Munger: Are you a one-legged investor in a butt-kicking contest?

Below is an excerpt from a speech by Charlie Munger entitled “A Lesson on Elementary, Worldly Wisdom as It Relates to Investment Management and Business,” given to a class of Professor Guilford Babcock’s students at the USC Marshall School of Business on April 14, 1994.

So let's briefly review what kind of models and techniques constitute this basic knowledge that everybody has to have before they proceed to being really good at a narrow art like stock picking.

First there's mathematics. Obviously, you've got to be able to handle numbers and quantities—basic arithmetic.

And the great useful model, after compound interest, is the elementary math of permutations and combinations. And that was taught in my day in the sophomore year in high school. I suppose by now in great private schools, it's probably down to the eighth grade or so.

It's very simple algebra. It was all worked out in the course of about one year between Pascal and Fermat. They worked it out casually in a series of letters.

It's not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it's fundamental truth. So you simply have to have the technique.

Many educational institutions—although not nearly enough—have realized this. At Harvard Business School, the great quantitative thing that bonds the first-year class together is what they call decision tree theory. All they do is take high school algebra and apply it to real life problems. And the students love it. They're amazed to find that high school algebra works in life.

By and large, as it works out, people can't naturally and automatically do this. If you understand elementary psychology, the reason they can't is really quite simple: The basic neural network of the brain is there through broad genetic and cultural evolution. And it's not Fermat/Pascal. It uses a very crude, shortcut-type of approximation. It's got elements of Fermat/Pascal in it. However, it's not good.

So you have to learn in a very usable way this very elementary math and use it routinely in life—just the way if you want to become a golfer, you can't use the natural swing that broad evolution gave you. You have to learn—to have a certain grip and swing in a different way to realize your full potential as a golfer.

If you don't get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest. You're giving a huge advantage to everybody else.

One of the advantages of a fellow like Buffett, whom I've worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations. [1]

It’s interesting that Munger points to Buffett as someone who naturally thinks in terms of permutations and combinations, concepts which form the foundation of probability. This is because probability is equally important in the field of insurance. Perhaps that’s why NICO, the first insurance company Buffett bought, never had an actuary – because the math is rather quite simple if you can keep it that way. Insurance, like stock picking, is about probabilities of various outcomes, such that one can arrive at an expected value today – expected future cash flows in the former and expected future claims losses in the latter. We’ll go into the role of probability in the field of insurance in the next post.

[1] Edited by Peter D. Kaufman, Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger, Expanded Third Edition (PCA Publications: 2014), 168-169.