Friday, August 28, 2009

Munger on Elementary, Worldly Wisdom

Below are some excerpts from a 1994 speech by Charlie Munger at the USC Business School. It's well worth reading the whole speech but below I've highlighted some noteworthy things:

Latticework of Models
"What is elementary, worldly wisdom? Well, the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together o­n a latticework of theory, you don't have them in a usable form.

You've got to have models in your head. And you've got to array your experience both vicarious and direct o­n this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You've got to hang experience o­n a latticework of models in your head.

What are the models? Well, the first rule is that you've got to have multiple models because if you just have o­ne or two that you're using, the nature of human psychology is such that you'll torture reality..."

Elementary Mathematics
"'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."

"At Harvard Business School, the great quantitative thing that bonds the first year class together is what they call decision tree theory. All they do is take high school algebra and apply it to real life problems. And the students love it. They're amazed to find that high school algebra works in life..."

"If you don't get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a o­ne‑legged man in an ass‑kicking contest. You're giving a huge advantage to everybody else."

Limitations of Accounting
"Obviously, you have to know accounting. It's the language of practical business life. It was a very useful thing to deliver to civilization. I've heard it came to civilization through Venice which of course was o­nce the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention."

"But you have to know enough about it to understand its limitations - because although accounting is the starting place, it's o­nly a crude approximation."

"In terms of the limitations of accounting, o­ne of my favorite stories involves a very great businessman named Carl Braun who created the CF Braun Engineering Company. It designed and built oil refineries ‑ which is very hard to do. And Braun would get them to come in o­n time and not blow up and have efficiencies and so forth. This is a major art.

And Braun, being the thorough Teutonic type that he was, had a number of quirks. And o­ne of them was that he took a look at standard accounting and the way it was applied to building oil refineries and he said, 'This is asinine.'

So he threw all of his accountants out and he took his engineers and said, "Now, we'll devise our own system of accounting to handle this process. "And in due time, accounting adopted a lot of Carl Braun's notions. So he was a formidably willful and talented man who demonstrated both the importance of accounting and the importance of knowing its limitations."

Most Reliable Models
"Which models are the most reliable? Well, obviously, the models that come from hard science and engineering are the most reliable models o­n this Earth."

"I don't think it's necessary for most people to be terribly facile in statistics. For example, I'm not sure that I can even pronounce the Poisson distribution. But I know what a Gaussian or normal distribution looks like and I know that events and huge aspects of reality end up distributed that way. So I can do a rough calculation.

But if you ask me to work out something involving a Gaussian distribution to ten decimal points, I can't sit down and do the math. I'm like a poker player who's learned to play pretty well without mastering Pascal.

And by the way, that works well enough. But you have to understand that bell‑shaped curve at least roughly as well as I do.

And, of course, the engineering idea of a backup system is a very powerful idea. The engineering idea of breakpoints that's a very powerful model, too. The notion of a critical mass that comes out of physics is a very powerful model."

"I suppose the next most reliable models are from biology/ physiology because, after all, all of us are programmed by our genetic makeup to be much the same."

Psychology and the Limitations of Cognitive Apparatus
"And then when you get into psychology, of course, it gets very much more complicated. But it's an ungodly important subject if you're going to have any worldly wisdom.

And you can demonstrate that point quite simply: There's not a person in this room viewing the work of a very ordinary professional magician who doesn't see a lot of things happening that aren't happening and not see a lot of things happening that are happening.

And the reason why is that the perceptual apparatus of man has shortcuts in it. The brain cannot have unlimited circuitry. So someone who knows how to take advantage of those shortcuts and cause the brain to miscalculate in certain ways can cause you to see things that aren't there.

Now you get into the cognitive function as distinguished from the perceptual function. And there, you are equally...more than equally in fact...likely to be misled. Again, your brain has a shortage of circuitry and so forth and it's taking all kinds of little automatic shortcuts."

"And so just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations."

"So the most useful and practical part of psychology which I personally think can be taught to any intelligent person in a week is ungodly important. And nobody taught it to me by the way. I had to learn it later in life, o­ne piece at a time. And it was fairly laborious. It's so elementary though that, when it was all over, I felt like a fool.

And yeah, I'd been educated at Cal Tech and the Harvard Law School and so forth. So very eminent places mis-educated people like you and me.

The elementary part of psychology - the psychology of misjudgment, as I call it is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important.

Terribly smart people make totally bonkers mistakes by failing to pay heed to it. In fact, I've done it several times during the last two or three years in a very important way. You never get totally over making silly mistakes." - Charlie Munger

Later in the talk, Munger gets more specific about stocks and investing models. I'll follow up on this in a separate post.


Munger on Elementary, Worldly Wisdom - Part II

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