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3 Ways Warren Buffett & Charlie Munger Broke Their Investing Rules—And How To Know When You Can

Charlie Munger, Bruce Lee, & Elon Musk on Risk-Taking

November 16, 2024

Read Time: 6-minutes

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Today, we’re going to look at:

  1. 3 ways Warren Buffett & Charlie Munger broke their investing rules—and how to know when we can, by way of a story about Benjamin Franklin's negotiation with the French (for the American Revolution).

  2. A mental model from the discipline of systems thinking — Feedback Loops — & its 3 applications for investing.

  3. Insights from Charlie Munger, Elon Musk, & Bruce Lee on risk-taking, failure, & goal-setting.

Let’s get started.

Publishing Note: After next week's newsletter, I need to pause publishing for the time being. Thank you for your understanding.

1. Story

"My favorite Benjamin Franklin story:

'Early to bed, early to rise, makes a man healthy, wealthy and wise.’ — Benjamin Franklin

Benjamin Franklin was visiting France alongside John Adams. Both were in Paris networking for support for the American Revolution. They needed to get powerful people in France on their side.

John Adams woke up every day first thing ready to work. Franklin did the exact opposite. He stayed up all night drinking with the French in the salon. He would roll out of bed at noon with a raging hangover.

John Adams couldn't get over the hypocrisy.

How ironic that the guy behind the quote: 'Early to bed, early to rise, makes a man healthy, wealthy and wise’ — wasn't following his own advice.

Franklin understood something Adams did not.

Franklin wasn't a hypocrite. Franklin was pragmatic. He was getting more business done for the American mission at 2am drinking with the French than Adams did at 8am in the office.

That's the way Paris Politics worked.”

Rules are helpful until they aren't.

Franklin understood different environments call for varying strategies.

We must be willing to bend or temporarily set aside rules when the situation calls for it.

This applies to investing, too.

For example, Buffett used to follow Benjamin Graham's rule of buying "cigar butts." These were underpriced stocks of low-quality companies where he could get "one last smoke" or good trade from these investments.

But Charlie Munger convinced him of a better way. Buying high-quality companies at reasonable prices. Buffett dropped his old rule because he found a new, better one.

Beyond this well-known strategy shift, Buffett also dabbled in arbitrage situations:

“Because my mother isn’t here tonight, I’ll even confess to you that I have been an arbitrageur.”

— Warren Buffett

Buffett's guiding principle was finding value: situations where there were large margins of safety to ensure success. A mispricing that allowed for a high probability of making a better-than-average investment return. Sometimes, arbitrage situations met that definition, and he ignored his other rules.

Charlie Munger also discarded his own rules when necessary.

Munger's well known for saying:

"Smart men go broke three ways - liquor, ladies, and leverage."

— Charlie Munger

Leverage, or borrowing additional capital to invest, is a double-edged sword: amplifying gains but also losses.

So, Charlie was asked at the 2023 Daily Journal meeting about his use of leverage:

Source: CNBC

“Well, yes, it’s true. I operated with no leverage for long stretches of my old age, and Warren’s the same way. And recently I did use a little bit of leverage here and in another place because the opportunities were so ridiculously good. I thought it was desirable to do that. So you’re right, it’s unusual for us. But we did find a few things.

And by the way, if you go back early in my career, I used some leverage. I sometimes ask myself a mental question. I say:

'What is the appropriate percentage of your net worth you should put in the stock if you think it’s an absolute cinch?'

Well, if you’re the kind of fellow who’s right when you think something is a cinch, the answer is 100% or maybe 150%. But nobody teaches people to think that way in finance. But if the opportunity is great enough, the logical answer is 100%. Or maybe 200%.”

— Charlie Munger

When pressed whether his actions conflicted with his advice:

“I think most people should avoid [leverage], but maybe not everybody need play by those rules. I have a friend who says, ‘The young man knows the rules and the old man knows the exceptions.’”

— Charlie Munger

And that's the overarching lesson: the experienced investor knows when rules apply and when they don't.

Judgment is the ultimate ability.

2. Mental Model

"You must know the big ideas in the big disciplines and use them routinely — all of them, not just a few.” — Charlie Munger

So, what's one of the best ways to improve our judgment?

Well, as the saying goes:

"Good judgment comes from experience and experience comes from bad judgment."

Experience—if we choose to learn from it—can be the raw material for improving our judgment. And that's the focus of today's Mental Model: the "Feedback Loop." A mental model that comes to us from the discipline of Systems Thinking.

The Feedback Loop mental model describes a process where outputs are re-routed as inputs to produce future outputs.

As investors, there are multiple Feedback Loops available and it's crucial we make sure we're paying attention to the right ones—at the right times.

1. Financial Markets:

Ultimately, of course, investors look to markets for feedback. Eventually, we must be compensated by the markets for the risks we've taken.

However, because markets can act wildly irrational, they're pretty unreliable in the short term:

2. Economic Data

Another common Feedback Loop is considering economic data. This data is widely publicized and a hot topic for most financial news outlets.

Perhaps we can glean some helpful information here, but investors like Buffett & Munger typically don't put much weight on economic data. When asked what macroeconomic measures Munger monitors:

“None. I find by staying abreast of our Berkshire subsidiaries and by regularly reading business newspapers and magazines, I am exposed to an enormous amount of material at the micro level. I find that what I see going on there pretty much informs me of what’s happening at the macro level.”

— Charlie Munger

3. Business Fundamentals:

Rather than fixate on market quotations or economic data, Buffett & Munger focus on business results:

Because, as Buffett put it:

3. Insights

Martial artist and actor Bruce Lee on setting big goals:

"Don't fear failure. Not failure, but low aim, is the crime. In great attempts it is glorious even to fail."

— Bruce Lee

Elon Musk on 1 risk of success:

"This is how civilizations decline. They quit taking risks. And when they quit taking risks, their arteries harden. Every year there are more referees and fewer doers. When you've had success for too long, you lose the desire to take risks."

— Elon Musk

Charlie Munger on the greatest tragedy in life:

Conclusion:

While it would certainly be nice for investing rules to work well all the time, it's probably pretty unrealistic to assume that will be the case. Even the best investors like Buffett & Munger broke their own rules when warranted.

The key is to develop the judgment to know when it's appropriate to bend or even temporarily discard our investing rules. And judgment comes from learning from our experiences.

That's where paying attention to proper Feedback Loops comes into play. While many look to market price quotations for immediate feedback, the best investors tend to focus on underlying business fundamentals.

Because if businesses do well, their stocks eventually do, too.

Well, that's it for this week.

I hope you found it valuable.

See you next Saturday.

Two resources I think you might like:

  1. Book Summaries: One of the most important lessons from Charlie Munger is to strive to become a little bit wiser each day. To accelerate my learning on everything from investing & decision-making to negotiating & habit-building, I use Blinkist (Thank you to the Blinkist team as their affiliate program helps keep this newsletter free to the reader). Blinkist offers easily readable book summaries to help you get the most valuable ideas from the most popular books. You can check out Blinkist here.

  2. Mental Exercises: To paraphrase Morgan Housel, the common factor among elite investors is they have complete control over the space in between their ears. Financial news networks and social media can create a lot of "noise" for investors. To stay focused and calm, I like to use Headspace (I don't receive any compensation from Headspace currently). Headspace offers mindset and breathing exercises to help you keep control over the space between your ears. You can check out Headspace here.

Disclaimers

This material is not investment advice. No responsibility for loss occasioned to any person or corporate body acting or refraining to act as a result of reading this material can be accepted by the publisher. Additional disclaimers here.

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