My views on the market, tech, and everything else

Charlie Munger on The Psychology of Human Misjudgment

“…the brain should be using the simple probability mathematics of Fermat and Pascal applied to all reasonably obtainable and correctly weighted items of information that are of value in predicting outcomes…”  Charlie Munger  http://www.rbcpa.com/Mungerspeech_june_95.pdf

To cope with information and computation overload, humans have developed simple “rules of thumb” called “heuristics” which  allow them to make decisions.  It would be great if people could do what Charlie describes above, but it is just not possible.  Decision making heuristics are sometimes beneficial and sometimes not.  Catching a fly ball in a baseball games involves a heuristic which works very well.  Really skillful people who know their limitations well can sometimes use heuristics to their advantage including his partner Warren Buffett and Ajit Jain.  Munger points out:

“There is a close collaboration between Warren and Ajit Jain. I’ve known both a long long time and if there are two better people on this earth to do this [super cat underwriting], I don’t know who they are. We can’t guarantee results, but they’ve done fine — in fact, more than fine.  Sometimes they will do things where it’s a straight Pascalian calculation — the odds are x and we get paid at a rate that give us better odds than Las Vegas. The reason other people won’t do it is because if they’re wrong, it’ll be a big money loss, but Berkshire can handle a big number loss. I’m quite comfortable watching those two people do it.  I wish I could do it, but I can’t. It’s reasonable heuristics by two tough, sharp-minded men.”  http://www.tilsonfunds.com/motley_berkshire_wscmtg03notes.php

Unfortunately, particularly in the context of human activities that are not really part of our evolutionary past (such as investing), euristics can produce boneheaded mistake after mistake.  Zeckhauser, who Charlie Munger admires greatly for his decision making processes in bridge, writes that “individuals tend to extrapolate heuristics from situations where they make sense to those where they do not.”  Charlie notes:

“bias [arises] from the non-mathematical nature of the human brain in its natural state as it deal with probabilities employing crude heuristics, and is often misled”   http://www.rbcpa.com/Mungerspeech_june_95.pdf

Why does this happen?

“The simple truth is that we aren’t adapted to face the world as it is today. We evolved in a very different environment, and it is that ancestral evolutionary environment that governs the way in which we think and feel. We can learn to push our minds into alternative ways of thinking, but it isn’t easy as we have to overcome the limits to learning posed by self-deception. In addition, we need to practice the reframing of data into more evolutionary familiar forms if we are to process it correctly.”  James Montier  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=373321

“Sometimes heuristics are good for making decisions, while at other times heuristics are bad for making decisions. The reason for this mixed or nuanced answer is namely heuristics act faster than rational deliberation, but precisely because of their speed, heuristics can mislead us into systematic errors in making decisions”.  Huang  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=474661

Some of Charlie’s most powerful writing consists of a narrative list of the various dysfunctional heuristics that impact human decision making.   Munger’s writing and speaking in not as academic as others like Dan Ariely, Daniel Kahneman, James  Montier and Michael Mauboussin (see generally   http://www.theatlantic.com/business/archive/2013/01/the-irrational-consumer-why-economics-is-dead-wrong-about-how-we-make-choices/267255/   ), but he is often more amusing and practical.  He is certainly more direct in many cases.  For a great graphic see:  This is your brain on behavioural economics http://www.ritholtz.com/blog/2013/01/this-is-your-brain-on-behavioural-economics/

As was discussed previously in this series of blog posts, investing is less than a zero sum game due to expenses. If you are buying an investment someone else is selling and vice versa.  Someone is by definition wrong.  If the other person does not understand behavioral economics and you do, that is a potential edge.  As a professor at Colombia business school noted recently:  “There is a lot of behavioral finance confirming Ben Graham’s original judgment.” http://www4.gsb.columbia.edu/valueinvesting/news/item/7232425/Greenwald%3A+How+to+Beat+the+Market+with+Discipline#

The essay in Poor Charlie’s Almanack is his most recent and comprehensive version of what he calls “The Psychology of Human Misjudgment.”   There is not much point in rewriting what Charlie says in different words, but perhaps I can find more recent examples that are informative and/or amusing.

  1. Reward and Punishment Super-response Tendency”

“almost everyone thinks he fully recognizes how important incentives and disincentives are in changing cognition and behavior. But this is not often so. For instance, I think I’ve been in the top five percent of my age cohort almost all my adult life in understanding the power of incentives, and yet I’ve always underestimated that power. Never a year passes but I get some surprise that pushes a little further my appreciation of incentive superpower.”  Munger

Structuring compensation incentives is critical. For example, it is surprising how many people fail to recognize how performance suffers if you pay someone in advance.  As was noted in an earlier post in this series, Munger and Buffet delegate most management activity, but they keep compensation decisions from themselves.

It is easy to find examples of how improper incentives are, in Munger’s words, “damaging civilization.”  A current example of this problem is raised by Nassim Taleb

“… instead of relying on thousands of meandering pages of regulation, we should enforce a basic principle of “skin in the game” when it comes to financial oversight: “The captain goes down with the ship; every captain and every ship.” In other words, nobody should be in a position to have the upside without sharing the downside, particularly when others may be harmed.”  http://www.fooledbyrandomness.com/sais.pdf

Investment bankers who spend their days creating and selling toxic derivatives have long since abandoned their moral principles driven by the financial incentives that motivate their actions. The Libor rigging scandal is just one recent example.

On the positive side, stock options can motive people to work to create new value in a start up like nothing else really. The idea that a person can win the lottery like an early Instagram employee is a powerful motivator (which is not fully rational but this is getting to another heuristic). Unfortunately, that incentive can go too far and people can end up living in their parent’s basement due to overinvestment in a technology sector.

2.       Liking/Loving Tendency

Munger is pointing out that people tend to ignore or deny the faults of people they love and even distort facts to facilitate that love. There are obviously positive aspects to this tendency for society, but they rarely have place in making investment decisions.  You may like or even love your friend, but that does not mean that you should trust him or her with your money.  I suspect that Charlie is saying that one needs to be particularly careful with decisions when you like/love someone. Rihanna getting back together with Chris Brown seems fraught with risk. 😉

3.        Disliking/Hating Tendency

This is of course the inverse of the previous tendency. Munger is clear that life is too short to do business with people you don’t like.  Charlie advises: “Avoid evil, particularly if they’re attractive members of the opposite sex.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf

That someone is “family” does not mean they fall outside of the dislike/hating tendency.  Munger quotes Buffett in this section: “a major difference between rich and poor people is that the rich people can spend more of their time suing their relatives.”  Again, being extra careful in your decision making process when you dislike someone seems to be the suggestion from Charlie. Stay rational.

4.       Doubt-Avoidance Tendency

Particularly in the face of stress or puzzlement people tend to remove any doubt that might interfere with a decision.  It is in Munger’s words: “counterproductive for a prey animal that is threatened by a predictor to take a long time in deciding what to do.”  Munger feels this tendency can express itself in religion. As another example: What were Madoff’s investors thinking when month after month they received financial statements that were positive with little volatility?  A blogger puts it this way in reviewing one of Munger’s favorite books (Influence by Cialdini):  “Faced with vast amounts of data and a shortage of time we opt for simplicity, and focus on a few salient signals which generally work.” http://www.psyfitec.com/2011/09/robert-cialdini-and-weapons-of.html

5.       Inconsistency-Avoidance Tendency

“The brain of man conserves programing spaces by being reluctant to change.” Munger

Munger believes that if you combine Doubt-Avoiding Tendency with a desire to resist any change in that conclusion, ugly things can result.  An example might be DEC which refused to recognize that the personal computer was a threat to its business.  Steve Wozniak has said that HP turned down making the Apple I five times.

A positive example of how this heuristic might operate may be found in how very young company founders who are not wedded to old ideas can sometimes create disruptive business more easily.  Mark Twain’s statement comes to mind on this tendency:  “All you need in this life is ignorance and confidence; then success is sure.”  Twain should have added that 19 people adopting that approach will lose everything and one might strike it rich, but that is another set of topics (e.g., optionality; survivor bias).

6.       Curiosity Tendency

I have a hard time with Munger’s description on this one when it comes to downside risk.  He describes curiosity as something good for society. There must be some flip side that I he does not reveal along the lines of “curiosity kills the cat.”  Perhaps he is referring to the tycoon who is curious to see whether he or she can finally be the person to make a profit in the airline business. Kingfisher in India is a recent example of a company that is in trouble due to excessive curiosity related to airlines.   Richard Branson may have a very fine airline in Virgin in terms of quality, but profitability is elusive. Buffett himself jokes that he has a 1-800 number he calls which will talk him out of investing in airlines whenever he gets the urge.

7.       Kantian Fairness Tendency

“modern acculturated man displays and expects from others a lot of fairness”  Munger

All in all, this tendency seems a very good thing.  In terms of generating dysfunction, perhaps Charlie is referring to how humans will act irrationally to punish those who are not fair.  A leading blogger on the psychology of investing writes:  “Economists for a long time took the view that people would accept any offer made to them as long as they were better off, yet many studies have shown that this isn’t true and that people will reject offers they view as unfair.”   http://www.psyfitec.com/2011/09/robert-cialdini-and-weapons-of.html

8.       Envy/Jealousy Tendency

The dangers of envy are a frequent Munger topic.  How can I improve on the master?

 “The idea of caring that someone is making money faster [than you are] is one of the deadly sins. Envy is a really stupid sin because it’s the only one you could never possibly have any fun at. There’s a lot of pain and no fun. Why would you want to get on that trolley?”  http://www.fool.com/news/commentary/2003/commentary030509wt.htm    

“…Missing out on some opportunity never bothers us. What’s wrong with someone getting a little richer than you? It’s crazy to worry about this….”  http://www.tilsonfunds.com/wscmtg05notes.pdf

“Here’s one truth that perhaps your typical investment counselor would disagree with: if you’re comfortably rich and someone else is getting richer faster than you by, for example, investing in risky stocks, so what?! Someone will always be getting richer faster than you. This is not a tragedy.  http://www.fool.com/BoringPort/2000/boringport00051501.htm 

“We have a higher percentage of the intelligentsia engaged in buying and selling pieces of paper and promoting trading activity than in any past era. A lot of what I see now reminds me of Sodom and Gomorrah. You get activity feeding on itself, envy and imitation. It has happened in the past that there came bad consequences.”  http://money.cnn.com/2005/05/01/news/fortune500/buffett_talks/index.htm

“Well envy/jealousy made, what, two out of the ten commandments? Those of you who have raised siblings you know about envy, or tried to run a law firm or investment bank or even a faculty? I’ve heard Warren say a half a dozen times, “It’s not greed that drives the world, but envy.”  http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htm  

9.       Reciprocation Tendency

People behave irrationally when they feel the need to reciprocate. That’s why the Hare Krishna fundraiser gives away a flower when he or she approaches.  A professor writes:

“When we are given a gift, we feel indebted to the giver, often feel uncomfortable with this indebtedness, and feel compelled to cancel the debt…often against our better judgment. The rule of reciprocation is widespread across human cultures, suggesting that it is fundamental to creating interdependencies on which societies, cultures, and civilizations are built. In effect, the rule of reciprocation assures that someone can give something away first, with the relative assurance that this initial gift will eventually be repaid–nothing is lost.” http://www.media-studies.ca/articles/influence.htm

As one example, Munger notes:

“…people are really crazy about minor decrements down. And then, if you act on them, then you get into reciprocation tendency, because you don’t just reciprocate affection, you reciprocate animosity, and the whole thing can escalate. And so huge insanities can come from just subconsciously over-weighing the importance of what you’re losing or almost getting and not getting.” http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htmv

10.   Influence-from-Mere Association Tendency

Humans can easily be misled by mere association.  Munger writes in Poor Charlie’s Almanack: responsive behavior, creating a new habit, is directly triggered by reward previously bestowed.”  He goes on to write about a range of phenomena that arise from this tendency like Persian Messenger Syndrome (AKA “shoot the messenger”).

“Think how association, pure association, works. Take Coca-Cola company (we’re the biggest share-holder). They want to be associated with every wonderful image: heroics in the Olympics, wonderful music, you name it. They don’t want to be associated with presidents’ funerals and so-forth.”  http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htm

“At most corporations if you make an acquisition and it turns out to be a disaster, all the paperwork and presentations that caused the dumb acquisition to be made are quickly forgotten. You’ve got denial, you’ve got everything in the world. You’ve got Pavlovian association tendency. Nobody even wants to even be associated with the damned thing or even mention it. At Johnson & Johnson, they make everybody revisit their old acquisitions and wade through the presentations. That is a very smart thing to do. And by the way, I do the same thing routinely.”   http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htm

The next blog post in this series about Munger’s Methods’ will discuss Munger’s 15 other tendencies.


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