Charlie Munger: The 4 Steps of Investment

Buffett's partner speaks about his process

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Jun 13, 2018
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Charlie Munger (Trades, Portfolio) is one of the wealthiest men in the world, and one of the world's best thinkers.

But if you were to say that he didn't get this position by sitting on his butt, you would be wrong. Don't get me wrong, I'm not trying to criticize either

Charlie Munger (Trades, Portfolio) or Warren Buffett (Trades, Portfolio), but I will acknowledge that a considerable part of their success has been thanks to their lack of action (when it comes to investing anyway).

To put it another way, Munger and Buffett have made a name for themselves by holding fire almost all of the time and making a few select bets when the time is right.

What I find fascinating about the investment approach employed by both of these billionaires is its simplicity. I have been criticized for calling Buffett lazy (and I need to emphasize this is only a reference to his investment strategy; inactive might be a better description), but I continue to believe this is at the core of his successes.

To add more color to this statement, I want to reference an interview Munger gave to the BBC at the height of the financial crisis. The interview, given at a time when the financial world looked as if it was falling apart, focused on Munger and Buffett's investment strategy and how they were investing in the environment.

When asked what he looked for in a particular investment, Munger gave this highly distilled checklist of four items, which I've broken down for ease of reading.

1. "We have to deal with things that we’re capable of understanding."
2. "Once we’re over that filter we need to have a business with some characteristics that give us a durable competitive advantage."
3. "Them, of course, we would vastly prefer management in place with a lot of integrity and talent."
4. "Finally, no matter how wonderful it 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."

If this strategy looks simple, it's because it is. The question is if it is so simple to be successful at investing, why do more professional investors not succeed at beating the S&P 500?

Well, according to Munger it's because the strategy is just too simple, and to -- for lack of a better word -- lazy:

"It is a very simple set of ideas and the reason why our ideas have not spread faster is because they are too simple. The professional classes cannot justify their existence if that is all they have to say. If it is all so obvious and so simple, what would they have to do with the rest of the semester?"

Suggesting that, to be a better investor, you need to be lazy or inactive, might seem misleading or incorrect, but there's plenty of evidence to prove that this is the correct course of action.

Investors are not naturally conditioned to do nothing. It's fascinating that this is one of the most significant factors holding back investors. Luckily it's also easy to rectify ... if you know what you're looking for.

Nobel laureate Daniel Kahneman has produced a wealth of research on the topic of human psychology, notably his Prospect Theory, which considered the way most people think about risk, especially when it comes to making financial decisions.

Part of Kahneman's advice for eliminating some of our natural drawbacks is to ask for advice, from a particular type of person. In an interview with UBS, he said, “Slow down and get advice from a particular kind of person. Somebody who likes you, but doesn’t care too much about your feelings. That person is more likely to give you good advice.” Precisely the relationship Buffett and Munger have cultivated over the years.

Disclosure: The author owns no stock mentioned.

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