Lesson 3 of 7
Munger: quality and misjudgment
Munger's two contributions, a fair price for a wonderful business, and a long list of the ways judgment goes wrong.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Munger's first contribution: a fair price for a wonderful business beats a wonderful price for a fair one, and Buffett credits him with seeing it first.
- His second: a long, named list of the ways judgment goes wrong, used as a check on your own reasoning, not only other people's.
- The two work together: a sound business chosen for a bad reason is still a bad decision.
Munger's name sits on two ideas in this method. One is about what to buy: a good business at a fair price, held for a long time. The other is about the buyer: a list of how a reasoning mind talks itself into a bad decision.
What each half of Munger's method asks
A wonderful business
- Understandable to the person buying it.
- Run by a manager expected to stay, without needing help from headquarters.
- Bought at a fair price, not the lowest one on offer.
A misjudging mind
- The reward and punishment tendency: an incentive shapes the conclusion, unnoticed.
- The social-proof tendency: copies what others are doing because they are doing it.
- The inconsistency-avoidance tendency: sticks with a past decision to stay consistent with it.
One question is about the business. The other is about the person judging it.
A fair price for a good business
Munger's own account of the Berkshire system, written in the 2014 annual report, states the buying rule plainly: pay a fair price for a good business the chairman can understand. A good manager should already be in place, expected to stay a long time and run the business without help from headquarters.
Buffett's 1989 letter credits the underlying shift, from a statistical bargain to a wonderful company at a fair price, to Munger directly. Buffett credits Munger with grasping this before he did, and calls himself the slower learner. His 2014 letter makes a related point: Munger's blueprint for Berkshire was to buy wonderful businesses at fair prices, not fair businesses at wonderful prices.
A long list of how judgment goes wrong
Munger's other contribution, set out at length in the collection Poor Charlie's Almanack, is a long, named catalogue of the ways a reasoning mind misjudges a situation. He argued for a latticework of mental models drawn from many disciplines, and this list of tendencies is psychology's share of it.
| Tendency | What it does | An investing example |
|---|---|---|
| Reward and punishment tendency (incentive-caused bias) | An incentive quietly shapes the conclusion a person reaches | A broker paid by commission tends to find reasons to trade |
| Social-proof tendency | An idea gains credibility only because others already hold it | A stock looks safer simply because a crowd already owns it |
| Inconsistency-avoidance tendency | A past decision gets defended rather than reconsidered, because it was already made | Holding a loser to avoid admitting the first purchase was wrong |
None of these requires bad faith. Each one operates on a reasonable person who has not named it.
Why the list matters as much as the price rule
A checklist of business quality answers whether the company is good. The misjudgment list answers a different question: whether the person doing the judging can trust their own conclusion. Put together, the two lists say something neither says alone: a good business bought at a fair price can still be a bad decision, if the reasoning that got you there was social proof or a past commitment rather than the business.
Check yourself
In Munger's account of the Berkshire buying rule (2014 letter), what does the business need to be, beyond a fair price?
- The cheapest one available in its industry
- Understandable to the buyer, with a good manager already in place who is expected to stay
- Diversified across as many unrelated industries as possible
Show the answer
Answer: B.
Munger's account adds conditions beyond price: a business the chairman can understand, run by a manager already in place who is expected to stay and needs no help from headquarters.The shrinking business bought at 8x pays out all of its earnings instead of retaining them. What happens to its annualised return over the ten years?
- It stays at −5.0 percent, since the earnings still shrink 5 percent a year
- It rises to about +6.9 percent, since the earnings paid out as cash offset most of the decline
- It rises to +10.0 percent, matching the compounder
Show the answer
Answer: B.
An 8x multiple is a 12.5 percent earnings yield. Paid out in cash every year, that yield outweighs the 5 percent shrinkage, for a return of about 6.9 percent a year.What does the inconsistency-avoidance tendency do to a past investment decision?
- It makes the decision easier to reverse
- It makes a person defend the decision because they already made it, not because the case still holds
- It has no effect on investing decisions
Show the answer
Answer: B.
The tendency defends a past choice for its own sake. A decision journal and a written thesis are the usual defence against it.Sources
- Berkshire Hathaway shareholder letter, 1989: the cigar-butt approach, and a wonderful company at a fair price, credited to Munger.
- Munger, Vice Chairman's Thoughts: Past and Future, Berkshire Hathaway 2014 annual report.
- Kaufman (editor), Poor Charlie's Almanack, 2005: "The Psychology of Human Misjudgment."
What this leaves out
- The two businesses and their growth rates in the worked example are round invented inputs, holding the exit multiple fixed to isolate the earnings effect; a real multiple moves too.
- The misjudgment list is not exhaustive here and names only a few of the tendencies the source describes at length.
- Naming a bias is not the same as being immune to it, including while reading this page.
- Nothing here is advice about any security.