Charlie Munger is a well-known value investor and the vice chairman of Berkshire Hathaway. He is also known for his development of mental models, which are frameworks that help people understand business situations and make better decisions.
In this speech, Munger deconstructs the standard causes of human misjudgment. These include psychological denial, Pavlovian association, and bias from jealousy.
Incentives
Behind every lauded genius, there is often a No. 2—a Pippen to Michael, a Woz to Jobs, or a Munger to Buffett. Munger has been Buffett’s right-hand man for decades and plays a key role in managing Berkshire Hathaway’s $178 billion stock portfolio. He also has a long history of charitable work.
When it comes to investing, Munger believes that risk and reward are best managed by focusing on value. He seeks out companies with powerful brands and loyal customer bases, scalable business models, and excellent management teams. He also looks for a margin of safety, meaning that the market price is below the intrinsic value of the company.
He also doesn’t believe in the short game, where investors try to make comparisons and aspire to get better than their competition. Instead, he prefers the long game, which is much more fun. He says that it is important to keep learning and avoid letting your ego get ahead of you.
Second-order thinking
Having a solid second-order thinking mental model is an important skill that will help you make better decisions. It allows you to see the bigger picture and consider long term consequences. This is what separates exceptional investors from others. Examples of this include Warren Buffett, Mohnish Pabrai, Howard Marks, and Ray Dalio. It is akin to Daniel Kahneman’s concept of System One and System Two thinking.
A simple example of second order thinking is deciding not to eat pie when you’re hungry because it could lead to health issues in the future. Another is to think about a company’s structure and culture before making an investment. This will help you avoid mistakes like the Bandwagon Effect.
It’s important to understand that first order thinking has short term benefits but long term costs. For instance, if you hire someone for a position in your business because they can handle the immediate problem, you’re sacrificing the potential for future growth of the company.
Cross-pollination of ideas
Like in nature when different flowers come into contact with one another, cross-pollination of ideas creates a hybrid that benefits both the plant and itself. The same principle applies in business. Mixing people from different departments and backgrounds can help you develop imaginative new ideas.
This allows your brain to see the world in different ways, discover hidden patterns, and make connections that might not have otherwise been apparent. It also improves your ability to generate innovative solutions and gives you a competitive advantage.
Keeping your mind open to new ways of thinking will help you avoid the common pitfalls that lead to poor decisions. One of those is overconfidence, which Munger described in a speech called “How to Guarantee a Life of Misery.” In it, he discusses 24 standard causes of human misjudgment, including ingesting chemicals, Pavlovian association, envy and resentment, and self-delusion. To avoid these pitfalls, read diverse books, listen to a wide variety of podcasts and Ted Talks, and attend events that bring together people from many different industries and areas of expertise.
Circle of competence
According to the circle of competence, an individual’s true skill set sits inside a small circle. Everything outside the circle represents skills that they do not understand. This principle is important because it prevents people from making mistakes. In the investing world, it is critical to know your circle of competence and stick to it. It is also essential to be aware of when you are operating outside the circle.
Buffett has always urged investors to stay within their circle of competence. This means investing in industries and businesses that they genuinely understand. However, he also supports gradually and consistently expanding the circle. This process should be slow and deliberate, and not based on fads or trends.
Some people take mental models like the circle of competence too literally and mistake them for iron rules. For example, they may avoid learning anything new and never venture outside their comfort zone. While this can be dangerous, it’s also not a good idea to constantly stay inside your circle of competence.