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Charlie Munger’s speech “Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs” at Herb Kay Undergraduate Lecture in 2003 gives me insights into how he thinks and what investors should learn.
Fatal unconnectedness, leading to ‘man with a hammer syndrome,’ often causing overweighting what can be counted
Munger’s first objection to economics is that it doesn’t grab models from other disciplines, which leads to them to see every problem as a nail. An example of the hammer syndrome is overweighting the countable. Economics and business are complex systems that throw out a lot of wonderful numbers. But “there are other factors that are terribly important, yet there’s no precise numbering you can put to these factors.” Therefore, if you don’t have a repertoire of tools at your disposal, you’re going to “(1) overweighs the stuff that can be numbered, and (2) doesn’t mix in the hard-to-measure stuff that may be more important.”
Growth is an example of overweighting what’s countable. It is easy to look at the past growth rate and extrapolate those numbers into the future. But what’s more important is durability. If a fast-growing firm cannot fend off its competitors and new entrants, then sooner or later, growth will collapse. You can’t put a number on durability. But it is nonetheless important.
The antidote here is “to have a full kit of tools.” And “You’ve got to use those tools checklist-style, because you’ll miss a lot if you just hope that the right tool is going to pop up unaided whenever you need it. But if you’ve got a full list of tools, and go through them in your mind, checklist-style, you will find a lot of answers that you won’t find any other way.”
Failure to follow the fundamental full attribution ethos of hard science
When you grab from other disciplines, it is best to grab them with “full attribution and full discipline, using all knowledge plus extreme reductionism where feasible. If you don’t do that, it’s like running a business with a sloppy filing system. It reduces your power to be as good as you can be.”
Munger used an example of reductionism by imagining that you own a store and caught an employee for stealing—a 60 years old lady who has worked at the store for 30 years. She pleads for forgiveness since this is her first time and she did it for her ailing husband. She swears she will never do it again. Should you forgive or fire her? “Well, how likely is it that she never did it before? If you’re gonna catch ten embezzlements a year, what are the chances that any one of them, applying what Tversky and Kahneman called baseline information, will be somebody who only did it this once? And the people who have done it before and are gonna do it again, what are they all gonna say?”
Physics Envy
“I want economics to pick up the basic ethos of hard science, the full attribution habit, but not craving for an unattainable precision that comes from physics envy.”
What is the basic ethos of hard science like physics, chemistry, and biology? Richard Feynman’s first principle is you must not fool yourself. “It’s a kind of scientific integrity, a principle of scientific thought that corresponds to a kind of utter honesty—a kind of leaning over backwards.”
For example, if you think a company is a buy for whatever reason, you need to test your hypothesis, you have to think about things that “might make it invalid—not only what you think is right about it; but also other causes that could possibly explain your results”. It is another way of saying beware of confirmation bias, and that’s the ethos you’ve to pick up in science and use it in investing. Reductionism is another, as explained earlier. Although one has to be careful with reductionism is that it doesn’t work that well on the stock market’s emergent behavior.
And the thing to avoid is physics envy, “once you try to put a lot of false precision into a complex system like economics, the errors can compound.” Moreover, precision in economics and investing often create a false sense of security. Just as turning on a headlamp doesn’t make drink driving less dangerous, valuing a stock down to three decimals doesn’t make it a safer investment. It is better to be roughly right than precisely wrong.
Too much emphasis on macroeconomics
Another problem with economics is that there’s “too much emphasis on macroeconomics and not enough on microeconomics. People are often wrong on macroeconomics because of extreme complexity in the system they wish to understand.”
Munger then demonstrated the power of microeconomics with Nebraska Furniture Mart:
“Berkshire Hathaway just opened a furniture and appliance store in Kansas City. At the time Berkshire opened it, the largest selling furniture and appliance store in the world was another Berkshire Hathaway store, selling $350 million worth of goods per year. The new store in a strange city opened up selling at the rate of more than $500 million a year.
Now, tell me what explains the runaway success of this new furniture and appliance store, which is outselling everything else in the world? Well, let me do it for you. Is this a low-priced store or a high-priced store? It’s not going to have a runaway success in a strange city as a high-priced store. That would take time. Number two, if it’s moving $500 million worth of furniture through it, it’s one hell of a big store, furniture being as bulky as it is. And what does a big store do? It provides a big selection. So what could this possibly be except a low-priced store with a big selection?
But, you may wonder, why wasn’t it done before, preventing it being done first now? Again, the answer just pops into your head: it costs a fortune to open a store this big. So, nobody’s done it before. So, you quickly know the answer. With a few basic concepts, these microeconomic problems that seem hard can be solved much as you put a hot knife through butter.”
And you can solve problems like these “using some rough algorithms that work pretty well in a great many complex systems, and those algorithms run something like this: Extreme success is likely to be caused by some combination of the following factors:
Extreme success is likely to be caused by some combination of the following factors:
Economics has too little synthesis “not only with matter outside traditional economics, but also within economics.”
Generally, we learn that when the price goes up, quantity falls and vice versa; the supply and demand curves. Are there instances that quantity increases as the price goes up? Plenty. Veblen goods are one. Another is the agency problem, “namely that when the customer is not involved directly in the purchasing decision, then higher prices can be used to bribe the purchaser’s agent and can result in both higher profit margins and sales volumes.”
Edward Chancellor of Marathon Asset Management illustrates this with Geberit, a Swiss sanitary systems manufacturer. “The company sells its product to plumbers via wholesalers who then install them in the end-customer’s home or commercial building. Geberit has a push-pull marketing strategy whereby plumbers are educated to “pull” the product through the wholesale channel, and company sales representatives “push” the product to wholesalers.” There’s little to no pricing pressure. The plumbers welcomed the price increase because “they were paid on a percentage commission basis for the system installation.”
Agency problems are prevalent in healthcare as well. Physicians tend to prescribe a brand name drug over generic ones because of direct or indirect benefits such as sponsorship, board seats, gifts, and payments from pharmaceutical companies.
Incentive is a superpower.
Extreme and counterproductive psychological ignorance
“You own a small casino in Las Vegas. It has fifty standard slot machines. Identical in appearance, they’re identical in the function. They have exactly the same payout ratios. They occur in the same percentages. But there’s one machine in this group of slot machines that, no matter where you put it among the fifty, there will be 25% more winnings from this one machine than from any other machine. What is different about that heavy winning machine?
What’s different about that machine is people have used modern electronics to give a higher ratio of near misses. That machine is going bar, bar, lemon. Bar, bar, grapefruit, way more often than normal machines, and that will cause heavier play. How do you get an answer like that? Easy. Obviously, there’s a psychological cause: That machine is doing something to trigger some basic psychological response.”
What else produces near miss? The stock market. The market produces a lot of wonderful near misses through randomness. Got out of a position right before a rally? Or wish you hold onto a stock longer instead of selling out early? All these ‘I’m so close to winning’ misses produce excitement that encourages trading behavior and all sorts of psychological misjudgments.
Munger’s two-track analysis are:
Too little attention to second and higher-order effects.
“Consequences have consequences, and consequences of the consequences have consequences.”
Berkshire Hathaway didn’t invest in any new loom machine to improve efficiency because of second-order effects. “You keep buying these looms for 20 years, and their equivalent, and you keep making 4% on capital, you never go anywhere. And the answer is, it wasn’t that technology didn’t work, it’s that the laws of economics caused the benefit from the new looms to go to people that bought the textiles, not the guy that owned the textile plant.”
Why does the benefit from the new looms go to people that bought the textiles instead of the guy (Berkshire Hathaway) that owned the plant? Because textile is an undifferentiated (or commodity) product. And when a business is a price taker, the only way to survive is to keep the cost as low as possible. The game theory further tells you that your competitors are going to make decisions that maximize their payoff. When these two interact, undifferentiated product and game theory, you come to the answer that everyone who can get their hands on the new technology eventually will, and since the only way to survive is to keep the cost low, the benefit from the new looms eventually goes to people who bought them.
We can also find second-order effects in the stock market. If the market correctly predicted a market crash is on the horizon and took drastic measures to prevent it, the crash will never happen because of those precautionary steps. The opposite is just as possible. If the crowd predicted a crash when there is none, that precautionary selling might turn into a self-fulfilling prophecy that triggers the crash. Prediction introduces second-order effects that change the outcome.
Not enough attention to the concept of febezzlement
”Is there a functional equivalent of embezzlement? I came up with a lot of wonderful affirmative answers. Some were in investment management. After all, I’m near investment management. I considered the billions of dollars totally wasted in the course of investing common stock portfolios for American owners. As long as the market keeps going up, the guy who’s wasting all this money doesn’t feel it, because he’s looking at these steadily rising values. And to the guy who is getting the money for investment advice, the money looks like well earned income, when he’s really selling detriment for money, surely the function equivalent of undisclosed embezzlement.”
Not enough attention to virtue and vice effects
“It has been plain to me since early life that there are enormous virtue effects in economics, and also enormous vice effects. I would say that the spreading of double-entry bookkeeping was a big virtue effect in economics. It made business more controllable, and it made it more honest. Then the cash register. It was a really powerful phenomenon to make an economic system work better, just as, in reverse, a system that can be easily defrauded ruins a civilization.
I say economic systems work better when there’s an extreme reliability ethos. And the traditional way to get a reliability ethos was through religion. The religions instilled guilt. And this guilt, derived from religion, has been a huge driver of reliability ethos, which has been very helpful to economic outcomes for man.”
The best example of a virtue effect is Berkshire Hathaway. From the beginning, Buffett and Munger have conducted themselves with integrity, honesty, and good ethics from how they run their business to how they choose to associate themselves with people who carry the same ethos. And this becomes part of their judgment on buying businesses as well. All the businesses that Berkshire acquired over the decades are run by owner-operators who are obsessed with the business instead of the money. Furthermore, Buffett’s reputation also attracts others who think similarly to do business with him. Compound this over 40+ years, what you get is Berkshire Hathaway’s extreme decentralization. Each subsidiary of Berkshire Hathaway makes its own decisions without any input from the corporate headquarter. Instead of having layers of line managers who manage and report to one another, as almost every company the size of Berkshire would need, you have an efficient machine built on a system of trust that’s effective and agile.
When it comes to vice effects like excessive pay to directors and management, one way to reduce that is through reciprocity. “If directors were significant shareholders who got a pay of zero, you’d be amazed what would happen to unfair compensation of corporate executives as we dampened effects from reciprocity tendency.”
It isn’t always a vice when a system is deliberately made unfair because “to function best, morality should sometimes appear unfair, like most worldly outcomes. The craving for perfect fairness causes a lot of terrible problems in system function. Some systems should be made deliberately unfair to individuals because they’ll be fairer on average for all of us. I frequently cite the example of having your career over, in the Navy, if your ship goes aground, even if it wasn’t your fault. I say the lack of justice for the one guy that wasn’t at fault is way more than made up by a greater justice for everybody when every captain of a ship always sweats blood to make sure the ship doesn’t go aground. Tolerating a little unfairness to some to get a greater fairness for all is a model I recommend to all of you.”
Chancellor, E. (2015). Capital Returns: Investing Through the Capital Cycle: Palgrave MacMillan
Farnam Street. The Psychology of Human Misjudgment, by Charlie Munger. Retrieved from https://fs.blog/great-talks/psychology-h...sjudgment/
Feynman, R. (1974). Cargo Cult Science: Some remarks on science, pseudoscience, and learning how to not fool yourself. Caltech. Retrieved from http://calteches.library.caltech.edu/51/2/CargoCult.pdf
Munger, C. (2003). Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs. Tilson Funds. Retrieved from https://www.tilsonfunds.com/MungerUCSBspeech.pdf
Charlie Munger’s speech “Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs” at Herb Kay Undergraduate Lecture in 2003 gives me insights into how he thinks and what investors should learn.
Fatal unconnectedness, leading to ‘man with a hammer syndrome,’ often causing overweighting what can be counted
Munger’s first objection to economics is that it doesn’t grab models from other disciplines, which leads to them to see every problem as a nail. An example of the hammer syndrome is overweighting the countable. Economics and business are complex systems that throw out a lot of wonderful numbers. But “there are other factors that are terribly important, yet there’s no precise numbering you can put to these factors.” Therefore, if you don’t have a repertoire of tools at your disposal, you’re going to “(1) overweighs the stuff that can be numbered, and (2) doesn’t mix in the hard-to-measure stuff that may be more important.”
Growth is an example of overweighting what’s countable. It is easy to look at the past growth rate and extrapolate those numbers into the future. But what’s more important is durability. If a fast-growing firm cannot fend off its competitors and new entrants, then sooner or later, growth will collapse. You can’t put a number on durability. But it is nonetheless important.
The antidote here is “to have a full kit of tools.” And “You’ve got to use those tools checklist-style, because you’ll miss a lot if you just hope that the right tool is going to pop up unaided whenever you need it. But if you’ve got a full list of tools, and go through them in your mind, checklist-style, you will find a lot of answers that you won’t find any other way.”
Failure to follow the fundamental full attribution ethos of hard science
When you grab from other disciplines, it is best to grab them with “full attribution and full discipline, using all knowledge plus extreme reductionism where feasible. If you don’t do that, it’s like running a business with a sloppy filing system. It reduces your power to be as good as you can be.”
Munger used an example of reductionism by imagining that you own a store and caught an employee for stealing—a 60 years old lady who has worked at the store for 30 years. She pleads for forgiveness since this is her first time and she did it for her ailing husband. She swears she will never do it again. Should you forgive or fire her? “Well, how likely is it that she never did it before? If you’re gonna catch ten embezzlements a year, what are the chances that any one of them, applying what Tversky and Kahneman called baseline information, will be somebody who only did it this once? And the people who have done it before and are gonna do it again, what are they all gonna say?”
Physics Envy
“I want economics to pick up the basic ethos of hard science, the full attribution habit, but not craving for an unattainable precision that comes from physics envy.”
What is the basic ethos of hard science like physics, chemistry, and biology? Richard Feynman’s first principle is you must not fool yourself. “It’s a kind of scientific integrity, a principle of scientific thought that corresponds to a kind of utter honesty—a kind of leaning over backwards.”
For example, if you think a company is a buy for whatever reason, you need to test your hypothesis, you have to think about things that “might make it invalid—not only what you think is right about it; but also other causes that could possibly explain your results”. It is another way of saying beware of confirmation bias, and that’s the ethos you’ve to pick up in science and use it in investing. Reductionism is another, as explained earlier. Although one has to be careful with reductionism is that it doesn’t work that well on the stock market’s emergent behavior.
And the thing to avoid is physics envy, “once you try to put a lot of false precision into a complex system like economics, the errors can compound.” Moreover, precision in economics and investing often create a false sense of security. Just as turning on a headlamp doesn’t make drink driving less dangerous, valuing a stock down to three decimals doesn’t make it a safer investment. It is better to be roughly right than precisely wrong.
Too much emphasis on macroeconomics
Another problem with economics is that there’s “too much emphasis on macroeconomics and not enough on microeconomics. People are often wrong on macroeconomics because of extreme complexity in the system they wish to understand.”
Munger then demonstrated the power of microeconomics with Nebraska Furniture Mart:
“Berkshire Hathaway just opened a furniture and appliance store in Kansas City. At the time Berkshire opened it, the largest selling furniture and appliance store in the world was another Berkshire Hathaway store, selling $350 million worth of goods per year. The new store in a strange city opened up selling at the rate of more than $500 million a year.
Now, tell me what explains the runaway success of this new furniture and appliance store, which is outselling everything else in the world? Well, let me do it for you. Is this a low-priced store or a high-priced store? It’s not going to have a runaway success in a strange city as a high-priced store. That would take time. Number two, if it’s moving $500 million worth of furniture through it, it’s one hell of a big store, furniture being as bulky as it is. And what does a big store do? It provides a big selection. So what could this possibly be except a low-priced store with a big selection?
But, you may wonder, why wasn’t it done before, preventing it being done first now? Again, the answer just pops into your head: it costs a fortune to open a store this big. So, nobody’s done it before. So, you quickly know the answer. With a few basic concepts, these microeconomic problems that seem hard can be solved much as you put a hot knife through butter.”
And you can solve problems like these “using some rough algorithms that work pretty well in a great many complex systems, and those algorithms run something like this: Extreme success is likely to be caused by some combination of the following factors:
Extreme success is likely to be caused by some combination of the following factors:
- Extreme maximization or minimization of one or two variables. Example Costco or our furniture and appliance store
- Adding success factors so that a bigger combination drives success, often in a non-linear fashion, as one is reminded by the concept of breakpoint and the concept of critical mass in physics. Often results are not linear. You get a little bit more mass, and you get a lollapalooza result. And of course I’ve been searching for lollapalooza results all my life, so I’m very interested in models that explain their occurrence.
- An extreme of good performance over many factors. Example: Toyota or Les Schwab.
- Catching and riding some sort of big wave. Example, Oracle.”
Economics has too little synthesis “not only with matter outside traditional economics, but also within economics.”
Generally, we learn that when the price goes up, quantity falls and vice versa; the supply and demand curves. Are there instances that quantity increases as the price goes up? Plenty. Veblen goods are one. Another is the agency problem, “namely that when the customer is not involved directly in the purchasing decision, then higher prices can be used to bribe the purchaser’s agent and can result in both higher profit margins and sales volumes.”
Edward Chancellor of Marathon Asset Management illustrates this with Geberit, a Swiss sanitary systems manufacturer. “The company sells its product to plumbers via wholesalers who then install them in the end-customer’s home or commercial building. Geberit has a push-pull marketing strategy whereby plumbers are educated to “pull” the product through the wholesale channel, and company sales representatives “push” the product to wholesalers.” There’s little to no pricing pressure. The plumbers welcomed the price increase because “they were paid on a percentage commission basis for the system installation.”
Agency problems are prevalent in healthcare as well. Physicians tend to prescribe a brand name drug over generic ones because of direct or indirect benefits such as sponsorship, board seats, gifts, and payments from pharmaceutical companies.
Incentive is a superpower.
Extreme and counterproductive psychological ignorance
“You own a small casino in Las Vegas. It has fifty standard slot machines. Identical in appearance, they’re identical in the function. They have exactly the same payout ratios. They occur in the same percentages. But there’s one machine in this group of slot machines that, no matter where you put it among the fifty, there will be 25% more winnings from this one machine than from any other machine. What is different about that heavy winning machine?
What’s different about that machine is people have used modern electronics to give a higher ratio of near misses. That machine is going bar, bar, lemon. Bar, bar, grapefruit, way more often than normal machines, and that will cause heavier play. How do you get an answer like that? Easy. Obviously, there’s a psychological cause: That machine is doing something to trigger some basic psychological response.”
What else produces near miss? The stock market. The market produces a lot of wonderful near misses through randomness. Got out of a position right before a rally? Or wish you hold onto a stock longer instead of selling out early? All these ‘I’m so close to winning’ misses produce excitement that encourages trading behavior and all sorts of psychological misjudgments.
Munger’s two-track analysis are:
- What are the factors that govern the interests involved, rationally considered?
- 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 malfunction?
Too little attention to second and higher-order effects.
“Consequences have consequences, and consequences of the consequences have consequences.”
Berkshire Hathaway didn’t invest in any new loom machine to improve efficiency because of second-order effects. “You keep buying these looms for 20 years, and their equivalent, and you keep making 4% on capital, you never go anywhere. And the answer is, it wasn’t that technology didn’t work, it’s that the laws of economics caused the benefit from the new looms to go to people that bought the textiles, not the guy that owned the textile plant.”
Why does the benefit from the new looms go to people that bought the textiles instead of the guy (Berkshire Hathaway) that owned the plant? Because textile is an undifferentiated (or commodity) product. And when a business is a price taker, the only way to survive is to keep the cost as low as possible. The game theory further tells you that your competitors are going to make decisions that maximize their payoff. When these two interact, undifferentiated product and game theory, you come to the answer that everyone who can get their hands on the new technology eventually will, and since the only way to survive is to keep the cost low, the benefit from the new looms eventually goes to people who bought them.
We can also find second-order effects in the stock market. If the market correctly predicted a market crash is on the horizon and took drastic measures to prevent it, the crash will never happen because of those precautionary steps. The opposite is just as possible. If the crowd predicted a crash when there is none, that precautionary selling might turn into a self-fulfilling prophecy that triggers the crash. Prediction introduces second-order effects that change the outcome.
Not enough attention to the concept of febezzlement
”Is there a functional equivalent of embezzlement? I came up with a lot of wonderful affirmative answers. Some were in investment management. After all, I’m near investment management. I considered the billions of dollars totally wasted in the course of investing common stock portfolios for American owners. As long as the market keeps going up, the guy who’s wasting all this money doesn’t feel it, because he’s looking at these steadily rising values. And to the guy who is getting the money for investment advice, the money looks like well earned income, when he’s really selling detriment for money, surely the function equivalent of undisclosed embezzlement.”
Not enough attention to virtue and vice effects
“It has been plain to me since early life that there are enormous virtue effects in economics, and also enormous vice effects. I would say that the spreading of double-entry bookkeeping was a big virtue effect in economics. It made business more controllable, and it made it more honest. Then the cash register. It was a really powerful phenomenon to make an economic system work better, just as, in reverse, a system that can be easily defrauded ruins a civilization.
I say economic systems work better when there’s an extreme reliability ethos. And the traditional way to get a reliability ethos was through religion. The religions instilled guilt. And this guilt, derived from religion, has been a huge driver of reliability ethos, which has been very helpful to economic outcomes for man.”
The best example of a virtue effect is Berkshire Hathaway. From the beginning, Buffett and Munger have conducted themselves with integrity, honesty, and good ethics from how they run their business to how they choose to associate themselves with people who carry the same ethos. And this becomes part of their judgment on buying businesses as well. All the businesses that Berkshire acquired over the decades are run by owner-operators who are obsessed with the business instead of the money. Furthermore, Buffett’s reputation also attracts others who think similarly to do business with him. Compound this over 40+ years, what you get is Berkshire Hathaway’s extreme decentralization. Each subsidiary of Berkshire Hathaway makes its own decisions without any input from the corporate headquarter. Instead of having layers of line managers who manage and report to one another, as almost every company the size of Berkshire would need, you have an efficient machine built on a system of trust that’s effective and agile.
When it comes to vice effects like excessive pay to directors and management, one way to reduce that is through reciprocity. “If directors were significant shareholders who got a pay of zero, you’d be amazed what would happen to unfair compensation of corporate executives as we dampened effects from reciprocity tendency.”
It isn’t always a vice when a system is deliberately made unfair because “to function best, morality should sometimes appear unfair, like most worldly outcomes. The craving for perfect fairness causes a lot of terrible problems in system function. Some systems should be made deliberately unfair to individuals because they’ll be fairer on average for all of us. I frequently cite the example of having your career over, in the Navy, if your ship goes aground, even if it wasn’t your fault. I say the lack of justice for the one guy that wasn’t at fault is way more than made up by a greater justice for everybody when every captain of a ship always sweats blood to make sure the ship doesn’t go aground. Tolerating a little unfairness to some to get a greater fairness for all is a model I recommend to all of you.”
Notes
Bakshi, S. (2005). Explaining Mr Munger’s “Kantian Fairness Tendency”. Fundoo Professor. Retrieved from Explaining Mr. Munger’s “Kantian Fairness Tendency” | Fundoo ProfessorChancellor, E. (2015). Capital Returns: Investing Through the Capital Cycle: Palgrave MacMillan
Farnam Street. The Psychology of Human Misjudgment, by Charlie Munger. Retrieved from https://fs.blog/great-talks/psychology-h...sjudgment/
Feynman, R. (1974). Cargo Cult Science: Some remarks on science, pseudoscience, and learning how to not fool yourself. Caltech. Retrieved from http://calteches.library.caltech.edu/51/2/CargoCult.pdf
Munger, C. (2003). Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs. Tilson Funds. Retrieved from https://www.tilsonfunds.com/MungerUCSBspeech.pdf