Munger's mental models #11: The bell curve fallacy

Mental models

In this short series of blogs and videos, in honour of the late Charles Munger, I take a look at some of his most powerful mental models.

The Bell Curve distribution

The bell curve is a very useful statistical concept in many circumstances, measuring a distribution of outcomes.

We can intuitively understand when the Bell Curve might be a useful mental model.

For example, when measuring the distribution of the IQ, height, or weight of humans, which we expect to show a 'normal' distribution. 

We won't meet someone who's over 9 feet tall or 220 years old, after all, even if we occasionally meet someone who is very tall or old! 

Expected the unexpected

There are some problems here, though.

For example, in the world of business, investing, and life, there are outsized events which fall outside the normal course of the world we've experienced to date.

Outliers and major unexpected events can have a massive and unexpected impact, and come around surprisingly often...unprecedented black swan events which no expert forecaster or model can reliably predict. 

It's one of the things that makes writing 10-year life plans so tricky, because, well...who knows what might happen?

Bell Curve fallacy

Thinking of a distribution of outcomes in a bell curve can be useful when assessing normal events, such as when an actuary is thinking about life expectancy (or when calculating insurance premiums for flood risk, for example).

We might see high and low outcomes - which might be impressive individually - but they won't affect the averages too much.

But financial markets often follow power laws, where random and unexpected events can trigger dramatic outcomes. 

There are always going to be events which fall outside the realm of the normal distribution, which we saw on 9/11 in 2001. 

By the way, black swan events can be positive as well as negative.

But we do need to appreciate that they can and will happen, probably more regularly than we expect...and position ourselves accordingly.

That means being flexible, resilient, and not having a plan which relies on specific forecasts too heavily.

I discussed this a little further in the short video below:

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