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Tuesday, 21 April 2009

The Buffet Munger Paradox

Financial Focus or Latticeworks of Mental Models?

Warren Buffett and Charlie Munger, Chair and Vice-Chair of Berkshire Hathaway, are the most successful investors of all time as measured by monetary value, insight and wit. Don’t underestimate the intrinsic value of those latter two components – to retain senses of proportion and humour in the face of wealth unimaginable to the majority of us should immediately mark out these men as having characters extraordinary.

Yet at the heart of this enduring relationship is a curious paradox. When asked to identify the most important factor in his financial success Buffett replies with a single word: “focus”. Munger, on the other hand, extols the need for investors to develop a broad education in which to ground their investment activities. How can we reconcile these two different approaches?

Buffett’s Focus

Everything about Warren Edward Buffett seems to spring from a hunger, a focus, for making money. An early photograph shows him holding his favourite toy – a coin counter. By age 19 he had amassed the small fortune of $10,000 through various moneymaking schemes from paper rounds to a pinball machine hire business. He went to Columbia in pursuit of Ben Graham, maxed out on his courses and then pestered Graham until he gave in and made him the first non-Jewish employee of his firm.

When Graham retired Buffett packed his New York bags and returned to his home town of Omaha where he set up his own partnership, raking in fees based on profits made on capital from his investors with one single rule: astonishingly he wouldn’t tell them what he was investing in. They weren’t complaining – the young Warren made money hand over fist by taking Ben Graham’s lessons and applying focus – small and concentrated portfolios of value based stocks. The Buffett Partnership made 20%+ per year through the late fifties and sixties until, out of the blue, Buffett announced that he was winding up his investment firm.

Folding His Hand

Buffett had made the calculation that his tried and trusted investment techniques would no longer work in the booming markets of the late sixties: value was dead, as periodically happens. Unwedded to convention and with the clarity of vision that many other so-called gurus can only dream of, he coolly assessed the situation at the table where he’d won so much money, folded his hand and walked away. Within months the markets started crumbling.

In winding up the Buffett Partnership and distributing the funds to his shocked investors there were a couple of stocks left over that he also distributed, remarking that he believed that these would offer above average growth over the coming years. Unremarked amongst them was a failing textiles company called Berkshire Hathaway.

Most people who met the young Buffett were impressed by his focus, his intelligence, his energy and, above all, his honesty. Amongst the many who were wooed was a young lawyer, introduced to Buffett by a mutual friend: a dude by the name of Charles Thomas Munger.

Munger’s Mental Models

Munger stays in the shadow of Buffett, largely because that’s the way he likes it. Whereas Buffett is happy to write for the popular press, is delighted to pick up the phone to talk live to financial commentators on TV and loves nothing more than a big gathering of business people Munger shies away from the limelight. Even at Berkshire Hathaway’s AGM’s legendary question and answer sessions Munger lets Buffett do most of the talking.

So when Charlie Munger does decide to say something it’s usually something worth listening to and something that bears thinking about. And what he mostly talks about is mental models.

The core concept behind Munger’s philosophy is what he calls a “latticework of mental models upon which to array ideas”. He believes that people who approach investing with a limited set of mental models are bound to fail when situations change. Perhaps his greatest scorn is reserved for that part of the academic community which sponsors the Efficient Market Hypothesis – this, he believes, is a perfect example of a group who have a single model which they apply to all situations and all times.

When the evidence shows that they’re wrong rather than changing their model they change the evidence required. Munger calls this “man with a hammer syndrome”.

A Snowball’s Chance in Karnataka

To escape this trap we need to take ideas from all sorts of different areas, many of which have little or nothing to do with investing. Munger’s ideas range over areas as diverse as psychology, physics, biology, history and economics. Yet very often the point he’s trying to make gets lost in the detail as investors try to figure out which models to use from these subjects. That’s not – quite – the point.

Assume you lived in Southern India five hundred years ago and some stranger arrives and starts telling you about a strange phenomenon called “snow”. It’s white, it’s wet, it’s cold, it falls from the sky, lies about for ages and you make men out of it. Would you believe them?

Well, if your only model of the world is that you’ve experienced at home then the likelihood is that you won’t because snow isn’t something that you’re going to have personally witnessed. However, if you’re widely read and a budding philosopher or scientist you may be able to do a little better than simply dissing the idea – for a start you know that there may be things out there that you’ve never experienced, so you don’t dismiss it out of hand. But how can you decide whether this “snow” stuff is imaginary or not?

Arraying Your Knowledge

As you’re a student of physics or psychology you’ll know a few tricks of your own. You can probe for a few simple inconsistencies and to ask for some corroborating evidence – like what kind of clothes do people wear and does it snow all the time? With a few simple ideas you can perform enough of a cross check to conclude that, on the balance of probabilities, this stranger isn’t completely mad.

This is Munger’s concept of mental models. You don’t need to know everything but when that financial advisor arrives with his sheaves of papers showing the unbelievable returns to be gained from the new Ponzi bonds you need to know enough to crosscheck the ideas and the figures. To run a sanity check.

So all “arraying knowledge” on a mental model means is that when you come across new concepts you need to test them against multiple, pre-existing models. If all you have is a single model – it doesn’t snow in India – you won’t be investing in the new fangled refrigeration. Watch that fortune just walk out the door.

Focus or Mental Models?

So on one hand we have the incredibly focused Warren Buffett. On the other we have Charles Munger and his bag of broadly focused mental models. And back in the early seventies they started the process of integrating their investments into the behemoth has become Berkshire Hathaway. Unlike most investors, who suffer from the Law of Big Numbers – the increasing difficult of generating large returns from larger and larger amounts of capital – Buffett and Munger have carried on generating 20% per year.

Despite their apparently widely differing approaches they’re obviously doing something right. So how, exactly, does this partnership work?

To be continued in: Investing Like Berkshire Hathaway


The Snowball: Warren Buffett and the Business of Life Benjamin Graham: The Memoirs of the Dean of Wall StreetDamn Right: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger

 
Related Posts: The Rediscovered Ben Graham, Is Intrinsic Value Real?, Warren Buffett Bias

1 comment:

  1. we know that berk's investments fit buffet's value criteria. we don't have any idea what mental models are associated with these investments.

    it could all be a gigantic crock of dung, this mental model approach to investing thing.

    ReplyDelete