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.
- “‘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.
- “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.
- “[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.”
- “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.
- “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.
- “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.
- “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.
- “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.
- “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.
- “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.
- “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.”
- “[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
- A Dozen Things I’ve Learned from Charlie Munger about Mental Models and Worldly Wisdom