A detailed overview of the lessons of Warren Buffett and Charlie Munger to help improve your decision making in a complex world.
“The first principle is that you must not fool yourself — and you are the easiest person to fool.”
If we understand what influences us, we might avoid certain traps and understand why others act as they do. We can’t eliminate mistakes, but we can prevent those that can really hurt us. The best way to learn what, how, and why things work is to master the best of what other people have already figured out. Achieving wisdom is best achieved by learning the big ideas that underlie reality.
What Influences Our Thinking
To understand the way we think and why we make misjudgments, we must first determine what influences our behavior. Our behavior is influenced by evolution (nature) and the environment we are raised in (nurture).
The major mechanisms of evolution that are responsible for how our brain evolved are genetic mutations and natural selection. These mechanisms shaped our behavior to maximize our chances of survival and reproduction. We are driven by our need to avoid pain (and punishment) and a desire to gain pleasure (and reward). Feelings of pain and pleasure are a useful guide to what is good or bad for us.
Our behavior is also influenced by our upbringing, nutrition, education, social stamping, physical, social, and cultural setting. Differences in our environments cause different life experiences, which lead to having unique behaviors.
“Our life is what our thoughts make it.”
The Psychology of Misjudgments
How to avoid fooling ourselves; a checklist of 28 reasons for misjudgments and mistakes:
1. Bias from Mere Association
- People can influence us by associating a product, service, person, investment, or a situation with something you like.
2. Underestimating the Power of Rewards and Punishment
- We do what is rewarding and avoid what we are punished for. Install systems and rules that encourage the behavior you want.
3. Underestimating Bias from Own Self-Interest and Incentives
- Don’t automatically trust people who have something at stake from your decision. Understand people’s motivations: money, status, love of work, reputation, position, power, and envy.
4. Self-Serving Bias
- We tend to overestimate our abilities and future prospects when we are knowledgable on a subject, feel in control, or after we have been successful.
5. Self-Deception and Denial
- We deny and distort reality to fee more comfortable, especially when reality threatens our self-interest.
6. Bias from Consistency Tendency
- We look for evidence that confirms our ideas, beliefs, and actions. Devising reasons why we might be wrong doesn’t come easily.
7. Bias from Deprival Syndrome
- We put a higher value on the things we already own than we are willing to pay for the same things if we didn’t own them.
8. Status Quo Bias and Do-Nothing Syndrome
- We are bothered more by the harm that comes from action than the harm that comes from inaction. Deciding to do nothing is also a decision, and the cost of doing nothing could be higher.
- We give more weight to the present than to the future. We seek pleasure today at the cost of what may be better in the future.
10. Bias from Envy and Jealousy
- We evaluate our situation by comparing what we have with what others have.
11. Distortion by Contrast Comparison
- We judge stimuli by differences and changes and not by absolute magnitudes. How we value things depends on what we compare them with.
12. Bias from Anchoring
- We are over-influenced by certain information acting as a reference “anchor” for future judgments.
13. Over-Influence by Most Recent Information
- The more dramatic, salient, personal, entertaining, or emotional some information, event, or experience is, the more influenced we are. We loved to be entertained.
14. Omission and Abstract Blindness
- When planning, we often place too much importance on the specific future event and not enough on other possible events and their consequences that can cause the event to be delayed or not happen.
15. Bias from Reciprocation Tendency
- We tend to repay in kind what others have done for us — good or bad.
16. Bias from Over-Influence by Liking Tendency
- We want to be liked and accepted. We believe, trust, and agree with people we know and like.
17. Bias from Over-Influence by Social Proof
- In a group, we are easily seduced because of our need for social acceptance. We also feel anonymous in group settings, which reduces are feelings of responsibility, leading to overconfident, risky behavior.
18. Bias from Over-Influence by Authority
- We are most easily influenced by credible authorities instead of evaluating the truth of a statement based on its underlying facts.
- We underestimate the influence of chance. We want to find reasons for all kinds of events — random or not.
- We underestimate the importance of giving people a reason. It is often easier to get people to change with a well-explained reason backed by solid evidence.
21. Believing First and Doubting Later
- The more distracted or pressured we are, the more likely we believe in something we normally would find dubious.
22. Memory Limitations
- Our memory is selective. We remember certain things and distort or forget others. We only remember fragments of our real past experiences.
23. Do-Something Syndrome
- We sometimes act because we feel bored, impatient, threatened, pressured, or desire excitement and stimulation.
24. Mental Confusion from Say-Something Syndrome
- We tend to speak out even if we have nothing to contribute.
25. Emotional Arousal
- When we feel sad, we may want to change our circumstances so we will feel better. This can cause us to overpay for something or buy things we don’t need. When going through an emotional experience, you should hold off on important decisions.
26. Mental Confusion from Stress
- The more stress we experience, the more we tend to make short-term decisions.
27. Mental Confusion from Physical or Psychological Pain
- We become confused when we are in pain, under the influence of chemicals, or have a physical or mental illness. Drugs, stimulants, and depressants distort our senses.
28. Bias from Over-Influence of Many Psychological Tendencies Operating Together
- Our behavior is influenced by social situational factors, conditions and circumstances, the structure or description of a problem or choice, and our desires, mood, and expectations.
Three pieces of advice from Charles Munger:
- Learn how to handle mistakes and new facts that change the odds. You have to learn to quit sometimes when holding a much-loved hand.
- Use a two-track analysis: Ask what the factors that govern the interests involved and what are the subconscious influences where the brain at a subconscious level is automatically doing these things are.
- Take all the main models from psychology and use them as a checklist in reviewing the outcomes of complex systems.
The Physics and Mathematics of Misjudgments
1. Systems Thinking
- Failing to consider that actions have both intended and unintended consequences. No matter how carefully we plan, we can’t anticipate everything.
2. Scale and Limits
- Failing to consider that changes in size or time influences form, function, and behavior.
- Not understanding what causes desired results. Believing cause resembles effect.
4. Numbers and their Meaning
- Failing to consider relationships and magnitudes. Underestimating the effect of exponential growth and the time value of money.
5. Probabilities and Number of Possible Outcomes
- Underestimating risk exposure in situations where relative frequency and/or magnitude of consequences is unknown or changing over time.
- Overestimating the probability of scenarios and underestimating the probability of systems failure.
7. Coincidences and Miracles
- Underestimating that surprises and improbable events happen.
8. Reliability of Case Evidence
- Overweighing individual case evidence and under-weighing the prior probability.
9. Misrepresentative Evidence
- Failing to consider changes in factors, context, or conditions when using past evidence to predict likely future outcomes.
“Those who cannot remember the past are condemned to repeat it.”
You cannot understand what is happening without any reference to the past. Forgetting to record your mistakes instead of confessing your errors and learning from them leads to repeat errors. To prevent the same mistakes from happening again, you should look into their causes and ask:
- What was my original reason for doing something?
- How did reality work out relative to my original guess?
- Given the available information, should I have been able to predict what was going to happen?
- What worked well?
- What should I do differently?
- What must I stop doing?
Guidelines to Better Thinking
“The brain can be developed just the same way as the muscles can be developed, if one will only take the pains to train the mind to think.”
Building a foundation for rational thinking starts with having the right tools. These 12 tools are the ideas that help us when achieving goals, explaining “why,” preventing and reducing mistakes, solving problems, and evaluating statements.
1. Models of Reality
- A model is an idea that helps us better understand how the world works. A valuable model produces meaningful explanations and predictions while being easy to use. The models that come from hard science and engineering (mathematics, physics, chemistry, biology, and psychology) are the most reliable.
- Understanding “meaning” requires you to observe and ask basic questions. If you can’t explain something simply, then you don’t understand it well enough.
- Make fewer and better decisions. It forces you to think more about each decision and thereby reduces your chance of mistakes. Having more information doesn’t equate to more knowledge or understanding. Reducing your mistakes by learning what areas, situations, and people to avoid is often a better use of time than seeking out new ways of succeeding.
4. Rules and Filters
- Establish some “what to do” and “what to avoid” rules for your life. Use checklist procedures to reduce your chance of harm.
- Meaningful goals should be clearly defined, focused on results, realistic and logical, measurable, tailored to your needs, and be subject to change when necessary.
- Measure your choices against your own opportunity cost. Your time and money are limited. If you decide to do one thing, you are deciding not to do something else. If you decide to change something, you should measure it against the best of what you already have.
- Consider the secondary and long-term effects of an action. Whenever you take action, remember these four key things:
- Pay attention to the whole system, the direct and indirect effects.
- You can’t estimate all possible consequences but look out for the one unintended consequence.
- Consider the effects of feedback, time, scale, repetition, critical thresholds, and limits.
- Estimate the net effects over time and how desirable these are compared to what you want.
- Have a strong understanding of math so you can depend on your ability to quantify and understand patterns and relationships, proportions, and magnitudes.
- Evidence comes from facts, observations, experiences, comparisons, and experiments. Use the scientific method to strive for objectivity. Observe the problem, form a hypothesis, and test your guess with an experiment. Don’t spend your time on already disproved ideas or arguments that can’t be disproved.
10. Backward Thinking
- Instead of thinking about how you can achieve a goal, ask: What don’t you want to achieve? How can you avoid the non-goal?
- Reflect on what can go wrong. Ask: What is the potential downside? What’s the worst thing that could happen? What can I do to prevent it? If the decision is important, you should largely ignore what has happened in the past and focus on the consequences of being wrong. Have backups or a considerable margin of safety.
- Part of avoiding misjudgments and improving your life is having the right attitude towards life. You should act in a way that agrees with your nature, advantages, limitations, and personal values.
Benjamin Graham’s three timeless ideas for investing:
- Look at stocks as part ownership of a business.
- Look at market fluctuations as your friend by profiting from folly instead of participating in it.
- Have a margin of safety.
How to evaluate a business:
- Can you understand the business — predictability?
- Does it look like the business has some sustainable competitive advantage?
- Does the business have able and honest management?
- Is the price right?
- Disprove — what are the ways the business can fail?
- What are the consequences if you are wrong?
“I confess that I have been blind as a mole, but it is better to learn wisdom late than never to learn it at all.”
—Sherlock Holmes (Arthur Conan Doyle, The Man with the Twisted Lip)