Charlie Munger and Warren Buffett jointly developed the “circle of competence.”
The circle of competence circumscribes one’s area of expertise, envisioned geometrically.
As Warren teaches:
“Know your circle of competence and stick within it. The size of the circle is not very important. Knowing its boundaries, however, is vital.” - Warren E. Buffett
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Charlie reinforced the boundaries in this timeless pronouncement:
“It’s not a competence if you don’t know the edge of it.” - Charlie Munger
Competence Defined
But how is competence defined?
Thinking mathematically, as Charlie would advise, when do we achieve competence?
“Whenever you can, count.” - Francis Galton
When the odds break 50%!
If the outcome is more likely than not, you enter your circle of competence.
There the relentless magic of time and compounding engage.
Sooner or later, but eventually and inevitably, you win.
And win big!
“I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000…. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that’s $2 trillion for those of you who are not government statisticians) by 1962.” - Warren E. Buffett
The Magic of House Odds
“I won’t bet $100 against house odds between now and the grave.” - Charlie Munger
“You don’t have to be brilliant, only a little bit wiser than the other guys, on average, for a long, long time.” - Charlie Munger
“Warren wants the odds in his favor, not somebody else. It’s just so simple. If you’re Warren, you want to be the house, not the punter [gambler].” - Charlie Munger
If we are to understand the world better ancient wisdom is the best proven.
The New York Stock Exchange was established in 1792 under a Buttonwood tree at 68 Wall Street.
Gambling began in antiquity.
In gambling there is the house and there are players.
If the gambling house is to remain standing house odds must exceed 50%. That is, more likely than not.
That is house odds or house edge.
The house edge can vary. It can be a large or small, even a multiple, but in the fullness of time any edge grants success.
“Call it sad. Call it funny. But it’s better than even money…” - Frank Loesser
You Learned It At The Movies
The house edge is a rule of math, a rule of life and a rule of evolution.
Here’s Frank Sinatra, Stubby Kaye and Johnny Silver as Nathan Detroit, Nicely-Nicely Johnson and Benny Southstreet singing of odds and the vagaries of romance in Frank Loesser’s “Guys and Dolls” (1955):
In Martin Scorsese’s classic “Casino,” Robert DeNiro, as Ace Rothstein, pares casino gambling to its essence:
“In the casino the cardinal rule is to keep them playing and keep them coming back. The longer they play, the more they lose. In the end, we get it all.” - Robert DeNiro as Sam “Ace” Rothstein in “Casino” (1995)
World-weary Robert Mitchum, as wayward private detective Jeff Bailey, teaches faux-naif femme fatale Jane Greer’s Kathie Moffett the reality of house odds in the classic film noir “Out of the Past” (1947):
As Bailey explains, against house odds one can only hope to lose more slowly.
Which begs the question: if you don’t have an edge, why play at all?
Why take a bad bet?
“The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t bet. It’s just that simple.” - Charlie Munger
The Allure of the Bad Bet
What is a bad bet?
A bad bet is a bet you are very, very likely to lose.
The proverbial “sucker bet.”
Why would anyone take a bad bet when there are good bets around, even sure bets.
But people choose bad bets all the time. They buy lottery tickets and play the numbers, the horses, roulette wheels, slots and blackjack. Bets where they risk all they bet on the off-chance they might win big.
Why? Why bet if you’re probably going to lose?
B.F. Skinner thought he had the answer in reinforcement theory. All animals in his experiments responded best to irregular and unpredictable rewards, like those of bad bets in gambling.
Three great thinkers: Charlie Munger and psychologists Daniel Kahneman and Amos Tversky looked more deeply into the question and found additional reasons:
- Availability: Bad bets are in your face all the time: lottery tickets and casino gambling, off and online. Good bets are not advertised and sure bets, like stock market index funds, are well-hidden in plain sight;
- Associations: Bad bets are vivid and exciting: Vegas, showgirls, beautiful people, celebrities, entertainment. Movie producers love to feature gambling and casinos in their movies. The first commandment of entertainment is “Thou shalt not bore.” People are bored by mundane, humdrum bets, even then they are sure bets;
- Thrill of risk: We intuitively admire risk-takers. Risk is a rush. Risk-takers at the casino who lose big are still respected as “high rollers,” admired for “taking it like a man” when they lose. Winning that’s a foregone conclusion---shooting fish in a barrel---is dull and even cowardly. Our best entertainments feature beautiful people taking terrible risks, surviving and saving the day. By contrast movie villains are risk averse, hiding behind power and wealth, flunkies and stooges;
- Survivorship bias: we only see the winners. Losers are MIA. Likewise, gamblers delight in their wins and repress their losses. There are no TV stories about lottery addicts, ruined gamblers and options traders gone bankrupt;
- Thrill of fast money: As Charlie Munger teaches, “The desire to get rich fast is pretty dangerous.” Of course, danger is part of the thrill.
A Perennial Win is Boring
There is a marvelous old “Twilight Zone” episode out of the first season called “A Nice Place to Visit.”
Spoiler alert!
Small-time gambler and hood, Henry “Rocky” Valentine, is shot to death in a failed robbery and awakens in a magical, transformed world.
There a jovial Sebastian Cabot, dressed in angelic whites, grants sociopathic Rocky’s every wish: easy money, adoring beauties and infinite luck.
Rocky just can’t lose.
Initially, Rocky is delighted. But after a month of endless wins he is bored and enraged, desperate to escape from this seeming heaven:
Rocky’s afterlife is no heaven for him.
It’s the other place.
Because for Rocky it was never the win that drew him. It was the thrill of risk. Without risk his games yield no pleasure. Indeed they are boring as Hell.
So as Rod Serling snickers his concluding admonishments we absorb our lesson:
There is a little Rocky Valentine in all of us, seeking the thrill of gambling, rather than the reasonable, consistent returns of playing it safe.
