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