From one thing you can know 10,000 things.
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.
The summary of balances for a person or organization.
Split into 3 sections:
- 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.
The decrease in value of assets. Up-front cost is typically allocated over time.
- Example: The difference from “new” to “used” car.
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.
- Income And Expenses (Gains And Losses)
- Contributions By And Distributions To Owners
- Cash Flows
This info is used to predict the timing and certainty of future cash flows.
A document that shows revenues and expenses over a certain period. It compares net income with expenses (including write-offs and taxes).
A cost that has occurred and cannot be recovered.
- Read: What’s The Value Of Time?
The study of genes, genetic variation, and heredity.
The variation of survival and reproduction due to different traits. Phenotypes with an advantage tend to become more common. The most useful forms survive.
The study of chemical or physical functions in a living system.
The field is divided into:
An industry’s barrier to entry or brand’s competitive advantages. Awareness helps you play to your strengths.
- Read: The Dip by Seth Godin
A framework used to analyze the level of competition within an industry.
- Threat Of New Entrants
- Threat Of Substitutes
- Bargaining Power Of Buyers
- Bargaining Power Of Suppliers
- Industry Rivalry
A change in one of these variables requires your business to re-assess the market.
A brand is a set of indicators used to identify your product.
Aspects of brand are:
- Identity (USP/differentiation)
- Communication (logo/trademarks)
- Equity (total worth)
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).
Model of the atom. Used for transition, mass, and energy calculations.
The study of motion and its causes. (Analyzing centers of pressure – the point of force application).
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.
The thickness of a fluid.
- 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.
A self-contained, step-by-step set of operations to be performed.
Programming which takes different actions based on conditions. This alters the control flow.
When a thing is defined in terms of itself or its type. (Infinite loop within limits).
Where a representative is motivated to act in his own best interest, contrary to principal.
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.
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:
- Heuristics – Decisions made on rules of thumb, not logic
- Framing – Anecdotes and stereotypes that make up mental emotional filters
- Market Inefficiencies – Mis-pricings and non-rational decision making
The long term consequences of early fortune. Advantages increase exposure to opportunity.
- Read: Life Is A Contradiction
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).
The attribute that allows an organization to out-perform. Often included in USP (unique selling proposition).
- High-entry barriers
- Access to a rare resource
A mutation that revolutionizes an old structure from within. This destroys it by creating a new one.
The point at which an extra unit leads to a decrease in return.
- Eating Food
- Working Out
- Taking Medicine
Economies of Scale
Cost per unit of output generally decreases as scale increases. Fixed cost is spread over more units.
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?
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.
A plane where parties make exchanges. Can be classified and regulated.
The cost of producing one more unit of a good.
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.
The number of users makes a product more or less valuable.
- More: Phones/social networks
- Less: Traffic
The loss of potential gain from other alternatives when a choice is made.
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:
- Personalized Pricing – selling to each customer at a different price
- Product Versioning – creating slightly different products for different price points
- Group Pricing – dividing the market into segments (student discounts)
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.
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.
- Read: Mastery – Book Review
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:
- Production costs
- Expectations about future prices
- Number of suppliers
Demand can be determined by:
- Prices of related goods or services
- Expectations about future prices and incomes
- Number of potential customers
Any impediment to a customer’s changing of suppliers (cancellation fee, etc).
This is why it can be difficult to dump things.
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.
The satisfaction experienced by the user of a good.
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).
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 with your finances. This protects you from unseen problems.
“Fools who live for the moment die from their silly mistakes”.
Duplicating critical components or functions to increase reliability or improve performance
- Electric Power Distribution
- Backup Hard-drives
- Cables On Bridge
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).
The process of looking at past landmark decisions to guide current ones. If a current issue is distinct, it sets a new precedent.
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.
- 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.
The sincere intention to be open, honest, and fair without regard for outcome.
Failure to exercise appropriate care.
Presumption of Innocence
The burden of proof is on the one who declares.
A reasonable person would not doubt the outcome of the decision.
The hypothesis with the fewest assumptions is usually correct.
“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.
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.
- The Internet
- 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.
A way of selecting items such that the order of selection doesn’t matter.
A decision support tool that uses a tree-like graph of decisions and their potential consequences.
These could include:
- Chance event outcomes
- Resource costs
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.
- 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
Random variables tend to settle in a bell curve.
Arranging the numbers of a set into some sequence or order. Different from combinations where order doesn’t matter.
- Example: Rubik’s cube
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.
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.
A linear transformation that enlarges or shrinks objects by a scale factor that is the same in all directions.
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:
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.
Where a metaphor directly relates things, a simile draws comparisons. (Using “like” or “as”).
Seeking the simplest and most likely explanation.
(Making an uncertain assumption useful in orientating yourself to your surroundings).
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.
The idea that reality is independent from perception.
(Your cognitive map isn’t reality).
Making connections between phenomena or theories by reducing one to another (making more simpler or basic).
- Ontological – the belief that reality consists of a minimal number of parts
- Methodological – the attempt to provide explanation in terms of smaller entities
- Theory – A newer theory does not absorb or replace the old, but reduces it to more basic terms.
The smallest amount of material needed for a sustained reaction.
The study of electromagnetic force, the interaction between electrically charged particles.
The condition in which all competing influences are balanced.
The resistance of any physical object to change in its state of motion.
The foundation of classical mechanics.
- First Law – An object in motion stays in motion. An object at rest stays at rest.
- Second Law – Force = Mass multiplied by acceleration.
- Third Law – When one force is exerted, it’s met with an equal and opposite force.
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.
The branch of physics concerned with atoms and photons. Subatomic particles are neither particle nor wave, but have properties of each.
The explanation of gravity to other forces of nature. Energy and mass are equivalent and transmutable.
The maximum rate that info can be transmitted across a channel in the presence of noise.
The relation of heat to forces.
Relevant Reading: Poor Charlie’s Almanack
Definitions from Wikipedia