The Mental Master

Earlier this year, we decided to dedicate every Wednesday edition of HX Daily to sharing the wisdom of a great financial or economic mind. 

One of the most fascinating aspects of putting together these issues has been looking at the different types of insights from these great intellects.

Many (most) of the smartest investors are not great at communicating their wisdom. Their quotes are often too complicated or obtuse.

There are few, however, that stand out for the simplicity of their wisdom.

It won’t surprise you to learn that one of those is the great Charlie Munger.

Munger’s ability to generate a pithy – and incredibly insightful – quote is incomparable.

Recently, we read a piece by our colleague Sean King of The Rude Awakening, and he introduced me to Munger’s “mental models.” 

As Sean says, these are “…guiding principles and ways of thinking that he’s (Munger) curated from a broad spectrum of disciplines. Munger’s approach isn’t about memorizing facts or executing rigid strategies but constructing a ‘latticework of mental models’ that integrate knowledge from psychology, economics, biology, and other fields to make better decisions.”

We loved the mental models Sean shared in his piece, and we are going to share some of them with you today.

By the way, you can sign up for Sean’s great free email newsletter here.

Here are some of Munger’s “mental models” …

1. Inversion

I quickly recognized most of the mental principles that Sean shared. However, when I read the title of this one, I had no idea what he was talking about.

The idea here is that sometimes, the best way to figure something out is to think about it backward. Don't think about what you are trying to do but what you are trying to avoid.

When it comes to investing, instead of thinking about what makes a “good” investor – focus on what makes a “bad investor.” Then work to eliminate those characteristics from your process.

In our three decades as professional investors, we have almost never seen someone run a big fund without a good process for making money. Most of them, however, did NOT outperform the markets.

The reason was because they didn't eliminate their bad habits. Their ideas were good, but their processes around them were poor.

Start by identifying potential failures and working to remove those elements from your strategy. This is probably Munger's most powerful insight.

2. Opportunity Cost

Most investors are familiar with this concept.

The idea is that in addition to the straightforward cost of doing something, there is another cost—the "opportunity cost"—incurred by NOT doing something else.

It is a very well-known concept in economics.

What we think is hugely underappreciated is HOW important this is for your process.

Investors understand it is important but don't make it a priority. We constantly push SELECTIVITY.

Too often, investors focus on making a good return when they could be focused on making a great one. There is only so much time and capital; you should be ruthless in deciding where to allocate them.

3. Circle of Competence

This is a favorite of Munger's and was a big part of his life. The key is knowing both what you DO know and what you DO NOT know.

Figuring out where you don't have the expertise or the ability to have insight is essential to avoid mistakes.

Also, it is crucial to have the humility to go to others with that competence when you need it.

4. Confirmation Bias

In the past, we have often written about different psychological biases that influence (negatively) our TRADING and INVESTING. This is the most powerful one.

We are mentally programmed to seek information that supports what we believe or want to believe. We don't like hearing contradictory information.

This bias is not just in finance but in all areas of life.

One of the keys to success is becoming comfortable with being UNCOMFORTABLE.

Seek out the arguments for why you are wrong. Like the idea of "inversion,” embracing critical and negative feedback is a key to growth.

5. The Lollapalooza Effect

Munger coined this term. It describes a situation in which multiple mental models, tendencies, or biases work together to create extreme outcomes.

These outcomes could be good or bad. These are feedback circles that are built into human psychology.

This concept is also related to George Soros' "reflexivity" concept, which we have written about in the past. You can read that note here.

These human feedback loops are some of the most powerful forces in all of finance and human activity.

In case you are wondering, the word “Lollapalooza” is a 19^th -century American slang word that refers to something unusual, extraordinary, or exceptional.