Introduction
"You've got to have models in your head and you've got to array your experience – both vicarious and direct – onto this latticework ofmental models." Charlie Munger
Mr. Charles T. Munger, Vice Chairman of Berkshire Hathaway, is Warren Buffett's partner at Berkshire Hathaway. He is famous for his cutting and insightful commentary on issues that concern him and he is a preeminent investor. He is a voracious reader and devotee of great thinkers such as Ben Franklin, whose wisdom he partially credits with developing his thought processes. Mr. Buffett has frequently given credit to Mr. Munger for providing him with key insights into the investment process. Mr. Munger does not pretend that investing is easy. He advises that it takes sharp wits, strategy, and a lot of discipline to be successful in the investment field. Mr. Munger contends that more individuals could achieve better investment results than they actually do, if only they'd employ some of the basic "mental methods" he and Mr. Buffett have used throughout their careers. "The number one idea," he said in a 2001 Harvard Law Bulletin interview1, "is to view a stock as an ownership of the business [and] to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash flow than you're paying for. Move only when you have an advantage. It's very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor." Mr. Buffett is clearly a master of betting only when the odds are in his favor.
This excerpt from the Berkshire Hathaway 1980 annual report shows how he uses this concept to his advantage: "GEICO's problems at that time [1976] put it in a position analogous to that of American Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies, temporarily reeling from the effects of fiscal blow that did not destroy their exceptional underlying economics. The GEICO and American Express situations, extraordinary business franchises with a localized excisable cancer (needing, to be sure, a skilled surgeon), should be distinguished from the true "turnaround" situation in which the managers expect – and need – to pull off a corporate Pygmalion." This article will attempt to list a series of models that cover areas of knowledge that individuals have almost certainly amassed during their lifetimes. This article will also discuss how most individuals understand these concepts only as they relate to the task they are currently performing or pondering. For example, most engineers would never consider adapting their knowledge of breakpoint to the investing process. It is my hope that, after reading this article in the focus investing series, the reader will understand how to develop and use his or her own system of mental models. I believe that developing the habit of examining problems using this multidisciplinary approach should not only help you become a better investor but, much more importantly, a better thinker.
A Network of Mental Models
The idea of developing a network of mental models is based on the concept that everyone should approach problem-solving from many difference perspectives. The traditional teaching method used in the typical American classroom revolves around the idea that topics should be learned in isolation from other topics. This inhibits students from learning that ideas from multiple disciplines can be used with great success when trying to solve problems. Focus investors should develop their own systems of mental models to help them make better investment decisions. In the following section of this article the various individual areas of knowledge that Mr. Munger has discussed in several of his speeches will be covered on an individual basis. This information should help everyone develop and enhance his or her own system of mental models.
Mathematics
It is critical that investors have at least an understanding of high school level mathematics. Compound interest, the time value of money, and the basic ideas of probability theory, for example, are vital concepts that all investors should have a firm grasp on; they must be a part of their basic repertoire of skills. If investors fail to add these skills to their repertoire they will be at a severe disadvantage to others in the investing field who are equipped with these skills. Let's examine more mathematical concepts that should be part of your investment toolkit. In this section we will cover probability theory, decision trees, and the law of large numbers. Compound interest and the time value of money were covered in Part 1 of the Focus Investing Series and as such will not be covered here. Probability Theory "Fear of harm ought to be proportional not merely to the gravity of the harm, but also to the probability of the event [occurring]" Blaise Pascal "Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we're trying to do. It's imperfect, but that's what it's all about."
Warren Buffett2 In 1654, Blaise Pascal, a prominent French scientist, mathematician, and philosopher, and Pierre de Fermat, a government official and mathematician, exchanged a series of letters that discussed the odds involved in games of chance. They formed in those letters the basis of what today is known as probability theory. Probability theory is the branch of mathematics that develops models to help explain random phenomena. Traditional questions that involve randomness include, `will it rain today?' or `will I be dealt a royal flush today?' These two questions have one common feature: the outcome (it rains today; being dealt a royal flush) cannot be accurately predicted on a consistent basis in advance, but we know that if enough days are observed, it will rain, and someone will eventually be dealt a royal flush. The practical aspects of the theory were soon realized. For instance, the study of human mortality by life insurance companies resulted from applying this theory. Probability theory is now a major branch of mathematics with widespread applications in science and engineering.
Here is the link to the entire report: http://www.focusinvestor.com/FocusSeriesPart3.pdf
"You've got to have models in your head and you've got to array your experience – both vicarious and direct – onto this latticework ofmental models." Charlie Munger
Mr. Charles T. Munger, Vice Chairman of Berkshire Hathaway, is Warren Buffett's partner at Berkshire Hathaway. He is famous for his cutting and insightful commentary on issues that concern him and he is a preeminent investor. He is a voracious reader and devotee of great thinkers such as Ben Franklin, whose wisdom he partially credits with developing his thought processes. Mr. Buffett has frequently given credit to Mr. Munger for providing him with key insights into the investment process. Mr. Munger does not pretend that investing is easy. He advises that it takes sharp wits, strategy, and a lot of discipline to be successful in the investment field. Mr. Munger contends that more individuals could achieve better investment results than they actually do, if only they'd employ some of the basic "mental methods" he and Mr. Buffett have used throughout their careers. "The number one idea," he said in a 2001 Harvard Law Bulletin interview1, "is to view a stock as an ownership of the business [and] to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash flow than you're paying for. Move only when you have an advantage. It's very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor." Mr. Buffett is clearly a master of betting only when the odds are in his favor.
This excerpt from the Berkshire Hathaway 1980 annual report shows how he uses this concept to his advantage: "GEICO's problems at that time [1976] put it in a position analogous to that of American Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies, temporarily reeling from the effects of fiscal blow that did not destroy their exceptional underlying economics. The GEICO and American Express situations, extraordinary business franchises with a localized excisable cancer (needing, to be sure, a skilled surgeon), should be distinguished from the true "turnaround" situation in which the managers expect – and need – to pull off a corporate Pygmalion." This article will attempt to list a series of models that cover areas of knowledge that individuals have almost certainly amassed during their lifetimes. This article will also discuss how most individuals understand these concepts only as they relate to the task they are currently performing or pondering. For example, most engineers would never consider adapting their knowledge of breakpoint to the investing process. It is my hope that, after reading this article in the focus investing series, the reader will understand how to develop and use his or her own system of mental models. I believe that developing the habit of examining problems using this multidisciplinary approach should not only help you become a better investor but, much more importantly, a better thinker.
A Network of Mental Models
The idea of developing a network of mental models is based on the concept that everyone should approach problem-solving from many difference perspectives. The traditional teaching method used in the typical American classroom revolves around the idea that topics should be learned in isolation from other topics. This inhibits students from learning that ideas from multiple disciplines can be used with great success when trying to solve problems. Focus investors should develop their own systems of mental models to help them make better investment decisions. In the following section of this article the various individual areas of knowledge that Mr. Munger has discussed in several of his speeches will be covered on an individual basis. This information should help everyone develop and enhance his or her own system of mental models.
Mathematics
It is critical that investors have at least an understanding of high school level mathematics. Compound interest, the time value of money, and the basic ideas of probability theory, for example, are vital concepts that all investors should have a firm grasp on; they must be a part of their basic repertoire of skills. If investors fail to add these skills to their repertoire they will be at a severe disadvantage to others in the investing field who are equipped with these skills. Let's examine more mathematical concepts that should be part of your investment toolkit. In this section we will cover probability theory, decision trees, and the law of large numbers. Compound interest and the time value of money were covered in Part 1 of the Focus Investing Series and as such will not be covered here. Probability Theory "Fear of harm ought to be proportional not merely to the gravity of the harm, but also to the probability of the event [occurring]" Blaise Pascal "Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we're trying to do. It's imperfect, but that's what it's all about."
Warren Buffett2 In 1654, Blaise Pascal, a prominent French scientist, mathematician, and philosopher, and Pierre de Fermat, a government official and mathematician, exchanged a series of letters that discussed the odds involved in games of chance. They formed in those letters the basis of what today is known as probability theory. Probability theory is the branch of mathematics that develops models to help explain random phenomena. Traditional questions that involve randomness include, `will it rain today?' or `will I be dealt a royal flush today?' These two questions have one common feature: the outcome (it rains today; being dealt a royal flush) cannot be accurately predicted on a consistent basis in advance, but we know that if enough days are observed, it will rain, and someone will eventually be dealt a royal flush. The practical aspects of the theory were soon realized. For instance, the study of human mortality by life insurance companies resulted from applying this theory. Probability theory is now a major branch of mathematics with widespread applications in science and engineering.
Here is the link to the entire report: http://www.focusinvestor.com/FocusSeriesPart3.pdf
