Would You Use These Charlie Munger Mental Models To Become Rich?

charlie munger mental models

From one thing you can know 10,000 things.

-Mushashi

These models detail the patterns of the universe.

They explain energy and rhythm.

By applying them to various situations, you can see the bigger picture.

Both Munger and Buffett used these models to amass their fortunes. If they can do it, so can you. At the very least, they will greatly improve your quality of life (and save you from making stupid decisions).

Whether you’re starting your own business, or simply want to become a better strategist, these Charlie Munger mental models will help you get what you want out of life.

Accounting:

Balance Sheet

The summary of balances for a person or organization.

Split into 3 sections:

  1. Assets
  2. Liabilities
  3. Ownership Equity (Difference between assets and liabilities)

Cash Flow Statement

A document that shows how changes in the balance sheet affect liquidity. It’s main purpose is to identify the short-term viability of a company or strategy.

Depreciation

The decrease in value of assets. Up-front cost is typically allocated over time.

  • Example: The difference from “new” to “used” car.

Double-Entry

A system of bookkeeping requiring a corresponding and opposite entry to a different account. The sum of debits and credits must be equal.

  • Example: Earnings sent to debit as “cash” and to credit as “revenue”.

Generally Accepted Accounting Principles

The common global language for business affairs.

  1. Assets
  2. Liabilities
  3. Equity
  4. Income And Expenses (Gains And Losses)
  5. Contributions By And Distributions To Owners
  6. Cash Flows

This info is used to predict the timing and certainty of future cash flows.

Income Statement

A document that shows revenues and expenses over a certain period. It compares net income with expenses (including write-offs and taxes).

Sunk Cost

A cost that has occurred and cannot be recovered.

 

Biology:

Genetics

The study of genes, genetic variation, and heredity.

Natural Selection

The variation of survival and reproduction due to different traits. Phenotypes with an advantage tend to become more common. The most useful forms survive.

Physiology

The study of chemical or physical functions in a living system.

The field is divided into:

  1. Animal
  2. Plant
  3. Cellular
  4. Microbial
  5. Bacterial
  6. Viral

 

Business:

Moats

An industry’s barrier to entry or brand’s competitive advantages. Awareness helps you play to your strengths.

Five Forces

A framework used to analyze the level of competition within an industry.

  1. Threat Of New Entrants
  2. Threat Of Substitutes
  3. Bargaining Power Of Buyers
  4. Bargaining Power Of Suppliers
  5. Industry Rivalry

A change in one of these variables requires your business to re-assess the market.

Brand

A brand is a set of indicators used to identify your product.

Aspects of brand are:

  1. Identity (USP/differentiation)
  2. Communication (logo/trademarks)
  3. Awareness
  4. Loyalty
  5. Management
  6. Equity (total worth)

 

Chemistry:

Autocatalytic reactions

A single chemical reaction. Spontaneous order creation.

A decrease in system entropy (disorder) leads to an increase in the entropy of its surroundings (and vice versa).

Bohr Model

Model of the atom. Used for transition, mass, and energy calculations.

Kinetics

The study of motion and its causes. (Analyzing centers of pressure – the point of force application).

 

Thermodynamics:

Uncertainty Principle

A limit to the precision of which physical properties can be known. Measurements of certain systems can’t be made without affecting the systems. The presence of an observer may affect outcome.

Viscosity

The thickness of a fluid.

 

Computer Science:

Abstractions

  • Closure – Data structure storing function in environment.
  • List – Abstract data type representing a sequence of values.
  • Monad – Structure that represents calculations defined as a sequence. Chains operations or functions together.
  • Trigger – Code that automatically executes in response to certain events.

Algorithms

A self-contained, step-by-step set of operations to be performed.

If-statements

Programming which takes different actions based on conditions. This alters the control flow.

Recursion

When a thing is defined in terms of itself or its type. (Infinite loop within limits).

triforce

Example: Triforce

 

Economics:

Agency Problem

Where a representative is motivated to act in his own best interest, contrary to principal.

Asymmetric Information

When one party has more or better information than the other.

Oftentimes, we don’t get charged for labor. We get charged for knowledge.

i.e. Knowing what to draw. Knowing where to hit. Knowing what to avoid.

  • Example: Mechanic taking advantage of your car ignorance to charge more.

Behavioral Economics

The study of psychological, social, cognitive, and emotional factors on economic decisions. Observing the impact of different types of behavior, in different environments, on outcomes.

Most important is *risk tolerance*, the willingness to engage in activity whose outcome is uncertain.

The 3 prevalent themes are:

  1. Heuristics – Decisions made on rules of thumb, not logic
  2. Framing – Anecdotes and stereotypes that make up mental emotional filters
  3. Market Inefficiencies – Mis-pricings and non-rational decision making

Cumulative Advantage

The long term consequences of early fortune. Advantages increase exposure to opportunity.

Comparative Advantage

Being able to produce a product at a lesser opportunity cost. We tend to produce more and consume less of what we have a comparative advantage in.

(Finding out how to employ something to its greatest strength).

Competitive Advantage

The attribute that allows an organization to out-perform. Often included in USP (unique selling proposition).

  • Location
  • High-entry barriers
  • Access to a rare resource

Creative Destruction

A mutation that revolutionizes an old structure from within. This destroys it by creating a new one.

Diminishing Utility

The point at which an extra unit leads to a decrease in return.

  1. Eating Food
  2. Working Out
  3. Taking Medicine

Economies of Scale

Cost per unit of output generally decreases as scale increases. Fixed cost is spread over more units.

Elasticity

Ratio of change. How responsive one variable is to a change in another.

  • Elastic variable: strong response to other variables.
  • Inelastic variable: changes less proportionally to other variables.

If you lower the price, how much will it sell?

If you raise the price, will it affect the sales of other goods?

If the market price goes down, how will it affect the willingness of a vendor to supply the market?

Externalities

Costs not accounted for in the cost of a product. Just because they aren’t accounted for doesn’t mean they don’t exist. Someone always bears the cost.

Markets

A plane where parties make exchanges. Can be classified and regulated.

Marginal Cost

The cost of producing one more unit of a good.

Marginal Utility

The change in benefit from using a product or good. The first unit consumed typically yields the most utility.

Monopoly and Oligopoly

A monopoly is where one person or company dominates a market.

An oligopoly is where a few people or companies do.

These entities have significant market power. They can charge overly high prices.

Network effect

The number of users makes a product more or less valuable.

  • More: Phones/social networks
  • Less: Traffic

Opportunity Cost

The loss of potential gain from other alternatives when a choice is made.

Price Discrimination

Identical or similar goods offered at different prices by the same provider in different markets. It relies on a variation in the customer’s willingness to pay.

It can be broken into:

  1. Personalized Pricing – selling to each customer at a different price
  2. Product Versioning – creating slightly different products for different price points
  3. Group Pricing – dividing the market into segments (student discounts)

Prisoner’s Dilemma

A situation in which the outcome depends on the choice made by another.

  • A snitches and is released. B receives max punishment
  • A & B snitch. Both receive medium punishment
  • A & B remain silent. Both receive minimum punishment

Public and Private Goods

Public Good – Use by one person doesn’t affect another (i.e. Air).

Private Good – An item that yields positive benefits and is exclusive. Its consumption can prevent that of another.

Specialization

The separation of tasks in a system. By employing things to their strengths, you’re able to accomplish tasks otherwise impossible. This is the motive for trade.

Supply and Demand

The unit price for a good (or traded item) will vary until it settles. It’s the equilibrium between price and quantity.

Supply can be determined by:

  1. Production costs
  2. Expectations about future prices
  3. Number of suppliers

Demand can be determined by:

  1. Income
  2. Tastes
  3. Prices of related goods or services
  4. Expectations about future prices and incomes
  5. Number of potential customers

Switching Costs

Any impediment to a customer’s changing of suppliers (cancellation fee, etc).

This is why it can be difficult to dump things.

Transaction Costs

Costs occurred in making an exchange.

  • Search and information costs (Looking for availability, comparing prices, etc)
  • Bargaining costs (drawing contracts)
  • Policing and enforcement costs (through the legal system)

Tragedy of the Commons

Where individual users act contrary to the common good of all in a shared-resource system.

Time Value of Money

The greater benefit of receiving money now rather than later.

This principle underlies investment. People are willing to spend now if they expect a favorable return.

Utility

The satisfaction experienced by the user of a good.

 

Engineering:

Breakpoints

An intentional stopping place in a program. It’s purpose is for the programmer to inspect the test environment. (To see if it’s functioning as expected).

Feedback loops

When outputs are routed back to inputs as a chain of “cause and effect”.

Strongly related to “confirmation bias”. (We see what we expect to see).

Margin of Safety

Never go all in. This protects you from unseen problems.

“Fools who live for the moment die from their silly mistakes”.

Redundancy

Duplicating critical components or functions to increase reliability or improve performance

  1. Electric Power Distribution
  2. Backup Hard-drives
  3. Cables On Bridge

 

Law:

Burden of Proof

The duty of a party in a trial to produce evidence that will shift the conclusion.

(Usually on the person who brings the claim).

Common law

The process of looking at past landmark decisions to guide current ones. If a current issue is distinct, it sets a new precedent.

Due Process

The state must respect all legal rights owed to a person.

Duty Of Care

The standards of reasonable care when performing acts that could harm others. The grounds for imposing liability.

Determined by:

  • Forseeability of harm
  • Degree of certainty of injury
  • Closeness of connection between conduct and injury
  • Policy of preventing future harm.
  • Availability, cost, and prevalence of insurance.

Good Faith

The sincere intention to be open, honest, and fair without regard for outcome.

Negligence

Failure to exercise appropriate care.

Presumption of Innocence

The burden of proof is on the one who declares.

Reasonable doubt

A reasonable person would not doubt the outcome of the decision.

 

Management Science:

Occam’s razor

The hypothesis with the fewest assumptions is usually correct.

Parkinson’s Law

“Work expands to fill the time available for its completion.”

Process versus Outcome

Focusing on systems over results lets you learn faster, be more successful, and be happier throughout the process.

 

Mathematics, Probability and Statistics:

Agent Based Models

A model that simulates the actions and interactions of autonomous agents with a view to assess their effects on the system as a whole. A key notion is that simple behavioral rules generate complex behavior. Another central tenet is that the whole is greater than the sum of the parts.

Bayes Theorem

Identifying the probability of an event based on prior knowledge of conditions that might be related to the event.

  • Example: If cancer is related to age, then a person’s age can be used to more accurately assess the probability thereof.

Central Limit Theorem

For most scenarios, their sum tends towards a normal distribution (bell curve), even if the original variables don’t.

Complex Adaptive Systems

A collection of relatively similar and partially-connected micro structures formed to adapt to the changing environment and increase its survivability.

Examples include:

  • The Internet
  • Corporations
  • Any Ecosystem

Correlation versus Causation

Correlation is a class of relationships involving dependence. It’s the suggestion of a trend.

Causation is a connection between processes where one variable is partly (or fully) responsible for the other. It’s the confirmation of a trend.

Combinations

A way of selecting items such that the order of selection doesn’t matter.

Compounding

Decision Trees

A decision support tool that uses a tree-like graph of decisions and their potential consequences.

These could include:

  1. Chance event outcomes
  2. Resource costs
  3. Utility

Inversion

Asking the opposite question.

i.e. “What’s the best way to fail?”

Kelly Optimization Model

A formula used to determine the optimal size of a series of bets. The basic idea is to bet a pre-determined fraction of assets.

If losing, the size of your bet should get cut. If winning, the stake increases.

Examples:

  • Effective advertising spend
  • Dollar cost average into index funds

Law of Large Numbers

The average results obtained from a large number of trials should be close to the expected value. It will tend to become closer as more trials are performed.

Mean, Median, Mode

With regards to a data set:

  • Mean = Sum over total
  • Median = The value separating the higher half from the lower half
  • Mode =  The value that appears most often

Normal Distribution

Random variables tend to settle in a bell curve.

Permutations

Arranging the numbers of a set into some sequence or order. Different from combinations where order doesn’t matter.

  • Example: Rubik’s cube

Power Law

A relationship between two quantities where a change in one quantity results in a proportional change in the other quality. One quality varies as a power of another.

  • If the length of a square is doubled, its area multiplies by 4.

Regression Analysis

Using independent and dependent variables to determine unknown parameters.

Return to the Mean

If a variable is extreme on its first measurement, it will be closer to the average on its second measurement.

In any system, units move towards its center of gravity.

Scaling

A linear transformation that enlarges or shrinks objects by a scale factor that is the same in all directions.

Sensitivity Analysis

Uncertainty in outputs can be attributed to different sources of uncertainty in inputs. Attention should be focused on the inputs that cause significant uncertainty in the output. You can also search for errors by examining unexpected relationships between inputs and outputs.

The question to ask is, “Which variables cause deviations”?

Philosophy, Literature and Rhetoric:

Metaphors

A figure of speech that refers to one thing by mention of another. It may provide clarity or identify hidden similarities between the two ideas.

Similes

Where a metaphor directly relates things, a simile draws comparisons. (Using “like” or “as”).

Abduction

Seeking the simplest and most likely explanation.

(Making an uncertain assumption useful in orientating yourself to your surroundings).

Pragmatism

Pragmatists consider thought as an instrument or tool for prediction, problem-solving, and action. Topics are best viewed in terms of practical uses and successes.

Realism

The idea that reality is independent from perception.

(Your cognitive map isn’t reality).

Reductionism

Making connections between phenomena or theories by reducing one to another (making more simpler or basic).

  1. Ontological – the belief that reality consists of a minimal number of parts
  2. Methodological – the attempt to provide explanation in terms of smaller entities
  3. Theory – A newer theory does not absorb or replace the old, but reduces it to more basic terms.

 

Physics:

Critical Mass

The smallest amount of material needed for a sustained reaction.

Electromagnetism

The study of electromagnetic force, the interaction between electrically charged particles.

Equilibrium

The condition in which all competing influences are balanced.

Inertia

The resistance of any physical object to change in its state of motion.

Newton’s Laws

The foundation of classical mechanics.

  1. First Law – An object in motion stays in motion. An object at rest stays at rest.
  2. Second Law – Force = Mass multiplied by acceleration.
  3. Third Law – When one force is exerted, it’s met with an equal and opposite force.

Momentum

A rocket spends most of its energy to leave the earth’s atmosphere. After that it’s only a few bursts to keep course and enjoy the view.

In chess (and life), it’s easier to set the tone in the beginning of the game.

Quantum Mechanics

The branch of physics concerned with atoms and photons. Subatomic particles are neither particle nor wave, but have properties of each.

Relativity

The explanation of gravity to other forces of nature. Energy and mass are equivalent and transmutable.

Shannon’s Law

The maximum rate that info can be transmitted across a channel in the presence of noise.

Thermodynamics

The relation of heat to forces.


Relevant Reading: Poor Charlie’s Almanack

Definitions from Wikipedia

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