In "Poor Charlie's Almanack," the definitive guide to how Charlie Munger (Trades, Portfolio) thinks, the guru's 10-point Investing Principles Checklist is discussed. The list summarizes his investment methodology in 10 simple points.
The first, and arguably most important, point on the list is risk. Measuring risk in an investment is both the most critical and challenging part of the process. Munger believes all investment evaluations should begin by measuring risk, especially reputational.
While the average investor might not be too worried about taking a hit to their reputations, it is essential to consider the reputations of others. In particular, the managers of the companies you're considering as part of the risk analysis process.
According to Munger, there are five components of the risk equation investors should consider. These are:
- The margin of safety.
- Avoid dealing with people of questionable character.
- Insist upon proper compensation for risk assumed.
- Always beware of inflation and interest rate exposures.
- Avoid big mistakes; shun permanent capital loss.
The margin of safety
One of the facts of life is we don't know what the future holds for any company, stock, bond, private company or even our own lives.
As a result, trying to accurately predict the earnings of a company five years out is virtually impossible. Investing, however, is all about predicting the future growth of a business. With this being the case, investors should make sure they incorporate a margin of safety into their figures. This way, there will be no surprises if the scenario you anticipated does not work out.
If you incorporate a margin of safety into all of your figures, including your estimate of intrinsic value, you can be wrong and still make money. That's the trick.
Avoid dealing with people of questionable character
A pretty clear red flag for investors is untrustworthy management. If managers have lied or misled shareholders in the past, what's to say they won't try to do it again?
Investors need to be sure they can trust managers to act in the best interest of shareholders. If management can't be trusted, the risk of investing increases substantially.
Insist upon proper compensation for risk assumed
Mohnish Pabrai has previously said he would only make investments in "heads, I win; tails, I don't lose much" opportunities. What he means by this is that he'll only buy stocks where the risk of a permanent capital impairment is low, but the reward is high in the best-case scenario.
Nothing is guaranteed in investing. There will be losses as well as profits. Taking on a lot of risk for not much reward might make sense for a time, but as the managers of Long-Term Capital Management found out, picking up pennies in front of a bulldozer is bound to end in disaster sooner or later.
Insisting upon proper compensation for the risk assumed is the only way to win long term in investing.
Always beware of inflation and interest rate exposures
Rising interest rates and inflation can erode profit margins and generate unforeseen interest costs. Too much of either can turn a highly successful business into a catastrophe over time. Stick with businesses that have the pricing power to increase prices with inflation and watch out for high levels of borrowing.
Avoid big mistakes; shun permanent capital loss
The most important lesson of all: Avoiding a permanent capital loss should be the primary objective of every investor. It is impossible to avoid making mistakes as an investor, but it is possible to avoid making any serious mistakes.
Staying within your circle of competence and avoiding overleveraged companies as well as focusing on cash generation will help you get there. Remember, if you lose 100%, you're going to have to work almost twice as hard to get it back.
Read more here:
- Warren Buffett's Advice on Investing in a Recession From 2007
- Forget Stock Picking: Asset Allocation Is More Important for Investment SuccessÂ
- Is It Still Possible to Buy $1 for 50 Cents?Â
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