Keeping Things Simple – Podcast Episode 473
Key Take-aways:
- Charlie Munger convinced Warren Buffett to shift from “buying fair businesses at wonderful prices” to “buying wonderful businesses at fair prices,” significantly impacting Berkshire Hathaway’s success.
- Munger advocates for simplicity in investing and avoiding complex math, which can be misleading and unnecessary for individual investors.
- Understanding basic algebra and probability is crucial in investment decision-making, as it allows one to solve problems both forwards and backwards.
- Keeping investments simple can involve strategies like not interrupting the compounding of returns and ensuring short-term needs are met without exposing necessary funds to market volatility.
- Inflation must be considered when calculating the “real rate of return” on investments, as earning less than the inflation rate effectively erodes purchasing power.
- Munger emphasizes the importance of being able to handle significant market drops without panic, as overreacting to market fluctuations can lead to mediocre investment returns.
- Long-term investments should be expected to experience volatility, while short-term financial needs should be secured in stable, low-risk assets.
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Keeping Things Simple – Podcast Episode 473 – Transcript
Welcome back to the podcast, this is episode number 473.
Today we want to talk about complex math versus “keeping things simple.”
Charlie Munger has arguably been one of the best investors in history. He even convinced Warren Buffett to change HIS approach to investing, in the late 1970’s – Munger joined Buffet at Berkshire Hathaway in 1979 – and well into the 1980’s and beyond, for the better.
And he was able to accomplish this turnaround with Buffet by teaching Buffet about keeping things simple.
Buffet’s approach – previously – was based on what he called “the cigar butt theory.”
And the idea goes something like this. You buy something – you buy a company – at such a low price, it was practically free.
But the “intrinsic” value of the company was still there. What Buffet meant by the “intrinsic” value was even if the company went out of business and you sold the assets, it would be worth far more than what the stock was trading at.
When Buffett would talk about examples like this, he would speak of a cigar butt that he would find laying on the sidewalk.
The theory was you could pick it up – for free and get one or two free puffs out of what’s left of the cigar. That’s the “cigar butt” theory.
And this was value investing, as he learned from his professor at Columbia University, Benjamin Graham.
What Munger was able to convince Warren Buffett to do was instead of “buying fair businesses, at wonderful prices;” (the cigar butt theory). He turned Buffet around to focus on “buying wonderful businesses, at fair prices.”
That’s a huge difference in approach. And you can see while Berkshire Hathaway was doing very well in the 1960’s and through the seventies, things really started to take off when they took this approach, just keeping things simple.
Munger always talked about avoiding complex math. And we agree.
But keeping things simple sometimes is hard to do.
Here are some examples of information from two emails I received recently from wholesalers.
I cannot share the exact details with you, because they’re (labeled) “for internal use only.”
I will say that I get nearly a dozen of these emails every day. So I’ll just read you the highlights from one of them.
This is someone who’s offering a product that we would then show, or buy, for our clients — which we would not do.
The headlines:
- “We offer zero market risk.” That’s a red flag right there: “we offer zero market risk.”
- “Earn up to eleven percent, based on the S&P 500.”
- “With zero internal fees to the client.”
These are three three points that they’re making in their email. Three misleading points. It really gives our industry a bad name.
Here’s another one (email):
“We offer a unit investment trust…” — which advisors and brokers should be able to easily understand — but most individual investors couldn’t tell you what an unit investment trust is.
“We offer unit investment trusts with flex options.”
Here’s three examples of the unit investment trusts they’re offering:
- The first one has a 30% buffer and it’s tied to the S&P 500.
- The second one projects a 20% return and offers a 10% buffer, tied to the NASDAQ index (QQQ).
- The third product that they’re selling offers a 2X upside to the S&P 500 with a 15% buffer.
They also add – in very very small font at the bottom of the email – that the buffer is before sales charges, costs and any associated fees.
And then right below that, it also offers – in even smaller print – the objective is they “hope to return capped upside and defined downside protection.”
I will say that both of these email examples came with – in almost invisible ink – in the bottom of their email, the footers, of their emails close to three pages of legal disclaimers.
This is highly complex math that individual investors do not need. And shouldn’t be anywhere close to.
But yet people come in, to meet with us for the first time, and they will show us statements from their investment accounts at other brokerage firms.
We find these products — and that’s what they are — we find these products littered through client client statements.
And they cannot explain what they are, or how they work.
These are just two emails of the dozen that I receive daily of “complex math.”
That’s not keeping things simple.
So let’s continue to talk about how keeping things simple is really important for you.
Charlie Munger learned they rely on high school algebra at Harvard Business School. Munger is quoted as saying “students were amazed that algebra works in real life problems.”
Remember when you took high school algebra – we always talked about “solve for x.”
And the way that you would “solve for x” is sometimes they would tell you “x=1” and you had to “back your way into” it.
And so what Munger is trying to tell you is that if you understand how algebra works, you can solve a formula — forward — like we normally do (from left to right). But you can also solve from right to left. That’s how algebra works.
You need to understand how algebra works, to keep things relatively simple.
Munger goes on to say “…by and large, as it works out, people can’t naturally and automatically do this.” He’s talking about algebra. So you have to learn. “If you don’t get this elementary but mildly unnatural mathematics of probability into your repertoire, then you go through life like a one-legged man and a butt kicking contest.”
He closes that quote by saying “you’re giving a huge advantage to everyone else.”
What Buffet and Munger really understood, by capitalizing on basic things like high school algebra, in the the quest of keeping things simple is that this shouldn’t be a complicated business — investing.
But you need to understand how things work – backwards AND forwards.
One of the very famous quotes that Munger said – and this whole episode seems to be about famous quotes from Charlie Munger – he talks about “Invert, always invert.”
It’s the same way when we say, in algebra class, “solve for x.”
So it’s important to understand how math works, what the probabilities are, and how to “solve for x” because if you can “solve for x,” you can back your way into what things ought to look like.
What’s a few examples of keeping things simple?
- Well the first one, again, another quote from Charlie Munger – and we’ve used this on several videos and several podcasts.
“Don’t interrupt the compounding.”
People want to “tear up the script” because of a lot of different reasons:
- Because their guy didn’t get elected to the White House, or
- Because taxes are going up, or
- Because the Fed seems to be changing their policy on interest rates, or
- …some other, let’s just call them “cooked-up catastrophes.”
In forty years in the business I’ve seen one time where it may have paid to bail on stocks.
And we’re talking about a five or six month window of time in 2008 — where it may have been to your benefit to bail out on stocks.
And if you didn’t do anything – if you just sat there and held on throughout – you were fine.
“Don’t interrupt the compounding.”
That’s one way of keeping things simple.
2. Another example of keeping things simple: “the market is going to do its thing” and 2008 was a perfect example.
From time to time, the market is going to do its thing. Make sure that money you are going to need over the next 3 months, 6 months, 9 months, 12 months is NOT at risk.
This is how we are keeping things simple.
And for some folks that might be two years of expenses that you need to keep out of market volatility.
The market is going to do its thing from time to time, we need to be keeping things simple. So this money “over here” that is at risk, that’s going to go up and down
We know it’s for the future.
The money we’re going to need in the short term, 3 months, 6 months, 9 months, 12 months needs to be…sitting in something completely safe.
What’s another example of keeping things simple?
3. One of the lines that we say here around the office is “Most people retire once in their lives. We retire people every day of the week around here.”
It doesn’t need to be complicated. But it does involve some math.
The main thing about retirement is not necessarily that your expenses your spending needs to go on a diet — it usually doesn’t.
The the main thing is that there’s usually less income coming in through the normal channels – like by a paycheck.
So we have to adjust. And for some people that’s a huge adjustment.
What’s another example of keeping things simple?
4. The “silent killer” is not heart disease …or veganism. It’s inflation.
When you retire, you trade your old paycheck for new streams of income. If you have nothing — that is to say — no asset that will keep pace with inflation, you WILL eventually fall behind. And that CAN lead to your expenses needing to go on a diet.
The issue – the big problem – that we face, on a daily basis in our line of work is many people (getting ready to retire) they want to reduce the risk in their investments upon retiring. Too much allocating in the wrong way is going to hurt you. If you’re going for a fixed or safer way of earning money on your investments, you’re going to fall behind with inflation.
And that that leads to number five, the fifth example of keeping things simple.
5. And that is losing sight of what is the “real rate of return.”
I’m a little stunned that more people don’t seem to grasp this concept. Let’s walk through an example.
If inflation is 3.5%, and you are earning 4.5% or 5% risk-free, on short term treasuries or in a bank account, your real rate of return is somewhere between 1.0% and 1.5%. That’s your real rate of return.
It’s the return after subtracting inflation. You have to find a way to keep your investments growing faster than the rate of inflation.
Now, let’s take a walk back, a year ago. If inflation were say, 6.0% and you’re earning 5.0% at the bank – for the first time in fifteen years – you’re pretty happy that you can get five percent at the bank!
But if inflation is 6.0%, your “real rate of return” is negative one percent.
You’re actually losing money because you’re not keeping up with inflation.
I’ll give you another example – from (about) the years 2011 through 2016. Those five or six years there.
If inflation was averaging between 1.0% and 1.5% percent, what were you earning on risk-free investments, like treasury bills, or short term investments at the bank like a short term CD?
If inflation was between one and one and a half percent, you are likely earning zero at the bank, or on your short term treasuries. And we can go back in history during that period of time and see that happening.
So the last example that I want to share with you, on keeping things simple.
6. The 6th example of this — again we’re going back to another quote from Charlie Munger. And this is a little brutal, but it’s true.
Munger said, “if you can’t handle two or three market drops of over fifty percent in a century, you’re not cut out for investing. You’ll only achieve mediocre investment returns compared to those who can rationally handle market fluctuations.”
That’s a tough pill to swallow, but it’s realistic.
We have to focus on keeping things simple when it comes to investing. We have to let the market do what it’s going to do. And yes, there will be times where you’ll pull up your account online, or look at your statements, and see you’re down 10%.
That can happen — on average that happens one time a year — for almost a hundred years now.
A 5% drop in the market can happen without any any rhyme or reason.
We also see drops of 20% – 25% routinely. If that bothers you, if you can’t handle that, you’re probably not cut out for investing.
Have to work at keeping things simple. You have to keep money that is for the long term, invested. It’s going to go up, down, sideways.
Money that you’re going to need in the short term, needs to say in stay in something secure.
So this is — we should probably call this one the Charlie Munger episode — because of all the quotes that we used. But I appreciate you listening to podcast episode number 473. We’ll catch up with you on the next episode.
Tom Mullooly is an investment advisor representative with Mullooly Asset Management. All opinions expressed by Tom his podcast guests are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management. This podcast is for information no purposes only, and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions in securities discussed in this podcast.
