See book on Amazon.
I thought I knew the power of compound interest, but this gave me a new perspective and got me thinking. Seven percent annual compound interest is a somewhat reasonable expectation for a return on investment. Charlie himself achieved some stable 15-20% compound returns with his partner Warren Buffett at Berkshire Hathaway, and he definitely is an authority to look up to if you're interested in a sound investment philosophy.
To me, compound interest makes perfect sense, it’s just that we as humans never quite think in such long time spans or let our capital work for us without unnecessarily interrupting this process that Einstein called “the eighth wonder of the world”. More than three centuries is a long time-horizon, but 7% compound annual growth is quite reasonable in terms of what many investors today would strive for against the risk assumed.
It's interesting for me to learn about Charlie’s approach to mental models and checklists as a simple, yet incredibly powerful set of tools in all walks of life. He showcases how, when combined, they become a profound and interwoven framework to organize our thoughts in the complex world around us.
What I found very interesting about Charlie was that he too thinks that Freud, as the "father of psychoanalysis", is one of the biggest fools in history. It’s an unfortunate mess in academic psychology that some practical psychological phenomena are nowhere to be found in even the greatest universities. Things like envy, social-proof and many other related and core human biases and psychological workings are missing in most schools. Additionally, in the greater picture there is a mind-boggling lack of cross-disciplinarity in academia.
On the other hand, I’m not as sure of the exact usefulness of inverting problems like Charlie recommends you to always try, neither do I still know where and how to most usefully employ the psychological behavior checklist that he presented in his last, expanded talk of the book. Understanding all this is nonetheless critical so you can start recognizing the human factors and variables in play at any given time.
Let’s jump right in.
- Mental models
- "I'll do it myself"
- Investing approach
- The limits of compounding
- Why don't we see more of such thinking?
- Reducing complexity
- On financial statements and making an assessment
- Projections and forecasting
- On old age
- Other quotes
Munger’s “Multiple Mental Models” approach to business analysis and assessment: “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 and try to solve all problems 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.
Multiple mental models serve as a framework for gathering, processing and acting on information. They borrow from and really stitch together the analytical tools, methods and formulas from such traditional disciplines as history, psychology, mathematics, engineering, biology, physics, chemistry, statistics and economics.
Just as multiple factors shape almost every system, multiple models from a variety of disciplines, applied with fluency are needed to understand the system.
“You have to realize the truth of biologists Julian Huxley’s idea that life is just one damn relatedness after another so you must have mental models and you must see the relatedness and the effects from the relatedness.”
When properly collected and organized his “Multiple Mental Models” (about one hundred in number, Charlie estimates) provide a context or “latticework” that leads to remarkable insights as to the purpose and nature of life.
“I’ll do it myself”
When my friend Buffett and I left our respective graduate schools, we found huge predictable patterns of obvious extreme irrationality in the business world. This irrationality was grossly important in what we were trying to do, yet it had never been mentioned by our professors. Our solution, one we learned at a very early age in the nursery: “Then I’ll do it myself,” said the little red hen. So if your professors won’t give you an appropriate multidisciplinary approach, if each wants to overuse his own models and underuse the important models in other disciplines, you can correct that folly yourself.
Since human beings began investing, they have been searching for a magic formula or easy recipe for wealth.
Charlie’s approach to investing is quite different from the more rudimentary systems used by most investors. Instead of making a superficial stand-alone assessment of a company’s financial information, Charlie conducts a comprehensive analysis of both the internal workings of the investment candidate as well as the larger, integrated “ecosystem” in which it operates.
It is as if he lives in a different world from the most investors when it comes to investment analysis. His approach accepts the reality that investment problems are inherently complex. Aligned with the rigor of scientific enquiry he attacks it with a staggering degree of preparation and broad based research.
He seeks to discover the universe hitched to each of his investment candidates by gaining a firm grasp on all, or at least most, of the relevant factors comprising both its internal and external environment. His models supply the analytical structure that enables him to reduce the inherent chaos and confusion of a complex investment problem into a clarified set of fundamentals.
Examples of these models include:
- the redundancy/backup system model from engineering,
- the compound interest model from mathematics,
- the breakpoint/tipping-moment/autocatalysis models from physics and chemistry,
- the modern Darwinian synthesis model from biology and
- cognitive misjudgement models from psychology.
Charlie counts preparation, patience, discipline and objectivity among his most fundamental guiding principles. He will not deviate from these principles, regardless of group dynamics, emotional itches, or popular wisdom that “this time around it’s different.” When faithfully adhered to, these traits result in one of the best-known Munger characteristics: not buying or selling often! Munger, like Buffett, believes a successful investment career boils down to only a handful of decisions. So when Charlie likes a business, he makes a very large bet and typically holds the position for a long period.
In his view a portfolio of three companies is plenty of diversification. Accordingly, Charlie is willing to commit uncommonly high percentages of his investment capital to individual “focused” opportunities. Find a Wall Street organization, financial advisor, or mutual fund manager willing to make that statement!
The limits of compounding
The $ 24 real estate investment by the Dutch to buy the island of Manhattan would today, by some estimates, be roughly equivalent to $ 3 trillion. Over 378 years, that’s about a seven percent annual compound rate of return.
Why don’t we see more of such thinking?
Perhaps the answer is that, for most people, Charlie’s multidisciplinary approach is simply too hard. Further, few investors share Charlie’s willingness to appear foolish by not following “the herd”. Religious in his objectivity, Charlie is content to swim against the tide of popular opinion - indefinitely if necessary, which is a rare attribute in the average investor. And while this behavior can at times appear simply stubborn or contrarian, that is not the defining characteristic. Charlie is simply content to trust his own judgement even when it runs counter to the wisdom of the herd.
“It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.” - Charlie Munger
“In making investments, I have always believed that you must act with discipline whenever you see something you truly like. As a securities investor, you can watch all sorts of business propositions in the form of security prices thrown at you all the time. For the most part, you don’t have to do a thing other than be amused. One common problem for investors is that they tend to swing too often. This is true for both individuals and for professional investors operating under institutional imperatives, one version of which drove me out of the conventional long/short hedge fund operation. However, the opposite problem is equally harmful to long-term results: You discover a great opportunity but are unable to swing with the full weight of your capital.”
Charlie strives to reduce complex situations to their most basic, unemotional fundamentals. Yet, within this pursuit of rationality and simplicity, he is careful to avoid what he calls “physics envy”, the common human craving to reduce enormously complex systems (such as those in economics) to one-size-fits-all Newtonian formulas. Instead he faithfully honors Albert Einstein’s admonition, “A scientific theory should be as simple as possible, but no simpler.” Or in his own words, “What I’m against is being very confident and feeling that you know, for sure, that your particular action will do more good than harm. You’re dealing with highly complex systems wherein everything is interacting with everything else.”
On financial statements and making an assessment
Charlie treats financial reports and their underlying accounting with a “midwestern” dose of skepticism. At best, they are merely the beginning of a proper calculation of intrinsic valuation, not the end. The list of additional factors he examines is seemingly endless and includes such things as the current and future regulatory climate, state of labor, supplier and customer relations, potential impact of changes in technology, competitive strengths and vulnerabilities, pricing power, scalability, environmental issues, and notably, the presence of hidden exposures (Charlie knows that there is no such thing as a riskless investment candidate, he’s searching for those few risks that are easily understandable). He records all financial statement figures to fit his own view of reality, including the actual free or “owners” cash being produced, inventory and other working capital assets, fixed assets, and such frequently overstated intangible assets as goodwill.
He also completes an assessment of the true impact, current and future, of the cost of stock options, pension plans, and retiree medical benefits. He applies equal scrutiny to the liability side of the balance sheet. For example, under the right circumstances, he might view an obligation such as insurance float-premium income that may not be paid out in claims for many years more properly as an asset.
He especially assesses a company’s management well beyond conventional number crunching, in particular, the degree to which they are “able, trustworthy and owner-oriented.” For example, do they deploy cash? Do they allocate it intelligently on behalf of the owners, or do they overcompensate themselves, or pursue ego-oriented growth for growth’s sake? Above all he attempts to assess and understand the competitive advantage in every respect. Products, markets, trademarks, employees, distribution channels, societal trends and so on, as well as the durability of these advantages.
Superior companies have deep moats that are continuously widened to provide enduring protection. In this vein, Charlie carefully considers “competitive destruction” forces that, over the long term, lay siege to most companies. Few businesses survive over multiple generations.
Finally, Charlie seeks to calculate the intrinsic value of the whole business and, with allowance for potential dilution, etc., to determine an approximate value per share to compare to market prices.
At this point only a superior investment candidate will still be in the running. But Charlie does not immediately rush out and buy it. Knowing that a necessary companion to proper valuation is proper timing. Prior to pulling the trigger, he consults his checklist, which is especially useful in evaluating what he refers to as “close calls”. The checklist includes such items as: What are current price, volume, and trading considerations? What disclosure timing or other sensitivities exist? Do contingent exit strategies exist? Are better uses of capital currently or potentially available? Is sufficient liquid capital currently on hand or must it be borrowers? What is the opportunity cost of capital? And so on.
While poor outcomes are excusable in the Munger - Buffett world, given the fact that some outcomes are outside of their control. Sloppy preparation and decision making are never excusable because they ARE controllable.
“How can smart people so often be wrong? They don’t do what I’m telling you to do: use a checklist to be sure you get all the main modes and use them together in a multi modular way.” - Charlie Munger
You’ve got all the tools. And you’ve got to have one more trick. You’ve got to use those tools checklist-style because you’ll miss a lot if you just hope that the right tool is going to pup up unaided whenever you need it. But if you’ve got a full list of tools and go through them in your mind, checklist-style, you will find a lot of answers that you won’t find any other way.
List of practical psychological factors
Charlie maintains his own checklist for practical psychological effects which are not for whatever reason looked very much into by typical academic psychology, as summarized by Farnam Street:
- Under recognition of the power of what psychologists call reinforcement and economists call incentives.
- Simple psychological denial.
- Incentive-caused bias.
- Bias from consistency and commitment tendency, including the tendency to avoid or promptly resolve cognitive dissonance.
- Bias from Pavlovian association, misconstruing past correlation as a reliable basis for decision-making.
- Bias from reciprocation tendency, including the tendency of one on a roll to act as other persons expect.
- Over-influence by social proof.
- Bias from contrast caused distortions of sensation, perception, and cognition.
- Over-influence by authority.
- Bias from deprival super reaction syndrome, including bias caused by present or threatened scarcity, including threatened removal of something almost possessed but never possessed.
- Bias from envy/jealousy.
- Bias from chemical dependency.
- Bias from gambling compulsion.
- Bias from liking distortion, including the tendency to especially like oneself, one’s own kind, and one’s own idea structures, and the tendency to be especially susceptible to being misled by someone liked.
- Bias from the non-mathematical nature of the human brain in its natural state as it deals with probabilities employing crude heuristics and is often misled by mere contrast.
- Bias from over-influence by extra vivid evidence.
- Stress-induced mental changes, small and large, temporary and permanent.
- The tendency to lose ability through disuse.
- Mental and organizational confusion from the say-something
What happens when these standard psychological tendencies combine? A truly insane compounded effect!
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What should a young person look for in a career?
Three basic rules, meeting all three is nearly impossible, but you should try anyway:
- Don’t sell anything you wouldn’t buy yourself.
- Don’t work for anyone you don’t respect and admire.
- Work only with people you enjoy.
I had the idea at a very early age that the safest way to try to get what you want is to try to deserve what you want. It’s such a simple idea. It’s the golden rule. You want to deliver to the world what you would buy if you were on the other end. There is no ethos in my opinion that is better for any lawyer (Charlie was professionally a lawyer) or any other person to have. By and large, the people who’ve had this ethos win in life, and they don’t win just money and honors. They win the respect and the deserved trust of the people they deal with. And there is huge pleasure in life to be obtained from getting deserved trust.
Another idea, and this may remind you of Confucius too, is that the acquisition of wisdom is a moral duty. It’s not something you do just to advance in life. And there’s a corollary to that idea that is very important. It requires that you are hooked on lifetime learning. Without lifetime learning, you are not going to do very well. You are not going to get very far in life based on what you already know.
Over the years, we’ve tried to figure out why the competition in some markets gets sort of rational from the investor’s point of view so that the shareholders do well, while in other markets there’s destructive competition that destroys shareholder wealth. If it’s a pure commodity like airline seats, you can understand why no one makes any money.
The constant curse of scale is that it leads to big, dumb bureaucracy which, of course, reaches its highest and worst form in government where the incentives are really awful. It doesn’t mean we don’t need government, because we do. But it’s a terrible problem to get big bureaucracies to behave.
Complex bureaucratic procedure does not represent the highest reach. One higher form is a seamless, non-bureaucratic web of deserved trust. Not much fancy procedure, just totally reliable people correctly trusting one another.
Ideal company management, imagining to re-construct the Coca-Cola company: “... third, with so much success coming, we must avoid bad effects from envy, which is given a prominent place in the Ten Commandments, because envy is so much a part of human nature. The best way to avoid envy, recognized by Aristotle, is to plainly deserve the success we get. We will be fanatic about product quality, quality of product presentation, and reasonableness of prices, considering the harmless pleasure we will provide...”
Projections and forecasting
Usually, I don’t use formal projections. I don’t let people do them for me because I don’t like throwing up on the desk, but I see them made in a very foolish way all the time, and many people believe in them, no matter how foolish they are. It’s an effective sales technique in America to put a foolish projection on a desk.
And if you’re an investment banker, it’s an art form. I don’t read their projections either. Once Warren and I bought a company, and the seller had a big study done by an investment banker. It was about this thick. We just turned it over as if it were a diseased carcass. He said, “We paid $2 million for that.” I said, “We don’t use them. Never look at them.”
I have what I call an “iron prescription” that helps me keep sane when I drift toward preferring one intense ideology over another. I feel that I’m not entitled to have an opinion unless I can state the arguments against my own position better than the people who are in opposition. I think that I am qualified to speak only when I’ve reached that state.
Blindly following some extreme ideologies leads to a rigid mindset.
The business of not drifting into extreme ideology is very very important in life. If you want to end up wise, heavy ideology is very likely to prevent that outcome.
On old age
According to Cicero, a passage in the “de Sertare”:
“The best armour of old age is a well spent life preceding it.”
A life employed in the pursuit of useful knowledge, in honorable actions and the practice of virtue; in which he who labors to improve himself from his youth, will in age reap the happiest fruits of them; not only because these never leave a man, nor even in the extremist(ic) old age; but because a conscience bearing witness that our life was well-spent, together with the remembrance of past good actions, yields an unspeakable comfort to the soul.
“Most players gain pleasure from feeling accepted or belonging to the group. The good player however gains pleasure from his ability to cope with the realities of the game.” A personal comment from Santeri: I think especially for kids this is not true. To be sociable and accepted by others is also important. Without social cohesion and capability to interact with others, a human being alienates himself from normal societal development, so be careful with this one.
“Price is what you pay, value is what you get.” Referring to how the United States bought Alaska for 7.2 USD million in gold, in 2006 dollars being an equivalent of 1.67 USD billion, certainly not a folly in terms of the value of oil, minerals, and strategic advantages obtained.
On egalitarianism: “You do not want to choose a brain surgeon for your child by drawing straws to select one of fifty applicants, all of whom take turns doing procedures. You don’t want your airplanes designed in too egalitarian a fashion. You want to provide a lot of playing time for your best players…”
“Another thing to cope with is that life is very likely to provide terrible blows, unfair blows. Some people recover, and others don’t. One’s duty is not to become immersed in self-pity, but to utilize each terrible blow in a constructive fashion.”
“The great lesson in microeconomics is to discriminate between when technology is going to help you and when it’s going to kill you.”
“Ethical practices aren’t good because they pay, they pay because they are good.”
“No matter how smart you are, there are smart people out there who can fool you if they really want to. So, be sure you can trust the smart people you work with.”
Cicero: “To be ignorant of what happened before you were born is to be ever a child. For what is man’s lifetime unless the memory of past events is woven with those of earlier times?”
“I think track records are very important, if you start early trying to have a perfect one in some simple thing like honesty, you’re well on your way to success in this world.”
“If anything, I now believe even more strongly that (1) Reliability is essential for progress in life and (2) While quantum mechanics is unlearnable for a vast majority, reliability can be learned to great advantage by almost anyone.”
“I think the game of competitive life often requires maximizing the experience of the people who have the most aptitude and the most determination as learning machines.”
Bernard de Mandeville: “Altruism harms the state and its intellectual progress. Self-interested human vice is the real engine of progress - private vices are public benefits.”
“Mimicking the herd invites regression to the mean (namely average performance).”
“Develop into a lifelong self-learner through voracious reading, cultivate curiosity and strive to become a little wiser every day.”
“Develop fluency in mental models from the major academic disciplines.”
“Analytic rigor: Use of the scientific method and effective checklists to minimize errors and omissions.”
“Be a business analyst, not a market, macroeconomic or security analyst.”
“Remember that highest and best use is always measured by the next best use (opportunity cost).”
“Don’t fall in love with an investment, be situation dependent and opportunity driven.”
“Compound interest is the eight wonder of the world, as spoken by 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.”
Decisiveness: “When proper circumstances present themselves, act with decisiveness and conviction. Opportunity doesn’t come often, so seize it when it does.”
“Be fearful when others are greedy, and greedy when others are fearful.”
“Enjoy the process along with the proceeds, because the process is where you live.”
“Incorporate an appropriate margin of safety, avoid dealing with people of questionable character and insist upon proper compensation for risk assumed.”
“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.”
“Remember that reputation and integrity are your most valuable assets and can be lost in a heartbeat.”
“The more hard lessons you can learn vicariously, instead of from your own terrible experiences, the better off you will be.”
“Honesty is the best policy.”
See more great book notes here.