were valued at US $43.5 million. The purpose of the donation was to build a graduate student housing complex. While not the wealthiest, Charlie Munger is still one of the best investors in the world. So, let’s learn from the best on how we can improve our investment style and strategies.

Charlie Munger and his Investment Philosophy

We are always searching for a formula to get rich quick. But Charlie’s excellent performance doesn’t come from a magic formula. Nor from a business-school-inspired system or a textbook model. It comes from the philosophy he developed by constantly searching for better methods of thought. It comes from rigorous and remarkable preparations of his multidisciplinary research model. Charlie Munger’s and Warren Buffett’s investment strategies are quite alike. But Munger places emphasis on one particular element – human behaviour. He has spent his life studying the very best ideas of different disciplines. His success is not just luck or a chance. His persistency to find answers to various patterns paid off when he understood how flawed human behaviour is.

Munger’s Mental Models

Mental models shape the way we think and take decisions. Investing is more than just analysing figures and making buy or sell decisions. A large part of investing involves individual behaviour. Emotional processes, mental errors, and personality traits often interfere with investment decisions. We often make financial decisions based on impulse. These mental models help us understand how our biases influence our decisions. In his 1990 speech, Munger talked about how learning the basic models of numerous disciplines is the way to be ahead in the business world and life in general. He believes that if we understand 80 to 90 of these models, we’ll know just about enough to figure the world out. But learning these mental models needs dedication and consistency. In the speech, he said ‘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.’ All of this comes down to Charlie’s most basic guiding principle… fundamental philosophy of preparation, patience, decisiveness and discipline. These attributes are inter-dependent. Individually, they are lost without the other. But together they result in a ball of positive effects. Munger famously calls this the lollapalooza. Something that is extraordinarily impressive.

The Lollapalooza Effect

The basis of this effect is that humans have many inherent biases and tendencies. They can collectively sway and influence our behaviour. When several of these biases act together to drive us toward a particular action, it is called as lollapalooza effect. Charlie Munger minted the term Lollapalooza effect in his 1995 Harvard speech titled The Psychology of Human Misjudgement. He reviewed many causes of human misjudgement. He used an example of open outcry auctions to explain the same. Let’s have a look at it – There are four tendencies when participants of open auction are pushed to bid.

1. Reciprocity

Reciprocity is a social pattern of responding to a positive action with another positive action. So, the participants feel entitled to buy something just because they were invited to the auction. ‘I must buy something because I am invited by the host.’

2. Consistency

It refers to a thought process when an individual does not want to break a chain. For example, if the participant is famous for liking a particular type or a product, they feel obligated to buy it. ‘I am known to buy such products. I must buy this one for the record.’

3. Commitment Tendency

If the participant is bidding in the outcry auction, they feel a tendency to continue bidding just because they started with it. ‘I must continue because I am already bidding.’

4. Social Proof

Humans have a habit to try and find a way to fit in a social crowd to validate themselves. Social proof is a tendency where the participant does something just because a group of social peers are doing the same. ‘I should buy such pieces because my peers are buying it.’

Why is lollapalooza effect important for investors to understand?

Munger says that in financial markets, the ’lollapalooza effect’ can result in herd mentality. One investor’s behaviour can influence other investors’ behaviour. For example, a particular news can result in millions of investors buying one sector and selling another sector. This could result in extreme market volatility. This is similar to the snowball effect but at a psychological level. Herd mentality is every investor’s worst enemy. After all, everyone is out on a run to sell. Who really is profiting? No one. The herd impulse explains why people tend to follow others. When the market goes up or down, investors fear that others have more information than them. As a result, investors feel a strong impulse to do what others are doing. One assumption that gripped investors in the late 1990s was that any sudden drop is a buying opportunity. But buying on dips does not guarantee profits. Buying a stock that is cheaper than before doesn’t mean it is a good investment. There are various contributing factors to the rise and fall in the market. Relying completely on the ‘buy on dips’ approach can lead to losses. Such biases often occur on both microeconomic and macroeconomic scales. Hence, Munger believes that it is wise to keep a check on psychological factors. Charlie’s investment philosophy mainly focuses on what to buy and very little on when to sell. He says that one way to do this is by taking notes of whatever you read and saving them for reference. This subjective process of understanding mental models can be very rewarding. It helps us gain a better understanding of mental models. He also follows a process to keep a track of his mental model. He strongly advocates for the checklist methodology. He says, ‘You need a different checklist and different mental models for different companies. I can never make it early by saying, ‘Here are three things.’ You have to derive it yourself to ingrain it in your head for the rest of your life.’

The Checklist Approach

Charlie Munger invests with principles based on his own rules and requirements. He sticks to his method of using checklists to make every investment decision. He believes that being firm, practical, and organised is the best way to become a successful investor. It helps reduce the volume and severity of mistakes investors make while buying stocks. It forces investors to consider a wide range of factors before purchasing a company. One very important thing to note here is that there is no ‘common for all’ checklist. Every investor must come up with his own checklist and update it as and when needed. In other words, a checklist can evolve over time. This reduces the chances of making the same mistake in the future.

Munger’s Advice to Investors

‘It’s kind of fun to sit there and outthink people who are way smarter than you are because you’ve trained yourself to be more objective and more multidisciplinary. Furthermore, there is a lot of money in it, as I can testify from my own personal experience.’ – Charlie Munger

1. Treat your shares as if you have the proportional ownership of the business

Here is a question for you – Would you want to be a proportional owner of a company that has no vision? Or a fundamentally weak company? No, right? Munger says that if you invest with a conscious thought that you are actually owning a share of the company, you will start making better choices. He believes that understanding their business model plays a vital role in understanding its values. He looks at production cost, brand loyalty, network effects, etc., to determine a company’s success. If the company’s foundation is strong, the company will have the capability to grow.

2. Buy at a significant discount to intrinsic value

Munger says, ‘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.’ Intrinsic value measures what an asset is worth. The margin of safety shows the difference between the current market price and the intrinsic value. It is an important factor in investment and is also advocated by Warren Buffett as well as Benjamin Graham. By maintaining a margin of safety, investors can shift the odds of success in their favour.

3. Be rational, focused, and patient

‘A majority of life’s errors are caused by forgetting what one is really trying to do.’ We are prone to making faulty decisions due to emotional biases. Munger says rationality is the antidote for such mistakes. It is the fundamental quality of a successful investor. How to be rational? For starters, begin by practicing patience. This sounds like the easiest thing to do but yet is difficult for most investors. Like Buffett, Munger believes in value investing. And the one thing you need to be a disciplined value investor is to be patient. Why? Because when you shut down the outside noise and focus on the long-term plan, you will witness the magic of compounding. This is exactly how Charlie Munger and Warren Buffett created wealth worth billions of dollars. Watch how to analyse value stocks and best value stocks to buy in 2021:

Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger

Originally published in: 2005 ‘What are the secret of success? – one word answer: rational’

Poor Charlie’s Almanack is Charlie Munger’s biography. The book brings together his investing thoughts. So far we understood that Charlie strongly advocates to first understand the mental patterns and then follow a checklist method. But the question is, which mental model one needs to understand? There are hundreds of such biases. To put an end to your quest, Poor Charlie’s Almanack majorly focuses on the 25 cognitive biases. The book includes his talks and speeches that Charlie gave on various occasions. These talks will give you further insights on various mental models.. In this 550 pages long book of financial wisdom, Munger also writes about the great financial scandal of 2003 and how behaviour finance influences our every move. It also shares various investment practices of leading charitable foundations. Recommended Read: 7 books Warren Buffett wants every investor to read.

End Note

Bill Gates has said that Munger is the broadest thinker he has ever encountered. Buffett has been working with Munger for more than 55 years now. His emphasis on doing business only with people he trusts stands as a testament to Munger’s honesty and authenticity. His approach to investment in mental models has made him a successful investor. His methods have enabled him to grow wealth over the years. His style takes a lot of patience and systematic processes. But over time, it has proven to be very effective and rewarding. Munger says that to be successful in life, all you need to do is be non-idiotic. He is referring to herd mentality and buying highly speculative stocks. They are often overvalued. Instead, understand your mental model and prepare your own checklist. Munger once said, ‘Nobody expects you to know everything about everything. When you don’t know and you don’t have any special competence, don’t be afraid to say so.’ So don’t shy away if you don’t know anything. Learn and start investing smartly!Take your first step towards stock market by opening a FREE Demat account with Samco.