Munger: How to deal with significant drawdowns in investments?
Munger: If I knew where I would die, I would never go to that place.
This article is compiled from a minority investment.
You need to have patience, discipline, and the ability to stay sane even in the face of losses and adversity.
-Charlie Munger, 2005
Undoubtedly, Netflix, Amazon, and Google are the three most successful companies of the past decade. Their products have profoundly changed our way of life, and if their shareholders can hold onto their stocks for the long term, they will also reap huge investment returns. However, one of the oldest financial rules is that returns always come with risks. If you want to achieve huge investment returns, you are also destined to bear the accompanying risks.
Since its initial public offering in 1997, Amazon's stock price has soared by as much as 38,600%, equivalent to a compound annual growth rate of 35.5%. This means that an initial investment of $1,000 would have turned into $387,000 today. However, in reality, turning that $1,000 into $387,000 over the past 20 years is no easy feat. Historically, Amazon's stock price has experienced three declines of over 50%. The first was from December 1999 to October 2001, where it lost 95% of its market value. During that period, an initial hypothetical $1,000 investment would have plummeted from a high of $54,433 to $3,045, resulting in a loss of $51,388.
This is why it is said that buying and holding onto a long-term winner is not easy. Perhaps you do know that "Amazon will change the world," but even so, it does not make investing any easier.
Another revolutionary company, Netflix, has had a compound annual growth rate of 38% since its IPO in May 2002. But achieving this return has almost exceeded the investment discipline that people can bear. Netflix's stock price has experienced four declines of over 50%, with a drop of over 82% from July 2011 to September 2012. This means that an initial investment of $1,000 would have risen to $36,792, then shrunk to $6,629. Can investors really endure their initial investment retracting more than thirty times? Especially when a 500% return vanishes in just 14 months!
Google is the youngest of these three companies, with a compound annual growth rate of 25% since its IPO in 2004. It has provided investors with a better investment experience than holding Amazon or Netflix. Google's stock price has only experienced one decline of over 50%, which occurred from November 2007 to November 2008, with a drop of 65%. Many investments could not withstand this period of significant price retracement. During these 264 days, Google's turnover reached $845 billion, while Google's average market value was less than $153 billion. In other words, the stock changed hands 5.5 times during this period, causing many investors to miss out on the opportunity to gain a 515% return over the next eight years.
Charlie Munger has never been interested in investing in companies like Amazon, Netflix, or Google. But the companies he has long invested in, which have brought him huge investment returns, have also experienced significant retracements in a short period. Munger, the vice chairman of Berkshire Hathaway, is famous for being a long-term partner of Warren Buffett.
Charlie Munger's wise and philosophical quotes are collectively known as Mungerism. He enjoys approaching problems from different perspectives and one of his famous quotes is "If I know where I will die, I will never go there." At the Berkshire Hathaway shareholders' meeting in 2002, he mentioned, "People calculate too much and think too little."
One thing that sets Munger apart from most of us ordinary people is that he is never attracted to investments outside his circle of competence. He once said, "We have three baskets: in, out, and too hard." Investors should follow his advice, "If the investment target is too difficult to analyze, we turn to other investment targets. Is there anything simpler than this?"
Today, many new products have emerged in the market to serve investors, these products are like purple and green fish baits: I believe the reason our investment management is in trouble is revealed in the conversation I had with a fishing tackle shop owner. I asked him, "My goodness, these purple and green fish baits! Do fish really bite on them?" He replied, "Sir, I don't sell fish."
In 1948, Munger graduated from Harvard Law School and successfully pursued a legal career following his father's footsteps. In his early investment career, he made his first million dollars through real estate investments. In 1959, his investment enthusiasm was ignited when Ed Davis introduced him to Buffett as one of Buffett's first investors. Buffett was surprised that he easily obtained $100,000 from Ed Davis, as Davis seemed not too concerned about Buffett's investment strategy. The reason behind this was that Buffett resembled another investor whom Davis trusted wholeheartedly, Charlie Munger. They were so alike that Davis once wrote Munger's name on a check intended for Buffett.
Munger and Buffett hit it off. After years of communication, learning from each other, and sharing, Munger co-founded a law firm (Munger, Tolles & Olson; Charlie left in 1965) with other partners in 1962, and also established a hedge fund company (Wheeler, Munger & Company).
Munger's investment performance is remarkable. From 1962 to 1969, the fund's annualized return before fees reached an incredible 37.1%. Especially considering the market conditions at that time, this achievement is even more commendable. During these eight years, stock picking was not an easy task. In fact, the S&P 500 index (including dividends) only rose by 6.6% during the same period. Over the 14 years of the fund's existence, Munger achieved an annual return of 24% and a compound return of 19.82%, far exceeding the index. Meanwhile, the S&P 500 index (including dividends) had a compound return of only 5.2% during the same period. If Munger's limited partners could stick with him, they would also reap substantial profits, but just like holding onto Amazon stock, it's not that easy. Investors can learn the best lesson from past history: there are no good times without bad times. Long-term investments often involve significant short-term losses. If you cannot accept short-term losses, it's hard to reap long-term market returns. As Munger once said:
"If you can't handle two or three market drops of over 50% in a century, you're not cut out for investing. You'll only achieve relatively mediocre investment returns compared to those who can rationally handle market fluctuations."
Warren Buffett once praised Munger as someone "willing to accept greater performance fluctuations, a person with a concentrated psychological structure." Of course, Munger's focus is not that simple; his focus is based on diversified thinking at a higher level. By the end of 1974, 61% of his funds were invested in Blue Chip Stamps. In the worst bear market since the Great Depression, this company caused serious damage to Munger's investment portfolio. Blue Chip Stamps' sales exceeded $124 million that year but quickly began to decline. By 1982, sales plummeted to $9 million, and by 2006, it was only $25,000. "Considering Blue Chip Stamps' initial business, 'I predicted that its sales would drop from $120 million to less than $100,000, so I predicted from the start that its business alone was almost certain to fail.'"
However, Blue Chip Stamps, as an important asset in fund investment, later provided substantial funds for the acquisition of See's Candies, Buffalo Evening News, and Wesco Financial Corporation, and was eventually acquired by Berkshire Hathaway in 1983.
Munger lost 31.9% in 1973 (compared to -13.1% for the Dow Jones Industrial Average) and 31.5% in 1974 (compared to -23.1% for the Dow Jones Index). Munger said, "We were crushed by the market from 1973 to 1974, not because of undervalued real value, but market value, as our publicly traded securities had to trade at less than half their true value." "It was a tough experience - 1973 to 1974 was a very unpleasant experience." Munger was not alone; for many great investors, this was a very difficult process. Buffett's Berkshire Hathaway fell from $80 in December 1972 to $40 in December 1974. The bear market from 1973 to 1974 saw the S&P 500 drop by 50% (the Dow Jones Industrial Average fell by 46.6%, back to the level of 1958).
The $1,000 invested with Charlie Munger on January 1, 1973, would have turned into $467 by January 1, 1975. Even though the fund rose by 73.2% in 1975, Munger still lost his biggest investor, which left him frustrated and led him to the decision to liquidate the fund. Despite experiencing the harsh historical period from 1973 to 1974, the fund achieved a compound return of 24.3% before fees throughout its entire lifecycle. Not only those star stocks may experience a decline of over 50%. Even those long-term compound growth indices may also encounter retracements at some point. Since 1914, the Dow Jones Index has grown by 26,400%, including 9 retracements exceeding 30%. During the Great Depression, the Dow plummeted by over 90% and did not return to its 1929 peak until 1955. As a blue-chip stock index, the Dow Jones Index experienced two significant retracements in the first decade of the 21st century (a 38% decline during the burst of the tech bubble and a 54% decline during the financial crisis).
For most ordinary investors like us, if we seek high investment returns, significant losses are inevitably part of the journey, whether the investment period is a few years or a lifetime. Munger once said, "We are keen on keeping it simple." You can simplify everything you want, but it won't shield you from losses. Even a 50/50 stock and bond portfolio lost 25% during the financial crisis.
There are several ways to deal with losses.
The first is absolute loss, which refers to your investment losses. In Munger's case, he rarely experienced absolute losses. During his tenure managing his hedge fund, he faced a 53% decline, and the Berkshire Hathaway stock he held experienced 6 declines of over 20%. For the unfamiliar, a retracement is a downward movement from a peak. In other words, Berkshire Hathaway has experienced 6 instances of dropping over 20% after reaching historical highs.
The second type of loss is relative loss, which refers to your opportunity cost. In the late 1990s, when internet stocks were booming, Berkshire Hathaway did not invest in them, which cost them dearly. From June 1998 to March 2000, Berkshire fell by 49%. However, what was more painful was that internet stocks continued to soar. During the same period, the Nasdaq 100 index rose by 270%! In his 1999 letter to Berkshire Hathaway shareholders, Warren Buffett wrote, "Relative performance is the issue; during the period, poor relative performance led to unsatisfactory absolute performance."
Whether you are investing in stocks or indices, poor relative performance is a challenge you will face in investing. During the five-year internet bubble, Berkshire Hathaway's performance lagged behind the S&P 500 index by 117%! Many questioned whether Munger and Buffett were out of touch with the new world at that time.
The reason behind Munger's wealth continuously compounding over the past 55 years, in his own words, is: "Warren and I are not geniuses. We can't play chess blindfolded or be concert pianists. But our results are terrific because we have a temperamental advantage that compensates for a lack of IQ."
You must be able to handle losses calmly. The right time to sell is not after the stock price has dropped. If you invest this way, you are likely destined not to achieve good long-term returns. Learn from history, do not try to avoid losses. Losses are inevitable. Instead, focus on ensuring that you are not forced to sell. If you know that a stock has dropped by over 50% in the past, this situation will undoubtedly occur again in the future, so make sure you can face and bear such circumstances. How to do it? Here is an example. Suppose your investment portfolio is worth $100,000 and you know you cannot tolerate losses exceeding $30,000. Assuming that if the stock value decreases by half while the bonds will retain their value (this is purely hypothetical and not guaranteed), then do not allocate more than 60% of your assets to stocks. This way, even if this 60% of assets drops by half, you should be fine.
It is worth mentioning that recently, Berkshire Hathaway released Buffett's shareholder letter, see: