Charlie Munger: How to Get Rich During Inflation

What's the best advice you have for individual investors to optimally deal with the negative impact of inflation, other than owning quality equities? Well, according to Charlie Munger, if you aren't confused by what's going on, you're not paying attention. Inflation has been at its highest levels in generations in recent years, the impacts of which have been devastating. It's now even estimated that a staggering 61% of Americans are experiencing severe financial hardship due to the high inflation.

However, there is hope out there that the high levels of inflation seen in recent years were just a temporary thing. The belief is that relatively shortly, inflation will return to very low levels. Legendary investor Charlie Munger disagreed. Before his passing, Munger was ringing alarm bells about the future of inflation and the economy.

In this video, we're going to cover why Charlie Munger believed inflation is here to stay and, most importantly, how you can protect your money from the devastating impacts of high inflation. But first, listen to Charlie explain how we got into this mess in the first place.

"Anything that rises to your radar screen now that may be under the radar for other people? Well, nobody knows how much of this money printing we can do. And of course, we have politicians who like—and there are both parties—who like to believe that it doesn't matter how much you do. We can ignore the whole subject and just print money as convenient. Well, that's the way the Roman Empire behaved, and it was ruined. That's the way the wartime Republic was ruined. There is a point where it's dangerous, and of course, my attitude when something is big and dangerous is to stay a long way away from it. Other people want to come as close as possible without going in. That's too tricky for me. I don't like it."

Over the past couple of years, inflation has been at levels not seen in decades. In June 2022, inflation hit its peak at 99.1%. You have to go back roughly 40 years to the early 1980s to find a period of time in which inflation was this high. As Charlie mentioned in the clip, a big cause of the sky-high inflation is money printing.

Take a look at this chart of the money supply in the United States dating back to 1960. Money supply is exactly what it sounds like; it is a measure of all the readily available money floating around in the economy. As we can see in the chart here, the money supply in the U.S. was growing at an ever-increasing rate.

However, things really started to get crazy in 2020. In order to prevent a widespread financial collapse, the U.S. Federal Reserve took truly unprecedented actions. This, combined with drastic steps by the government to support the economy, led to trillions of new dollars getting printed.

In previous interviews, Charlie Munger compared this massive amount of money printing to an individual using illicit substances. "At first, it feels absolutely amazing, but over time there are very severe consequences when it comes to the economy." One of those severe consequences is inflation.

To quote the famous economist Milton Friedman, "Inflation happens when there is too much money chasing too few goods." While that may sound like a complicated concept, trust me, it's actually quite simple to demonstrate inflation in action.

We're going to use this supply and demand graph here. This line represents demand for a particular good or service. So, in this example, imagine we're talking about a house for sale in the town in which you live. So, in our case, the demand line here represents the number of people looking to purchase this house.

Importantly, and you'll see why this matters in just a second, the demand line also represents how much those buyers are willing and able to spend to make the purchase. Here we have the supply line. This supply line represents the number of houses available in the area to be purchased. The point at which the demand line and the supply line cross represents the current price for that particular good or service, so in this example, the price of a house.

As we talked about earlier, in 2020 and 2021, the U.S. government and Federal Reserve took drastic steps to attempt to protect the economy. These actions included sending cash directly to households, boosting unemployment benefits, and pausing required payments on certain types of debt. At the same time that all this money was getting injected into the economy, the FED cut interest rates to historically low levels.

These incredibly low rates made it much less expensive for people and businesses to borrow money to make purchases. Going back to our supply and demand graph, all of these actions resulted in an increase in demand for houses. Not only were more potential buyers in the market, but these buyers also could afford to pay more for a house because mortgage rates were so low and the economy was white hot.

This higher demand is represented in our demand line getting pushed to the right. It wasn't just the demand side of the equation that was impacted during this time; the supply of houses available on the market decreased. People didn't want to move, and supply chain issues made it difficult and more costly to build new houses. Less supply means our supply line gets pushed to the left.

As you can see, our two lines now cross at a higher price. At a very simplistic level, this is how inflation works: there are too many dollars chasing too few goods, or put another way, demand exceeds supply.

If what Munger said about higher inflation being here to stay is true, what can we do to protect ourselves financially from the potentially devastating impacts of inflation? Fortunately, we can look to Charlie's legendary career for insights. Over the last handful of years, I've spent hundreds of hours studying the lives of Munger and other great investors, and I have compiled all of that research into the three biggest things we can learn from Munger on how to get rich during inflation.

All I ask for in exchange is for you to hit that subscribe button because it's my goal to make you a better investor by studying the world's greatest investors.

Okay, let's get into the list. The Mungers have Berkshire stock, Costco stock, Chinese stock, a little bit of Daily Journal stock, and a bunch of apartment houses. Do I think that's perfect? No. Do I think it's okay? Yes. I think the great lesson from the Mungers is you don't need all this damn diversification. That's plenty.

If you're lucky, you've got four good assets. I think the finance professors and those that sell the idea that perfect diversification is professional investment—if you're trying to do better than average, you're lucky if you have four things to buy, and to ask for 20 is really asking for egg in your beer. Very few people have enough brains to get 20 good investments.

A big part of understanding why inflation is bad for investors is understanding the concept of what is referred to as your "real return." When investing, your real return is what your investment generated for you after factoring the impacts of inflation. So, let's say the average investor in the stock market is able to generate an 8% return before inflation. This is the so-called nominal return, which is just a fancy way of saying the return before the impact of inflation.

Whether that 8% nominal return is good or bad depends in large part on what the inflation rate is. This is where the concept of real return comes into play. The shorthand way of calculating real return is to take the nominal return, so in this case, 8%, and subtract out the inflation rate. For the sake of this example, let's say the inflation rate is 6%. Subtracting out the 6% inflation rate from our nominal return of 8% leaves us with a so-called real return of only 2%.

Much less impressive than that 8% nominal return. One way to lessen the impact of inflation on your real returns is to generate higher-than-average returns. To show you what I mean, I'm going to introduce you to John. For the sake of this example, let's say John is able to generate a 12% nominal return while the stock market overall returned 8%.

To start out, let's say inflation is only 2%. This means John generated a real return of 10%, and the stock market overall had a real return of 6%, again calculated by subtracting the inflation rate from the nominal, or non-inflation-adjusted return. Notice here how John's real return of 10% is a whopping 67% higher than the average stock market's real return of 6%. Very, very impressive.

But just wait until you see how this is magnified during high inflation. Let's say instead of 2% inflation, inflation is now 6%. This takes John's real return down to 6% and the average stock market's real return down to 2%. Notice now how John's real return is not 67% higher than the overall stock market; it is higher by a factor of three times.

As we can see here, as inflation increases, it becomes more and more important to generate higher-than-average investment returns. As Charlie Munger explained in that clip, one of the best ways to generate above-average returns is to have a concentrated portfolio of only your best investments.

Charlie Munger was a billionaire, and his entire investment portfolio consisted of just a few assets: stock in Berkshire Hathaway, Costco, the Daily Journal Corporation, money managed by his protégé, Li Lu, and finally, a portfolio of apartment buildings in Southern California. Conventional investing wisdom would say this is not properly diversified, but as Charlie frequently liked to say, "If I listened to conventional finance teachings, I would have a heck of a lot less money."

The next piece of advice from Charlie Munger on how to invest during inflation is to focus on what are referred to as asset-light businesses. Listen to Charlie describe what he means: "If you take a business that is a good business but not a fabulous business, they tend to fall into two categories. One is the business where the whole reported profit just sits there in surplus cash at the end of the year, and you can take it out of the business, and the business will do just as well without it as it would if it stayed in the business.

The second business is one that reports the 12% on capital, but there's never any cash. It reminds me of the used construction equipment business of my old friend John Anderson. He used to say, 'In my business, every year you make a profit, and there it is, sitting in the yard.' There are an awful lot of businesses like that where just to keep going, to stay in place, there's never any cash. That business doesn't enable headquarters to drag out a lot of cash and invest it elsewhere. We hate that kind of a business."

In this context, an asset is just a fancy way of saying physical objects that a business needs to operate. The amount of assets needed to operate and the cost of those assets is different for each business based on its industry. Think of it as a spectrum.

On the one side, you have so-called asset-light businesses. These are businesses that need very little, if any, physical objects to operate their day-to-day operations. On this side of the spectrum would be something like an accounting firm. With an accounting firm, there aren't a lot of expensive assets that need to be purchased since there isn't anything tangible being sold or made. There isn't any money that needs to be spent on inventory. There's also no expensive equipment that needs to be purchased.

All an accounting firm really needs to do is rent office space and buy furniture and basic technology like computers. That's about all the assets that are needed to run the business. On the other end of the spectrum, we have so-called asset-heavy businesses. As the name suggests, these are the opposite of asset-light businesses. These asset-heavy businesses need a ton of physical assets to run their operations.

One example of an asset-heavy business is an airline. In order to operate an airline, you obviously need airplanes, and those things are not cheap. A new Boeing 737 plane would set you back a staggering $106 million. Asset-heavy companies suffer during inflation as they are constantly having to spend larger and larger amounts of money replacing the vast amount of physical assets needed to run their business.

This is the exact problem Charlie Munger's friend in the equipment rental business faced each and every year. As the story goes, he would look up from his desk to see his annual profit sitting out in his equipment rental yard. What he means by this is that the equipment rental business is asset-heavy. Equipment gets old and breaks down and has to be replaced with newer equipment at today's higher prices.

Any profit that Charlie's friend made had to be put right back into the business just to maintain its current operations. Now compare that to an asset-light business. With an asset-light business, there aren't physical assets that have to be constantly replaced at ever-higher prices during inflation.

This is why Charlie Munger talks about why these asset-light businesses are superior, especially during inflation. Generating high investment returns through a concentrated portfolio and focusing on asset-light businesses are important to get rich during inflation. However, according to Charlie Munger, they both pale in comparison to his next piece of advice.

"One of the great defenses to being worried about inflation is not having a lot of silly needs in your life. In other words, if you haven't created a lot of artificial demand to drown in consumer goods, why, you have considerable defense against the vicissitudes of life."

Here's a little story to demonstrate what Charlie means. Meet John and Michael. John and Michael both live in the same neighborhood and make the same income. For the sake of this example, let's say that income is $6,000 a month. Each month John's expenses total $3,000, meaning he has an extra $3,000 a month to save and invest, calculated by taking his monthly income and subtracting out his monthly expenses.

Michael, on the other hand, did not follow Charlie's advice. As Charlie put it, Michael has a lot of "silly material needs" in his life. Michael's total monthly expenses are $5,000 a month. This leaves Michael with $1,000 left over each month that he can save and invest.

While both John and Michael are doing okay, now let's see what happens during inflation. Part of the reason why inflation is so difficult for most people financially is because it causes expenses to increase. However, at the same time, very often a person's income doesn't increase at the same rate as inflation.

Let's see that in action with John and Michael. Let's say inflation causes their expenses to increase by 10%. At the same time, unfortunately, their incomes stay the same. John's expenses are now $3,300 a month, and Michael's are $5,500. Both are still getting by financially, but Michael is now cutting it awfully close.

Let's say inflation continues, causing the monthly expenses to increase 20% from where they started. John's expenses are now $3,600 a month, Michael's monthly expenses are now $6,000. Ouch! Michael is in trouble; his income is now only just covering his monthly expenses because of inflation.

This is exactly what Charlie Munger meant when he said that living below your means is the best protection against inflation. Only time will tell what the future holds when it comes to inflation. However, as Charlie likes to say, following this advice will help prepare you for what he calls the vicissitudes of life.

So there we have it. I hope you enjoyed this video, and make sure to subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon.