Charlie Munger on Economics

I've read Shane Parrish's Farnam Street blog for years, and as a result have developed a real appreciation for Charlie Munger's approach to investing and thinking and life.

I've spent some time this week clearing out my Pocket (essential app!) of years of articles, blogs, interviews and videos.  I'm so glad I finally read Shane's transcript of Munger's Herb Kay Memorial Lecture from 2003.  

I'd encourage you to take the time to read the entire speech, as he covers so much ground with his signature mix of dry humor and healthy cynicism.

Munger's main critique of the academic treatment of economics (a.k.a. "the queen of the soft sciences") is that it is not handled with a multidisciplinary approach, that is, drawing insights from many different disciplines to bring a broader perspective to solving problems.

Before settling on Music and Psychology degrees at Ohio State, I switched majors all the time.  All.  The.  Time.  Ask my father.

One thing I noticed as I switched from Music to Astronomy to Zoology to Biology to Music to Psychology to Music (I think I got that right) is that not only did each major have their own building, but there was absolutely zero communication between any of the departments.  

Yet economics, like much else in academia, is too insular.
— Charlie Munger

I also remember my first (and only) economics course.  Honors Microeconomics 201.  I arrived the first day, and our professor explained that he was an econometrician and we would be focusing on things like Pareto efficiencies.

I learned many formulae and stared at many graphs over that semester, but I certainly learned very little about why people make decisions about things (which came later when I found the Psychology department).

So based on the two above anecdotes, I was thrilled to read Munger's nine critiques of economics.  Here are a few points that I found very relevant to investing.

Fatal Unconnectedness

"To the man with only a hammer, every problem looks pretty much like a nail."  To be a successful investor, you need a complete set of tools.  Not just fundamental ratios, or a quant model, or a technical screen.  You need to combine inputs in meaningful ways.  And not just financial inputs- also behavioral, psychological, biological, etc.  

As Charlie puts it, "You don't just have a hammer. You've got all the tools. And you've got to have one more trick."

He also advocated using a mental checklist for problem solving.  Reminds me of my recent post on the preflight checklist and parallels to proper technical analysis.

Physics Envy

In economics, we have a "craving for an unattainable precision" that I feel has gotten progressively worse in the industry.  The more we design models of the financial markets, the more we feel the models are the actual markets, when in fact they can be dramatically different.

Wes Gray and Jack Vogel did a great job addressing this in their book Quantitative Momentum, and I first heard this theme from Professor Andrew Lo.

In the words of John Maynard Keynes, "It is better to be roughly right than precisely wrong."

Too Little Synthesis

I see this as the challenge of applying what you learn from a textbook to solving actual real-life challenges.  

Reminds me of The Tao Jones Averages: A Guide to Whole-Brained Investing where author Bennett Goodspeed points out that being a fundamental analyst is primarily a left-brained effort.  Analyzing models, aggregating data, drawing conclusions.

It is better to be roughly right than precisely wrong.
— John Maynard Keynes

Being a portfolio manager is primarily a right-brained activity, where you need to see the "forest for the trees" as you make portfolio-level decisions like sector allocation and bet sizing.

Why is this an issue?  For years, top fundamental analysts would be promoted to portfolio manager, even though it calls for a very different skill set.  Similar problem as promoting one of your top salespeople to be a sales manager.

Little Attention to Higher Order Effects

Consequences have consequences which have even further consequences.  We love to simplify what we see around us, which comes from the basic wiring of humans struggling to make sense of a very complex environment.

As Munger puts it, "It gets very complicated. When I was a meteorologist I found this stuff very irritating. And economics makes meteorology look like a tea party."

Clinging to Failed Ideas

I feel his most stinging critique of economics is its passion for holding on to concepts that are increasingly proven to be inaccurate.  A perfect parallel to a concept near and dear to my heart- the continuing endorsement of the Efficient Markets Hypothesis in the face of a growing library of evidence for the existence of the momentum factor.

Overall, this was a fascinating read and very well worth the time to review in detail.  It's another reminder that I need to dust off my copy of Poor Charlie's Almanack and keep learning!


Disclaimer: This blog is for educational purposes only, and should not be construed as financial advice.  Please see the Disclaimer page for full details.