"You need a different checklist and different mental models for different companies. I can never make it easy by saying, 'Here are three things.' You have to derive it yourself to ingrain it in your head for the rest of your life." -- Charlie Munger (Trades, Portfolio)
Analyzing business is a full-time job, which is why no non-professional investor can have a realistic chance of being able to manage a well-diversified portfolio effectively. When I say well-diversified here, I mean diversified in the Wall Street sense of owning 30 or more stocks in a portfolio. Not what Warren Buffett (Trades, Portfolio) would call diversified, which is having just a few stocks in different sectors.
Even this level of diversification is going to be difficult for the average investor. Successful investing is all about controlling risk and buying undervalued businesses. The only way you are going to be able to manage risk is with research, understanding every company in your portfolio and what could cause it problems.
Risk and analysis
Some of the world's best value investors, including Buffett, Seth Klarman (Trades, Portfolio) and Mohnish Pabrai (Trades, Portfolio), spend days, weeks and months analysing potential investment before making a decision.
They do so because they want to understand the company and its prospects, to reduce the risks of making a grave mistake by investing in something they don't understand.
To further improve their research process, they stick to companies that fall inside their circle of competence, so there is no need to research a whole different industry as well. The more you have to research, the higher the chance that you will miss something that could seriously undermine your investment analysis.
Learning different mental models for evaluation is a timely and complicated process, as the quote from Munger above suggests. That is why the best investors stick to just a few mental models and then pound them into their heads, so they do not have to relearn these principles again and again and again.
A focus on real estate
For his part, Munger has not spent a tremendous amount of time learning about different models for different sectors. We know that he only owns a handful of Investments personally and another handful in the Daily Journal. He is more active in real estate than securities investing according to various comments he has made over the years, a sector that he knows and understands well.
Indeed, Munger has been an active real estate investor since he graduated from college. Over the last six or seven decades, he has almost certainly developed a robust and complex set of mental models for investing in the sector.
Unfortunately, there is never going to be any shortcuts to creating your own set of mental models or understanding of a particular sector and Industry. It requires plenty of hard work, time and effort as well as good and bad experiences. But this is just part of the investing process that every investor has to graduate from. Over the long term, these efforts are sure to pay off in profit generated from the stock market and potential losses avoided.
Munger is always talking about how important it is for investors to be selective when choosing potential stocks. And this goes hand in hand with his advice about building mental models for the evaluation of different companies.
If you do not have the time or resources to build mental models for a particular investment, then it makes sense to leave it. You might be leaving money on the table, but at the end of the day, leaving money on the table is much better than losing money.
Avoiding significant losses should be at the core of every investor's strategy.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- When To Buy A House According to Warren Buffett
- Warren Buffett: Businesses and Birds
- Passive vs. Active Investing: Do You Have the Time?
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