> Warren Buffett Blog: Invest like Charlie Munger by thinking like him

Monday, January 25, 2016

Invest like Charlie Munger by thinking like him

Warren Buffett's sidekick Charlie Munger says that you can't be a great stock picker if you don't have an elementary, worldly wisdom. By remembering isolated facts and figures without hanging them on "a latticework of theory, you don't have them in a usable form."

By having only one model, or one way of viewing problems, you conform to the old saying "to the man with only a hammer, every problem looks like a nail." The models also need to come from different disciplines such as math, science, literature, and physics. You don't need to know many models; a small number of them will do most of the heavy lifting.

The models to know in math come from basic arithmetic. Knowing how to figure out compound interest and basic algebra is a good place to start. 

Decision tree theory is a very useful tool for helping you choose among several courses of action. Munger says that it is nothing more than high school algebra applied to real-life problems. Decisions are all about probabilities: identifying relevant variables and attaching probabilities to each of them. 

Munger says that one of the major advantages that Warren Buffett has is that he automatically thinks in terms of decision trees.

Munger goes on to show how psychological models are extremely important in the financial world. But what is most surprising is that economic textbooks have barely a word on the influence psychology has on markets. He mentions several models, such as social proof, a need to view a behavior as correct only after seeing how others react, and availability mis-weighing tendency, a concept that says an idea or fact is not worth more simply because it is easily available. Just knowing how to recognize when this situation arise will give you a big leg up over everyone else.

Munger also mentions models in natural science and shows how the ecosystem model can offer insight. The ecosystem, a community of plants and microorganisms that are linked to one another and interact with the physical environment, is much like similar businesses in certain industries. Many species of animals and plants live in niches and not only survive but thrive; so too niche companies. 

"If you don't incorporate these elementary models into your thought process, then you will go through life like a one-legged man in an ass-kicking contest. You're giving a huge advantage to everybody else"