I advise all of you to read the annual reports of Berkshire Hathaway and Wesco Financial (Charles Munger is chairman). These reports are the best educational tools about how to think about investing and business. The lessons also show us how to behave in life.
How do people seduce us financially, politically or sexually? They make us first agree to a small request, so small that no one would refuse. This way they create a commitment. Then they make a second and larger request (the one they wanted all along). We are then more likely to comply. This "foot-in-the-door technique" is based on the principle that if people ask us to make a small commitment, we are more likely to agree to a larger request because we want to appear consistent.
The 17th Century English poet Samuel Butler wrote: "He that complies against his will, is of his own opinion still."
How do we get people to take inner responsibility for their actions? Make it voluntary. We take responsibility for our behavior in cases when we are internally motivated by satisfaction or interest, when we feel in control, and when we are free from incentives or outside pressure.
When you are asked to perform a future action but are uncertain, ask yourself: Would I do this if I had to do it tomorrow?
Warren Buffett says, "The most important thing to do when you find youtself in a hole is to stop digging." Merely because you've spent money or time on some project or investment doesn't mean you must continue to spend it in the future. Time, effort, and money spent are gone. Decisions should be based on where you want to be. Not where you've been. Base decisions on the present situation and future consequences. What happened in the past may be a guide for estimating how likely something is to happen in the future. Ask: What do I want to achieve? What causes that? Considering what I know today and what is likely to happen in the future, how should I act to achieve my goal? Will new money and time invested achieve my goal? Assume I never invested in this and it was presented to me for the first time, would I invest in it today? If not, then stop and do something about it.
We also feel that losing the opportunity to make money is less painful than losing the same amount of money. But a lost opportunity of making $100 has the same value as a real loss of $100.
Buffett: One of the important things in stocks is that the stock does not know that you own it. You have all these feelings about it: You remember what you paid. You remember who told you about it -all these little things. And it doesn't give a damn. It just sits there. If a stock's at $50, somebody's paid $100 and feels terrible; somebody else has paid $10 and feels wonderful-all these feelings. And it has no impact whatsoever.
Remember that people respond to immediate crisis and threats. Anything that happens gradually, they tend to put off. If we want people to take a risk, we should make them feel behind (losing). If we want them to stay with the status quo or reject risk, we should make them feel safe.
We prefer to keep things the way they are. We resist change and prefer effort minimization. We favor routine behavior over innovative behavior. The more emotional a decision is or the more choices we have, the more we prefer the status quo. This is why we stick with our old jobs, brand of car, etc. Even in cases where the costs of switching are very low.
We are easily influenced when we are told stories because we relate to stories better than to logic or fact. We love to be entertained. Information we receive directly, through our eyes or ears has more impact than information that may have more evidential value. A vivid description from a friend or family member is more believable than true evidence. Statistical data is often overlooked. Studies show that jurors are influenced by vivid descriptions. Lawyers try to present dramatic and memorable testimony.
Information that moves us emotionally makes us pay greater attention to the event itself than to its magnitude. Statistics rarely spark our emotions. An individual face and name will.
Separate noise and chance events from what is important. Ask: Is it relevant? Does it make sense? Is it representative evidence? Was it a random event?
Trends may be wrong. Ask: Is it a permanent or temporary effect?
We see the available information. We don't see what isn't reported. Missing information doesn't draw our attention. We tend not to think about other possibilities, alternatives, explanations, outcomes or attributes. When we try to find out if one thing causes another, we only see what happened, not what didn't happen. We see when a procedure works, not when it doesn't work.
Benjamin Franklin said: "He that would live in peace and at ease, must not speak all he knows, nor judge all he sees."
The less control we perceive we have over our lives, the easier we fall victim to stress. The more stress we experience, the more we tend to make decisions that are shortterm.
We create our own frames by doing mental accounting. We treat assets of the same value differently depending on where they come from or their importance. We put different values on the same dollar, and are more willing to risk money we have won than money we have earned.
Part of what you must learn is how to handle mistakes and new facts that change the odds. Life, in part, is like a poker game, wherein you have to learn to quit sometimes when holding a much-loved hand.
I've gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things -which by and large are useful, but which often misfunction. One approach is rationality -the way you'd work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions -many of which are wrong.
We identify the wrong cause because it seems the obvious one based on a single observed effect. As Bertrand Russell says: "Obviousness is always the enemy to correctness."
For similar situations, ask: Compared with what? Compare negative outcomes with positive. What factors differ? What were the underlying conditions and behavior where something bad happened compared to the conditions and behavior when things worked? What differentiates the situations? Don't draw conclusions from what may have been a unique or random event.
How much should we pay today for the right of receiving $1,000 a year from now? Or, how much do we need to invest today in order to have $1,000 a year from now? It's the same question. The answer depends on the interest rate. If the rate is 6%, then the answer is $943. If we invest $943 today at 6%, we have $1,000 one year from now. $943 is the present value of $1,000 a year from now. We have discounted or reduced $1,000 to its value today. The further out in time we receive the $1,000 or the higher the interest rate is, the less the present value is.
Ask: What do I end up with? How much will I have if I succeed and how much will I have if I fail? How certain am I? What is the expected utility?
Humans are pattern seeking, storytelling animals. We look for and find patterns in our world and in our lives, then weave narratives around those patterns to bring them to life and give them meaning.
— Michael Shermer (Publisher of Skeptic)
Deal with the situations in life by knowing what to avoid. Reducing mistakes by learning what areas, situations and people to avoid is often a better use of time than seeking out new ways of succeeding. Also, it is often simpler to prevent something than to solve it.
The key thing in economics, whenever someone makes an assertion to you, is to always ask, "And then what?" Actually, it's not such a bad idea to ask it about everything. But you should always ask, "And then what?"
— Warren Buffett
Occam's Razor is a principle attributed to the 14th Century logician William of Occam: "Entities should not be multiplied unnecessarily." If we face two possible explanations which make the same predictions, the one based on the least number of unproven assumptions is preferable, until more evidence comes along. Occam doesn't rule out other explanations. To paraphrase Albert Einstein: "Theories should be as simple as possible, but no simpler."
"There is no risk in using this medicine. " That there is no evidence of harm (or benefit) isn't the same as evidence that something is safe (or harmful). Only safe (or harmful) based on what we know so far. Compare archaeology -just because something hasn't been found doesn't mean it won't be found.
"Since a lot of evidence agrees with my explanation, I must be right. " Not necessarily, the same evidence may agree with other explanations. Look for evidence that disproves your explanation. Don't spend time on already disproved ideas or arguments or those that can't be disproved. Ask: What test can disprove this?
Engage in self-criticism. Question your assumptions. Explain the opposite of your beliefs. Ask: Assume I'm wrong, how will I know? Why may an opposite theory be correct? Assuming my answer is correct, what would cause me to change my mind? Then, look for that evidence. Often we don't see our weaknesses and thus are not motivated to improve. Therefore, encourage the right people to give objective feedback that will help us improve. Look back and measure how you are doing against your original expectations. Find your mistakes early and correct them quickly before they cause harm.
Reflect on what can go wrong. Ask: What may cause this to turn into a catastrophe? What is the potential downside? What should I worry about? What is the likelihood and magnitude of a possible loss? What's the worst thing that could happen? What can I do to prevent it? What will I do if it happens?
Experience tells me that the future will be similar to the past. It may or may not. We don't know the future. What if the consequences of being wrong are terrible and can cause us great harm? If the decision is important, we should largely ignore what has happened in the past and focus on the consequences of being wrong.
Albert Einstein said: "Whoever undertakes to set himself up as a judge of truth and knowledge is shipwrecked by the laughter of the gods." We can't predict what is going to happen in life. Never underestimate the chance of rare events. To protect us from all the unknowns that lie ahead we can either avoid certain situations, make decisions that work out for a wide range of outcomes, have backups or a huge margin of safety. For example, when investing money the following can guide us: know the underlying business value, don't use leverage, enter situations where the management is able and honest, and invest with a huge margin of safety.
You have to stick within what I call your circle of competence. You have to know what you understand and what you don't understand. It's not terribly important how big the circle is. But it's terribly important that you know where the perimeter is.
Ask: What is my nature? What motivates me? What is my tolerance for pain and risk? What has given me happiness and unhappiness in the past? What things and people am I comfortable with? What are my talents and skills? Do I know the difference between what I want and what I'm good at? Where do I have an edge over others? What are my limitations?
How can we do what is important if we don't have any values? If we don't stand for something, we fall for anything.
Act as an exemplar
Treat people fairly
Don't take life too seriously
Have reasonable expectations
Live in the present
Be curious and open-minded. Always ask "why"
Expect adversity. We encounter adversity in whatever we choose to do in life. Charles Munger gives his iron prescription for life: Whenever you think that some situation or some person is ruining your life, it is actually you who are ruining your life ... Feeling like a victim is a perfectly disastrous way to go through life. If you just take the attitude that however bad it is in any way, it's always your fault and you just fix it as best you can--the so-called "iron prescription".
When bad things happen, ask: What else does this mean? See life's obstacles as temporary setbacks, not disasters. Mark Twain says: "[Our] race, in its poverty, has unquestionably one really effective weapon -laughter ... Against the assault of laughter nothing can stand."
Philip Wylie observed: " You couldn't squeeze a dime between what they already know and what they will never learn."
Appealing to interest is likely to work better as a matter of human persuasion than appeal to anything else. That, again, is a powerful psychological principle with deep biological roots.
On 3 timeless ideas for investing:
His [Benjamin Graham] three basic ideas--and none of them are complicated or require any mathematical talent or anything of that sort--are: (1) that you should look at stocks as part ownership of a business, (2) that you should look at market fluctuations in terms of his "Mr. Market" example and make them your friend rather than your enemy by essentially profiting from folly rather participating in it, and finally, (3) the three most important words in investing are "margin of safety" --... always building a 15,000 pound bridge if you're going to be driving 10,000 pound truck across it ... So I think that it comes down to those ideas--although they sound so simple and commonplace that it kind of seems like a waste to go to school and get a Ph.D. in Economics and have it all come back to that. It's a little like spending eight years in divinity school and having somebody tell you that the ten commandments were all that counted. There is a certain natural tendency to overlook anything that simple and important. (Warren Buffett, speech at New York Society of Security Analysts, December 6, 1994, Outstanding Investor Digest, May 5,1995, p.3.)
On how to evaluate businesses:
Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn't smart enough to know it was 600 B.C.). The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was "a bird in the hand is worth two in the bush." To flesh out this principle, you must answer 273 only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term u.s. bonds)? If you can answer these three questions, you will know the maximum value of the bush -and the maximum number of the birds you now possess that should be offered for it. And, of course, don't literally think birds. Think dollars. Aesop's investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota -nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe. (Warren Buffett, Berkshire Hathaway Inc., 2000 Annual Report, p.13.)