Charlie Munger: "I Got Rich When I Understood This" (Mental Models)

Billionaire investor Charlie Munger has said on countless occasions he got rich when he finally understood the power of what I referred to as mental models. I have gone through hundreds of hours of Charlie Munger's interviews and writings to identify the six most important mental models that will change your life. Munger is one of the most celebrated investors in the world; as the vice president of Berkshire Hathaway and Warren Buffett's right-hand man, he has become one of the richest people in the world.

But how exactly did he do it? In this video, we're going to discuss the mental models Charlie Munger uses that he attributes to his success. A mental model is how we understand the world; they shape the way we think and understand the world and also how we shape the connections and opportunities we see. Our brains simply cannot remember every single detail of the world, so we use mental models to simplify complex ideas into understandable chunks, ultimately helping us make better and more profitable decisions.

So, without further ado, here are the six best mental models that helped make Charlie Munger a billionaire. The first mental model we are going to discuss is inversion. Inversion is a process of solving problems backwards. In fact, Charlie Munger has been quoted saying many problems can't be solved forward. When inverting a problem, you have to think about the opposite of what you want.

Let me explain with some examples. Let's say your goal is to become wealthy. Using inversion, you would flip things on their head. You would ask yourself, if my goal was instead to be poor, what would I do? That list would include things such as overspending your income, getting into large amounts of debt, and never investing any money. By using inversion, you know what you need to avoid in order to hit your goal of eventually becoming wealthy.

This line of thinking doesn't come naturally to most people, and yet many of the smartest people in history have done this naturally. Inverting a problem won't always help you solve it, but it will help you avoid trouble. You can think of inversion as a filter that helps you avoid stupidity. As Charlie Munger says, a big part of success is simply avoiding stupidity.

Inversion is one of the most versatile and adaptable mental models that can go well beyond investing. For example, if you want to get promoted at work, ask yourself, if it was my goal to not get promoted at work, what would I do? Here are some things that come to mind: showing up late to work, having a bad attitude, complaining, not developing new skills. You get the idea.

The point is to start with your goal, apply inversion, and then invest your energy in avoiding your blockers or potential pitfalls to achieve progress. Another mental model Charlie Munger uses is staying within your circle of competence. The concept of a circle of competence has been used by Charlie Munger and Warren Buffett for years as a way to focus investors on only investing in stocks they know best. Picture a circle; this represents your circle of competence. Stocks that fall within the circle are those that you are an expert on. You have a deep understanding of the company and its industry.

To put it another way, you have an edge. If you don't understand a certain stock, it is considered outside of your circle of competence and falls outside of the circle. Keep in mind, everyone's circle of competence is different because people have different levels of understanding of certain businesses and industries.

Let's say someone is a general manager of a clothing store and, as a result, has a deep understanding of the retail industry and companies that operate within it. Stocks such as Walmart, Target, The Home Depot, TJX Companies, Macy's, Dick's Sporting Goods, Nike, and Lululemon all may very well fall within this person's circle of competence, while high-tech stocks such as Nvidia, Tesla, Meta, Salesforce, and Snapchat would probably be outside of this person's circle of competence.

Warren Buffett has frequently said that when it comes to investing, it's not how large your circle of competence is; it's more important that you only stick to investing in the companies within that circle. This concept sounds so simple, but it is probably one of the biggest mistakes investors make. Most investors get themselves into trouble when they get overconfident and try to invest in companies that are outside of their circle. That's how investors can lose a lot of money.

It's obviously very important to develop a deep understanding of companies and industries so they can be included in your circle of competence. The third mental model Charlie Munger uses is the concept of Occam's razor. Munger has talked a lot about this. This idea is focused on how everything should be made as simple as possible, but no more simple. In other words, the simplest solutions tend to be the best.

Naturally, this concept also applies to investing. Warren Buffett and Charlie Munger have what they refer to as a "two hard bucket" on their desks, and the majority of the potential investment ideas they come across end up in that bucket. Warren and Charlie spend countless hours looking for simpler businesses that require fewer assumptions and fewer hypothetical scenarios to work out.

Charlie Munger once said, "People calculate too much and think too little. We have a passion for keeping things simple. If something is too hard, we move on to something else." What could be more simple than that? The first step to simplification is to avoid the unknowable and unimportant. In order for a piece of information to be included in an investment decision-making process, it needs to pass a simple two-step test. That information has to be, one, important, and two, knowable.

Let's use an example to demonstrate. Let's say I am considering investing in XYZ Corporation and I want to know whether the economy is going to enter a recession or not in the next five years. Naturally, how well the economy performs is going to greatly impact how well XYZ will perform. When it comes to choosing to invest in XYZ, understanding how well the economy is going to perform is certainly important, and surely passes the first part of this two-part test.

However, despite plenty of people that claim otherwise, no one can accurately and reliably predict the future of the economy because the future of the economy is unknowable. It fails the second part of our test. Instead, when deciding whether to make an investment in XYZ Corporation, you may want to ask things like how much pricing power the company has, what separates the company from its competitors, how much cash it will generate, what it will do with that cash, and whether it is undervalued at its current price.

These kinds of things are knowable and a much better use of your time. If you have watched any of my videos, you know I talk about margin of safety pretty frequently because it is critical to successful investing. Speaking of which, if you're enjoying this video, make sure to hit that subscribe button because it's my goal to make you the smartest and hopefully richest person in your friend group.

Margin of safety actually comes from a concept in engineering. Let me explain what I mean. Imagine you are the head engineer designing and constructing a bridge that crosses over a dangerous body of water. You want this bridge to be able to support 10,000 pounds without failing. However, you wouldn't want to make the bridge only be able to support ten thousand pounds before it collapses. Instead, you would want to make it stronger than that and be able to support more than just ten thousand pounds for safety purposes.

You would want it to be able to support, let's say, fifteen thousand pounds. Even though you would put a sign on the bridge warning that it can only support ten thousand pounds, you would want to design it to support more than that to factor in anything that could go wrong, such as errors in your design or people not using the bridge how it's supposed to be used. The difference between the 10,000 pounds you say the bridge can hold and the fifteen thousand pounds it can actually hold is five thousand pounds. This is what is referred to as your margin of safety.

The same concept applies to investing. You wouldn't want to buy a stock for one hundred dollars a share if you determine its true or intrinsic value is also one hundred dollars. You would only want to buy a stock that is selling for one hundred dollars a share if its intrinsic value is higher by a significant amount. Let's say 150; that 50 difference between what the stock is truly worth and what you paid for it is your margin of safety. It protects you from losing money in case your estimate of the intrinsic value is wrong or if the underlying business's performance deteriorates after you purchase it.

Moving on to the next mental model: learn from mistakes. Unfortunately, mistakes are just a natural part of investing. Every investor will make mistakes throughout their career. Some will be big, and some will be small. The key is to learn from those mistakes so there is no risk of repeating them. One of the best ways to learn from mistakes is to study the mistakes of others.

Charlie Munger knows this all too well. In fact, in a 2019 interview with the Wall Street Journal, Munger said, "I want to learn as much as I can vicariously. It's too painful to do it by personal hardship. Of course, I collect big calamities in my head and big stupidities. I do that so I can avoid them. Think of how little in the way of big calamity has ever come to Berkshire, and it's not that we don't ever have reverses and disappointments in that or never have whole businesses disappear, but averaged out, we have less misfortune than others."

To maximize how much he learns, Munger reads five newspapers a day and has been described as a book with legs sticking out. It is far better to learn vicariously when it comes to many of the more painful mistakes in life. At one shareholder meeting, Munger quoted Will Rogers when describing Berkshire's business mistakes: "There are three kinds of men: some learn by reading, some learn by observation, the rest of them must pee on an electric fence for themselves."

The final mental model we are going to discuss is opportunity cost. As humans, we live in a world of trade-offs, whether it's choosing between staying at home and studying or going out to the movies with your friends or choosing between two different companies to invest your money in. We deal with opportunity costs on a daily basis. Opportunity cost represents the trade-offs or losses incurred from not doing the next best alternative to your choice.

This is a critical mental model when it comes to investing, as investors are constantly thinking of allocating capital towards their best ideas. However, with limited capital to allocate and several alternatives, the idea of opportunity costs arises. Opportunity cost is a useful filter when it comes to investing. If you have one idea that's better than 98 of the other opportunities, then you can just screen out the other 98.

This mindset leads itself to having a concentrated investment portfolio, and this makes sense when you think about it. Here's how Charlie Munger described it: he said, "Professional investors work all year trying to find good investment ideas. Over all of those hours, they may find one or two great investment ideas that are likely winners. Munger says, why would it make sense for these investors to take money out of their best idea to put it into their 30th or maybe 40th best idea simply for the sake of having a diversified portfolio?"

Munger practices what he preaches; he frequently talks about how the Munger family fortune is invested in only three stocks: Berkshire Hathaway, Costco, and an investment in the fund managed by a man named Li Lu. So, there you have it. While this video touched on some of my favorite mental models from Charlie Munger, it really only scratched the surface of all of the mental models he uses and discusses.

Please let us know in the comments if you're interested in a part two of this video, and make sure to subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors. As always, talk to you again soon.