Everyone knows that investing is - ultimately - about numbers. After all, if you don’t have a good grasp of numbers, it’s unlikely that you will be able to come to the correct conclusions when analyzing a balance sheet or earnings statement. But investing is also about psychology. Understanding accounting can tell you if something is undervalued, but psychology can tell you why it’s undervalued. In a 1994 speech at the University of Southern California Business School, Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) Vice Chairman Charlie Munger (Trades, Portfolio) addressed both the importance of having a mathematical mind and a strong psyche.
Know the basics well
How advanced a mathematician do you have to be to be a successful investor? Luckily, you don’t have to have a Ph.D. Munger thinks that it’s much more important to have a very strong understanding of arithmetic:
“Obviously, you’ve got to be able to handle numbers and quantities - basic arithmetic. And the great useful model, after compound interest, is the elementary math of permutations and combinations...It’s very simple algebra. It was all worked out in the course of about one year between Pascal and Fermat. They worked it out casually in a series of letters. It’s not that hard to learn.”
Munger went on to say that even though mathematical rigor is important if you want to be a logical investor, it’s equally important to remember that accounting is not an exact science. Rather, it is an approximation of reality, with all the limitations that that implies. Therefore, the best investors marry their mathematical knowledge with the "common sense" part of their brain.
Incidentally, this is one reason to believe that computers may never replace long-term-orientated value investors: it’s probably not possible to write code that is capable of stopping and thinking, “I know this looks good on paper, but does this really make sense?” Munger uses this two-pronged approach all the time in his own analysis:
“Personally, I’ve gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? And second, what the subconscious influences where the brain at a subconscious level is automatically doing these things - which by and large are useful, but which often malfunction?”
Understanding human psychology will help you identify investment opportunities as they develop, and it will also give you a general sense for when you need to be careful. For instance, you don’t have to be a cryptocurrency expert to understand that the bitcoin mania of late 2017 was largely driven by speculative demand, as opposed to some intrinsic economic factor. If you are a good generalist, you can avoid a lot of different types of trouble.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Christopher Browne: Are Short-Term Performance and Value Investing Mutually Exclusive?
- What Investors Can Learn From the Bernie Madoff Ponzi Scheme
- Is the Bull Market Running Out of Steam?
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
