Editor’s note: This article was first published in August 2013, when Charlie Munger was Warren Buffett’s partner and vice chairman of Berkshire Hathaway. He died in November 2023, so its present tense is now out of date.
Charlie Munger is Warren Buffett’s right-hand man and, as such, another disciple of Benjamin Graham‘s investment method, a lover of intelligent investing and value investing. Like his partners, he lays out his arguments with great clarity. (Read: 5 steps to getting rich, by Charlie Munger)
Active or passive investing: which is more profitable?
For Charlie Munger, as for the rest of the great investors, the stock market is not a casino, and if you treat it like one, looking for daily or weekly gains, sooner or later you are going to lose money. There is no one-size-fits-all investment advice, because everything depends on the nature of the investor in question.
Of course, for Charlie, the secret or standard recipe for financial success for people who know nothing about investing is always the same: invest for the long term and in a completely passive way.
In Munger’s view, an ignorant investor is not an investor who knows nothing about economics or company accounts, because, paradoxically, when dumb money acknowledges its limitations, it ceases to be dumb. That is why there are more fools with university degrees in economics who lose money in the stock market through overconfidence than know-nothings who beat the returns of investment funds without knowing anything about the market. If the know-nothing picks several good companies for the long term, he increases his chances of beating investors whose management of their portfolio is too active.
To understand the value of an investment, you must understand the value of the underlying business, realising that buying shares is nothing more than acquiring a stake in the company’s business. So we shouldn’t look so much at the share price as at the value of the company. That, he says, has been Berkshire Hathaway’s secret: if we could buy a company of high value at a low price, so much the better.
Munger reminds us that an investor who knows nothing about the stock market shouldn’t be ashamed of it, because sometimes understanding other things will make you money in the market. For example, a doctor or a scientist will be able to analyse a pharmaceutical company much better than any Wall Street investor: analysts can study the charts, but the scientist can assess the quality and future of a drug or a scientific study. In that respect, the investor who knows nothing about the market but understands science starts out with knowledge and information that the expert investor lacks. The same would be true of renewable energy or textile companies.
Everyone makes money in a bull market
Given that anyone, with or without experience, can pick stocks at random and make money in the market, many people turn to investment funds that promise high returns. The secret of those high returns is the active management of their managers. Over the long term, a passively managed index fund has been shown to be far more profitable than the big funds that dazzle for two years in a rising market. When difficulties hit the market, active management ends up being more profitable for the managers (the owners of the fund) and less profitable for investors, because of management and custody fees and other added costs.
Managing our investments passively, with a long-term focus, will give us the highest returns after fees and expenses. Munger insists that, historically and to this day, this way of investing has outperformed every other management method peddled by the many snake-oil salesmen out there. What’s more, with this kind of investing, knowing we are in it for the long term, we can sleep better and spend our time on other activities.
The most important thing you need to know when investing in the stock market is your own limitations, because once we know we have limitations, we also limit the big investment mistakes.
(Read: The 5 most common mistakes of beginner investors)
The most active investors are really active because they are trying to beat the market, even knowing that 90% of investors fail to beat the index. They like to think they can belong to the other 10%, so they overestimate their abilities and skills as investors. Many fool themselves by not keeping a written record of their real returns after fees and expenses.
Munger loves to poke fun at professors, analysts and economists who put forward their theories about investing and talk about market efficiency, but who, once they apply those theories in real life, tend to meet with the biggest investment failures, while the small private investors who put their money into an index fund manage to make money.
So Charlie’s advice is not to try to beat the market, but simply to stay in it, intelligently invested.
(Read: The essence of intelligent investing to build wealth over the long term)
The rest of the people who fail in the stock market do so because they think they can be excellent, successful investors with highly active management (trading). The reality is that very few traders manage annual returns above those of an index fund, and the few who do are traders working together inside the big companies of the Wall Street financial industry, an industry increasingly dominated by high-frequency trading (machines instead of humans).
Watch: Documentary on Warren Buffett (Inside the mind of the genius)
Featured image: Nick, CC BY 2.0, via Wikimedia Commons.
