Munger: A Lesson on Elementary Worldly Wisdom (1994)
Charlie Munger · 1994 · 738 words
A Lesson on Elementary Worldly Wisdom As It Relates to Investment Management & Business — Charlie Munger, USC Business School, 1994
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 so that it fits your models, or at least you'll think it does.
You've got to have models across a fair array of disciplines. You may say, "My God, this is already getting too tough." But, fortunately, it isn't that tough — because 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person. And, of those, only a mere handful really carry very heavy freight.
So let me tip you off to the type of models I'm talking about. The first model is mathematics. We have to have facility in numbers — and any business that doesn't have a quantitative aspect doesn't work too well in the world today. Without permutation and combinations, you can't think mathematically about probabilities, expected utility, or the realities of life.
Strangely enough, basic algebra and elementary probability theory aren't even taught in most law schools. And if you go to most business schools, what they teach you about basic statistics and probability theory is sub-par. But the basic concepts are what you need.
Then accounting. Accounting is a great language for business. It's the basic mathematical model. And you have to have enough sense to know when its limits are. Because accounting works to a first approximation — but you have to know its limitations.
Then there's biology and physiology. Some of the basic ideas of biology, where we come from in evolutionary terms, the structure of human society, the structure of the brain. You don't need to know it the way a Ph.D. would, but you need the basic ideas.
Then psychology. The most important models in psychology are the ones I outlined in The Psychology of Human Misjudgment. You have to know basic psychology, and especially the so-called "non-egoistic biases." Without these, you can't make even halfway reasonable decisions in business or in life.
Then microeconomics — the basic ideas — and elementary game theory. Demand curves, the concept of opportunity cost, comparative advantage, scale advantages, network effects, learning curves.
The discipline that lets you remove the most ignorance is microeconomics, because microeconomics is so connected to incentives. Once you understand microeconomics, you understand a huge fraction of how the world works.
Now, what does that all mean to investing? Well, the basic idea is to find the rare business that has a sustainable competitive advantage — what we call a moat — that can compound capital at a high rate over a long time. The very fact that the moat exists means that returns above the cost of capital can be sustained.
Costco is an interesting example. They created a business model — selling top-quality goods at low prices — that delivers genuine value, in a way that locks in customer loyalty. The membership fee model is a brilliant alignment of incentives. Once people sign up, they tend to renew because the value proposition is real. And the buying scale lets them buy and sell goods at lower per-unit costs than competitors. That's a real moat — and one that gets stronger over time as scale increases.
Buying high-quality businesses at fair prices, then doing nothing, is the recipe for compounding wealth over decades. The first rule is don't lose. Avoid stupidity, especially the easy-to-detect stupidities. Most stupidities come from going outside your circle of competence. Acknowledge what you don't know, and the reasoning gets a lot easier.
— Charlie Munger
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 so that it fits your models, or at least you'll think it does.
You've got to have models across a fair array of disciplines. You may say, "My God, this is already getting too tough." But, fortunately, it isn't that tough — because 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person. And, of those, only a mere handful really carry very heavy freight.
So let me tip you off to the type of models I'm talking about. The first model is mathematics. We have to have facility in numbers — and any business that doesn't have a quantitative aspect doesn't work too well in the world today. Without permutation and combinations, you can't think mathematically about probabilities, expected utility, or the realities of life.
Strangely enough, basic algebra and elementary probability theory aren't even taught in most law schools. And if you go to most business schools, what they teach you about basic statistics and probability theory is sub-par. But the basic concepts are what you need.
Then accounting. Accounting is a great language for business. It's the basic mathematical model. And you have to have enough sense to know when its limits are. Because accounting works to a first approximation — but you have to know its limitations.
Then there's biology and physiology. Some of the basic ideas of biology, where we come from in evolutionary terms, the structure of human society, the structure of the brain. You don't need to know it the way a Ph.D. would, but you need the basic ideas.
Then psychology. The most important models in psychology are the ones I outlined in The Psychology of Human Misjudgment. You have to know basic psychology, and especially the so-called "non-egoistic biases." Without these, you can't make even halfway reasonable decisions in business or in life.
Then microeconomics — the basic ideas — and elementary game theory. Demand curves, the concept of opportunity cost, comparative advantage, scale advantages, network effects, learning curves.
The discipline that lets you remove the most ignorance is microeconomics, because microeconomics is so connected to incentives. Once you understand microeconomics, you understand a huge fraction of how the world works.
Now, what does that all mean to investing? Well, the basic idea is to find the rare business that has a sustainable competitive advantage — what we call a moat — that can compound capital at a high rate over a long time. The very fact that the moat exists means that returns above the cost of capital can be sustained.
Costco is an interesting example. They created a business model — selling top-quality goods at low prices — that delivers genuine value, in a way that locks in customer loyalty. The membership fee model is a brilliant alignment of incentives. Once people sign up, they tend to renew because the value proposition is real. And the buying scale lets them buy and sell goods at lower per-unit costs than competitors. That's a real moat — and one that gets stronger over time as scale increases.
Buying high-quality businesses at fair prices, then doing nothing, is the recipe for compounding wealth over decades. The first rule is don't lose. Avoid stupidity, especially the easy-to-detect stupidities. Most stupidities come from going outside your circle of competence. Acknowledge what you don't know, and the reasoning gets a lot easier.
— Charlie Munger