In the last video about Charlie Munger’s mental models we learned that:
- You need multiple models to cope with a complex world
- Some of the very best ideas come from those that are no longer with us
- Problems are sometimes easier to solve if you turn them upside-down
- Money in a stock market portfolio tend to grow exponentially - if you don’t mess things up; and
- If you want to become wise you must learn the ability to unlearn
In this video, you’ll discover five additional mental models which Charlie Munger has spoken
about publicly, and we’ll start with what is probably my own favourite model at the moment.
Opportunity Costs
Resources are not limitless.
Whenever you choose to do anything with your time or your money, you are foregoing many other things,
opportunities, that this time or money could have been used for. Let me give you are few examples:
- You invest $1,000 in Facebook. That means that you cannot invest those same $1,000
in other companies. The opportunity cost is the investment returns of
other companies which you also knew quite a bit about, as they were potential targets too.
- You marry person A. That means that (well, in most places) you cannot marry person B, C or D,
people that you consider you might have had a shot with otherwise.
The opportunity cost is the life that you never spent with person B, C or D.
- You watch a cat video. The opportunity cost is the knowledge that you could have gained
from an investment video that you never watched.
All we have to decide is what to do with the time that is given to us.
As you can see, this mental model spans many different areas of your life.
I’d go as far as saying all areas in your life.
The basic idea is that there’s always a choice to make,
and all choices are not created equal, so you’ll have to pick carefully.
Charlie Munger says that: “Opportunity cost is a superpower,
to be used by all people who have any hope of getting the right answer.”
Now, don’t overdo this.
I hope I’m not becoming too meta here, but even thinking about opportunity costs
and trying to optimize every choice that you make, has opportunity costs.
There’s something to be said for reaching “good enough”. Opportunity costs can actually act as a timesaver,
if you use the concept correctly.
Opportunity cost is a huge filter in life.
If you’ve got two suitors who are really eager to have you,
and one is way the hell better than the other,
you do not have to spend much time with the other.
And that’s the way we filter
stock buying opportunities.
Charlie Munger calls this the “measuring stick”.
The investing game revolves around finding the greatest possible baseline opportunity
and using that as a measuring stick to compare other investments against. Let me explain.
If you’ve found a company which you expect will generate a 10% return per year for the next 10 years,
you do not have to spend 30 seconds with someone who is trying to promote 10-year US Treasuries to you.
Your measuring stick, or your opportunity cost on invested capital, is 10%,
so why should you look twice at something which is currently offering 1.48%?
And the person who has found an investment opportunity expected to gain 20% per year is
of course in an even better position, that person can filter through a massive number
of investments in just a matter of minutes.
Considering opportunity costs is also good if you want to learn from your mistakes
by rubbing your nose in them, a habit of Charlie Munger’s.
For example, if a certain company that you bought in 2020 was down 10% on the year,
you lost more than just 10%.
You also lost the opportunity of gaining 17.9% which the market in general increased with during the year.
And I don’t even want to make the calculation for how much I lost when I spent around $10,000
AND 6 months of my time trying to develop an e-commerce business back in 2017 & 18.
The skillset that I acquired through that failure probably made up for it,
I don’t want to sound like some anti-entrepreneur here, but it was definitely a skill set that I paid a lot for.
Parimutuel Betting
Parimutuel betting is also known as pool betting,
and it is the wager system which is used at most horse racing tracks.
The biggest difference between this type of betting and normal sports betting
is that the odds are entirely decided by the bettors.
People bet on different horses and the total pool of money will, after the race, be distributed to
those who bet on the winning one.
The superior horses will presumably attract more money,
while the weaker ones will attract less.
Therefore, in case a strong horse wins,
the winners will have to split the pool between more wagered money, resulting in lower odds,
while the opposite is true if a weak horse wins.
So - different horses will get different odds.
In this case, the strongest horse has a ½ in odds, meaning that you’ll profit $5 on every $10 wagered
while the weakest one has 29/1 in odds, meaning a profit of $290 on every $10 wagered.
This is a good way to think about the stock market. Oftentimes, newcomers in the stock market
mix up the good company for being a good stock (in other words, a good bet).
Any fool can see that Apple is a strong company.
But for that reason, Apple is priced at 30.3 times earnings,
which is a fairly high price.
Charlie Munger says that:
“The investing game always involves considering both quality and price,
and the trick is to get more quality than you pay for in price.”
Moreover …
“We look for the horse with one chance in two of winning which pays you three to one.”
Mostly, Berkshire, in its history, has bought common stocks that practically couldn’t fail.
But occasionally, Berkshire just makes an intelligent gamble where there’s plenty of
chance of failure, but there’s enough chance of success so the gamble is worth taking.
The takeaway is that a good horse or a good company isn’t necessarily good as a bet or a as stock purchase.
Similarly, a weak horse or a weak company isn’t necessarily bad as a bet or a stock purchase either.
You must consider both the superiority of the horse and the odds that you are getting,
or conversely, the quality of the underlying company and the price that you are paying.
No matter what – the trick is always the same – you are looking for a mispriced gamble.
Survival of the fittest
In 1869 Charles Darwin released the fifth edition of “On the Origin of Species”,
and this is where he coined the term “survival of the fittest”.
Organism that are better adjusted to their environment are better at surviving and reproducing.
Note that it wasn’t called “survival of the strongest”.
The dinosaurs, for example, are dead proof of that.
Instead, what is required is a unique set of attributes and skills which allows each organism
to pass on its genes to the next generation.
Humans are unique, among other things, in our intelligence,
our ability to use tools and in that we sweat.
This has allowed us to be successful all over the world.
However, there are other species that apply very different sets of abilities and are competing successfully too.
The cockroach is one of the most interesting examples in my opinion,
as it hasn’t had to undergo any major changes for an estimated 300 million years.
Some other species aren’t as well-spread as humans or roaches, but they successfully occupy small
and peculiar niches through specialization. One example here is the sloth. On paper, it may not
look like it should be successful considering its physical stats, but it compensates by not
requiring too much energy to survive and eating leaves that there isn’t much competition for.
There’s a powerful analogy for entrepreneurship and investing here.
Species compete for earth’s food, water and space, while businesses compete for customers’ time and money.
Charlie Munger says that: “In nature and in business, specialization is key.
Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche.”
Say that you’re thinking about starting your own YouTube channel.
You’ve been going to the gym quite a bit lately, so you decide to start a channel about fitness.
Well, you are going to run into a lot of tough competition. There are soooo many great channels
on this general topic, so to succeed, you’d have to be exceptional at what you are doing.
If you want to succeed as a fitness YouTuber, or in business more generally for that matter,
you should try to specialize more, at least when first starting out.
For example, I found this guy who is a daily vlogger who is squatting every day.
He has a decent number of followers and is probably generating quite a bit of money from his channel,
despite not having well, the flashiest type of content.
How did he do it? By occupying a niche where few others would like to compete with him.
Squatting every day, are you kidding me? That’s tough!
I can remember, I would come down to the Omaha Club, and there was an old gentleman who hit
the Omaha Club about 10:30 every morning.
He obviously did almost no work, and yet was quite prosperous.
He became your ideal, huh?
Well, he made me very curious as a little boy.
I said to my father, “How in the hell does he do that?”
And he said, “Charlie,” he said, “A business where he enjoys practically no competition.
He gathers up and renders dead horses.”
This can be applied to investing too by the way.
If you are trying to spot undervaluations among the FAANG stocks, for example,
guess what? You’ll have a lot of company.
There are no less than 53 professional analysts with a public opinion about Facebook right now.
If you want to have a higher chance of finding what we discussed earlier
– mispriced gambles – you must look in more obscure places.
If you specialize and learn a lot about a few listed companies with, say, less than $100m in market cap,
you will sometimes get the opportunity to deploy your capital at very high rates of return.
Margin of Safety
I bet you’ve heard about this mental model before, but here, I will try to give it a spin.
Benjamin Graham, Warren Buffett’s teacher and the author of The Intelligent Investor,
coined the term “margin of safety” for stock market investments.
What this means is that you should only purchase a stock when you think that you can get it
at a fair discount of its true value, something Benjamin Graham calls “intrinsic value”.
Very simplified – if someone offers you something which looks like a $1 bill to you,
you should insist on paying no more than, say, 50 cents for it.
The reason why you should always insist on investing with a margin of safety
is because calculating the true value of an investment
typically involves a lot of estimations and assumptions.
You simply want to hedge yourself against the possibility
that you’ve been too optimistic in a few of those estimates.
Yeah, it’s an interesting example of Ben Graham’s margin of safety principle.
A whole lot has gone wrong that we didn’t predict, and yet we’re coming out fine.
Now, let’s add a spin to this to see where else a margin of safety can be applied:
- In engineering, when building bridges and powerplants, for example, a margin of safety is
required to keep these systems failsafe. Within this field the mental model is more frequently
referred to as “redundancy”. The principle of redundancy isn’t always followed though,
and this often has devastating consequences.
- There’s also something which Charlie Munger refers to as a “margin of trust”.
He says that you should never go into business with someone
(or worse, get into a marriage with someone), who you cannot fully trust. “
… if your marriage proposal has to come with a 47-page contract
about how you should split your resources, should you ever divorce
you may want to choose another spouse.”
- Even biology itself uses a margin of safety.
Think about the human body. We have two arms, two eyes, two ears, two kidneys,
two lungs, ten fingers, many teeth, energy storage in the form of fat etc.
A few of these have other benefits than adding a layer of redundancy too,
but I think it is interesting to see that the concept of a margin of safety
is built into pretty much every cleverly designed system. At least those that last over time.
The Superpower of Incentives
Speaking about a margin of safety. In ancient Rome, bridgebuilders used to have
to stand underneath their constructions when they were first opened to the public. Why?
Because the romans understood the superpower of incentives, and they knew that with this rule,
there wasn’t a single bridgebuilder who would forget about including a little bit of redundancy into his structure.
You’d definitely think twice about using cheaper materials that could compromise the quality of the bridge,
which of course also is in the interest of the public.
Later in this series, you will learn no less than 25 human tendencies,
which all are common causes for a great deal of misjudgement. However, one of these tendencies,
what Charlie Munger calls the “Reward and Punishment Superresponse Tendency”,
I think is so important that it deserves its own takeaway.
Benjamin Franklin used to say: “Would you persuade, speak of interest, not of reason.”
I'm gonna make him an offer he can't refuse.
A little story that Charlie Munger once told will help you to understand the power of incentives.
The delivery service company now known as FedEx used to have huge problems
with the most fundamental part of its business system
- shifting packages rapidly in a central location each night.
The company tried many different approaches to motivate their night shift workers into being more efficient.
They tried telling them about the moral part of the situation
– it’s your job, you get paid to do this! – but none of it worked.
Finally, someone realized that perhaps paying the workers by the hour
didn’t really incentivize them to work as fast as possible.
Instead, this person said, what if workers were paid per shift?
What if, once all the packages in the terminal had been redistributed for the night, the workers could go home?
As soon as this system was introduced,
FedEx’s problems disappeared immediately.
Always think about what the underlying incentives in a system are,
and realize that people are often looking to game them
as best as they can to serve their own interests.
Charlie Munger reflects on how immoral people will become if they have the wrong incentives:
Let me give you an example of that.
I have a young friend who sells private partnership interests to investors.
And he’s in a really tough field where it’s hard to get decent returns.
And I said, “What return do you tell them you’re aiming for?”
And he said, “20 percent.” And I said, “How did you pick that number?”
And he said, “If I chose any lower number, they wouldn’t give me the money.”
The English writer Samuel Johnson used to say that
“Truth is hard to assimilate in any mind when opposed by interest.”
Charlie Munger has said that in his whole long life,
he has never seen a report from a management consultant that didn’t end with the same advice:
“This problem needs more management consulting services.”
And now, I have nothing to add. In the next video you will, among other things,
learn about one of the greatest cures for not getting hurt by people with the wrong incentives.
Hope to see you for that one too. Cheers guys!