"Charlie has the best 30-second mind in the world. He goes from A to Z in one move. He sees the essence of everything before you can even finish the sentence," Warren Buffett (Trades, Portfolio) said when describing his business partner, Charlie Munger (Trades, Portfolio). It's an impressive skill that makes you wonder who the true oracle of the duo is. And it also makes you wonder how Munger does it.
Munger explained his philosophy in a speech he gave in the 1990s.
"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."
What are Munger's mental models? Read on to find out.
First principles thinking
To build up this latticework of mental models, Munger starts with first principles thinking, which means breaking down complex problems into basic elements to understand their fundamental truths.
Rather than relying on assumptions or surface-level analysis, first principles thinking gets to the core of an issue by focusing on foundational concepts. For example, when evaluating a business, Munger uses first principles to understand its basic viability and competitive position.
What core customer need does it serve? How much does it cost to operate versus customer willingness to pay? Thinking in first principles avoids superficial assessments and uncovers the essential factors that will determine success or failure.
The power of inversion
Another powerful mental model Munger uses is inversion, which involves solving problems by working backward. Inversion flips conventional thinking to gain a new perspective.
To understand what leads to failure, invert the problem and consider what actions you should avoid. The causes of ruin often become more apparent than the roots of success.
Munger frequently invokes inversion in investing. To identify overvalued stocks, he inverts the question and looks for signs of unrealistic optimism or assets priced far above intrinsic value. Inversion reveals risks and allows him to steer clear of potentially disastrous investments.
Staying within your circle of competence
Knowing the limits of one's knowledge is critical. Munger believes firmly in staying within your circle of competence – areas where you have deep expertise.
Acting only where you have mastery helps make sound decisions and mitigates risks. Venturing into domains where your understanding is limited often leads to poor judgment and mistakes.
For example, Munger and Buffett have avoided technology stocks over the years, as it was outside their sphere of competence. This discipline has served them well, as they focused their capital only on businesses they thoroughly grasped. Knowing what you don't know is wisdom.
Acquiring worldly wisdom
Central to Munger's thinking is acquiring worldly wisdom – learning core principles and models from diverse disciplines.
By studying an array of fields, from the sciences and humanities to mathematics and business, one develops a latticework of mental models to draw upon. This builds a more complete perspective to make flexible, insightful decisions in any context.
As an avid reader and autodidact, Munger extracted big ideas from multiple domains rather than siloing himself in any one area. He advocates we all become multi-disciplinary generalists to improve our reasoning and judgment.
Employing thought experiments
Munger is a practitioner of using thought experiments to pressure test ideas and concepts. Imagining different scenarios and alternate realities helps tease out the implications of decisions before acting.
Thought experiments assess consequences when empirical testing isn't feasible. They allow "rehearsing" events to prepare for various outcomes.
For example, Munger has said he frequently runs thought experiments on potential investments, envisioning worst cases and reflecting on past financial manias to gain insight. Though not real, these simulated tests refine his mental models and decision parameters based on reasoned speculation.
Implementing multi-disciplinary thinking
Tapping knowledge from a range of disciplines for cross-pollination is a signature of Munger's approach. He abides by his maxim that "all the wise people I know have multiple mental models."
Diverse fields often study the same universal principles through different lenses. Connecting these big ideas creates an interlocking understanding of how the world works.
Munger imports concepts from architecture about redundancy, draws parallels between biology and business strategy, and cites mathematical principles in assessing investment risk profiles. Synthesizing models from across domains helps compound your understanding into a powerful cognitive web.
Understanding psychology and human misjudgment
While Munger extracts many technical models from physics and math, he believes understanding psychology and behavior is the most important.
Overly relying on quantitative factors while ignoring human irrationality and bias is dangerous. Our shared cognitive weaknesses and tendencies have consistent, predictable effects in business and investing.
Studying disciplines like social psychology gives you insight into universal biases that may drive poor decisions.
Munger deeply understands the deep-rooted behaviors that lead to misjudgment so he can guard against them. Appreciating psychology provides an honest lens you can use to interpret facts, filter noise, and sharpen your judgment.
Learning from mistakes
"Rub your nose in your mistakes" is a motto of Munger's. Carefully analyzing your errors rather than sweeping them under the rug accelerates improvement.
Identifying missteps and unpacking the flawed thinking underlying them helps you gain wisdom to avoid repeats in the future. He believes that the quality of our decisions is shaped profoundly by mistakes if we study them rigorously.
Munger views mistakes as growth opportunities, not reasons for embarrassment. He does exhaustive post-mortems on investing errors and business losses with the aim of deriving instructive general principles. Munger learns more from these instructive failures than from successes.
Considering opportunity costs
Opportunity cost is a crucial model Munger employs for rational capital allocation. Before committing resources, he carefully considers the value of the best alternative uses.
Choices often involve forfeiting the returns other potential investments could have generated. Quantifying and weighing opportunity costs leads to better capital deployment decisions.
For example, when analyzing a stock, Munger compares prospective returns to other available investments. If another business promises far higher owner earnings, pursuing the initial opportunity has significant opportunity costs. This model allows him to identify the most promising investments.
Applying feedback loops
Understanding system dynamics through models like feedback loops is critical. Feedback loops describe a process whereby system output is fed back into the system as input, influencing future actions.
Both positive and negative feedback loops drive complex phenomena in business and investing that you must map. Positive feedback loops are self-reinforcing, fueling growth like a company's brand becoming a status symbol and attracting more customers.
On the other hand, negative feedback loops self-correct, like plunging sales triggering price cuts to stabilize demand. Mapping and anticipating feedback loops allow you to navigate non-linear systems better.
Achieving outlier results
Munger's latticework aims at what he calls the "Lollapalooza Effect," which essentially entails achieving exponential success. This combines multiple models and factors synergistically into an outcome far greater than the sum of its parts.
For example, evaluating a business through multiple mental models creates a multilayered insight into its fundamentals and value.
Stacking multiple models provides a rich, nuanced assessment. Viewing investments through multiple lenses, including competitive advantage, industry structure, management quality, and valuation, helps you identify the most promising opportunities.
Munger's latticework
By internalizing models from an array of disciplines, Munger has constructed a powerful latticework for comprehending reality.
Combining modes of thinking from the sciences, social sciences and mathematics creates a multi-model approach to understanding opportunities and avoiding dangers.
This latticework enabled Munger to become one of history's most successful capital allocators and a genius polymath. Like the snowball effect of compounding, each model builds on the others to drive exponential success as an investor and business leader at Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial).
