Investing Errors Come From Psychology, Not Information — Charlie Munger (2 of 2)

“A latticework of mental models” describes ways that Charlie Munger sees intelligence and wisdom. Mental models describe more than simple IQ, or Intelligence Quotient.

Munger Avoids Investing Errors by Many Mental Models

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Mental Models in a Lattice

Munger believes a wise person is best served by 80 to 90 mental models from a variety of disciplines including science, engineering, biology, and more.  As we explored in my last blog post about Howard Marks, Charlie Munger pulls a surprising number of these mental models from the field of psychology that are important to investing success.

Munger’s “second level” analysis uses the models of psychology, human emotion, bureaucratic forces, and more. These become more relevant to an analysis of why an investment may be a good opportunity.  These mental models suggest when investments may be mispriced by others in the investment community.

Mental Practice Makes Perfect

Mental models are more than rules of thumb, but good ideas based on objective science and math, and then practiced.  In the book, “Thinking, Fast and Slow” Daniel Kahneman writes: “the accurate intuitions of experts are better explained by the effects of prolonged practice than by (rules of thumb).”

Faced With A Difficult Question, Avoid Answering Another

Similar to the mental discipline developed by Howard Marks and Munger, Kahneman gives us some mental models and pitfalls to avoid when making decisions: “when faced with a difficult question, we often answer an easier one instead, usually without noticing the substitution.” That sloppy substitution he calls intuitive heuristics and they can be both quick and wrong.  Business needs both fast and slow thinking but knowing the correct question comes first.

In the book “Thinking, Fast and Slow” he also emphasizes the importance of understanding statistics.  Kahneman tries to explain “why is it so difficult for us to think statistically?” We can think in metaphors or stories but there’s a puzzling limitation in our mind when numbers contradict what we believe we know. We have an unfortunate tendency to treat problems in isolation, not in their actual context.”  Statistics can force us to see the context. Statistics can show when what we believe we know to be false.

Munger’s Mental Models Against Investing Errors

Here are some of the psychological mental models that Munger has mentioned:

  • Social Proof.  Most of us are more comfortable in a crowded restaurant. We are more likely to believe the food is good when we have the social proof.  This exists in many other things.  Venture capitalists, for example, are famous for needing social proof for where they are placing their bets, even when that is probably one area where social proof is not very helpful.
  • Confirmation Bias.  We often overweight observations that confirm our existing beliefs.
  • Consistency. We use actions that helped us before.  When we have done something and it worked, we are likely to keep doing that action even when circumstances have changed.
  • Reciprocation Tendency.  This is the tendency to want to pay back someone who has done something for you.
  • Authority.  Most of us are trained to defer to authority.
  • Scarcity. Most people desire objects that are hard to obtain.

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