A Dozen Things I’ve Learned from Charlie Munger about Capital Allocation


1. “Proper allocation of capital is an investor’s number one job.” Capital allocation is not just the number one job of an investor but of anyone involved in any business. This is a core part of why Buffett and Munger say that being an investor makes you a better business person and being a better business person makes you a better investor. Making capital allocation decisions is core to any business, including a hot dog stand. Everyone must decide how to deploy their firm’s resources. Michael Mauboussin and Dan Callahan describe the core task in allocating capital simply: “The net present value (NPV) test is a simple, appropriate, and classic way to determine whether management is living up to this responsibility. Passing the NPV test means that $1 invested in the business is worth more than $1 in the market. This occurs when the present value of the long-term cash flow from an investment exceeds the initial cost.” Of course just passing the NPV test is not enough since the investor or business person’s job to seek the most attractive opportunity of all the opportunities that are available. Building long-term value per share is the capital allocator’s ultimate objective. Buffett puts it this way: “If we’re keeping $1 bills that would be worth more in your hands than in ours, then we’ve failed to exceed our cost of capital.”

2. “It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books, so there’s a lot of twaddle and fuzzy concepts that have been introduced that don’t add much.” Munger is not a fan of academic approaches to capital allocation. He would rather keep the analysis simple. One issue that concerns both Buffett and Munger is that many CEOs arrive in their job without having sound capital allocation skills. The jobs that they have had previously in many cases do not provide them with sufficient capital allocation experience. Buffett has written: “Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.” The best way to learn to wisely allocate capital is to actually allocate capital and get market feedback on those decisions. Allocating capital requires judgment and the best way to have good judgment is often to have experienced some effects of bad judgment. This lack of capital allocation experience can create problems since many people tend to focus on short-term stock prices and quarterly results. Munger believes that if an investor or CEO focuses on wise capital allocation and long term value the stock price will take care of itself.

3. “In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That’s your opportunity cost. That’s what you learn in freshman economics. The game hasn’t changed at all. That’s why Modern Portfolio Theory is so asinine.” “It’s your alternatives that matter. That’s how we make all of our decisions. The rest of the world has gone off on some kick — there’s even a cost of equity capital. A perfectly amazing mental malfunction.” “I’ve never heard an intelligent discussion on cost of capital.” Munger has on several occasions expressed his unhappiness with academic approaches to finance. Buffett describes their approach as follows: “Cost of capital is what could be produced by our 2nd best idea and our best idea has to beat it.” All capital has an opportunity costs – what you can do with the next best alternative. If your next best alternative is 1%, it is 1% and if it is 10% it is 10%, no matter what some formula created in academia might say. Allocating capital to a sub-optimal use is a mis-allocation of capital. As an example, if you are a startup founder and you are buying expensive chairs for your conference room the same process should apply. Is that your best opportunity to deploy capital? Those chairs can potentially be some of the most expensive chairs ever purchased on an opportunity cost basis. I have heard second hand that if you drive an expensive sports car Buffett has in the past on the spot calculated in his head what your opportunity cost is in buying that car versus investing.

4. “We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we’d change. Our hurdles reflect our estimate of future opportunity costs.” “Finding a single investment that will return 20% per year for 40 years tends to happen only in dreamland.” The current interest rate environment is a big departure from the past. Andy Haldane has pointed out that interest rates appear to be lower than at any time in the past 5,000 years. These very low interest rates driven by a “zero interest rate policy” or ZIRP have created new challenges for investors and business people. One issue that seems to exists today is a stickiness of hurdle rate at some businesses. Hurdle rates that were put in place in the past may not be appropriate in today’s world. Buffett has said: “The real test is whether the capital that we retain generates more in market value than is retained. If we keep billions, and the present value is more than we’re keeping, we’ll do it. We bought a company yesterday because we thought it was the best thing that we could do with $3 million on that day.” In 2003 Buffett said: The trouble isn’t that we don’t have one [a hurdle rate] – we sort of do – but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly. Everything is a function of opportunity cost.” Warren also recently said that he wasn’t just going to buy using today’s very low rates just because they were his current best opportunity. These sorts of questions are very hard to sort out given the economic environment we are in now is new. The last point Munger makes is that when someone promises you a long term return of something like 20% for 40 years hold on to your wallet tightly and run like the wind.

5. “There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.” Munger likes a business that generates free cash flow that need not be reinvested and not just an accounting profit. Some business with an accounting profit require that you reinvest all or nearly all of any cash generated into the business and Munger is saying businesses like this are not favored. Coke and See’s Candies are attractive businesses based on this test. Airlines by contrast are not favored. Munger calls an airlines “marginal cost with wings.” Munger is also not a fan of creative accounting’s attempt to hide real costs: “People who use EBITDA are either trying to con you or they’re conning themselves. Interest and taxes are real costs.” “I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.” Buffett says: “Interest and taxes are real expenses. Depreciation is the worst kind of expense: You buy an asset first and then pay a deduction, and you don’t get the tax benefit until you start making money.”

6. “Of course capital isn’t free. It’s easy to figure out your cost of borrowing, but theorists went bonkers on the cost of equity capital.” “A phrase like cost of capital means different things to different people. We just don’t know how to measure it. Warren’s way of describing it, opportunity cost, is probably right. The answer is simple: we’re right and you’re wrong.” “A corporation’s cost of capital is 1/4 of 1% below the return on capital of any deal the CEO wants to do. I’ve listened to many cost of capital discussions and they’ve never made much sense. It’s taught in business school and consultants use it, so Board members nod their heads without any idea of what’s going on.” Berkshire does not “want managers to think of other people’s money as ‘free money’” says Buffett, who points out that Berkshire imposes a cost of capital on its managers based on opportunity cost. One thing I love about this set of quotes is Munger admitting that Buffett is only “probably” right and that they don’t know how to measure something others talk about. It indicates that Munger is always willing to consider that he is wrong. While he has said that he has a “a black belt in chutzpah,” he has also said that if he does not overturn a treasured belief at least once a year, it is a wasted year since it means he is not always looking hard at whether his beliefs are correct. In his new book Superforecasting, Professor Philip Teltock might as well have been writing about Charlie Munger when he wrote: “The humility required for good judgment is not self doubt – the sense that you are untalented, unintelligent or unworthy. It is intellectual humility. It is a recognition that reality is profoundly complex, that seeing things clearly is a constant struggle, when it can be done at all, and that human judgment must therefore be riddled with mistakes.”

7. “We’re partial to putting out large amounts of money where we won’t have to make another decision.” Attractive opportunities to put capital to work at high rates of return don’t come along that often. Munger is saying that if you are a “know something investor” when you find one of these opportunities you should load up the truck and invest in a big way. He is also saying that he agrees with Buffett that their preferred holding period “is forever.” Buffett looks for a business: “where you have to be smart only once instead of being smart forever.” That inevitably means a business that has a solid sustainable moat. Buffett believes that finding great investment opportunities is a relatively rare event: “I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches – representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.” When he finds a really great business the desire of Charlie Munger is to hold on to it. Munger elaborates on the benefits of not selling: “You’re paying less to brokers, you’re listening to less nonsense, and if it works, the tax system gives you an extra one, two, or three percentage points per annum.”

8. “We have extreme centralization at headquarters where a single person makes all the capital allocation decisions.” Centralization of capital allocation decisions at Berkshire to take advantage of Warren Buffett’s extraordinary abilities is an example of opportunity cost analysis at work. Why allow your second best capital allocator or 50th best do this essential work? Here’s Buffett on his process: “In allocating Berkshire’s capital, we ask three questions: Should we keep the capital or pay it out to shareholders? If pay it out, then you have to decide whether to repurchase shares or issue a dividend.” “To decide whether to retain the capital, we have to answer the question: do we create more than $1 of value for every dollar we retain? Historically, the answer has been yes and we hope this will continue to be the case in the future, but it’s not certain. If we decide to retain and invest the capital, then we ask, what is the risk?, and seek to do the most intelligent thing we can find. The cost of a deal is relative to the cost of the second best deal.” As was noted in the previous blog post in this series, nearly everything else other than capital allocation and executive compensation is decentralized at Berkshire.

9. “We’re not going to put huge amounts of new capital into a lousy business. There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.” This is such an important idea and yet it is often poorly understood. Many investments in a business are only going to benefit customers because the business has no moat. In economic terminology, the investment produces all “consumer surplus” and no “producer surplus.” Some businesses must continue to plow capital into their business to remain competitive in a business that is still going to deliver lousy financial returns. Journalists often talk about businesses that “earn” some amount without noting that what they refer to is revenue not profit. What makes a business thrive is profit and absolute dollar free cash flow. One thing I am struck by in today’s world is how hard nearly every business is in terms of making a significant genuine profit. The business world is consistently hyper competitive. There is no place to hide from competition and potential disruption. If you have a profit margin, it is someone else’s opportunity. Now more than ever. People who don’t think this contributes the inability of central banks to create more inflation are not living in the real business world.  Making a sustained profit in a real business is very hard.

10. “I don’t think our successors will be as good as Warren at capital allocation.” There will never be another Warren Buffett just as there will never be another Charlie Munger. But that does not mean you can’t learn from the way they make decisions, including, but not limited to, capital allocation decisions. Learning from others is strangely underutilized despite its huge rewards. Some of this aversion to learning from others must come from overconfidence. This overconfidence is good for society since it results in a lot of intentional and accidental discovery. But at an individual level it is hard on the people doing the experimentation. Reading widely about how others investors and business people approach capital allocation is wise. As an example, Howard Marks and Seth Klarman are people who have learned from Buffett and Munger and vice versa. Having said that, we are all unique as investors. There is no formula or recipe for successful investing. But there are approaches and processes that are far more sound than others that can generate an investing edge if you are willing to do the necessary work. These better decision making process are applicable in life generally. If you are not willing to do the work that an investor like Munger does in his investing, you should buy a diversified low cost portfolio of index funds/ETFs. A dumb “know nothing investor” can transform themselves into a smart investor by acknowledging that they are dumb. Buffett calls this transformation from dumb to smart of they admit they are dumb an investing paradox.

11. “All large aggregations of capital eventually find it hell on earth to grow and thus find a lower rate of return.” Munger is saying that the more assets you must manage the harder it is to earn an above market return. Putting large amounts of money to work means it takes more time to get in and out of positions and for that reason it becomes hard to effectively invest in relatively smaller opportunities. Buffett puts it this way: “There is no question that size is an anchor to performance. We intend to prove that up to the point that it really starts biting. We can’t earn the same returns on capital with over $300 billion in market cap. Archimedes said he could move the world with a long enough lever. I wish I had his lever.”

12. “Size will hurt returns. We can only buy big positions, and the only time we can get big positions is during a horrible period of decline or stasis. That really doesn’t happen very often.” There are times when Mr. Market turns fearful and huge amounts of capital can be put to work even by Berkshire as was the case in 2008. To be able to take advantage of this requires that the investor (1) be patient and (2) be aggressive when it is time. Jumping in when things are falling apart takes courage. Not jumping is during a period of investing frenzy takes character. Bill Ruane believes: “Staying small in terms of the size of fund is simply good business. There aren’t that many great companies.” The bigger the fund the harder it is to outperform. Bill Ruane famously closed his fund to new investors to be “fair” to his clients. 

In terms of an example of outperforming during what for others was a horrible time, the following example of Munger in action below speaks for itself. Bloomberg wrote at the time: “By diving into stocks amid the market panic of 2009, Munger reaped millions in paper profits for the Daily Journal. The investment gains, applauded by Buffett at Berkshire Hathaway’s annual meeting in May, have helped triple Daily Journal’s own share price. While Munger’s specific picks remain a mystery, a bet on Wells Fargo (WFC) probably fueled the gains, according to shareholders who have heard Munger, 89, discuss the investments at the company’s annual meetings. ‘Here’s a guy who’s in his mid-80s at the time, sitting around with cash at the Daily Journal for a decade, and all of a sudden hits the bottom perfect.’”

Munger having the necessary cash to do this investment in size at the right time in 2009 was not accidental. You don’t have the cash at the right time by following the crowd. As Buffett points out holding cash is not costless: “The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing. Cash is going to become worth less over time. But good businesses are going to become worth more over time.” That available cash was a residual of a disciplined buying process focused on a bottoms-up analysis by Munger of individual stocks. His ability to do this explains why he is a billionaire and we are not.


Michael Mauboussin: http://covestreetcapital.com/wp-content/uploads/2015/07/Mauboussin-June-2015.pdf [The bibliography in this essay is extensive.]

Superforecasting  http://www.amazon.com/Superforecasting-The-Art-Science-Prediction/dp/0804136696

A Dozen Things I’ve Learned about Great CEOs from “The Outsiders” (Written by William Thorndike)  http://25iq.com/2014/05/26/a-dozen-things-ive-learned-about-great-ceos-from-the-outsiders-written-by-william-thorndike/

Bloomberg on Munger’s Golden Touch http://www.bloomberg.com/bw/articles/2013-07-25/berkshire-hathaways-charlie-munger-shows-a-golden-touch

A Dozen Things I’ve Learned from Charlie Munger About The Berkshire System

1. “There are two main reasons Berkshire has succeeded. One is its decentralization. Decentralization almost to the point of abdication. There are only 28 people at headquarters in Omaha. The other reason is our extreme centralization of capital deployment. Our centralization is just as extreme as our decentralization.” Systems are important in Charlie Munger’s world. I have already written a blog post in this series about one system called “the value investing system.” This post is about another system known as “the Berkshire System.” These two systems are related, but distinct. A system can be defined as a set of processes and methods that produce a desired result that is more than the sum of the parts. Charlie Munger is an example of a “systems level thinker.” Munger thinks deeply about things like understanding that local optimizations that actually decrease performance of the overall system.  Munger also talks a lot about lollapaloozas and the impact of 2nd and 3rd order effects. Howard Marks is doing this too with his second level thinking idea. Nassim Taleb thinks in the same way, including the nonlinear impact of systems level interactions. The best investors and business people think hard and a lot about systems.

The Berkshire system is not the only system for operating a business but it is a very good one. Attempts have been made to replicate the Berkshire system but they are unlikely to be successful without adopting all of the elements that will be described below. In other words, half of the Berkshire system will not be much of an effective system. For example, delegating control without trustworthy people throughout the organization will fail. Decentralization of everything including capital allocation will fall prey to what Buffett calls “the Institutional Imperative: “rationality frequently wilts when the institutional imperative comes into play. For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated…Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.” Professor Lawrence Cunningham, who has written an excellent book on Berkshire writes: “The only qualifications on managerial autonomy at Berkshire appear in a short letter Buffett sends its unit chiefs every two years. The missive states the mandates Berkshire places on subsidiary CEOs: (1) guard Berkshire’s reputation; (2) report bad news early; (3) confer about post-retirement benefit changes and large capital expenditures (including acquisitions, which are encouraged); (4) adopt a fifty-year time horizon; (5) refer any opportunities for a Berkshire acquisition to Omaha; and (6) submit written successor recommendations.”

People sometimes are get confused about what Warren Buffett does at Berkshire. Munger puts it simply: “We have extreme centralization at headquarters where a single person makes all the capital allocation decisions, and we have decentralization among our operations without a big bureaucracy. That’s the Berkshire Hathaway model.” It is worth noting that it is Buffett and not Munger who ultimately who makes the capital allocation decisions. Buffett seeks Munger’s guidance and thoughts but Buffett pulls the capital allocation trigger. I have another blog post in the works on the capital allocation process at Berkshire, which will take the total number of planned posts on Munger up to a Spinal Tap-style #11.  Buffett has said on the capital allocation system: “Berkshire wants the capital in the most logical place. Berkshire is a tax efficient way to move money from business to business, and we can redeploy capital in places that need them. Most of the managers of companies we own are already independently rich. They want to work, but don’t have to. They don’t horde capital they don’t need.” The management at a subsidiary like See’s Candies is given a capital allocation by Buffett, not the reverse. Superior capital allocation skill is one of Warren Buffett’s unique gifts. Some people can do things like skateboard very well and some people can allocate capital very well. Buffett has pointed out: “If all of us were stranded on a desert island somewhere and we were never going to get off of it, the most valuable person there would be the one who could raise the most rice over time. I can say, “I can allocate capital!” You wouldn’t be very excited about that. So I have been born in the right place.”

2. “Good character is very efficient. If you can trust people, your system can be way simpler. There’s enormous efficiency in good character and dis-efficiency in bad character.” These three sentences capture the essence of what drives the success of the Berkshire System and the necessary preconditions for that system to work effectively. Firms exist to reduce the cost of coordinating economic activity versus the alternative approach. The Berkshire System implemented in a firm will not generate the desired efficiency and results unless the organization has trust in trustworthy people. That efficiency makes the businesses, managers and employees in the Berkshire system better able to adapt to changes in the environment. Professor Lawrence Cunningham relays this interesting snippet from a private conversation: “Munger told me: take Coase seriously/avoid middlemen.” People talk about capitalism being the most efficient way to allocate resources, but it is capitalism’s ability to drive innovation via discovering new innovation that makes is the best possible economics system. A person saying that socialism is more efficient than capitalism since it is more efficient to have only a few types of phones is an absurdity. Innovation and progress requires failure. Lots of failure. Munger has said, after giving the hat tip to Allen Metzger for the phrasing: “I regard it as very unfair, but capitalism without failure is like religion without hell.” If course, markets sometimes fail too, which is why programs and policies like a social safety net are needed. Munger described this in his typical blunt fashion: “Greenspan was a smart man but he overdosed on Ayn Rand at a young age.” Munger also said once at one of his most famous speeches given at USC: “Another thing I think should be avoided is extremely intense ideology because it cabbages up one’s mind. … When you’re young it’s easy to drift into loyalties and when you announce that you’re a loyal member and you start shouting the orthodox ideology out, what you’re doing is pounding it in, pounding it in, and you’re gradually ruining your mind.”

3. “The highest form a civilization can reach is a seamless web of deserved trust.” “The right culture, the highest and best culture, is a seamless web of deserved trust.” “Not much procedure, just totally reliable people correctly trusting one another. That’s the way an operating room works at the Mayo Clinic.” “One solution fits all is not the way to go. All these cultures are different. The right culture for the Mayo Clinic is different from the right culture at a Hollywood movie studio. You can’t run all these places with a cookie-cutter solution.” The culture of a business is more than the sum of its parts. The totality of the vision, values, norms, systems, symbols, language, assumptions, beliefs, and habits of a business is what creates the culture of a business. Munger and Buffett are huge proponents of creating a strong organizational culture: “Our final advantage is the hard-to-duplicate culture that permeates Berkshire. And in businesses, culture counts.…Cultures self-propagate.” Winston Churchill once said, “You shape your houses and then they shape you.” That wisdom applies to businesses as well. Bureaucratic procedures beget more bureaucracy, and imperial corporate palaces induce imperious behavior.”

4. “We want people where every aspect about their personality makes you want to be around them. Trust first, ability second.” The greater efficiency that Munger talks about flows from trust. When trust exists you can eliminate lots of inefficient procedures which must exist in a system that must deal with people who are not trustworthy. This means trust is an essential element in hiring people and that exhibiting a lack of trust is something that should result in a dismissal from the business. Buffett’s stated philosophy on this point is well known: “Lose money for the firm and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.” Are they perfect in implementing this philosophy? No. They admit mistakes for the reasons my previous blog posts have discussed.  Mistakes are feedback and if you don’t try to learn from mistakes you are not only missing and opportunity, you are a fool.

5. “Our success has come from the lack of oversight we’ve provided, and our success will continue to be from a lack of oversight. But if you’re going to provide minimal oversight, you have to buy carefully.” “The interesting thing is how well it [our acquisition strategy/process] has worked over a great many decades, and how few people copy it.” The acquisition process Berkshire uses is very deliberate. Berkshire only buys businesses that meet certain criteria including having an existing moat and existing high quality management. They do not want to create moats or supply management. They greatly admire people who create moats but know that creating moats is not their best game in terms of circle of competence. Munger has said: “We don’t train executives, we find them. If a mountain stands up like Everest, you don’t have to be a genius to figure out that it’s a high mountain.” The same principle applies to moats: spotting a business with an existing moat is vastly easier than trying to spot a new moat emerging from a complex adaptive system.  Seeing something emerging from nothing is a really hard problem compared to seeing something that is already there. Munger does not like really hard problems.  He likes easy problems that have very favorable odds of a big payoff if he is right.

6. “We’re successful because of simplicity itself: We let people who play the game very well keep doing it. Our successor won’t change this. The big worry is that the culture is tampered with and there’s oversteering. But our board and owners won’t allow this.” Munger is talking about the importance of creating and maintaining the Berkshire culture which enables and depends upon trust. It is tremendously cost efficient to have a culture that is based on trust, since you don’t have the cost or the inefficiency associated with layers of management and complex systems that try to act as a substitute. David Larcker and Brian Tayan in a paper cited in the notes below write:“A trust-based system [requires] the development and maintenance of a culture that encourages responsible behavior. As Munger says, “People are going to adopt to whatever the ethos is that suffuses the place.” Which means that this ethos is worth paying close attention to and developing well including being based on a high degree of trust.

7. “A lot of people think if you just had more process and more compliance — checks and double- checks and so forth — you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust.” “I think your best compliance cultures are the ones which have this attitude of trust and some of the ones with the biggest compliance departments, like Wall Street, have the most scandals.” Buffett has said: “Charles T. Munger, Berkshire Hathaway’s vice-chairman, and I really have only two jobs… One is to attract and keep outstanding managers to run our various operations. The other is capital allocation.” Lawrence Cunningham writes in his book: “At most companies, CEOs might formulate a general acquisition program with little board involvement and then present specific proposals to the board, which discusses deal terms and approves funding. The board’s role in this setting is an example of its service as an intermediary. Berkshire does the opposite, enabling Buffett to seize opportunities that would be lost if prior board involvement occurred…. Berkshire’s success at such internal capital reallocation has vindicated its conglomerate business model that has otherwise been denigrated across corporate America. The strategy skillfully avoids intermediaries. Cash transferring subsidiaries distribute cash to Berkshire without triggering any income tax consequences. Cash-receiving subsidiaries obtain corporate funding without frictional costs of borrowing, such as bank interest rates, loan covenants, and other constraints. Some subsidiaries generate tax credits in their businesses that they cannot use but can be used by sister subsidiaries.”

8. “Everybody likes being appreciated and treated fairly, and dominant personalities who are capable of running a business like being trusted. A kid trusted with the key to the computer room said, ‘It’s wonderful to be trusted.’” “We promised our CEOs that they could spend 100% of their time on their business. We place no impediments on them running their businesses. Many have expressed to me how happy they are that they don’t have to spend 25% of time on activities they didn’t like.” People value working for a business that trusts them. In other words, working for a business that trusts you is a non-financial employee benefit. When this trust exists great people like to work for the business and that makes recruiting other people easier. This attracts other great people since this attribute and success feeds back on itself. One of the attractions of Berkshire as a buyer to a person selling a business is that Buffett and Munger will continue to let them run their business and won’t break it into pieces like an automobile chop shop like most private equity buyers. The managers of Berkshire subsidies love Buffett and Munger for giving them freedom to run their business.

9. “When you get a seamless web of deserved trust, you get enormous efficiencies. … Every once in a while, it doesn’t work, not because someone’s evil but because somebody drifts to inappropriate behavior and then rationalizes it.” “In any big business, you don’t worry whether someone is doing something wrong, you worry about whether it’s big and whether it’s material. You can do a lot to mitigate bad behavior, but you simply can’t prevent it altogether.” “By the standards of the rest of the world, we over-trust. So far it has worked very well for us. Some would see it as weakness.” There will be instances where someone is not as trustworthy as anticipated. This is a necessary price to pay to harvest the operational efficiencies when trust is deserved. Mistakes will happen and must be corrected. For example, CNBC noted: “Buffett did admit that he “obviously made a big mistake by not saying ‘Well, when did you buy it?’ when Sokol first told him he owned Lubrizol stock in January.  Buffett also apologized for not including more ‘outrage’ in his March 30 letter announcing Sokol’s ‘resignation.” Munger added, ‘I think we can concede that that press release was not the cleverest press release in the history of the world.’” Everyone makes mistakes and will keep making mistakes.  Don’t let one or even a few lousy outcomes throw you off  the right path. If you have a sound process you will make less mistakes overall and come out ahead.

10. “There’s money in being trusted. It’s such a simple idea, and yet everybody rushes into every scummy activity that seems to work.” Munger is saying that not only is being trustworthy the right thing to do morally, ethically and in terms of being happy in life, but it is the most profitable way to live your life. In short, being trustworthy is more profitable than being untrustworthy. “A trust-based system can be more efficient than a compliance-based system, but only if self-interested behavior among employees and managers is low” write Larcker and Tayan in the previously cited paper.

11. “We want very good leaders who have a lot of power, and we want to delegate a lot of power to those leaders. It’s crazy not to distribute power to people with the most capacity and diligence. Every time I see an opportunity to choose somebody, the second best guy is just awful compared to the guy we hire. Usually the decision is a no-brainer. We have to give power to the people who can wield it efficiently in serious game of survival.” “A lot of corporations are run stupidly from headquarters, driving divisions to increase earnings every quarter. We don’t do that. The stupidity of management practices in the rest of the corporate world will last long enough to give us an advantage well into the future.” Tom Murphy once described the best approach to decentralization of operating decisions this way: “don’t hire a dog and try to do the barking.” Managers who are on the line in a business actually interacting with customers and systems are in the best position to make the necessary decisions if they are the right people.  So work really hard to get the right people with the right skills and let them do their job. By accepting that sometimes businesses have lumpy earnings and letting talented managers run their business without interference Berkshire earns a superior long term return. The idea that this advantage is not possible or sustainable because markets are perfectly efficient is rubbish to anyone actually running a business.

12. “One of the greatest ways to avoid trouble is to keep it simple.” “When you make it vastly complicated—and only a few high priests in each department can pretend to understand it—what you’re going to find all too often is that those high priests don’t really understand it at all…. The system often goes out of control.” “We operate Berkshire [via] a seamless web of deserved trust. We get rid of the craziness, of people checking to make sure it’s done right.” “Our approach has worked for us. Look at the fun we, our managers, and our shareholders are having. More people should copy us. It’s not difficult, but it looks difficult because it’s unconventional — it isn’t the way things are normally done. We have low overhead, don’t have quarterly goals and budgets or a standard personnel system, and our investing is much more concentrated than average. It’s simple and common sense.” A simpler system results in fewer mistakes and makes life much more pleasant. What could be more simple?


Lawrence Cunningham: Berkshire Beyond Buffett: The Enduring Value of Values http://www.amazon.com/Berkshire-Beyond-Buffett-Enduring-Values/dp/0231170041 and Berkshire’s Disintermediation: Buffett’s New Managerial Model http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2602825

Corporate Governance According to Charles T. Munger https://www.gsb.stanford.edu/sites/default/files/38_Munger_0.pdf

A Dozen Things I’ve Learned from Charlie Munger about Mistakes

1. “There’s no way that you can live an adequate life without many mistakes.” “Of course, there’s going to be some failure in making the correct decisions. Nobody ‘bats a thousand.’” “I don’t want you to think we have any way of learning or behaving so you won’t make mistakes.” Everyone makes mistakes sang Big Bird on the first episode of Sesame Street. Albert Einstein said once that anyone who has never made a mistake (if there is such a person) has never tried anything new. Warren Buffett agrees: “I make plenty of mistakes and I’ll make plenty more mistakes, too. That’s part of the game. You’ve just got to make sure that the right things overcome the wrong.” Charlie Munger has learned about business in the best way possible: by making mistakes and being successful actually being in business. Reading about business is vital, but Munger has said that there is no substitute for wading in and actually taking the plunge as a business manager or owner. Yes, you can learn vicariously by watching others and by reading. Learning from the mistakes of others is essential. To maximize how much he learns Munger reads five newspapers a day and has been described as a book with legs sticking out. It is far better to learn vicariously when it comes to many of the more painful mistakes in life.  At one shareholder meeting Munger when describing Berkshire’s mistakes in the shoe business quoted Will Rogers: “There are three kinds of men. Some learn by reading. Some learn by observation. The rest of them must pee on the electric fence for themselves.”

2. “For a security to be mispriced, someone else must be a damn fool. It may be bad for the world, but not bad for Berkshire.” The flip side of mistakes for an investor is that they are not just a source of problems, but also the underlying source of opportunity for investors. Howard Marks writes: “In order for one side of a transaction to turn out to be a major success, the other side has to have made a big mistake. Active management has to be seen as a search for mistakes.” This inescapable math explains the old folk wisdom that if you don’t see who the sucker is at the poker table, it is you. Munger believes: “You have to look for a special area of competency and focus on that…. Go where there’s dumb competition.” If you don’t see who is the dumb competition, it is you. Mr. Market is often not wise so don’t treat him as if he is.  Mr. Market is your servant, not your master.

3. “Forgetting your mistakes is a terrible error if you are trying to improve your cognition. Reality doesn’t remind you.” Hindsight bias is the tendency of people to believe that their forecasts and predictions were more accurate than they were in reality. People tend to forget their mistakes and exaggerate their successes. In retrospect, events often appear to be much more predictable than at the time of any given forecast. One way to reduce hindsight bias is to write down your decisions in a journal and to go back and take an objective look at your decision-making record. Shane Parrish points out: “A decision journal will not only allow you to reduce your hindsight bias, but it will force you to make your rationale explicit upfront. We often get the outcome we think will happen, but for the wrong reasons.” Neal Roese, a professor of marketing at the Kellogg School of Management at Northwestern University, has said: “You begin to think: ‘Hey, I’m good. I’m really good at figuring out what’s going to happen.’ You begin to see outcomes as inevitable that were not.”

4. “Why not celebrate stupidities?” “I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.” It is through the process of making mistakes and having success in the real world that you can learn and establish sound business judgment. Buying Berkshire Hathaway itself can arguably be put into the mistake category. The New England textile mill when bought in the 1960s was a lousy business. Buying the textile business was certainly valuable in one way in that it taught Buffett and Munger what not to do. Munger notes: “Chris Davis [of the Davis funds] has a temple of shame. He celebrates the things they did that lost them a lot of money. What is also needed is a temple of shame squared for things you didn’t do that would have made you rich.” Learning from mistakes does not mean wallowing in failure too much. Buffett says: “it is better to learn from other people’s mistakes as much as possible. But we don’t spend any time looking back at Berkshire. I have a partner, Charlie Munger; we have been pals for forty years—never had an argument. We disagree on things a lot but we don’t have arguments about it.”

5. “A trick in life is to get so you can handle mistakes. Failure to handle psychological denial is a common way for people to go broke.” “Warren and I aren’t prodigies. We can’t play chess blindfolded or be concert pianists. But the results are prodigious, because we have a temperamental advantage that more than compensates for a lack of IQ points.” Munger is getting at the importance of temperament to success as an investor. Most mistakes are psychological and emotional. Munger believes that he and Buffett have an advantage that is based more on temperament than IQ. If you can’t handle mistakes, Munger suggests that you buy a diversified portfolio of low fee index funds and leave active investing to others. Unfortunately, even if you do select an index-based approach you still must make some investing decisions such as assets allocation, fund selection and asset rebalancing periods.

6. “Terribly smart people make totally bonkers mistakes.” “Smart people aren’t exempt from professional disasters from overconfidence. Often, they just run aground in the more difficult voyages.” Munger is saying that smart people are not exempt from making mistakes. Overconfidence can cause a person with a high IQ to make more mistakes than someone who has an IQ that is 30 points lower. It is the person with the high IQ who falsely thinks that is 30 points higher than it really is that gets you into serious trouble says Munger. People who are genuinely humble about their IQ can sometimes make far fewer mistakes if they do the necessary work, have a sound investment process and think in rational ways.

7. “Most of Berkshire’s success grew from stupidity and failure that we learned from.” Berkshire has made many mistakes. Paying too much for Conoco Phillips was a mistake as was Berkshire buying US Airways. The best way to become a millionaire is to start with a billion dollars and buy an airline is an old joke in business. Munger has said that: “Hochschild, Kohn the department store chain was bought at a discount to book and liquidating value. It didn’t work [as an investment.” He added on another occasion: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” Buying Dexter Shoes was definitely a multi-billion dollar mistake for Berkshire. In doing the Dexter due diligence analysis Buffett and Munger made the mistake of not making sure the business had what they call a “moat” and being too focused on what they thought was an attractive purchase price. Buffett said once about Dexter: “What I had assessed as durable competitive advantage vanished within a few years.” Capitalism inherently means that others will always be trying to replicate any business that is profitable and that means you are always in a battle to keep what you have. Dexter lost that battle in a very swift fashion. If you make a mistake, capitalism’s competitive destruction forces will expose it swiftly and sometimes brutally.

8. “Where you have complexity, by nature you can have fraud and mistakes.” “In terms of business mistakes that I’ve seen over a long lifetime, I would say that trying to minimize taxes too much is one of the great standard causes of really dumb mistakes. I see terrible mistakes from people being overly motivated by tax considerations. Warren and I personally don’t drill oil wells. We pay our taxes. And we’ve done pretty well, so far. Anytime somebody offers you a tax shelter from here on in life, my advice would be don’t buy it.” “We try more to profit from always remembering the obvious than from grasping the esoteric.” Complexity can be your friend or your enemy depending on the circumstances. I am somewhat surprised by the fact that fees and incomes in finance are so high when there seem to be a lot of competition. There is clearly an asymmetric information problem in finance. But it would seem like technology should have brought fees and incomes down faster in finance as it has in some other sectors. The answer must lie in the fact that humans tend to make so many psychological and emotional mistakes and what Professor Cialdini calls “compliance professionals” are able to milk that tendency to keep fees high.

9 . “The most extreme mistakes in Berkshire’s history have been mistakes of omission. We saw it, but didn’t act on it. They’re huge mistakes — we’ve lost billions. And we keep doing it. We’re getting better at it. We never get over it. There are two types of mistakes [of omission]: 1) doing nothing; what Warren calls “sucking my thumb” and 2) buying with an eyedropper things we should be buying a lot of.” “Our biggest mistakes were things we didn’t do, companies we didn’t buy.” “Since mistakes of omission don’t appear in the financial statements, most people don’t pay attention to them.” Munger and Buffett not investing in Wal-Mart is just one example of a mistake of omission. Buffett has said that just this one mistake with Wal-Mart cost them $10 billion. In 1973 Tom Murphy offered to sell some television stations to Berkshire for $35 million and Buffett declined. “That was a huge mistake of omission,” Buffett has admitted.  Buffett also has said: mistakes of omission…are where we knew enough about the business to do something and where, for one reason or another, sat they’re sucking out thumbs instead of doing something. And so we have passed up things where we could have made billions and billions of dollars from things we understood, forget about things we don’t understand.”

10. “It’s important to review your past stupidities so you are less likely to repeat them, but I’m not gnashing my teeth over it or suffering or enduring it. I regard it as perfectly normal to fail and make bad decisions. I think the tragedy in life is to be so timid that you don’t play hard enough so you have some reverses.” Of course, you can also learn from success, particularly if you remember that success can be a lousy teacher since what you may believe is the outcome of skill may instead be an outcome based luck. As noted above they try to learn from mistakes but them to move on. Use the feedback from mistakes to improve the process if you can’t but spend no time wallowing in failure. If you never make mistakes, you are not being ambitious enough.

11. “Banking has turned out to be better than we thought. We made a few billion [dollars] from Amex while we misappraised it. My only prediction is that we will continue to make mistakes like that.” “Well, some of our success we predicted and some of it was fortuitous. Like most human beings, we took a bow.” Munger has said that more than once that he and Buffett have made a mistake only to be bailed out by luck. Confusing luck with skill is easy to do. If luck does happen, embrace it.  Bad luck may arrive soon enough to balance the score. On the topic of the relationship between luck and skill, read Michael Mauboussin. http://www.michaelmauboussin.com/books.html or watch him.  https://www.youtube.com/watch?v=zSgYqwuguPc  One of the luckiest things that ever happened to me was becoming his friend. As just one example, I would not have written my book on Charlie Munger if not for his friendship.

12. “You can learn to make fewer mistakes than other people- and how to fix your mistakes faster when you do make them.”“Confucius said that real knowledge is knowing the extent of one’s ignorance. Aristotle and Socrates said the same thing. …. Knowing what you don’t know is more useful than being brilliant.” “Around here I would say that if our predictions have been a little better than other people’s, it’s because we’ve tried to make fewer of them.”  Charlie Munger freely admits he still makes mistakes even after many decades as a business person and investor. But Munger does advise people to strive to make new mistakes rather than repeat old mistakes. Munger has said that he made more mistakes earlier in life than he is making now. In other words, even though he continues to make mistakes like everyone else, he has marginally improved his ability to avoid mistakes over the years. Munger likes to be able to understand why he made a mistake, so he can learn from the experience. The mistakes can be a source of clues for improving a decision making process. For example, if you can’t explain why you failed, the business was too complex for you to have invested in the first place or outside your circle of competence. Munger is fond of quoting Richard Feynman: “The first principle is that you must not fool yourself – and you are the easiest person to fool.”

A Dozen Things I’ve Learned from Charlie Munger about Inversion (including the Importance of being Consistently Not Stupid)


1. “Think forwards and backwards — invert, always invert.” “Many hard problems are best solved when they are addressed backward.” “The way complex adaptive systems work and the way mental constructs work is that problems frequently get easier, I’d even say usually are easier to solve, if you turn them around in reverse. In other words, if you want to help India, the question you should ask is not “how can I help India,” it’s “what is doing the worst damage in India? What will automatically do the worst damage and how do I avoid it?” “Figure out what you don’t want and avoid it and you’ll get what you do want. How can you best get what you want? The answer: Deserve what you want! How can it be any other way?” Charlie Munger has adopted an approach to solving problems that is the reverse of the approach that many people use in life. Inversion and thinking backwards are two descriptions of this method. As an illustrative example, one great way to be happy is to avoid things that make you miserable. Munger once gave a speech where he spoke about a famous Johnny Carson talk in which the comedian described all the ways one can be miserable. Munger said: “What Carson said was that he couldn’t tell the graduating class how to be happy, but he could tell them from personal experience how to guarantee misery. Carson’s prescriptions for sure misery included: 1) Ingesting chemicals in an effort to alter mood or perception; 2) Envy; and 3) Resentment. What Carson did was to approach the study of how to create X by turning the question backward, that is, by studying how to create non-X.” As another example of Munger’s inversion approach, a very effective way to be smart, is to consistently not be dumb. The good news about this approach is that is it easier to not be dumb than it is to be smart since you can often simply avoid certain types of decisions and activities that are ripe with opportunities to demonstrate that you are not smart. Munger gives some example here: “Just avoid things like racing trains to the crossing, doing cocaine, etc. Develop good mental habits.” “A lot of success in life and business comes from knowing what you want to avoid: early death, a bad marriage, etc.” With regard to financial matters, you should avoid things like buying assets with a 200 page prospectus, or services from highly commissioned salespeople. Don’t attend the “free” dinner paid for by a salesperson or the “free” weekend stay in a time share.

2. “[The great Algebra pioneer Jacobi] knew that it is in the nature of things that many hard problems are best solved when they are addressed backward.” “In life, unless you’re more gifted than Einstein, inversion will help you solve problems.” Charlie Munger likes to say that simple high school Algebra can help anyone solve a lot of problems in life. Looking at a problem backward instead of just forward can help you create and reveal new solutions. Munger even jokes that he wants to know where he will die so he can just not go there. A process of elimination, can also be helpful in making decisions. Munger’s friend, the investor Li Liu, points out that “when you have a difficult problem in social science, a good way to solve it is to invert it. After you compile all the reasons you should buy a stock, invert the question and state the reasons why you should not buy the stock. By doing this, you ensure that your research process is more complete.” Munger himself tells this story: “I have a physicist son who has been trained more in the type of thinking I like. And he immediately got the right answer, and here’s the way he reasoned: It can’t be anything requiring a lot of hand-eye coordination. Nobody 85 years of age is going to win a national billiards tournament, much less a national tennis tournament. It just can’t be. Then he figured it couldn’t be chess, which this physicist plays very well, because it’s too hard. The complexity of the system, the stamina required are too great. But that led into checkers. And he thought, “Ah ha! There’s a game where vast experience might guide you to be the best even though you’re 85 years of age.” And sure enough that was the right answer. Anyway, I recommend that sort of mental trickery to all of you, flipping one’s thinking both backward and forward.” The memo from Howard Marks that was published this week (citation in the notes) contained a great inversion example: “If what’s obvious and what everyone knows is usually wrong, then what’s right? The answer comes from inverting the concept of obvious appeal. The truth is, the best buys are usually found in the things most people don’t understand or believe in. These might be securities, investment approaches or investing concepts, but the fact that something isn’t widely accepted usually serves as a green light to those who’re perceptive (and contrary) enough to see it.”

3. “I think part of the popularity of Berkshire Hathaway is that we look like people who have found a trick. It’s not brilliance. It’s just avoiding stupidity.” The amazing thing is we did so well while being so stupid.” As an example of this idea being put to work, people often try to read too much into the “margin of safety” concept developed by Ben Graham as part of his value investing system. The idea is simple: If you buy at a very attractive bargain price you can make a mistake and still do well financially. For example, if you pay 30% less than the intrinsic value of an asset based on conservative calculations that bargain is a cushion that can help avoid mistakes caused by stupidity. The desire to avoid being dumb is why Seth Klarman describes value investing as a risk-averse approach. It is also why Warren Buffett says that the first and second rules of investing are “don’t lose money.” Again, it is a good idea to not over-complicate the margin of safety approach. The idea is to buy an assets at a substantial bargain to conservatively calculated intrinsic value and then wait. It’s that simple. The hardest parts of the value investing system are emotional and psychological rather than understanding the system itself.

4. “Let me use a little inversion now. What will really fail in life? What do you want to avoid?” “Having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control.” “When you have a huge convulsion, like a fire in this auditorium right now, you do get a lot of weird behavior. If you can be wise [during such times, you’ll profit].” Charlie Munger uses an inversion process not only on thoughts and processes, but emotions. Christopher Davis, the chairman of fund manager Davis Advisors points out that Charlie Munger: “seems to be able to invert emotions, becoming uninterested when other people are euphoric and then deeply engaged when others are uncertain or fearful.” By leaning against the wind emotionally, Charlie Munger harnesses the power of the “return to the mean” phenomenon. The advice is simple: Be greedy when others are fearful, and fearful when others are greedy. This is easy to say but hard to do. This is why successful investing is simple, but not easy.

5. “I’m really better at determining my level of incompetency and then just avoiding that. And I prefer to think that question through in reverse.” Humans remember when they mistakenly touch an electric fence or a hot stove. When we fail at something, particularly if it is a painful experience, we tend to remember it. One factor making failure so memorable is loss-aversion. We feel the pain of loss much more than a comparable gain. Charlie Munger points out: “People are really crazy about minor decrements down.” As an example, Larry Bird likes to say that he hates to lose more than he loves to win. Because we feel the pain of losses more it is easier to avoid incompetency than to determine whether you have the necessary skill. Natural human overconfidence makse this set of problems hard, but with practice you can improve your ability to “not be dumb.”

6. “It is remarkable how much long-term advantage [we] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” Charlie Munger has pointed out that the long term advantage of not being stupid is under-appreciated. In other words, the benefits of not being an idiot as often as most people compound like interest on an investment. The word “consistently” in the quotation is important since consistency implies that you are not avoiding stupidity just via luck. By having a sound investing process you can prosper even if sometimes you have a bad outcome despite a good process. Adopting this attitude requires situational humility. Be humble especially, when you are out of your circle of competence. Munger says: “If you want to be the best tennis player in the world, you may start out trying and soon find out that it is hopeless—that other people blow right by you. However, if you want to become the best plumbing contractor in Bemidji, that is probably all right by two-thirds of you. It takes will. It takes the intelligence. But after a while, you will gradually know all about the plumbing business and master the art. That is an attainable objective, given enough discipline. And people who could never win a chess tournament or stand in center court in a respectable tennis tournament can rise quite high in life by slowly developing a circle of competence—which results partly from what they were born with and partly from what they slowly develop through work. So some edges can be acquired. And the game of life to some extent for most of us is trying to be something like a good plumbing contractor in Bemidji. Very few of us are chosen to win the world’s chess tournament.”

7. “There are a lot of things we pass on. We have three baskets: in, out, and too tough. We have to have a special insight, or we’ll put it in the ‘too tough’ basket. All of you have to look for a special area of competency and focus on that.” “The amazing thing is we did so well while being so stupid. That’s why you’re all here: you think that there’s hope for you. Go where there’s dumb competition.” Investors often have a high IQ (or at least think they do) and for that reason will often assume that there is some sort of prize in investing for making difficult decisions. There is no such prize in investing. One irony of investing is that a high IQ may lead an investor to seek hard problems believing they will reap some benefits from their intelligence ig it is not coupled with humility. Munger believes that the far greater opportunity is to apply high IQ when the problem is easy and the odds of success are very favorable. He favors working with people who believe their IQ is less than is actually is. The idea of having a “too tough” or “too hard” pile is particularly appealing and has been very useful to me. This approach harnesses the idea of opportunity cost thinking. Investing your time and capital in your best opportunities is also such a powerful but simple idea. “Should you buy stock x” is not the right question. The right question instead is: “Of all the stocks I can buy, is x the very best alternative?”

8. “You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.” “The amazing thing is we did so well while being so stupid. That’s why you’re all here: you think that there’s hope for you. Go where there’s dumb competition.” In business, unlike sports, it pays to play against weak competition. In other words, business and investing are very different from professional sports where the players in the most competitive leagues make the most money. Why would an investor want to compete when they have no special advantage? What the wise investor seeks is an unfair advantage and odds of success that are very favorable.

9. “The secret to Berkshire is we are good at ignorance removal. The good news is we have a lot of ignorance left to remove.” “Just as a man working with his tools should know its limitations, a man working with his cognitive apparatus must know its limitations.” As you go through life you have the opportunity to learn from your inevitable mistakes and the mistakes of others. This process is unlikely to produce positive results unless you are honest with yourself and paying attention. Thinking your IQ is less than it actually is can be a significant benefit in investing. Humility helps reduce the number of mistakes caused by hubris. The work to learn more in life never ends. New information and ideas are constantly arriving and must be considered. If you don’t want to do that work you should buy a low cost diversified portfolio of index funds. As a test I suggest you buy my new book on Charlie Munger. If you can’t find the time and energy to read the whole book, you should definitely buy a low cost diversified portfolio of index funds.  Putting yourself to that test may be the best dollar-for-dollar investment you ever make!

10. “If you have competence, you pretty much know its boundaries already. To ask the question is to answer it.” “We know the edge of our competency better than most. That’s a very worthwhile thing.” The “circle of competence” idea is very simple. Risk comes from not knowing what you are doing. So it is wise to stay within a circle of competence where you know what you are doing. The margin of safety idea applies to circles of competence as well. Why get anywhere near the edge of your competence when you have the option not to do so? It is a very good idea to play it safe if the limits of your competence are unclear. Being less inept and dumb than the competition is such a huge advantage.

11. “Warren and I avoid doing anything that someone else at Berkshire can do better.” Life is both easier and better if you let people who do things better than you do those things. As an example, an investor like Charlie Munger finds his “comparative advantage” in investing rather than “making sure the trains run on time” as an operator of a business like Matt Rose of Burlington Northern. As another example, Munger has focused his efforts on buying moats rather than building them. It is easier for him to see an existing Mount Everest than to spot a mountain that may be created in the future. Munger leaves moat creation to entrepreneurs and venture capitalists and feels fine putting that activity in “too hard” pile. Munger has said that if he were young today he might devote his life to technology rather than investing, but at this point in his life technology is not the source of his greatest comparative advantage. Every business that he is involved in as an investor uses technology, but a pure technology business is not ideal for inclusion in his portfolio.

12. “Every person is going to have a circle of competence. And it’s going to be very hard to advance that circle. If I had to make my living as a musician…. I can’t even think of a level low enough to describe where I would be sorted out to if music were the measuring standard of the civilization.” We all have certain talents and skills. And we should all strive to advance those skills. But understanding the limits of your current skill development is wise. Especially when what is at risk is significant it is wise to be conservative when it comes to self-appraisals. One of the major problems that arises from the psychology of human misjudgment is overconfidence. Munger has famously said: “In the 5th century B. C. Demosthenes noted that: ‘What a man wishes, he will believe.’ And in self-appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90 percent of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert’s public assessment is that he is above average, no matter what is the evidence to the contrary.”

Howard Marks: “It’s not Easy” http://www.oaktreecapital.com/MemoTree/It’s%20Not%20Easy.pdf

A Dozen Things I’ve Learned from Charlie Munger about Risk

  1. “Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.” Risk has many different dimensions that must be considered including sources, magnitude, outcomes and decision making inputs. In terms of a definition, Seth Klarman writes that risk is: “described by both the probability and the potential amount of loss.” Charlie Munger emphasizes an important point in his quotation since it is the permanent loss which should be the focus of investors since temporary drops can actually represent an opportunity for an investor if they can purchase more of an asset at the lower price and ride out the drop in price. The focus of this definition of risk is on potential “outcomes.” In terms of “sources” of risk, Warren Buffett believes that “risk comes from not knowing what you’re doing” and that “the best way to minimize risk is to think.” This is why Charlie Munger spends so much time thinking about thinking. The magnitude of risk assumed by a given investor on any investment depends on the nature of the asset, but also the price paid for the asset. In addition to not knowing what you are doing, one way to increase risk to pay such a high price for an asset that there is no margin for error.  Seth Klarman makes the important point that “risk and return must be assessed independently or every investment…. risk does not create incremental return only price can do that.” Howard Marks makes the insightful point that risk itself cannot be counted on to generate higher financial returns, since if this was the case the assets would not actually be riskier. Richard Zeckhauser has his own definition of risk focused on the “inputs” a person has in the decision-making process rather that the “outcome” based definition of Buffett and Klarman.  Zeckhauser believes that “risk” is limited to situations where all potential future states and their probabilities are known. Roulette in his view involves risk since you know all future states and probabilities in playing the game.  When the probabilities of potential future states are not known, Zeckhauser calls that situation “uncertainty” and when you don’t know all potential future states he refers to that as “ignorance.”  Most of life is uncertain rather than risky. True risk, as Zeckhauser defines it, is actually not that common in real life. For the rest of this blog post when I refer to “risk” I will be referring to the Klarman/Buffett/Marks definition of risk as an outcome (‘the possibility of loss or injury”) because that is what I believe Charlie Munger is referring to in each quotation.


  1. “Using [a stock’s] volatility as a measure of risk is nuts.” There is a yet another way that some people talk about risk.  Howard Marks writes: “Volatility is the academic’s choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in calculations and models of modern finance theory….However, while volatility is quantifiable and machinable – and can be an indicator or symptom of riskiness and even a specific form of risk – I think it falls far short as “the” definition of investment risk. In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility. In fact, I’ve never heard anyone say, ‘The prospective return isn’t high enough to warrant bearing all that volatility.’ What they fear is the possibility of permanent loss.” Munger rejects the use of volatility to define risk. He describes part of the reason for the desire of some people  to qualify risk as follows: “Practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and (2) doesn’t mix in the hard-to-measure stuff that may be more important. That is a mistake I’ve tried all my life to avoid, and I have no regrets for having done that.”  Munger has also said: “Beta and modern portfolio theory and the like — none of it makes any sense to me. We’re trying to buy businesses with sustainable competitive advantages at a low, or even a fair, price.” Why do some people want so badly to equate risk with volatility? This assumption allows them to create beautiful mathematical models that can be included in their papers. Seth Klarman describes the motivation for this line of thinking in his book:  “A positive correlation between risk and return would hold consistently only in an efficient market.”  To be able to create this beautiful math Munger believes they distort the world to be fully rational to support their mathematical theories even though it defies common sense. This attempt to equate risk and volatility is a classic case of confirmation bias. Munger says: “I have a name for people who went to the extreme efficient market theory—which is ‘bonkers.’ It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality.” Risk is not a number and it certainly can’t be calculated simply based on volatility. Volatility can be “a” risk for some people in some situations, but it certainly does not “define” risk.  As an analogy, an apple is fruit but apples do not define fruit. There is certainly a time element to risk and life events like retirement or a college bill can turn volatility into an important type of risk, especially over shorter time frames. But value investors are usually focused on long-term returns and understand that they may be able to earn a premium by accepting short-term volatility when buying an asset. As an example, short term US Treasuries may have lower short-term volatility but they have significant long-term risk of underperformance in comparison to equities.  Seth Klarman writes: “some insist that risk and return are always positively correlated…yet this is not always true. Others mistakenly equate risk with volatility, ignoring the risk of making overpriced, ill-conceived and poorly managed investments.” Volatility is actually the friend of the investor since lower prices are what create opportunities to buy mispriced assets at a significant discount to intrinsic value.


  1. “Volatility is an overworked concept. You shouldn’t be imprisoned by volatility.” “Some great businesses have very volatile returns – for example, See’s usually loses money in two quarters of each year – and some terrible businesses can have steady results.” Charlie Munger and Warren Buffett are very focused on finding investments which possess odds of success that are substantially in their favor.  If the process of generating returns along the way is lumpy that is not only perfectly acceptable but it can be a significant financial advantage since others may be unwilling to do so creating mispriced assets that can be purchased at a bargain price. Howard Marks argues: “in order to achieve superior results, an investor must be able – with some regularity – to find asymmetries: instances when the upside potential exceeds the downside risk. That’s what successful investing is all about.” A regular reader of this blog will recognize what Howard Marks is taking about as an objective as positive optionality (big upside and a small downside).


  1. “We don’t give a damn about lumpy results. Everyone else is trying to please Wall Street. This is not a small advantage.” Munger is pointing out that buying what is unpopular or requires a long term viewpoint tends to be underpriced. Since buying underpriced assets creates a margin of safety, it lowers risk and increases financial returns. On volatility, Ben Graham once wrote: “A serious investor is not likely to believe that the day-to-day or month-to-month fluctuations of the stock market make him richer or poorer…. The holder of marketable securities actually has a double status, and with it the privilege of taking advantage of either at his choice. On the one hand his position is analogous to that of a minority shareholder or silent partner in a private business.  Here his results are entirely dependent on the profits of the enterprise or a change in the underlying value of its assets. He would usually determine the value of such a private-business interest by calculating his share of the net worth as shown in the most recent balance sheet. On the other hand, the common-stock investor holds a piece of paper, an engraved stock certificate, which can be sold in a matter of minutes at a price which varies from moment to moment – when the market is open, that is — and often is far removed from the balance sheet value.” One reason why volatility is such a big focus for managers, as opposed to investors, is that it presents a big risk for them. Investors tend to flee an advisor or fund when there is underperformance or drop in price.


  1. “This great emphasis on volatility in corporate finance we regard as nonsense. Let me put it this way; as long as the odds are in our favor and we’re not risking the whole company on one throw of the dice or anything close to it, we don’t mind volatility in results. What we want are favorable odds.” Charlie Munger has said that he is a “focus” investor since he is not a “know nothing” investor. In his personal accounts and fund he manages he is not a believer in diversification. He is also careful to note that few people should invest like him and should instead buy a diversified portfolio of low cost index funds. Warren Buffett’s statement about what he and Charlie Munger do at Berkshire is as famous as it is succinct. “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.” For Howard Marks, risk is “the possibility of permanent loss… downward fluctuation which by definition is temporary doesn’t present a big problem if the investor is able to hold on and come out the other side.” The same idea applies to a manager in a business investing capital. Some opportunities require that you be willing to have volatile earnings.  See’s Candies is just such an example. Since profits happen in the box candy business mostly during the holidays See’s will inevitably have poor financial results half the year but that will be offset by two very profitable quarters.


  1. “All investment evaluations should begin by measuring risk, especially reputational. This is said to involve incorporating an appropriate margin of safety, avoiding permanent loss of capital and insisting on proper compensation for risk assumed.” If you decide to incur risk and face the possibility of loss or injury, you should insist on being paid for doing so. Munger is saying that the best way to manage investment risk is to buy assets at a price that reflects enough of a margin of safety that the outcome will be favorable even if you make a mistake (i.e., buy with a margin of safety- which is a discount to expected value). This is why Howard Marks says that risk is always relative to the amount paid for the asset.  Buffett wrote in his postscript to The Intelligent Investor (2003 edition) about the way value investors should view risk: “Sometimes risk and reward are correlated in a positive fashion… the exact opposite is true in value investing. If you buy a dollar for 60 cents, it is riskier than if you buy a dollar for 40 cents, but the expectation for reward is greater in the latter case.”


  1. “[With] a lot of judgment, a lot of discipline and an absence of hyperactivity… I think most intelligent people can take a lot of risk out of life.” The three best ways to reduce risk are diversification, hedging and buying with a margin of safety argues Seth Klarman. Making life less risky is also assisted greatly if you make fewer decisions in domains where you do not know what you are doing after doing a significant amount of thinking about the domain involved and the decision. Doing this requires discipline since we all make psychological and emotional mistakes. One technique for avoiding risk is to place decisions that fall in the domain of “I don’t know” into a “too hard” pile if you can. Sometimes a decision is unavoidable and judgment will be required. Munger puts the investor’s objective simply: “What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don’t get a big edge often.”


  1. “Each person has to play the game given his own marginal utility considerations and in a way that takes into account his own psychology. If losses are going to make you miserable – and some losses are inevitable – you might be wise to utilize a very conservative patterns of investment and saving all your life. So you have to adapt your strategy to your own nature and your own talents. I don’t think there’s a one-size-fits-all investment strategy that I can give you.” “If we’d used the leverage that some others did, Berkshire would have been much bigger… But we would have been sweating at night. It’s crazy to sweat at night.” There is no recipe or formula for investing or dealing with risk. Everyone has a unique tolerance for risk since we are all more or less comfortable with various factors that create it. Some people find it useful to have heuristics (rules of thumb) to guide them in assessing whether a comfortable level of risk tolerance exists. Whether you can sleep soundly at night is a one heuristic. If your investments are preventing you from getting a good night’s sleep it may be wise to adjust your portfolio so that it is consistent with a comfortable sleep. Seth Klarman agrees with Charlie Munger on this point: “Investors should always keep in mind that the most important metric is not the returns achieved but the returns weighed against the risks incurred. Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.”


  1. “This is an amazingly sound place. We are more disaster-resistant than most other places. We haven’t pushed it as hard as other people would have pushed it. I don’t want to go back to Go. I’ve been to Go. A lot of our shareholders have a majority of their net worth in Berkshire, and they don’t want to go back to Go either.” “I wanted to get rich so I could be independent, and so I could do other things like give talks on the intersection of psychology and economics.”  The factors which determine the level of risk that is appropriate for any given person include life goals, age and wealth. For example, Charlie Munger left the practice of law to become an investor since he had a fierce desire to acquire wealth so he could be independent. He did not want to have other people dictate what he did in life. The value of that freedom once acquired can be so high that a person can become unwilling to put at risk the amount of money require to ensure that this independence continues. Playing the game of life with house money (money that you don’t really need to be happy) is underrated. At the point where you are playing with house money the game substantially changes since your basic financially driven level of happiness is not at stake. Of course, you can still be rich and miserable, but that comes from other problems, attitudes and mistakes.


  1. “There is a lot to be said that when the world is going crazy, to put yourself in a position where you take risk off the table.” “Here’s one truth that perhaps your typical investment counselor would disagree with: if you’re comfortably rich and someone else is getting richer faster than you by, for example, investing in risky stocks, so what? Someone will always be getting richer faster than you. This is not a tragedy.” There are times in life when the world will not make much sense, at least to you. As an example, the Intent bubble of 1999-2001 was a time like that. In my book on Charlie Munger I describe a decision I made to sell half of my telecom and Internet portfolio near the height of the bubble. The sale ensured that I would not be a burden to anyone in my retirement and that my children would be able to go to college with my financial assistance. Taking a little risk off the table if you plan to double down on some new risky investments is wise.


  1. “A lot of our major capitalistic institutions that parade as really respectable, they’re just casinos in drag. What do you think a derivative trading desk is? It’s a casino in drag. People feeling they’re contributing to the economy, and they’re managing risk. They make the witch doctors look good.” “I knew a guy who had $5 million and owned his house free and clear. But he wanted to make a bit more money to support his spending, so at the peak of the internet bubble he was selling puts on internet stocks. He lost all of his money and his house and now works in a restaurant. It’s not a smart thing for the country to legalize gambling [in the stock market] and make it very accessible.” “Gambling does not become wonderful just because it pertains to commerce. It’s a casino.” One definition of gambling is: an activity involving chance that has a negative net present value after fees. Some people find gambling entertaining, since it produces brain chemicals that can be pleasurable.  I don’t personally see the point of doing something that could potentially turn into a destructive addiction and potentially wipe you out financially. In my view there are many other non-addictive things that one can do to get a dopamine buzz that are not addictive and are potentially profitable. Munger says: “intelligent people make decisions based on opportunity costs — in other words, it’s your alternatives that matter. That’s how we make all of our decisions…. Opportunity cost is a huge filter in life. If you’ve got two suitors who are really eager to have you and one is way the hell better than the other, you do not have to spend much time with the other.” Gambling fails the opportunity cost test for me. The other point Munger is making is that gambling is not a productive activity. You are not building anything valuable when you gamble. The societal contribution of the activity is negative.


  1. “When any person offers you a chance to earn lots of money without risk, don’t listen to the rest of their sentence. Follow this and you’ll save yourself a lot of misery.” When it comes to investing it is wise to follow the advice of Howard Marks and think of the future as a probability distribution rather than some fixed outcome that is knowable or predictable in advance.  Almost nothing about the future is certain except death and taxes. No one says it better than Howard Marks when it comes to risk: “not being able to know the future doesn’t mean we can’t deal with it. It’s one thing to know what’s going to happen and something very different to have a feeling for the range of possible outcomes and the likelihood of each one happening. Saying we can’t do the former doesn’t mean we can’t do the latter.”



Seth Klarman, Margin of Safety:  http://www.amazon.com/Margin-Safety-Risk-Averse-Strategies-Thoughtful/dp/0887305105/ref=sr_1_1?s=books&ie=UTF8&qid=1440948033&sr=1-1&keywords=margin+of+safety&pebp=1440948041940&perid=0WWQT72EYEERGSDRH74C


Howard Marks, The Most Important Thing:   http://www.amazon.com/Most-Important-Thing-Illuminated-Thoughtful/dp/0231162847/ref=sr_1_1?s=books&ie=UTF8&qid=1440948159&sr=1-1&keywords=the+most+important+thing


Richard Zeckhauser, Investing in the Unknown and Unknowable  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2205821

A Dozen Things I’ve Learned from Charlie Munger About Benjamin Graham’s Value Investing System

Charlie Munger has developed a powerful system that is useful in making any type of decision. One notable application of this system by Munger relates to investing and involves another system developed by Benjamin Graham. It is useful to understand what is known as “value investing” not just for its own sake, but to understand how Munger thinks and makes decisions. Even if you find value investing boring or have no intention to follow its principles, you can learn from understanding how it works and has evolved from its original nature based on the ideas of a few people including Munger. For this reason, it is important to understand a little about Graham himself.

“Benjamin Graham was salutatorian of the class of 1914 and, weeks before graduation, was offered teaching positions in three different faculties: Greek and Latin philosophy, English, and mathematics. He was all of 20 years old. Needing to support his siblings and widowed mother, he went to work on Wall Street. In 1934, he wrote Security Analysis, the first book ever to put the study of investments on a systematically logical footing. In 1949, he published The Intelligent Investor, which Warren Buffett has called “the best book about investing ever written.” Warren Buffett….has said that he was struck by the force of Graham’s teachings ‘like Paul on the road to Damascus.’”

What follows are the usual “dozen things” quotations from Charlie Munger stitched together from his writing and statements made at different times and places (in this case over many over decades).

1. “Graham didn’t want to ever talk to management. And his reason was that, like the best sort of professor aiming his teaching at a mass audience, he was trying to invent a system that anybody could use. And he didn’t feel that the man in the street could run around and talk to managements and learn things. He also had a concept that the management would often couch the information very shrewdly to mislead. Therefore, it was very difficult. And that is still true, of course human nature being what it is.” “Warren trained under Ben Graham, who said, ‘Just look at the facts. You might lose an occasional valuable insight, but you won’t get misled.’” The most important word in these quotations from Charlie Munger is “system,” which can be defined as a set of processes or elements that interact in ways that can achieve an objective not obtainable from the processes or elements alone. A second important point made by Charlie Munger is about Ben Graham’s desire to create something an “ordinary person” can potentially use successfully. It is important to note that Charlie Munger believes that only a tiny number of people can actually outperform a market using the value investing system because they lack factors like the necessary work ethic and the right emotional and psychological temperament. It is possible that an ordinary investor can us the value investing systems to outperform that market but it is far from the usual case. If an investor does try to outperform a markets Charlie Munger is also saying that it is easy to be misled by promoters and business managers about the value of a business or other assets. Ben Graham believed that by focusing on a rational appraisal of objective facts fewer investing mistakes will be made than by relying on subjective opinions.

2. “Ben Graham had this concept of value to a private owner – what the whole enterprise would sell for if it were available. And that was calculable in many cases. Then, if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you’ve got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety – as he put it – by having this big excess value going for you.” Ben Graham’s system involves four bedrock principles, two of which Charlie Munger introduces here: 1) a share of stock is a proportional ownership of a business and 2) buy at a significant discount to intrinsic value to create a margin of safety. On the first principle, if a security is not a proportional interest in a business then what exactly is it? It certainly isn’t a piece of paper to be traded like a baseball card or a painting. In terms of the second principle on “margin of safety,” the fundamental idea is to buy an asset at a significant enough bargain price that the result will be good even if a mistakes was made in evaluating the asset. Since risk is always relative to the price paid, buying with a margin of safety is a risk-averse approach. A range of future outcomes can still produce a satisfactory result if you buy an asset at a significant bargain.

3. “Ben Graham [had] his concept of “Mr. Market.” Instead of thinking the market was efficient, he treated it as a manic-depressive who comes by every day. And some days he says, “I’ll sell you some of my interest for way less than you think its worth.” And other days, “Mr. Market” comes by and says, “I’ll buy your interest at a price that’s way higher than you think its worth.” And you get the option of deciding whether you want to buy more, sell part of what you already have or do nothing at all. To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct.” Charlie Munger is introducing the Mr. Market metaphor in making these statements. Mr. Market shows up every day willing to quote you a price. Unfortunately, Mr. Market is, in the words of Warren Buffett, a drunk bipolar psycho. For this reason and others, Mr. Market should always be treated as your servant rather than your master. Why would anyone ever treat someone like this as wise? Mr. Market, in the short term, is a voting machine driven by highly volatile and fickle public opinion instead of a weighing machine measuring return on investment. When Mr. Market offers you a price for an asset you have the option to do nothing. In other words, there are no “called strikes” in investing. There is no premium given in investing for activity and in fact there is a penalty since it results in fees and taxes. For a value investor, it is Mr. Market’s irrationality that creates the opportunity for value investors. As Charlie Munger points out: “For a security to be mispriced, someone else must be a damn fool. It may be bad for world, but not bad for Berkshire.” The best returns accrue to investors who are patient and yet aggressive when they are offered a price for an asset that meets the requirements of value investing.

4. “The idea of a margin of safety, a Graham precept, will never be obsolete. The idea of making the market your servant will never be obsolete. The idea of being objective and dispassionate will never be obsolete. So Graham had a lot of wonderful ideas. Warren worshiped Graham. He got rich, starting essentially from zero, following in the footsteps of Graham.” Charlie Munger introduces final bedrock principle of value investing here: be objective and dispassionate. In other words, be as rational as you can when making investing decisions. Despite this objective, an investor will always make some emotional and psychological mistakes, but if you can do things like learn from your mistakes, use techniques like checklists, have the right emotional temperament, exhibit a strong work ethic and are a “learning machine,” he believes some investors can outperform the market. Only a very small number of “know something” investors can do this. Charlie Munger believes that most everyone is a “know nothing” investor and should instead invest in a diversified portfolio of index funds and ETFs.

5. “The supply of cigar butts was running out. And the tax code gives you an enormous advantage if you can find some things you can just sit with.” “Ben Graham could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on. But he was, by and large, operating when the world was in shell shock from the 1930s—which was the worst contraction in the English-speaking world in about 600 years. Wheat in Liverpool, I believe, got down to something like a 600-year low, adjusted for inflation. The classic Ben Graham concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and it wouldn’t click. Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they’d always done. And it still worked pretty well.” The beauty of some systems is that they have the ability to evolve so as to adapt to new conditions. And that is precisely what happened in the case of value investing. After the Great Depression many people simply gave up on owning stocks. Loss aversion was so strong among potential buyers that they were simply not rational when it came to the stock market. During this period it was possible for businesses to be bought at less than liquidation value. This was a boon for investors like Ben Graham. Unfortunately for them, that period of time only lasted for so long as memories faded and new investors entered the market. Every so often some pundit will drag out one quote from Ben Graham about how it became to do value investing at one point. These pundits not only take the quote out of context buy ignore the fact that the followers of Graham were even before then time taking Graham’s principles and defining a bargain in a new way considering the quality of the business and in some cases considering what are called “catalysts” to the value of a business. Value investing has evolved significantly since the time of Ben Graham and Charlie Munger has played a big part in that evolution.

6. “I don’t love Ben Graham and his ideas the way Warren does. You have to understand, to Warren — who discovered him at such a young age and then went to work for him — Ben Graham’s insights changed his whole life, and he spent much of his early years worshiping the master at close range. But I have to say, Ben Graham had a lot to learn as an investor. His ideas of how to value companies were all shaped by how the Great Crash and the Depression almost destroyed him, and he was always a little afraid of what the market can do. It left him with an aftermath of fear for the rest of his life, and all his methods were designed to keep that at bay.” “I liked Graham, and he always interested and amused me. But I never had the worship for buying the stocks he did. So I don’t have the worship for that Warren does. I picked up the ideas, but discarded the practices that didn’t suit me. I don’t want to own bad businesses run by people I don’t like and say, ‘no matter how horrible this is to watch, it will bounce by 25%.’ I’m not temperamentally attracted to it.” Charlie Munger is always looking for ways to evolve, adopt and even reverse his views. He is a learning machine. Charlie Munger is also excited by great managers running great businesses. And he gets positively ecstatic when every once in a while these managers are running businesses that are available for purchase in whole or in part at bargain prices. This does not happen very often so most of the time he patiently does nothing. But Charlie is prepared to act very aggressively in a big way when the time is right.

7. “I think Ben Graham wasn’t nearly as good an investor as Warren is or even as good as I am. Buying those cheap, cigar-butt stocks was a snare and a delusion, and it would never work with the kinds of sums of money we have. You can’t do it with billions of dollars or even many millions of dollars. But he was a very good writer and a very good teacher and a brilliant man, one of the only intellectuals – probably the only intellectual — in the investing business at the time.” Charlie Munger is in this set of quotations is discussing another reason why the value investing system had to evolve for Berkshire. The amount of money that Berkshire must put to work each year is way too big to hope that enough so-called “cigar butt” businesses with a few remaining puffs left in them can be found to compose a full portfolio. When buying a business anything remotely as big as Heinz or Precision Cast Parts it is very unlikely that they will be buying any cigar butts. Berkshire must find assets that represent a bargain defined in terms of quality. As an example Warren Buffett used $23 billion of Berkshire’s $66.6 billion in cash to buy Precision Castparts. Buffet has said that “We will always have $20 billion in cash on hand.” So they won’t be buying a business as big as Precision Castparts for a while.

8. “Having started out as Grahamites which, by the way, worked fine we gradually got what I would call better insights. And we realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentum implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other. And once we’d gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses. We’ve really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high quality businesses. And most of the other people who’ve made a lot of money have done so in high quality businesses.” Charlie Munger makes two key points here: 1) some bargains are only visible if you understand qualitative factors and 2) there sometimes are catalysts that can boost the value of the stock even further based on factors like scale advantages, favorable regulatory changes, improving secular phenomenon and better systems or business momentum. Charlie Munger likes to “find a few great companies and then sit on your ass.” When he finds a great business with excellent management like Costco he is like “a pig in slop” and does not want to leave the pig pen.

9. “The great bulk of the money has come from the great businesses. And even some of the early money was made by being temporarily present in great businesses. Buffett Partnership, for example, owned American Express and Disney when they got pounded down. However, if we’d stayed with classic Graham the way Ben Graham did it, we would never have had the record we have.” “Iscar is not a Ben Graham stock – in fact, it would be the ultimate non-Ben Graham stock. It’s located a few miles from the Lebanese border in Israel. It has a high ROE, doing business all over the earth, using a certain technology to produce carbide cutting tools. The reason I got so high on it so fast was that the people are so outstandingly talented.” Charlie Munger has made the point many times that only a few great decisions delivered most of Berkshire’s financial returns. Warren Buffett has said that as few as 20 bets in a lifetime can make you very rich. Charlie Munger has also said repeatedly that a high quality business selling a bargain price is not a common event and that if you are not prepared to act aggressively when that happens the opportunity will be lost. In thinking about the value of a business, Munger also strayed far from a view that looking at the quality of management is not something that should be considered because it is too easy to be misled. When Berkshire buys a business they want the moat and the management (the two M’s) to be in place already. Berkshire does not build moats itself and it does not want to supply management.

10. “We bought [the Washington Post] at about 20% of the value to a private owner. So we bought it on a Ben Graham-style basis – at one-fifth of obvious value – and, in addition, we faced a situation where you had both the top hand in a game that was clearly going to end up with one winner and a management with a lot of integrity and intelligence. That one was a real dream. They’re very high class people – the Katharine Graham family. That’s why it was a dream – an absolute, damn dream.” These quotations list many of the elements that Charlie Munger looks for in a business. At the time it was first bought the business known as the Washington Post had both a strong management team and a moat. A significant partial ownership stake was also available for purchase at a bargain price. Of course, the moat of the Washington Post has significantly atrophied as the Internet has enabled competitors to avoid the need for big printing process and physical distribution systems. All moats are under attack by competitors and change in strength and value over time. It is perhaps not surprising that the Washington Post was purchased by an expert moat builder like Jeff Bezos. The task of the new owner is to rebuild the moat of the Washington Post which is not easy given that the news is non-rival and non-excludable.

11. “Ben Graham said it’s not the bad ideas that do you in. It’s the good ideas that get you. You can’t ignore it and it’s easy to overdo it.” Almost everything can be taken to a point where what is wonderful eventually becomes toxic. The great humorist Mark Twain said once that: “Water, taken in moderation, cannot hurt anybody.” Even water in sufficient quantity is not good for you. The same phenomenon applies to investing. What a wise person does at first, the fool does at the end. This particular quotations was made in the context of the Internet bubble which was an extreme example of good ideas taken way too far.

12. “Warren Buffett came to investing at the knee of Ben Graham, who ran a Geiger counter over the detritus of the 1930s. Stocks were ridiculously cheap. Graham bought companies that were quite mediocre on average, but made 20% when their stock bounced.” “Warren trained under this system and made money, so he was slower to come to the idea I learned that the best way to make money is to buy great businesses that earn high returns on capital over long periods of time. We’re applying Graham’s basic ideas, but now we’re trying to find undervalued GREAT companies. That concept was foreign to Ben Graham. Warren would have morphed into a great investor without Ben Graham. He is a greater investor than Graham was. Warren would have been great had he never met anyone else. He would have excelled at any field that required a high IQ, quantitative skills and risk taking. He wouldn’t have done well at ballet though.” The point about Warren Buffett being an unlikely ballet star is important since it raises the idea of “circle of competence.” Risk comes from not knowing what you are doing, so it is wise to know what you are doing (i.e., stay within your circle of competence). The skill of every human being has limits. Knowing in which situations you are skilled or not is very valuable in life. An important point in all of this is: you are not Charlie Munger and you are not going to be Charlie Munger. Having said that, you can learn from Charlie Munger and make better decisions than you would otherwise. Those decisions may be limited to things like choosing a mutual fund or allocating assets between categories. They also might include selecting a college or a spouse. Charlie Munger is trying to convey the idea that in making decisions in life it is wise to be rational, try to filter out sources psychological dysfunction and apply a range of mental models and worldly wisdom.

A Dozen Things I’ve Learned from Charlie Munger about Mental Models and Worldly Wisdom

1. “I think it is undeniably true that the human brain must work in models. The trick is to have your brain work better than the other person’s brain because it understands the most fundamental models: ones that will do most work per unit.” “If you get into the mental habit of relating what you’re reading to the basic structure of the underlying ideas being demonstrated, you gradually accumulate some wisdom.”

Every human can assimilate only so much information through their senses and has only so much memory and processing power. Humans must make decisions constantly. Charlie Munger’s belief is that by learning and thinking using the big models which have been developed by the very best minds, you can become “worldly wise.” The good news is that you don’t need to have perfect understanding of all these models.  What you will need is greater knowledge and understanding of the models than the other people you compete with in a given activity like investing. You will naturally know some models better than others. Some mental models work better than others in some situations and knowing which models to use and when is a key part of good judgment. For better or worse, having good judgment often comes from making bad judgments. The process of acquiring wisdom is just that – a process. Acquiring wisdom takes time and effort.


2. “You’ve got to have models in your head. And you’ve got to array your experience ‑ both vicarious and direct ‑ on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You’ve got to hang experience on a latticework of models in your head.”

Richard Feynman liked to tell this story about something his father taught him: “You can know the name of that bird in all the languages of the world, but when you’re finished, you’ll know absolutely nothing whatever about the bird.” Rather than just knowing the names of various mental models, Charlie Munger is very focused on acquiring a deep understanding of these models so they can help him better understand the world. He believes that it is through the application of models in a varied range of settings in life that genuine learning takes place. Mistakes, folly and foibles are an inevitable part of this process. Robert Hagstrom describes the lattice approach as follows: “each discipline entwines with, and in the process strengthens, every other. From each discipline the thoughtful person draws significant mental models, the key ideas that combine to produce a cohesive understanding.”

For Charlie Munger this approach comes naturally: “For some odd reason, I had an early and extreme multidisciplinary cast of mind. I couldn’t stand reaching for a small idea in my own discipline when there was a big idea right over the fence in somebody else’s discipline. So I just grabbed in all directions for the big ideas that would really work. Nobody taught me to do that; I was just born with that yen.”  Charlie Munger notes that some knowledge and skill acquisition happens based on personal experience and some vicariously through the experiences of other people. Watching other people make big mistakes is a lot less painful than making those mistakes yourself. Reading widely in a range of different domains is the most effective technique to expand the opportunities to learn from the experiences of others. Of course, Charlie Munger reads constantly. A great investor who does not read a lot is rarer than hen’s teeth.


3. “Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ‘em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form.”

This quotation from Charlie Munger reminds me of the scene in the movie The Paper Chase when a character named Brooks is faced with a need to think and reason during Socratic dialogue a classroom but instead tries to use his photographic memory of facts from the cases to find a response. Perfect recall of facts is not enough and Brooks found himself floundering in the classroom when asked to think and reason. Speaking of memory, I remember well when I first read Robert Hagstrom on this latticework concept which Charlie Munger espouses since it made me feel much better about my curiosity about all aspects of the world: “Those who cultivate this broad view are well on their way to achieving worldly wisdom, that solid mental foundation without which success in the market–or anywhere else–is merely a short-lived fluke. To drive his point home, Charlie used a memorable metaphor to describe this interlocking structure of ideas: a latticework of models. ‘You’ve got to have models in your head,’ he explained, ‘and you’ve got to array your experience-both vicarious and direct-on this latticework of models.’ So immediate is this visual image that latticework has become something of a shorthand term in the investment world, a quick and easily recognized reference to Munger’s approach.”


4. “What are the models? Well, the first rule is that you’ve got to have multiple models ‑ because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models, or at least you’ll think it does.”

Charlie Munger is bringing up the tendency of humans to drift into dysfunctional patterns of thought like psychological denial when faced with something unpleasant. There are many sources of psychological and emotional dysfunction which will be discussed throughout Munger Month on this blog and many mental models that can be used to try to prevent mistakes from occurring. Using the right models can help you avoid what Munger calls “the psychology of human misjudgment.” Munger believes that by applying a lattice of models from disciplines like behavioral economics an investor can discover decision-making errors. Perfection is not possible to achieve, but following a better decision making process is possible. Focusing on having a sound decision making process rather than outcomes in any given case is wise. In the long term, it is a better process that will generate the better overall result. Reading too much into a good outcome that results from a bad process or a bad outcome that results from a good process, can create big problems.


5. The models have to come from multiple disciplines ‑ because all the wisdom of the world is not to be found in one little academic department. That’s why poetry professors, by and large, are so unwise in a worldly sense. They don’t have enough models in their heads. So you’ve got to have models across a fair array of disciplines. You may say, ‘My God, this is already getting way too tough.’ But, fortunately, it isn’t that tough ‑ because 80 or 90 important models will carry about 90% of the freight in making you a worldly ‑ wise person. And, of those, only a mere handful really carry very heavy freight.” 

You do not need to know every mental model or even know them all deeply to make better decisions, but you do need to understand how most of them work at a basic level at least. It is also important that you read often and broadly especially since these models do change and are updated over time. The goal is to acquire wisdom and common sense rather than to be an academic expert in one or even a few narrow domains. One piece of good news about this process is that each new model is easier to learn since the other models you already know give you a foundation which makes incremental learning easier.


6. “When I urge a multidisciplinary approach- that you’ve got to have the main models from a broad array of disciplines and you’ve got to use them all – I’m really asking you to ignore jurisdictional boundaries. If you want to be a good thinker, you must develop a mind that can jump these boundaries. You don’t have to know it all. Just take in the best big ideas from all these disciplines. And it’s not that hard to do.”  It is important that you read outside of your domain if you want to avoid failing based on man with a hammer syndrome. If all you know is medieval poetry or auto mechanics you are not going to acquire usable wisdom in life. Without worldly wisdom, you end up like a one-legged man in an ass-kicking contest says Charlie Munger. Read widely and be curious. Think for yourself and be open to new ideas. Use many models from many disciplines when thinking about a problem. For example, when thinking about an economy or a business Munger has suggested it is useful to apply models from biology. Munger has said for example “Common stock investors can make money by predicting the outcomes of practice evolution. You can’t derive this by fundamental analysis — you must think biologically” and “I find it quite useful to think of a free market economy—or partly free market economy—as sort of the equivalent of an ecosystem.”


7. “You must know the big ideas in the big disciplines, and use them routinely — all of them, not just a few. Most people are trained in one model — economics, for example — and try to solve all problems in one way. You know the old saying: to the man with a hammer, the world looks like a nail. This is a dumb way of handling problems.”  Munger believes that thinking clearly is a trained response. He points out that “if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer.”

Some people take to this mental models approach and some people don’t. Some people find it interesting and some people don’t. One sure way to fail is to look at the world only through the lens of only one model. The surgeon or nutritionist who only thinks about the world through the lens of their particular discipline is a danger to themselves and others.


8.”You have to realize the truth of biologist Julian Huxley’s idea that ‘Life is just one damn relatedness after another'”

“You must have the models, and you must see the relatedness and the effects from the relatedness.”

One of the most enjoyable thing about the lattice approach is when you see how “it all fits together.” When you use a lattice of mental models approach you quickly learn that everything is related including the models themselves. This relatedness often allows an investor to use analogies to solve problems and find opportunities. The more you know about more things in life, the more you see how it all fits together. The process is like solving a huge puzzle that is never fully completed. The last three words in the previous sentence (“never fully completed”) are very important. The more you know, the more you know, that there is more that you do not know.


9. “I’ve been searching for lollapalooza results all my life, so I’m very interested in models that explain their occurrence.”

One particularly important phenomenon related to mental models is what are called “complex adaptive systems.” If you adopt the model of complex adaptive systems you accepts the idea that the whole of many things is more than the sum of the arts and that there are many systems that cannot be modeled with certainty. Even after the fact, causation is impossible to prove with certainty when it comes to this phenomenon. Once you accept the idea that some things are simply not predictable, your world view changes. In Munger’s view it is better to have common sense and be Worldly Wise than futz around with a lot of models that are precisely wrong rather than approximately right.  This is in part why Munger likes to say: “People calculate too much and think too little.”


10. “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.”

Faced with the tendency of humans to fall down when making decisions based on the use of dysfunctional heuristics, humans can benefit from using tools or nudges to stay rational. Checklist are just such a tool.  Despite the fact that a checklist is helpful in developing a better decision making process there is no formula or recipe for success in investing or most other aspects of life. Even with the best investing systems judgment and wisdom are required since risk, uncertainty and ignorance are constants in life. Life is always throwing new situations at you but they sometimes are quite familiar.


11. “Acquire worldly wisdom and adjust your behavior accordingly. If your new behavior gives you a little temporary unpopularity with your peer group … then to hell with them.”

To use worldly wisdom properly you must be prepared to be a contrarian. Being a contrarian will inevitably sometimes make you unpopular or lonely.  Accepting this solitary state of affairs at times is essential since it is mathematically provable that you cannot outperform the crowd if you are the crowd. In the longer term you will ironically be more popular as long as you are right enough in your contrarian views. Of course, being a contrarian and wrong is not helpful and it is magnitude of correctness and not frequency of correctness that should be tracked on your scorecard.


12. “If you don’t keep learning, other people will pass you by. Temperament alone won’t do it – you need a lot of curiosity for a long, long time.” 

“The theory of modern education is that you need a general education before you specialize. And I think to some extent, before you’re going to be a great stock picker, you need some general education.”  

“If you skillfully follow the multidisciplinary path, you will never wish to come back. It would be like cutting off your hands.” 

“It’s kind of fun to sit there and outthink people who are way smarter than you are because you’ve trained yourself to be more objective and more multidisciplinary. Furthermore, there is a lot of money in it, as I can testify from my own personal experience.”

Charlie Munger, Robert Hagstrom, Michael Mauboussin and others I admire are advocates of a broad liberal arts education. I am not just talking about what you take as courses in school but what you learn about throughout your life. The best investors never stop learning. I particularly love the original title of Robert Hagstrom’s book Investing: The Last Liberal Art since it is such a true statement. Knowing a lot about a lot in many disciplines and being “a learning machine” are attributes of the best investors.

To sum up this blog post it is useful I think to just quote Charlie Munger on the benefits of his approach: “I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you.…so if civilization can progress only with an advanced method of invention, you can progress only when you learn the method of learning. Nothing has served me better in my long life than continuous learning. I went through life constantly practicing (because if you don’t practice it, you lose it) the multi-disciplinary approach and I can’t tell you what that’s done for me. It’s made life more fun, it’s made me more constructive, it’s made me more helpful to others, and it’s made me enormously rich. You name it, that attitude really helps.” 


A partial list of some Mental Models used by Charlie Munger, compiled from many sources


Balance Sheet

Cash Flow Statement



Generally Accepted Accounting Principles

Income Statement

Sunk Cost




Natural Selection





Five Forces




Autocatalytic reactions

Bohr Model



Uncertainty Principle



Computer Science:







Agency Problem

Asymmetric Information

Behavioral Economics

Cumulative Advantage

Comparative Advantage

Competitive Advantage

Creative Destruction

Diminishing Utility

Economies of Scale




Marginal Cost

Marginal Utility

Monopoly and Oligopoly

Network effects

Opportunity Cost

Price Discrimination

Prisoner’s Dilemma

Public and Private Goods.


Supply and Demand

Switching Costs

Transaction Costs

Tragedy of the Commons

Time Value of Money





Feedback loops

Margin of Safety




Burden of Proof

Common law

Due Process

Duty of care

Good Faith


Presumption of Innocence

Reasonable doubt


Management Science:

Occam’s razor

Parkinson’s Law

Process versus Outcome


Mathematics, Probability and Statistics:

Agent Based Models

Bayes Theorem

Central Limit Theorem

Complex Adaptive Systems

Correlation versus Causation



Decision Trees


Kelly Optimization Model

Law of Large Numbers

Mean, Median, Mode

Normal Distribution


Power Law

Regression Analysis

Return to the Mean


Sensitivity Analysis


Philosophy, Literature and Rhetoric:









Critical Mass




Newton’s Laws


Quantum Mechanics


Shannon’s Law



A Dozen Things I’ve Learned from Charlie Munger about Making Rational Decisions


I have written a book about Charlie Munger. While the book is written in the context of investing, understanding what Charlie Munger teaches will help you make rational decisions about anything in your life.  Everyone must make decisions and by understanding how Charlie Munger thinks you can improve your decision making skills. Even people who have decided to use an index fund-based approach must chose index funds and allocate between asset classes. Making at least some investment decisions is unavoidable. Learning to make better decisions of any kinds requires that you spend some time thinking about thinking. The good news is that this learning process is fun. Charlie Munger puts it this way: “Learning has never been work for me. It’s play.” Life gets better if you adopt this approach to learning.

  1. “‘Charlie,’ she said, ‘What one word accounts for your remarkable success in life?’ I told her I was rational.” If the actor in the television commercials for the famous beer is “the most interesting man in the world,” then perhaps Charlie Munger is “the most rational investor in the world.” His rationality and honesty in no small part explain why he is so popular. What Charlie Munger says is often so funny because he is perfectly willing to speak the truth in a completely unrestrained and direct manner. In other words, he appeals to so many people because of his honest insight about life, in much the same way as great comics like Louis C.K., Amy Schumer or Chris Rock are so appealing. Individuals who speak the truth openly are often interesting, insightful and funny. To understand Charlie Munger’s appeal it is useful to think about the nature of rationality. Michael Mauboussin explains that there are different forms of rationality: “Cognitive scientists and philosophers talk about “instrumental” and “epistemic” rationality. Instrumental rationality is behaving in such a way that you get what you want the most, subject to constraints. Expected utility theory, which is based on a series of axioms, provides a normative framework for how to do this. You’ll be instrumentally rational if you follow the axioms. Epistemic rationality describes how well a person’s beliefs map onto the world. If you believe in the tooth fairy, for instance, you are showing a lack of epistemic rationality. Here’s a catchier way to remember the two terms: instrumental rationality is “what to do” and epistemic rationality is “what is true.” Charlie Munger understands and is focused on being both “epistemically” and instrumentally rational.


  1. “The right way to think is the way [Harvard Professor Richard] Zeckhauser plays bridge. It’s just that simple.” To be “rational” is to think in terms of expected value, which Michael Mauboussin points out “is the weighted average value for a distribution of possible outcomes.”  In the 1989 Berkshire Hathaway Annual Meeting Warren Buffett put it this way: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.” Michael Mauboussin describes the rational approach perfectly: “Success in a probabilistic field requires weighing probabilities and outcomes — that is, an expected value mindset.” Robert Hagstrom argues http://blogs.cfainstitute.org/insideinvesting/2013/09/03/what-buffett-believes-but-cannot-prove/: “Jon Elster is a Norwegian social and political theorist who has written extensively on rational-choice theory. He tells us that being able to wait and using indirect strategies are central features of human choice. Indeed, Elster argues that human rationality is characterized by the capacity to relate to the future, in contrast to the myopic gradient-climbing organism found in the natural world. Elster’s gradient-climbing organism has eyes fixed to the ground, incapable of seeing what might happen next. Future events for the myopic organism have no effect on decision making. Put differently, for the myopic organism, tomorrow’s events are the same as today’s events. In contrast, Elster claims that man can be seen as a rational, global-maximizing machine capable of relating to the future, choosing the best alternative by scanning several possible moves and then selecting the best choice among them. The irrational investor, the myopic gradient-climber, sees only today and postulates that tomorrow will be much the same. In contrast, Buffett sees stock price declines as temporary. Irrational investors see the same price declines and believe them to be permanent. The cornerstone of rationality is the ability to see past the present and analyze possible scenarios, eventually making a deliberate choice.” As an aside, if you are not reading Robert Hagstrom’s books you are missing out on some very good thinking and writing.


  1. “[What was] … worked out in the course of about one year between Pascal and Fermat… is not that hard to learn.” “So you have to learn in a very usable way this very elementary math and use it routinely in life ‑ just the way if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer.”  Charlie Munger is saying that the expected value aspects of investing are relatively simple to learn but that it is not a natural way of thinking. He believes that using this process skillfully in real life is a trained response since aspects of the process will require you to overcome certain biases as well as certain often dysfunctional emotional and psychological tendencies. “Your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge. ‘For example’, people do not react symmetrically to loss and gain. Well maybe a great bridge player like Zeckhauser does, but that’s a trained response.” The best way to learn to play bridge or invest is to actually play. You can’t really simulate it. Over a lifetime you can learn from actual direct and indirect experience to overcome different types of dysfunctional thinking. For example, says Munger “If people tell you what you really don’t want to hear what’s unpleasant—there’s an almost automatic reaction of antipathy. You have to train yourself out of it.” 



  1. “The Fermat/Pascal system is dramatically consonant with the way that the world works. If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one‑legged man in an ass‑kicking contest. You’re giving a huge advantage to everybody else.” Charlie Munger is famous for his view that simple mathematic techniques like algebraic inversion are essential to making wise decisions. Adopting this approach is neither easy or natural but will inevitably pay big dividends. He believes that if you don’t do this work you will inevitably end up being the patsy at the poker table of life.  If you are playing in a poker game and don’t see a sucker, get up and walk away from the table. You’re the sucker. The future is best thought of as a probability distribution so naturally thinking probabilistically puts you are a competitive advantage in relation to competitors.


  1. “I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? The first track is rationality-the way you’d work out a bridge problem: by evaluating the real interests, the real probabilities and so forth.”  Having a system is important says Warren Buffett: “The approach and strategies [in bridge and investing] are very similar. In the stock market you do not base your decisions on what the market is doing, but on what you think is rational. With bridge, you need to adhere to a disciplined bidding system. While there is no one best system, there is one that works best for you. Once you choose a system, you need to stick with it.” The analytical system Charlie Munger uses starts with rationality. But that is only the first step in a two step process that is his systematic approach to investing. He is saying that the rational decision-making track comes first, just like putting on your pants should precede putting on your shoes.


  1. “Second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things-which by and large are useful, but which often malfunctions.” Ordinary people, subconsciously affected by their inborn tendencies.”  After an expected value process is completed and you believe your decisions is rational, Charlie Munger suggests that the decision be cross-checked for possible errors. The reality is that no one has a fully rational mindset. It would not be possible to get out of bed in the morning if every human decision had to be made based on careful expected value calculations. Heuristics have been developed by humans to get through a day which sometimes cause decisions to become irrational, especially in a modern world which is very unlike most of history.  In other words, no human is perfectly rational because everyone is impacted by emotional and psychological tendencies when making decisions. As a result, thinking rationally is a trained response. To be as rational in your daily life as Richard Zeckhauser is in playing bridge a person must overcome errors based on emotional or psychological mistakes. Rationality is in practical terms relative.  Charlie Munger believes staying rational is hard work and requires constant practice and lifelong effort. Making mistakes is inevitable and will never stop, but you can learn to make less than your statistical share of mistakes.


  1. “Your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge. For example, people do not react symmetrically to loss and gain. Well maybe a great bridge player like Zeckhauser does, but that’s a trained response. Thinking in a way that is as rational as possible requires work and training, especially when it comes to avoiding psychological and emotional mistakes. What is the source of these mistakes? The list of factors causing mistakes is very long. Warren Buffett writes: “It’s ego. It’s greed. It’s envy. It’s fear. It’s mindless imitation of other people. I mean, there are a variety of factors that cause that horsepower of the mind to get diminished dramatically before the output turns out. And I would say if Charlie and I have any advantage it’s not because we’re so smart, it is because we’re rational and we very seldom let extraneous factors interfere with our thoughts. We don’t let other people’s opinion interfere with it… we try to get fearful when others are greedy. We try to get greedy when others are fearful. We try to avoid any kind of imitation of other people’s behavior. And those are the factors that cause smart people to get bad results.” What Buffett describes is an example of what Charlie Munger calls decisional inversion. Instead of just trying to be smart, it is wise to focus on not being stupid.


  1. What is hard is to get so you use it routinely almost every day of your life.” Training your mind to do what Charlie Munger suggests is the ultimate goal of anyone who wants to emulate his system. Warren Buffett has written: “Chains of habit are too light to be felt until they are too heavy to be broken…At my age, I can’t change any of my habits. I’m stuck. But you will have the habits 20 years from now that you decide to put into practice today. So I suggest that you look at the behavior that you admire in others and make those your own habits, and look at what you really find reprehensible in others and decide that those are things you are not going to do. If you do that, you’ll find that you convert all of your horsepower into output.” One  good aspect of habits is that they can be put to good use if they are the right habits. It’s a bit like Alcoholics Anonymous, which Charlie Munger believes is a cult, but for the good. What an investor needs is a system that includes habits that reinforce rationality. If you want to say that people who follow Munger are a cult for the good, you won’t be far off in too many cases.  Munger himself has referred to people who attend Berkshire shareholder meetings as cult followers.


  1. “We have a temperamental advantage that more than compensates for a lack of IQ points.” “A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains.” Charlie Munger is making the point that high IQ does not mean you have high rationality quotient (RQ).  Temperament is far more important than IQ. Warren Buffett has said about Charlie Munger: “He lives a very rational life. I’ve never heard him say a word that expressed envy of anyone. He doesn’t waste time on senseless emotions.”  Warren Buffett suggests that some of this aspect of human nature may be innate: “A lot of people don’t have that. I don’t know why it is. I’ve been asked a lot of times whether that was something that you’re born with or something you learn. I’m not sure I know the answer. Temperament’s important.” High IQ can be problematic. What you want is to have a high IQ but think it is less than it actually is. That gap between actual and perceived IQ creates valuable humility and protects against mistakes caused by hubris. It is the person who thinks their IQ is something like 40 points higher than it actually is who creates the most havoc in life.


  1. “Personally, I’ve gotten so that I have a full kit of tools … go through them in your mind checklist-style.” Charlie Munger is a big believer is the use of checklist and is fan of Atul Gwande’s book The Checklist Manifesto. Checklists are a foundational part of systems that can help people identify dysfunctional thinking and bias. A checklist is in effect a “nudge” that helps you deal with bias and dysfunction by prodding you in the right direction. As an aside the full kit of tools required when using Charlie Munger’s system requires that you have “worldly wisdom” which will be the topic of another blog post in this series.


  1. “Rationality …requires developing systems of thought that improve your batting average over time.” “Luckily, I have selected very easy problems all my life, and I have a reasonable batting average.” “You don’t have to have perfect wisdom to get very rich – just a bit better than average over a long period of time.” No one is going to make the right decision all the time even if they strive to be rational. Howard Marks believes:Most people understand and accept that in their effort to make correct investment decisions, they have to accept the risk of making mistakes.  Few people expect to find a lot of sure things or achieve a perfect batting average.” The important thing is to have a system, but don’t expect it to be perfect. Michael Mauboussin points out: “Constantly thinking in expected value terms requires discipline and is somewhat unnatural. But the leading thinkers and practitioners from somewhat varied fields have converged on the same formula: focus not on the frequency of correctness, but on the magnitude of correctness.”


  1. “[Berkshire] is a very rational place.” “Warren and I know better than most people what we know and what we don’t know. That’s even better than having a lot of extra IQ points. Mr. Munger continued: “People chronically mis-appraise the limits of their own knowledge; that’s one of the most basic parts of human nature. Knowing the edge of your circle of competence is one of the most difficult things for a human being to do. Knowing what you don’t know is much more useful in life and business than being brilliant.” IQ is not the primary cause of investing success. Warren Buffett points out that the key to making wise decisions is rationality: “How I got here is pretty simple in my case. It’s not IQ, I’m sure you’ll be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output–the efficiency with which that motor works–depends on rationality. A lot of people start out with 400-horsepower motors but only get a hundred horsepower of output. It’s way better to have a 200-horsepower motor and get it all into output.” For Buffett and Munger the circle of competence point is critical. Since risk comes from not knowing what you are doing, know what you are doing when you are doing something. If you don’t know what you are doing put it in the too hard pile and move on to something else. The more you know, the more you know, that there is even more than you do not know.

A Dozen Things I’ve Learned from David Einhorn About Investing



David Einhorn is the President of Greenlight Capital which is “a value oriented investment advisor… that emphasizes intrinsic value will achieve consistent absolute investment returns and safeguard capital regardless of market conditions.” “He learned the hedge fund business from Gary Siegler and Peter Collery, who managed the SC Fundamental Value Fund. David Einhorn is one of the most successful long/short equity hedge fund managers of the past decade.” He is the author of Fooling Some of the People All of the Time: A Long Short Storyhttp://www.amazon.com/Fooling-People-Complete-Updated-Epilogue/dp/0470481544/ref=sr_1_1?s=books&ie=UTF8&qid=1439654903&sr=1-1&keywords=long+short+story+Einhorn


  1. “We take the traditional value investor’s process and just flip it around a little bit. We start by identifying situations in which there is a reason why something might be misunderstood, where it’s likely investors will not have correctly figured out what’s going on. Then we do the more traditional work to confirm whether, in fact, there’s an attractive investment to make. That’s as opposed to starting with something that’s just cheap and then trying to figure out why. We think our way is more efficient.”  David Einhorn is at his core a value investor who has developed a twist on the customary process. Finding reasons for a likely mispricing of assets and then doing the traditional value investing analysis is not fundamentally different than doing the traditional value investing analysis first. He feels his approach consumes less of his firm’s resources since they are not doing the work on businesses which are unlikely to see substantial asset appreciation. Reasons for an asset being mispriced include spin-offs, accounting issues and changes in secular or technology trends.


  1. “What I like is solving the puzzles. I think that what you are dealing with is incomplete information. You’ve got little bits of things. You have facts. You have analysis. You have numbers. You have people’s motivations. And you try to put this together into a puzzle — or decode the puzzle in a way that allows you to have a way better than average opportunity to do well if you solve on the puzzle correctly, and that’s the best part of the business.” Value investing when done right is a lot of fun if you like to solve puzzles. The process is like being a detective. Sherlock Holmes might have been a good value investor.  The task of a investor is to discover puzzle solutions in situations that involve different combinations of what Richard Zeckhauser calls risk, uncertainty, and ignorance (see the chart below). The process of discovering puzzle answers is inherently probabilistic in nature.

    Escalating Challenges to Effective Investing


  1. “Our goal is to make money, or at least to preserve capital, on every investment.” “Securities should be sufficiently mispriced, so that if we are right we will do well, but we are mostly wrong, we will roughly break even.” “The trick is to avoid losers. Losers are terrible because it takes a success to offset them just to get back to even.” Risk is always relative to the price paid for the asset. If you buy at an attractive price you can have a margin of safety. You can see this margin of safety principle at work in Warren Buffett’s two rules of investing: “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” Howard Marks and Seth Klarman all espouse this same philosophy. How do you “not lose money?” Always protect the downside.  If you buy at a substantial discount to intrinsic value you can make a mistakes and still end up with a solid investment.


  1. “There were three basic questions to resolve: First, what are the true economics of the business? Second how do the economics compare to the reported earnings? Third, how are the interests of the decision makers aligned with the investors?” The best value investors have an investing system that involves asking and answering a series of questions. For example, does the business have a moat? What should the economics of the  business be in a normal situation? Then: Do earnings reports match the strength of the moat? Is there untapped pricing power? Is management underperforming? Are there problems you have not yet seen? Then: Are the incentives of management aligned with the incentives of investors? In the book Fooled By Randomness Nassim Taleb writes:  “… instead of relying on thousands of meandering pages of regulation, we should enforce a basic principle of ‘skin in the game’ when it comes to financial oversight: ‘The captain goes down with the ship; every captain and every ship.’ In other words, nobody should be in a position to have the upside without sharing the downside, particularly when others may be harmed.”


  1. “I’m not really good a predicting the market on a very near term kind of basis. So what it does from day-to-day is not within my competency to even hazard a guess at.”  This comment is a blend of Ben Graham’s Mr. Market metaphor and the “circle of competence” concept. When David Einhorn buys assets he does not have a short term timeline in mind for how long he will own the assets. The objective of a value investor is to buy the assets at a bargain price and then wait. this word wait is an important one. What is meant by the value investor is waiting would any short term timing. Trying to make short-term forecasts instead of waiting is folly and value investors instead rely on the combined long term effects of a buying with a margin of safety knowing that over the long terms prices will return to the mean.


  1. “We don’t try to solve the most intractable problems. At Greenlight, when we look at investments, some opportunities are just too hard to assess. We pass on those, even though many may work out perfectly well. We prefer situations that play to our strengths, where we can develop a differentiated analytical edge. This enables us to make investments where we are confident that the reward exceeds the risk.” Having what Charlie Munger calls a “too hard pile” is a tremendously valuable thing. If an investment is too hard, just move on to the many other opportunities that are not hard. Why get involved in investments where you do not know what you are doing especially when there are other bets where you do? Playing against weak competitors is not a sin in investing or business. There are no bonus points in investing for doing things that are really hard.


  1. “Investing and poker require similar skills. I don’t play a lot of hands. But I don’t just wait for the perfect hand. They don’t come up often enough.” “With poker, you have a resolution of the hand within a couple of minutes.”  “Whereas, even if the thought process in investing is very much the same, you’re looking at an outcome that could be 2, 3, 4, 5 years from when you make the original decision. And the mindset related to that is very different.”  “We find things that we think are exceptional only occasionally.” Markets are far from perfectly efficient.  But they are efficient enough that finding mispriced assets is hard, especially inside your circle of competence, which narrows the possible universe of bets. When the markets do serve up a mispriced bet an investor should act quickly and aggressively to place a bet if it is within their circle of competence. A number of very successful investors are excellent card players. Charlie Munger puts it this way: “The right way to think is the way Zeckhauser plays bridge. It’s just that simple.”  Warren Buffett has a similar view: “Bridge is the best game there is. You’re drawing inferences from every bid and play of a card, and every card that is or isn’t played. It teaches you about partnership and other human skills. In bridge, you draw inferences from everything and that carries over well into investing. In bridge, similar to in life, you’ll never get the same hand twice but the past does have a meaning. The past does not make the future definitive but you can draw from those experiences. I think the partnership aspect of bridge is a great lesson for life. If I’m going into battle, I want to partner with the best. I was playing with a world champion and we were playing against my sister and her husband. We lost, so I took the score pad and I ate it.”


  1. “We believe in constructing our portfolio so that we put our biggest amount of money in our highest conviction idea, and then we view our other ideas relative to that.” “I decided to run a concentrated portfolio.”  This statement illustrates that David Einhorn is a “focus” investor like Charlie Munger and that he adopts an opportunity cost approach. At Greenlight 20 percent of capital might be put in a single long bet and up to 60 percent in its five largest long bets. David Einhorn cites Joel Greenblatt as an inspiration for his view. Greenblatt argues that the addition of more stocks in a portfolio that already has six to eight stocks in different industries doesn’t significantly decrease volatility. In any event, volatility is only on type of risk. You can see his recent holdings and his most recent letter here: http://www.octafinance.com/david-einhorns-greenlight-capital-had-a-bad-q2-bringing-2015-ytd-loss-to-3-3/101385/  David Einhorn currently has a significant position in gold.  Some value investors own gold (e.g., Eveillard) and some don’t (e.g., Buffett, Munger).  I have never owned gold since it doesn’t have earnings that can be used to calculate an intrinsic value.  While some value investors may buy gold, buying gold is not value investing since it does not fit with the Ben Graham system. Why buy gold when you can buy a partial ownership interest in a real productive business instead of a lump of inert metal?


  1. “On any given day a good investor or a good poker player can lose money.” A good process can lead to a bad outcome in the real world, just as a bad process can lead to a good outcome. In other words, both good andbad luck can play a part in investing results. But the best investors understand that over time a sound process will outperform. The best way to understand this point being made by David Einhorn is to read Michael Mauboussin, who tells this story:  “[A baseball executive] was in Las Vegas sitting next to a guy who has got a 17. So the dealer is asking for hits and everybody knows the standard in blackjack is that you sit on a 17. The guy asked for a hit. The dealer flips over 4, makes the man’s hand, right, and the dealer sort of smiles and says, “Nice hit, sir?”  Well, you’re thinking nice hit if you’re the casino, because if that guy does that a hundred times, obviously the casino is going to take it the bulk of the time. But in that one particular instance: bad process, good outcome. If the process is the key thing that you focus on, and if you do it properly, over time the outcomes will ultimately take care of themselves. In the short run, however, randomness just takes over, and even a good process may lead to bad outcomes. And if that’s the case: You pick yourself up. You dust yourself off. You make sure you have capital to trade the next day, and you go back at it.”


  1. “[Our] goal is to achieve high absolute rates of return.” “We do not compare our results to long only indexes. This mean out goal is to try to achieve positive results over time regardless of the environment. Does the reward of this investment outweigh the risk?” The goal David Einhorn sets for himself is not to outperform a benchmark. This section from Seth Klarman’s book Margin of Safety describes a value investor’s desire for “absolute return”: “Most institutional and many individual investors have adopted a relative-performance orientation…They invest with the goal of outperforming either the market, other investors, or both and are apparently indifferent as to whether the results achieved represent an absolute gain or loss. Good relative performance, especially short-term relative performance, is commonly sought either by imitating what others are doing or by attempting to outguess what others will do. Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring. Good absolute performance is obtained by purchasing undervalued securities while selling holdings that become more fully valued. For most investors absolute returns are the only ones that really matter; you cannot, after all, spend relative performance. Absolute-performance-oriented investors usually take a longer-term perspective than relative-performance-oriented investors. A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular. To do otherwise would jeopardize near-term results. Relative-performance-oriented investors may actually shun situations that clearly offer attractive absolute returns over the long run if making them would risk near-term underperformance. By contrast, absolute-performance-oriented investors are likely to prefer out-of-favor holdings that may take longer to come to fruition but also carry less risk of loss.”


  1. “I’m a big believer in not making decisions before they need to be made. Circumstances change, people change, facts change, and options change. Why commit early when you can have the benefit of deciding later with more information?” Having the option to make the best choice at a later point in time when you have more information is valuable since markets are always changing. As an example, Craig McCaw has said to me many times over the years that “flexibility is heaven,” which means that he was willing at times to pay a financial price to keep his options open. When change is constant, having the ability to adapt at a later point in time is a very good thing.


  1. “At the top of the bubble, technology stocks seemed destined to consume all the world’s capital. It was not enough for all the new money to go into this sector. In order to feed the monster, investors sold everything from old economy stocks to Treasuries to get fully invested in the bubble. Value investing fell into complete disrepute.” “Market extremes occur when it becomes too expensive in the short-term to hold for the long-term.” “One of the things I have observed is that American financial markets have a very low pain threshold.” David Einhorn is pointing out that people often need to act based on short-term needs. Often that short-term need is to generate liquidity. Sometimes liquidity is needed because some people selling an asset cause a drop in price, which causes more people to sell that asset due to the price drop [repeat]. George Soros calls this phenomenon “reflectivity.” When people start acting in some way because other people are acting in the same or similar ways nonlinear results can happen both to the upside and the downside. For example, cash can quickly move from being available quite easily, to being very scarce. As another example, the price of an asset can suddenly jump in a big way. The speed at which this can happen is often forgotten by people and is underappreciated until that time arises. Market extremes do occur since people do not make decisions independently. They are not perfectly informed rational agents. The longer you investment timeframe and the lumpier the returns you are willing to accept the happier you will be and the better your returns will be.





Charlie Rose interview:  http://www.businessweek.com/magazine/content/10_51/b4208052554248.htm


CNBC interview http://www.cnbc.com/id/102107346#




Value Investing Congress Speech   http://www.grahamanddoddsville.net/wordpress/Files/Gurus/David%20Einhorn/einhornspeech200611.pdf


Ira Sohn comment:  http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ayIKbq6xULBA


Fooling Some of the People All of the Time, A Long Short Story   http://www.amazon.com/Fooling-People-Complete-Updated-Epilogue/dp/0470481544/ref=sr_1_1?s=books&ie=UTF8&qid=1439654903&sr=1-1&keywords=long+short+story+Einhorn


Presentation at Grant’s (Interest Rate Observer) Spring Investment Conference  http://seekingalpha.com/article/73260-things-go-better-with-coke-in-the-market-too  and http://www.naachgaana.com/2008/04/12/grant%E2%80%99s-spring-investment-conference/


Risk Mismanagement  http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?pagewanted=all


Helping People Get Along Better  http://www.gurufocus.com/news/325793/helping-people-get-along-better–a-lecture-from-david-einhorn







A Dozen Things I’ve Learned from Sam Zell about Investing and Business


Sam Zell is the founder and chairman of Equity Group Investments, which started in the real estate business but now owns a range of businesses. Sam Zell’s nickname is “the Grave Dancer” since he is often a distressed asset investor. This is a blog post about Sam Zell the investor.  As is the case with all of my blog posts, if you have an issue with the political views of the featured investor, I suggest that you try another blog.


  1. “The first thing you need to understand is how little you know.” The best investors understand that the more you know, the more you know that there is even more you do not know. Creating a taxonomy that categorizes your lack of knowledge is helpful since problems in life most often come from not knowing what you are doing. There are three categories: (1) you may know the potential future states and the probability that those potential future states may come to pass. This is known as “risk” and is rare. (2) you may know the potential future states, but not the probability that any of those potential future states will happen. This is uncertainty and is most common. (3) you may encounter future states that you had no prior idea were even possible. This is the domain of “ignorance.” This third domain (Black Swans) impacts people’s lives way more than they imagine since even though events in this domain do not happen that often, when they do, it produces massive disruptive change.


  1. “When everyone is going right, look left.” “I‘ve spent my whole life listening to people explain to me that I just don‘t understand, but it didn‘t change my view. Many times, however, having a totally independent view of conventional wisdom is a very lonely game.” Sam Zell is expressing the same view as investors like Howard Marks who recognize that it is mathematically provable that without being a contrarian in some instances (and being right about that contrarian view in those instances) it is not possible to outperform a market. You simply can’t follow the crowd and beat the crowd. Being contrarian for its own sake is, of course, unwise. Sam Zell is saying that you should “look” left, which does not necessarily mean you should “go” left. But sometimes that look left will give you enough confidence to place contrarian bets since you will see that the odds are substantially in your favor.


  1. “Listen, business is easy. If you’ve got a low downside and a big upside, you go do it. If you’ve got a big downside and a small upside, you run away. The only time you have any work to do is when you have a big downside and a big upside.” This statement is all about the value of seeking positive optionality. Every once in a while, if you are looking hard for opportunities, you will find a mispriced bet within your circle of competence with a relatively capped downside and a huge potential upside. It is wise to bet aggressively in these cases since it allows you to harvest positive optionality.  Betting when the optionality of the situation is negative is a fool’s errand. Situations with a big up side and a big downside are by contrast problematic.  This situation is likely to result in the most work and for that reason alone it may be wise to put decisions within it in the “too hard” pile.


  1. “At all times, we are keenly aware of what our exposure is.  As a result we are much more of a Benjamin Graham kind of investor.  We are very focused on what the liquidation value is.  Barnard Baruch, who was a very famous financier said ‘Nobody went broke taking a profit.’  In the same manner, I have never suffered from any transaction turning out to be too good.  The real issue is ‘What is the downside’.”  “My own formula is very simple. It starts and ends with replacement cost because that is the ultimate game. In the late 1980s and early 1990s, I was the only buyer of real estate in America. People asked me, ‘How could you buy it?’ How could I project yields? Rents? For me, it came down to these issues: Is the building well built? Is it in a good location? How much less than the cost of replacement is its price? I bought stuff for 30 cents on the dollar and 40 cents on the dollar.” Sam Zell likes to buy assets with a Ben Graham-style margin of safety, even if the asset class is commercial real estate. The value investing formula is simple: buy at a bargain and wait. I suggest that you don’t try to make it more complex than that. Most value investors are happy with a 30% margin of safety, but Sam Zell is saying here that he has sometimes been able to buy real estate at what he considered to be as much as a 70% margin of safety. In doing so Sam Zell is also taking a view similar to Howard Marks in that he is controlling risk.  Howard Marks believes: “Success in investing is not a function of what you buy. It’s a function of what you pay.”


  1. “I pound on my people: taking risk is great. You’ve got to be paid to take the risk. The risk/return ratio is probably the most significant determinant of success as an investor.” “Measuring and gauging the risk reward ratio is the biggest [margin of] safety issue every investor has.” Getting paid for any risk you take is a key part of risk control. In my post on Jeffrey Gundlach I wrote:Taking in risk for its own sake is a sucker’s bet. More risk does not necessarily mean more investment return.” Sam Zell is talking about the same principle here. What you want to find is mispriced risk or uncertainty so you get paid for taking that risk or uncertainty since as Howard Marks has pointed out: “If riskier investments necessarily delivered higher returns they wouldn’t be risky.”


  1. “You can have all of the assets in the world you want, but if you have no liquidity it doesn’t matter.” “Liquidity equals value. At no time in my career has it ever been more clearly brought home to me than in the (2008)-09 period. If you had liquidity, you had value. … Everything comes down to liquidity, everything comes down to exit strategies, everything comes down to knowing when you get in how you are going to get out.” A repeating theme of this series on my blog is Harold Geneen’s admonition: the only unforgivable sin in business is to run out of cash. Being in a situation where lots of people have lots of assets but no cash is like being in a big earthquake. You can’t believe it is happening, but there it is. Sam Zell pointed out http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1069&context=crer that once in 1990 he read in a magazine that he was worth a billion dollars and yet he did not know if he had enough liquidity to make payroll the next Friday. 


  1. “The problem with leverage is that you need to pay it back. The biggest measure of success or failure is how entrepreneurs address and deal with leverage. If you are in the real estate business without leverage, that’s like being a boxer in the ring without a glove.” Some people are more comfortable with debt than others. Some people sleep well knowing that they or businesses they control owe other people billions of dollars. Others can’t seep while owning anyone much of anything.  Learning how to manage debt and you reaction to being in debt is a valuable skill.  Sam Zell is saying that leverage in his business is a not avoidable so he has learned to be really good at managing leverage. 


  1. “Anytime you don’t sell, you buy. So if we had chosen not to sell Equity Office for $39 billion, we would be buying Equity Office for $39 billion.” Sam Zell is talking about what Charlie Munger calls “opportunity cost” thinking. Munger says: “In life, if opportunity A is better than B, and you have only one opportunity, you do A. There’s no one-size-fits-all. If you’re really wise and fortunate, you get to be like Berkshire. We have high opportunity costs. We always have something we like and can buy more of, so that’s what we compare everything to. We know we’ve got opportunity X, which is better than the new opportunity. Why do we want to waste two seconds thinking about the new opportunity?”


  1. “I would tell you whatever business I’ve been in — real estate, barges, rail cars — it’s all about supply and demand.” “When there is no supply, real estate performs very well. Almost without regard, within reason to the economic conditions. When there is over supply, it doesn’t matter what’s going on real estate is going to suffer.” Economics is far simpler than most people imagine, especially for a business person.  Your task in business is to create a situation where supply is at least somewhat limited by some phenomenon. successfully deal with competitors a business will need what Harvard Business School Professor Michael calls a “sustainable competitive advantage.” Warren Buffett calls this same characteristic a “moat.” Michael Porter: “That free entry dissipates economic profit is one of the most powerful insights in economics, and it has profound implications for strategy. Firms that base their strategies on products that can be easily imitated or skills and resources that can be easily acquired put themselves at risk. To attain a competitive advantage, a firm must secure a position in the market that protects itself from imitation and entry.”


  1. “Arthur Miller did a huge disservice to entrepreneurship by writing Death of a Salesman. Salesmen are not scummy and dirty – people you would not want to ring your doorbell. In fact, all successful entrepreneurs are salesmen.” Selling is a highly underrated skill in life. Everyone can benefit from learning how to sell better since in addition to products and services people must sell ideas, causes and many other things in life. Salespeople tend to be highly compensated since the activity is (1) hard and (2) requires real skill. Sam Zell has gone as far as to say: “Nothing is bought and everything is sold.”


  1. “Business schools are beginning to change, but particularly in the ‘80s the business schools focused on if you could just turn the page there’s the formula that tells you how to do it. And the answer is there are no formulas and – and success and failure are – are a combination of judgment and an external event. But it starts and ends with a simple idea.”  “Don’t get confused by education: Simpler solutions are most often better solution!” Sam Zell is talking about a point made by Ben Horowitz in his book The Hard Things About Hard Things which I wrote a post about recently http://25iq.com/2015/07/05/a-dozen-things-ive-learned-from-ben-horowitz-about-management-investing-and-business/.  The real world of business cannot be navigated successfully simply by applying simple formulas or following a recipe for success. There is no substitute for things like learning from experience, good judgment and hard work in life.


  1. “Entrepreneurs basically not only see the opportunities, but also the solutions.” “A critical element to a successful entrepreneur- he or she thinks in themes, not in single events.”  “I don’t know too many insecure successful entrepreneurs.” “Fear and courage are very closely related. Anybody who does not understand fear does not know courage.” “Entrepreneurs don’t fail – things sometimes just don’t work out. But, that’s it.” “Entrepreneurs don’t just deal with risk, they have risk appetite. They look for change that will make the difference.” “An entrepreneur is a guy who thinks outside of the box, a person who does not accept the conventional. He constantly asks ‘what if?’, ‘could I?’, or ‘should I?’”  “There is a Confucian saying: ‘The definition of a schmuck is someone who reached his goal.’ Entrepreneurs always keep going – they never stop.   “It is lonely being an entrepreneur. Often, you turn around and ask: where is everybody?” This set of quotes makes an number of important points about being an entrepreneur including the idea that courage is a highly underappreciated driver of the success of entrepreneurs. If you don’t get in the game, you can’t win. Perhaps the best way to end this post is with a joke Sam Zell once told:  I’ll tell you a story that I think is probably the most significant advice that I give young entrepreneurs. A pious Jew is facing bankruptcy, and he beseeches God repeatedly each week to let him win the lottery to save his livelihood. The first week, he doesn’t win. The second week, he doesn’t win. But the third time, a flash of light appears, and from up high, comes a voice — and it’s the voice of God — and he says ‘You’ve got to buy a ticket!’”




Rough Rider http://www.newyorker.com/magazine/2007/11/12/rough-rider


Entrepreneurship Talk http://innovateblue.umich.edu/memorable-quotes-from-sam-zells-entrepreneurship-talk-by-thomas-zurbuchen/


Kellog School http://kelloggschool.tumblr.com/post/77181962926/a-packed-auditorium-welcomed-equity-group


Bloomberg Interview http://genius.com/Sam-zell-2-5-2014-bloomberg-interview-annotated


Grave Dancer http://www.valuewalk.com/2015/06/grave-dancers-sam-zell/


Wharton: http://knowledge.wharton.upenn.edu/article/real-estate-developer-and-grave-dancer-sam-zell-its-all-about-supply-and-demand/


Interview: http://knowledge.ckgsb.edu.cn/2012/09/26/finance-and-investment/investment-guru-sam-zell-any-time-you-dont-sell-you-buy/


Forbes: http://www.forbes.com/sites/kerenblankfeld/2011/01/27/billionaire-sam-zells-advice-to-entrepreneurs/


Ackman and Zell: http://www.ibtimes.com/bill-ackman-and-sam-zell-turnarounds-opportunities-and-success-440096