Transcription
"Nothing has served me better in my long life than continuous learning. I went through life constantly practicing (...) the multidisciplinary approach and I can't tell you what that's done for me. It's made life more fun, it's made me more constructive, it's made me more helpful to others, and it's made me enormously rich."
In this whole video series about Charlie Munger's Mental Models, we try to acquire or imitate the just mentioned multidisciplinary approach. It consists of acquiring the basic mental models from multiple disciplines. In the first video of this series, we dealt with the models about hard sciences. And this is how far we build our latticework. Now, if you ask yourself what the hell I'm talking about or something like this, feel free to check out the first video because this starts with an introduction. And in this video today, the second video of this whole series, we will look at General Mental Models and models from microeconomics.
"The mental process that really has worked for me my whole life, and I use it all the time, is turning everything into reverse. I figure out what I don't like instead of figuring out what I like in order to get what I like. I sometimes think straightforward too, of course. But thinking of what I didn't like and how I can avoid it has just worked wonders for me."
The mental model of inversion basically means thinking backward and turning the subject matter into its reverse. Instead of looking at X, we look at -X.
"For instance, if you want to help India, the question you should consider asking is not 'How can I help India?' Instead, you should ask 'How can I hurt India?' You find what will do the worst damage and then try to avoid it."
Let's take another example of eating healthy. So, when we want to eat more healthy, how do we normally approach it? We would ask ourselves, "What food is healthy to eat?" The problem with this question is that we are not so sure what food is healthy to eat, maybe besides vegetables. But for example, science is often changing, and it's often not so clear or not so visible of what is healthy to eat. Now, we can inverse the question and ask, "Which food is unhealthy to eat?" And then we avoid the answers from this question. What is unhealthy to eat? For example, fast foods, sugary beverages, etc. Somehow, this negative side is easier to identify, and by inversing the question and avoiding the reverse, in this case, the unhealthy food, we achieve our goal of eating more healthily.
I made a whole video about Charlie Munger's life wisdom in which he talked about things to avoid. So, not advice what we should do, but things what we should not do. If you're interested in that, feel free to check it out.
"People chronically misappraise the limits of their own knowledge; that's one of the most basic parts of human nature. Knowing the edge of your circle of competence is one of the most difficult things for a human being to do. Knowing what you don't know is much more useful in life and business than being brilliant."
The circle of competence shows the areas in which we got knowledge in. The areas we know nothing or nearly nothing about lay outside of our circle of competence. The important point is to know where the border is. We can say that the circle of competence helps us to be aware of our own ignorance, to be skeptical of what we think we know, and being aware of what we don't know. This can help us to stay out of big decision mistakes on subjects we have no idea about. And not just this, by being realistic about our circle of competence, we play on our strength.
"If you want to be the best tennis player in the world, you may start out trying and soon find out that it's hopeless - that other people blow right by you. However, if you want to become the best plumbing contractor in Bemidji, that is probably doable by two-thirds of you. It takes a will. It takes intelligence. But after a while you'd gradually know all about the plumbing business in Bemidji and master the art. That is an attainable objective, given enough discipline. And people who could never win a chess tournament or stand in Center Court in a respectable tennis tournament can rise quite high in life by slowly developing a circle of competence - which results partly from what they were born with and partly from what they slowly developed through work."
What this is all about is to be realistic and honest to oneself. Where do I got a natural advantage over others? In what am I naturally good in, and can I somehow use it to my advantage? In addition, what area of skill can I improve in?
"Everybody's got a different circle of competence. The important thing is not how big the circle is. The important thing is staying inside the circle."
As Warren Buffett said, it isn't important how big the circle is, but we have to stay inside it. When I should play tennis or do complex mathematical calculations, in which both I don't have much knowledge in, I would just fail compared to others. But I have a curious mind that is interested in reading many different topics and combining them to get practical wisdom for life. I don't know if that's an advantage, but it can be. That's why I'm doing these videos. I can't make videos about how to play tennis or calculate complex mathematics. It requires one to be honest and humble to oneself. Honest because, well, when we lie to ourselves, we set ourselves up for failure. Humble because we have to accept how we are. Of course, we can work on ourselves and improve, but if I'm 5.6 ft tall, I will not be a basketball player.
"I frequently tell the apocryphal story about how Max Planck, after he won the Nobel Prize, went around Germany giving the same and standard lecture on the new quantum mechanics. Over time his chauffeur memorized the lecture and said, 'Would you mind Professor Plank, because it's so boring to stay in our routine. [What if] I gave the lecture in Munich and you just sat in front wearing my chauffeur's head?' Plank said, 'Why not?' And the chauffeur got up and gave this long lecture on quantum mechanics, after which a physics Professor stood up and asked a perfectly ghastly question. The speaker said, 'Well, I am surprised that in an advanced city like Munich I get such an elementary question. I'm going to ask my chauffeur to reply.'"
He goes on to differentiate between two types of knowledge.
"In this world we have two kinds of knowledge. One is Planck knowledge, the people who really know. They've paid the dues, they have the aptitude. And then we have got chauffeur knowledge. They have learned the talk. They may have a big head of hair, they may have fine temper in the voice, they'll make a hell of an impression. But in the end, all they have is chauffeur knowledge."
It is pretty easy to just memorize something and give it back, especially compared to the hard part of understanding the topic at hand.
"Knowledge is a skyscraper. You can take a shortcut with a fragile foundation of memorization, or build slowly upon a steel frame of understanding."
How can we check ourselves if we have chauffeur knowledge or Planck knowledge? The first thing we can do is to check if we are in our circle of competence. Did we acquire to some degree the competence in the subject matter? Second, we can ask ourselves the question, "Why?" Like, I see a complex mathematical formula and ask myself, "Why is it the way it is?" And pretty fast, I would notice that I don't have much idea about it, even if I would like to think I have. As I said in the chapter before, to reflect our own knowledge requires honesty and to be humble. I talk from experience. Someone like me who creates educational videos is often confronted with a situation of talking about something interesting because I want to share it. But this talk can be totally different from understanding. In many cases, I had to stop myself from publishing something, going back, and doing the real work of trying to understand the underlying principles of the topic.
Carl Braun, the founder of the Braun company, had specific requirements if someone wanted to give another person an order.
"His rule for all the Braun Company's communication was called the five W's - you had to tell who was going to do what, where, when, and why. (...) Just as you think better if you array knowledge on a bunch of models that are basically answers to the question why, why, why, if you always tell people why, they will understand it better, they will consider it more important, and they will be more likely to comply. Even if they don't understand your reason, they will be more likely to comply."
Also here, let's take an example. Compare the following two ways of communicating an order:
1. Make a backup of your day's work every single day.
2. It would be immensely important if you make a backup of your day's work in the cloud at the end of a day every single day. Because when there is some loss of data, we could lose your important work, what will hurt the company and yourself.
What do you think is it easier to comply with the first order or with the second order?
The mental model of second-order thinking involves considering not just the immediate or direct consequences of a decision or action, what we call here the first-order consequences, but also the potential consequences that may result from those initial outcomes, what we will call here the second-order consequences. It is called second-order thinking, but it doesn't stop there. It includes also third-order thinking, fourth-order thinking, and so on. That's what we call the nth-order thinking. It helps us to avoid possible negative outcomes of our actions or decisions, which we don't see when we only look at the first-order consequences.
In other words, Frédéric Bastiat, I hope I pronounce this French name at least a little bit correct, who was a French Economist, talks in his essay "That which is seen, and that which is not seen" about the difference between people, in this case economists, but applies to any domain, who can think one step ahead and those who can't.
"Between a good and a bad Economist this constitutes the whole difference - the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favorable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad Economist pursues a small present good, which will be followed by a great evil to come, while the true Economist pursues a great good to come and at the risk of a small present evil."
Another example from daily life (this is no advice of course or no medical advice in this case. This is only here for information purposes or like for purposes to show the concept of second-order thinking). So, we do the action of frequently taking painkillers for temporary pain relief, for example, against headaches. The first-order consequence is in this case positive because the pain, or in our case, the headache is relieved, and we feel better. Now, we can look at the second-order consequences. So, first, we can possibly develop a medication tolerance, needing a higher dose for the same pain relief. Second, we can become dependent on those painkillers and all the time taking them, which also leads, of course, to the medication tolerance. Third, we mask with this underlying issues because with the painkiller, we not attack the root cause of the disease, so to speak, but we only attack the symptoms. The third-order consequences could look like that we first, develop some health risks through long-term use of those painkillers because they can cause damage to organs. And second, we can neglect underlying issues, what we already had in second-order consequences, but the longer we neglect them, the bigger the issues can become.
With the mental model of second-order thinking, just be aware that we can't predict the future. Of course, some consequences are obvious to foresee. Just we have to be careful with any prediction, especially in complex systems we are all in. Still, it is really helpful to think long-term for decision-making. Imagine that many of our decisions are immediately good but will kill us in the long-term. That, of course, we want to avoid. If you are interested in a deeper dive into second-order thinking, feel free to check out my video about it.
"I always liked Occam's Razor, now that is a wonderful way to think."
The following is the definition of Occam's Razor: "Entities must not be multiplied beyond necessity." In other words: Among competing hypotheses, the one with the few assumptions should be selected. Occam's Razor advises that when we have two hypotheses explaining the same thing, we prefer the simpler theory over the complex one. What we learned so far to really understand something is to ask a question, "Why?" So, why should we go with a simpler theory? Because in most cases, it is the most likely one. And why should we go with it? Because of base rates.
Consider the case of a person A, who died in a car accident. The simple solution would be that the person A died due to driver error. The more complex solution would be, person A died due a rare medical condition that caused a sudden loss of consciousness. And an even more complex solution would be: person A died due to a rare medical condition combined with a sudden mechanical failure in the car. Now, I will make up some numbers here to just show the point. In 100 cases of car accident fatalities, we have the following: The simple explanation, the driver error, is the most common and likely, 80 out of 100. Then we got 17 who died of other reasons, which we can exclude for the sake of the argument. The more complex explanation, a rare medical condition, is less common, 2 out of 100. The even more complex explanation, a rare medical condition and mechanical failure together, requires two rare events happening simultaneously, making it even less likely, 1 out of 100. Each additional assumption decreases the overall likelihood of the scenario, making simple explanations generally more probable according to Occam's Razor. Still, keep that rare one in the back of your mind, unlikely but still can happen.
"You can argue that Einstein's whole career was just a marvelous demonstration of Occam's Razor. E=mc² is a pretty damn simple idea, but think of the power of [it]. (...) And then Einstein developed, some people say, a counter corollary to Occam's Razor. This may be apocryphal because I've never seen it in any original source that I trusted, but I have seen that Einstein was quoted with this observation over and over again. Everything should be made as simple as possible but no more simple."
Simple is in many cases good, but too simple is not good. Why? This we will have a look at in the next chapter.
"It is my view that economics could avoid a lot of [the] trouble that comes from physics envy. I want economics to pick up the basic ethos of hard science, the full attribution habit, but not the craving for an unattainable precision that comes from physics envy. The sort of precise, reliable formula that includes Boltzmann's constant is not going to happen by and large, in economics. Economics involves too complex a system. And the craving for that physics-style precision does little but get you in terrible trouble (...). Economics should emulate physics' basic ethos, but it's search for precision in physics-like formulas is almost always wrong in economics."
We like it when we can pinpoint something, when we can label something, and calculate a clear answer. While this is possible in mathematics and sometimes in physics where approximations come close to reality. In economics and social sciences, this is pretty difficult because we deal with highly complex systems where we can't even be sure to know all factors which are at play.
Definition of physics envy: "(...) the common human craving to reduce enormously complex systems (such as those in economics) to one-size-fits-all Newtonian formulas."
It looks always convincing when some theories are proven with complex mathematical formulas, and the layman, like me, thinks this makes it all more trustworthy. But in the end, what in fields like economics often happens, it is just a simplification or rather an oversimplification which often doesn't include all factors. Consider this. We have here the real world with all the contributing factors to one thing, for example. Economics tries to get all these factors to play in one formula. Now, this formula proves or shows much less factors because we are maybe not aware of all factors that are at play, or some factors are even interacting with other factors and making another factor much stronger. So, all those we can't even show in this formula. That's why this formula is much more oversimplified, letting out some factors.
"Decisions in life are all about opportunity costs ... And wise people think in terms of personal opportunity costs ... in other words, it is your alternatives that matter."
Let's assume we have two options: option A and the best alternative to option A, option B. When taking option A, our opportunity costs are the potential missed benefits of option B, and vice versa. Take, for example, Elon Musk. He could cook his lunch meal by himself for one hour, let's say. Another opportunity would be that he works for the advancement of humanity (and we include here now only the monetary value and not some potential relaxation which he would get through cooking or something like that, okay, only the monetary value). When he decides to cook the meal by himself, measured by monetary aspects, he would have a huge opportunity cost because he misses the other opportunity.
Why do opportunity costs exist? I would say because we can't take all the opportunities we have. Why can't we take all those opportunities?
"Our time and money are limited. If we make a decision to do one thing, we are deciding not to do some other available thing. Every minute we choose to spend on one thing is a minute unavailable to spend on other things (...). Choices have costs."
If we think our time is infinite and we can make it all at the same time, we are mistaken. Time is limited, it is a constraint. We have to make decisions, and we will miss out on some things; this is how life works. But we can decide that we put our energy and time into things which are important to us. Opportunities and opportunity costs are personal. We can't compare our opportunities to someone else's opportunities.
"You are located in a certain place, you have a certain amount of opportunities, and you find opportunity A that's better than opportunity B, which is the best alternative you know of. You therefore do A instead of B. Somebody else may have a better bet. But opportunity A may be the best you have given where you are located and what you know. So you don't have one-size-fits-all solutions as you go through life."
This we can combine with the circle of competence. In which area do we have an advantage of knowledge and talent? This can determine what opportunities we get.
"Like all other things in life, you have to look for your best option and live with it. You have to marry the best person who you can conveniently find who is also willing to have you. And the person who would have you whom you can't find doesn't do you any good:"
"Checklist routines (...) prevent a lot of errors and not just for pilots. You should not only possess wide-ranging elementary wisdom but also go through mental checklist routines in using it. There's no other procedure that will work as well."
I think we all know what are checklists. Lists with points on which we have to tick off in order to proceed. Charlie Munger uses an example to take mental models themselves on this checklist. Let's say we face a problem or a decision we have to solve. In short, the problem: What is a good way of building a habit of daily reading? So, the first mental model of our checklist is the mental model of inversion. The first question is if this mental model is applicable to this problem? And I guess the mental model of inversion is so universal that it's nearly always applicable. What are factors which would block the habit of daily reading? We inverse the question, right? And the answer could be: no discipline, no exciting books, no clear time frame, and so on. And we have to avoid these in order to develop our habit of reading. So, let's go now to the next checklist point, which is the circle of competence mental model. First, we ask again if this mental model is applicable. If not, we just go to the next mental model. If yes, we do it and see what is the outcome. So, it is also here applicable, and we can ask ourselves: do I know enough of building habits? How to do it, and so on. And then we can answer the question by ourselves. In my case, probably it would be a yes, and we can go on with the next mental models or points on the checklist.
"But don't put all your trust in checklists which can cause a false sense of security and control just like wearing a seat belt makes drivers feel more secure, making them drive faster or more recklessly."
These words of caution from Peter Bevelin hold not just true for checklists. Mental Models in general fall also under that. We are not acting in some certain territory, like for example, a chess game where we can make precise calculations. The real world is just too complex, considering the uncertainty and complexity.
Filters are mechanisms to filter things out. The value of filters is, as so often, best explained with some examples. And these examples here are borrowed from Peter Bevelin's book "Seeking Wisdom".
Example One: A man is rushed to the hospital suspecting a heart attack. The doctor has to make a fast decision if it's serious or false alarm. How does he or she do it? The doctor uses filters.
"Late statistic Professor Leo Breiman and colleagues at the University of California, Berkeley, developed a method to classify high-risk heart attack patients using only a maximum of three variables. Blood pressure, age, and sinus tachycardia, which is rapid heartbeat. If a patient's minimum systolic blood pressure over the initial 24-hour period is less than 91, he's immediately classified as high risk. If not, the second variable is age. If the patient is over 62.5 years old, then - one more variable, sinus tachycardia, is needed to classify him as high or low risk. If the patient displays sinus tachycardia, he is classified as high risk."
The next example deals with the area of investment or on how Warren Buffett filters out business ideas:
"Can I understand it? If it passes this filter, 'Does it look like it has some kind of sustainable competitive advantage?' If it passes this filter, 'Is the management composed of able and honest people?' If it passes this filter, 'Is the price right?' If it passes this filter, then write the check."
And one more example from myself on how I use filters in selecting what videos I will upload about which topics. The first one is: is the topic valuable? If no, discard it. If yes, do I understand what I'm talking about, do I have enough knowledge? If no, can I compensate by doing the work and research? If no, drop it. If yes, do I have the time to do it? If no, put it in the backlog. If yes, get to work! What I try to do, I start with the most important filter: "Do I think this topic is valuable for you?" And what we can see here, I define what is valuable. So, in this case, my filters are subjective. In the medicine example from before, the filters were objective. Anyway. Start with the most important filters and go down. If there's a "no," likely it's discarded. Filters are similar to checklists but different. Filters are about selection, while checklists are about inclusion to not forgetting certain points.
A free market economy is a system in which buyers and sellers of goods and services are guided by supply and demand. Since it's free, there is no intervention from the outset or minimal intervention from the outside, for example, from governments.
"(...) I find it quite useful to think of a free-market economy - or partly free market economy - as sort of the equivalent of an ecosystem..."
About the mental model of an ecosystem, we dealt with in the first part in this Charlie Munger's Mental Models Series. Feel free to check it out if you haven't yet.
"Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as animals flourish in niches, similarly, people who specialize in the business world and get very good because they specialize - frequently find good economics that they wouldn't get any other way."
This thinking we can break down one step further. One small part of the whole general economy is the creator economy, okay, one really tiny part. Now, on YouTube, for example, there are many creators who occupy little niches and are very successful in it. Now, that doesn't mean that this will always be like it; there's always a danger of disruption or shifting demand. But this is what it is. If you're the best at your little niche, you can go far with it.
What are scale effects?
"Change in size or time influences form, function, and behavior. If something of a certain size is made bigger or smaller, it may not work the same way. Some things get better and others get worse. For example, changes in the size of an organism affect its strengths, surface area, complexity, metabolism, longevity, and speed of movement."
Scale effects are in many cases not linear, but they are nonlinear (okay, when they are not linear, it implies that they are nonlinear, or?). Meaning that many things don't grow in proportion to its size. For example, when an animal doubles in size, it often triples its strengths and not just doubles its strengths because we could probably think, hey, it's double the size, so it will also double its strengths, right? But it is not working like this. Everything comes with side effects.
What are the disadvantages of scale?
"The constant curse of scale is that it leads to big, dumb bureaucracy - which, of course, reaches its highest and worst form in government where the incentives are really awful. That doesn't mean we don't need governments - because we do. But it is a terrible problem to get big bureaucracies to behave."
Then there is another model from microeconomics which I find very interesting. When technology moves as fast as it does in a civilization like ours, you get a phenomenon which I call competitive destruction. You know. You have the finest buggy whip factory, and all of a sudden, in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you are dead - you're destroyed. It happens again, and again, and again.
In the last video, we talked about Evolution and how we have to adapt. This refers to our skills too. Some skills like speaking many languages and being a professional translator get disrupted by AI translation. It doesn't necessarily mean that all translators get out of business, but rather that only the best survive, and the whole population of translators gets drastically reduced. What can we do? Well, we can try to adapt.
"And when these new businesses come in, there are huge advantages for the early birds. And when you are an early bird, there's a model that I call 'surfing' - when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallows... But people get long runs when they are right on the edge of the wave - whether it's Microsoft or Intel or all kinds of people (...)."
One way to stay on the wave is to be an early bird. People who move to Silicon Valley to stay at the forefront of technology are in my opinion exactly those. Though through the internet, we all got the possibility to stay on the wave. What is needed for adaptation? Continuous learning.
"Personally, I have gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interest involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things - which by and large are useful but which often misfunction."
Imagine you are leading a meeting where everyone has his or her own interest. When someone gives his opinion, we can use this two-track analysis to analyze his opinion. What is his rational interest, like what he thought out? And the second way: in how far is his subconscious mind, which includes his thinking errors, emotional influences, and biases, influencing him?
In the last 25 Models, we talked about the more rational side of things. So, in this one way, we acquired the knowledge that we can now apply and train with. The psychological track will be the subject in the next video, where we will acquire Charlie Munger's 25 psychological Mental Models. How our brain and emotions, our social makeup, influences us either consciously or unconsciously.
Thank you so much for watching this video today. If you got any questions or you have some feedback to give me, just feel free to write me in the comments below. This is how far we build our latticework in this video. The next and final part of the three-part series about Charlie Munger's psychological mental models, you will find here. The first part, you will find here.
"I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little bit wiser than they were when they got up, and boy, does that help particularly when you have a long run ahead of you."