“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 post, we are happy to present the second 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 (view the first part here). The post was originally featured on Griffin’s blog, 25iq.
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A Dozen Things I’ve Learned from Charlie Munger about Making Rational Decisions, Part 2
By Tren Griffin
“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 [are] 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.
“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.”
Thinking in a way that is as rational as possible requires work and training, especially when it comes to avoiding psychological and emotional mistakes. What is the source of these mistakes? The list of factors causing mistakes is very long. Warren Buffett writes: “It’s ego. It’s greed. It’s envy. It’s fear. It’s mindless imitation of other people. I mean, there are a variety of factors that cause that horsepower of the mind to get diminished dramatically before the output turns out. And I would say if Charlie and I have any advantage it’s not because we’re so smart, it is because we’re rational and we very seldom let extraneous factors interfere with our thoughts. We don’t let other people’s opinion interfere with it… we try to get fearful when others are greedy. We try to get greedy when others are fearful. We try to avoid any kind of imitation of other people’s behavior. And those are the factors that cause smart people to get bad results.” What Buffett describes is an example of what Charlie Munger calls decisional inversion. Instead of just trying to be smart, it is wise to focus on not being stupid.
“What is hard is to get so you use it routinely almost every day of your life.”
Training your mind to do what Charlie Munger suggests is the ultimate goal of anyone who wants to emulate his system. Warren Buffett has written: “Chains of habit are too light to be felt until they are too heavy to be broken…At my age, I can’t change any of my habits. I’m stuck. But you will have the habits 20 years from now that you decide to put into practice today. So I suggest that you look at the behavior that you admire in others and make those your own habits, and look at what you really find reprehensible in others and decide that those are things you are not going to do. If you do that, you’ll find that you convert all of your horsepower into output.” One good aspect of habits is that they can be put to good use if they are the right habits. It’s a bit like Alcoholics Anonymous, which Charlie Munger believes is a cult, but for the good. What an investor needs is a system that includes habits that reinforce rationality. If you want to say that people who follow Munger are a cult for the good, you won’t be far off in too many cases. Munger himself has referred to people who attend Berkshire shareholder meetings as cult followers.
“We have a temperamental advantage that more than compensates for a lack of IQ points.” “A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains.”
Charlie Munger is making the point that high IQ does not mean you have high rationality quotient (RQ). Temperament is far more important than IQ. Warren Buffett has said about Charlie Munger: “He lives a very rational life. I’ve never heard him say a word that expressed envy of anyone. He doesn’t waste time on senseless emotions.” Warren Buffett suggests that some of this aspect of human nature may be innate: “A lot of people don’t have that. I don’t know why it is. I’ve been asked a lot of times whether that was something that you’re born with or something you learn. I’m not sure I know the answer. Temperament’s important.” High IQ can be problematic. What you want is to have a high IQ but think it is less than it actually is. That gap between actual and perceived IQ creates valuable humility and protects against mistakes caused by hubris. It is the person who thinks their IQ is something like 40 points higher than it actually is who creates the most havoc in life.
“Personally, I’ve gotten so that I have a full kit of tools … go through them in your mind checklist-style.”
Charlie Munger is a big believer is the use of checklist and is fan of Atul Gwande’s book The Checklist Manifesto. Checklists are a foundational part of systems that can help people identify dysfunctional thinking and bias. A checklist is in effect a “nudge” that helps you deal with bias and dysfunction by prodding you in the right direction. As an aside the full kit of tools required when using Charlie Munger’s system requires that you have “worldly wisdom” which will be the topic of another blog post in this series.
“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.”
No one is going to make the right decision all the time even if they strive to be rational. Howard Marks believes: “Most people understand and accept that in their effort to make correct investment decisions, they have to accept the risk of making mistakes. Few people expect to find a lot of sure things or achieve a perfect batting average.” The important thing is to have a system, but don’t expect it to be perfect. Michael Mauboussin points out: “Constantly thinking in expected value terms requires discipline and is somewhat unnatural. But the leading thinkers and practitioners from somewhat varied fields have converged on the same formula: focus not on the frequency of correctness, but on the magnitude of correctness.”
“[Berkshire] is a very rational place.” “Warren and I know better than most people what we know and what we don’t know. That’s even better than having a lot of extra IQ points… People chronically mis-appraise 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.”
IQ is not the primary cause of investing success. Warren Buffett points out that the key to making wise decisions is rationality: “How I got here is pretty simple in my case. It’s not IQ, I’m sure you’ll be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output–the efficiency with which that motor works–depends on rationality. A lot of people start out with 400-horsepower motors but only get a hundred horsepower of output. It’s way better to have a 200-horsepower motor and get it all into output.” For Buffett and Munger the circle of competence point is critical. Since risk comes from not knowing what you are doing, know what you are doing when you are doing something. If you don’t know what you are doing put it in the too hard pile and move on to something else. The more you know, the more you know that there is even more than you do not know.