How do you become a better investor? One of Charlie Munger’s famous lines offers a simple explanation. He says “To get what you want, you have to deserve what you want”, and it couldn’t be more true when it comes to investing.
Deserving better returns on your investment comes from being thoughtful about where you invest, and to be thoughtful, you first must understand the process of investing.
Otherwise you’re a monkey throwing darts at a dart board. Without a unified investing strategy and a framework for evaluating investments, you don’t stand a chance at earning out-sized returns over a long period of time.
So if you’re trying to gain an investing edge, where do you start? Well, this book is a great place.
It simply explains the way Charlie Munger and Warren Buffett think. What are the strategies they rely on when making investing decisions? What are the biases that might cause them to make poor decisions? How do they avoid bad bets?
One of my favorite sections of the book covers the four main pillars of the Benjamin Graham investing system. Both Warren Buffett and Charlie Munger have heavily relied on these throughout their careers.
These four pillars, or principles, are the building blocks for every single investment Warren Buffett and Charlie Munger make. Whether they’re looking at businesses in retail, media, software, or any other industry, they’re building off these 4 principles to make a decision.
Principle 1: Treat a share of stock as a proportional ownership of a business
This principle really just means that if you don’t understand how a business works, you won’t understand the value of the stock or the bond or whatever you’re buying. And if you don’t understand the value of what you’re buying, you’re lost. Every decision from that point forward becomes a gamble, you’re just guessing.
So the best way to determine the value of a business, is to think of yourself as a private investor looking to buy an entire business. You can estimate the future cash flows of all sorts of companies by reading through all their annual and quarterly financial statements, and then you can compare them. Then ask yourself, would you buy the entire business of Company X at its current price?
Will it return more money to you as an owner than you put up for it? If the answer is no, then you shouldn’t spend a single dollar buying up shares. The stakes may appear to be small if you’re a retail investor, but you’re getting an equally small proportion of ownership (and profits) in the company. If it’s a bad price, it doesn’t matter whether you have $100 or $10 million. It’s a bad deal.
Principle 2: Buy at a significant discount to intrinsic value to create a margin of safety
This is not only an important principle in investing, but across all sorts of life decisions you’ll make. When you buy a car, or a home, it would be foolish to do so without a margin of safety. Jay Z’s famous line is that if you can’t afford to buy it twice, you can’t afford it.
In investing, your margin of safety is the only thing protecting you against unforeseen events. And because you can’t predict the future, it’s wise to give yourself as wide a margin of safety as possible.
For example, maxing out your credit cards to buy Bitcoin or weed stocks is a great example of how to lose all your money. One small drop in prices can jumpstart a terrible set of events for anyone who forgets to consider their margin of safety. First, prices drop, then you panic sell, then you default on your credit card, then you can’t pay rent, and just like that you’re kicked out of your home and onto the streets. Maybe that last part is a bit of a stretch, but it’s wise to avoid the whole situation all-together. Since every investor will eventually make some errors, you must account for unforeseen circumstances beforehand.
While a healthy margin of safety is a different number across different assets, you can determine a good margin of safety by first considering your level of uncertainty. If your investment comes with a high degree of uncertainty, you’ll want a larger margin of safety. Nobody is 100% certain of the future, but it’s probably fair to say that assets like early stage startups are going to be a lot more uncertain than ones like Apple and Amazon.
Principle 3: Make the market your servant, not your master
Because the market can never exactly agree on the perfect price for a given asset, take advantage of the market whenever prices get too high or too low.
And in order to know what “too high” or “too low” a price is for a given asset, go back to the first principle and first understand how the business works and how much it’s worth. Then, don’t forget the second principle, you must establish a margin of safety. You see how all these principles work together?
Only then, can you step in to buy when you see businesses priced far lower than what they’re worth, or sell when your businesses are being priced far higher than what they’re worth. Take control of the market, don’t let it control you.
Principle 4: Be rational, objective, and unemotional
Turn off CNBC, log off Twitter, and go for a walk. Do some independent thinking and arrive at your own conclusion based on facts. Don’t let your emotions get in the way of sound reasoning. It’s easier said than done, but it’s also easier if you know your stuff, and you’ve done enough research to know what a business is worth. There’s no secret investing shortcut here, at the end of the day if you want to be a better investor, you must put in the work.
But hopefully these 4 principles can guide you in the right direction. Again, if you’re serious about becoming a better investor, this is the book that will lay out how the best investors in the world think.