We finally made it!
It is with some sadness and some relief that I say that this is the last episode
in the series which covers the billionaire investor Charlie Munger and his mental models.
Let’s have one final recap of what happened last time:
- Limits can be very useful to consider when comparing, measuring and weighing stuff
in the real world
– you’ll get an upper bound to relate to when making your calculations
- 1 amount of input doesn’t always result in 1 amount of output
- Joy in life is arguably a result of both expectations and results.
The simplest way to happiness is to reduce expectations,
rather than trying to achieve the near-impossible
- If you want to be successful in life you mustn’t feel sorry for yourself
or feel that the world is mistreating you
- When you are trying to get someone else to do something for you
always address the 5Ws - who, what where, when, and why.
The Two-Track Analysis
We’ve previously seen that we can be really irrational when we are making our decisions.
We’ll soon get into a brief summary of, arguably, humans’ 25 most important tendencies and biases
– what Charlie Munger refers to as “Psychology of Human Misjudgement”.
Much like a model has its limitations and you don’t want to become like the man with the hammer,
you need to realize that human cognition has its limitations too.
In a modern world, it isn’t very strange that we sometimes fail in interpreting situations rationally.
After all, our species, Homo sapiens, is estimated to have emerged some 300,000 years ago
from Homo erectus.
In other words – we haven’t spent a lot of time in a modern society with internet,
a trading stock market, dating sites etc.
Our brains were simply developed for another time and age.
Molly Munger, Charlie Munger’s daughter, cannot think about a single situation in which
Charlie ever said “just go with your gut!”.
He has probably seen too much madness himself to give such advice.
Because of our irrationalities it can be useful to analyse situations from two perspectives,
and this is Charlie Munger’s Two-Track Analysis.
View situations that you encounter through two separate lenses:
First – try to decipher what is really going on here, rationally speaking.
Then – try to understand and pinpoint the subconscious influences that human irrationality
may have on the issue.
If other people than yourself are included in the situation, their biases and tendencies
must be included, but even if you are on your own, you should try to understand
your own biases and tendencies.
Let’s take an example from the stock market.
Well, generally, you can say that stocks are valued in two different ways.
One, they’re valued much the way wheat is valued, in terms of its perceived practical
utility to the user of the wheat.
And there’s a second way that stocks are valued, which is the way Rembrandts are valued.
And to some extent, Rembrandts are valued high, because in the past,
they’ve gone up in price.
Firstly – rationally speaking – what is a stock actually worth?
We’ve discussed this before, and the answer is that, in a rational world,
it is worth the sum of its future dividends – discounted at an appropriate interest rate.
But we know that his isn’t always the case.
Stocks aren’t always valued at their rational levels.
In the next model, we shall list 25 of the most common biases and irrationalities
of our species, according to Charlie Munger.
Keep an eye out for factors that you think may influence a share price to be
irrationally high or irrationally low.
Psychology of Human Misjudgement
Here follows 25 human tendencies which sometimes leads us to do really crazy things:
1. Reward and Punishment.
People will repeat behaviour that seem to work and try to quit behaviour that seem to hurt.
2. Liking/Loving.
We tend to ignore faults of that which we like or love.
3. Dislike/Hating.
We tend to amplify faults of that which we do not like.
4. Doubt Avoidance.
We tend to come to conclusions too quickly.
5. Inconsistency Avoidance.
It’s difficult to change habits and beliefs.
6. Curiosity.
We want answers and we seek them.
7. Kantian Fairness.
We expect people to follow a behaviour that, if followed by others, creates a system
which works best for everybody.
8. Envy/Jealousy.
We think it is painful to see someone else in possession of that which we aspire to have.
If you haven’t seen the video of the two monkeys who receive different rewards
for the same task, I think you should.
9. Reciprocation.
An eye for an eye and a gift for a gift.
10. Influence from Mere Association.
We tend to like things that are associated with what we already like, and dislike things
that are associated with what we already dislike.
11. Pain-Avoiding Denial.
If reality is too tough to handle, we’ll distort it until it becomes bearable.
12. Excessive Self-Regard.
90% of Swedes think they are above average drivers.
13. Overoptimism.
We think that we are likely to defy the odds, even in activities which clearly involves
no skills, such as lotteries.
14. Deprival.
It’s cliché, but you don’t know what you’ve got ‘til you’re missing it a lot.
15. Social Proof.
This is the herd mentality that can bring destruction to you as an investor
if you succumb to it.
16. Contrast.
We think that the $50 bowtie is cheap right after we’ve purchased the $500 suit.
17. Stress.
Heavy stress causes much cognitive dysfunction, and it often exaggerates
what has already been discusses.
18. Availability Misweighing.
Vivid and recent experiences are more memorable which causes us to think
that they are more important when making decisions.
19. Use it or Lose it.
All skills deteriorate over time, and skills of a very high order may have to be maintained daily.
20. Drug Misinfluence.
Don’t drink and invest.
21. Senescence.
With age cognitive functions will deteriorate.
22. Authority.
We tend to follow authority without asking too many questions.
23. Twaddle.
As social animals we sometimes speak without thinking first
– some are more prone to this that others.
24. Reason Respecting.
We respect the “why”, even though it may be complete nonsense
such as in Ellen Langer’s experiment with the copy machine.
25. Lollapalooza.
We haven’t revived this mental model yet, but we shall really soon.
Many of these ideas come from Robert Cialdini who wrote the book Influence.
Charlie Munger actually gave Cialdini a share of Berkshire Class A to thank him for what
he had contributed to mankind.
Checklists
This is such a simple, yet such an effective tool.
No pilot ever takes off without first checking his list of security questions,
and for good reasons.
A mistake at high altitude can be truly costly for both himself, his crew,
and the passengers on the plane.
As we are close to the end of this series, this mental model of approaching
the world checklist-style makes sense to discuss.
Any time you want to make a rational decision, when the outcome of that decision is important
enough for you to spend some energy on it, you should go through the mental models
that we’ve discussed in this series in a checklist-manner.
This is how Charlie Munger himself applies them.
If you don’t use your mental models checklist style you’ll miss a lot,
because the right tool is probably not going to pop up
whenever you need it if you haven’t practiced a ton before.
You can apply the same method when you are evaluating
the second part of the Two-Track analysis that we just discussed.
Run through the list of the 25 tendencies of the Psychology of Human Misjudgement.
Actually, let’s do that now to answer the question that we posed before
– why are stocks sometimes valued at irrational levels?
Well, the first point is definitely included.
If a stock has gone up previously, people have gotten rich from this, and this tends
to motivate other people to buy that same stock,
to repeat the behaviour that arguably have worked in the past.
Point number 5 of Inconsistency Avoidance can oftentimes be involved too.
This is the reason why you probably shouldn’t go around
and talk about your stock market investments.
You’ll set yourself up for some painful decisions later on when you may have to go
against what you’ve previously boasted about.
Point number 13 is involved from time to time, especially when it comes to companies
that are more of the lottery-ticket type.
Number 15 may be the most important one.
Once a critical mass of people are involved in a certain behaviour
it is very difficult to avoid getting on the band-wagon yourself.
This makes it so that behaviour is self-reinforcing to some degree.
You see that there are a lot of reasons as to why the stock market can be valued
irrationally from time to time.
When these factors work in tandem in a certain direction, you’ll get a Lollapalooza Effect.
When multiple forces act in the same direction – it’s high-stakes time.
It can kill you, or it can make you very, very rich, for instance,
depending on the direction of the forces.
The Lollapalooza Effect is one of Charlie Munger’s most cited mental models,
and it basically means the following: 1 + 1 isn’t always equal to 2.
Sometimes it might be 3.
And 1 + 1 + 1 definitely isn’t always 3, it may be as high as 5 or 6.
Let’s take the example of entrepreneurship.
One could argue that an entrepreneur’s success depends on three different factors:
Marketable skills, leverage, and effort.
(Mind you that this is very simplified, there are many more involved)
With marketable skills I mean simply how valuable your knowledge or work is to the world.
Knowing how to do heart surgery is arguably going to be more valuable to other people
than knowing the history of landscaping in your garden.
Leverage is how many outside people and how much outside capital that you can add
in your business system and effort should be quite self-explanatory.
Now, for those of you who like to think about these things mathematically,
this cube represents the entrepreneur, and its volume represents his or her success.
Each side of the cube represents one of the three factors – either marketable skills,
leverage or effort.
Say that the cube starts at 1 cubic success, each side has a value of 1.
What happens if you add 1 to your effort?
Your entrepreneurial success just grew to 2, that’s great!
But what if you add 1 in effort and 1 in marketable skills?
1 + 1?
Your entrepreneurial success just grew to a 4! 1 + 1 = 4.
And yep, you guessed it, if you add 1 + 1 + 1, it will get even crazier.
Your entrepreneurial success just grew to an 8.
One of the most publicized experiments on human psychology was conducted by
Stanley Milgram in the 1960s and it shows the opposite side of the Lollapalooza Effect
– what happens when multiple factors reinforce each other to cause harm.
In this experiment, participants were asked by authoritative figures to send increasingly
harmful electrical shocks through other people.
The shocks were of course fake, but they seemed real to the participants.
The experiment concluded that people are willing to hurt others, albeit reluctantly,
to obey authorities.
The experiment also concluded that this may explain the inhuman behavior seen
during concentration camps and the Holocaust.
What the researchers missed, according to Munger, is that authority is far from
the only factor from Human Misjudgement at play here.
There were a Lollapalooza Effect of combining factors working in the same direction
which caused people to be able to do such cruel things to their fellow men.
Chauffeur Knowledge
There is a difference between knowing the path and walking the path.
Max Planck, a Nobel Prize winning physicists,
used to give standard lectures about quantum physics around Germany.
According to the story he had the same chauffeur driving him to these lectures,
and Planck practiced for his lecture so much that,
after a while, the chauffeur had memorized the whole thing.
This must have been an unusual chauffeur indeed.
He decided to asked Planck if it would be possible for him to give the lecture
while Planck himself sat in the front row wearing his chauffeur hat?
Planck tested the chauffeur and decided that it could be a funny prank.
So, the chauffeur got up on the stage in Munich
and gave this standard lecture on quantum physics.
By the end of the lecture a physic professor in the audience stood up
and asked a really advanced question.
The witty chauffeur-speaker said:
“Well, I’m surprised that in an advanced city like Munich, I get such an elementary question.
I’m going to ask my chauffeur to reply.”
While this story’s purpose primarily is to be entertaining,
it contains an important lesson.
You do not want to be the person with this “chauffeur knowledge”.
A person who has only chauffeur knowledge is someone who has learned to repeat
what someone else is saying, Max Planck for instance,
but when he gets a question which is related to what he’s been repeating, he cannot answer.
Almost like a parrot – he can mimic some sounds,
but he has no clue what he is talking about.
With that – I want to say that you cannot learn these mental models
like you learn them for a test in school.
You need to learn them so that they will become a part of your daily repertoire.
You need to go through them, checklist-style,
whenever you bump into a problem with high stakes.
Keep running them against reality and you will soon learn how they actually work,
and you will go beyond chauffeur knowledge.
Munger argues that an effective way to repeat your skills and avoid becoming rusty
is to read the leading business papers, such as the Wall Street Journal, Barron’s,
the Economist etc. and apply your models there.
Repetition is the mother of all learning, and you’d rather learn from other peoples’
mistakes and experiences than from your own.
Both because there’s less downside, and because you can speed up your learning process.
With that said, I really have nothing to add.
35 mental models later, I hope that some of your previously cherished beliefs have been
crushed like I promised in the beginning of this, I know some of mine have.
If you just cannot get enough about mental models, I would suggest that you check out
Nassim Taleb’s famous Incerto series.
Taleb is, alongside Munger and Buffett, the person who have influenced
my own thinking process the most during the last few years.
Cheers!