“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.” http://www.scribd.com/fullscreen/110302239?access_key=key-28dmiqkoda00xd7b7mae
A Lattice of Mental Models
Understanding how humans make decisions is critical for any investor. Unless careful attention is devoted to decision making processes the brain can be a mistake-making machine.
“It is remarkable how much long-term advantage people like [Warren Buffett and myself] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471446912,descCd-tableOfContents.html
One way to “be less stupid” is to adopt what Charlie calls a “lattice of mental models” approach to evaluating decisions. He believes that by using a range of different “models” from different disciplines like psychology, history, mathematics, physics, biology and economics, a person can use the combined output to produce something he calls “Worldly Wisdom.”
Munger’s method is to first assemble all the relevant facts and then apply a rational process to produce an analysis of those facts and an investing thesis. To increase the probability that the process is actually rational Munger applies multiple models from various disciplines like psychology, mathematics, statistics history, physics, biology and economics searching for sources of human misjudgment. It is in effect a form of “double/multiple check” on the investing process. Munger believes that by going over your decision making process carefully using these additional “filters” from many disciplines you can more consistently “not be stupid”. You will always make some bone-headed mistakes even if you are careful, but Munger’s process is designed to decrease the probability of mistakes.
Munger refers to this approach to problem solving as a:
“2 track analysis: what are the factors that really govern the interests involved here rationally considered (i.e. macro and micro level economic factors) and what are the subconscious influences where the brain at a subconscious level is automatically forming conclusions (i.e. influences from instincts, emotions, cravings, and so on)”
“what are the factors that really govern the interests involved rationally considered (i.e. macro and micro level economic factors) and what are the subconscious influences where the brain at a subconscious level is automatically” http://moneyarchive.wordpress.com/2008/09/07/the-charlie-munger-checklists/
Munger believes that it is critical for a person think broadly since to not do so is to invite mistakes.
“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.” http://www.thinkfn.com/en/content/view/52/?id=124
In creating his “lattice of mental models” approach Munger took his cue from Benjamin Franklin a renaissance man/polymath who he admires greatly.
In the language of Philip Tetlock http://en.wikipedia.org/wiki/The_Hedgehog_and_the_Fox, Munger is a “fox” (knows a little about a lot) by nature rather than a “hedgehog” (knows a lot about very little). In terms of “foxes” that one may encounter in life Charlie is someone truly special. Bill Gates has said about Charlie: “Charlie Munger is truly the broadest thinker I have ever encountered.”
What an investor is dealing with when making investing decisions is a nest of “complex adaptive systems” which makes his or her job genuinely hard. This means, says Munger:
“An investment decision in the common stock of a company frequently involves a whole lot of factors interacting … the one thing that causes the most trouble is when you combine a bunch of these together, you get this lollapalooza effect.” http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htm
If one adopts the model of “complex adaptive systems” one accepts the idea that there are many things that can not be modeled with certainty. In Charlie’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. Munger: “People calculate too much and think too little.” http://www.fool.com/news/foth/2002/foth020515.htm
Charlie’s breadth of knowledge is something that is naturally part of his character but also something that he intentionally cultivates. To know nothing about an important subject is to invite problems.
“What is elementary, worldly wisdom? 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. 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.” http://www.amazon.com/exec/obidos/ASIN/1578643031/consciousinve-20/104-7644521-2497538
Munger illustrates this idea by pointing out that many professionals often think only about their own discipline and think that whatever it is that they do for a living will cure all problems. A nutritionist may feel as if she can cure anything for example. Or a chiropractor may believe he can cure depression. Munger calls this “man with a hammer” syndrome since to such a person “everything looks like nail” even though it may not be a nail.
Charlie has said many times that someone who is really smart but has devoted all their time to being an expert in a narrow area may actually be dangerous to themselves and others. One example of this are most macroeconomists who think they understand the economy but are disasters in investing their own portfolios. As another example, marketing experts may think that most everything can be solved via that discipline. Financiers tend to think similarly about their own profession. Too many people believe what they do at work is hard and what others do is easy.
Charlie believes that the best approach to dealing with this set of problems can be found in adopting a multidisciplinary approach.
“you’ve got to have multiple models. And 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. … 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.” http://www.amazon.com/exec/obidos/ASIN/1578643031/consciousinve-20/104-7644521-2497538
Munger believes that by learning to recognize certain dysfunctional decision making processes an investor can learn to make fewer mistakes. As was noted in the first post in this series mistakes can’t be eliminated. The best one can hope for is to reduce their frequency and hopefully magnitude. Charlie:
“Man’s imperfect, limited-capacity brain easily drifts into working with what’s easily available to it. And the brain can’t use what it can’t remember or when it’s blocked from recognizing because it is heavily influenced by one or more psychological tendencies bearing strongly on it…” “…the deep structure of the human mind requires that the way to full scope competency of virtually any kind is learn it all to fluency – like it or not.” http://www.poorcharliesalmanack.com/pca.php
To sum up is blog post it is useful I think to just quote Charlie 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.” http://www.valueinvestingworld.com/2007/05/charlie-munger-usc-law-school.html
In blog posts to follow I will try to apply “Munger’s methods” to a series to specific problems. For example, in looking at a decision: are there dysfunctional decision making heuristics from psychology that may have caused an error? As another example, Charlie likes to use a model from Algebra and “invert” to find a solution for problems. Looking for models to explain mistakes so one can accumulate “Worldly Wisdom” is actually lots of fun. It is like a puzzle to be solved.
Charlie likes checklists.
“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.” http://investdigest.blogspot.com/2006/02/charlie-mungers-investing-mental.html
His most comprehensive checklist can be found in Poor’s Charlie Almanack http://www.amazon.com/Poor-Charlies-Almanack-Wisdom-Charles/dp/1578643031 which is reproduced below. Some of the topics have been covered to date and some have not. I hope to get to most if not all of them eventually.
Risk – All investment evaluations should begin by measuring risk, especially reputational
- Incorporate an appropriate margin of safety
- Avoid dealing with people of questionable character
- Insist upon proper compensation for risk assumed
- Always beware of inflation and interest rate exposures
- Avoid big mistakes; shun permanent capital loss –
Independence “Only in fairy tales are emperors told they are naked”
- Objectivity and rationality require independence of thought
- Remember that just because other people agree or disagree with you doesn’t make you right or wrong – the only thing that matters is the correctness of your analysis and judgment
- Mimicking the herd invites regression to the mean (merely average performance)
Preparation “The only way to win is to work, work, work, work, and hope to have a few insights”
- Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day
- More important than the will to win is the will to prepare
- Develop fluency in mental models from the major academic disciplines
- If you want to get smart, the question you have to keep asking is “why, why, why?”
Intellectual humility – Acknowledging what you don’t know is the dawning of wisdom
- Stay within a well-defined circle of competence
- Identify and reconcile disconfirming evidence
- Resist the craving for false precision, false certainties, etc.
- Above all, never fool yourself, and remember that you are the easiest person to fool –
Analytic rigor – Use of the scientific method and effective checklists minimizes errors and omissions
- Determine value apart from price; progress apart from activity; wealth apart from size
- It is better to remember the obvious than to grasp the esoteric
- Be a business analyst, not a market, macroeconomic, or security analyst
- Consider totality of risk and effect; look always at potential second order and higher level impacts
- Think forwards and backwards – Invert, always invert –
Allocation – Proper allocation of capital is an investor’s number one job
- Remember that highest and best use is always measured by the next best use (opportunity cost)
- Good ideas are rare – when the odds are greatly in your favor, bet (allocate) heavily
- Don’t “fall in love” with an investment – be situation-dependent and opportunity-driven –
Patience – Resist the natural human bias to act
- “Compound interest is the eighth wonder of the world” (Einstein); never interrupt it unnecessarily
- Avoid unnecessary transactional taxes and frictional costs; never take action for its own sake
- Be alert for the arrival of luck
- Enjoy the process along with the proceeds, because the process is where you live –
Decisiveness – When proper circumstances present themselves, act with decisiveness and conviction
- Be fearful when others are greedy, and greedy when others are fearful
- Opportunity doesn’t come often, so seize it when it comes
- Opportunity meeting the prepared mind; that’s the game –
Change – Live with change and accept unremovable complexity
- Recognize and adapt to the true nature of the world around you; don’t expect it to adapt to you
- Continually challenge and willingly amend your “best-loved ideas”
- Recognize reality even when you don’t like it – especially when you don’t like it –
Focus – Keep things simple and remember what you set out to do
- Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat
- Guard against the effects of hubris (arrogance) and boredom
- Don’t overlook the obvious by drowning in minutiae (the small details)
- Be careful to exclude unneeded information or slop: “A small leak can sink a great ship”
- Face your big troubles; don’t sweep them under the rug [checklist from http://www.valueinvestingworld.com/2007/12/investing-principles-checklist-from.html quoting Poor Charlie’s Almanack]
- Charlie Munger on Investment Concentration versus Diversification
- Charlie Munger on The Psychology of Human Misjudgment