Speaking at an investor's conference in Sydney, Australia earlier this month, Charlie Munger gave away the big secret to his and longtime-partner Warren Buffett's success in the stock market. If you understand this, you can be a successful investor, just like these two titans.
"We're better than most people at knowing what we know and what we don't know," he said.
Ok, maybe it's not a huge secret. Buffett has stressed the importance of understanding and operating within one's "circle of competence" for years. But Munger insists neither he nor Buffett are any smarter or more diligent than the average investor. They've just made the best use of their particular skills and avoided going into areas where they're weak.
Everyone's a genius in a bull market
There's been a surge in interest in investing since the coronavirus crash in early 2020. I've had countless people tell me about the great investments they made in the stock market over the past couple of years.
I typically smile and enthusiastically say, "That's awesome!" And I truly mean it. I love that they're interested in investing and that they had an early success that could stoke that interest long term.
But the truth is that everyone looks like a genius investor in a bull market. You would have to be extremely unlucky to have found a losing investment if you bought in April of 2020.
If you don't really know why you invested in a company -- you haven't studied it, fully understand how the business makes money, how it can grow, and importantly, why the stock is worth the price -- you might have a problem once a bear market hits.
Will your great investment still be a great investment if the stock price drops 50%? If you're holding the stock today, it should be an even better investment at half price -- unless it turns out there's an unanticipated reason for the drop.
Two Buffett quotes come to mind: "Risk comes from not knowing what you're doing," and "Never invest in a business you cannot understand."
You can see incredible investment gains in the short run without knowing what you're doing. The last 20 months are evidence of that. But over the long run, it's important to invest in companies you understand and for which you have a well-thought-out investment thesis. Then these companies are more likely to consistently produce the returns you're looking for. Otherwise, you're more likely to make a mistake like selling too early or too late or buying bad companies only because they're popular at the moment.
You can put in the work to learn what you don't know. Take the time to learn about an industry, determine what sets apart the winners and losers, evaluate the stocks of those with meaningful competitive advantages, and continue expanding your circle of competence. There are practically unlimited resources to help you get started investing in stocks.
If you're not willing to do that kind of work, there are other options that can produce excellent returns.
You don't have to be a stock market genius
You should feel no obligation to devote your valuable time and brainpower toward becoming the next Munger or Buffett. A better investment of your time, for example, may be improving your professional skills and working toward a promotion at your job.
Buffett calls most non-professional investors "know-nothing" investors. He doesn't view it as an insult, but as a fact. He once pointed out, "I'm a know-nothing dentist." We live in an economy that values specialization.
There's one easy way to get your fair shake of good stock market returns while being a know-nothing investor: You can simply invest in a lot of different stocks. While investors like Munger and Buffett have highly concentrated portfolios with very specific investments, most people will benefit from diverse investment portfolios.
"Diversification is protection against ignorance," Buffett once said. "It makes little sense if you know what you're doing," he added.
If you admit you fall into the know-nothing side than the know-it-all side of the investor-knowledge spectrum, diversification is an easy choice. The simplest and most efficient way of achieving a diversified portfolio of stocks is by investing in a broad-based index fund. An S&P 500 index fund or total stock market index fund should have a very low expense ratio and will produce good returns.
In fact, Buffett once told Jack Bogle, the founder of Vanguard and creator of the first index fund, "By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals." And he put his money where his mouth is when he issued a challenge to hedge fund managers betting $1 million they wouldn't beat an S&P 500 index fund over a 10-year period. In 2018, his lone challenger paid up. He also advises his estate's trustee to invest 90% of his money in an S&P 500 index fund after his passing.
Being a know-nothing investor isn't so bad if the one thing you do know about investing is that you're a know-nothing investor.