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Summary: Charlie Munger's first rule of compounding is to never permanently impair your capital. The word permanently is doing all the work. A fall and a loss are different things. And the only investor who turns one into the other is the investor themselves.
Recently, I came across this poster that distilled Charlie Munger’s investing philosophy into a single sheet, listing eight of the most useful things that he said for ordinary investors. I have written columns around a few of them earlier, like inverting a problem and staying within your circle of competence. In the list that’s before me now, there’s another one that might be the most useful, which is that "the first rule of compounding is never permanently impair your capital, and if you avoid a permanent loss, time and reasonable return expectations will do the work."
Note my usage of the word ‘permanently’ because that’s the most important thing. Permanence is the difference between a fall and a loss. My most fervently held belief in investing, built on decades of firsthand experience, is that the market itself never permanently takes money from diversified long-term investors. Every fall, even if it felt like the end of the world at the time, has reversed. Not just that, it has reversed a lot more quickly than it appeared possible during the fall. Permanent losses, those that never get paid back, are always manufactured by the investor’s own actions. And they are always manufactured by panic, not by the losses.
As I said upfront, Munger’s point is best understood by appreciating that a fall is not a loss. If the market falls 10 per cent this month, and the number on your Value Research Online Portfolio Manager is red and has a minus in front of it, you haven’t lost anything in any meaningful sense. That number will become the reality, and you will convert the fall into a loss only if you decide to do something about it.
In my experience with investor behaviour, this conversion of a fall into a loss happens for only two reasons. One, you have no conviction in your investments: you have no idea what they are actually worth, and why you bought them, so you panic and sell. Two, you borrowed and overcommitted during the green phase, so when the red phase arrives, you have no choice but to sell at the worst possible time. In either case, the losses were not created by the market but by your response.
I have been receiving readers' letters for decades, and I have never come across someone whose whole portfolio became trash because they failed to react in time. The ruin was always caused by the opposite behaviour: people sold everything in March 2008 or April 2020, then held cash while the recovery came and went, and they made it permanent with their own actions.
The moral of the story, what Charlie Munger is pointing at, is quite simple, which is also why few people manage to do it. During a serious market fall, the most valuable thing you can do is nothing, and the second most valuable thing is to carry on with your regular investments because, one day soon, you will be thankful for buying the shares and units when they were really, really cheap. To be able to do so, you will have to have belief in your convictions, in why you invested, but that is non-negotiable anyway. In Munger’s list, he warns against businesses with fragile economics, high fixed costs, poor management, excessive leverage, or dependence on conditions you can’t control. These are the basics of investing that you should always pay attention to. Psychological factors layer on top of these and make matters worse.
Also read: Why everyone having the same tools helps no one
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