A Latticework of Mental Models

We've discussed Mental Models before, in particular in the context of Charlie Munger.  Or maybe it was in my other blog.  At any rate, this is a great reminder. The link is at the bottom of the page. (Blogger isn't letting me put in any images for some reason.)

Latticework of Mental Models

Munger is best known for  emphasising the power amp; importance of multi-disciplinary learning (or he calls it, quot;worldly wisdomquot;) to become successful at stock-picking as well as life generally. He argues that investors should not just focus on a few narrow topics but expand their horizons to understand many different subjects. This allows savvy investors to avoid myopia - quot;If you have a hammer everything will start to look like a nailquot; - and profit from others' shortsightedness.
The best example of this thinking was a speech he gave in 1994 to the University of Southern California Business School entitled quot;A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management amp; Businessquot;. Rather than discussing the stock market specifically, he challenged the students to see the market, of finance, and of economics as part of a larger body of knowledge, that also incorporates psychology, engineering, mathematics, physics, and the humanities. To drive his point home, Charlie used a memorable metaphor to describe this interlocking structure of ideas:
quot;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.... 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...  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 departmentquot;
While this may seem intimidating and beyond the capacity of mere mortals, Munger suggest about that 80 or 90 important models will do 90% of the work and, of those, only a mere handful are the most important. Unfortunately, he doesn't specify exactly which models he's referring to, but others have speculated on the list and it seems clear from his writings that he's refering to concepts like auto-catalysis, decision-trees, operant conditioning social proof, and natural selection.

The Power of Checklists

Munger is also an advocate of employing a checklist approach in order to try to marshall acquired knowledge effectively. As he noted in a speech to the University of Southern California Law School :
quot;Checklist routines avoid a lot of errors. You should have all this elementary [worldly] wisdom and then you should go through a mental checklist in order to use it. There is no other procedure in the world that will work as well.quot; 
He also noted in another speech:
quot;The antidote to man with a hammer is a tool kit full of tools, not just a hammer. And use the tools checklist style because you’ll miss a lot if you hope the right tool just pops up unaided whenever you need it. But if you’ve got a full list of tools and you go through them in your mind checklist-style, you will find a lot of the answers you won’t find any other way.”

An Investing Principles Checklist

On that note, Charlie's Almanack contains a fascinating 10 point investing principles checklist, along with some interesting comments/observations in support of each point. It is emphasised that this isn't used by Charlie in a one-by-one procedural fashion, nor are the principles prioritized in terms of importance. Nevertheless, the idea is that each of these elements should be considered as part of the investment analysis process...

1. Measure risk: All investment evaluations should begin by measuring risk, especially reputational.  This is said to involve incorporating an appropriate margin of safety, avoiding permanent loss of capital and insisting on proper compensation for risk assumed. 
2. Be independent: Only in fairy tales are emperors told they're naked.  Remember that just because other people agree or disagree with you doesn’t make you right or wrong – the only thing that matters is the correctness of your analysis.
3. Prepare ahead: The only way to win is to work, work, work, and hope to have a few insights. If you want to get smart, the question you have to keep asking is “why, why, why?”
4. Have intellectual humility: Acknowledging what you don't know is the dawning of wisdom.  Stay within a well-defined circle of competence amp; identify and reconcile disconfirming evidence.
5. Analyze rigorously: Use effective checklists to minimize errors and omissions. Determine value apart from price; progress apart from activity; wealth apart from size. Think forwards and backwards – Invert, always invert
6. Allocate assets wisely: Proper allocation of capital is an investor's No. 1 job. You should remember that good ideas are rare – when the odds are greatly in your favor, bet heavily. At the same time, don’t “fall in love” with an investment.
7. Have patience: Resist the natural human bias to act. “Compound interest is the eighth wonder of the world” (Einstein); never interrupt it unnecessarily and avoid unnecessary transactional taxes and frictional costs.
8. Be decisive: When proper circumstances present themselves, act with decisiveness and conviction. Be fearful when others are greedy, and greedy when others are fearful. Opportunity doesn’t come often, so seize it when it comes.
9. Be ready for change: Accept unremovable complexity. Continually challenge and willingly amend your “best-loved ideas” and recognize reality even when you don’t like it – especially when you don’t like it
10. Stay focused: Keep it simple and remember what you set out to do. Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat. Face your big troubles; don’t sweep them under the rug.

Of course, how one translate this into an actionable set of investment ideas is the $200 billion question, but it's still a very interesting list of principles to reflect upon when investing!

The Lollapolooza Effect

A final idea that Munger introduces is the  quot;Lollapalooza Effectquot;. This describes multiple biases, tendencies or mental models acting at the same time in the same direction. This tends to produce extreme outcomes and investor misjudgement. During a talk at Harvard in 1995, Munger mentioned Tupperware parties and open outcry auctions as good examples of this effect:

the open-outcry auction is just made to turn the brain into mush: you've got social proof, the other guy is bidding, you get reciprocation tendency, you get deprival super-reaction syndrome, the thing is going away... I mean it just absolutely is designed to manipulate people into idiotic behavior.

From the Source

In addition to the quot;Poor Charlie's Almanackquot; compilation (available on Amazon or direct from the website itself), there are a number of interesting speeches by Munger available online:

• Munger on Human Misjudgments 
• A Lesson on Elementary, Worldly Wisdom as it Relates to Investment Management amp; Business
• The Great Financial Scandal of 2003
• On The Psychology Of Human Misjudgement
• USC Law School Commencement
• Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs

It's also worth checking out the excellent Munger resource page at Value Walk.


Read more: http://www.stockopedia.co.uk/content/charlie-munger-investing-success-from-mental-models-checklists-63841/#ixzz318VKjZyn