WWII 055: Charlie Munger Mental Model Permutations and Combinations, Covered Calls, Activists in $RMTI

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Main Topic: Charlie Munger's Mental Model for Permutations and Combinations

This episode is about one of the hundred mental models that Charles T. Munger, Vice Chairman of Berkshire Hathaway and investing partner to Warren Buffett uses to make excellent decisions. Here is his description of what a mental model is and how it's a better way to learn and gain wisdom than by simple rote memorization and regurgitation (from Poor Charlie's Almanac which I reviewed in Episode 54):

“What is elementary, wordly 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 whatever is remembered. Well, they fail in school and fail in life. You’ve got to hang experience on a latticework of models in your head.”

The elementary math of permutations and combinations is basic algebra. This math originated in letters written by Pascal and Fermat. This type of math is actually useful in real life. Most people cannot automatically apply this math to real life,

Charlie says that “if you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through life like a one-legged man in an ass kicking contest.”

Let’s start by defining what a permutation is, and then what a combination is.

Permutation sounds complicated, and it is. With permutations, every little detail matters. Nathanial, June and Bobby are different from June, Nathanial and Bobby

Combinations, on the other hand, are pretty easy going. The details don’t matter. Alice, Bob and Charlie is the same as Charlie, Bob and Alice.

Permutations are for lists (order matters) and combinations are for groups (order doesn’t matter).

Permutations are all the possible ways of doing something.

Combinations are all the ways things can go together.

Here is a simple example of permutations. You are starting a club and you have ten people in the club. Out of the ten people, you need to choose a President, Vice President, and Secretary (remember, details matter). Since all ten people could be chosen for each of the three different positions, there are 720 possible permutations.

Here’s an example of combinations. You have the same ten people, but you are choosing a team of three (as a group). The number of possible combinations of three are 120.

This isn’t about the math formula as much as it is about having this mental model in your mind when going through your investment process. A working understanding of permutations and combinations is a working knowledge about probabilities.

Your investing process should include studies of probabilities of various events occurring that could benefit, or harm, your investments. With the permutations and combinations mental model in place, you will recognize situations with multiple possible outcomes, and will be in position to make a rational decision about the probability of each outcome.

A more specific example would be merger arbitrage. With merger arbitrage, you must estimate the probability of a transaction closing as part of your analysis of the situation. There may be both permutations, and combinations of events that could occur to improve, or decrease the odds of the transaction closing. Recognizing all the potential outcomes is the starting point. Then comes the process of estimating which outcome is most likely.

Here are some investing specific examples:

Permutations:

Suppose an investor has decided to purchase shares in the stocks of two aerospace companies, two energy development companies, and to electronics companies. In how many ways may the investor select the group of six companies for investment from the recommended list of five aerospace companies, three energy development companies, and four electronics companies?

This question is a combination question, as the order in which the companies are selected is not important. However, if we added a requirement that of the two electronics companies, one has to be large cap, and one small cap, we have introduced a permutation.

If you become facile with this elementary math, you will begin to look at the world a little differently and start to think about the probabilities of things happening around you. This will lead to better decision trees when you are evaluating potential investments and comparing several to each other, as I discuss in Episode 32 about opportunity cost.

Ask JB: What is a Covered Call?

submitted 14 days ago by buffalo_Fart

JB Says: A Call is a type of option you can buy where you are essentially betting that the underlying stock price will rise. A Covered Call is call that you sell to someone else where the underlying stock is one you currently own. If the option that you sold is in the money and exercised, your stock will be transferred to the owner of the option. Example, I own 100 shares of Apple. I write a covered call with a strike price of $140 and sell it to someone else. The price of Apple rises to above $140 and the option is in the money. The holder of the option exercises it, and all 100 shares of my Apple stock are transferred to the option holder. I keep the premium I was paid for the option, and am paid $140 per share for the stock, less commissions and fees.

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Activist Investor Action Alert in the Stock of $RMTI

Richmond Brothers are seeking two board positions at this long term holding, seeking to unlock what they estimate is $35 per share of shareholder value.

Thoughts on this podcast? Disagree with me on some point? Something I missed? Leave a comment!

About the Author

Jeremy Scott Bailey is an investor, author, entrepreneur and host of the "What Works In Investing?" podcast now available on iTunes. He is founder and Chief Investment Officer of Burgeón Group, Inc. an investment advisory firm that provides portfolio management services to families and individuals.

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