Charlie Munger is the vice-chairman of Berkshire Hathaway, the conglomerate controlled by Warren Buffett — the world’s best-known investor.
Munger was a successful investor on his own long before hooking up with Buffett and has also been influential in the building up of Berkshire Hathaway over the years. He’s worth listening to when he’s offering advice about investment strategy.
For example, he once said, “Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.”
I reckon it’s easy to be so caught up in the ins and outs of strategies to make money from shares that we forget to consider the risks we are taking every time we buy a stock. However, considering risk first, before any other aspect, is perhaps the out-in-the-open ‘secret’ that could help propel you to meaningful gains from the stock market during 2020.
The risk of permanent capital loss
Share prices bounce around no matter how good the underlying business is or how reasonable the valuation. I reckon it’s almost impossible to consistently buy stocks without experiencing periods when the share price falls below what you paid.
Over time, if the underlying business is of good quality and growing, and if the valuation is reasonable, the shares will likely rise to reflect improvements in trading. In the end, the volatility in the share price along the way will likely be overridden by a long-term uptrend.
However, if a share price permanently collapses along with the money you’ve invested, the disadvantage to you could be greater than you might think. The bigger the loss, the bigger deal it becomes.
Consider the maths. If you lose 5% of your money, you’ll need to make a 5.26% gain on your next investment just to break even. But if you make a 25% loss, you’ll need to gain just over 33% to break even.
The numbers accelerate against us. For example, if we lose 75% of our invested money, we’ll need to make a gain of 300% to break even! Indeed, permanent capital loss has the potential to set your investing career behind — permanently.
The risk of inadequate return
Munger is big on talking about the process of compounding. It’s key to investing your way to a fortune, and he doesn’t want anything to interrupt it. And small changes in the annualised returns you achieve and compound make big differences to the amount of money you eventually end up with.
Munger sees risk in only compounding small annualised returns. For example, If I compounded a return of, say, 1.4% a year, it wouldn’t matter how long I kept doing it because I’d probably end up losing some of the spending power of my money. Why? because general inflation tends to compound at a higher rate than that.