CHARLIE MUNGER: LATTICE WORK OF MENTAL MODELS (Math, Economics, Accounting & Engineering)
Charlie talks during his 1994 speech at USC Business School about worldly wisdom, mental models and addresses them throughout other lectures, writings and video appearances in the past. I figured there is no “full set” of these mental models (he does say he has roughly 80-90 of them in which carry 90% of the weight) so I will start with math, economics, accounting and engineering concepts.
“One of the advantages of a fellow like Buffett, whom I’ve worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations.” – Charlie Munger
Break Point – Essentially, in complex engineering systems an intentional small pause is performed for safety, reflection and debugging. It is a great idea to have a few break points in your investment checklist, the more decisions you must make, the more room for error you are susceptible to.
Back-Up Systems – It is important for investors or any profession where complex decision processes occur (pilots, surgeons, investors, engineering) should have back-up systems in place in case of failure of the routine mechanisms. Investors should take notes during the investment process and focus on a margin of safety and intrinsic value band of an asset. This will be especially helpful if liberal estimates are used and prove to be more optimistic then the future.
Handle numbers and Quantities – basic arithmetic taught at an elementary level, multiplication, division, addition, subtraction, strong working memory (handle 6-9 digits), etc.
Compound Interest – Time value of money, present value, future value, basic annuities, growing annuities, effective interest rate, exponents, the rule of 72.
Permutations and Combinations – Probability theory, utility theory, decision trees, statistics, expected values, standard deviation, sampling, variance, normal distributions, mean, median, mode, regression to the mean, outliers, chaos theory, power law and Bayesian probability. (Read into 17th century math history of Fermat and Pascal.)
A great way to learn probabilities is analyze casino games (without playing) computing basic odds. A more advanced learning tool is playing poker or bridge and every investor should play at least one recreationally.
Understanding basic tax law, GAAP and IFRS as well as the limitations. – These are the languages of businesses everywhere; learning to speak the language fluently is a definite competitive advantage. There are some great books out there to get started but like any discipline it takes time to accumulate knowledge. I would suggest starting with all of Berkshire Hathaway shareholder letters and Quality of Earnings by Thornton O’Glove. There are plenty of resources on the Internet, read as many as you can.
Law of Large Numbers – Beautifully summarized by the following “test” from Warren Buffet.“Here’s a test: Examine the record of, say, the 200 highest earning companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years.” – Warren Buffett
As companies grow into the mega cap space it is impossible to remain growing at rates that out pace global productivity advancements, population growth, and global GDP growth for long periods of time. Take Exxon Mobile as an example; if it were able to achieve a 25% annual return for the next 40 years, Exxon would own the entire world or most of it. 400B (1.25^40) = 3 Quadrillion
Marginal Utility – Diminishing marginal utility is the important factor in my opinion, as each additional unit of a particular product or service is consumed, the next is less satisfying. When you eat a hamburger the first is amazing, the second is good, the third is ok, the forth is not very good and the fifth is gross. The difference between burger 4 and 5 is small in terms of utility lost but the difference from the first and the third burgers consumed is massive. Understanding this relationship is key to understanding tradeoffs and why someone may give a more valuable unit for something of lesser value, provided they have abundance or why the first unit is worth the most provided there is scarcity.
Elasticity of Demand – I talked briefly about elasticity of demand in another article and the example I gave was socks, ketchup and toothpaste. “Elasticity of demand for a particular product or service. Essentially, what are the alternatives and at what price will a consumer make the switch. Take a recent investment of Berkshire in Heinz, a well-known brand of ketchup in almost every house in North America. It is a globally recognized brand and if they decided to raise the price 2% to 5% above their competitors each year, it is unlikely a large exodus would occur. Like they say, “Heinz and no other kinds.” Another great example is toothpaste brand Colgate. When a product is being used in an area as sensitive as my mouth, I want a product I know and trust. I am not going to buy mystery brand “X” to save myself 10 cents on a $2.50 purchase. Colgate could actually raise the price a quarter; maybe even 50 cents and I would continue to pay it, also known as a low elasticity of demand or inelastic. Contrast a pair of socks: I really don’t care what brand I put on my feet and want the absolute cheapest per unit price I can find. Demand is elastic.”
Supply & Demand – Supply and Demand are basic economic concepts and are keys to understanding surpluses and shortages as well as constraints such as bottlenecks or over-regulation.
Scarcity – Usually occurs due to supply constraints of limited resources.
Economies of scale – “are the cost advantages that enterprises obtain due to size, throughput, or scale of operation, with cost per unit of output generally decreasing with increasing scale as fixed costs are spread out over more units of output. Often operational efficiency is also greater with increasing scale, leading to lower variable cost as well.”
Monopolies, Duopolies, and Oligopolies – In a monopoly one company or organization controls the market with no optionality for consumers, prices are usually fixed or non-competitive. A Duopoly is the same as a monopoly other than two companies control the market. Oligopolies includes a lot of the Fortune 500 as well as modern day capitalism, while a small handful of companies dominate a market, price is usually managed by the lowest cost producer while others adapt.
Opportunity Cost, Sunk Costs and Relevant Costs – Opportunity Costs relate to the time value of money or almost any choice we make on a routine basis. Think about the decision to go out for dinner or stay in. Lets assume going out costs $100 for you and your wife while staying in will only cost $20. You now have a choice would you rather go out for dinner or stay in for dinner and save $80, the opportunity cost of going out for dinner is $80. Sunk costs influence our decisions and can be expressed as costs that cannot be recovered. (I.e. you pre-purchase a baseball ticket and then hear they are calling for severe thunderstorms, but you decide to go anyway so you don’t lose money. The decision outcome would be presumably different if you had “won” the tickets.)
Tradeoffs – “a situation that involves losing one quality or aspect of something in return for gaining another quality or aspect.” Refer to Wikipedia for more on “Tradeoffs.”
Wealth Effect, Income Effect, Substitution Effect – The wealth effect is the increase in spending that is correlated with the increase in perceived wealth. Think of the Federal Reserves mission for QE3, as asset prices are raised, people feel wealthier and thus spend more. The income effect is a little different as it is the correlation of change in consumption and real income. Finally the substitution effect is related to marginal utility and price elasticity of demand. Simply stated a product or service can be a substitution for one another, also known as a complementary product or service. Some examples of substitute goods are tea for coffee or margarine for butter.
I will continue to assemble a list of mental models from other disciplines, mainly psychology. In the meantime you can check out Cognitive Biases Investors May Be Able To Exploit and read up on Pavlov’s experiments related to association.