Thursday, September 13, 2007

Lecture 01: Introduction to Mental Models & Mental Tricks

Here is a list of topics covered in my BFBV class (in which I had an opportunity of discussing Charles Munger and Charles Ponzi together!)

  1. Mental models: definition, utility, Herb Simon's and Charlie Munger's idea of using checklists, the man-with-a-hammer syndrome.
  2. Warren Buffett's decision to shut down textile operations of BRK (students were given his essay in his 1985 letter as pre-reading material). Dissection of Buffett's textile experience into multiple mental models - competition from microeconomics, return on capital from accounting, opportunity cost from microeconomics, prisoners' dilemma from game theory, contrast effect from psychology and bias from commitment and consistency from psychology.
  3. The necessity of "jumping jurisdictional boundaries" and the futility of using a single tool like Microsoft excel to make decisions.
  4. The mental model framework - the Lollapalooza effect, the need to look at extreme outcomes and working backwards to mental models and also to see how mental models work together to produce lollapalooza effects (thinking forwards).
  5. Inherent contradictions between some mental models e.g. Adam Smith's invisible hand and Garrett Hardin's invisible foot.
  6. Feedback loops from engineering, their application in other disciplines, positive feedback loops (spiral, runaway, vicious circles) and negative feedback loops (self correcting e.g. business cycles). Examples of bank runs and stock market crashes and successful business models with embedded positive feedback loops (e.g. Buffett's example of dominant newspapers wherein circulation and advertising feed on each other, and Wal-Mart where low-prices create high volumes, which creates scale economics for the company which are passed on to customers in the form of low prices which create high volumes....)
  7. Regression to the mean from statistics - applicable in a gaussian bell curve world, Buffett on markets performance regressing to underlying business performance over time, the Graham voting machine weighing machine metaphor, mean reversion strategies, all trends are not destiny.
  8. Creative Destruction by Schumpeter and its relation to extinction in evolution - Sometimes trends ARE destiny, examples of digital cameras vs analogue cameras, mobile phones vs fixed line telephony etc - fascination about observing what goes on inside the heads of entrenched player in a industry who is about to be dislodged by an upstart who has made a better mousetrap, the light at the end of the tunnel coming from an oncoming train metaphor.
  9. Ponzi scheme from mathematics - importance of thinking in terms of Munger's "functional equivalents" i.e. in this case embedded ponzi schemes in RIETS, business models like Amway, venture capital, greater fool theory in IPOs, chain letters, pension funds etc.
  10. As a follow up reading, students were asked to read Charlie Munger's essay on S&Ls in Wesco Financial's annual report for 1990. They were asked to analyze his marvelous decision to get out of the S&L business when he could see the threat from money market funds and Freddie Mac (oncoming train), and how not only he got out of the way of that metaphorical train, he jumped on to it and made a billion dollars for his investors in the process.


Anonymous said...

Congratulations on an excellent blog -- I am curious if you can expound on this comment "Ponzi scheme from mathematics - importance of thinking in terms of Munger's "functional equivalents" i.e. in this case embedded ponzi schemes in RIETS"

I assume you are referring to the fact that REITS must payout earnings and therefore growth is funded not organically (eg. by income), by constantly tapping the markets, both debt and equity, to raise investment equity, but I would be very interested in hearing your case for REITs as a ponzi scheme. Thank you.

Sanjay Bakshi said...


You're right.

Its fascinating to see how markets sometimes do not distinguish between businesses which can pay dividends from internal cash generation with no need to resort to capital markets for the money to finance the dividends, and businesses which essentially rob Peter to pay Paul...

In India, I can see several companies which have very high market caps in relation to the underlying true economic earning power, but the high stock price enables the companies to continue to raise capital at higher and higher prices - capital provided by greater and greater fools. Eventually, however, the supply of greater fools is exhausted. And when that happens, as it inevitably must, then you get situations similar to the one described at:

Thanks for writing.

Jimmy said...

Hi sir,

I am also a great fa of Charlie Munger for his concept of Mental Models.

In fact i first came to know of Mr. Munger just in May'07 ..too late..but frm then i have read as much i could...It's really fantastic thing to do in life.

Actually, i know Mr. Chetan Parikh quite well and was very happy reading ur interview on, wld like to have get in touch with you...pls let me know of any of ur contact IDs...basicaly i am also an investor in Indian Equities..

Sanjay Bakshi said...

Jimmy, my email address is

Thanks for posting your comment here...

raj said...

Dear Prof Bakshi
It would really help everyone who would be interested in learning from you if you could post the video recordings of your classes on your website. Just a suggestion.