Charlie Munger: Mental Models for the Rest of Your Life (PART 3)

This is the third part in the series where we dive into the most important mental models of the billionaire investor Charlie Munger. In the last part we learned that: - There are always choices to make and saying yes to something means that you are indirectly saying no to something else - In the stock market, we are looking for the equivalent of a racehorse that has a one chance in two of winning, but which pays three to one - It’s easier to achieve success if you specialize – seek out a niche where there is little competition - If you use a margin of safety in your investing, a whole lot can go wrong, but you will still be able to come out on top; and - Always consider the incentives involved when you are dealing with people Also in the last video, I promised you a cure for not getting hurt by people with the wrong incentives and that is the first mental model of this video: Independent Thinking How many legs does a dog have if you call his tail a leg? Four.

Saying that a tail is a leg doesn’t make it into one. It is terribly important to have independent thinking in a world where incentives rule. It’s the classical problem that you shouldn’t ask the barber if you need a haircut.

Sure, the barber probably knows more about the decision than a non-professional like you or me do, but you must also consider the incentives. The barber makes money if he says yes and makes no money if he says no. If you think that such fraudulent behaviour can only possibly extend to innocent things such as haircuts, you’d be wrong, unfortunately.

You can't handle the truth! Given improper incentives, people have gone as far as doing heart surgeries on those who didn’t need it in order to satisfy their own monetary desires. One of the best prescriptions to not get hurt by people with the wrong incentives is to always fear professional advice when it is good for the advisor.

Another recommendation, which could be argued to be closely related, is independent thinking. Warren Buffett says this: Charlie will not accept anything I say just because I say it, although most of the world will. (I myself might fall victim to this at times).

In investing, independent thinking is often called contrarianism and Benjamin Graham said it best: “The stock investor is neither right or wrong because others agreed or disagreed with him he is right because his facts and analysis are right. ” One of the largest investments that Buffett and Munger ever made was in a company called Blue Chip Stamps. This was a business in trouble with something like 10 legal cases again it at the time of their purchase.

The investing community definitely did not like this company, but that was also reflected in its price, and Buffett and Munger saw the opportunity as a mispriced gamble. The closer we are to danger, the farther we are from harm. Charlie Munger is oftentimes criticizing the conventional wisdom on Wall Street, and something which he has been especially against is the usage of EBITDA as a measurement of the performance of a stock market company.

EBITDA is short for earnings before interest, taxes, depreciation and amortization and what Munger is most upset about is excluding those depreciation charges. Depreciation is not only a cost – it is the worst kind of cost. It represents a cash outlay that was made sometimes many years ago, in other words, it’s a cost with a high opportunity cost attached to it.

You can definitely not exclude this when you are discussing the performance of a company. Yeah, I think you would understand any presentation using the word EBITDA, if every time you saw that word you just substituted the phrase, “bullshit earnings. ” Using EBITDA for measuring the performance of a company is like using a tinder conversation as a proxy for deciding to marry someone.

Sure, it’s not useless, but there are better alternatives available. Simplicity In competitive diving you are scored based on both the performance of your dive and something which is called degree of difficulty. The more flips and twists that you add to your dive, among other things, the higher the degree of difficulty and therefore the higher the potential ending score.

Not so with investing. The easy decisions can be just as profitable as the more complex ones are. You do not need to invest in advanced derivative contracts or companies operating at the cutting edge of technology to be a successful investor.

In fact, that’s probably a recipe for disaster as we’ll get to later - “it is the strong swimmers who drown”. Very few people adhere to all these simple ideas that have been, and will be, presented throughout this series, and that is a shame. For example, Wall Street completely ignores the Fat-Pitch-Strategy, which says that you mustn’t stay active all the time to be a successful investor, you only have to swing when you feel very confident.

Instead, Wall Street hires a ton of people, all who specialize in a single industry orsector to try to have an opinion about almost every company in the market. Nobody knows if a stock's going up, down or f***ing sideways, least of all stockbrokers. They can hire however many people they want, some stocks just won’t succumb to predictability due to the complexity of our world.

Around here I would say that if our predictions have been a little better than other people’s, it’s because we tried to make fewer of them. Charlie Munger has a rule for life in general: 1. Take a simple, basic idea; and 2.

Take it very seriously This applies pretty much everywhere. Only 9% of you voted for physical workout when I asked what you are interested in besides investing so I’ll try to keep examples from this area to a minimum, but let me use it this once to illustrate the power of simplicity. You want to get in good shape?

It’s super-simple. Go to a gym regularly. Have a routine so you don’t just go in there and do stuff randomly.

Focus on the exercises which are the most bang for your buck – such as bench, deadlifts and squats. Invert, always invert and understand that it is important to avoid injuries so don’t sacrifice form for more weight. Eat well.

Sleep well. And that is it. Optimizing your routine with different types of macro and meso cycles can prove beneficial, but nothing is more important than taking these simple and basic ideas seriously.

You can let everyone else get lost in the maze of complexity, while you just cut through it with simplicity. Common sense is not so common after all. Technology as a Problem Here’s an interesting one.

We all know that both Charlie Munger and Warren Buffett stay far away from the stock market companies which are involved in new technology. You may think that they are old dinosaurs who have a problem with understanding how these new things work, but in fact, we all have problems with understanding how these new things work. Predictions about the future are infamously difficult to make.

For example, just before the outbreak of the financial crises, the rating agencies had given their top rating – the AAA – to thousands of mortgaged-backed securities. The rating agency Standard & Poor’s said that the AAAs only had a 0. 12% risk of defaulting.

How many of these mortgage-backed securities defaulted in reality? A whopping 28%, 200 times more than the agencies had predicted. Some predictions can be made with a higher degree of certainty (or perhaps I should say lower degree of uncertainty) than others though.

Let’s try this. Which one do you think is more likely? A.

We are still using chairs in 2030 Yeah, the peanut brittle has very little technological change, too. B. We are still using TikTok in 2030 Now we are getting to the point.

Technology is a problem for the investor because it makes predictions more difficult to make, and predictions are an inevitable part of stock market investing. Putting your money in Facebook is essentially a prediction that social media will stay relevant. The more the technological change, the higher the degree of uncertainty of such predictions.

This is the reason why Munger and Buffett avoid investing in industries with a lot of change in them. They are more difficult to predict, and not just for the dynamic duo, but for anyone. The World’s Most Intelligent Question We all have a built-in curiosity in us.

When we were younger, we kept asking life’s most important question – why? - Why are the dinosaurs gone? - Why do people get sick?

- Why does Pete have more toys than me? Of course, what he’s saying there, when he talks about why — that’s the most important question of all. And it doesn’t apply just to investment.

It applies to the whole human experience. If you want to get smart, the question you've got to keep asking is: Why? Why?

Why? Why? Perhaps we were too often told “because mommy and daddy say so”.

Understanding be damned – just stop bothering me. But it is a terribly important question. Try to get that kid’s cast of mind back.

Try to figure out why things are happening or why they are not happening, because over time such information will help you graspreality better. Within statistics, people sometimes throwout the so-called outliers, the results that you didn’t expect to get and that divert a lot from the rest of the data. What you want to do if you want to understand reality, is probably the exact opposite of that.

Study the outliers and ask “why? ”. How did they end up here?

- Why did Warren Buffett become the richest investor of all time? - Why was my uncle forced to file for personal bankruptcy? - Why is Coke probably the most consumed product in the world?

- Why was Enron able to cook its financial books and fool the investing community for so long? The idea of picking some extreme example and asking my favourite question which is "What in hell is going on here? " - that is the way to wisdom in this world.

Circle of Competence Thomas Watson, the founder of IBM, said: “I’m no genius. I’m smart in spots, and I stay around those spots. ” No one is surprised that if you practice swimming, golf, football, horse riding, and powerlifting simultaneously you are not going to be as successful within one of the sports as you could otherwise have been.

It’s not very different in investing. In a previous video we talked about the idea that investing is all about getting more quality than you pay for in price. You want to buy a stock when you can get it at a discount to its intrinsic value.

We also talked about the fact that calculating the intrinsic value of a business involves answering three quite difficult questions: 1. How much cash will the business generate? 2.

When will it generate this cash? 3. Where will interest rates be at?

In other words – what will my opportunity cost be? If you make better predictions about the future cash flows of businesses in relation to their prices than other people do, you are going to win the game of investing. How can you increase your chances of doing that?

Well, one way is to limit your guesses to areas where you are more competent. You are not going to be equally competent everywhere, and if you try to value every business you are going to fail through lack of specialization. Charlie Munger says that him and Warren Buffett put investment opportunities in three different buckets - yes, no, and too tough.

The ones that end up in the too tough basket are those outside of their circle of competence. A great way to think about the boundaries of your circle of competence is to ask yourself the following question: 10 years from now, what will the industry that this business is in look like and how will the firm perform compared to competitors? Sometimes some companies may seem like they are right on the boundary.

Munger has an answer to this. If you have competence, you almost automatically have a feeling of where the edge of the competence is. Because after all, it wouldn’t be much of a competence if you didn’t know its boundary.

So, I think you’ve asked a question that almost answers itself. It’s the same as asking yourself if you can afford a certain luxury item or not. If you have to ask, you cannot afford it.

And with that, I have nothing more to add. In the next video, you will learn how your circle of competence can make your investment process much more efficient through the application of filters. Hope to see you again for the next one.

Cheers guys!