The Mental Master

Two weeks ago, we shared several of Charlie Munger’s “mental models.”

While we are very familiar with Munger's wit and wisdom, we had not read about these until we saw a note from our colleague Sean Ring of The Rude Awakening.

He introduced us to these “mental models” in a recent piece.

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.”

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

As we said last week - we loved the mental models Sean shared in his piece, and we will share some more of them with you today.

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

1. Second-Order Thinking

This is the concept that when we consider the impact of an action or decision, we often only consider what is likely to happen next. It is difficult for us to consider the greater ramifications.

This can have significant impacts on trading and investing.

A change in commodity prices might impact one of your holdings in a certain way. Looking beyond the initial reaction might lead to the conclusion that it affects it in the exact opposite way.

Getting this wrong can lose you a lot of money.

We spoke about a version of this concept in our recent note about legendary investor Howard Marks. You can read that note here.

2. The Map Is Not the Territory

We had never heard this saying before, but Munger is making the point that no matter how well thought out a model might be, it doesn't represent reality.

No matter how sophisticated the model is, we cannot 100% capture the complexity of the real world.

A dangerous outcome related to this insight is what is called "false precision."

When we make decisions based on the result of a "model" without accepting it, we may be wrong. More data does NOT mean more accuracy.

3. Mr. Market

This is a clever term coined by the father of value investing – Benjamin Graham.

"Mr. Market" is a fictional character Graham created to illustrate that markets are emotional and volatile by nature. After all, they are made up of humans!

Much of Graham's (and Munger's) work is based on the idea that fundamentals drive ultimate stock prices. We don't always agree, but the concept of "Mr. Market" was their acknowledgment of human emotion's role in asset prices.

4. Social Proof

This is a powerful concept in psychology.

We feel better about making a decision or taking an action when we see our peers doing the same. This is the key to herd mentality and the creation of asset bubbles.

When we see everyone else buying a winning growth stock (that is going up), we feel good about buying it as well. Regardless of what our analysis might tell us.

This brings up the old stock market adage about money management – “No one ever got fired for buying IBM.” Today’s version might be NVIDIA instead…

5.  Occam’s Razor

This is one of our favorites. "Occam's Razor" states that when given a range of potential explanations for something, the simplest and most straightforward is the most likely.

We think this is true in most things in life.

It is also one of the more challenging insights for "sophisticated" investors to accept. The most straightforward answer seldom sounds the smartest.

Many (most) professionals are more interested in sounding smart than being right.

Remembering "Occam's Razor" when doing your analysis can give you a leg up on them!