charlie munger the most logical person ever edited by andrew kunian

1 Charlie Munger: The Most Logical Person Ever


Charlie Munger: The Most Logical Person Ever

A Compilation of His Speeches Sourced from the Internet

Edited by Andrew Kunian


Dedicated to Pop and Lolo


Preface:

Charlie Munger's message needs to be shouted from the rooftops! That's my motivation for publishing a free Kindle book compilation of his speeches and other materials I found on the Internet. I also wanted to try creating a book in Kindle. I first took notice of Munger when I read his advice to college graduates, "Don't try cocaine. Avoid the AIDS situation." Interesting advice from a septuagenarian. I created this book because Munger's pièce de résistance, "Poor Charlie's Almanac" wasn't available in the Kindle format. And it costs $49 - $140 thereby putting it out of the reach of the people who need it the most: the poor and the youth. And "Poor Charlie's Almanac" is the size of the Yellow Pages. It would come in handy if you encountered a grizzle bear at the Berkshire Hathaway annual meeting. But what if you are waiting in line at the DMV or your flight is delayed? At least you can entertain yourself with some instant wisdom from the "The Most Logical Man Ever". If you like this free compilation and need an item that can moonlight as a weapon, go buy "Poor Charlie's Almanac". It is inspiring that Munger didn't take an interest in the stock market until he was forty-two years old. His transformation is hope for anybody suffering through a mid-life crisis (not that Munger was). If the politicians of the world implemented my favorite speech, "The Psychology of Human Misjudgment", the streets would be paved with gold and every child would own a pet unicorn. In the immortal words of Alec Baldwin's character from David Mamet's 'Glengarry Glenn Ross': "Go and do likewise gents. The money's out there. You pick it up, it's yours. You don't? I got no sympathy for ya."


Table of Contents

The Psychology of Human Misjudgment ...................................................................................................... 7

A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business ........... 20

Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs ............................ 33

Prescriptions for Guaranteed Misery in Life ............................................................................................... 46

The Great Financial Scandal of 2003 ........................................................................................................... 50

Charlie Munger's Recommended Reading List ........................................................................................... 58


The Psychology of Human Misjudgment

Speech at Harvard University

Estimated date: June, 1995

Transcription, comments [in brackets] and minor editing by Whitney Tilson ([email protected])

Charlie Munger creates a new version of this speech in "Poor Charlie's Almanac"

Moderator: …and they discovered extreme, obvious irrationality in many areas of the economy that they looked at. And they were a little bit troubled because nothing that they had learned in graduate school explained these patterns. Now I would hope that Mr. Munger spends a little bit more time around graduate schools today, because we’ve gotten now where he was 30 years ago, and we are trying to explain those patterns, and some of the people who are doing that will be speaking with you today

So I think he thinks of his specialty as the Psychology of Human Misjudgment, and part of this human misjudgment, of course, comes from worrying about the types of fads and social pressures that Henry Kaufman talked to us about. I think it’s significant that Berkshire Hathaway is not headquartered in New York, or even in Los Angeles or San Francisco, but rather in the heart of the country in Nebraska.

When he referred to this problem of human misjudgment, he identified two significant problems, and I’m sure that there are many more, but when he said, “By not relying on this, and not understanding this, it was costing me a lot of money,” and I presume that some of you are here in the theory that maybe it’s costing you even a somewhat lesser amount of money. And the second point that Mr. Munger made was it was reducing…not understanding human misjudgment was reducing my ability to help everything I loved. Well I hope he loves you, and I’m sure he’ll help you. Thank you. [Applause]

Munger: Although I am very interested in the subject of human misjudgment -- and lord knows I’ve created a good bit of it -- I don’t think I’ve created my full statistical share, and I think that one of the reasons was I tried to do something about this terrible ignorance I left the Harvard Law School with

When I saw this patterned irrationality, which was so extreme, and I had no theory or anything to deal with it, but I could see that it was extreme, and I could see that it was patterned, I just started to create my own system of psychology, partly by casual reading, but largely from personal experience, and I used that pattern to help me get through life. Fairly late in life I stumbled into this book, Influence, by a psychologist named Bob Cialdini, who became a super -tenured hotshot on a 2,000-person faculty at a very young age. And he wrote this book, which has now sold 300-odd thousand copies, which is remarkable for somebody. Well, it’s an academic book aimed at a popular audience that filled in a lot of holes in my crude system. In those holes it filled in, I thought I had a system that was a good-working tool, and I’d like to share that with you

And I came here because behavioral economics. How could economics not be behavioral? If it isn’t behavioral, what the hell is it? And I think it’s fairly clear that all reality has to respect all other reality. If you come to inconsistencies, they have to be resolved, and so if there’s anything valid in psychology, economics has to recognize it, and vice versa. So I think the people that are working on this


fringe between economics and psychology are absolutely right to be there, and I think there’s been plenty wrong over the years.

Well let me romp through as much of this list as I have time to get through:

24 Standard Causes of Human Misjudgment.

1)Under-recognition of the power of what psychologists call ‘reinforcement’ and economists call ‘incentives.’

Well you can say, “Everybody knows that.” Well I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.

One of my favorite cases about the power of incentives is the Federal Express case. The heart and soul of the integrity of the system is that all the packages have to be shifted rapidly in one central location each night. And the system has no integrity if the whole shift can’t be done fast. And Federal Express had one hell of a time getting the thing to work. And they tried moral suasion, they tried everything in the world, and finally somebody got the happy thought that they were paying the night shift by the hour, and that maybe if they paid them by the shift, the system would work better. And lo and behold, that solution worked.

Early in the history of Xerox, Joe Wilson, who was then in the government, had to go back to Xerox because he couldn’t understand how their better, new machine was selling so poorly in relation to their older and inferior machine. Of course when he got there he found out that the commission arrangement with the salesmen gave a tremendous incentive to the inferior machine.

And here at Harvard, in the shadow of B.F. Skinner - there was a man who really was into reinforcement as a powerful thought, and, you know, Skinner’s lost his reputation in a lot of places, but if you were to analyze the entire history of experimental science at Harvard, he’d be in the top handful. His experiments were very ingenious, the results were counter-intuitive, and they were important. It is not given to experimental science to do better. What gummed up Skinner’s reputation is that he developed a case of what I always call man-with-a- hammer syndrome: to the man with a hammer, every problem tends to look pretty much like a nail. And Skinner had one of the more extreme cases in the history of Academia, and this syndrome doesn’t exempt bright people. It’s just a man with a hammer…and Skinner is an extreme example of that. And later, as I go down my list, let’s go back and try and figure out why people, like Skinner, get man-with-a-hammer syndrome.

Incidentally, when I was at the Harvard Law School there was a professor, naturally at Yale, who was derisively discussed at Harvard, and they used to say, “Poor old Blanchard. He thinks declaratory judgments will cure cancer.” And that’s the way Skinner got. And not only that, he was literary, and he scorned opponents who had any different way of thinking or thought anything else was important. This is not a way to make a lasting reputation if the other people turn out to also be doing something important.

2)Psychological denial.

This first really hit me between the eyes when a friend of our family had a super-athlete, super-student son who flew off a carrier in the north Atlantic and never came back, and his mother, who was a very sane woman, just never believed that he was dead. And, of course, if you turn on the television,


you’ll find the mothers of the most obvious criminals that man could ever diagnose, and they all think their sons are innocent. That’s simple psychological denial. The reality is too painful to bear, so you just distort it until it’s bearable. We all do that to some extent, and it’s a common psychological misjudgment that causes terrible problems.

3)Incentive-cause bias, both in one’s own mind and that of one's trusted advisor, where it creates what economists call ‘agency costs.’

Here, my early experience was a doctor who sent bushel baskets full of normal gall bladders down to the pathology lab in the leading hospital in Lincoln, Nebraska. And with that quality control for which community hospitals are famous, about five years after he should’ve been removed from the staff, he was. And one of the old doctors who participated in the removal was also a family friend, and I asked him: I said, “Tell me, did he think, ‘Here’s a way for me to exercise my talents’” -- this guy was very skilled technically -- “’and make a high living by doing a few maimings and murders every year, along with some frauds?’” And he said, “Hell no, Charlie. He thought that the gall bladder was the source of all medical evil, and if you really love your patients, you couldn’t get that organ out rapidly enough.”

Now that’s an extreme case, but in lesser strength, it’s present in every profession and in every human being. And it causes perfectly terrible behavior. If you take sales presentations and brokers of commercial real estate and businesses… I’m 70 years old, I’ve never seen one I thought was even within hailing distance of objective truth. If you want to talk about the power of incentives and the power of rationalized, terrible behavior: after the Defense Department had had enough experience with cost- plus percentage of cost contracts, the reaction of our republic was to make it a crime for the federal government to write one, and not only a crime, but a felony.

And by the way, the government’s right, but a lot of the way the world is run, including most law firms and a lot of other places, they’ve still got a cost-plus percentage of cost system. And human nature, with its version of what I call ‘incentive-caused bias,’ causes this terrible abuse. And many of the people who are doing it you would be glad to have married into your family compared to what you’re otherwise going to get. [Laughter]

Now there are huge implications from the fact that the human mind is put together this way, and that is that people who create things like cash registers, which make most [dishonest] behavior hard, are some of the effective saints of our civilization. And the cash register was a great moral instrument when it was created. And Patterson knew that, by the way. He had a little store, and the people were stealing him blind and never made any money, and people sold him a couple of cash registers and it went to profit immediately. And, of course, he closed the store and went into the cash register business…And so this is a huge, important thing. If you read the psychology texts, you will find that if they’re 1,000 pages long, there’s one sentence. Somehow incentive-caused bias has escaped the standard survey course in psychology.

4)This is a superpower in error-causing psychological tendency: bias from consistency and commitment tendency, including the tendency to avoid or promptly resolve cognitive dissonance. Includes the self-confirmation tendency of all conclusions, particularly expressed conclusions, and with a special persistence for conclusions that are hard-won.

Well what I’m saying here is that the human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in. The human mind has a big tendency of the same sort. And here again, it doesn’t just catch ordinary mortals; it catches the deans of physics. According to Max Planck, the really innovative, important new physics


was never really accepted by the old guard. Instead a new guard came along that was less brain-blocked by its previous conclusions. And if Max Planck’s crowd had this consistency and commitment tendency that kept their old inclusions intact in spite of disconfirming evidence, you can imagine what the crowd that you and I are part of behaves like.

And of course, if you make a public disclosure of your conclusion, you’re pounding it into your own head. Many of these students that are screaming at us, you know, they aren’t convincing us, but they’re forming mental change for themselves, because what they’re shouting out [is] what they’re pounding in. And I think educational institutions that create a climate where too much of that goes on are…in a fundamental sense, they’re irresponsible institutions. It’s very important to not put your brain in chains too young by what you shout out.

And all these things like painful qualifying and initiation rituals pound in your commitments and your ideas. The Chinese brainwashing system, which was for war prisoners, was way better than anybody else’s. They maneuvered people into making tiny little commitments and declarations, and then they’d slowly build. That worked way better than torture.

5)Bias from Pavlovian association, misconstruing past correlation as a reliable basis for decision-making.

I never took a course in psychology, or economics either for that matter, but I did learn about Pavlov in high school biology. And the way they taught it, you know, so the dog salivated when the bell rang. So what? Nobody made the least effort to tie that to the wide world. Well the truth of the matter is that Pavlovian association is an enormously powerful psychological force in the daily life of all of us. And, indeed, in economics we wouldn’t have money without the role of so-called secondary reinforcement, which is a pure psychological phenomenon demonstrated in the laboratory.

Practically…I’d say 3/4 of advertising works on pure Pavlov. Think how association, pure association, works. Take Coca-Cola company (we’re the biggest share-holder). They want to be associated with every wonderful image: heroics in the Olympics, wonderful music, you name it. They don’t want to be associated with presidents’ funerals and so-forth. When have you seen a Coca-Cola ad…and the association really works.

And all these psychological tendencies work largely or entirely on a subconscious level, which makes them very insidious. Now you’ve got Persian messenger syndrome. The Persians really did kill the messenger who brought the bad news. You think that is dead? I mean you should’ve seen Bill Paley in his last 20 years. He didn’t hear one damn thing he didn’t want to hear. People knew that it was bad for the messenger to bring Bill Paley things he didn’t want to hear. Well that means that the leader gets in a cocoon of unreality, and this is a great big enterprise, and boy, did he make some dumb decisions in the last 20 years.

And now the Persian messenger syndrome is alive and well. I saw, some years ago, Arco and Exxon arguing over a few hundred millions of ambiguity in their North Slope treaties before a superior court judge in Texas, with armies of lawyers and experts on each side.

Now this is a Mad Hatter’s tea party: two engineering- style companies can’t resolve some ambiguity without spending tens of millions of dollars in some Texas superior court? In my opinion what happens is that nobody wants to bring the bad news to the executives up the line. But here’s a few hundred million dollars you thought you had that you don’t. And it’s much safer to act like the Persian messenger who goes away to hide rather than bring home the news of the battle lost.


Talking about economics, you get a very interesting phenomenon that I’ve seen over and over again in a long life. You’ve got two products; suppose they’re complex, technical products. Now you’d think, under the laws of economics, that if product A costs X, if product Y costs X minus something, it will sell better than if it sells at X plus something, but that’s not so. In many cases when you raise the price of the alternative products, it’ll get a larger market share than it would when you make it lower than your competitor’s product. That’s because the bell, a Pavlovian bell -- I mean ordinarily there’s a correlation between price and value -- then you have an information inefficiency. And so when you raise the price, the sales go up relative to your competitor. That happens again and again and again. It’s a pure Pavlovian phenomenon. You can say, “Well, the economists have figured this sort of thing out when they started talking about information inefficiencies,” but that was fairly late in economics that they found such an obvious thing. And, of course, most of them don’t ask what causes the information inefficiencies.

Well one of the things that causes it is pure old Pavlov and his dog. Now you’ve got bios from Skinnerian association: operant conditioning, you know, where you give the dog a reward and pound in the behavior that preceded the dog’s getting the award. And, of course, Skinner was able to create superstitious pigeons by having the rewards come by accident with certain occurrences, and, of course, we all know people who are the human equivalents of superstitious pigeons. That’s a very powerful phenomenon. And, of course, operant conditioning really works. I mean the people in the center who think that operant conditioning is important are very much right, it’s just that Skinner overdid it a little.

Where you see in business just perfectly horrible results from psychologically- rooted tendencies is in accounting. If you take Westinghouse, which blew, what, two or three billion dollars pre -tax at least loaning developers to build hotels, and virtually 100% loans? Now you say any idiot knows that if there’s one thing you don’t like it’s a developer, and another you don’t like it’s a hotel. And to make a 100% loan to a developer who’s going to build a hotel… [Laughter] But this guy, he probably was an engineer or something, and he didn’t take psychology any more than I did, and he got out there in the hands of these salesmen operating under their version of incentive-caused bias, where any damned way of getting

Westinghouse to do it was considered normal business, and they just blew it.

That would never have been possible if the accounting system hadn’t been such but for the initial phase of every transaction it showed wonderful financial results. So people who have loose accounting standards are just inviting perfectly horrible behavior in other people. And it’s a sin, it’s an absolute sin. If you carry bushel baskets full of money through the ghetto, and made it easy to steal, that would be a considerable human sin, because you’d be causing a lot of bad behavior, and the bad behavior would spread. Similarly an institution that gets sloppy accounting commits a real human sin, and it’s also a dumb way to do business, as Westinghouse has so wonderfully proved.

Oddly enough nobody mentions, at least nobody I’ve seen, what happened with Joe Jett and Kidder Peabody. The truth of the matter is the accounting system was such that by punching a few buttons, the Joe Jetts of the world could show profits, and profits that showed up in things that resulted in rewards and esteem and every other thing... Well the Joe Jetts are always with us, and they’re not really to blame, in my judgment at least. But that bastard who created that foolish accounting system who, so far as I know, has not been flayed alive, ought to be.

6)Bias from reciprocation tendency, including the tendency of one on a roll to act as other persons expect.


Well here, again, Cialdini does a magnificent job at this, and you’re all going to be given a copy of Cialdini’s book. And if you have half as much sense as I think you do, you will immediately order copies for all of your children and several of your friends. You will never make a better investment.

It is so easy to be a patsy for what he calls the compliance practitioners of this life. At any rate, reciprocation tendency is a very, very powerful phenomenon, and Cialdini demonstrated this by running around a campus, and he asked people to take juvenile delinquents to the zoo. And it was a campus, and so one in six actually agreed to do it. And after he’d accumulated a statistical output he went around on the same campus and he asked other people, he said, “Gee, would you devote two afternoons a week to taking juvenile delinquents somewhere and suffering greatly yourself to help them,” and there he got 100% of the people to say no. But after he’d made the first request, he backed up a little, and he said, “Would you at least take them to the zoo one afternoon?” He raised the compliance rate from a third to a half. He got three times the success by just going through the little ask-for-a-lot-and-back-off.

Now if the human mind, on a subconscious level, can be manipulated that way and you don’t know it, I always use the phrase, “You’re like a one-legged man in an ass-kicking contest.” I mean you are really giving a lot of quarter to the external world that you can’t afford to give. And on this so-called role theory, where you tend to act in the way that other people expect, and that’s reciprocation if you think about the way society is organized. A guy named Zimbardo had people at Stanford divide into two pieces: one were the guards and the other were the prisoners, and they started acting out roles as people expected. He had to stop the experiment after about five days. He was getting into human misery and breakdown and pathological behavior. I mean it was…it was awesome. However, Zimbardo is greatly misinterpreted. It’s not just reciprocation tendency and role theory that caused that, it’s consistency and commitment tendency. Each person, as he acted as a guard or a prisoner, the action itself was pounding in the idea. [For more on this famous experiment, see http://www.prisonexp.org. Wherever you turn, this consistency and commitment tendency is affecting you. In other words, what you think may change what you do, but perhaps even more important, what you do will change what you think. And you can say, “Everybody knows that.” I want to tell you I didn’t know it well enough early enough.

7)Now this is a lollapalooza, and Henry Kaufman wisely talked about this: bias from over-influence by social proof -- that is, the conclusions of others, particularly under conditions of natural uncertainty and stress.

And here, one of the cases the psychologists use is Kitty Genovese, where all these people -- I don’t know, 50, 60, 70 of them -- just sort of sat and did nothing while she was slowly murdered. Now one of the explanations is that everybody looked at everybody else and nobody else was doing anything, and so there’s automatic social proof that the right thing to do is nothing. That’s not a good enough explanation for Kitty Genovese, in my judgment. That’s only part of it. There are microeconomic ideas and gain/loss ratios and so forth that also come into play. I think time and time again, in reality, psychological notions and economic notions interplay, and the man who doesn’t understand both is a damned fool.

Big-shot businessmen get into these waves of social proof. Do you remember some years ago when one oil company bought a fertilizer company, and every other major oil company practically ran out and bought a fertilizer company? And there was no more damned reason for all these oil companies to buy fertilizer companies, but they didn’t know exactly what to do, and if Exxon was doing it, it was good enough for Mobil, and vice versa. I think they’re all gone now, but it was a total disaster.


Now let’s talk about efficient market theory, a wonderful economic doctrine that had a long vogue in spite of the experience of Berkshire Hathaway. In fact one of the economists who won -- he shared a Nobel Prize -- and as he looked at Berkshire Hathaway year after year, which people would throw in his face as saying maybe the market isn’t quite as efficient as you think, he said, “Well, it’s a two-sigma event.” And then he said we were a three- sigma event. And then he said we were a four- sigma event. And he finally got up to six sigmas -- better to add a sigma than change a theory, just because the evidence comes in differently. [Laughter] And, of course, when this share of a Nobel Prize went into money management himself, he sank like a stone.

If you think about the doctrines I’ve talked about, namely, one, the power of reinforcement -- after all you do something and the market goes up and you get paid and rewarded and applauded and what have you, meaning a lot of reinforcement, if you make a bet on a market and the market goes with you. Also, there’s social proof. I mean the prices on the market are the ultimate form of social proof, reflecting what other people think, and so the combination is very powerful. Why would you expect general market levels to always be totally efficient, say even in 1973-74 at the pit, or in 1972 or whatever it was when the Nifty 50 were in their heyday? If these psychological notions are correct, you would expect some waves of irrationality, which carry general levels, so they’re inconsistent with reason.

8)What made these economists love the efficient market theory is the math was so elegant.

And after all, math was what they’d learned to do. To the man with a hammer, every problem tends to look pretty much like a nail. The alternative truth was a little messy, and they’d forgotten the great economists Keynes, whom I think said, “Better to be roughly right than precisely wrong.”

9)Bias from contrast-caused distortions of sensation, perception and cognition.

Here, the great experiment that Cialdini does in his class is he takes three buckets of water: one’s hot, one’s cold and one’s room temperature, and he has the student stick his left hand in the hot water and his right hand in the cold water. Then he has them remove the hands and put them both in the room temperature bucket, and of course with both hands in the same bucket of water, one seems hot, the other seems cold because the sensation apparatus of man is over-influenced by contrast. It has no absolute scale; it’s got a contrast scale in it. And it’s a scale with quantum effects in it too. It takes a certain percentage change before it’s noticed.

Maybe you’ve had a magician remove your watch -- I certainly have -- without your noticing it. It’s the same thing. He’s taking advantage of contrast-type troubles in your sensory apparatus. But here the great truth is that cognition mimics sensation, and the cognition manipulators mimic the watch-removing magician. In other words, people are manipulating you all day long on this contrast phenomenon.

Cialdini cites the case of the real estate broker. And you’ve got the rube that’s been transferred into your town, and the first thing you do is you take the rube out to two of the most awful, overpriced houses you’ve ever seen, and then you take the rube to some moderately overpriced house, and then you stick him. And it works pretty well, which is why the real estate salesmen do it. And it’s always going to work.

And the accidents of life can do this to you, and it can ruin your life. In my generation, when women lived at home until they got married, I saw some perfectly terrible marriages made by highly desirable women because they lived in terrible homes. And I’ve seen some terrible second marriages


which were made because they were slight improvements over an even worse first marriage. You think you’re immune from these things, and you laugh, and I want to tell you, you aren’t.

My favorite analogy I can’t vouch for the accuracy of. I have this worthless friend I like to play bridge with, and he’s a total intellectual amateur that lives on inherited money, but he told me once something I really enjoyed hearing. He said, “Charlie,” he say, “If you throw a frog into very hot water, the frog will jump out, but if you put the frog in room temperature water and just slowly heat the water up, the frog will die there.” Now I don’t know whether that’s true about a frog, but it’s sure as hell true about many of the businessmen I know [laughter], and there, again, it is the contrast phenomenon. But these are hot -shot, high-powered people. I mean these are not fools. If it comes to you in small pieces, you’re likely to miss, so if you’re going to be a person of good judgment, you have to do something about this warp in your head where it’s so misled by mere contrast.

10)Bias from over-influence by authority.

Well here, the Milgrim experiment, as it's called -- I think there have been 1,600 psychological papers written about Milgrim. And he had a person posing as an authority figure trick ordinary people into giving what they had every reason to expect was heavy torture by electric shock to perfectly innocent fellow citizens. And he was trying to show why Hitler succeeded and a few other things, and so this really caught the fancy of the world. Partly it’s so politically correct, and over-influence by authority…

You’ll like this one: You get a pilot and a co- pilot. The pilot is the authority figure. They don’t do this in airplanes, but they’ve done it in simulators. They have the pilot do something where the co-pilot, who's been trained in simulators a long time -- he knows he’s not to allow the plane to crash -- they have the pilot to do something where an idiot co-pilot would know the plane was going to crash, but the pilot’s doing it, and the co-pilot is sitting there, and the pilot is the authority figure. 25% of the time the plane crashes. I mean this is a very powerful psychological tendency. It’s not quite as powerful as some people think, and I’ll get to that later.

11)Bias from deprival super-reaction syndrome, including bias caused by present or threatened scarcity, including threatened removal of something almost possessed, but never possessed.

Here I took the Munger dog, a lovely, harmless dog. The only way to get that dog to bite you is to try and take something out of its mouth after it was already there. And you know, if you’ve tried to do takeaways in labor negotiations, you’ll know that the human version of that dog is there in all of us. And I have a neighbor, a predecessor who had a little island around the house, and his next door neighbor put a little pine tree on it that was about three feet high, and it turned his 180 degree view of the harbor into 179 3/4. Well they had a blood feud like the Hatfields and McCoys, and it went on and on and on…

I mean people are really crazy about minor decrements down. And then, if you act on them, then you get into reciprocation tendency, because you don’t just reciprocate affection, you reciprocate animosity, and the whole thing can escalate. And so huge insanities can come from just subconsciously over-weighing the importance of what you’re losing or almost getting and not getting.

And the extreme business case here was New Coke. Coca-Cola has the most valuable trademark in the world. We’re the major shareholder -- I think we understand that trademark. Coke has armies of brilliant engineers, lawyers, psychologists, advertising executives and so forth, and they had a trademark on a flavor, and they’d spent the better part of 100 years getting people to believe that trademark had all these intangible values too. And people associate it with a flavor. And so they were going to tell


people not that it was improved, because you can’t improve a flavor. A flavor is a matter of taste. I mean you may improve a detergent or something, but don’t think you’re going to make a major change in a flavor. So they got this huge deprival super-reaction syndrome. Pepsi was within weeks of coming out with old Coke in a Pepsi bottle, which would’ve been the biggest fiasco in modern times. Perfect insanity. And by the way, both Goizuetta [Coke's CEO at the time] and Keough [an influential former president and director of the company] are just wonderful about it. I mean they just joke. Keough always says, “I must’ve been away on vacation.” He participated in every single decision -- he’s a wonderful guy. And by the way, Goizuetta is a wonderful, smart guy -- an engineer. Smart people make these terrible boners. How can you not understand deprival super-reaction syndrome? But people do not react symmetrically to loss and gain. Well maybe a great bridge player like Zeckhauser does, but that’s a trained response. Ordinary people, subconsciously affected by their inborn tendencies…

12)Bias from envy/jealousy.

Well envy/jealousy made, what, two out of the ten commandments? Those of you who have raised siblings you know about envy, or tried to run a law firm or investment bank or even a faculty? I’ve heard Warren say a half a dozen times, “It’s not greed that drives the world, but envy.”

Here again, you go through the psychology survey courses, and you go to the index: envy/jealousy, 1,000-page book, it’s blank. There’s some blind spots in academia, but it’s an enormously powerful thing, and it operates, to a considerable extent, on the subconscious level. Anybody who doesn’t understand it is taking on defects he shouldn’t have.

13)Bias from chemical dependency.

Well, we don’t have to talk about that. We’ve all seen so much of it, but it’s interesting how it’ll always cause this moral breakdown if there’s any need, and it always involves massive denial. See it just aggravates what we talked about earlier in the aviator case, the tendency to distort reality so that it’s endurable.

14)Bias from mis-gambling compulsion.

Well here, Skinner made the only explanation you’ll find in the standard psychology survey course. He, of course, created a variable reinforcement rate for his pigeons and his mice, and he found that that would pound in the behavior better than any other enforcement pattern. And he says, “Ah ha! I’ve explained why gambling is such a powerful, addictive force in this civilization.” I think that is, to a very considerable extent, true, but being Skinner, he seemed to think that was the only explanation, but the truth of the matter is that the devisors of these modern machines and techniques know a lot of things that Skinner didn’t know.

For instance, a lottery. You have a lottery where you get your number by lot, and then somebody draws a number by lot, it gets lousy play. You have a lottery where people get to pick their number, you get big play. Again, it’s this consistency and commitment thing. People think if they have committed to it, it has to be good. The minute they’ve picked it themselves it gets an extra validity. After all, they thought it and they acted on it.

Then if you take the slot machines, you get bar, bar, walnut. And it happens again and again and again. You get all these near misses. Well that’s deprival super-reaction syndrome, and boy do the people who create the machines understand human psychology. And for the high IQ-crowd they’ve got


poker machines where you make choices. So you can play blackjack, so to speak, with the machine. It’s wonderful what we’ve done with our computers to ruin the civilization.

But at any rate, mis-gambling compulsion is a very, very powerful and important thing. Look at what’s happening to our country: every Indian has a reservation, every river town, and look at the people who are ruined by it with the aid of their stock brokers and others. And again, if you look in the standard textbook of psychology you’ll find practically nothing on it except maybe one sentence talking about Skinner’s rats. That is not an adequate coverage of the subject.

15)Bias from liking distortion, including the tendency to especially like oneself, one’s own kind and one’s own idea structures, and the tendency to be especially susceptible to being misled by someone liked. Disliking distortion, bias from that, the reciprocal of liking distortion and the tendency not to learn appropriately from someone disliked.

Well here, again, we’ve got hugely powerful tendencies, and if you look at the wars in part of the Harvard Law School, as we sit here, you can see that very brilliant people get into this almost pathological behavior. And these are very, very powerful, basic, subconscious psychological tendencies, or at least party subconscious.

Now let’s get back to B.F. Skinner, man-with-a-hammer syndrome revisited. Why is man-with-a- hammer syndrome always present? Well if you stop to think about it, it’s incentive-caused bias. His professional reputation is all tied up with what he knows. He likes himself and he likes his own ideas, and he’s expressed them to other people -- consistency and commitment tendency. I mean you’ve got four or five of these elementary psychological tendencies combining to create this man-with-a-hammer syndrome.

Once you realize that you can’t really buy your thinking -- partly you can, but largely you can’t in this world -- you have learned a lesson that’s very useful in life. George Bernard Shaw had a character say in The Doctor’s Dilemma, “In the last analysis, every profession is a conspiracy against the laity.” But he didn’t have it quite right, because it isn’t so much a conspiracy as it is a subconscious, psychological tendency.

The guy tells you what is good for him. He doesn’t recognize that he’s doing anything wrong any more than that doctor did when he was pulling out all those normal gall bladders. And he believes his own idea structures will cure cancer, and he believes that the demons that he’s the guardian against are the biggest demons and the most important ones, and in fact they may be very small demons compared to the demons that you face. So you’re getting your advice in this world from your paid advisor with this huge load of ghastly bias. And woe to you.

There are only two ways to handle it: you can hire your advisor and then just apply a windage factor, like I used to do when I was a rifle shooter. I’d just adjust for so many miles an hour wind. Or you can learn the basic elements of your advisor's trade. You don’t have to learn very much, by the way, because if you learn just a little then you can make him explain why he’s right. And those two tendencies will take part of the warp out of the thinking you’ve tried to hire done. By and large it works terribly. I have never seen a management consultant’s report in my long life that didn’t end with the following paragraph: "What this situation really needs is more management consulting." Never once. I always turn to the last page. Of course Berkshire doesn’t hire them, so I only do this on sort of a voyeuristic basis. Sometimes I’m at a non-profit where some idiot hires one. [Laughter]


16)Bias from the non-mathematical nature of the human brain in its natural state as it deal with probabilities employing crude heuristics, and is often misled by mere contrast, a tendency to overweigh conveniently available information and other psychologically misrouted thinking tendencies on this list.

When the brain should be using the simple probability mathematics of Fermat and Pascal applied to all reasonably obtainable and correctly weighted items of information that are of value in predicting outcomes, the right way to think is the way Zeckhauser plays bridge. It’s just that simple. And your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge. Now, you notice I put in that availability thing, and there I’m mimicking some very eminent psychologists [Daniel] Kahneman, Eikhout[?] (I hope I pronounced that right) and [Amos] Tversky, who raised the idea of availability to a whole heuristic of misjudgment. And they are very substantially right.

I mean ask the Coca -Cola Company, which has raised availability to a secular religion. If availability changes behavior, you will drink a helluva lot more Coke if it’s always available. I mean availability does change behavior and cognition. Nonetheless, even though I recognize that and applaud Tversky and Kahneman, I don’t like it for my personal system except as part of a greater sub- system, which is you’ve got to think the way Zeckhauser plays bridge. And it isn’t just the lack of availability that distorts your judgment. All the things on this list distort judgment. And I want to train myself to kind of mentally run down the list instead of just jumping on availability. So that’s why I state it the way I do.

In a sense these psychological tendencies make things unavailable, because if you quickly jump to one thing, and then because you jumped to it the consistency and commitment tendency makes you lock in, boom, that’s error number one. Or if something is very vivid, which I’m going to come to next, that will really pound in. And the reason that the thing that really matters is now unavailable and what’s extra-vivid wins is, I mean, the extra - vividness creates the unavailability. So I think it’s much better to have a whole list of things that would cause you to be less like Zeckhauser than it is just to jump on one factor.

Here I think we should discuss John Gutfreund. This is a very interesting human example, which will be taught in every decent professional school for at least a full generation. Gutfreund has a trusted employee and it comes to light not through confession but by accident that the trusted employee has lied like hell to the government and manipulated the accounting system, and it was really equivalent to forgery. And the man immediately says, “I’ve never done it before, I’ll never do it again. It was an isolated example.” And of course it was obvious that he was trying to help the government as well as himself, because he thought the government had been dumb enough to pass a rule that he’d spoken against, and after all if the government’s not going to pay attention to a bond trader at Salomon, what kind of a government can it be? At any rate, this guy has been part of a little clique that has made, well, way over a billion dollars for Salomon in the very recent past, and it’s a little handful of people. And so there are a lot of psychological forces at work, and then you know the guy’s wife, and he’s right in front of you, and there’s human sympathy, and he’s sort of asking for your help, which encourages reciprocation, and there’s all these psychological tendencies are working, plus the fact he’s part of a group that had made a lot of money for you. At any rate, Gutfreund does not cashier the man, and of course he had done it before and he did do it again. Well now you look as though you almost wanted him to do it again. Or God knows what you look like, but it isn’t good. And that simple decision destroyed Jim Gutfreund, and it’s so easy to do.

Now let’s think it through like the bridge player, like Zeckhauser. You find an isolated example of a little old lady in the See’s Candy Company, one of our subsidiaries, getting into the till. And what


does she say? “I never did it before, I’ll never do it again. This is going to ruin my life. Please help me.” And you know her children and her friends, and she’d been around 30 years and standing behind the candy counter with swollen ankles. When you’re an old lady it isn’t that glorious a life. And you’re rich and powerful and there she is: “I never did it before, I’ll never do it again.” Well how likely is it that she never did it before? If you’re going to catch 10 embezzlements a year, what are the chances that any one of them -- applying what Tversky and Kahneman called baseline information -- will be somebody who only did it this once? And the people who have done it before and are going to do it again, what are they all going to say? Well in the history of the See’s Candy Company they always say, “I never did it before, and I’m never going to do it again.” And we cashier them. It would be evil not to, because terrible behavior spreads.

Remember…what was it? Serpico? I mean you let that stuff…you’ve got social proof, you’ve got incentive-caused bias, you’ve got a whole lot of psychological factors that will cause the evil behavior to spread, and pretty soon the whole damn…your place is rotten, the civilization is rotten. It’s not the right way to behave. And I will admit that I have…when I knew the wife and children, I have paid severance pay when I fire somebody for taking a mistress on an extended foreign trip. It’s not the adultery I mind, it’s the embezzlement. But there, I wouldn’t do it like Gutfreund did it, where they’d been cheating somebody else on my behalf. There I think you have to cashier. But if they’re just stealing from you and you get rid of them, I don’t think you need the last ounce of vengeance. In fact I don’t think you need any vengeance. I don’t think vengeance is much good.

17)Bias from over-influence by extra-vivid evidence.

Here’s one that…I’m at least $30 million poorer as I sit here giving this little talk because I once bought 300 shares of a stock and the guy called me back and said, “I’ve got 1,500 more,” and I said, “Will you hold it for 15 minutes while I think about it?” And the CEO of this company -- I have seen a lot of vivid peculiarities in a long life, but this guy set a world record; I’m talking about the CEO -- and I just mis-weighed it. The truth of the matter was the situation was foolproof. He was soon going to be dead, and I turned down the extra 1,500 shares, and it’s now cost me $30 million. And that’s life in the big city. And it wasn’t something where stock was generally available. So it’s very easy to mis-weigh the vivid evidence, and Gutfreund did that when he looked into the man’s eyes and forgave a colleague.

18) Mental confusion caused by information not arrayed in the mind and theory structures, creating sound generalizations developed in response to the question “Why?” Also, mis-influence from information that apparently but not really answers the question “Why?” Also, failure to obtain deserved influence caused by not properly explaining why.

Well we all know people who’ve flunked, and they try and memorize and they try and spout back and they just…it doesn’t work. The brain doesn’t work that way. You’ve got to array facts on the theory structures answering the question “Why?” If you don’t do that, you just cannot handle the world.

And now we get to Feuerstein, who was the general counsel with Salomon when Gutfreund made his big error, and Feuerstein knew better. He told Gutfreund, “You have to report this as a matter of morality and prudent business judgment.” He said, “It’s probably not illegal, there’s probably no legal duty to do it, but you have to do it as a matter of prudent conduct and proper dealing with your main customer.” He said that to Gutfreund on at least two or three occasions. And he stopped. And, of course, the persuasion failed, and when Gutfreund went down, Feuerstein went with him. It ruined a considerable part of Feuerstein’s life.


Well Feuerstein, [who] was a member of the Harvard Law Review, made an elementary psychological mistake. You want to persuade somebody, you really tell them why. And what did we learn in lesson one? Incentives really matter? Vivid evidence really works?

He should’ve told Gutfreund, “You’re likely to ruin your life and disgrace your family and lose your money.” And is Mozer worth this? I know both men. That would’ve worked. So Feuerstein flunked elementary psychology, this very sophisticated, brilliant lawyer. But don’t you do that. It’s not very hard to do, you know, just to remember that “Why?” is very important.

19) Other normal limitations of sensation, memory, cognition and knowledge.

Well, I don’t have time for that.

20)Stress-induced mental changes, small and large, temporary and permanent.

Here, my favorite example is the great Pavlov. He had all these dogs in cages, which had all been conditioned into changed behaviors, and the great Leningrad flood came and it just went right up and the dog’s in a cage. And the dog had as much stress as you can imagine a dog ever having. And the water receded in time to save some of the dogs, and Pavlov noted that they’d had a total reversal of their conditioned personality. And being the great scientist he was, he spent the rest of his life giving nervous breakdowns to dogs, and he learned a helluva lot that I regard as very interesting.

I have never known any Freudian analyst who knew anything about the last work of Pavlov, and I’ve never met a lawyer who understood that what Pavlov found out with those dogs had anything to do with programming and de-programming and cults and so forth. I mean the amount of elementary psychological ignorance that is out there in high levels is very significant.


A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business

USC Business School, 1994

I'm going to play a minor trick on you today because the subject of my talk is the art of stock picking as a subdivision of the art of worldly wisdom. That enables me to start talking about worldly wisdom—a much broader topic that interests me because I think all too little of it is delivered by modern educational systems, at least in an effective way.

And therefore, the talk is sort of along the lines that some behaviorist psychologists call Grandma's rule after the wisdom of Grandma when she said that you have to eat the carrots before you get the dessert.

The carrot part of this talk is about the general subject of worldly wisdom which is a pretty good way to start. After all, the theory of modern education is that you need a general education before you specialize. And I think to some extent, before you're going to be a great stock picker, you need some general education.

So, emphasizing what I sometimes waggishly call remedial worldly wisdom, I'm going to start by waltzing you through a few basic notions.

What is elementary, worldly wisdom? Well, the first rule is that you can't really know anything if you just remember isolated facts and try and bang'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form.

You've got to have models in your head. And you've got to array your experience—both vicarious and direct—on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You've got to hang experience on a latticework of models in your head.

What are the models? Well, the first rule is that you've got to have multiple models—because if you just have one or two that you're using, the nature of human psychology is such that you'll torture reality so that it fits your models, or at least you'll think it does. You become the equivalent of a chiropractor who, of course, is the great boob in medicine.

It's like the old saying, "To the man with only a hammer, every problem looks like a nail." And of course, that's the way the chiropractor goes about practicing medicine. But that's a perfectly disastrous way to think and a perfectly disastrous way to operate in the world. So you've got to have multiple models.

And the models have to come from multiple disciplines—because all the wisdom of the world is not to be found in one little academic department. That's why poetry professors, by and large, are so unwise in a worldly sense. They don't have enough models in their heads. So you've got to have models across a fair array of disciplines.

You may say, "My God, this is already getting way too tough." But, fortunately, it isn't that tough—because 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person. And, of those, only a mere handful really carry very heavy freight.


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 every day 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 asskicking 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....

Obviously, you have to know accounting. It's the language of practical business life. It was a very useful thing to deliver to civilization. I've heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention.

And it's not that hard to understand.

But you have to know enough about it to understand its limitations— because although accounting is the starting place, it's only a crude approximation. And it's not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn't make it anything you really know.


In terms of the limitations of accounting, one of my favorite stories involves a very great businessman named Carl Braun who created the CF Braun Engineering Company. It designed and built oil refineries—which is very hard to do. And Braun would get them to come in on time and not blow up and have efficiencies and so forth. This is a major art.

And Braun, being the thorough Teutonic type that he was, had a number of quirks. And one of them was that he took a look at standard accounting and the way it was applied to building oil refineries and he said, "This is asinine."

So he threw all of his accountants out and he took his engineers and said, "Now, we'll devise our own system of accounting to handle this process." And in due time, accounting adopted a lot of Carl Braun's notions. So he was a formidably willful and talented man who demonstrated both the importance of accounting and the importance of knowing its limitations.

He had another rule, from psychology, which, if you're interested in wisdom, ought to be part of your repertoire—like the elementary mathematics of permutations and combinations.

His rule for all the Braun Company's communications was called the five W's—you had to tell who was going to do what, where, when and why. And if you wrote a letter or directive in the Braun Company telling somebody to do something, and you didn't tell him why, you could get fired. In fact, you would get fired if you did it twice.

You might ask why that is so important? Well, again that's a rule of psychology. Just as you think better if you array knowledge on a bunch of models that are basically answers to the question, why, why, why, if you always tell people why, they'll understand it better, they'll consider it more important, and they'll be more likely to comply. Even if they don't understand your reason, they'll be more likely to comply.

So there's an iron rule that just as you want to start getting worldly wisdom by asking why, why, why, in communicating with other people about everything, you want to include why, why, why. Even if it's obvious, it's wise to stick in the why.

Which models are the most reliable? Well, obviously, the models that come from hard science and engineering are the most reliable models on this Earth. And engineering quality control—at least the guts of it that matters to you and me and people who are not professional engineers—is very much based on the elementary mathematics of Fermat and Pascal:

It costs so much and you get so much less likelihood of it breaking if you spend this much. It's all elementary high school mathematics. And an elaboration of that is what Deming brought to Japan for all of that quality control stuff.

I don't think it's necessary for most people to be terribly facile in statistics. For example, I'm not sure that I can even pronounce the Poisson distribution. But I know what a Gaussian or normal distribution looks like and I know that events and huge aspects of reality end up distributed that way. So I can do a rough calculation.

But if you ask me to work out something involving a Gaussian distribution to ten decimal points, I can't sit down and do the math. I'm like a poker player who's learned to play pretty well without mastering Pascal.


And by the way, that works well enough. But you have to understand that bell shaped curve at least roughly as well as I do.

And, of course, the engineering idea of a backup system is a very powerful idea. The engineering idea of breakpoints—that's a very powerful model, too. The notion of a critical mass—that comes out of physics—is a very powerful model.

All of these things have great utility in looking at ordinary reality. And all of this cost-benefit analysis—hell, that's all elementary high school algebra, too. It's just been dolled up a little bit with fancy lingo.

I suppose the next most reliable models are from biology/ physiology because, after all, all of us are programmed by our genetic makeup to be much the same.

And then when you get into psychology, of course, it gets very much more complicated. But it's an ungodly important subject if you're going to have any worldly wisdom.

And you can demonstrate that point quite simply: There's not a person in this room viewing the work of a very ordinary professional magician who doesn't see a lot of things happening that aren't happening and not see a lot of things happening that are happening.

And the reason why is that the perceptual apparatus of man has shortcuts in it. The brain cannot have unlimited circuitry. So someone who knows how to take advantage of those shortcuts and cause the brain to miscalculate in certain ways can cause you to see things that aren't there.

Now you get into the cognitive function as distinguished from the perceptual function. And there, you are equally—more than equally in fact—likely to be misled. Again, your brain has a shortage of circuitry and so forth—and it's taking all kinds of little automatic shortcuts.

So when circumstances combine in certain ways—or more commonly, your fellow man starts acting like the magician and manipulates you on purpose by causing your cognitive dysfunction—you're a patsy.

And so just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations. And this knowledge, by the way, can be used to control and motivate other people....

So the most useful and practical part of psychology—which I personally think can be taught to any intelligent person in a week—is ungodly important. And nobody taught it to me by the way. I had to learn it later in life, one piece at a time. And it was fairly laborious. It's so elementary though that, when it was all over, I felt like a fool.

And yeah, I'd been educated at Cal Tech and the Harvard Law School and so forth. So very eminent places mis-educated people like you and me.

The elementary part of psychology—the psychology of misjudgment, as I call it—is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important.


Terribly smart people make totally bonkers mistakes by failing to pay heed to it. In fact, I've done it several times during the last two or three years in a very important way. You never get totally over making silly mistakes.

There's another saying that comes from Pascal which I've always considered one of the really accurate observations in the history of thought. Pascal said in essence, "The mind of man at one and the same time is both the glory and the shame of the universe."

And that's exactly right. It has this enormous power. However, it also has these standard misfunctions that often cause it to reach wrong conclusions. It also makes man extraordinarily subject to manipulation by others. For example, roughly half of the army of Adolf Hitler was composed of believing Catholics. Given enough clever psychological manipulation, what human beings will do is quite interesting.

Personally, 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.

Now we come to another somewhat less reliable form of human wisdom— microeconomics. And here, I find it quite useful to think of a free market economy—or partly free market economy—as sort of the equivalent of an ecosystem....

This is a very unfashionable way of thinking because early in the days after Darwin came along, people like the robber barons assumed that the doctrine of the survival of the fittest authenticated them as deserving power—you know, "I'm the richest. Therefore, I'm the best. God's in his heaven, etc."

And that reaction of the robber barons was so irritating to people that it made it unfashionable to think of an economy as an ecosystem. But the truth is that it is a lot like an ecosystem. And you get many of the same results.

Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as animals flourish in niches, similarly, people who specialize in the business world—and get very good because they specialize—frequently find good economics that they wouldn't get any other way.

And once we get into microeconomics, we get into the concept of advantages of scale. Now we're getting closer to investment analysis— because in terms of which businesses succeed and which businesses fail, advantages of scale are ungodly important.

For example, one great advantage of scale taught in all of the business schools of the world is cost reductions along the so-called experience curve. Just doing something complicated in more and more volume enables human beings, who are trying to improve and are motivated by the incentives of capitalism, to do it more and more efficiently.


The very nature of things is that if you get a whole lot of volume through your joint, you get better at processing that volume. That's an enormous advantage. And it has a lot to do with which businesses succeed and fail....

Let's go through a list—albeit an incomplete one—of possible advantages of scale. Some come from simple geometry. If you're building a great spherical tank, obviously as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel.

And there are all kinds of things like that where the simple geometry—the simple reality—gives you an advantage of scale.

For example, you can get advantages of scale from TV advertising. When TV advertising first arrived—when talking color pictures first came into our living rooms—it was an unbelievably powerful thing. And in the early days, we had three networks that had whatever it was—say 90% of the audience.

Well, if you were Procter & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so many cans and bottles. Some little guy couldn't. And there was no way of buying it in part. Therefore, he couldn't use it. In effect, if you didn't have a big volume, you couldn't use network TV advertising which was the most effective technique.

So when TV came in, the branded companies that were already big got a huge tail wind. Indeed, they prospered and prospered and prospered until some of them got fat and foolish, which happens with prosperity—at least to some people....

And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30 cents, am I going to take something I don't know and put it in my mouth— which is a pretty personal place, after all—for a lousy dime?

So, in effect, Wrigley , simply by being so well known, has advantages of scale—what you might call an informational advantage.

Another advantage of scale comes from psychology. The psychologists use the term social proof. We are all influenced—subconsciously and to some extent consciously—by what we see others do and approve. Therefore, if everybody's buying something, we think it's better. We don't like to be the one guy who's out of step.

Again, some of this is at a subconscious level and some of it isn't. Sometimes, we consciously and rationally think, "Gee, I don't know much about this. They know more than I do. Therefore, why shouldn't I follow them?"

The social proof phenomenon which comes right out of psychology gives huge advantages to scale—for example, with very wide distribution, which of course is hard to get. One advantage of Coca-Cola is that it's available almost everywhere in the world.

Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup—which is slowly won by a big enterprise—gets to be a huge


advantage.... And if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you.

There's another kind of advantage to scale. In some businesses, the very nature of things is to sort of cascade toward the overwhelming dominance of one firm.

The most obvious one is daily newspapers. There's practically no city left in the U.S., aside from a few very big ones, where there's more than one daily newspaper.

And again, that's a scale thing. Once I get most of the circulation, I get most of the advertising. And once I get most of the advertising and circulation, why would anyone want the thinner paper with less information in it? So it tends to cascade to a winner take all situation. And that's a separate form of the advantages of scale phenomenon.

Similarly, all these huge advantages of scale allow greater specialization within the firm. Therefore, each person can be better at what he does.

And these advantages of scale are so great, for example, that when Jack Welch came into General Electric, he just said, "To hell with it. We're either going to be # 1 or #2 in every field we're in or we're going to be out. I don't care how many people I have to fire and what I have to sell. We're going to be #1 or #2 or out."

That was a very tough minded thing to do, but I think it was a very correct decision if you're thinking about maximizing shareholder wealth. And I don't think it's a bad thing to do for a civilization either, because I think that General Electric is stronger for having Jack Welch there.

And there are also disadvantages of scale. For example, we—by which I mean Berkshire Hathaway—are the largest shareholder in Capital Cities/ABC. And we had trade publications there that got murdered where our competitors beat us. And the way they beat us was by going to a narrower specialization.

We'd have a travel magazine for business travel. So somebody would create one which was addressed solely at corporate travel departments. Like an ecosystem, you're getting a narrower and narrower specialization.

Well, they got much more efficient. They could tell more to the guys who ran corporate travel departments. Plus, they didn't have to waste the ink and paper mailing out stuff that corporate travel departments weren't interested in reading. It was a more efficient system. And they beat our brains out as we relied on our broader magazine.

That's what happened to The Saturday Evening Post and all those things. They're gone. What we have now is Motocross—which is read by a bunch of nuts who like to participate in tournaments where they turn somersaults on their motorcycles. But they care about it. For them, it's the principal purpose of life. A magazine called Motocross is a total necessity to those people. And its profit margins would make you salivate.

Just think of how narrowcast that kind of publishing is. So occasionally, scaling down and intensifying gives you the big advantage. Bigger is not always better.


The great defect of scale, of course, which makes the game interesting—so that the big people don't always win—is that as you get big, you get the bureaucracy. And with the bureaucracy comes the territoriality—which is again grounded in human nature.

And the incentives are perverse. For example, if you worked for AT&T in my day, it was a great bureaucracy. Who in the hell was really thinking about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-basket into somebody else's in-basket. But, of course, it isn't. It's not done until AT&T delivers what it's supposed to deliver. So you get big, fat, dumb, unmotivated bureaucracies.

They also tend to become somewhat corrupt. In other words, if I've got a department and you've got a department and we kind of share power running this thing, there's sort of an unwritten rule: "If you won't bother me, I won't bother you and we're both happy." So you get layers of management and associated costs that nobody needs. Then, while people are justifying all these layers, it takes forever to get anything done. They're too slow to make decisions and nimbler people run circles around them.

The constant curse of scale is that it leads to big, dumb bureaucracy— which, of course, reaches its highest and worst form in government where the incentives are really awful. That doesn't mean we don't need governments—because we do. But it's a terrible problem to get big bureaucracies to behave.

So people go to stratagems. They create little decentralized units and fancy motivation and training programs. For example, for a big company, General Electric has fought bureaucracy with amazing skill. But that's because they have a combination of a genius and a fanatic running it. And they put him in young enough so he gets a long run. Of course, that's Jack Welch.

But bureaucracy is terrible.... And as things get very powerful and very big, you can get some really dysfunctional behavior. Look at Westinghouse. They blew billions of dollars on a bunch of dumb loans to real estate developers. They put some guy who'd come up by some career path—I don't know exactly what it was, but it could have been refrigerators or something—and all of a sudden, he's loaning money to real estate developers building hotels. It's a very unequal contest. And in due time, they lost all those billions of dollars.

CBS provides an interesting example of another rule of psychology— namely, Pavlovian association. If people tell you what you really don't want to hear what's unpleasant—there's an almost automatic reaction of antipathy. You have to train yourself out of it. It isn't fore destined that you have to be this way. But you will tend to be this way if you don't think about it.

Television was dominated by one network—CBS in its early days. And Paley was a god. But he didn't like to hear what he didn't like to hear. And people soon learned that. So they told Paley only what he liked to hear. Therefore, he was soon living in a little cocoon of unreality and everything else was corrupt—although it was a great business.

So the idiocy that crept into the system was carried along by this huge tide. It was a Mad Hatter's tea party the last ten years under Bill Paley.

And that is not the only example by any means. You can get severe misfunction in the high ranks of business. And of course, if you're investing, it can make a lot of difference. If you take all the acquisitions that CBS made under Paley, after the acquisition of the network itself, with all his advisors—


his investment bankers, management consultants and so forth who were getting paid very handsomely—it was absolutely terrible.

For example, he gave something like 20% of CBS to the Dumont Company for a television set manufacturer which was destined to go broke. I think it lasted all of two or three years or something like that. So very soon after he'd issued all of that stock, Dumont was history. You get a lot of dysfunction in a big fat, powerful place where no one will bring unwelcome reality to the boss. So life is an everlasting battle between those two forces—to get these advantages of scale on one side and a tendency to get a lot like the U.S. Agriculture Department on the other side—where they just sit around and so forth. I don't know exactly what they do. However, I do know that they do very little useful work.

On the subject of advantages of economies of scale, I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power—which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization.

If one little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he's going to make a lot of poor decisions. But if your buying is done in headquarters for a huge bunch of stores, you can get very bright people that know a lot about refrigerators and so forth to do the buying.

The reverse is demonstrated by the little store where one guy is doing all the buying. It's like the old story about the little store with salt all over its walls. And a stranger comes in and says to the storeowner, "You must sell a lot of salt." And he replies, "No, I don't. But you should see the guy who sells me salt."

So there are huge purchasing advantages. And then there are the slick systems of forcing everyone to do what works. So a chain store can be a fantastic enterprise.

It's quite interesting to think about Wal-Mart starting from a single store in Bentonville, Arkansas against Sears, Roebuck with its name, reputation and all of its billions. How does a guy in Bentonville, Arkansas with no money blow right by Sears, Roebuck? And he does it in his own lifetime— in fact, during his own late lifetime because he was already pretty old by the time he started out with one little store....

He played the chain store game harder and better than anyone else. Walton invented practically nothing. But he copied everything anybody else ever did that was smart—and he did it with more fanaticism and better employee manipulation. So he just blew right by them all.

He also had a very interesting competitive strategy in the early days. He was like a prizefighter who wanted a great record so he could be in the finals and make a big TV hit. So what did he do? He went out and fought 42 palookas. Right? And the result was knockout, knockout, knockout—42 times.

Walton, being as shrewd as he was, basically broke other small town merchants in the early days. With his more efficient system, he might not have been able to tackle some titan head-on at the time. But with his better system, he could destroy those small town merchants. And he went around doing it time after time after time. Then, as he got bigger, he started destroying the big boys.

Well, that was a very, very shrewd strategy.


You can say, "Is this a nice way to behave?" Well, capitalism is a pretty brutal place. But I personally think that the world is better for having Wal-Mart. I mean you can idealize small town life. But I've spent a fair amount of time in small towns. And let me tell you shouldn't get too idealistic about all those businesses he destroyed.

Plus, a lot of people who work at Wal-Mart are very high grade, bouncy people who are raising nice children. I have no feeling that an inferior culture destroyed a superior culture. I think that is nothing more than nostalgia and delusion. But, at any rate, it's an interesting model of how the scale of things and fanaticism combine to be very powerful.

And it's also an interesting model on the other side—how with all its great advantages, the disadvantages of bureaucracy did such terrible damage to Sears, Roebuck. Sears had layers and layers of people it didn't need. It was very bureaucratic. It was slow to think. And there was an established way of thinking. If you poked your head up with a new thought, the system kind of turned against you. It was everything in the way of a dysfunctional big bureaucracy that you would expect.

In all fairness, there was also much that was good about it. But it just wasn't as lean and mean and shrewd and effective as Sam Walton. And, in due time, all its advantages of scale were not enough to prevent Sears from losing heavily to Wal-Mart and other similar retailers.

Here's a model that we've had trouble with. Maybe you'll be able to figure it out better. Many markets get down to two or three big competitors—or five or six. And in some of those markets, nobody makes any money to speak of. But in others, everybody does very well.

Over the years, we've tried to figure out why the competition in some markets gets sort of rational from the investor's point of view so that the shareholders do well, and in other markets, there's destructive competition that destroys shareholder wealth.

If it's a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world—safe travel, greater experience, time with your loved ones, you name it. Yet, the net amount of money that's been made by the shareholders of airlines since Kitty Hawk, is now a negative figure—a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business.

Yet, in other fields—like cereals, for example—almost all the big boys make out. If you're some kind of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make 40%. But why are cereals so profitable—despite the fact that it looks to me like they're competing like crazy with promotions, coupons and everything else? I don't fully understand it.

Obviously, there's a brand identity factor in cereals that doesn't exist in airlines. That must be the main factor that accounts for it.

And maybe the cereal makers by and large have learned to be less crazy about fighting for market share—because if you get even one person who's hell-bent on gaining market share.... For example, if I were Kellogg and I decided that I had to have 60% of the market, I think I could take most of the profit out of cereals. I'd ruin Kellogg in the process. But I think I could do it.

In some businesses, the participants behave like a demented Kellogg. In other businesses, they don't. Unfortunately, I do not have a perfect model for predicting how that's going to happen.


For example, if you look around at bottler markets, you'll find many markets where bottlers of Pepsi and Coke both make a lot of money and many others where they destroy most of the profitability of the two franchises. That must get down to the peculiarities of individual adjustment to market capitalism. I think you'd have to know the people involved to fully understand what was happening.

In microeconomics, of course, you've got the concept of patents, trademarks, exclusive franchises and so forth. Patents are quite interesting. When I was young, I think more money went into patents than came out. Judges tended to throw them out—based on arguments about what was really invented and what relied on prior art. That isn't altogether clear.

But they changed that. They didn't change the laws. They just changed the administration—so that it all goes to one patent court. And that court is now very much more pro-patent. So I think people are now starting to make a lot of money out of owning patents.

Trademarks, of course, have always made people a lot of money. A trademark system is a wonderful thing for a big operation if it's well known.

The exclusive franchise can also be wonderful. If there were only three television channels awarded in a big city and you owned one of them, there were only so many hours a day that you could be on. So you had a natural position in an oligopoly in the pre-cable days.

And if you get the franchise for the only food stand in an airport, you have a captive clientele and you have a small monopoly of a sort.

The great lesson in microeconomics is to discriminate between when technology is going to help you and when it's going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does.

For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles—which are a real commodity product. And one day, the people came to Warren and said, "They've invented a new loom that we think will do twice as much work as our old ones."

And Warren said, "Gee, I hope this doesn't work because if it does, I'm going to close the mill." And he meant it.

What was he thinking? He was thinking, "It's a lousy business. We're earning substandard returns and keeping it open just to be nice to the elderly workers. But we're not going to put huge amounts of new capital into a lousy business."

And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners.

That's such an obvious concept—that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that's still going to be lousy. The money still won't come to you. All of the advantages from great improvements are going to flow through to the customers.


Conversely, if you own the only newspaper in Oshkosh and they were to invent more efficient ways of composing the whole newspaper, then when you got rid of the old technology and got new fancy computers and so forth, all of the savings would come right through to the bottom line.

In all cases, the people who sell the machinery—and, by and large, even the internal bureaucrats urging you to buy the equipment—show you projections with the amount you'll save at current prices with the new technology. However, they don't do the second step of the analysis which is to determine how much is going stay home and how much is just going to flow through to the customer. I've never seen a single projection incorporating that second step in my life. And I see them all the time. Rather, they always read: "This capital outlay will save you so much money that it will pay for itself in three years.

So you keep buying things that will pay for themselves in three years. And after 20 years of doing it, somehow you've earned a return of only about 4% per annum. That's the textile business. And it isn't that the machines weren't better. It's just that the savings didn't go to you. The cost reductions came through all right. But the benefit of the cost reductions didn't go to the guy who bought the equipment. It's such a simple idea. It's so basic. And yet it's so often forgotten.

Then there's another model from microeconomics which I find very interesting. When technology moves as fast as it does in a civilization like ours, you get a phenomenon which I call competitive destruction. You know, you have the finest buggy whip factory and all of a sudden in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you're dead—you're destroyed. It happens again and again and again.

And when these new businesses come in, there are huge advantages for the early birds. And when you're an early bird, there's a model that I call "surfing"—when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallows...

But people get long runs when they're right on the edge of the wave— whether it's Microsoft or Intel or all kinds of people, including National Cash Register in the early days.

The cash register was one of the great contributions to civilization. It's a wonderful story. Patterson was a small retail merchant who didn't make any money. One day, somebody sold him a crude cash register which he put into his retail operation. And it instantly changed from losing money to earning a profit because it made it so much harder for the employees to steal....

But Patterson, having the kind of mind that he did, didn't think, "Oh, good for my retail business." He thought, "I'm going into the cash register business." And, of course, he created National Cash Register.

And he "surfed". He got the best distribution system, the biggest collection of patents and the best of everything. He was a fanatic about everything important as the technology developed. I have in my files an early National Cash Register Company report in which Patterson described his methods and objectives. And a well-educated orangutan could see that buying into partnership with Patterson in those early days, given his notions about the cash register business, was a total 100% cinch.


And, of course, that's exactly what an investor should be looking for. In a long life, you can expect to profit heavily from at least a few of those opportunities if you develop the wisdom and will to seize them. At any rate, "surfing" is a very powerful model.


Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs

Herb Kay Undergraduate Lecture, Ecomomics Department University of California, Santa Barbara

October 3, 2003

Transcript by Whitney Tilson, T2 Partners LLC ([email protected]) who did original light

editing and added web links. Later light editing by the speaker.

Introduction by Rajnish Mehra

Good afternoon. I am Rajnish Mehra, chair of the Economics Departmentand on behalf of the

entire department it is my pleasure to welcome you to our annual Herb Kay Undergraduate Lecture,

underwritten by the generosity of Herb Kay. Herb was on our faculty in the ‘60s and has remained a

friend and benefactor of the Department. We are very fortunate to have Herb here in the audience

today. So please join me in giving him a very warm welcome. (Applause).

Mr. Munger’s achievements are very great. They are too numerous for me to detail here. He

attended Caltech and Harvard, and in addition to being Vice Chair at Berkshire Hathaway, he’s the chair

of a major legal newspaper corporation and also Wesco Financial Corporation. He’s the President of the

Alfred C. Munger Foundation, a philanthropic foundation named after his father. He’s on the Forbes 400

list – and what makes that achievement remarkable is that he got there the old fashioned way: He

earned it. (Laughter).

He’s – after Warren Buffett – the largest shareholder in Berkshire Hathaway. And as you can see

he’s a fan of Coke, both of the stock and the drink. (Laughter).

It’s a personal privilege to introduce Mr. Munger to the UCSB community. I have long been a fan

of his Mungerisms. And to quote a particular favorite one that has served me in good stead: Never

wrestle with a pig, for if you do, you will both get dirty, but the pig will enjoy it.

Ladies and gentlemen, please join me in welcoming Charles Munger. He will speak to us today

on Interdisciplinary Wisdom Involving Economics.

Munger’s Opening Remarks:

I’ve outlined some remarks in a rough way, and after I’m finished talking from that outline, I’ll

take questions as long as anybody can endure listening, until they drag me away to wherever else I’m

supposed to go.

As you might guess, I agreed to do this because the subject of getting the soft sciences so they

talked better to each other has been one that has interested me for decades. And, of course, economics

is in many respects the queen of the soft sciences. It’s expected to be better than the rest. It’s my view


that economics is better at the multidisciplinary stuff than the rest of the soft science. And it’s also my

view that it’s still lousy, and I’d like to discuss this failure in this talk.

As I talk about strengths and weaknesses in academic economics, one interesting fact you are

entitled to know is that I never took a course in economics. And with this striking lack of credentials, you

may wonder why I have the chutzpah to be up here giving this talk. The answer is I have a black belt in

chutzpah. I was born with it. Some people, like some of the women I know, have a black belt in

spending. They were born with that. But what they gave me was a black belt in chutzpah.

But I come from two peculiar strands of experience that may have given me some useful

economic insights. One is Berkshire Hathaway and the other is my personal educational history.

Berkshire, of course, has finally gotten interesting. When Warren took over Berkshire, the

market capitalization was about ten million dollars. And forty something years later, there are not many

more shares outstanding now than there were then, and the market capitalization is about a hundred

billion dollars, ten thousand for one. And since that has happened, year after year, in kind of a grind-

ahead fashion, with very few failures, it eventually drew some attention, indicating that maybe Warren

and I knew something useful in microeconomics.

Non-use of Efficient Market Theory at Berkshire

For a long time there was a Nobel Prize-winning economist who explained Berkshire Hathaway’s

success as follows:

First, he said Berkshire beat the market in common stock investing through one sigma of luck,

because nobody could beat the market except by luck. This hard-form version of efficient market theory

was taught in most schools of economics at the time. People were taught that nobody could beat the

market. Next the professor went to two sigmas, and three sigmas, and four sigmas, and when he finally

got to six sigmas of luck, people were laughing so hard he stopped doing it.

Then he reversed the explanation 180 degrees. He said, “No, it was still six sigmas, but is was six

sigmas of skill.” Well this very sad history demonstrates the truth of Benjamin Franklin’s observation in

Poor Richard’s Almanac. If you would persuade, appeal to interest and not to reason. The man changed

his view when his incentives made him change it, and not before.

I watched the same thing happen at the Jules Stein Eye Institute at UCLA. I asked at one point,

why are you treating cataracts only with a totally obsolete cataract operation? And the man said to me,

“Charlie, it’s such a wonderful operation to teach.” (Laughter). When he stopped using that operation, it

was because almost all the patients had voted with their feet. Again, appeal to interest and not to

reason if you want to change conclusions.

Well, Berkshire’s whole record has been achieved without paying one ounce of attention to the

efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea,

which came out of academic economics and went into corporate finance and morphed into such

obscenities as the capital asset pricing model, which we also paid no attention to. I think you’d have to


believe in the tooth fairy to believe that you could easily outperform the market by seven-percentage

points per annum just by investing in high volatility stocks.

Yet, believe it or not, like the Jules Stein doctor, people once believed this stuff. And the belief

was rewarded. And it spread. And many people still believe it. But Berkshire never paid any attention to

it. And now I think the world is coming our way and the idea of perfection in all market outcomes is

going the way of the DoDo bird.

It was always clear to me that the stock market couldn’t be perfectly efficient, because as a

teenager, I’d been to the racetrack in Omaha where they had the pari-mutuel system. And it was quite

obvious to me that if the house takes the croupier’s take, was 17%, some people consistently lost a lot

less than 17% of all their bets, and other people consistently lost more than 17% of all their bets. So the

pari-mutuel system in Omaha had no perfect efficiency. And so I didn’t accept the argument that the

stock market was always perfectly efficient in creating rational prices. Indeed, there’s been some

documented cases since, of people getting so good at understanding horses and odds, that they actually

are able to beat the house in off-track betting. There aren’t many people who can do that, but there are

a few people in America who can.

Personal Multidisciplinary Education

Next, my personal education history is interesting because its deficiencies and my peculiarities

eventually created advantages. For some odd reason, I had an early and extreme multidisciplinary cast

of mind. I couldn’t stand reaching for a small idea in my own discipline when there was a big idea right

over the fence in somebody else’s discipline. So I just grabbed in all directions for the big ideas that

would really work. Nobody taught me to do that; I was just born with that yen. I also was born with a

huge craving for synthesis. And when it didn’t come easily, which was often, I would rag the problem,

and then when I failed I would put it aside and I’d come back to it and rag it again. It took me 20 years to

figure out how and why the Reverend Moon’s conversion methods worked. But the psychology

departments haven’t figured it out yet, so I’m ahead of them.

But anyway, I have this tendency to want to rag the problems. Because WW II caught me. I

drifted into some physics, and the Air Corps sent me to Caltech where I did a little more physics as part

of being made into a meteorologist. And there, at a very young age, I absorbed what I call the

fundamental full attribution ethos of hard science. And that was enormously useful to me. Let me

explain that ethos.

Under this ethos, you’ve got to know all the big ideas in all the disciplines less fundamental than

your own. You can never make any explanation, which can be made in a more fundamental way, in any

other way than the most fundamental way. And you always take with full attribution to the most

fundamental ideas that you are required to use. When you’re using physics, you say you’re using

physics. When you’re using biology, you say you’re using biology. And so on and so on. I could early see

that that ethos would act as a fine organizing system for my thought. And I strongly suspected that it

would work really well in the soft sciences as well as the hard sciences, so I just grabbed it and used it all

through my life in soft science as well as hard science. That was a very lucky idea for me.


Let me explain how extreme that ethos is in hard science. There is a constant, one of the

fundamental constants in physics, known as Boltzmann’s constant. You probably all know it very well.

And the interesting thing about Boltzmann’s constant is that Boltzmann didn’t discover it. So why is

Boltzmann’s constant now named for Boltzmann? Well, the answer was that Boltzmann derived that

constant from basic physics in a more fundamental way than the poor forgotten fellow who found the

constant in the first place in some less fundamental way. The ethos of hard science is so strong in favor

of reductionism to the more fundamental body of knowledge that you can wash the discoverer right out

of history when somebody else handles his discovery in a more fundamental way. I think that is correct.

I think Boltzmann’s constant should be named for Boltzmann.

At any rate, in my history and Berkshire’s history Berkshire went on and on into considerable

economic success, while ignoring the hard form efficient markets doctrine once very popular in

academic economics and ignoring the descendants of that doctrine in corporate finance, where the

results became even sillier than they were in the economics. This naturally encouraged me.

Finally, with my peculiar history, I’m also bold enough to be here today, because at least when I

was young I wasn’t a total klutz. For one year at the Harvard Law School, I was ranked second in my

group of about a thousand, and I always figured that, while there were always a lot of people much

smarter than I was, I didn’t have to hang back totally in the thinking game.

The Obvious Strengths of Academic Economics

Let me begin by discussing the obvious strengths of academic economics. The first obvious

strength, and this is true of lot of places that get repute, is that it was in the right place at the right time.

Two hundred years ago, aided by the growth of technology and the growth of other developments in

the civilization, the real output per capita of the civilized world started going up at about 2% per annum,

compounded. And before that, for the previous thousands of years, it had gone up at a rate that

hovered just a hair’s breadth above zero. And, of course, economics grew up amid this huge success.

Partly it helped the success, and partly it explained it. So, naturally, academic economics grew. And

lately with the collapse of all the communist economies, as the free market economies or partially free

market economies flourished, that added to the reputation of economics. Economics has been a very

favorable place to be if you’re in academia.

Economics was always more multidisciplinary than the rest of soft science. It just reached out

and grabbed things as it needed to. And that tendency to just grab whatever you need from the rest of

knowledge if you’re an economist has reached a fairly high point in Mankiw's new textbook. I checked

out that textbook. I must have been one of the few businessmen in America that bought it immediately

when it came out because it had gotten such a big advance. I wanted to figure out what the guy was

doing where he could get an advance that great. So this is how I happened to riffle through Mankiw's

freshman textbook. And there I found laid out as principles of economics: opportunity cost is a

superpower, to be used by all people who have any hope of getting the right answer. Also, incentives

are superpowers.


And lastly, the tragedy of the commons model, popularized by UCSB’s Garrett Hardin Hardin

caused the delightful introduction into economics – alongside Smith’s beneficent invisible hand – of

Hardin’s wicked evildoing invisible foot. Well, I thought that the Hardin model made economics more

complete, and I knew when Hardin introduced me to his model, the Tragedy of the Commons, that it

would be in the economics textbooks eventually. And, low and behold, it finally made it about 20 years

later. And it’s right for Mankiw to reach out into other disciplines and grab Hardin’s model and anything

else that works well.

Another thing that helped economics is that from the beginning it attracted the best brains in

soft science. Its denizens also interacted more with the practical world than was at all common in soft

science and the rest of academia, and that resulted in very creditable outcomes like the three cabinet

appointments of economics PhD George Schultz and the cabinet appointment of Larry Summers. So this

has been a very favored part of academia.

Also, economics early on attracted some of the best writers of language in the history of the

earth. You start out with Adam Smith. Adam Smith was so good a thinker, and so good a writer, that in

his own time, Emmanuel Kant, then the greatest intellectual in Germany, simply announced that there

was nobody in Germany to equal Adam Smith. Well Voltaire, being an even more pithy speaker than

Kant, which wouldn’t be that hard, immediately said, “Oh well, France doesn’t have anybody who can

even be compared to Adam Smith.” So economics started with some very great men and great writers.

And then there have been later great writers like John Maynard Keynes, whom I quote all the

time, and who has added a great amount of illumination to my life. And finally, even in the present era,

if you take Paul Krugman and read his essays, you will be impressed by his fluency. I can’t stand his

politics; I’m on the other side. But I love this man’s essays. I think Paul Krugman is one of the best

essayists alive. And so economics has constantly attracted these fabulous writers. And they are so good

that they have this enormous influence far outside their economic discipline, and that’s very uncommon

in other academic departments.

Okay, now it’s time to extend criticism, instead of praise. We’ve recognized that economics is

better than other soft-science academic departments in many ways. And one of the glories of

civilization. Now it’s only fair that we outline a few things that are wrong with academic economics.

What’s Wrong with Economics

1)Fatal Unconnectedness, Leading To “Man With A Hammer Syndrome,” Often Causing Overweighing

What Can Be Counted

I think I’ve got eight, no nine objections, some being logical subdivisions of a big general

objection. The big general objection to economics was the one early described by Alfred North

Whitehead when he spoke of the fatal unconnectedness of academic disciplines, wherein each professor

didn’t even know the models of the other disciplines, much less try to synthesize those disciplines with

his own.


I think there’s a modern name for this approach that Whitehead didn’t like, and that name is

bonkers. This is a perfectly crazy way to behave. Yet economics, like much else in academia, is too

insular.

The nature of this failure is that it creates what I always call, “man with a hammer syndrome.”

And that’s taken from the folk saying: To the man with only a hammer, every problem looks pretty much

like a nail. And that works marvelously to gum up all professions, and all departments of academia, and

indeed most practical life. The only antidote for being an absolute klutz due to the presence of a man

with a hammer syndrome is to have a full kit of tools. You don’t have just a hammer. You’ve got all the

tools. And you’ve got to have one more trick. You’ve got to use those tools checklist-style, because you’ll

miss a lot if you just hope that the right tool is going to pop up unaided whenever you need it. But if

you’ve got a full list of tools, and go through them in your mind, checklist-style, you will find a lot of

answers that you won’t find any other way. So limiting this big general objection that so disturbed Alfred

North Whitehead is very important, and there are mental tricks that help do the job.

Overweighing what can be counted

A special version of this “man with a hammer syndrome” is terrible, not only in economics but

practically everywhere else, including business. It’s really terrible in business. You’ve got a complex

system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there

are other factors that are terribly important, [yet] there’s no precise numbering you can put to these

factors. You know they’re important, but you don’t have the numbers. Well practically everybody (1)

overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught

in academia, and (2) doesn’t mix in the hard-to -measure stuff that may be more important. That is a

mistake I’ve tried all my life to avoid, and I have no regrets for having done that.

The late, great, Thomas Hunt Morgan, who was one of greatest biologists who ever lived, when

he got to Caltech, had a very interesting, extreme way of avoiding some mistakes from over counting

what could be measured, and undercounting what couldn’t. At that time there were no computers and

the computer substitute then available to science and engineering was the Frieden calculator, and

Caltech was full of Frieden calculators. And Thomas Hunt Morgan banned the Frieden calculator from

the biology department. And when they said, “What the hell are you doing, Mr. Morgan?,” He said,

“Well, I am like a guy who is prospecting for gold along the banks of the Sacramento River in 1849. With

a little intelligence, I can reach down and pick up big nuggets of gold. And as long as I can do that, I’m

not going to let any people in my department waste scarce resources in placer mining.” And that’s the

way Thomas Hunt Morgan got through life.

I’ve adopted the same technique, and here I am in my 80th year. I haven’t had to do any placer

mining yet. And it begins to look like I’m going to get all the way through, as I’d always hoped, without

doing any of that damned placer mining. Of course if I were a physician, particularly an academic

physician, I’d have to do the statistics, do the placer mining. But it’s amazing what you can do in life

without the placer mining if you’ve got a few good mental tricks and just keep ragging the problems the

way Thomas Hunt Morgan did.


2)Failure To Follow The Fundamental Full Attribution Ethos of Hard Science

What’s wrong with the way Mankiw does economics is that he grabs from other disciplines

without attribution. He doesn’t label the grabbed items as physics or biology or psychology, or game

theory, or whatever they really are, fully attributing the concept to the basic knowledge from which it

came. If you don’t do that, it’s like running a business with a sloppy filing system. It reduces your power

to be as good as you can be. Now Mankiw is so smart he does pretty well even when his technique is

imperfect. He got the largest advance any textbook writer ever got.

But, nonetheless he’d be better if he had absorbed this hard science ethos that I say has been

so helpful to me.

I have names for Mankiw’s approach, grabbing whatever you need without attribution.

Sometimes I call it “take what you wish,” and sometimes I call it “Kipplingism.” And when I call it

Kipplingism, I’m reminding you of Kippling’s stanza of poetry, which went something like this: “When

Homer smote his blooming lyre, he’d heard men sing by land and sea, and what he thought he might

require, he went and took, the same as me.” Well that’s the way Mankiw does it. He just grabs. This is

much better than not grabbing. But it is much worse than grabbing with full attribution and full

discipline, using all knowledge plus extreme reductionism where feasible.

3)Physics Envy

The third weakness that I find in economics is what I call physics envy. And of course, that term

has been borrowed from penis envy as described by one of the world’s great idiots, Sigmund Freud. But

he was very popular in his time, and the concept got a wide vogue.

Washington Post case study

One of the worst examples of what physics envy did to economics was cause adaptation and

hard-form efficient market theory. And then when you logically derived consequences from this wrong

theory, you would get conclusions such as: it can never be correct for any corporation to buy its own

stock. Because the price by definition is totally efficient, there could never be any advantage. QED. And

they taught this theory to some partner at McKinsey when he was at some school of business that had

adopted this crazy line of reasoning from economics, and the partner became a paid consultant for the

Washington Post. And Washington Post stock was selling at a fifth of what an orangutan could figure

was the plain value per share by just counting up the values and dividing. But he so believed what he’d

been taught in graduate school that he told the Washington Post they shouldn’t buy their own stock.

Well, fortunately, they put Warren Buffett on the Board, and he convinced them to buy back more than

half of the outstanding stock, which enriched the remaining shareholders by much more than a billion

dollars. So, there was at least one instance of a place that quickly killed a wrong academic theory.

It’s my view that economics could avoid a lot of this trouble that comes from physics envy. I

want economics to pick up the basic ethos of hard science, the full attribution habit, but not the craving

for an unattainable precision that comes from physics envy. The sort of precise reliable formula that


includes Boltzmann’s constant is not going to happen, by and large, in economics. Economics involves

too complex a system. And the craving for that physics-style precision does little but get you in terrible

trouble, like the poor fool from McKinsey.

Einstein and Sharon Stone

I think that economists would be way better off if they paid more attention to Einstein and

Sharon Stone. Well, Einstein is easy because Einstein is famous for saying, “Everything should be made

as simple as possible, but no more simple.” Now, the saying is a tautology, but it’s very useful, and some

economist – it may have been Herb Stein – had a similar tautological saying that I dearly love: “If a thing

can’t go on forever, it will eventually stop.”

Sharon Stone contributed to the subject because someone once asked her if she was bothered

by penis envy. And she said, “absolutely not, I have more trouble than I can handle with what I’ve got.”

(Laughter).

When I talk about this false precision, this great hope for reliable, precise formulas, I am

reminded of Arthur Laffer, who’s in my political party, and who is one of the all-time horses’ asses when

it comes to doing economics. His trouble is his craving for false precision, which is not an adult way of

dealing with his subject matter.

The situation of people like Laffer reminds me of a rustic legislator – and this really happened in

America. I don’t invent these stories. Reality is always more ridiculous than what I’m going to tell you. At

any rate, this rustic legislator proposed a new law in his state. He wanted to pass a law rounding Pi to an

even 3.2 so it would be easier for the school children to make the computations. Well, you can say that

this is too ridiculous, and it can’t be fair to liken economics professors like Laffer to a rustic legislator like

this. I say I’m under-criticizing the professors. At least when this rustic legislature rounded Pi to an even

number, the error was relatively small. But once you try to put a lot of false precision into a complex

system like economics, the errors can compound to the point where they’re worse than those of the

McKinsey partner when he was incompetently advising the Washington Post. So, economics should

emulate physics’ basic ethos, but its search for precision in physics–like formulas is almost always wrong

in economics.

4)Too Much Emphasis on Macroeconomics

My fourth criticism is that there’s too much emphasis on macroeconomics and not enough on

microeconomics. I think this is wrong. It’s like trying to master medicine without knowing anatomy and

chemistry. Also, the discipline of microeconomics is a lot of fun. It helps you correctly understand

macroeconomics. And it’s a perfect circus to do. In contrast, I don’t think macroeconomics people have

all that much fun. For one thing they are often wrong because of extreme complexity in the system they

wish to understand.

Case study: Nebraska Furniture Mart’s new store in Kansas City


Let me demonstrate the power of microeconomics by solving two microeconomic problems.

One simple and one a little harder. The first problem is this: Berkshire Hathaway just opened a furniture

and appliance store in Kansas City. At the time Berkshire opened it, the largest selling furniture and

appliance store in the world was another Berkshire Hathaway store, selling $350 million worth of goods

per year. The new store in a strange city opened up selling at the rate of more than $500 million a year.

From the day it opened, the 3,200 spaces in the parking lot were full. The women had to wait outside

the ladies restroom because the architects didn’t understand biology. (Laughter). It’s hugely successful.

Well, I’ve given you the problem. Now, tell me what explains the runaway success of this new

furniture and appliance store, which is outselling everything else in the world? (Pause). Well, let me do it

for you. Is this a low-priced store or a high-priced store? (Laughter). It’s not going to have a runaway

success in a strange city as a high-priced store. That would take time. Number two, if it’s moving $500

million worth of furniture through it, it’s one hell of a big store, furniture being as bulky as it is. And

what does a big store do? It provides a big selection. So what could this possibly be except a low-priced

store with a big selection?

But, you may wonder, why wasn’t it done before, preventing its being done first now? Again,

the answer just pops into your head: it costs a fortune to open a store this big. So, nobody’s done it

before. So, you quickly know the answer. With a few basic concepts, these microeconomic problems

that seem hard can be solved much as you put a hot knife through butter. I like such easy ways of

thought that are very remunerative. And I suggest that you people should also learn to do

microeconomics better.

Case study: Les Schwab Tires

Now I’ll give you a harder problem. There’s a tire store chain in the Northwest, which has slowly

succeeded over 50 years, the Les Schwab tire store chain [ www.lesschwab.com/]. It just ground ahead.

It started competing with the stores that were owned by the big tire companies that made all the tires,

the Goodyears and so forth. And, of course, the manufacturers favored their own stores. Their “tied

stores” had a big cost advantage. Later, Les Schwab rose in competition with the huge price discounters

like Costco and Sam’s Club and before that Sears Roebuck and so forth. And yet here is Schwab now,

with hundreds of millions of dollars in sales. And here’s Les Schwab in his 80s, with no education, having

done the whole thing. How did he do it? (Pause). I don’t see a whole lot of people looking like a light

bulb has come on. Well, let’s think about it with some microeconomic fluency.

Is there some wave that Schwab could have caught? The minute you ask the question, the

answer pops in. The Japanese had a zero position in tires and they got big. So this guy must have ridden

that wave some in the early times. Then the slow following success has to have some other causes. And

what probably happened here, obviously, is this guy did one hell of a lot of things right. And among the

things that he must have done right is he must have harnessed what Mankiw calls the superpower of

incentives. He must have a very clever incentive structure driving his people. And a clever personnel

selection system, etc. And he must be pretty good at advertising. Which he is. He’s an artist. So, he had

to get a wave in Japanese tire invasion, the Japanese being as successful as they were. And then a


talented fanatic had to get a hell of a lot of things right, and keep them right with clever systems. Again,

not that hard of an answer. But what else would be a likely cause of the peculiar success?

We hire business school graduates and they’re no better at these problems than you were.

Maybe that’s the reason we hire so few of them.

Causes of problem-solving success

Well, how did I solve those problems? Obviously I was using a simple search engine in my mind

to go through checklist-style, and I was using some rough algorithms that work pretty well in a great

many complex systems, and those algorithms run something like this: Extreme success is likely to be

caused by some combination of the following factors:

A) Extreme maximization or minimization of one or two variables. Example, Costco or our furniture and

appliance store.

B)Adding success factors so that a bigger combination drives success, often in non-linear fashion, as one

is reminded by the concept of breakpoint and the concept of critical mass in physics. Often results are

not linear. You get a little bit more mass, and you get a lollapalooza result. And of course I’ve been

searching for lollapalooza results all my life, so I’m very interested in models that explain their

occurrence.

C)An extreme of good performance over many factors. Example, Toyota or Les Schwab.

D)Catching and riding some sort of big wave. Example, Oracle. By the way, I put down Oracle before I

knew that the Oracle CFO was a big part of the proceedings here today.

Generally I recommend and use in problem solving cut-to-the quick algorithms, and I find you

have to use them both forward and backward. Let me give you an example. I irritate my family by giving

them little puzzles, and one of the puzzles that I gave my family not very long ago was when I said,

“There’s an activity in America, with one-on-one contests, and a national championship. The same

person won the championship on two occasions about 65 years apart.” “Now,” I said, “name the

activity,” (Pause). Again, I don’t see a lot of light bulbs going on. And in my family not lot of light bulbs

were flashing. But I have a physicist son who has been trained more in the type of thinking I like. And he

immediately got the right answer, and here’s the way he reasoned:

It can’t be anything requiring a lot of hand-eye coordination. Nobody 85 years of age is going to

win a national billiards tournament, much less a national tennis tournament. It just can’t be. Then he

figured it couldn’t be chess, which this physicist plays very well, because it’s too hard. The complexity of

the system, the stamina required are too great. But that led into checkers. And he thought, “Ah ha!

There’s a game where vast experience might guide you to be the best even though you’re 85 years of

age.”

And sure enough that was the right answer.


Anyway, I recommend that sort of mental trickery to all of you, flipping one’s thinking both

backward and forward. And I recommend that academic economics get better at very small scale

microeconomics as demonstrated here.

5)Too Little Synthesis in Economics

My fifth criticism is there is too little synthesis in economics. Not only with matter outside

traditional economics, but also within economics. I have posed at two different business schools the

following problem. I say, “You have studied supply and demand curves. You have learned that when you

raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the

volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes. And I say,

“Now tell me several instances when, if you want the physical volume to go up, the correct answer is to

increase the price?” And there’s this long and ghastly pause. And finally, in each of the two business

schools in which I’ve tried this, maybe one person in fifty could name one instance. They come up with

the idea that occasionally a higher price acts as a rough indicator of quality and thereby increases sales

volumes.

This happened in the case of my friend Bill Ballhaus. When he was head of Beckman

Instruments it produced some complicated product where if it failed it caused enormous damage to the

purchaser. It wasn’t a pump at the bottom of an oil well, but that’s a good mental example. And he

realized that the reason this thing was selling so poorly, even though it was better than anybody else’s

product, was because it was priced lower. It made people think it was a low quality gizmo. So he raised

the price by 20% or so and the volume went way up.

But only one in fifty can come up with this sole instance in a modern business school – one of

the business schools being Stanford, which is hard to get into. And nobody has yet come up with the

main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy’s

purchasing agent? (Laughter). Is that going to work? And are there functional equivalents in economics –

microeconomics – of raising the price and using the extra sales proceeds to drive sales higher? And of

course there are zillion, once you’ve made that mental jump. It’s so simple.

One of the most extreme examples is in the investment management field. Suppose you’re the

manager of a mutual fund, and you want to sell more. People commonly come to the following answer:

You raise the commissions, which of course reduces the number of units of real investments delivered

to the ultimate buyer, so you’re increasing the price per unit of real investment that you’re selling the

ultimate customer. And you’re using that extra commission to bribe the customer’s purchasing agent.

You’re bribing the broker to betray his client and put the client’s money into the high- commission

product. This has worked to produce at least a trillion dollars of mutual fund sales.

This tactic is not an attractive part of human nature, and I want to tell you that I pretty

completely avoided it in my life. I don’t think it’s necessary to spend your life selling what you would

never buy. Even though it’s legal, I don’t think it’s a good idea. But you shouldn’t accept all my notions

because you’ll risk becoming unemployable. You shouldn’t take my notions unless you’re willing to risk

being unemployable by all but a few.


I think my experience with my simple question is an example of how little synthesis people get,

even in advanced academic settings, considering economic questions. Obvious questions, with such

obvious answers. Yet people take four courses in economics, go to business school, have all these IQ

points and write all these essays, but they can’t synthesize worth a damn. This failure is not because the

professors know all this stuff and they’re deliberately withholding it from the students. This failure

happens because the professors aren’t all that good at this kind of synthesis. They were trained in a

different way. I can’t remember if it was Keynes or Galbraith who said that economics professors are

most economical with ideas. They make a few they learned in graduate school last a lifetime. (Laughter).

The second problem with synthesis

The second interesting problem with synthesis involves two of the most famous examples in the

economics. Number one is Ricardo’s principle of comparative advantage in trade, and the other is Adam

Smith’s pin factory. And both of these, of course, work to vastly increase economic output per person,

and they’re similar in that each somehow directs functions into the hands of people who are very good

at doing the functions. Yet they’re radically different examples in that one of them is the ultimate

example of central planning, the pin factory, where the whole system was planned by somebody, while

the other example, Ricardo’s, happens automatically as a natural consequence of trade.

And, of course, once you get into the joys of synthesis, you immediately think. “Do these things

interact?” Of course they interact. Beautifully. And that’s one of the causes of the power of a modern

economic system. I saw an example of that kind of interaction years ago. Berkshire had this former

savings and loan company, and it had made this loan on a hotel right opposite the Hollywood Park

Racetrack. In due time the neighborhood changed and it was full of gangs, pimps, and dope dealers.

They tore copper pipe out of the wall for dope fixes, and there were people hanging around the hotel

with guns, and nobody would come. We foreclosed on it two or three times, and the loan value went

down to nothing. We seemed to have an insolvable economic problem -- a microeconomic problem.

Now we could have gone to McKinsey, or maybe a bunch of professors from Harvard, and we

would have gotten a report about 10 inches thick about the ways we could approach this failing hotel in

this terrible neighborhood. But instead, we put a sign on the property that said: “For sale or rent.” And

in came, in response to that sign, a man who said, “I’ll spend $200,000 fixing up your hotel, and buy it at

a high price on credit, if you can get zoning so I can turn the parking lot into a putting green.” “You’ve

got to have a parking lot in a hotel,” we said. “What do you have in mind?” He said. “No, my business is

flying seniors in from Florida, putting them near the airport, and then letting them go out to Disneyland

and various places by bus and coming back. And I don’t care how bad the neighborhood is going to be

because my people are self-contained behind walls. All they have to do is get on the bus in the morning

and come home in the evening, and they don’t need a parking lot; they need a putting green.” So we

made the deal with the guy. The whole thing worked beautifully, and the loan got paid off, and it all

worked out.


Obviously that’s an interaction of Ricardo and the pin factory examples. The odd system that

this guy had designed to amuse seniors was pure pin factory, and finding the guy with this system was

pure Ricardo. So these things are interacting.

Well, I’ve taken you part way through the synthesis. It gets harder when you want to figure out

how much activity should be within private firms, and how much should be within the government, and

what are the factors that determine which functions are where, and why do the failures occur, and so

on and so on.

It’s my opinion that anybody with a high IQ who graduated in economics ought to be able to sit

down and write a ten-page synthesis of all these ideas that’s quite persuasive. And I would bet a lot of

money that I could give this test in practically every economics department in the country, and get a

perfectly lousy bunch of synthesis. They’d give me Ronald. They’d talk about transaction costs. They’d

click off a little something that their professors gave them and spit it back. But in terms of really

understanding how it all fits together, I would confidently predict that most people couldn’t do it very

well.


Prescriptions for Guaranteed Misery in Life

Harvard School Commencement Speech

June 13 1986

Now that Headmaster Berrisford has selected one of the oldest and longest—serving trustees to make a commencement speech, it behooves the speaker to address two questions in every mind:

1)Why was such a selection made? and,

2)How long is the speech going to last?

I will answer the first question from long experience alongside Berrisford. He is seeking enhanced reputation For our school in the manner of the man who proudly displays his horse which can count to seven. The man knows that counting to seven is not much of a mathematical feat but he expects approval because doing so is creditable, considering that the performer is a horse.

The second question, regarding length of speech, I am not going to answer in advance. It would deprive your upturned Faces of lively curiosity and obvious keen anticipation, which I prefer to retain, regardless of source.

But I will tell you how my consideration of speech length created the subject matter of the speech itself I was puffed up when invited to speak. While not having significant public- speaking experience, I do hold a black belt in chutzpah, and, I immediately considered Demosthenes and Cicero as role models and anticipated trying to earn a compliment like Cicero gave when asked which was his favorite among the orations of Demosthenes. Cicero replied: “The longest one. ”

However, fortunately for this audience, I also thought of Samuel Johnson's famous comment when he addressed Milton's famous poem, "Paradise Lost", and correctly said: “No one ever wished it longer.” And that made me consider which of all the twenty Harvard School graduation speeches I had heard that I wished longer. There was only one such speech, that given by Johnny Carson, specifying Carson’s prescriptions for guaranteed misery in life. I therefore decided to repeat Carson’s speech but in expanded form with some added prescriptions of my own.

After all, I am much older than Carson was when he spoke and have failed and been miserable more often and in more ways than was possible for a charming humorist speaking at younger age. I am plainly well-qualified to expand on Carson’s theme. What Carson said was that he couldn't tell the graduating class how to be happy, but he could tell them from personal experience how to guarantee misery Carson's prescriptions for sure misery included:

1)Ingesting chemicals in an effort to alter mood or perception;

2)Envy; and

3)Resentment.

I can still recall Carson’s absolute conviction as he told how he had tried these things on occasion after occasion and had become miserable every time.


It is easy to understand Carson’s first prescription for misery - ingesting chemicals. I add my voice. The four closest friends of my youth were highly intelligent, ethical, humorous types, favored in person and background. Two are long dead, with alcohol a contributing factor, and a third is a living alcoholic - if you call that living. While susceptibility varies, addiction can happen to any of us, through a subtle process where the bonds of degradation are too light to be felt until they are too strong to be broken. And I have yet to meet anyone, in over six decades of life, whose life was worsened by over-fear and over-avoidance of such a deceptive pathway to destruction.

Envy, of course, joins chemicals in winning some sort of quantity price for causing misery. It was wreaking havoc long before it got a bad press in the laws of Moses. If you wish to retain the contribution of envy to misery I recommend that you never read any of the biographies of that good Christian, Samuel Johnson, because his life demonstrates in an enticing way the possibility and advantage of transcending envy.

Resentment has always worked for me exactly as it worked for Carson. I cannot recommend it highly enough to you if you desire misery: Johnson spoke well when he said that life is hard enough to swallow without squeezing in the bitter rind of resentment.

For those of you who want misery I also recommend refraining from practice of the Disraeli compromise, designed for people who find it impossible to quit resentment cold turkey. Disraeli, as he rose to become one of the greatest Prime Ministers, learned to give up vengeance as a motivation for action, but he did retain some outlet for resentment by putting the names of people who wronged him on pieces of paper in a drawer. Then, from time to time, he reviewed these names and took pleasure in noting the way the world had taken his enemies down without his assistance.

Well, so much for Carson’s three prescriptions. Here are four more prescriptions from Munger:

First, be unreliable. Do not faithfully do what you have engaged to do. If you will only master this one habit you will more than counterbalance the combined effect of all your virtues, howsoever great. If you like being distrusted and excluded from the best human contribution and company, this prescription is for you. Master this one habit and you can always play the role of the hare in the fable, except that instead of being outrun by one fine turtle you will be outrun by hordes and hordes of mediocre turtles and even by some mediocre turtles on crutches.

I must warn you that if you don`t follow my first prescription it may be hard to end up miserable, even if you start disadvantaged. I had a roommate in college who was and is severely dyslexic. But he is perhaps the most reliable man I have ever known. He has had a wonderful life so far, outstanding wife and children, chief executive of a multibillion dollar corporation.

If you want to avoid a conventional, main-culture, establishment result of this kind, you simply can’t count on your other handicaps to hold you back if you persist in being reliable.

I cannot here pass b a reference to a life described as °°wonderful so far,” without reinforcing the “so far" acts of the human condition by repeating the remark of Croesus, once the richest king in the world. Later, in ignominious captivity; as he prepared to be burned alive, he said: “Well now do I remember the words of the historian Solon: “No man's life should be accounted a happy one until it is over.”


My second prescription for misery is to learn everything you possibly can from our own personal experience, minimizing what you learn vicariously from the good and bad experience of others, living and dead. This prescription is a sure-shot producer of misery and second-rate achievement.

You can see the results of not learning from others’ mistakes by simply looking about you. How little originality there is in the common disasters of mankind - drunk driving deaths, reckless driving maimings, incurable venereal diseases, conversion of bright college students into brainwashed zombies as members of destructive cults, business failures through repetition of obvious mistakes made by predecessors, various forms of crowd folly and so on. I recommend as a memory clue to finding the way to real trouble from heedless, unoriginal error the modern saying: “If at first you don`t succeed, well, so much for hang gliding.”

The other aspect of avoiding vicarious wisdom is the rule for not learning from the best work done before yours. The prescription is to become as non-educated as you reasonably can.

Perhaps you will better see the of non-miserable result you can thus avoid if I render a short historical account. There once was a man who assiduously mastered the work of his best predecessors, despite a poor start and very tough time in analytic geometry: Eventually his own original work attracted wide attention and he said of that work:

“If I have seen a little farther than other men it is because I stood on the shoulders of giants.”

The bones of that man lie buried now, in Westminster Abbey under an unusual inscription:

“Here lie the remains of all that was mortal in Sir Isaac Newton.°°

My third prescription for misery is to go down and stay down when you get your first, second, or third severe reverse in the battle of life. Because there is so much adversity out there, even for the lucky and wise, this will guarantee that, in due course, you will be permanently mired in misery. Ignore at all cost the lesson contained in the accurate epitaph written for himself by Epictetus: “Here lies Epictetus, a slave, maimed in body, the ultimate in poverty, and favored by the Gods.”

My final prescription to you for a life of fuzzy thinking and infelicity is to ignore a story they told me when I was very young about a rustic who said: “I wish I knew where I was going to die, and then I'd never go there.” Most people smile (as you did) at the rustic's ignorance and ignore his basic wisdom. If my experience is any guide, the rustic's approach is to be avoided at all cost by someone bent on misery: To help fail you should discount as mere quirk, with no useful message, the method of the rustic, which is the same one used in Carson’s speech.

What Carson did was to approach the study of how to create X by turning the question backward, that is, by studying how to create non-X. The great algebraist, Jacobi, had exactly the same approach as Carson and was known for his constant repetition of one phrase: “Invert, always invert.” It is in the nature of things, as Jacobi knew, that many hard problems are best solved only when they are addressed backward. For instance, when almost everyone else was trying to revise the electromagnetic laws of Maxwell to be consistent with the motion laws of Newton, Einstein discovered special relativity as he made a 180 degree turn and revised Newton’s laws to fit Maxwell’s.

It is my opinion, as a certified biography nut, that Charles Robert Darwin would have ranked near the middle of the Harvard School graduating class of l 986. Yet he is now famous in the history of


science. This is precisely the type of example you should learn nothing from if bent on minimizing your results from your own endowment.

Darwin’s result was due in large measure to his working method, which violated all my rules for misery and particularly emphasized a backward twist in that he always gave priority attention to evidence tending to disconfirm whatever cherished and hard-won theory he already had. In contrast, most people early achieve and later intensify a tendency to process new and disconfirming information so that any original conclusion remains intact. They become people of whom Philip Wylie observed: “ You couldn't squeeze a dime between what they already know and what they will never learn.”

The life of Darwin demonstrates how a turtle may outrun the hares, aided by extreme objectivity, which helps the objective person end up like the only player without blindfold in a game of pin-the-donkey.

If you minimize objectivity, you ignore not only a lesson from Darwin but also one from Einstein. Einstein said that his successful theories came from: "Curiosity, concentration, perseverance and self-criticism." And by self-criticism he meant the testing and destruction of his own well-loved ideas.

Finally, minimizing objectivity will help you lessen the compromises and burdens of owning worldly goods, because objectivity does not work only for great physicists and biologists. It also adds power to the work of a plumbing contractor in Bemidji, Therefore, if you interpret being true to yourself as requiring that you retain every notion of your youth you will be safely underway, not only toward maximizing ignorance, but also toward whatever misery can be obtained through unpleasant experiences in business.

It is fitting now that a backward sort of speech end with a backward sort of toast, inspired by Elihu Roofs repeated accounts of how the dog went to Dover, “leg over leg.” To the class of 1986:

Gentlemen, may each of you rise high by spending each day of a long life aiming low.


The Great Financial Scandal of 2003

NOTE: This article was distributed at the 2001 Wesco annual meeting, as part of a package of

materials entitled "Some Investment-Related Talks and Writings Made or Selected by Charles T.

Munger".

Unlike the other readings in this booklet, I don't believe this has ever been published before. It

details a hypothetical financial scandal in 2003 (so Munger is a little early), triggered by dishonest

accounting, especially for options, at an imaginary tech company called Quant Tech (which appears to

be a bit of Cisco, IBM and the like).

After 2003, people came to see the Quant Tech story as a sort of morality play, divided into two

acts. Act One, the era of the great founding engineer, was seen as a golden age of sound values. Act

Two, the era of the founder's immediate successors, was seen as the age of false values with Quant Tech

becoming, in the end, a sort of latter day Sodom or Gomorrah.

In fact, as this account will make clear, the change from good to evil did not occur all at once

when Quant Tech's founder died in 1982. Much good continued after 1982, and serious evil had existed

for many years prior to 1982 in the financial culture in which Quant Tech had to operate.

The Quant Tech story is best understood as a classic sort of tragedy in which a single flaw is

inexorably punished by remorseless Fate. The flaw was the country's amazingly peculiar accounting

treatment for employee stock options. The victims were Quant Tech and its country. The history of the

Great Financial Scandal, as it actually happened, could have been written by Sophocles.

As his life ended in 1982, Albert Berzog Quant delivered to his successors and his Maker a

wonderfully prosperous and useful company. The sole business of Quant Tech was designing, for fees,

all over the world, a novel type of super-clean and super-efficient small power plant that improved

electricity generation.

By 1982 Quant Tech had a dominant market share in its business and was earning $100 million

on revenues of $1 billion. It's costs were virtually all costs to compensate technical employees engaged

in design work. Direct employee compensation cost amounted to 70% of revenues. Of this 70%, 30%

was base salaries and 40% was incentive bonuses being paid out under an elaborate system designed by

the founder. All compensation was paid in cash. There were no stock options because the old man had

considered the accounting treatment required for stock options to be "weak, corrupt and

contemptible," and he no more wanted bad accounting in his business than he wanted bad engineering.

Moreover, the old man believed in tailoring his huge incentive bonuses to precise performance

standards established for individuals or small groups, instead of allowing what he considered

undesirable compensation outcomes, both high and low, such as he believed occurred under other

companies' stock option plans.


Yet, even under the old man's system, most of Quant Tech's devoted longtime employees were

becoming rich, or sure to get rich. This was happening because the employees were buying Quant Tech

stock in the market, just like non-employee shareholders. The old man had always figured that people

smart enough, and self-disciplined enough, to design power plants could reasonably be expected to take

care of their own financial affairs in this way. He would sometimes advise an employee to buy Quant

Tech stock, but more paternalistic than that he would not become.

By the time the founder died in 1982, Quant Tech was debt free and, except as a reputation-

enhancer, really didn't need any shareholders' equity to run its business, no matter how fast revenues

grew. However, the old man believed with Ben Franklin that "it is hard for an empty sack to stand

upright," and he wanted Quant Tech to stand upright. Moreover, he loved his business and his

coworkers and always wanted to have on hand large amounts of cash equivalents so as to be able to

maximize work-out or work-up chances if an unexpected adversity or opportunity came along. And so in

1982 Quant Tech had on hand $500 million in cash equivalents, amounting to 50% of revenues.

Possessing a strong balance sheet and a productive culture and also holding a critical mass of

expertise in a rapidly changing and rapidly growing business, Quant Tech, using the old man's methods,

by 1982 was destined for 20 years ahead to maintain profits at 10% of revenues while revenues

increased at 20% per year. After this 20 years, commencing in 2003, Quant Tech's profit margin would

hold for a very long time at 10% while revenue growth would slow down to 4% per year. But no one at

Quant Tech knew precisely when its inevitable period of slow revenue growth would begin.

The old man's dividend policy for Quant Tech was simplicity itself: He never paid a dividend.

Instead, all earnings simply piled up in cash equivalents.

Every truly sophisticated investor in common stocks could see that the stock of cash-rich Quant

Tech provided a splendid investment opportunity in 1982 when it sold at a mere 15 times earnings and,

despite its brilliant prospects, had a market capitalization of only $1.5 billion. This low market

capitalization, despite brilliant prospects, existed in 1982 because other wonderful common stocks were

also then selling at 15 times earnings, or less, as a natural consequence of high interest rates then

prevailing plus disappointing investment returns that had occurred over many previous years for holders

of typical diversified portfolios of common stocks.

One result of Quant Tech's low market capitalization in 1982 was that it made Quant Tech's

directors uneasy and dissatisfied right after the old man's death. A wiser board would then have bought

in Quant Tech's stock very aggressively, using up all cash on hand and also borrowing funds to use in the

same way. However, such a decision was not in accord with conventional corporate wisdom in 1982.

And so the directors made a conventional decision. They recruited a new CEO and CFO from outside

Quant Tech, in particular from a company that then had a conventional stock option plan for employees

and also possessed a market capitalization at 20 times reported earnings, even though its balance sheet

was weaker than Quant Tech's and its earnings were growing more slowly than earnings at Quant Tech.

Incident to the recruitment of the new executives, it was made plain that Quant Tech's directors wanted

a higher market capitalization, as soon as feasible.


The newly installed Quant Tech officers quickly realized that the company could not wisely

either drive its revenues up at an annual rate higher than the rate in place or increase Quant Tech profit

margin. The founder had plainly achieved an optimum in each case. Nor did the new officers dare tinker

with an engineering culture that was working so well. Therefore, the new officers were attracted to

employing what they called "modern financial engineering" which required prompt use of any and all

arguably lawful methods for driving up reported earnings, with big, simple changes to be made first.

By a strange irony of fate, the accounting convention for stock options that had so displeased

Quant Tech's founder now made the new officers' job very easy and would ultimately ruin Quant Tech's

reputation. There was now an accounting convention in the United States that, provided employees

were first given options, required that when easily marketable stock was issued to employees at a

below-market price, the bargain element for the employees, although roughly equivalent to cash, could

not count as compensation expense in determining a company's reported profits. This amazingly

peculiar accounting convention had been selected by the accounting profession, over the objection of

some of its wisest and most ethical members, because corporate managers, by and large, preferred that

their gains from exercising options covering their employers' stock not be counted as expense in

determining their employers' earnings. The accounting profession, in making its amazingly peculiar

decision, had simply followed the injunction so often followed by persons quite different from

prosperous, entrenched accountants. The injunction was that normally followed by insecure and

powerless people: "His bread I eat, his song I sing." Fortunately, the income tax authorities did not have

the same amazingly peculiar accounting idea as the accounting profession. Elementary common sense

prevailed, and the bargain element in stock option exercises was treated as an obvious compensation

expense, deductible in determining income for tax purposes.

Quant Tech's new officers, financially shrewd as they were, could see at a glance that , given the

amazingly peculiar accounting convention and the sound income-tax rules in place, Quant Tech had a

breathtakingly large opportunity to increase its reported profits by taking very simple action. The fact

that so large a share of Quant Tech's annual expense was incentive bonus expense provided a "modern

financial engineering" opportunity second to none.

For instance, it was mere child's play for the executives to realize that if in 1982 Quant Tech had

substituted employee stock option exercise profits for all its incentive bonus expense of $400 million,

while using bonus money saved, plus option prices paid, to buy back all shares issued in option exercises

and keeping all else the same, the result would have been to drive Quant Tech 1982 reported earnings

up by 400% to $500 million from $100 million while shares outstanding remained exactly the same! And

so it seemed that the obviously correct ploy for the officers was to start substituting employee stock

option exercise profits for incentive bonuses. Why should a group of numerate engineers care whether

their bonuses were in cash of virtually perfect equivalents of cash? Arranging such substitutions, on any

schedule desired, seemed like no difficult chore.

However, it was also mere child's play for the new officers to realize that a certain amount of

caution and restraint would be desirable in pushing their new ploy. Obviously, if they pushed their new

ploy too hard in any single year there might be rebellion from Quant Tech's accountants or undesirable


hostility from other sources. This, in turn, would risk killing a goose with a vast ability to deliver golden

eggs, at least to the officers. After all, it was quite clear that their ploy would be increasing reported

earnings only by adding to real earnings an element of phony earnings - phony in the sense that Quant

Tech would enjoy no true favorable economic effect (except temporary fraud-type effect similar to that

from over counting closing inventory) from that part of reported earnings increases attributable to use

of the ploy. The new CEO privately called the desirable, cautious approach "wisely restrained

falsehood".

Plainly, the new officers saw, it would be prudent to shift bonus payments to employee stock

option exercise profits in only a moderate amount per year over many years ahead. They privately called

the prudent plan they adopted their "dollop by dollop system" which they believed had four obvious

advantages:

First , a moderate dollop of phony earnings in any single year would be less likely to be noticed

than a large dollop.

Second , the large long-term effect from accumulating many moderate dollops of phony

earnings over the years would also tend to be obscured in the "dollop by dollop system." As the CFO

pithily and privately said: "If we mix only a moderate minority share of turds with the raisins each year,

probably no one will recognize what will ultimately become a very large collection of turds."

Third , the outside accountants, once they had blessed a few financial statements containing

earnings increases only a minority share of which were phony, would probably find it unendurably

embarrassing not to bless new financial statements containing only the same phony proportion of

reported earnings increase.

Fourth , the "dollop by dollop system" would tend to prevent disgrace, or something more

seriously harmful, for Quant Tech's officers. With virtually all corporations except Quant Tech having

ever-more-liberal stock option plans, the officers could always explain that a moderate dollop of shift

toward compensation in option-exercise form was needed to help attract or retain employees. Indeed,

given corporate culture and stock market enthusiasm likely to exist as a consequence of the strange

accounting convention for stock options, this claim would often be true.

With these four advantages, the "dollop by dollop system" seemed so clearly desirable that it

only remained for Quant Tech's officers to decide how big to make their annual dollops of phony

earnings. This decision, too, turned out to be easy. The officers first decided upon three reasonable

conditions they wanted satisfied:

First , they wanted to be able to continue their "dollop by dollop system" without major

discontinuities for 20 years.

Second , they wanted Quant Tech's reported earnings to go up by roughly the same percentage

each year throughout the whole 20 years because they believed that financial analysts, representing


institutional investors, would value Quant Tech's stock higher if reported annual earnings growth never

significantly varied.

Third , to protect credibility for reported earnings, they never wanted to strain credulity of

investors by reporting, even in their 20th year, that Quant Tech was earning more than 40% of revenues

from designing power plants.

With these requirements, the math was easy, given the officers assumption that Quant Tech's

non-phony earnings and revenues were both going to grow at 20% per year for 20 years. The officers

quickly decided to use their "dollop by dollop system" to make Quant Tech's reported earnings increase

by 28% per year instead of the 20% that would have been reported by the founder.

And so the great scheme of "modern financial engineering" went forward toward tragedy at

Quant Tech. And few disreputable schemes of man have ever worked better in achieving what was

attempted. Quant Tech's reported earnings, certified by its accountants, increased regularly at 28% per

year. No one criticized Quant Tech's financial reporting except a few people widely regarded as

impractical, overly theoretical, misanthropic cranks. It turned out that the founder's policy of never

paying dividends, which was continued, greatly helped in preserving credibility for Quant Tech's reports

that its earnings were rising steadily at 28% per year. With cash equivalents on hand so remarkably high,

the Pavlovian mere-association effects that so often impair reality recognition served well to prevent

detection of the phony element in reported earnings.

It was therefore natural, after the "dollop by dollop system" had been in place for a few years,

for Quant Tech's officers to yearn to have Quant Tech's reported earnings per share keep going up at

28% per year while cash equivalents grew much faster than they were then growing. This turned out to

be a snap. By this time, Quant Tech's stock was selling at a huge multiple of reported earnings, and the

officers simply started causing some incremental stock-option exercises that were not matched either

by reductions in cash bonuses paid or by repurchases of Quant Tech's stock. This change, the officers

easily recognized, was a very helpful revision of their original plan. Not only was detection of the phony

element in reported earnings made much more difficult as cash accumulation greatly accelerated, but

also a significant amount of Ponzi-scheme or chain-letter effect was being introduced into Quant Tech,

with real benefits for present shareholders, including the officers.

At this time the officers also fixed another flaw in their original plan. They saw that as Quant

Tech's reported earnings, containing an increasing phony element, kept rising at 28%, Quant Tech's

income taxes as a percentage of reported pre-tax earnings kept going lower and lower. This plainly

increased chances for causing undesired questions and criticism. This problem was soon eliminated.

Many power plants in foreign nations were built and owned by governments, and it proved easy to get

some foreign governments to raise Quant Tech's design fees, provided that in each case slightly more

than the fee increase was paid back in additional income taxes to the foreign government concerned.

Finally, for 2002, Quant Tech reported $16 billion in earnings on $47 billion of revenues that

now included a lot more revenue from interest on cash equivalents than would have been present

without net issuances of new stock over the years. Cash equivalents on hand now amounted to an


astounding $85 billion, and somehow it didn't seem impossible to most investors that a company

virtually drowning in so much cash could be earning the $16 billion it was reporting. The market

capitalization of Quant Tech at its peak early in 2003 became $1.4 trillion, about 90 times earnings

reported for 2002.

However, all man's desired geometric progressions, if a high rate of growth is chosen, at last

come to grief on a finite earth. And the social system for man on earth is fair enough, eventually, that

almost all massive cheating ends in disgrace. And in 2003 Quant Tech failed in both ways.

By 2003, Quant Tech's real earning power was growing at only 4% per year after sales growth

had slowed to 4%. There was now no way for Quant Tech to escape causing a big disappointment for its

shareholders, now largely consisting of institutional investors. This disappointment triggered a shocking

decline in the price of Quant Tech stock which went down suddenly by 50%. This price decline, in turn,

triggered a careful examination of Quant Tech's financial reporting practices which, at long last,

convinced nearly everyone that a very large majority of Quant Tech's reported earnings had long been

phony earnings and that massive and deliberate misreporting had gone on for a great many years. This

triggered even more price decline for Quant Tech stock until in mid-2003 the market capitalization of

Quant Tech was only $140 billion, down 90% from its peak only six months earlier.

A quick 90% decline in the price of the stock of such an important company, that was previously

so widely owned and admired, caused immense human suffering, considering the $1.3 trillion in market

value that had disappeared. And naturally, with Quant Tech's deserved disgrace, the public and political

reaction included intense hatred and revulsion directed at Quant Tech, even though its admirable

engineers were still designing the nation's best power plants.

Moreover, the hatred and revulsion did not stop with Quant Tech. It soon spread to other

corporations, some of which plainly had undesirable financial cultures different from Quant Tech's only

in degree. The public and political hatred, like the behavior that had caused it, soon went to gross excess

and fed upon itself. Financial misery spread far beyond investors into a serious recession like that of

Japan in the 1990s following the long period of false Japanese accounting.

There was huge public antipathy to professions following the Great Scandal. The accounting

profession, of course, got the most blame. The rule-making body for accountants had long borne the

acronym "F.A.S.B." And now nearly everyone said this stood for "Financial Accounts Still Bogus".

Economics professors likewise drew much criticism for failing to blow the whistle on false

accounting and for not sufficiently warning about eventual bad macroeconomic effects of widespread

false accounting. So great was the disappointment with conventional economists that Harvard's John

Kenneth Galbraith received the Nobel Prize in economics. After all, he had once predicted that massive,

undetected corporate embezzlement would have a wonderfully stimulating effect on the economy. And

people could now see that something very close to what Galbraith had predicted had actually happened

in the years preceding 2003 and had thereafter helped create a big, reactive recession.


With Congress and the S.E.C. so heavily peopled by lawyers, and with lawyers having been so

heavily involved in drafting financial disclosure documents now seen as bogus, there was a new "lawyer"

joke every week. One such was: "The butcher says 'the reputation of lawyers has fallen dramatically',

and the check-out clerk replies: "How do you fall dramatically off a pancake?'"

But the hostility to established professions did not stop with accountants, economists and

lawyers. There were many adverse "rub-off" effects on reputations of professionals that had always

performed well, like engineers who did not understand the financial fraud that their country had made

not a permissible option but a legal requirement.

In the end, much that was good about the country, and needed for its future felicity, was widely

and unwisely hated.

At this point, action came from a Higher Realm. God himself, who reviews all, changed His

decision schedule to bring to the fore the sad case of the Great Financial Scandal of 2003. He called in

his chief detective and said, "Smith, bring in for harsh but fair judgment the most depraved of those

responsible for this horrible outcome."

But when Smith brought in a group of security analysts who had long and uncritically touted the

stock of Quant Tech, the Great Judge was displeased. "Smith," he said, "I can't come down hardest on

low-level cognitive error, much of it subconsciously caused by the standard incentive systems of the

world."

Next, Smith brought in a group of S.E.C. Commissioners and powerful politicians. "No, no," said

the Great Judge, "These people operate in a virtual maelstrom of regrettable forces and can't reasonably

be expected to meet the behavioral standard you seek to impose."

Now the chief detective thought he had gotten the point. He next brought in the corporate

officers who had practiced their version of "modern financial engineering" at Quant Tech. "You are

getting close," said the Great Judge, "but I told you to bring in the most depraved. These officers will, of

course, get strong punishment for their massive fraud and disgusting stewardship of the great

engineer's legacy. But I want you to bring in the miscreants who will soon be in the lowest circle in Hell,

the ones who so easily could have prevented all this calamity."

At last the chief detective truly understood. He remembered that the lowest circle of Hell was

reserved for traitors. And so he now brought in from Purgatory a group of elderly persons who, in their

days on earth, had been prominent partners in major accounting firms. "Here are your traitors," said the

chief detective. "They adopted the false accounting convention for employee stock options. They

occupied high positions in one of the noblest professions, which, like Yours, helps make society work

right by laying down the right rules. They were very smart and securely placed, and it is inexcusable that

they deliberately caused all this lying and cheating that was so obviously predictable. They well knew

what they were doing was disastrously wrong, yet they did it anyway. Owing to press of business in Your

Judicial System, you made a mistake at first in punishing them so lightly. But now you can send them

into the lowest circle in Hell."


Startled by the vehemence and presumption, the Great Judge paused. Then He quietly said:

"Well done, my good and faithful servant."

This account is not an implied prediction about 2003. It is a work of fiction.

Except in the case of Professor Galbraith, any resemblances to real persons or companies is

accidental. It was written in an attempt to focus possibly useful attention on certain modern behaviors

and belief systems.


Charlie Munger's Recommended Reading List

"Deep Simplicity: Bringing Order to Chaos and Complexity" by John Gribbin, Random House 2005

"F.I.A.S.C.O.: The Inside Story of a Wall Street Trader" by Frank Portnoy, Penguin Books (1999)

"Ice Age" by John and Mary Gribbin, Barnes & Noble (2002)

"How the Scots Invented the Modern World" by Arthur Herman, Three Rivers Press (2002)

"Models of My Life" by Herbert A. Simon, The MIT Press (1996)

"A Matter of Degrees: What Temperature Reveals About the Past and Future of Our Species, Planet, and

Universe" by Gino Segre, Viking Books (2002)

"Andrew Carnegie" by Joseph Frazier Wall, Oxford University Press (1970)

"Guns, Germs, and Steel: The Fate of Human Societies" Jared M. Diamond, W. W. Norton & Co (1999)

"The Third Chimpanzee: The Evolution and Future of the Human Animal" by Jared M. Diamond,

Perennial (1999)

"Influence: The Psychology of Persuasion" by Robert B. Cialdini, Perennial Currents (1998)

"The Autobiography of Benjamin Franklin" by Benjamin Franklin, Yale Nota Bene (2003)

"Living Within Limits: Ecology, Economics, and Population Taboos" by Garrett Hardin, Oxford University

Press (1995)

"The Selfish Gene" by Richard Dawkins, Oxford University Press (1990)

"Titan: The Life and Times of John D. Rockefeller." by Ron Chernow, Vintage (2004)

"The Wealth and Poverty of Nations: Why Some Are So Rich and Some Are So Poor" by David S. Landes,

W. W. Norton and Co. (1998)

"The Warren Buffet Portfolio: Mastering the Power of the Focus Investment Strategy" by Robert G.

Hagstrom, Wiley (2000)

"Genome: The Autobiography of a Species in 23 Chapters" by Matt Ridley, HarperCollins Publishers

(2000)

"Getting to Yes: Negotiating Agreement Without Giving In" by Robert Fisher, William Ury, and Bruce

Patton, Penguin Books (1991)


"Three Scientists and Their Gods: Looking for Meaning in an Age of Information" by Robert Wright,

HarperCollins Publishers (1989)

"Only the Paranoid Survive" by Andy Grove, Currency (1996)

charlie munger the most logical person ever edited by andrew kunian

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