How to think like Charlie Munger

Hi, The Investor’s Podcast Network Community!

It’s noon on Thursday, which means it’s time to welcome you back to We Study Markets!

The S&P 500 is up four of the last five sessions, hitting its highest level since early June. The European Central Bank ended an eight-year experiment with negative interest rates announcing a larger-than-expected half-percentage point interest rate increase.

Today, we’ll also be discussing inflation hedges, rising U.S. home prices, and investing thoughts from Peter Lynch and George Soros. All in just 4.5 minutes to read.

Let’s go!

IN THE NEWS

🚗 Tesla Beats Profit Expectations and Sells Bitcoin (Reuters)

Explained:

• Tesla reported its first sequential decline in quarterly profit in more than a year. The world’s most valuable car company reported a profit of $2.3 billion in the second quarter, which beat the $1.9 billion that Wall Street was expecting. Profit in the first quarter was a record $3.3 billion. Musk said, “It’s been kind of supply-chain hell for several years.” The stock closed Wednesday at $752.50 and was up less than 1% after hours.
• The company also announced it sold nearly $1 billion of Bitcoin, which comprised 75% of its total holdings in the digital currency.

What to know:

• Tesla is recovering from an extended shutdown of its Shanghai assembly plant and is battling headwinds including supply-chain disruptions, a global chip drought, and higher material and logistical costs.
• The bitcoin sale took place to maximize the company’s cash position as they were uncertain when the Covid lockdowns in China would end. The Tesla CEO noted that the sale “should not be taken as a verdict on Bitcoin” and is “certainly open to increasing our Bitcoin holdings in the future.”

🏠 U.S. Homes Prices Hit Record of $416,000 (WSJ)

Explained:

• The median sale price of an existing home rose to $416,000 in June, up 13% for the year and the highest recorded level ever since records began in 1999. Sales of previously owned homes fell for a fifth straight month dropping 5.4% last month.
• Higher home prices and rising interest rates have increased the monthly payment on an average home by $700 a month, a 56% increase. Ouch! 🤕

What to know:

• There are many buyers sitting on the sidelines, waiting to see what happens with interest rates and the overall economy. People are nervous, and many have been priced out of today’s housing market.
• Many buyers are opting for adjustable-rate mortgages (ARMs) in response to rising interest rates. These loans can offer a lower interest rate in the early years of the loan.

⛽ Where Have All The Inflation Hedges Gone? (CNN)

Explained:

• It seems investors are hitting a snag regarding finding a safe haven to hedge against inflation. All traditional inflation hedges, including oil, gold, silver, real estate investment trusts (REITs), Treasury Inflation-Protected Securities (TIPS), and even bitcoin, have been down since June 1st. What’s an investor to do?
• The strength of the dollar is growing on a global scale despite purchasing less domestically. Job growth and other economic data remain relatively strong, which leads investors to believe the Fed will continue to raise interest rates to tame inflation. That boosts the dollar, which in turn hurts the price of gold and other traditional hedges. Time to go on vacation abroad?😇

What to know:

• Shawn Cruz, head trading strategist at TD Ameritrade, said, “Over the long haul, equities tend to outperform inflation by a wide margin. But it’s more like a marathoner beating a sprinter over the long run.”
• The inflation trade may be over, according to Cruz. The markets have priced in, trust the Fed will be true to its word, and will stamp out inflation. The best bet may be to stick with equities and ride out the current market volatility.

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LESSONS FROM MUNGER’S “THE PSYCHOLOGY OF HUMAN MISJUDGMENT” SPEECH

Nick Sleep was one of the investing legends featured in William Green’s outstanding book, Richer, Wiser, Happier. He was the fund manager of Nomad Investment Partnership, which returned 921% over 13 years to his investors, compared to just 116% for the MSCI World Index over the same period. Sleep commented that Charlie Munger’s “Psychology of Human Misjudgement” speech given at Harvard in the mid-1990s was one of the finest investment talks ever given. Munger didn’t even speak directly about investments, but instead discussed the biases and inconsistencies that go on in the space between our ears. That is to say, one of the biggest hurdles to becoming a great investor is understanding and managing our own psychology. Munger spent a lifetime trying to avoid stupid mistakes. He discusses 25 tendencies of human misjudgments in the speech to which we are all susceptible. It pays to understand them. Though we recommend listening to the speech here, we’ll discuss some of the major ones and how they can adversely affect our investing performance. As Nick Sleep said, understand these tendencies and then train yourself out of them.

1. The Liking/Loving Tendency – We all have been guilty of falling in love with our favorite investment, but objects, like pieces of paper traded on an exchange, don’t care who owns them. With investing, things quickly go bad when you ignore, or purposively distort, the bad news of a beloved equity. This confirmation bias drives you to look only for confirming evidence of good news related to your stock. We can live in an echo chamber and tune out anything that conflicts with our viewpoint. This is dangerous, and the worst-case scenario is it becomes impossible to let go of investments you “fell” in love with even though you should.

2. The Doubt-Avoidance Tendency – The ability to make a quick decision comes in handy when you’re being mugged or chased by a lion, and our biology can serve us well in these instances. When the market crashes and the instinctual need to run kicks in, it can cause bad investing decisions. When there’s doubt in general, that can lead to excessive stress and anxiety around making decisions, which can lead to putting off making a decision entirely. Doubt avoidance is what prevents us from buying after a market crash.

3. Excessive Self-Regard Tendency – This is also known as the endowment effect, which can lead us to overestimate our skills, decisions, or possessions. We all have come across individuals who think quite highly of themselves. In investing, this leads to people who think they have superior stock picking skills when they don’t or put a higher value on their investments than the market does. The cure for this is to be objective, open-minded, humble, and accepting of mistakes.

4. Over-Optimism – How many of us have bought a stock without any research, sure it was going to be a winner and make money? Excess optimism drives people to believe that the stock market, the casino, or the lottery is of source for quick riches. Thinking in terms of probabilities is one way to remember that various outcomes in any investment are possible.

5. Social Proof Tendency – Social proof leads us to fall prey to groupthink and herd behavior. In investing, it feels better to be part of the crowd, and many investors would rather be wrong with everybody else than wrong by themselves. Every successful investor, however, thinks for themselves and isn’t afraid to stand alone.

6. Simple Pain-Avoiding Psychological Denial – Sometimes when things go wrong, we can play ostrich and stick our head in the sand. Denial, by avoiding pain or bad news, tends to compound our problems. Whether it is permanent or temporary, losing on an investment hurts. Once experienced, many of us will go to great lengths to avoid experiencing this pain again, which can lead to complete loss aversion and avoidance of risk. This usually does not lead to superior long-term investment results.

7. Inconsistency Avoidance Tendency – Stated most simply, people do not like to change. We are creatures of habit. Have you recently tried to break a bad habit or create a good one? It’s tough! We tend to stay in our comfort zone and go on living and thinking as we always have. When it comes to investing, it pays to challenge your confirmation bias and continually question your views. Purposely seek out counterarguments to your investing theories.

8. Twaddle Tendency – Charlie wouldn’t call it this, but it’s our tendency to BS ourselves and others. It’s the habit of talking to talk or to espouse something we know nothing about but pretend to. You can see this first-hand by watching an hour of your favorite talking investment head on TV. The solution to this is to know when you’re outside your circle of competency and not be afraid to claim ignorance. It’s okay to say, “I don’t know.” You’ll learn more and garner the respect of others.

So what?

Why should we care what a 98-year old man has to say about human psychology, unless, of course, he is one of the greatest investors of all time? Not being aware of how these psychological tendencies affect our behavior is a major disadvantage compared to someone who has taken the time to understand and root out any poor thinking or errors in judgments. In general, we don’t want to do anything foolish, and by avoiding these errors in thinking, we will be well on our way to having a successful investing career.

QUOTE OF THE DAY

“The real key to making money in stocks is not to get scared out of them.”

— Peter Lynch

Peter Lynch is the legendary former manager of Fidelity’s Magellan Fund, which had an annualized return of 29.2% during his helm there. Not too shabby, considering this was more than twice what the S&P 500 earned during the same period. His success allowed him to retire at 46 and devote his time to philanthropic activities. He got interested in the stock market at age 11 while working as a caddy and overhearing conversations amongst his clients while golfing. He went on to write the best-selling investment books One Up On Wall Street and Beating the Street.

Lynch is credited with inventing the price-to-earnings-growth ratio, which helps to determine if a stock is inexpensive given its growth potential. He felt that individual investors could do well by investing in what they understand, investing for the long term, and buying stocks with assets that Wall Street has undervalued.

Meaning

It’s not a simple task to keep one’s emotions under control while watching the vagaries of the markets and experiencing your portfolio declining in value. Given the market performance this year, most of us don’t have to try too hard to imagine what this feels like. It can be daunting to experience watching a stock you love plummet in price.

One of us here at We Study Markets fell in love with Amazon during the company’s early years, bought the stock at around $80 during the heady dot com era, and watched the stock rise to an all-time high of $113. When the bubble burst, Amazon traded back down to below $6 per share. Sadly, we panicked while watching the devastation unfolding and exited the position at around $20.

While it’s impossible to time markets or to have known that Amazon would have emerged from the wreckage, Lynch’s advice to not get scared out of a stock you have strong conviction in is something to always remember. It’s tough to stomach while the market is falling, but if you can zoom out and look at the bigger picture, think more of the long-term outlook, and keep your lizard brain from making your decisions, you will be able to hang on to the winners that will eventually live to see a better day.

Please share your stories with us! We’d love to hear from you. Tell us we are not alone in getting scared out of what eventually turned into a winning position.

SEE YOU NEXT TIME!

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