13 lessons from Warren Buffett and Charlie Munger

By Larissa Fernand |  15-11-22 | 
 

These legendary investors have inspired the financial world and shaped the way we think at Morningstar. Haywood Kelly, president of Morningstar Research, on wisdom from two of the world’s most successful investors.

1) Always be learning.

Both Buffett and Munger are always reading, and Munger in particular emphasizes the importance of science—including an understanding of evolution—as essential for understanding what makes people tick.

Many of my favorite books were Munger recommendations, including Influence: The Psychology of Persuasion, by Robert Cialdini, The Selfish Gene by Richard Dawkins, and Guns, Germs, and Steel by Jared Diamond.

Munger once said, “You’d be amazed at how much Warren reads—at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.”

2) It’s OK to do nothing.

Buffett compared investing to a baseball hitter waiting for a fat pitch—a nice straight ball down the heart of the plate. But unlike in baseball, in investing you’re not called out after three strikes. You can let as many pitches whiz past as you want.

In my personal portfolio, I’ve never felt pressure to swing if I’m not comfortable. Letting cash pile up is fine. There will usually be a market correction at some point to bring prices down again to attractive levels.

3) Volatility is not Risk.

Given that writing massive insurance policies is a significant part of Berkshire Hathaway’s business, it’s no surprise that risk has consumed a large part of Buffett’s and Munger’s attention. They have a very different conception of risk than academic finance and its emphasis on metrics like beta or standard deviation.

Risk, says Buffett, is the chance you suffer a permanent loss of capital.

Financial academics like using volatility as a proxy for risk (largely because it’s so easy to measure), but that has the perverse effect of implying that an asset becomes riskier when it drops in price—the exact opposite of how a rational buyer thinks about a lower price.

Buffett and Munger have consistently emphasized systemic and existential risks—for example, the risk that derivatives cause a series of financial institutions with interlocking exposures to collapse like dominoes, or the risk of nuclear war or biological infection (natural or otherwise). As investors and citizens, we need to acknowledge these risks and do what we can to minimize them.

4) Moats are important.

More than 20 years ago, Morningstar borrowed the term moat from Buffett to refer to the competitive advantages a firm might have. Our innovation was that we took the concept and systematized it, assigning Morningstar Economic Moat Ratings to each of the companies we cover (now more than 1,500) and identifying the source of the moat: customer switching costs, intangible assets, cost advantage, efficient scale, or network effect.

The biggest risk facing any company can be thought of as competitive risk—it’s the reason almost all companies fail within a few years of getting started. Does the company offer anything special versus what consumers can get elsewhere? That’s why understanding competitive advantage is the bedrock of stock investing.

5) Inflation is another reason to favour moats.

Until 2022, it had been easy for Americans to ignore inflation for about 40 years. But any student of Buffett’s writings knows that inflation was a regular topic of his in the 1970s and early 1980s.

What he emphasized then was the difficulty for companies, especially those most exposed to inflationary cost pressures, to earn decent returns for shareholders in a period of high inflation. Very few companies—those with strong economic moats—can raise prices to offset the erosion of purchasing power. This underlying pricing power is one reason we like wide-moat companies so much. They’re better able to withstand what the macro environment throws their way.

(A company whose competitive advantages are strong enough to fend off competition and earn high returns on capital for 20 years or more has a wide moat.)

6) No good investor is either “Value” or “Growth”

Munger famously helped induce Buffett to move beyond Ben Graham’s cigar-butt-style of value investing (which consists of looking for stocks with one good puff left in them) and embrace great companies—even if it means paying higher prices for them. The key insight is that the worth of any company is a function of its growth prospects and how confident one can be that the growth will materialize. You shouldn’t analyze a “value” company any differently than a “growth” company.

7) Markets are good, but not perfect.

My first job was analyzing Japanese stocks just as the bubble in Japanese asset prices, arguably the most egregious asset-price bubble in history, was bursting. It was an early lesson that sometimes markets go haywire—or more precisely, the people who make up markets go haywire and come to believe that trees grow to the sky. It’s amusing now to think about it now, but serious people in the late 1980s and early 1990s concocted stories about why price/earnings ratios of 80 or 90, which were common in Japan at the time, were reasonable, or recommended allocating 30% or 40% of a portfolio to Japanese stocks because that offered the optimal mix of risk and reward.

Reading Buffett and the kinds of books Buffett and Munger recommend, you come to internalize that while markets usually do a wonderful job of allocating capital, they’re only as reliable as the (imperfect) humans making up the market.

8) Index funds are a wonderful invention.

Markets may sometimes go haywire, but it’s still mighty hard to outperform them. When I started at Morningstar in 1991, index funds made up a tiny percentage of overall fund assets. My, how things have changed.

I remember many Morningstar conferences at which active managers pooh-poohed index funds as un-American or as settling for mediocrity. Buffett, by contrast, has consistently heaped praise on index funds as the best way for most investors to gain exposure to the stock market. He repeatedly singled out Bogle for special praise for launching the index revolution. Buffett showed that intellectually you can embrace both active and passive investing—it’s not either/or.

9) Simplicity is good.

Buffett and Munger have been consistent critics of derivatives, catastrophe bonds, crypto, and other types of financial “innovation.” The way they run Berkshire Hathaway reflects this prudence. The company operates with very little debt and a large cushion of cash and investments.

One of my favorite Buffett quotes is, “If you’ve been playing poker for a half an hour and you still don’t know who the patsy is, you’re the patsy.” Unfortunately, the financial industry is chock-full of players eager to induce you to play the game on their terms, always with a hefty entry fee attached.

10) Fund Boards Are Lap Dogs.

That was Buffett’s conclusion in his classic 2002 letter to shareholders. Despite their explicit role as guardians for fund shareholders, fund directors—even independent directors—rarely push back against fund managers, and almost never vote to fire the fund manager.

Buffett criticized corporate boards for the same reason: Their culture of rubber-stamping what management or compensation consultants put in front of them. (He’s even been critical of his own performance as a board member.)

The lesson: Look for board members with business experience and skin in the game (in the form of meaningful ownership in the company they oversee), but even then don’t expect much. Most important is that the management team and other employees have integrity. Hoping that a board of directors, no matter how independent on paper, can effectively police a management team is a pipe dream.

11) Integrity.

Buffett famously said to the employees of Salomon Brothers when he stepped in to run the company in 1991: “Lose money for the firm, and I’ll be understanding. Lose a shred of reputation for the firm, and I’ll be ruthless.”

He also suggested the following as a guide to behaviour: If you would be comfortable having your actions described in detail on the front page of your local newspaper, where your family and friends will read it, go ahead and do it.

12) Birth Lottery.

Buffett has emphasized how lucky he was to be born in the U.S. and in the 20th century. Had he been born in another time or place, his somewhat specialized talents of company assessment would have been worthless. He’s called this the birth lottery. It’s a good reminder to all of us the role luck has played in our lives.

13) Happiness.

The key to a happy marriage isn’t a beautiful spouse, smart kids, or pleasant conversation. No, say Buffett and Munger, the key to a happy marriage is finding someone with low expectations.

The same holds for reading articles like this one; I hope you clicked on it with sufficiently low expectations. And the same holds true for investment success. I make a habit of mentally lopping off 30% of whatever my portfolio value happens to be, simply because stuff happens. Generalizing this bit of wisdom, I’d suggest that low expectations are pretty much the best way to ensure a lack of regrets on one’s deathbed. And the best way not to be disappointed after death, too!

The above text has been taken from 12 Lessons on Money and More From Warren Buffett and Charlie Munger and What We’ve Learned From Warren Buffett and Charlie Munger, and edited for an Indian audience .

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