Tag: Investing

Charlie Munger on Getting Rich, Wisdom, Focus, Fake Knowledge and More

“In the chronicles of American financial history,” writes David Clark in Tao of Charlie Munger: A Compilation of Quotes from Berkshire Hathaway's Vice Chairman on Life, Business, and the Pursuit of Wealth,” Charlie Munger will be seen as the proverbial enigma wrapped in a paradox— he is both a mystery and a contradiction at the same time.”

On one hand, Munger received an elite education and it shows: He went to Cal Tech to train as a meteorologist for the Second World War and then attended Harvard Law School and eventually opened his own law firm. That part of his success makes sense.

Yet here's a man who never took a single course in economics, business, marketing, finance, psychology or accounting, and managed to become one of the greatest, most admired, and most honorable businessmen of our age, noted by essentially all observers for the originality of his thoughts, especially about business and human behavior. You don't learn that in law school, at Harvard or anywhere else.

Bill Gates said of him: “He is truly the broadest thinker I have ever encountered.” His business partner Warren Buffett put it another way: “He comes equipped for rationality…I would say that to try and typecast Charlie in terms of any other human that I can think of, no one would fit. He's got his own mold.”

How does such an extreme result happen? How is such an original and unduly capable mind formed? In the case of Munger, it's clearly a combination of unusual genetics and an unusual approach to learning and life.

While we can't have his genetics, we can try to steal his approach to rationality. There's almost no limit to the amount one could learn from studying the Munger mind, so let's at least get started by running down some of his best ideas.

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Wisdom and Circle of Competence

“Knowing what you don’t know is more useful than being brilliant.”
“Acknowledging what you don’t know is the dawning of wisdom.”

Identify your circle of competence and use your knowledge, when possible, to stay away from things you don't understand. There are no points for difficulty at work or in life.  Avoiding stupidity is easier than seeking brilliance.

Of course this relates to another of Munger's sayings, “People are trying to be smart—all I am trying to do is not to be idiotic, but it’s harder than most people think.”

And this reminds me of perhaps my favorite Mungerism of all time, the very quote that sits right beside my desk:

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

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Divergence

“Mimicking the herd, invites regression to the mean.”

Here's a simple axiom to live by: If you do what everyone else does, you're going to get the same result that everyone else gets. This means, taking out luck (good or bad), if you act average, you're going to be average. If you want to move away from average, you must diverge. You must be different. And if you want to outperform, you must be different and correct. As Munger would say, “How could it be otherwise?”

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Know When to Fold Em

“Life, in part, is like a poker game, wherein you have to learn to quit sometimes when holding a much-loved hand— you must learn to handle mistakes and new facts that change the odds.”

Mistakes are an opportunity to grow. How we handle adversity is up to us. This is how we become personally antifragile.

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False Models

Echoing Einstein, who said that “Not everything that counts can be counted, and not everything that can be counted counts,” Munger said about his and Buffett's shift to acquiring high quality businesses for Berkshire Hathaway:

“Once we’d gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses.”

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Being Lazy

“Sit on your ass. You’re paying less to brokers, you’re listening to less nonsense, and if it works, the tax system gives you an extra one, two, or three percentage points per annum.”

Time is the friend to a good business and the enemy of the poor business. It's also the friend of knowledge and the enemy of the new and novel. As Seneca said “Time discovers truth.”

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Investing is a Pari-mutual System

You’re looking for a mispriced gamble,” says Munger. “That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.”  At another time he added: “You should remember that good ideas are rare— when the odds are greatly in your favor, bet heavily.

May the odds forever be in your favor. Actually, learning properly is one way you can tilt the odds in your favor.

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Focus

When asked about his success, Munger says, “I succeeded because I have a long attention span.”

Long attention spans allow for a deep understanding of subjects. When combined with deliberate practice focus allows you to increase your skills and get out of your rut. The Art of Focus is a divergent and correct strategy that can help you identify where the leverage points are and apply your effort toward them.

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Fake Knowledge

“Smart people aren’t exempt from professional disasters from overconfidence.”

We're so used to outsourcing our thinking to others that we've forgotten what it's like to really understand something from all perspectives. We've forgotten just how much work that takes. The path of least resistance, however, is just a click away. Fake knowledge, which comes from reading headlines and skimming the news seems harmless, but it's not because it makes us overconfident. It's better to remember a simple trick: anything you're getting easily through google or twitter is likely to be widely known and should not be given undue weight.

However, Munger adds, “If people weren’t wrong so often, we wouldn’t be so rich.

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Sit Quietly

Echoing Pascal, who said some version of ‘All of humanity's problems stem from man's inability to sit quietly in a room alone,' Munger adds an investing twist:  “It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait.”

The ability to be alone with your thoughts, and turn ideas over and over, without the do something syndrome affects so many of us. A perfectly reasonable deviation is to hold your ground and await more information.

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Deal With Reality

“I think that one should recognize reality even when one doesn’t like it; indeed, especially when one doesn’t like it.”

Munger clearly learned from Joseph Tussman's wisdom. This means facing harsh truths that you have forced yourself to ignore. It means meeting the world on the worlds terms, not how you wish it would be. If this causes temporary pain, so be it. “Your pain,” writes Kahil Gibran in The Prophet, “is the breaking of the shell that encloses your understanding.”

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There is No Free Lunch

We like quick solutions that don't require a lot of effort. We're drawn to the modern equivalent of an old hustler selling an all curing tonic. Only the world does not work that way. Munger expands:

“There isn’t a single formula. You need to know a lot about business and human nature and the numbers…It is unreasonable to expect that there is a magic system that will do it for you.”

Acquiring knowledge is hard work. It's reading and adding to your knowledge so it compounds. It's going deep and developing fluency, something Darwin knew well.

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Maximization/Minimization

In business we often find that the winning system goes almost ridiculously far in maximizing and or minimizing one or a few variables— like the discount warehouses of Costco.

When everything is a priority nothing is a priority. Attempting to maximize competing variables is a recipe for disaster. Picking one variable, and relentlessly focusing on it, which is an effective strategy, diverges from the norm. It's hard to compete with businesses who have correctly identified the right variables to maximize or minimize. When you focus on one variable, you'll increase the odds you're quick and nimble — and can respond to changes in the terrain.

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Map and Terrain

At Berkshire there has never been a master plan. Anyone who wanted to do it, we fired because it takes on a life of its own and doesn’t cover new reality. We want people taking into account new information.”

Plans are maps that we become attached to. Once we've told everyone there is a plan and what that plan is, especially multi-year plans, we're psychologically more likely to hold to it because coming out and changing it would be admitting we're wrong. This creates a scenario where we're staking the odds against us in changing when things change. Detailed 5-year plans (that will clearly be wrong) are as disastrous as overly-general five year plans (which can never be wrong). Scrap it, isolate the key variables that you need to maximize and minimize, and follow the agile path blazed by Henry Singleton and followed by Buffett and Munger.

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The Keys to Good Government

There are three keys: honesty, effectiveness, and efficiency.

Munger says:

“In a democracy, everyone takes turns. But if you really want a lot of wisdom, it’s better to concentrate decisions and process in one person. It’s no accident that Singapore has a much better record, given where it started, than the United States. There, power was concentrated in an enormously talented person, Lee Kuan Yew, who was the Warren Buffett of Singapore.”

Lee Kuan Yew put it this way himself: “With few exceptions, democracy has not brought good government to new developing countries. . . . What Asians value may not necessarily be what Americans or Europeans value. Westerners value the freedoms and liberties of the individual. As an Asian of Chinese cultural background, my values are for a government which is honest, effective, and efficient.”

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One Step At a Time

“Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Slug it out one inch at a time, day by day. At the end of the day— if you live long enough— most people get what they deserve.”

An incremental approach to life that reminds one of the nature of compounding. There will always be some going faster than you but we can learn from the Darwinian guide to overachieving your natural IQ. In order for this approach to be effective you need a long axis of time as well as continuous incremental progress.

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Getting Rich

“The desire to get rich fast is pretty dangerous.” 

Getting rich is a function of being happy with what you have, spending less than you make, and time.

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Mental Models

“Know the big ideas in the big disciplines and use them routinely— all of them, not just a few.”

Mental Models are the big ideas from multiple disciplines. While most people agree these are worth knowing, they often think they can identify which models will add the most value, and in so doing they miss something important. There is a reason that the “know nothing” index fund almost always beats the investors who think they “know.” Understanding this idea in greater detail, will change a lot of things including how you read. Acquiring the big ideas — without selectivity — is the way to mimic a know nothing index fund.

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Know-it-alls

“I try to get rid of people who always confidently answer questions about which they don’t have any real knowledge.”

Few things have made as much of a difference in my life as systemically eliminating (and when not possible, reducing the importance of) people who think they know the answer to everything.

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Stoic Resolve

“There’s no way that you can live an adequate life without many mistakes. In fact, one trick in life is to get so you can handle mistakes. Failure to handle psychological denial is a common way for people to go broke.”

While we all make mistakes, it's how we respond to failure that defines us.

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Thinking

“We all are learning, modifying, or destroying ideas all the time. Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side.”

“It’s bad to have an opinion you’re proud of if you can’t state the arguments for the other side better than your opponents. This is a great mental discipline.”

Thinking is a lot of work. “My first thought,” William Deresiewicz said in one of my favorite speeches, “is never my best thought. My first thought is always someone else’s; it’s always what I’ve already heard about the subject, always the conventional wisdom.”

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Choose Your Associates Wisely

“Oh, it’s just so useful dealing with people you can trust and getting all the others the hell out of your life. It ought to be taught as a catechism. . . . But wise people want to avoid other people who are just total rat poison, and there are a lot of them.”

No comment needed there.

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Complement Tao of Charlie Munger with this excellent Peter Bevelin Interview.

The Green Lumber Fallacy: The Difference between Talking and Doing

“Clearly, it is unrigorous to equate skills at doing with skills at talking.”
— Nassim Taleb

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Before we get to the meat, let's review an elementary idea in biology that will be relevant to our discussion.

If you're familiar with evolutionary theory, you know that populations of organisms are constantly subjected to “selection pressures” — the rigors of their environment which lead to certain traits being favored and passed down to their offspring and others being thrown into the evolutionary dustbin.

Biologists dub these advantages in reproduction “fitness” — as in, the famously lengthening of giraffe necks gave them greater “fitness” in their environment because it helped them reach high up, untouched leaves.

Fitness is generally a relative concept: Since organisms must compete for scarce resources, their fitnesses are measured in the sense of giving a reproductive advantage over one another.

Just as well, a trait that might provide great fitness in one environment may be useless or even disadvantageous in another. (Imagine draining a pond: Any fitness advantages held by a really incredible fish becomes instantly worthless without water.) Traits also relate to circumstance. An advantage at one time could be a disadvantage at another and vice versa.

This makes fitness an all-important concept in biology: Traits are selected for if they provide fitness to the organism within a given environment.

Got it? OK, let's get back to the practical world.

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The Black Swan thinker Nassim Taleb has an interesting take on fitness and selection in the real world:  People who are good “doers” and people who are good “talkers” are often selected for different traits. Be careful not to mix them up.

In his book Antifragile, Taleb uses this idea to invoke a heuristic he'd once used when hiring traders on Wall Street:

The more interesting their conversation, the more cultured they are, the more they will be trapped into thinking that they are effective at what they are doing in real business (something psychologists call the halo effect, the mistake of thinking that skills in, say, skiing translate unfailingly into skills in managing a pottery workshop or a bank department, or that a good chess player would be a good strategist in real life).

Clearly, it is unrigorous to equate skills at doing with skills at talking. My experience of good practitioners is that they can be totally incomprehensible–they do not have to put much energy into turning their insights and internal coherence into elegant style and narratives. Entrepreneurs are selected to be doers, not thinkers, and doers do, they don't talk, and it would be unfair, wrong, and downright insulting to measure them in the talk department.

In other words, the selection pressures on an entrepreneur are very different from those on a corporate manager or bureaucrat: Entrepreneurs and risk takers succeed or fail not so much on their ability to talk, explain, and rationalize as their ability to get things done.

While the two can often go together, Nassim figured out that they frequently don't. We judge people as ignorant when it's really us who are ignorant.

When you think about it, there's no a priori reason great intellectualizing and great doing must go together: Being able to hack together an incredible piece of code gives you great fitness in the world of software development, while doing great theoretical computer science probably gives you better fitness in academia. The two skills don't have to be connected. Great economists don't usually make great investors.

But we often confuse the two realms.  We're tempted to think that a great investor must be fluent in behavioral economics or a great CEO fluent in Mckinsey-esque management narratives, but in the real world, we see this intuition constantly in violation.

The investor Walter Schloss worked from 9-5, barely left his office, and wasn't considered an entirely high IQ man, but he compiled one of the great investment records of all time. A young Mark Zuckerberg could hardly be described as a prototypical manager or businessperson, yet somehow built one of the most profitable companies in the world by finding others that complemented his weaknesses.

There are a thousand examples: Our narratives about the type of knowledge or experience we must have or the type of people we must be in order to become successful are often quite wrong; in fact, they border on naive. We think people who talk well can do well, and vice versa. This is simply not always so.

We won't claim that great doers cannot be great talkers, rationalizers, or intellectuals. Sometimes they are. But if you're seeking to understand the world properly, it's good to understand that the two traits are not always co-located. Success, especially in some “narrow” area like plumbing, programming, trading, or marketing, is often achieved by rather non-intellectual folks. Their evolutionary fitness doesn't come from the ability to talk, but do. This is part of reality.

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Taleb calls this idea the Green Lumber Fallacy, after a story in the book What I Learned Losing a Million Dollars. Taleb describes it in Antifragile:

In one of the rare noncharlatanic books in finance, descriptively called What I Learned Losing a Million Dollars, the protagonist makes a big discovery. He remarks that a fellow named Joe Siegel, one of the most successful traders in a commodity called “green lumber,” actually thought it was lumber painted green (rather than freshly cut lumber, called green because it had not been dried). And he made it his profession to trade the stuff! Meanwhile the narrator was into grand intellectual theories and narratives of what caused the price of commodities to move and went bust.

It is not just that the successful expert on lumber was ignorant of central matters like the designation “green.” He also knew things about lumber that nonexperts think are unimportant. People we call ignorant might not be ignorant.

The fact that predicting the order flow in lumber and the usual narrative had little to do with the details one would assume from the outside are important. People who do things in the field are not subjected to a set exam; they are selected in the most non-narrative manager — nice arguments don't make much difference. Evolution does not rely on narratives, humans do. Evolution does not need a word for the color blue.

So let us call the green lumber fallacy the situation in which one mistakes a source of visible knowledge — the greenness of lumber — for another, less visible from the outside, less tractable, less narratable.

The main takeaway is that the real causative factors of success are often hidden from usWe think that knowing the intricacies of green lumber are more important than keeping a close eye on the order flow. We seduce ourselves into overestimating the impact of our intellectualism and then wonder why “idiots” are getting ahead. (Probably hustle and competence.)

But for “skin in the game” operations, selection and evolution don't care about great talk and ideas unless they translate into results. They care what you do with the thing more than that you know the thing. They care about actually avoiding risk rather than your extensive knowledge of risk management theories. (Of course, in many areas of modernity there is no skin in the game, so talking and rationalizing can be and frequently are selected for.)

As Taleb did with his hiring heuristic, this should teach us to be a little skeptical of taking good talkers at face value, and to be a little skeptical when we see “unexplainable” success in someone we consider “not as smart.” There might be a disconnect we're not seeing because we're seduced by narrative. (A problem someone like Lee Kuan Yew avoided by focusing exclusively on what worked.)

And we don't have to give up our intellectual pursuits in order to appreciate this nugget of wisdom; Taleb is right, but it's also true that combining the rigorous, skeptical knowledge of “what actually works” with an ever-improving theory structure of the world might be the best combination of all — selected for in many more environments than simple git-er-done ability, which can be extremely domain and environment dependent. (The green lumber guy might not have been much good outside the trading room.)

After all, Taleb himself was both a successful trader and the highest level of intellectual. Even he can't resist a little theorizing.

The Knowledge Project: Morgan Housel on Reading, Writing, Filtering Information

On this episode, I’m happy to have Morgan Housel (@morganhousel)

Morgan works at Collaborative Fund. He’s a former columnist at the Motley Fool, and a former columnist of the Wall Street Journal. His work has also been published in Time, USA Today, World Affairs, and Business Insider.
You name it, he’s been there. Simply put, he’s one of the shining lights of the business press.

More than that, though, he’s one of the few people that I read all the time. As I’ve gotten to know him over the years, I can also tell you he’s an exceptional person. I hope you enjoy this conversation as much as I did.

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Listen

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Transcript:
A complete transcript is available for members.

Peter Bevelin on Seeking Wisdom, Mental Models, Learning, and a Lot More

One of the most impactful books we've ever come across is the wonderful Seeking Wisdom: From Darwin to Munger, written by the Swedish investor Peter Bevelin. In the spirit of multidisciplinary learning, Seeking Wisdom is a compendium of ideas from biology, psychology, statistics, physics, economics, and human behavior.

Mr. Bevelin is out with a new book full of wisdom from Warren Buffett & Charlie Munger: All I Want to Know is Where I'm Going to Die So I Never Go There. We were fortunate enough to have a chance to interview Peter recently, and the result is the wonderful discussion below.

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What was the original impetus for writing these books?

The short answer: To improve my thinking. And when I started writing on what later became Seeking Wisdom I can express it even simpler: “I was dumb and wanted to be less dumb.” As Munger says: “It’s ignorance removal…It's dishonorable to stay stupider than you have to be.” And I had done some stupid things and I had seen a lot of stupidity being done by people in life and in business.

A seed was first planted when I read Charlie Munger’s worldly wisdom speech and another one where he referred to Darwin as a great thinker. So I said to myself: I am 42 now. Why not take some time off business and spend a year learning, reflecting and write about the subject Munger introduced to me – human behavior and judgments.

None of my writings started out as a book project. I wrote my first book – Seeking Wisdom – as a memorandum for myself with the expectation that I could transfer some of its essentials to my children. I learn and write because I want to be a little wiser day by day. I don’t want to be a great-problem-solver. I want to avoid problems – prevent them from happening and doing right from the beginning. And I focus on consequential decisions. To paraphrase Buffett and Munger – decision-making is not about making brilliant decisions, but avoiding terrible ones. Mistakes and dumb decisions are a fact of life and I’m going to make more, but as long as I can avoid the big or “fatal” ones I’m fine.

So I started to read and write to learn what works and not and why. And I liked Munger’s “All I want to know is where I’m going to die so I’ll never go there” approach. And as he said, “You understand it better if you go at it the way we do, which is to identify the main stupidities that do bright people in and then organize your patterns for thinking and developments, so you don’t stumble into those stupidities.” Then I “only” had to a) understand the central “concept” and its derivatives and describe it in as simple way as possible for me and b) organize what I learnt in a way that was logical and useful for me.

And what better way was there to learn this from those who already knew this?

After I learnt some things about our brain, I understood that thinking doesn’t come naturally to us humans – most is just unconscious automatic reactions. Therefore I needed to set up the environment and design a system that helped me make it easier to know what to do and prevent and avoid harm. Things like simple rules of thumbs, tricks and filters. Of course, I could only do that if I first had the foundation. And as the years have passed, I’ve found that filters are a great way to save time and misery. As Buffett says, “I process information very quickly since I have filters in my mind.” And they have to be simple – as the proverb says, “Beware of the door that has too many keys.” The more complicated a process is, the less effective it is.

Why do I write? Because it helps me understand and learn better. And if I can’t write something down clearly, then I have not really understood it. As Buffett says, “I learn while I think when I write it out. Some of the things, I think I think, I find don’t make any sense when I start trying to write them down and explain them to people … And if it can’t stand applying pencil to paper, you’d better think it through some more.”

My own test is one that a physicist friend of mine told me many years ago, ‘You haven’t really understood an idea if you can’t in a simple way describe it to almost anyone.' Luckily, I don’t have to understand zillion of things to function well.

And even if some of mine and others thoughts ended up as books, they are all living documents and new starting points for further, learning, un-learning and simplifying/clarifying. To quote Feynman, “A great deal of formulation work is done in writing the paper, organizational work, organization. I think of a better way, a better way, a better way of getting there, of proving it. I never do much — I mean, it’s just cleaner, cleaner and cleaner. It’s like polishing a rough-cut vase. The shape, you know what you want and you know what it is. It’s just polishing it. Get it shined, get it clean, and everything else.

Which book did you learn the most from the experience of writing/collecting?

Seeking Wisdom because I had to do a lot of research – reading, talking to people etc. Especially in the field of biology and brain science since I wanted to first understand what influences our behavior. I also spent some time at a Neurosciences Institute to get a better understanding of how our anatomy, physiology and biochemistry constrained our behavior.

And I had to work it out my own way and write it down in my own words so I really could understand it. It took a lot of time but it was a lot of fun to figure it out and I learnt much more and it stuck better than if I just had tried to memorize what somebody else had already written. I may not have gotten everything letter perfect but good enough to be useful for me.

As I said, the expectation wasn’t to create a book. In fact, that would have removed a lot of my motivation. I did it because I had an interest in becoming better. It goes back to the importance of intrinsic motivation. As I wrote in Seeking Wisdom: “If we reward people for doing what they like to do anyway, we sometimes turn what they enjoy doing into work. The reward changes their perception. Instead of doing something because they enjoy doing it, they now do it because they are being paid. The key is what a reward implies. A reward for our achievements makes us feel that we are good at something thereby increasing our motivation. But a reward that feels controlling and makes us feel that we are only doing it because we’re paid to do it, decreases the appeal.

It may sound like a cliché but the joy was in the journey – reading, learning and writing – not the destination – the finished book. Has the book made a difference for some people? Yes, I hope so but often people revert to their old behavior. Some of them are the same people who – to paraphrase something that is attributed to Churchill – occasionally should check their intentions and strategies against their results. But reality is what Munger once said, “Everyone’s experience is that you teach only what a reader almost knows, and that seldom.” But I am happy that my books had an impact and made a difference to a few people. That’s enough.

Why did the new book (All I Want To Know Is Where I'm Going To Die So I'll Never Go There) have a vastly different format?

It was more fun to write about what works and not in a dialogue format. But also because vivid and hopefully entertaining “lessons” are easier to remember and recall. And you will find a lot of quotes in there that most people haven’t read before.

I wanted to write a book like this to reinforce a couple of concepts in my head. So even if some of the text sometimes comes out like advice to the reader, I always think about what the mathematician Gian-Carlo Rota once said, “The advice we give others is the advice that we ourselves need.”

How do you define Mental Models?

Some kind of representation that describes how reality is (as it is known today) – a principle, an idea, basic concepts, something that works or not – that I have in my head that helps me know what to do or not. Something that has stood the test of time.

For example some timeless truths are:

  • Reality is that complete competitors – same product/niche/territory – cannot coexist (Competitive exclusion principle). What works is going where there is no or very weak competition + differentiation/advantages that others can’t copy (assuming of course we have something that is needed/wanted now and in the future)
  • Reality is that we get what we reward for. What works is making sure we reward for what we want to achieve.

I favor underlying principles and notions that I can apply broadly to different and relevant situations. Since some models don’t resemble reality, the word “model” for me is more of an illustration/story of an underlying concept, trick, method, what works etc. that agrees with reality (as Munger once said, “Models which underlie reality”) and help me remember and more easily make associations.

But I don’t judge or care how others label it or do it – models, concepts, default positions … The important thing is that whatever we use, it reflects and agrees with reality and that it works for us to help us understand or explain a situation or know what to do or not do. Useful and good enough guide me. I am pretty pragmatic – whatever works is fine. I follow Deng Xiaoping, “I don’t care whether the cat is black or white as long as it catches mice.” As Feynman said, “What is the best method to obtain the solution to a problem? The answer is, any way that works.

I'll tell you about a thing Feynman said on education which I remind myself of from time to time in order not to complicate things (from Richard P. Feynman, Michael A. Gottlieb, Ralph Leighton, Feynman's Tips on Physics: A Problem-Solving Supplement to the Feynman Lectures on Physics):

“There's a round table on three legs. Where should you lean on it, so the table will be the most unstable?”
The student's solution was, “Probably on top of one of the legs, but let me see: I’ll calculate how much force will produce what lift, and so on, at different places.”
Then I said, “Never mind calculating. Can you imagine a real table?”
“But that's not the way you're supposed to do it!”
“Never mind how you're supposed to do it; you’ve got a real table here with the various legs, you see? Now, where do you think you’d lean? What would happen if you pushed down directly over a leg?”
“Nothin'!”
I say, “That's right; and what happens if you push down near the edge, halfway between two of the legs?”
“It flips over!”
I say, “OK! That's better!”
The point is that the student had not realized that these were not just mathematical problems; they described a real table with legs. Actually, it wasn't a real table, because it was perfectly circular, the legs were straight up and down, and so on. But it nearly described, roughly speaking, a real table, and from knowing what a real table does, you can get a very good idea of what this table does without having to calculate anything – you know darn well where you have to lean to make the table flip over. So, how to explain that, I don't know! But once you get the idea that the problems are not mathematical problems but physical problems, it helps a lot.
Anyway, that's just two ways of solving this problem. There's no unique way of doing any specific problem. By greater and greater ingenuity, you can find ways that require less and less work, but that takes experience.

Which mental models “carry the most freight?” (Related follow up: Which concepts from Buffett/Munger/Mental Models do you find yourself referring to or appreciating most frequently?)

Ideas from biology and psychology since many stupidities are caused by not understanding human nature (and you get illustrations of this nearly every day). And most of our tendencies were already known by the classic writers (Publilius Syrus, Seneca, Aesop, Cicero etc.)

Others that I find very useful both in business and private is the ideas of Quantification (without the fancy math), Margin of safety, Backups, Trust, Constraints/Weakest link, Good or Bad Economics slash Competitive advantage, Opportunity cost, Scale effects. I also think Keynes idea of changing your mind when you get new facts or information is very useful.

But since reality isn’t divided into different categories but involves a lot of factors interacting, I need to synthesize many ideas and concepts.

Are there any areas of the mental models approach you feel are misunderstood or misapplied?

I don’t know about that but what I often see among many smart people agrees with Munger’s comment: “All this stuff is really quite obvious and yet most people don’t really know it in a way where they can use it.”

Anyway, I believe if you really understand an idea and what it means – not only memorizing it – you should be able to work out its different applications and functional equivalents. Take a simple big idea – think on it – and after a while you see its wider applications. To use Feynman’s advice, “It is therefore of first-rate importance that you know how to “triangulate” – that is, to know how to figure something out from what you already know.” As a good friend says, “Learn the basic ideas, and the rest will fill itself in. Either you get it or you don’t.”

Most of us learn and memorize a specific concept or method etc. and learn about its application in one situation. But when the circumstances change we don’t know what to do and we don’t see that the concept may have a wider application and can be used in many situations.

Take for example one big and useful idea – Scale effects. That the scale of size, time and outcomes changes things – characteristics, proportions, effects, behavior…and what is good or not must be tied to scale. This is a very fundamental idea from math. Munger described some of this idea’s usefulness in his worldly wisdom speech. One effect from this idea I often see people miss and I believe is important is group size and behavior. That trust, feeling of affection and altruistic actions breaks down as group size increases, which of course is important to know in business settings. I wrote about this in Seeking Wisdom (you can read more if you type in Dunbar Number on Google search). I know of some businesses that understand the importance of this and split up companies into smaller ones when they get too big (one example is Semco).

Another general idea is “Gresham’s Law” that can be generalized to any process or system where the bad drives out the good. Like natural selection or “We get what we select for” (and as Garrett Hardin writes, “The more general principle is: We get whatever we reward for).

While we are on the subject of mental models etc., let me bring up another thing that distinguishes the great thinkers from us ordinary mortals. Their ability to quickly assess and see the essence of a situation – the critical things that really matter and what can be ignored. They have a clear notion of what they want to achieve or avoid and then they have this ability to zoom in on the key factor(s) involved.

One reason to why they can do that is because they have a large repertoire of stored personal and vicarious experiences and concepts in their heads. They are masters at pattern recognition and connection. Some call it intuition but as Herbert Simon once said, “The situation has provided a cue; this cue has given the expert access to information stored in memory, and the information provides the answer. Intuition is nothing more and nothing less than recognition.

It is about making associations. For example, roughly like this:
Situation X Association (what does this remind me of?) to experience, concept, metaphor, analogy, trick, filter… (Assuming of course we are able to see the essence of the situation) What counts and what doesn’t? What works/not? What to do or what to explain?

Let’s take employing someone as an example (or looking at a business proposal). This reminds me of one key factor – trustworthiness and Buffett’s story, “If you’re looking for a manager, find someone who is intelligent, energetic and has integrity. If he doesn’t have the last, make sure he lacks the first two.”

I believe Buffett and Munger excel at this – they have seen and experienced so much about what works and not in business and behavior.

Buffett referred to the issue of trust, chain letters and pattern recognition at the latest annual meeting:

You can get into a lot of trouble with management that lacks integrity… If you’ve got an intelligent, energetic guy or woman who is pursuing a course of action, which gets put on the front page it could make you very unhappy. You can get into a lot of trouble. ..We’ve seen patterns…Pattern recognition is very important in evaluating humans and businesses. Pattern recognition isn’t one hundred percent and none of the patterns exactly repeat themselves, but there are certain things in business and securities markets that we’ve seen over and over and frequently come to a bad end but frequently look extremely good in the short run. One which I talked about last year was the chain letter scheme. You’re going to see chain letters for the rest of your life. Nobody calls them chain letters because that’s a connotation that will scare you off but they’re disguised as chain letters and many of the schemes on Wall Street, which are designed to fool people, have that particular aspect to it…There were patterns at Valeant certainly…if you go and watch the Senate hearings, you will see there are patterns that should have been picked up on.

This is what he wrote on chain letters in the 2014 annual report:

In the late 1960s, I attended a meeting at which an acquisitive CEO bragged of his “bold, imaginative accounting.” Most of the analysts listening responded with approving nods, seeing themselves as having found a manager whose forecasts were certain to be met, whatever the business results might be. Eventually, however, the clock struck twelve, and everything turned to pumpkins and mice. Once again, it became evident that business models based on the serial issuances of overpriced shares – just like chain-letter models – most assuredly redistribute wealth, but in no way create it. Both phenomena, nevertheless, periodically blossom in our country – they are every promoter’s dream – though often they appear in a carefully-crafted disguise. The ending is always the same: Money flows from the gullible to the fraudster. And with stocks, unlike chain letters, the sums hijacked can be staggering.

And of course, the more prepared we are or the more relevant concepts and “experiences” we have in our heads, the better we all will be at this. How do we get there? Reading, learning and practice so we know it “fluently.” There are no shortcuts. We have to work at it and apply it to the real world.

As a reminder to myself so I understand my limitation and “circle”, I keep a paragraph from Munger’s USC Gould School of Law Commencement Address handy so when I deal with certain issues, I don’t fool myself into believing I am Max Planck when I’m really the Chauffeur:

In this world I think we have two kinds of knowledge: One is Planck knowledge, that of the people who really know. They've paid the dues, they have the aptitude. Then we've got chauffeur knowledge. They have learned to prattle the talk. They may have a big head of hair. They often have fine timbre in their voices. They make a big impression. But in the end what they've got is chauffeur knowledge masquerading as real knowledge.

Which concepts from Buffett/Munger/Mental Models do you find most counterintuitive?

One trick or notion I see many of us struggling with because it goes against our intuition is the concept of inversion – to learn to think “in negatives” which goes against our normal tendency to concentrate on for example, what we want to achieve or confirmations instead of what we want to avoid and disconfirmations. Another example of this is the importance of missing confirming evidence (I call it the “Sherlock trick”) – that negative evidence and events that don’t happen, matter when something implies they should be present or happen.

Another example that is counterintuitive is Newton’s 3d law that forces work in pairs. One object exerts a force on a second object, but the second object also exerts a force equal and opposite in direction to the force acting on it – the first object. As Newton wrote, “If you press a stone with your finger, the finger is also pressed by the stone.” Same as revenge (reciprocation).

Who are some of the non-obvious, or under-the-radar thinkers that you greatly admire?

One that immediately comes to mind is one I have mentioned in the introduction in two of my books is someone I am fortunate to have as a friend – Peter Kaufman. An outstanding thinker and a great businessman and human being. On a scale of 1 to 10, he is a 15.

What have you come to appreciate more with Buffett/Munger’s lessons as you’ve studied them over the years?

Their ethics and their ethos of clarity, simplicity and common sense. These two gentlemen are outstanding in their instant ability to exclude bad ideas, what doesn’t work, bad people, scenarios that don’t matter, etc. so they can focus on what matters. Also my amazement that their ethics and ideas haven’t been more replicated. But I assume the answer lies in what Munger once said, “The reason our ideas haven’t spread faster is they’re too simple.”

This reminds me something my father-in-law once told me (a man I learnt a lot from) – the curse of knowledge and the curse of academic title. My now deceased father-in-law was an inventor and manager. He did not have any formal education but was largely self-taught. Once a big corporation asked for his services to solve a problem their 60 highly educated engineers could not solve. He solved the problem. The engineers said, “It can’t be that simple.” It was like they were saying that, “Here we have 6 years of school, an academic title, lots of follow up education. Therefore an engineering problem must be complicated”. Like Buffett once said of Ben Graham’s ideas, “I think that it comes down to those ideas – although they sound so simple and commonplace that it kind of seems like a waste to go to school and get a PhD in Economics and have it all come back to that. It's a little like spending eight years in divinity school and having somebody tell you that the 10 commandments were all that counted. There is a certain natural tendency to overlook anything that simple and important.”

(I must admit that in the past I had a tendency to be extra drawn to elegant concepts and distracting me from the simple truths.)

What things have you come to understand more deeply in the past few years?

  • That I don’t need hundreds of concepts, methods or tricks in my head – there are a few basic, time-filtered fundamental ones that are good enough. As Munger says, “The more basic knowledge you have the less new knowledge you have to get.” And when I look at something “new”, I try to connect it to something I already understand and if possible get a wider application of an already existing basic concept that I already have in my head.
  • Neither do I have to learn everything to cover every single possibility – not only is it impossible but the big reason is well explained by the British statistician George Box. He said that we shouldn’t be preoccupied with optimal or best procedures but good enough over a range of possibilities likely to happen in practice – circumstances which the world really present to us.
  • The importance of “Picking my battles” and focus on the long-term consequences of my actions. As Munger said, “A majority of life's errors are caused by forgetting what one is really trying to do.”
  • How quick most of us are in drawing conclusions. For example, I am often too quick in being judgmental and forget how I myself behaved or would have behaved if put in another person’s shoes (and the importance of seeing things from many views).
  • That I have to “pick my poison” since there is always a set of problems attached with any system or approach – it can’t be perfect. The key is try to move to a better set of problems one can accept after comparing what appear to be the consequences of each.
  • How efficient and simplified life is when you deal with people you can trust. This includes the importance of the right culture.
  • The extreme importance of the right CEO – a good operator, business person and investor.
  • That luck plays a big role in life.
  • That most predictions are wrong and that prevention, robustness and adaptability is way more important. I can’t help myself – I have to add one thing about the people who give out predictions on all kinds of things. Often these are the people who live in a world where their actions have no consequences and where their ideas and theories don’t have to agree with reality.
  • That people or businesses that are foolish in one setting often are foolish in another one (“The way you do anything, is the way you do everything”).
  • Buffett’s advice that “A checklist is no substitute for thinking.” And that sometimes it is easy to overestimate one’s competency in a) identifying or picking what the dominant or key factors are and b) evaluating them including their predictability. That I believe I need to know factor A when I really need to know B – the critical knowledge that counts in the situation with regards to what I want to achieve.
  • Close to this is that I sometimes get too involved in details and can’t see the forest for the trees and I get sent up too many blind alleys. Just as in medicine where a whole body scan sees too much and sends the doctor up blind alleys.
  • The wisdom in Buffett’s advice that “You only have to be right on a very, very few things in your lifetime as long as you never make any big mistakes…An investor needs to do very few things right as long as he or she avoids big mistakes.”

What's the best investment of time/effort/money that you've ever made?

The best thing I have done is marrying my wife. As Buffett says and it is so so true, “Choosing a spouse is the most important decision in your life…You need everything to be stable, and if that decision isn’t good, it may affect every other decision in life, including your business decisions…If you are lucky on health and…on your spouse, you are a long way home.”

A good “investment” is taking the time to continuously improve. It just takes curiosity and a desire to know and understand – real interest. And for me this is fun.

What does your typical day look like? (How much time do you spend reading… and when?)

Every day is a little different but I read every day.

What book has most impacted your life?

There is not one single book or one single idea that has done it. I have picked up things from different books (still do). And there are different books and articles that made a difference during different periods of my life. Meeting and learning from certain people and my own practical experiences has been more important in my development. As an example – When I was in my 30s a good friend told me something that has been very useful in looking at products and businesses. He said I should always ask who the real customer is: “Who ultimately decides what to buy and what are their decision criteria and how are they measured and rewarded and who pays?

But looking back, if I have had a book like Poor Charlie’s Almanack when I was younger I would have saved myself some misery. And of course, when it comes to business, managing and investing, nothing beats learning from Warren Buffett’s Letters to Berkshire Hathaway Shareholders.

Another thing I have found is that it is way better to read and reread fewer books but good and timeless ones and then think. Unfortunately many people absorb too many new books and information without thinking.

Let me finish this with some quotes from my new book that I believe we all can learn from:

  • “There’s no magic to it…We haven’t succeeded because we have some great, complicated systems or magic formulas we apply or anything of the sort. What we have is just simplicity itself.” – Buffett
  • “Our ideas are so simple that people keep asking us for mysteries when all we have are the most elementary ideas…There's nothing remarkable about it. I don't have any wonderful insights that other people don't have. Just slightly more consistently than others, I've avoided idiocy…It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” – Munger
  • “It really is simple – just avoid doing the dumb things. Avoiding the dumb things is the most important.” – Buffett

Finally, I wish you and your readers an excellent day – Everyday!

 

Second-Level Thinking: What Smart People Use to Outperform

“Experience is what you got when you didn’t get what you wanted.”
— Howard Marks

***

Second Order Thinking

Successful decision making requires thoughtful attention to many separate aspects.

Decision making is as much art as science. The goal, if we have one, is not to make perfect decisions but rather to make better decisions than average. To do this we require either good luck or better insight. And since luck isn’t really much of a plan, we should probably focus on better insight.

In most of life you can get a step ahead of others by going to the gym or the library, or even a better school. In thinking, however, a lot of what you'd think gets you ahead is only window dressing.

Would be thinkers and deciders can attend the best schools, take the best courses and, if they are lucky, attach themselves to the best mentors. Yet only a few of them will achieve the skills and superior insight necessary to be an above average thinker. And we live in a world that, if it rewards anything, rewards better decisions. The rest is increasingly automated.

But how do we get there in a world where everyone else is also smart and well-informed? How do we get there in a world that is increasingly becoming computerized? You must find an edge. You must think differently.

In his exceptional book, The Most Important Thing, Howard Marks hits on the concept of second-level thinking.

First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.” Second-level thinking is deep, complex and convoluted.

Second-level thinkers take into account a lot of what we put into our decision journals. Things like, What is the range of possible outcomes? What’s the probability I’m right? What’s the follow-on? How could I be wrong?

The real difference for me is that first-level thinkers are the people that look for things that are simple, easy, and defendable. Second-level thinkers push harder and don't accept the first conclusion.

***

“It’s not supposed to be easy. Anyone who finds it easy is stupid.”
— Charlie Munger

***

Marks writes:

First-level thinkers think the same way other first-level thinkers do about the same things, and they generally reach the same conclusions. By definition, this can’t be the route to superior results.

This is where things get interesting. Extraordinary performance comes from being different. It must be that way. Of course, below average performance comes from being different too — on the downside.

So it's not enough to be different — you also need to be correct. “The problem is that extraordinary performance comes only from correct nonconsensual forecasts, but nonconsensual forecasts are hard to make, hard to make correctly and hard to act on,” writes Marks. The goal is not blind divergence but rather rather a way of thinking that sets you apart from others.

In short, you can’t do the same things that other people are doing and expect to outperform.

We can look at this as a simple two-by-two matrix (via The Most Important Thing).

Second Level Thinking Matrix

I’m generalizing a bit here, but if your thoughts and behavior are conventional, you’re likely to get conventional results. Steve Jobs was right.

This is where loss aversion comes in. Most people are simply unwilling to be wrong because that means they might look like a fool. Yet this is a grave mistake. The ability to risk looking like an idiot is necessary for being different. You never look like a fool if you look like everyone else. (Bringing to mind Keynes' dictum: Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.) Only by doing — or, in our case, thinking — something different do you put yourself at risk.

JOHN MAYNARD KEYNES

Conventional thinking and behavior is safe. But it guarantees mediocrity. You need to know when your performance is likely to be improved by being unconventional.

Here’s a pro tip. If you want to have fun at work this week, do one of two things. First, start digging below the surface of people’s opinions. Ask them why they think what they think. Second, ask them to take the other side of the argument.

Investing: The Rules of the Road

Investing money can seem a little rudderless at times.

One day you hear that stocks are risky and the next that they’re indispensable. Some days it seems like stocks only go up and sometimes that they only go down. Real estate used to seem like an automatic path to wealth, and then the housing crisis hit. For the uninitiated, it sometimes seems there are no central truths. And unlike certain fields, we all have to deal with money. We can’t “opt out” from financial concerns unless we plan to live in a monastery, and it is useful for all of us to understand the basic ideas.

Investing is not a science but a craft, and a craftsman needs tools. In the case of investing, the tools are mostly mental. If we accumulate a few simple mental tools, we can start evaluating the claims of experts, salesmen, or simply well-intentioned friends.

The Rules of the Road

(1) The value of an asset depends entirely on the net cash it will
generate from now to the hereafter.

This goes for a stock, an apartment house, a convenience store, a bakery, or an iPhone app startup. An asset only has value (in a financial sense) if it can generate net cash flow to its owner. The amount and timing of that cash determines the value of the business. The more cash to be expected and the sooner it’s expected to come, the more valuable the asset is today. This is the fundamental truth about investing. Nothing escapes the orbit of future cash flows.

The other determinant of value is interest rates: The average future interest that could have earned if you bought a “risk-free” asset is the opportunity cost of the asset you’re considering purchasing today. That risk-free interest rate determines the value of an asset’s future cash flows to you today. (Although we don’t recommend trying to compute the figure out to three decimal places.) If average risk-free interest rates are 6% over time and I offer you a chance to buy an apartment house that pays you 4% on cost, is that a good buy? You better feel confident that the 4% will grow over time, right? This basic form of reasoning can be applied to all types of cash-producing assets.

This is the thing you should be thinking about when you’re instead thinking about what the Fed will be doing or what Jim Cramer said on TV or what the hot industry is or what the CEO of some company had for breakfast. Do you have any idea what the business or property will earn over the next five, ten, or twenty years in relation to what it earns now? This Grand Unifying Theory of investing gets discussed surprisingly little.

It also generates some sub-conclusions that aren’t always recognized by lay investors and are frequently forgotten by professionals.

(A) What an asset has earned in the past does not determine its value. In stocks, looking at the last ten years of earnings is a useful exercise in trying to understand what type of business you’re dealing with, but while it’s a good guide, past earnings do not generate value. Future earnings do, and that goes for all types of assets. This means you must develop a view about the future, which we’ll address again in point (2) below.

(B) An asset that never earns any net profit after all expenses has no financial value. Please let that sink in. It is common for businesses to obscure this basic fact, and promote all sorts of alternative methodologies with which you’re supposed to see value. Book value, EBITDA, number of page views, number of users, brand recognition, and years of managerial experience do not, in and of themselves, tell you about the value of a business or an asset. The bare fact is that an asset must eventually generate net cash flows to its owner which are commensurate with the price paid in order for the investment to be worthwhile. Investing on another basis is, by definition, speculation.

(C) If you have no idea what an asset will earn in the future (at least in a general sense), then you have no idea what it’s worth. And if you do not know what the asset is worth, then you have no idea whether you are over-paying or under-paying for it, and as an intellectually honest person, you should consider both possibilities at least equally likely.

(D) Any future cash flows out of an asset must also be subtracted in determining today’s value. If a business is going to lose money for 10 years and only then start making it, it’s worth a hell of a lot less than one which will make the same amount of money starting this year. This is another idea which gets surprisingly little play in relation to its obvious importance.


***

(2) Buying a share of stock is a buying share of the underlying business.

Although we’re discussing general investment concepts, the stock market needs a bit more attention because of its seemingly abstract nature. No one gets confused as to what they’re buying when they invest in a local dry-cleaner. Most fixed income instruments are priced in a fairly straightforward manner. But when it comes to businesses traded on the public exchanges, which we call stocks, all sorts of weird theories abound.

Stocks, for all of their labels and all of the strange fears and speculations around them, are no more than a piece of an underlying business pie. When you buy stock in a business, you are buying the right to the net cash flows that its assets produce. Stocks do not escape the orbit of financial gravity no matter what the Fed is doing or what CNBC is saying. And buying into an index fund that owns many stocks means that you’re now part-owner in all of the underlying businesses; your return comes from the success of their business operations. If American business as a whole keeps on trucking, the index fund will reflect their success, assuming you paid a rational price. That’s why averaging into the indexes is such a common recommendation for non-professional investors. Buying individual businesses in the form of stocks carries a heavier burden of proof and much more specialized work.

One corollary to this idea is that stock prices tend to move around much more than intrinsic business values. If you were to take the ten year business record of any of a number of very stable corporations and then guess their high and low stock prices in the same period, you would almost certainly be surprised at the degree of variation. The reason for this can be found in point (3).

***

(3) Investing in any asset with uncertain cash flows requires an
element of speculation about the future.

Discerning an asset’s cash flows requires that we make intelligent guesses about a cloudy future. This idea has some deep corollaries:

(A) The more speculation needed to determine the value of the asset, the riskier it is all else equal, due to the higher probability of getting our estimates wrong. In the case of a 1-Year U.S. Treasury bill, we don’t have to offer any speculation beyond assuming that the U.S. government will be solvent and paying 12 months from now and that the U.S. dollar will continue to be accepted as legal tender. (If this ceases to be true, we’re all in big trouble.)

In the case of a biotechnology startup, on the other hand, our entire valuation is going to be based on speculation. In essence, the whole exercise of valuing such a start-up would be making difficult guesses about the future. The probability that we get all of our guesses correct approaches zero, although if we’re correct enough about one or two important factors we might still make money. But we’ll need great luck in doing so, whereas with the Treasury bill, we hardly need any luck at all.

(B) Investing in uncertain assets, including any kind of business-based investment like a farm or a technology stock, involves some difficult speculation, so it’s easy to predict that at times, investors will get caught up in their enthusiasms and mis-price assets. Charlie Munger has commented that stocks are valued partly like Treasury bonds, with obvious cash flows estimated and discounted at rational rates, and partly like art or collectibles, with speculation that the price will go higher or lower because of popularity, trend, or hope. The riskiest assets are the ones valued primarily on speculation because of our lack of ability to see into their economic future. That’s why a corporate bond tends to be less risky than a stock — you only need to establish that the corporation will be solvent for the bond to be a good investment, whereas with the stock, you must make much more complicated estimates.

(C) We know from watching horse-race betting, casino gambling, and lottery participation that people are frequently willing to speculate on odds-against bets that can only hurt them financially in the long-run. We observe the same behavior in the stock market and in other markets as well. (There was, for example, a speculative farming boom in the 1980s.) Financial markets cannot be perfectly efficient because of the speculative element. As with (B) above, more uncertain assets tend to have a greater speculative element attached.

(D) Assets with predictable cash flows tend to be inherently lower-risk than ones without predictable cash flows. Let’s use two different types of businesses to understand this point.

We can be essentially certain that over the next year, Visa and MasterCard will make a tremendous amount of money which is closely related to the amount they made last year — their cash flows are based on the number of transactions made on their cards and the amount of money they collect per transaction. Both elements tend to be extremely stable on a day to day and year to year basis, with a tendency towards growth as new cards make it into circulation. Unless hundreds of millions of people stop using their credit and debit cards or million of merchants find a way to pay a lot less to these intermediaries (who collect very little to start), the businesses will maintain a useful degree of economic predictability. The number of transactions you made on your card last month and the month before pretty closely predicts how much you’ll use it this month and the following one.

As we move out further to year 2, we can still be pretty sure that these characteristics will continue to hold, and thus we can predict with useful accuracy the kind of money Visa/Mastercard will make. The same goes for year 3. However, the longer we continue this exercise, the more our accuracy declines. Although things look pretty good this year, next year, and the year after, what about 30 years from now? By then, one can speculate on the possibility of certain changes to the financial system which might affect the economics of Visa/Mastercard. Our earnings estimate 30 years out is certain to be inaccurate even for a predictable business.

The opposite case is Twitter. Twitter has never shown a net profit to its shareholders and has not established a consistent business model which would allow it to do so. Thus, it would be very difficult to say what Twitter’s earnings might be in the next year, let alone 30 years from now. On this basis, investing in the common stock of Twitter contains a much larger speculative element than Visa/Mastercard. An investment in Visa/Mastercard at a fair price in relation to future earnings can be said to have far less risk than an investment in Twitter. Notice that we don’t come to this conclusion by saying that Visa/Mastercard are riskless, that we can predict their earnings forever, or that Twitter will never be a profitable investment. We are simply ranking potential investments on a sliding scale based on the predictability of their future cash flows. Any estimates will be necessarily imprecise, but they still have great value to us as investors.

***

(4) The price you pay determines the return you get.
Lower prices = higher returns.

You’ll often hear fables about how now is the time to invest because “The market has done really well over the past few years” or because “My friend has made a lot of money on this stock, I think it’s a good investment,” or some similar statement about other kinds of financial assets; real estate properties, oil royalties, McDonald’s franchises, etc.

Conversely, one frequently hears things like “That stock’s gone way down recently, it seems pretty risky” or “My friend bought a bunch of real estate that went way down, I think real estate is risky” and other notions to that effect.

These thoughts are 180 degrees wrong because they fail to understand the point that low prices create high future returns and that high prices create low future returns. (“High” and “low” being in relation to underlying value.) If a stock trades at 50% of its recent high price, then you are buying the same future cash flows for half the price. If a stock trades at 200% of a recent low price, then the opposite is true; you’re getting exactly half the value you would have before.

You should seek to buy assets with future cash earnings you can (roughly) estimate at prices that offer a fair return. The rest is almost always noise.


***

(5) Everyone has a unique circle of competence which allows them to
understand certain things best and other things not at all.

We discussed above in point (3) that certain investment situations are inherently speculative, as with the case of Twitter common stock. But even within the realm of knowable investment choices, each investor has his or her own unique circle of competence which they bring to the analysis. In the circle are the things that, through life experience and/or accumulated study, one can fairly evaluate and expect to end up in the right ballpark. Outside of the circle are things we don't have the experience to understand.

Although this point seems simple to the point of banality, it is constantly violated even by smart and financially-savvy people. Many an expert in construction businesses or plumbing businesses or restaurant businesses have tried their hand at buying apartment houses or energy stocks only to find out that their expertise did not carry over. And it is thus for all of us: We are prisoners to our talents, and we’re wise to think long and hard about what we really know and don’t know.

For example, if you do not have the ability to read financial statements, understand microeconomics, and assess the future underlying cash flows of an individual business, are stocks truly in your circle of competence? If you don’t know cap rates from Captain America, is it wise for you to try to get rich buying real estate properties? Unless and until we learn to be honest with ourselves, we will make mistakes that we don’t need to make.

***

Investing does not have to be rocket science. Once you understand the central concepts and begin learning to apply them, all it takes is discipline and intellectual honesty. Anyone can be a successful investor, broadly defined, by sticking to their circle of competence and not straying outside of it, by not speculating when they think they’re investing, and by always looking to pay a fair price in relation to what they’re buying. These three central tenets, closely followed, can allow any intelligent person to operate safely in the financial world.

Still Interested? Read more about Warren Buffett and Charlie Munger, whose ideas on investing have influenced generations of wise and successful investors. The best books we know of on the topic are The Intelligent Investor, Poor Charlie's Almanack, Berkshire Hathaway's Letters to Shareholders, and John Bogle's book The Little Book of Common Sense Investing to learn about indexing.