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Stepan Lavrouk
Stepan Lavrouk
Articles (634) 

Charlie Munger: How to Be a Rational Investor

This simple trick can help you focus your thinking

Even at the age of 96, Charlie Munger (Trades, Portfolio) is still as sharp as a tack. As well as being Warren Buffett (Trades, Portfolio)’s right-hand man and Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) vice chairman, Munger is the chairman of the Daily Journal Corp. (NASDAQ:DJCO). Last week, he spoke at the company’s annual conference, where - as usual - he provided many invaluable nuggets of wisdom for investors looking to improve their own processes.

The moral imperative to be rational

Munger subscribes to the belief that in order to be successful, investors need to maximize their rationality. When asked by a shareholder to expound on the types of tools he uses to facilitate rational thinking, Munger talked about his experience as a meteorologist during the World War II. His specific role was to clear pilots for takeoff, and in doing so he developed a process that he calls "inversion."

“Suppose I wanted to kill a lot of pilots - what would be the easy way to do it? I soon concluded that the easiest way to do it would be to get the planes into anything the planes couldn’t handle. Or to get the pilot into a place where he would run out of fuel before he could safely land. So I made up my mind: I was going to stay miles away from killing pilots. That helped me be a better meteorologist. I simply reversed the problem.”

In other words, rather than thinking, “How do I achieve outcome X?” think “How do I avoid the opposite of outcome X?” This type of systemized thinking can at first seem a little clunky, but in actuality it allows investors (and really all decision makers) to more clearly visualize the answers to their problems. You don’t think about what you want. Rather, you think about what you want to avoid. In investing, this means staying away from situations that have the potential to harm your account. For instance, you should aim to stay away from stocks that are high risk, high reward because of the potential negative outcome.

Why does this work? Humans are naturally risk-averse, meaning that we feel the pain of a loss more acutely than we value an equivalent gain. It’s better to not lose $100 than to find $100. This is why I believe Munger’s "inversion" process is so effective: by recasting things in terms of losses, rather than gains, you can really drill down to the core of what is important. Sure, it’s nice to make 10% annually, but is it worth the risk if there is a 50-50 chance of losing 10% annually? Most people would say no.

Value investing is all about minimizing potential risks while leaving the possibility for returns open. This is why if you ask Munger or Buffett whether they regret missing out on tech stocks like Google (NASDAQ:GOOG)(NASDAQ:GOOGL) or Amazon (NASDAQ:AMZN), their answer is always no. It’s far better to know that you are taking all the necessary precautions against loss and have a lower return on your portfolio than to risk losing it on a gamble.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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