A particularly astute student of human nature - particularly insofar as it relates to business and investing - Charlie Munger (Trades, Portfolio)'s counsel is highly prized and relied upon by friend and partner Warren Buffett (Trades, Portfolio). His insights are equally valued and sought after by more than a few OID subscribers and contributors (and editors).
Therefore, we were very pleased to be allowed to sit in on Munger's lecture at the University of Southern California last year on "investment expertise as a subdivision of elementary, worldly wisdom" and very gratefully acknowledge his generous permission to share it with you.
As always, we highly recommend a very careful reading (and re-reading) of his comments and
insights and hope that you find them as valuable as we do:
ALL TOO LITTLE WORLDLY WISDOM
IS DELIVERED BY MODERN EDUCATION.
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To be a great stock picker, you need some general education.
Charlie Munger (Trades, Portfolio): I'm going to play a minor trick on you today - because the subject of my talk is the art of stock picking as a subdivision of the art of worldly wisdom. That enables me to start talking about worldly wisdom - a much broader topic that interests me because I think all too little of it is delivered by modern educational systems, at least in an effective way.
And therefore, the talk is sort of along the lines that some behaviorist psychologists call Grandma's rule - after the wisdom of Grandma when she said that you have to eat the carrots before you get the dessert.
The carrot part of this talk is about the general subject of worldly wisdom which is a pretty good way to start. After all, the theory of modern education is that you need a general education before you specialize. And I think to some extent, before you're going to be a great stock picker, you need some general education.
So, emphasizing what I sometimes waggishly call remedial worldly wisdom, I'm going to start by waltzing you through a few basic notions.
WITHOUT MODELS FROM MULTIPLE DISCIPLINES,
YOU'LL FAIL IN BUSINESS AND IN LIFE.
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Without a latticework of models, you'll fail in school and life.
Munger: What is elementary, worldly wisdom? Well, the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form.
You've got to have models in your head. And you've got to array your experience - both vicarious and direct - on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and fail in life. You've got to hang experience on a latticework of models in your head.
Absent enough models, your brain will torture reality.
Munger: What are the models? Well, the first rule is that you've got to have multiple models - because if you just have one or two that you're using, the nature of human psychology is such that you'll torture reality so that it fits your models, or at least you'll think it does. You become the equivalent of a chiropractor who, of course, is the great boob in medicine.
It's like the old saying, "To the man with only a hammer, every problem looks like a nail." And of course, that's the way the chiropractor goes about practicing medicine. But that's a perfectly disastrous way to think and a perfectly disastrous way to operate in the world. So you've got to have multiple models.
And the models have to come from multiple disciplines - because all the wisdom of the world is not to be found in one little academic department. That's why poetry professors, by and large. are so unwise in a worldly sense. They don't have enough models in their heads. So you've got to have models across a fair array of disciplines.
Fortunately, it isn't all that tough....
Munger: You may say, "My God, this is already getting way too tough." But, fortunately, it isn't that tough - because 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person. And, of those, only a mere handful really carry very heavy freight.
So let's briefly review what kind of models and techniques constitute this basic knowledge that everybody has to have before they proceed to being really good at a narrow art like stock picking.
YOU'RE GIVING A HUGE ADVANTAGE TO OTHERS IF YOU DON'T LEARN THIS SIMPLE TECHNIQUE.
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The great useful model is permutations & combinations.
Munger: First there's mathematics. Obviously, you've got to he able to handle numbers and quantities - basic arithmetic.
And the great useful model, after compound interest, is the elementary math of permutations and combinations. And that was taught in my day in the sophomore year in high school. I suppose by now in great private schools, it's probably down to the eighth grade or so.
It's very simple algebra. And it was all worked out in the course of about one year in correspondence between Pascal and Fermat. They worked it out casually in a series of letters.
Your brain isn't designed to figure it out spontaneously.
Munger: It's not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it's fundamental truth. So you simply have to have the technique.
Many educational institutions - although not nearly enough - have realized this. At Harvard Business School, the great quantitative thing that bonds the first -year class together is what they call decision tree theory. All they do is take high school algebra and apply it to real life problems. And the students love it. They're amazed to find that high school algebra works in life....
By and large. as it works out, people can't naturally and automatically do this. If you understand elementary psychology, the reason they can't is really quite simple: The basic neural network of the brain is there through broad genetic and cultural evolution. And it's not Fermat/Pascal. It uses a very crude, shortcut-type of approximation. It's got elements of Fermat/Pascal in it. However, it's not good.
Without it, you're giving a huge advantage to others....
Munger: So you have to learn in a very usable way this very elementary math and use it routinely in life - just the way if you want to become a golfer, you can't use the natural swing that broad evolution gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer.
If you don't get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest. You're giving a huge advantage to everybody else.
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....
NEXT, YOU HAVE TO KNOW ACCOUNTING - ALONG WITH ITS LIMITATIONS.
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Double-entry bookkeeping was a hell of an invention.
Munger: Obviously, you have to know accounting. It's the language of practical business life. It was a very useful thing to deliver to civilization. I've heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention.
And it's not that hard to understand.
But you have to know accounting's limitations....
Munger: But you have to know enough about it to understand its limitations - because although accounting is the starting place, it's only a crude approximation. And it's not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn't make it anything you really know.
In terms of the limitations of accounting, one of my favorite stories involves a very great businessman named Carl Braun who created the CF Braun Engineering Company. It designed and built oil refineries - which is very hard to do. And Braun would get them to come in on time and not blow up and have efficiencies and so forth. This is a major art.
And Braun, being the thorough Teutonic type that he was, had a number of quirks. And one of them was that he took a look at standard accounting and the way it was applied to building oil refineries and he said, "This is asinine."
So he threw all of his accountants out and he took his engineers and said "Now, we'll devise our own system of accounting to handle this process." And in due time, accounting adopted a lot of Carl Braun's notions. So he was a formidably willful and talented man who demonstrated both the importance of accounting and the importance of knowing its limitations.
AN IRON RULE OF WORLDLY WISDOM:
ALWAYS, ALWAYS, ALWAYS TELL PEOPLE WHY.
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Braun's Five W's: Who, what, where, when and why.
Munger: He had another rule, from psychology, which, if you're interested in wisdom, ought to be part of your repertoire - like the elementary mathematics of permutations and combinations.
His rule for all the Braun Company's communications was called the five W's - you had to tell who was going to do what, where, when and why. And if you wrote a letter or directive in the Braun Company telling somebody to do something, and you didn't tell him why, you could get fired. In fact, you would get fired if you did it twice.
If you tell people why, they'll be much more likely to comply.
Munger: You might ask why that is so important? Well, again that's a rule of psychology. Just as you think better if you array knowledge on a bunch of models that are basically answers to the question, why, why, why, if you always tell people why, they'll understand it better, they'll consider it more important, and they'll be more likely to comply. Even if they don't understand your reason, they'll be more likely to comply.
So there's an iron rule that just as you want to start getting worldly wisdom by asking why, why, why in communicating with other people about everything, you want to include why, why, why. Even if it's obvious, it's wise to stick in the why.
ENGINEERING HAS MORE THAN ITS SHARE OF MODELS.
AND THEY'RE THE MOST RELIABLE ONES, AS WELL.
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The most reliable models? Engineering models, of course.
Munger: Which models are the most reliable? Well, obviously, the models that come from hard science and engineering are the most reliable models on this Earth. And engineering quality control - at least the guts of it that matters to you and me and people who are not professional engineers - is very much based on the elementary mathematics of Fermat and Pascal:
It costs so much and you get so much less likelihood of it breaking if you spend this much. It's all elementary high school mathematics. And an elaboration of that is what Deming brought to Japan for all of that quality control stuff.
You have to understand normal occurrence distributions.
Munger: I don't think it's necessary for most people to be terribly facile in statistics. For example, I'm not sure that I can even pronounce the Poisson distribution, although I know what it looks like and I know that events and huge aspects of reality end up distributed that way. So I can do a rough calculation.
But if you ask me to work out something involving a Poisson distribution to ten decimal points, I can't sit down and do the math. I'm like a poker player who's learned to play pretty well without mastering Pascal.
And by the way, that works well enough. But you have to understand that bell-shaped curve at least roughly as well as I do.
Engineering has more than its share of powerful models....
Munger: And, of course, the engineering idea of a backup system is a very powerful idea. The engineering idea of breakpoints - that's a very powerful model, too. The notion of a critical mass - that comes out of physics - is a very powerful model.
All of these things have great utility in looking at ordinary reality. And all of this cost -benefit analysis - hell, that's all elementary high school algebra. too. It's just been dolled up a little bit with fancy lingo.
THE HUMAN MIND HAS ENORMOUS POWER, BUT IT ALSO HAS STANDARD MISFUNCTIONS.
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Our brains take shortcuts. So we're subject to manipulation.
Munger: I suppose the next most reliable models are from biology/physiology because, after all, all of us are programmed by our genetic makeup to be much the same.
And then when you get into psychology, of course, it gets very much more complicated. But it's an ungodly important subject if you're going to have any worldly wisdom.
And you can demonstrate that point quite simply: There's not a person in this room viewing the work of a very ordinary professional magician who doesn't see a lot of things happening that aren't happening and not see a lot of things happening that are happening.
And the reason why is that the perceptual apparatus of man has shortcuts in it. The brain cannot have unlimited circuitry. So someone who knows how to take advantage of those shortcuts and cause the brain to miscalculate in certain ways can cause you to see things that aren't there.
Therefore, you must know your brain's limitations.
Munger: Now you get into the cognitive function as distinguished from the perceptual function. And there, you are equally - more than equally in fact - likely to be misled. Again, your brain has a shortage of circuitry and so forth - and it's taking all kinds of little automatic shortcuts.
So when circumstances combine in certain ways - or more commonly, your fellow man starts acting like the magician and manipulates you on purpose by causing your cognitive dysfunction - you're a patsy.
And so just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations. And this knowledge, by the way, can be used to control and motivate other people....
Very eminent places miseducate people like you and me.
Munger: So the most useful and practical part of psychology - which I personally think can be taught to any intelligent person in a week - is ungodly important. And nobody taught it to me by the way. I had to learn it later in life, one piece at a time. And it was fairly laborious. It's so elementary though that, when it was all over, I just felt like a total horse's ass.
And yeah, I'd been educated at Cal Tech and the Harvard Law School and so forth. So very eminent places miseducated people like you and me.
Psychology of misjudgment is terribly important to learn.
Munger: The elementary part of psychology - the psychology of misjudgment, as I call it - is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important.
Terribly smart people make totally bonkers mistakes by failing to pay heed to it. In fact, I've done it several times during the last two or three years in a very important way. You never get totally over making silly mistakes.
Man's mind can be manipulated in amazing ways.
Munger: There's another saying that comes from Pascal which I've always considered one of the really accurate observations in the history of thought. Pascal said, "The mind of man at one and the same time is both the glory and the shame of the universe."
And that's exactly right. It has this enormous power. However, it also has these standard misfunctions that often cause it to reach wrong conclusions. It also makes man extraordinarily subject to manipulation by others. For example, roughly half of the army of Adolf Hitler was composed of believing Catholics. Given enough clever psychological manipulation, what human beings will do is quite interesting.
Consider the real interests and the psychological factors....
Munger: Personally, I've gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things - which by and large are useful, but which often misfunction.
One approach is rationality - the way you'd work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions - many of which are wrong.
ORGANISMS, PEOPLE & COMPANIES WHO SPECIALIZE CAN GET TERRIBLY GOOD IN THEIR LITTLE NICHE.
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Like it or not, the economy is a lot like an ecosystem.
Munger: Now we come to another somewhat less reliable form of human wisdom - microeconomics. And here, I find it quite useful to think of a free market economy - or partly free market economy - as sort of the equivalent of an ecosystem....
This is a very unfashionable way of thinking because early in the days after Darwin came along, people like the robber barons assumed that the doctrine of the survival of the fittest authenticated them as deserving power - you know, "I'm the richest. Therefore, I'm the best. God's in his heaven, etc."
And that reaction of the robber barons was so irritating to people that it made it unfashionable to think of an economy as an ecosystem. But the truth is that it is a lot like an ecosystem. And you get many of the same results.
In nature and in business, specialization is key.
Munger: Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as animals flourish in niches, similarly, people who specialize in the business world - and get very good because they specialize - frequently find good economics that they wouldn't get any other way.
Advantages of scale are ungodly important.
Munger: And once we get into microeconomics, we get into the concept of advantages of scale. Now we're getting closer to investment analysis - because in terms of which businesses succeed and which businesses fail, advantages of scale are ungodly important.
For example, one great advantage of scale taught in all of the business schools of the world is cost reductions along the so-called experience curve. Just doing something complicated in more and more volume enables human beings, who are trying to improve and are motivated by the incentives of capitalism, to do it more and more efficiently.
The very nature of things is that if you get a whole lot of volume through your joint, you get better at processing that volume. That's an enormous advantage. And it has a lot to do with which businesses succeed and fail....
AND THERE ARE OTHER ECONOMIES: GEOMETRIC, ADVERTISING, INFORMATION, EVEN PSYCHOLOGICAL.
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There are even geometric economies of scale.
Munger: Let's go through a list - albeit an incomplete one of possible advantages of scale. Some come from simple geometry. If you're building a great circular tank, obviously as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel.
And there are all kinds of things like that where the simple geometry - the simple reality - gives you an advantage of scale.
For example, network TV advertising made the rich richer.
Munger: For example, you can get advantages of scale from TV advertising. When TV advertising first arrived - when talking color pictures first came into our living rooms - it was an unbelievably powerful thing. And in the early days, we had three networks that had whatever it was - say 90% of the audience.
Well, if you were Proctor & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so damn many cans and bottles. Some little guy couldn't. And there was no way of buying it in part. Therefore, he couldn't use it. In effect, if you didn't have a big volume, you couldn't use network TV advertising - which was the most effective technique.
So when TV came in, the branded companies that were already big got a huge tail wind. Indeed, they prospered and prospered and prospered until some of them got fat and foolish. which happens with prosperity - at least to some people....
The informational advantage of brands is hard to beat.
Munger: And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is $.40 and the other is $.30, am I going to take something I don't know and put it in my mouth - which is a pretty personal place, after all - for a lousy dime?
So, in effect, Wrigley, simply by being so well known, has advantages of scale - what you might call an informational advantage.
Everyone is influenced by what others do and approve.
Munger: Another advantage of scale comes from psychology. The psychologists use the term "social proof". We are all influenced - subconsciously and to some extent consciously - by what we see others do and approve. Therefore, if everybody's buying something, we think it's better. We don't like to be the one guy who's out of step.
Again, some of this is at a subconscious level and some of it isn't. Sometimes, we consciously and rationally think, "Gee, I don't know much about this. They know more than I do. Therefore, why shouldn't I follow them?"
All told, your advantages can add up to one tough moat.
Munger: The social proof phenomenon which comes right out of psychology gives huge advantages to scale - for example, with very wide distribution, which of course is hard to get. One advantage of Coca-Cola is that it's available almost everywhere in the world.
Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup - which is slowly won by a big enterprise - gets to be a huge advantage.... And if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you.
Read Part 2 of the lecture here.
Read Part 3 of the lecture here.
