We’re now at the, let’s see … one, two, three four …
… fourth part in the series where we take a look at the most important
mental models of the billionaire investor Charlie Munger.
In the last part we learned that:
- To avoid getting hurt by people with the wrong incentives,
you must learn to use independent thinking
- You can cut through the complexities of our world
by always focusing on the most fundamental ideas,
and be certain that you get these right
- Industries that are undergoing a lot of change are, by their nature, more difficult to predict,
which mean that technology is more of a problem than an opportunity for the long-term investor
- If you want to become wise – don’t stop asking why, why, why, just because you are an adult; and
- Limit your investment decisions to those areas that you understand very well
Now, let’s kick this video off with one of my favorite mental models for the modern investor:
Filters
Chess computers were first able to beat strong human chess players in the late 1980s,
although the crème de la crème were still better than the computers at this point.
The machines could make 100,000s of computations per second,
many more than any human could ever hope to reach.
So, how come that some humans were still beating the computers?
It was because humans used filters, while computers didn’t.
Humans were still superior because they could eliminate some 99.99% of all possible moves
without even thinking about them.
Filters is a hugely important tool for the modern investor.
There are tens of thousands of publicly traded companies in the world,
which means that you do not have time to consider all of them
on any kind of deeper level.
What you want to do is to narrow down the list of investment opportunities
to something more manageable, preferably to a new set of companies where you gauge
that the returns should be better than the average.
This is totally inverted by the way.
You are trying to find what you want to invest in by first excluding what you do not want to invest in.
Filters can be fairly personal, but let’s talk about what Charlie Munger and Warren Buffett
typically use in their investment approach.
Their first filter is the accounting figures of a company.
Munger has said the following:
“We tend to judge by the past record.
By and large, if the thing has a lousy past record and a bright future,
we’re going to miss the opportunity.”
It wasn’t explicitly stated here what Munger means with a “lousy past record”,
but I’m fairly certain that a company pass this filter
if it has a combination of historically stable earnings and a higher-than-average return on assets.
Also, make sure that these earnings are, at least to a large extent, distributable to shareholders.
Secondly, they apply something which we talked about in the last video – their circle of competence.
Just by reading the description of a company on, for instance, yahoo.com,
you can often filter out lots and lots of companies.
Thirdly, you can use my favorite mental model,
which is opportunity costs.
If you already own shares in a few great companies you can compare
new opportunities with these and eliminate them if they do not meet your previous standards.
I would argue that one filter that’s useful in investing is the simple idea of opportunity cost.
If you have one opportunity that you already have available in large quantity,
and you like it better than 98 percent of the other things you see,
well, you can just screen out the other 98 percent because you already know something better.
Fourthly, Munger stay away from companies where he does not feel that he can trust the managers.
This can be either: a. Because they seem dishonest;
or b. Because they seem to lack the needed skillset
This is not necessarily a complete list of Munger and Buffett’s filters,
but it is a start.
Choosing investments is a complex task, but you can simplify the matter
by starting out with the no-brainer decisions,
such as the filters that have been presented here.
The Fat-Pitch Strategy
You know, if a mountain stands up like Everest,
you don’t have to be a genius to recognize that it’s a high mountain.
In 1941, the legendary baseball player Ted Williams posted a 0.406 batting average for that season
which makes him the last Major League Baseball player to bat over 0.4 in single season.
His secret? He insisted on only hitting the ball when he was given a really good pitch.
He divided the strike zone into 77 cells, each representing the size of a baseball.
He then insisted on swinging at balls only in his best cells.
The investing game that Charlie Munger plays
is arguably very similar to how Ted Williams acted as a hitter.
Charlie calls this “sit on your ass investing”, and he has said the following:
“I didn’t get to where I am by going after mediocre opportunities.”
If a movie about great investing is ever made with Jim Carry in the lead role, it would be called “No man”.
Warren Buffett is famous for saying that he could improve most peoples’ lifetime investing results
by giving them a ticket with twenty punches in it,
representing all the investments that they are allowed to make over that lifetime.
If you’re only allowed to pick 20 stocks ever, you’ll think very carefully about each and every one of your decisions.
Life all comes down to a few moments. This is one of them.
Of course, the art of sitting on your ass and waiting for the perfect investment opportunities
sounds very easy in theory, but it is a lot more difficult in practice.
Especially when everyone around you, or at least those who talk about it on social media,
seem to become wealthy overnight by investing in Tesla or cryptos. Patience is key here.
If one adheres to this strategy, there will be very few mistakes in one’s investment career.
The mistakes will also change in their nature, from being errors of commission to errors of omission.
Munger and Buffett admit to having made a few large mistakes of omission
through their investing career.
For instance, they missed investing in the pharma industry back in the 80s.
Admittedly, they also missed Google and Walmart, businesses that were in their circle of competence
but that they couldn’t pull the trigger on.
Nonetheless, mistakes of omission are much more forgiving to make as an investor.
Remember, the first rule of investing club is - you do not lose money
The second rule of investing club is - you DO NOT lose money.
Perhaps even more importantly –
if you wait for the fat-pitch, you’ll have some dry powder to spend when it actually does show up.
Because You are Worth it
Charlie Munger has said the following:
“What’s the best way to get a good spouse?
The best single way is to deserve a good spouse because a good spouse is by definition not nuts.”
This is perhaps the oldest trick in the book, and surprise, surprise - it works.
The best way to get what you want (perhaps even the only way, which we’ll get to) is to deserve what you want.
If you work 14 hours a day to achieve something, you treat people well around you,
while keeping a long-term mindset, it is almost impossible to miss.
If you’re a fan of Jordan Peterson, you may have heard this one before.
Here, he says that one cannot twist the fabric of reality, basically meaning that
everyone will get what is coming for them sooner or later:
It is because you cannot twist the fabric of reality
without having it snap back.
I think it is bigger than you, you know. And I think that one of the things that really
tempts people is the idea that “Well, I can get away with it”.
It’s like, yeah, you try, you see how well that works. It’s like … you get away with nothing.
Let’s take an example. Some people earn a lot of money by scamming people on the internet,
by giving them faulty financial advice, pumping and dumping stocks or cryptos, or whatever.
These people think that they can twist the fabric of reality and get something
that they do not deserve, but most likely, reality will strike back.
Perhaps they’ll do get ahead financially, that could be the case. But life can hit back in many other ways.
For example, the scammer’s friends may take notice, if they are reasonable friends.
The scammer will probably not be able to find a high-value partner.
He might get sick from spinning that web of lies, etc. etc.
No, cutting corners is not the way to get what you want from life.
I always say that the best way to get what you want is to deserve what you want.
Probability Mindset
When Charlie Munger was stationed in the army during World War II
(in Alaska, far away from any battles) he learned how to play poker well.
With that, he discovered an invaluable investing takeaway.
You must fold when the odds are stacked against you
and be willing to bet big when the odds are clearly in your favor,
we discussed this previously in this series with the parimutuel betting system.
We’re now going to be diving into specifics. Munger has said that if you do not learn about
probability theory you are going through life like a one-legged man in an ass-kicking contest.
It’s doable, but you’re giving away a huge advantage to everyone else.
What kind of probability theory do we need to know about?
Yeah, we, I would say we try and think like Fermat and Pascal
as if they’d never heard of modern finance theory.
Pierre de Fermat and Blaise Pascal are two 17th century mathematicians who,
in an exchange of letters during the time, laid the foundation of probability theory.
Their correspondence discussed probability trees and conditional probabilities, among other things,
and do not turn off the video now, because this is not as difficult as it sounds.
Let’s assume that person A and B wager $100 each on a coin-flipping contest.
A wins if 5 heads are flipped first and B wins if 5 tails are flipped first. Before flipping the first coin,
we know that they each have 50% chance of winning this contest.
But, if we’d check in on them midways and see that,
for example, there’s been 4 heads and only 3 tails so far,
how have the probabilities changed?
What’s the probability that A wins, given that she has a 4-3 lead?
For this, we need a probability tree.
There are a total of 3 different outcomes from here.
A can win with 5-3 or 5-4 and A can lose (or B win) with 4-5.
These outcomes all have different probabilities attached to them,
the most likely outcome being that A wins by 5-3.
If we sum up these probabilities, we can see that, while A’s probability of winning at the start of
the game was 50%, her probability of winning given that she has a 4-3 lead is 75%.
Moreover, this would also mean that, if A was a betting person, she would want to be
offered at least $150 to end the game in this situation, or 75% of the total betting pool.
You are faced with decisions that can be analysed with probability trees
and conditional probabilities every day, even though, it’s never as clear-cut as this example.
What’s the probability that your business idea will succeed?
How does that probability change given that your mom tells you that it’s a great idea?
How does the probability change given that you’ve had your first paying customer?
What’s the probability that one of the companies you invest in go bankrupt?
How does this probability change given that the CEO, in the annual letter,
tells you that he is hopeful for the future?
How does the probability change given that the CEO himself sells a ton of shares in the company?
The Bell Curve
Apparently, this turned out to be the mathematical part of the mental model series,
because we are now moving on to statistics,
and within statistics, the most important distribution to understand is probably the normal distribution,
or, as it is also called, the Gaussian distribution, or as it is also called,
the Bell Curve,
so let’s talk about that here.
In statistics we plot data that we’ve gathered in a graph
for a more visual and easy-to-understand representation of the data.
What we’ll find if we plot the data of, for instance, the number of heads in a coin-flipping contest,
the height of people, the number of car accidents in a year, finishing times on a 100-meter sprint
or the salary of a graduate student (well, at least in Sweden)
is that they all follow this Bell Curve.
The normal distribution tells us that data will hover around the average,
or mean, and be increasingly unprobeable the further away from the mean that we get.
Take height. The average height of a Swedish male is 182 cm.
If you look at the likelihood that someone is 7 cm taller than that, 189 cm,
you may see that only 1/6.3 males are. An additional 7 cm, taller than 196 cm?
1/44.
Taller than 203 cm? Only 1/740.
Charlie Munger says that you do need to understand that many events and aspects in life are distributed this way,
but you do not need to be able to do the math or derive the formulas yourself,
at least not to be a great stock market investor.
In fact, believing too much in the mathematics of the Gaussian distribution
has arguably been a cause for much destruction in stock markets.
They got the idea that bad results in markets would be predicted by Gaussian distributions.
And the way they decided on that outcome was it made everything so easy to compute.
They don’t follow Gaussian distributions. You have to believe in the Tooth Fairy to believe that.
Be especially careful when applying the bell curve to data from any system that might be self-reinforcing.
For example, passing two meters in height arguably doesn’t make it easier for a human body to grow even more,
but passing two million in net worth makes earning additional money simpler
as you can put that money to work.
You see that building?
I bought that building ten years ago. My first real estate deal. Sold it 2 years later, made an $800,000 profit.
At the time, I thought that was all the money in the world; now it's a day's pay.
Height follows a Gaussian distribution while the net worth of individuals does not.
This leads us to the first topic of the next video.
We shall examine how humans crave elegancy
but how some areas cannot be reduced to Newtonian formulas,
and how dangerous it is to rely on precision in such areas.
Hope to see you then, cheers!