Charlie Munger & Mental Models

War­ren Buffett’s right-hand man is Char­lie Munger. I’ve read tran­scripts from sev­er­al of Munger’s speech­es, and I real­ly love the mul­ti­dis­ci­pli­nary way he approach­es invest­ment deci­sions.

When he cites the idea of mar­ket nich­es as a way to build a durable com­pet­i­tive advan­tage, he bor­rows that con­cept from the field of ecol­o­gy. In nature, it’s not the species with the great­est pop­u­la­tion that sur­vives. It’s the species that per­forms a niche func­tion in the eco­log­i­cal sys­tem that isn’t being served by anoth­er species.

When Munger talks about con­sumer brands reach­ing a crit­i­cal mass of con­sumer aware­ness, he bor­rows the con­cept of crit­i­cal mass from the field of physics.

One of my favorite Munger-isms is the con­cept of the men­tal mod­el. This is some­thing I’ve used for my entire career, and it was encour­ag­ing to real­ize that Munger uses some­thing sim­i­lar.

Here’s my ver­sion of a men­tal mod­el.

A men­tal mod­el is an idea you have in your head about a par­tic­u­lar sit­u­a­tion.

For exam­ple, the men­tal mod­el you have about your busi­ness is your men­tal pic­ture of how your busi­ness oper­ates.

Your men­tal mod­el is what enables you to have expec­ta­tions about how the busi­ness will per­form.

If you bring in 1,000 leads, you know through expe­ri­ence that you should pro­duce 100 clients, and you know the cor­re­spond­ing expect­ed rev­enue of each.

Now, here is the key insight when it comes to men­tal mod­els.

Your men­tal mod­el is going to even­tu­al­ly be wrong.

This occurs when there’s a devi­a­tion in what hap­pens in your busi­ness and what you expect­ed to hap­pen.

When this hap­pens, it means your men­tal mod­el is out of date.

This can occur if sales drop dras­ti­cal­ly, and you didn’t see it com­ing.

It can also occur when sales accel­er­ate sud­den­ly, and you didn’t see that com­ing either.

My direct reports all know that any­time any­thing devi­ates from what I expect, I will be ask­ing a series of ques­tions that begin with “why?”

Sce­nario 1:

Direct Report: “Sales went up 20%, unex­pect­ed­ly…”

Me: “Why?”

Sce­nario 2:

Direct Report: “Sales went down 20%, unex­pect­ed­ly…”

Me: “Why?”

Back in the 1990s, Gen­er­al Elec­tric was con­sid­ered an incred­i­bly well-run com­pa­ny. Its CEO at the time was the leg­endary Jack Welch. Welch was famous for absolute­ly grilling his exec­u­tives any­time actu­al finan­cial per­for­mance devi­at­ed from expect­ed per­for­mance.

Here’s the kick­er.

He was equal­ly harsh if the busi­ness over­per­formed ver­sus inter­nal expec­ta­tions.

In his view, when busi­ness per­for­mance was wild­ly dif­fer­ent than what was expect­ed, it meant the per­son run­ning the busi­ness didn’t real­ly know his or her busi­ness as well as they thought.

In oth­er words, the busi­ness unit leader’s men­tal mod­el of the busi­ness was not accu­rate.

The les­son from all of this is to pay atten­tion to devi­a­tions from your expec­ta­tions. If your cus­tomer sat­is­fac­tion rat­ings come back quite dif­fer­ent than what you expect­ed, that means you don’t real­ly know your cus­tomers as well as you think. If your end of month cash in the bank dif­fers from what you thought it would be, that means the men­tal mod­el of your oper­at­ing cash flow isn’t accu­rate.

When you real­ize your men­tal mod­el isn’t accu­rate (or isn’t accu­rate any­more), the sin­gle most impor­tant thing to do is to fig­ure out… why.