Tuesday, July 24, 2007

Success Secrets: Charlie Munger on Reducing Risk

This series of posts studies the concepts of billionaire Charlie Munger, associate of Warren Buffet. One source (among many on the internet) is this Morningstar article:

Concept: Deliberately remove risk from your life

What do we think about when we imagine someone who is making a lot of money? Buying new houses? Boats? Planes? How about buying more insurance? Sounds pretty boring. And yet, as Charlie Munger mentions, deliberately reducing risk is one of the key methods of staying wealthy. Microsoft founders Bill Gates and Paul Allen regularly sell portions of their Microsoft stock so they can diversify their risk. Modern portfolio theory also states that holding uncorrelated asset classes (stocks bonds, commodities, real estate, etc) greatly reduce risk. Over time, your portfolio will grow in a more stable fashion, with smaller overall downdrafts. But you need to have enough investable assets to do so.

Proper asset allocation also dictates selling portions of the assets that appreciate most. Are your stocks having a great year? Then it’s time to reduce those holdings. Did you get a windfall? How about paying off the mortgage?

Even the great Warren Buffett, in his search for a successor mentions, as a key quality he looks for, the ability to recognize unusual risk: In a recent Berkshire Hathaway annual report he posts a “want ad” for a successor. Here is a portion:

Over time, markets will do extraordinary, even bizarre, things. A single, big
mistake could wipe out a long string of successes. We therefore need someone
genetically programmed to recognize and avoid serious risks, including those
never before encountered. Certain perils that lurk in investment strategies
cannot be spotted by use of the models commonly employed today by financial

The very wealthy probably have less exposure to the stock market than you and I. Maybe none at all. They only need bond income, and probably municipal bonds or government bonds at that.

And another risk-reducing investment which is very “expensive” (to the uninitiated) is cash. That’s right. Just plain cash in the bank. Does it feel like you want to spend it? Invest it? Can’t stand seeing it just sit there? Wait till you’re downsized. Or the car dies. Or the kids need braces. You’ll be happy it’s there.

A friend of mine’s father had a business. After years of hard work, he landed a huge account. The profits from this account were enough to fulfill anyone’s dreams. One possible course of action was, first and foremost, to secure the future for him and his family. Buy annuities. Buy bonds. Pay off all mortgages. Set up trust funds for all the kids.

But this person bought boats, cars, and houses. His generosity to all around him came first, while Charlie Munger’s idea of removing risk from his life was not heeded. Unfortunately, the “big account” eventually went away (as most big accounts eventually do) and the man had to sell most of his acquisitions at “fire sale” prices, and eventually found himself in very humble circumstances.

Removing risk is boring. It seems a bad use for money. But if it is good enough for Charlie Munger, it is good enough for me.


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