Charlie Munger’s mental models could make you a better investor
By Philip van Wijngaarden
Want to learn how to really build wealth?
Take some lessons from Charlie Munger, who is Warren Buffett’s partner at the world’s leading investment firm Berkshire Hathaway. The firm doesn’t waste its time building complicated spreadsheets to pinpoint investment decisions. Instead, Munger has spent a lifetime learning and perfecting mental models that allow him to make quick investment decisions without the aid of computers or calculators. In the process, he’s made billions for himself and the company’s investors.
Mental toolbox
With a lot of effort and discipline you too can take advantage of his wisdom. Like no other portfolio manager, Munger has developed the ability to go straight to the heart of an investment decision. Buffett notes that Munger is better at making investment decisions in his 90s than at any other time in his life. Through mental models, if an investment isn’t obvious to both men, they don’t even look at it. Besides using mental models, Munger reads, thinks and asks questions a lot to better understand his investments and the ecosystems in which it operates. Munger and Buffett agree that it’s impossible to know anything about an investment from unrelated facts created in spreadsheets. You need to put it all together into working models to fully understand how the investment operates.
Mental models were invented way back in the 1940s. It is a mental toolbox to better understand how something in the world works. The idea is to simplify complex abstract ideas and put it all together for better decision making. We can’t store all the details of the world in our brains. We use mental models to simplify complex information into easy-to-understand bite-sized pieces to make better decisions. These mental models borrow unrelated major principles from a myriad of academic disciplines and apply them to investments.
Underlying concepts
Munger believes that investors should have a thorough understanding of these concepts that are taught in many university freshmen courses. The underlying concepts from subjects, ranging from natural sciences to the humanities, have something to offer all investors. For example, the concept of redundancy in engineering that lowers the odds of failure in a system can help investors avoid risk. If engineers didn’t use redundancy or have a backup plan in a spacecraft flying to Mars and there was a system failure, the billion-dollar craft would be a useless piece of junk floating in space. Redundancy is therefore insurance against failure. Redundancy can also be used when evaluating future cash flow and earnings to see if an investment is worth buying. Investors can borrow another concept from the field of accounting called the margin of safety principle.
With this principle, an investment should only be made if the price of the stock reflects the worst-case scenario if all projections went wrong. That way, investors won’t experience a dramatic loss.
Incentives
Another model the two men created is called the Circle of Competence. It can be summed up by saying that you should be honest with yourself and only stick to companies you fully understand. Under this model, individuals should only concentrate on investments they have the greatest familiarity. You don’t need to be an expert in every company. Investing in what you don’t fully understand can be disastrous. This strategy has been one of the main reasons that Munger and Buffett use when asked why they don’t invest in the technology sector.
The hidden power of Incentives is another model that many companies are not using optimally to motivate employees to perform at their best. It’s a concept borrowed from psychology called positive reinforcement. Many people and companies underestimate its power. Sometimes a behavioral problem can be solved by using the right incentives. The classic example Munger uses is when FedEx had problems motivating employees on the night shift to rapidly move parcels. The speed at which parcels are transferred is key to the success of FedEx’s delivery business and it was struggling to find a solution. It wasn’t until FedEx paid employees a fixed fee for completing the night shift instead of an hourly rate that its problems were resolved. That’s when management realized the hourly rate was incentivizing employees to work longer rather than take fewer hours to get the same job done. Now employees were paid the same rate no matter how long it took them to load planes. Suddenly, the job got done quicker.
Charlie Munger has many other mental models worth exploring. Learning and knowing how to implement his models will help everyone make better investment decisions. All you need is motivation and discipline to study and practice each one. The information is literally all at your fingertips to start building wealth by making better investment decisions with Charlie Munger’s mental models.
About the author: Philip van Wijngaarden, is a partner at Dutch private equity and venture capital firm Ramphastos Investments, which was established by billionaire Marcel Boekhoorn. Philip loves working with highly motivated entrepreneurs, who are determined to dominate upcoming and innovative industries. At Ramphastos Investments he has been involved in many start-ups and scale-ups in a multitude of industries like aviation, telecom, fintech and gaming.
