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Rupert Hargreaves
Rupert Hargreaves
Articles (1231)  | Author's Website |

Charlie Munger's Rule to Help Stay Away From Bad Investments

Avoiding these situations may help improve your returns over the long run

June 24, 2020

Over the years, Charlie Munger (Trades, Portfolio) has developed some rules and frameworks that help influence his thinking and guide his life. Even after nearly a decade of writing about the billionaire investor and his partner, Warren Buffett (Trades, Portfolio), I still cannot claim to know all of these rules off by heart.

However, the average person does not need to know and understand all of Munger's ideas and mental frameworks to get ahead. Knowing just a handful should be all it takes.

One of these rules is quite easy to follow and implement for every investor: stay away from things you don't understand.

Munger's rule

Munger explained this principle in his famous lecture, "The Art of Stock Picking." Towards the end of the lecture, Munger touched on the topic of tax avoidance and the desire of some investors to minimize tax obligations through schemes such as tax shelters.

"Anytime somebody offers you a tax shelter from here on in life, my advice would be don't buy it," he explained in the lecture."In fact, any time anybody offers you anything with a big commission and a 200-page prospectus, don't buy it."

If you follow this approach, which the billionaire affectionately labeled "Munger's rule," you might end up missing out on a fantastic opportunity at some point. However, these opportunities are few and far between. Investors are much more likely to lose everything or incur substantial losses in these hard-to-understand offers presented on a silver platter.

So, while investors might miss out on fantastic opportunities in the short term by following this rule, "over a lifetime, you'll be a long way ahead."

Munger went on to extoll the virtues of sitting back and doing nothing as an investor. By doing so, you end up paying less in fees to brokers, and you're also "listening to less nonsense." On top of this, if you end up making a great long-term investment that yields large capital gains, "the government tax system gives you an extra 1, 2 or 3 percentage points per annum compounded."

Of course, there are some dangers to taking this approach. Investing in great companies usually generates great investment returns, but there are also risks. Every so often, a great company will stumble, and it could cost investors dearly.

But this is just part of the game. As Munger explained, "everything in life has dangers." One of the easiest dangers to see and understand is that at high prices. Buying companies at high prices can be a quick way to lose money if those businesses do not live up to expectations.

Buying companies at low or reasonable prices is one of the best ways to get around this problem and reduce the risk of low investment returns from an overpriced asset. Or, as Munger put it, "nothing is automatic and easy. But if you can find some fairly-priced great company and buy it and sit, that tends to work out very, very well indeed especially for an individual."

Picking stocks and managing an investment portfolio successfully is not a science. It is more of an art form. These pieces of advice from Munger could help any investor stay away from some of the biggest pitfalls people managing their own money may fall into over the long-term.

Staying away from any investments you don't understand is always sensible. Letting tax rules dictate your investment decisions is also something that should be avoided as it may make you do something you are not comfortable with.

Finally, buying stocks at high valuations can sometimes lead to good results, but more often than not, buying shares at high prices can lead to losses further down the line.

Disclosure: The author owns no share mentioned.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website

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