How to Invest Wisely in the Stock Market

This article is an excerpt from the Shortform book guide to "Poor Charlie's Almanack" by Charles T. Munger. Shortform has the world's best summaries and analyses of books you should be reading.

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How do you master how to invest wisely? What is the investment strategy of Warren Buffett and Charlie Munger?

You master how to invest wisely when you learn to find fairly-priced, high-quality businesses with good management. Buffett and Munger applied these principles along with a focus on investing in companies that are underpriced by the market to become the legends they are today.

Read on to fully discover how to invest wisely in the stock market.

How to Invest Wisely

Buffett and Munger are disciples of value investor Benjamin Graham, who advocated for investing in businesses that were underpriced relative to their value. However, the two expand beyond Graham’s principles by considering more factors than just book value, such as the quality of a business, its growth prospects, and its management.

Here are their tips on how to invest wisely in the stock market:

Find High-Quality Businesses

Beyond just looking for cheap deals, Munger looks for high-quality businesses. In sum, these are profitable businesses that have a sustainable competitive advantage and good growth prospects. (Shortform note: We’ll discuss competitive advantage in the next chapter.)

When you fully grasp how to invest wisely in the stock market, you come to recognize that quality of a company may even override cheapness—”a great business at a fair price is superior to a fair business at a great price.” A company that returns 18% on capital over twenty years can get amazing results, even if you pay a price that looks expensive at first.

The benefit of a high-quality business is you don’t need to fret over when to sell it. When you buy a cheap low-quality company, you have to worry about when to exit your investment, since future opportunities may never come again. In contrast, great businesses will stay great for years or decades, and you can wait patiently to sell when it’s in your favor.

Not all profits are made equal. Some businesses earn 15% on capital, and you can take the profits out as cash. Other businesses make 15% too, but the cash needs to be reinvested to sustain the business, so there’s never cash that you can take out of the company.

Look for Excellent Management 

Ben Graham never accounted for management quality in his value investing principles, partially because he was writing to a mass audience who wouldn’t have the opportunity to talk to and assess management, and partially because he had an intrinsic distrust of management.

But Munger and Buffett believe management can make a big difference. For example, famed CEO Jack Welch made a big difference for General Electric, in ways that the manager of Westinghouse didn’t. 

Knowing how to invest wisely in the stock market means looking for companies with management that is 1) unusually skilled and 2) trustworthy

However, management shouldn’t be the dominant factor—it’s better to bet on a high-quality business than to bet on great management.

Value Companies Fairly

Of course, mastering how to invest wisely in the stock market is not just about finding great businesses, but also great businesses at great prices. Even a fantastic business can be a terrible investment if the price is too high.

Consider betting on a horse race. The best horse is often obvious, based on its track record, weight, health, and so on, and it’s clearly better than a sickly horse with a bad record. But the odds already reflect that—the best horse might have odds of 2 to 1, while the bad horse has odds of 50 to 1. Which is the better deal? It’s not immediately clear.

Likewise, a company with strong management, a great competitive moat, and a profitable business model is a sound business, but its price probably already reflects much of that. It’s not a good idea to invest in a business at any price.

However, the market is not perfectly efficient at all times. Great businesses can sometimes be found at great prices, due to the erratic nature of the market. Ben Graham conceptualized this in the idea of Mr. Market, a manic-depressive who shows up at your doorstep each day and offers you a price that can be far higher than what you think it’s worth, or far lower. You have the choice of whether to buy from Mr. Market, sell to him, or do nothing. If you’re patient, you can find the times when the market underprices a good company.

How to Invest Wisely in the Stock Market

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Here's what you'll find in our full Poor Charlie's Almanack summary:

  • A collection of Charlie Munger’s best advice given over 30 years
  • Why you need to know what you’re good at and what you’re bad at to make decisions
  • Descriptions of the 25 psychological biases that distort how you see the world

Joseph Adebisi

Joseph has had a lifelong obsession with reading and acquiring new knowledge. He reads and writes for a living, and reads some more when he is supposedly taking a break from work. The first literature he read as a kid were Shakespeare's plays. Not surprisingly, he barely understood any of it. His favorite fiction authors are Tom Clancy, Ted Bell, and John Grisham. His preferred non-fiction genres are history, philosophy, business & economics, and instructional guides.

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