It was Charlie Munger of Berkshire Hathaway, the unrelenting American investor, philanthropist, and intellectual and investment partner of Warren Buffett who is well known for using mental models.
He believed they were key to making better investment decisions.
Charlie Munger
“What you need is a latticework of mental models in your head. And, with that system, things gradually get to fit together in a way that enhances cognition. Without the right models, you’re like a one-legged man in an ass-kicking contest.”
He was a master of practical wisdom, capable of making sound decisions under real-life conditions by assimilating acquired knowledge, life experiences, and well-considered judgments. His investment decisions show that he regularly used specific mental models. He applied the ones he found more useful than others.
It’s fascinating to explore the core mental models Charlie Munger drew upon and consistently applied in his real-life investment decisions. (If you are looking for a comprehensive list of mental models, see Farnam Street by Shane Parrish)
Mental Models Charlie Munger Relied On Most
Inversion (From Mathematics and Logic disciplines)
The inversion mental model is about taking the question you would normally ask and turning it around. For example, not just asking “How can I succeed?” but rather “How could I fail, and how do I avoid that?”
In Charlie Munger’s speech at Harvard School Commencement Address on June 13 in 1986 he said “Invert, always invert. Many hard problems are best solved when they are addressed backward.”.
Inversion is practical and all about avoiding big mistakes, upfront.
Psychology of Human Misjudgment (From Behavioral Economics and Psychology)
This mental model helps you understand how cognitive biases distort thinking, leading to poor decision-making.
Cognitive bias influences an individuals personal view of the world. This personal view is based on their perception of the environment perceived that is filtered through their own personal cognitive biases.
From this cognitive process a personal version of reality is formed. The danger of seeing the world through a filter of cognitive bias is that reality become distorted and a person may loose their objectivity.
Charlie Munger gave a legendary talk in 1995 at Harvard entitled “The Psychology of Human Misjudgment” (and later included it in his book Poor Charlie’s Almanac), where he outlined more than 25 cognitive biases that lead people into error in perception.
Recognise your biases and maintain objectivity. Doing so provides an advantage. It enables you to benefit from opportunities created by others’ misjudgments and irrational behavior.
Why the Greatest Impact?
It is undoubtable that the use of mental models contributed directly to some of Berkshire Hathaway’s famous decisions and turning points.
- Inversion → shaped Charlie Munger’s approach to risk and problem-solving.
- Psychology of Human Misjudgment → gave Charlie Munger an edge in understanding markets, people, and business behaviour.
Inversion (“Avoiding mistakes first”)
Charlie Munger and Warren Buffett made the deliberate decision to steer clear of airlines and most tech stocks. Rather than chasing potential gains by asking, “How can we make money in these industries?” Munger inverted the question and focused on the more reliable path: “How do we avoid losing money in sectors plagued by brutal competition and rapid obsolescence?”
This simple but powerful shift in thinking spared Berkshire Hathaway enormous losses. First, this occurred during the dot-com bust in 2000. Countless technology darlings collapsed at that time. Over the years, this happened repeatedly as one major airline after another tumbled into bankruptcy.
By knowing what to avoid was far more effectively than many others who chased the hot sectors of the moment.
Psychology of Human Misjudgment (Behavioral Economics)
See’s Candies was acquired by Berkshire Hathaway in 1972 for $25 million. A price that that seemed expensive at the time.
Charlie Munger, nevertheless, saw something deeper. A powerful combination of a beloved brand, the habit-forming joy of gift giving chocolate, and strong social connection that kept customers coming back year after year.
He was convinced that these intangible qualities created a durable competitive advantage far more valuable than the balance sheet suggested.
The investment proved transformative. See’s Candies went on to generate billions in cumulative profits with remarkably little extra capital investment needed. The acquisition became a defining case study that highlighted the extraordinary power of economic “moats” that are rooted in consumer psychology
So what is a “moat” in this context?
It’s a lasting competitive edge that protects a business like a castle moat protects its castle. This lets the company earn strong profits for many years by keeping rivals away. The stronger and wider the moat, the easier it is for the business to charge higher prices. It can grow its earnings steadily and compound wealth. This happens without having to fend off dangerous competition or pour in huge amounts of new money.
It’s lessons like this that shaped the investment decision making of Charlie Munger and ultimately Berkshire Hathaway.
What can be learned from this?
Charlie Munger’s genius lay in not just keeping a “latticework” of powerful mental models in his head. He actually used them every day.
By asking “How do I avoid failure?” instead of just “How do I succeed?”, he kept out of ruinous industries like airlines and most tech stocks. And, by understanding how cognitive biases blind nearly everyone else, he spotted opportunities hidden inside companies like See’s Candies that others that had been dismissed as overpriced.
The result? Avoided catastrophes, made billions in profits from seemingly ordinary businesses, and one of the greatest investing records in history.
The lesson should be clear. You don’t need to be the smartest person in the room. You just need better mental tools than everyone else and, have the discipline to use them.
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