When the stock market begins to fall rapidly, it can be a frightening place. It may make you wonder if investing in stocks is even worthwhile.
Nonetheless, despite dozens of bear markets throughout history, stocks have created more than $47 trillion in wealth for shareholders since 1926.
Charlie Munger, vice chairman of Berkshire Hathaway, is one investor who has reaped the benefits of that wealth creation. Consider the following four Munger anecdotes to help you be a better investor in this down market. In this bear market, applying these four principles can help you avoid costly mistakes.
1. Avoid making stupid mistakes instead of attempting to be clever
Most investors try to make money by outwitting the market, but this is usually a fool’s errand. After all, some of the world’s smartest people work on Wall Street with seemingly limitless resources and struggle to succeed.
Charlie Munger, on the other hand, recognizes that successful investing is more about avoiding stupid mistakes, saying, “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid rather than trying to be very intelligent.”
The stock market is one of the few places where you can outperform the market simply by making average, level-headed decisions over time. You don’t have to be a genius to avoid mistakes, especially in a bear market.
If you avoid mistakes like selling stocks at the bottom, chasing hype stocks without doing research, and attempting to time the market, you will set yourself up for exceptional long-term returns.
2. The business’s quality is more important than its price
Munger stated at the University of Southern California Marshall School of Business in 1994:
Over the long term, it’s difficult for a stock to outperform the business that underpins it. If the company earns 6% on capital over 40 years and you hold it for 40 years, you won’t make much more than a 6% return – even if you buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay a high price, you’ll end up with a fantastic return.
With the market punishing high-priced stocks recently, it’s easy to become overly focused on the fair-value price while ignoring the underlying asset’s quality.
Apple is the epitome of this. The tech titan has rarely traded at a “cheap” price and has rewarded investors handsomely over the years, owing largely to its impressive return on invested capital (ROIC), which has hovered around 20% for more than a decade.
Stock prices are important, but they must be considered in the context of other performance metrics such as ROIC. High-ROIC stocks at a high price will almost certainly outperform low-ROIC stocks at a low price. Remember that a low price does not always imply a good investment. Stocks frequently trade at a discount for a reason.
3. To a point, diversification is beneficial
In this bear market, another Munger quote to remember is, “The idea of excessive diversification is madness.”
Diversification can be a perplexing subject. Most of us regard it as a universally beneficial practice. And don’t get me wrong: it’s crucial for successful investing. Over-diversification, however, poses a risk.
As you add more stocks to your portfolio, keeping track of them becomes increasingly difficult. You also reduce your potential upside, eventually approaching the market’s average returns.
If you need to own hundreds of stocks in your portfolio to sleep at night, you’re probably better off avoiding individual stock picking and instead investing in low-cost index funds.
Diversification is still one of the pillars of long-term investing, but Munger warns about the dangers of over-diversification as a crutch. You should not simply buy a lot of stocks to avoid learning about the companies you own.
4. Concentrate on the micro rather than the macro
Both Warren Buffett and Charlie Munger have stated repeatedly that they are uninterested in making investment decisions based on the macroeconomic environment.
They’ve made dozens of statements over the years, including this one from Munger: “Gigantic macroeconomic predictions are something I’ve never made any money on, and neither has Warren.”
The macroenvironment is extremely difficult to predict and can change in an instant. Even the world’s best economists consistently make incorrect forecasts and predictions.
The International Monetary Fund (IMF) reached the same conclusion in a 2018 study of how well economists forecast recessions, finding that experts missed their predictions “by a wide margin.”
Regardless of macroeconomic conditions, great businesses will continue to execute well and return profits to shareholders in the long run.
These four Mungerisms are sound advice in any market environment, but they are especially pertinent right now because investors frequently make catastrophic mistakes during bear markets. Simply avoiding big mistakes like over-diversification, focusing solely on price, or timing the market around the macro economy will allow you to do extremely well in the long run.
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