“Rationality … requires developing systems of thought that improve your batting average over time.” “Luckily, I have selected very easy problems all my life, and I have a reasonable batting average.” “You don’t have to have perfect wisdom to get very rich – just a bit better than average over a long period of time.” — Charlie Munger
This week our featured book is Charlie Munger: The Complete Investor, by Tren Griffin. In today’s second post (check out the first for Charlie Munger’s take on the importance of reading for the investor!), we are happy to present the first half of a post from Tren Griffin explaining Charlie Munger’s take on rationality, and why being rational is crucial for both investing and for life. The post was originally featured on Griffin’s blog, 25iq.
Don’t forget to enter our book giveaway for a chance to win a free copy of Charlie Munger: The Complete Investor!
A Dozen Things I’ve Learned from Charlie Munger about Making Rational Decisions, Part 1
By Tren Griffin
The subtitle of my recently published book is “The Complete Investor.” While the book is written in the context of investing, understanding what Charlie Muunger teaches will help readers make rational decisions about anything in their life. Everyone must make decisions in life and by understanding how Charlie Munger thinks, you can improve your decision making skills. Learning to make better decisions requires that you spend some time thinking about thinking. The good news is that this learning process is fun. Charlie Munger puts it this way: “Learning has never been work for me. It’s play.” Life gets better if you adopt this approach to learning.
“‘Charlie,’ she said, ‘What one word accounts for your remarkable success in life?’ I told her I was rational.”
If the actor in the television commercials for the famous beer is “the most interesting man in the world,” then perhaps Charlie Munger is “the most rational investor in the world.” His rationality and honesty in no small part explain why he is so popular. What Charlie Munger says is often so funny because he is perfectly willing to speak the truth in a completely unrestrained and direct manner. In other words, he appeals to so many people because of his honest insight about life, in much the same way as great comics like Louis C.K., Amy Schumer, or Chris Rock are so appealing. Individuals who speak the truth openly are often interesting, insightful and funny. To understand Charlie Munger’s appeal it is useful to think about the nature of rationality. Michael Mauboussin explains that there are different forms of rationality: “Cognitive scientists and philosophers talk about ‘instrumental’ and ‘epistemic’ rationality. Instrumental rationality is behaving in such a way that you get what you want the most, subject to constraints. Expected utility theory, which is based on a series of axioms, provides a normative framework for how to do this. You’ll be instrumentally rational if you follow the axioms. Epistemic rationality describes how well a person’s beliefs map onto the world. If you believe in the tooth fairy, for instance, you are showing a lack of epistemic rationality. Here’s a catchier way to remember the two terms: instrumental rationality is ‘what to do’ and epistemic rationality is ‘what is true.'” Charlie Munger understands and is focused on being both epistemically and instrumentally rational.
“The right way to think is the way Zeckhauser plays bridge. It’s just that simple.”
To be “rational” as an investor is to think in terms of expected value, which Michael Mauboussin writes is “is the weighted average value for a distribution of possible outcomes.” During the 1989 Berkshire Hathaway Annual Meeting, Warren Buffett put the essential task of an investor this way: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.” Michael Mauboussin describes the rational approach perfectly: “Success in a probabilistic field requires weighing probabilities and outcomes — that is, an expected value mindset.” Robert Hagstrom argues:
Jon Elster is a Norwegian social and political theorist who has written extensively on rational-choice theory. He tells us that being able to wait and using indirect strategies are central features of human choice. Indeed, Elster argues that human rationality is characterized by the capacity to relate to the future, in contrast to the myopic gradient-climbing organism found in the natural world. Elster’s gradient-climbing organism has eyes fixed to the ground, incapable of seeing what might happen next. Future events for the myopic organism have no effect on decision making. Put differently, for the myopic organism, tomorrow’s events are the same as today’s events. In contrast, Elster claims that man can be seen as a rational, global-maximizing machine capable of relating to the future, choosing the best alternative by scanning several possible moves and then selecting the best choice among them.”… The irrational investor, the myopic gradient-climber, sees only today and postulates that tomorrow will be much the same. In contrast, Buffett sees stock price declines as temporary. Irrational investors see the same price declines and believe them to be permanent. The cornerstone of rationality is the ability to see past the present and analyze possible scenarios, eventually making a deliberate choice.
As an aside, if you are not reading Robert Hagstrom’s books you are missing out on some very good thinking and writing.
“[What was] … worked out in the course of about one year between Pascal and Fermat… is not that hard to learn.” “So you have to learn in a very usable way this very elementary math and use it routinely in life just the way if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer.”
Charlie Munger is saying that the expected value aspects of investing are relatively simple to learn but that it is not a natural way of thinking. He believes that using this process skillfully in real life is a trained response since aspects of the process will require you to overcome certain biases as well as certain often dysfunctional emotional and psychological tendencies. “Your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge. For example, people do not react symmetrically to loss and gain. Well maybe a great bridge player like Zeckhauser does, but that’s a trained response.” Charlie Munger is saying that the expected value aspects of investing are relatively simple to learn but that it is not a natural way of thinking. He believes that using this process skillfully in real life is a trained response since aspects of the process will require you to overcome certain biases as well as certain often dysfunctional emotional and psychological tendencies. For example, says Munger, “If people tell you what you really don’t want to hear what’s unpleasant—there’s an almost automatic reaction of antipathy. You have to train yourself out of it.”
“The Fermat/Pascal system is dramatically consonant with the way that the world works.” “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.”
Charlie Munger is famous for his view that simple mathematic techniques like algebraic inversion are essential to making wise decisions. Adopting this approach is neither easy or natural but will inevitably pay big dividends. He believes that if you don’t do this work you will inevitably end up being the patsy at the poker table of life. If you are playing in a poker game and don’t see a sucker, get up and walk away from the table. You’re the sucker. The future is best thought of as a probability distribution so naturally thinking probabilistically puts you are a competitive advantage in relation to competitors.
“I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? The first track is rationality-the way you’d work out a bridge problem: by evaluating the real interests, the real probabilities and so forth.”
Having a system is important, says Warren Buffett: “The approach and strategies [in bridge and investing] are very similar. In the stock market you do not base your decisions on what the market is doing, but on what you think is rational. With bridge, you need to adhere to a disciplined bidding system. While there is no one best system, there is one that works best for you. Once you choose a system, you need to stick with it.” The analytical system Charlie Munger uses starts with rationality. But that is only the first step in a two-step process that is his systematic approach to investing. He is saying that the rational decision-making track comes first, just like putting on your pants should precede putting on your shoes.
“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 malfunctions.” Ordinary people, subconsciously affected by their inborn tendencies.”
After an expected value process is completed and you believe your decisions is rational, Charlie Munger suggests that the decision be cross-checked for possible errors. The reality is that no one has a fully rational mindset. It would not be possible to get out of bed in the morning if every human decision had to be made based on careful expected value calculations. Heuristics have been developed by humans to get through a day which sometimes cause decisions to become irrational, especially in a modern world which is very unlike most of history. In other words, no human is perfectly rational because everyone is impacted by emotional and psychological tendencies when making decisions. As a result, thinking rationally is a trained response. To be as rational in your daily life as Richard Zeckhauser is in playing bridge a person must overcome errors based on emotional or psychological mistakes. Rationality is in practical terms relative. Charlie Munger believes staying rational is hard work and requires constant practice and lifelong effort. Making mistakes is inevitable and will never stop, but you can learn to make less than your statistical share of mistakes.
Stay tuned for the second six things Tren Griffin learned from Charlie Munger about rational decisions, coming tomorrow!