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Wednesday 2 November 2022

Lessons from Charlie Munger's Folly


It’s good to learn from your mistakes. It’s better to learn from other people’s mistakes. ~ Warren Buffett
This quote has been embedded in my mind since I first read it. So, I try to observe the world and keep reflecting on the mistakes that I and that others around me make. There is a lot to learn. Today, I will discuss one such mistake. And one made by, perhaps, the person I admire most – Charlie Munger. So, when our guru makes a mistake, you should sit up and take notice.
The Alibaba Saga
Here is what happened. Charlie Munger took a bet on the Chinese giant Alibaba. This was just before the Chinese government decided that Jack Ma had grown too big for their comfort and pared his wings. Munger bought his initial stake at around $246 per share. So far so good. Alibaba was a giant in China. It was one of the largest B2B and C2C ecommerce sites in the world. Alibaba was on its way to launching the largest IPO on the Shanghai Exchange in Oct 2020. Just before this, Ma addressed an assembly of high-profile figures in China with a controversial speech that criticised the Chinese financial system. And then suddenly, he practically went missing for three months.
This more or less started the crash in Alibaba’s stock. From above $300 it has now crashed to close to $70, an overall fall close to 75%. 
Alibaba monthly price chart
Alibaba monthly price chart
source: tradingview.com
Munger probably convinced this was a passing phase and things will get back to normal after Jack Ma is “taught” a lesson in adhering to the government line, doubled down and kept adding as the stock kept falling. He added substantial quantities in the Jul-Sep quarter around $182 and again in the Oct-Dec quarter around $145. Each time he nearly doubled his position from before. He probably realised his mistake and sold half his position in the Jan-Mar quarter of 2022 at $115. Today the stock price is around $70.
Munger kept averaging down before booking partial losses
Munger kept averaging down before booking partial losses
Source: gurufocus.com
The Lessons
When I sit and think about this trade, here are the lessons I draw from it.
  1. Macro matters - Nothing really changed in the company. The underlying macro factors changed. The company kept doing the same business it was doing in 2019, yet the stock is down 75%. So, those who say that macro does not matter are simply wrong.
  2. Psychological Bias Impacts All – Even if you have devoted your life to studying and understanding human biases, no one is immune from them. The steadfast belief, a form of narrative fallacy bias, in the superior “Chinese system” that Munger kept alluding to in many of his talks probably blindsided him. Any autocratic system provides great results but only as long as the system works in your interests. If it works in the opposite interests, then the downside could also be equally large. Authority bias may also have had a role to play. Li Lu recommended Alibaba to Munger. Previously, Li Lu had recommended BYD, a Chinese EV giant, and Munger had invested in it and made significant profits. Li Lu is a Chinese-born American investor and familiarity with Chinese businesses was a major advantage for him. Li Lu is also the only person that Munger has given his own money to manage, so one can understand the trust he has in his views. Thirdly, social proof, also probably played a role. Munger had taken a very large and visible position. He had spoken about the great Chinese system. He had praised the Chinese government for stepping in “preemptively to stop speculation”. The challenge with mental biases is when you have a number of them lined up together, they combine and create a lollapalooza effect which has the potential to completely blindside a person.
  3. Lack of risk management system – It does not matter how great an investor you are, you will make mistakes from time to time. There has to be a safety net that you create for yourself when you make a mistake. The one that works well is to use a stop loss. The simple reason is that it puts a floor to the maximum loss to your capital. It lets you get out of your position and then assess more objectively if there is something wrong with your thesis. The worst that can happen is after reviewing your thesis if you think that the stock is still worth buying, you can always buy it back. Otherwise, you are paralysed with a stock with falling prices and keep hoping that something will happen to turn it around. Hope is never a good investment strategy.
Mistakes will be made. You need to keep your guard high all the time. As Richard Feynman famously said, “You must not fool yourself, and you are the easiest person to fool.” As investors, most of the time we keep fooling ourselves. The best way is to have a focus on building processes that will firstly, prevent you making a mistake, and secondly, even if you do, will protect you from making great damage to your portfolio.
Note: This article was first published on The Economic Times.

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