This is a continuation of my previous blog posts on “the Psychology of Human Misjudgment,” which is Charlie Munger’s description of dysfunctional decision making heuristics. Munger writes:
“…tendencies are probably much more good than bad. Otherwise, they wouldn’t be there, working pretty well for man, given his condition and his limited brain capacity. So the tendencies can’t be simply washed out automatically, and shouldn’t be. Nevertheless, the psychological thought system described, when properly understood and used, enables the spread of wisdom and good conduct and facilitates the avoidance of disaster. Tendency is not always destiny, and knowing the tendencies and their antidotes can often help prevent trouble that would otherwise occur.” Poor Charlie’s Almanack
Here is a personal example of potentially dysfunctional heuristics at work. For a few months I had been having slight pain in my biceps near my elbows. My doctor said it was probably an injury from lifting weights. One night about four weeks ago I was sleeping soundly when I was jolted awaked by much more significant bilateral pain in both of my biceps. I immediately thought: “I am having a heart attack; I need to get to an emergency room.” I woke my wife and asked her to get dressed quickly and to get in the car. As we were driving to the hospital the painful sensations in my biceps started to go away. It was at that point that I believe I started telling myself a story about the pain in my arms not really being from a heart attack. I am sure I was subconsciously thinking: “I have a busy schedule next week. I can’t afford to have a heart attack right now. This pain is probably nothing. I probably just hurt myself in the gym. Who gets bicep pain with a heart attack and no chest pain?” I then said to my wife: “Maybe we should go home.” My wife insisted we go to the emergency room. I might have argued with her, but at that moment I reminded myself about Munger and Buffett’s approach to risk:
“Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.” http://beta.fool.com/danielsparks/2012/12/14/berkshire-hathaways-downside-protection/18950/
Going to the emergency room emergency room for tests on my heart function was clearly wise since the amount of possible loss was so massive even if the probability was small (which it was not given the symptoms). After thinking about this formula I no longer argued with my wife about going to the emergency room. In this case rationality (and my wife) overcame psychological denial, over-optimism and other negative decision making heuristics. It turned out that my pain was from a small heart attack and three days later I was in the operating room for a triple bypass.
You might say: “Well that was stupid.” Yes it was very stupid. But the reality is that we all do things like this every single day by telling ourselves false stories to avoid the truth. Even if you spend a lot of time with behavioral economics you can only improve your skills on the margin. You will always make mistakes. Nobel Prize winner Daniel Kahneman, who has spent his life researching behavioral economics, has said: “Except for some effects that I attribute mostly to age, my intuitive thinking is just as prone to overconfidence, extreme predictions, and the planning fallacy.” http://chronicle.com/article/The-Anatomy-of-Influence/129688/ Just because you can’t be perfect does not mean you can’t get marginally better at avoiding mistakes and have an edge in the market over people who do not understand Munger’s tendencies and other aspects of behavioral economics.
Here are the remaining 15 of Munger’s tendencies not covered in the previous blog post:
11. Simple, Pain-Avoiding Psychological Denial
As I drove to the hospital I was in significant danger of falling prey to “psychological denial” that night I had the heart attack. Munger has his own example of psychological denial:
“This first really hit me between the eyes when a friend of our family had a super-athlete, super-student son who flew off a carrier in the north Atlantic and never came back, and his mother, who was a very sane woman, just never believed that he was dead. And, of course, if you turn on the television, you’ll find the mothers of the most obvious criminals that man could ever diagnose, and they all think their sons are innocent. That’s simple psychological denial. The reality is too painful to bear, so you just distort it until it’s bearable. We all do that to some extent, and it’s a common psychological misjudgment that causes terrible problems. http://www.rbcpa.com/Mungerspeech_june_95.pdf
Was I avoiding psychological denial whenever I ordered a bacon cheeseburger in the years leading up to my heart problem given I am genetically predisposed to the condition? You decide. We all need friends and colleagues who can help us find the truth. Sometimes we all need a cold rhetorical slap in the face from a friend or significant other. By definition you don’t have perspective on yourself.
In an investing context, smart investors should have known that Bernard Madoff generating consistent positive returns was not possible month after month. But the investor liked the result so much that they went into psychological denial mode.
“Failure to handle psychological denial is a common way for people to go broke.” http://boundedrationality.wordpress.com/quotes/charlie-munger/
12. Excessive Self-Regard Tendency
Munger likes to talk about the fact that way more than half of Swedish drivers think they are above average drivers. Thinking your IQ is higher than it is potentially a big problem. Thinking that your IQ is a bit lower than it actually is can be a good thing says Munger.
“We don’t like complexity and we distrust other systems and think it many times leads to false confidence. The harder you work, the more confidence you get. But you may be working hard on something that is false. We’re so afraid of that process so we don’t do it.” http://www.valueinvestingworld.com/2012/05/charlie-munger-quote-complexity-and.html
Unfortunately, some people think that only others are overconfident:
“… the trouble is that if even 90% are no good, everyone looks around and says, “I’m the 10%.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
Companies are not immune from this excessive self-regard tendency, including Berkshire portfolio companies:
“[GEICO] got to thinking that, because they were making a lot of money, they knew everything. And they suffered huge losses. All they had to do was to cut out all the folly and go back to the perfectly wonderful business that was lying there. http://ycombinator.com/munger.html
13. Overoptimism Tendency
In driving to the hospital I surely did not want to find I had heart disease. I suspect that I was thinking too optimistically that I had merely injured my biceps. I wanted to not have a medical problem, so I told myself a story that was contrary to the evidence I possessed. Munger describes the phenomenon:
“..in the 5th century B. C. Demosthenes noted that: “What a man wishes, he will believe.” And in self-appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90 percent of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert’s public assessment is that he is above average, no matter what is the evidence to the contrary.” http://220.127.116.11/search?q=cache:mgSaxC3O1IoJ:www.philanthropyroundtable.org/magazines/1999/march/munger.html+Berkshire+Hathaway%27s+vice+chairman+shreds+the+conventional+wisdom+on+foundation+investing&hl=en&gl=us&ct=clnk&cd=1
As I said above, even experts who spend their lives studying behavioral economics can prey to this problem. Daniel Khaneman writes:
“One of our biases is that we can ignore the lessons of experience. A group of people compiling a report will estimate they can do it in a year, even though every other similar report has taken comparable groups five years. … “When I started the book I told Richard Thaler (the author of Nudge) that I had 18 months to finish it. He laughed hysterically and said, ‘You have written about that, haven’t you? It’s not going to work the way you expect’.” How long did it take you, I ask. “Four years, and it was very painful.” http://forums.udacity.com/questions/10006251/no-fooling-nobel-winning-economist-daniel-kahneman
14. Deprival Superreaction Tendency
In the language of behavioral economics, this tendency is called loss aversion. Mauboussin writes:
“One of prospect theory’s most important contributions to finance is loss aversion, the idea that for most people, losses loom larger than corresponding gains. 7 The empirical evidence suggests we feel losses about two to two-and-a-half times more than we feel gains. Loss aversion is a clear-cut deviation from expected utility theory.” http://www.capatcolumbia.com/MM%20LMCM%20reports/Aver%20and%20Aversion.pdf
A good example of loss aversion at work can be found in the world of golf. A blogger writes:
“Research shows that even professional golfers display loss aversion. They do significantly better when putting to save par than when putting to make a birdie. Indeed, neuroscientists have found that loss aversion is wired into the human brain. And not just the human brain — monkeys are averse to losses, as well.” http://www.bloomberg.com/news/2012-12-24/people-hate-losses-and-that-affects-u-s-budget-talks.html
Football coaches punt too often in games for the same reason.
Munger advocates that people try to train their minds so as to overcome the tendency to the extent possible:
“Your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge. ‘For example’, people do not react symmetrically to loss and gain. Well maybe a great bridge player like Zeckhauser does, but that’s a trained response.” http://www.rbcpa.com/Mungerspeech_june_95.pdf
Investors sell their stocks too early and hold on to their losers to long for the same reason. Selling a stock that is way down and taking the loss is really hard for people who have not trained themselves to avoid this tendency. Do venture capitalists to often put more money into companies that they have invested in already even though they would no do so it it was a new investment?
People too often would rather fail conventionally than succeed unconventionally. Munger:
“I mean people are really crazy about minor decrements down. … 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.htm
15. Social-Proof Tendency
Humans have a natural tendency to herd. Bernard Madoff was a master at using social-proof tendency to get investors to give him their money. He worked hard to make sure that only successful people were a part of his Ponzi scheme. Professor Cialdini has an essay on how Madoff used social proof here: http://www.influenceatwork.com/wp-content/uploads/2012/02/Madoff_by_Cialdini.pdf
Social proof is a bedrock cause of bubbles that occur in the investing world as well as the path dependence which creates power laws. Using a classic Munger inversion apprapoch: if you see a power law, there is very likely social proof lurking behind it somewhere.
Munger has his own example from the corporate world:
“Big-shot businessmen get into these waves of social proof. Do you remember some years ago when one oil company bought a fertilizer company, and every other major oil company practically ran out and bought a fertilizer company? And there was no more damned reason for all these oil companies to buy fertilizer companies, but they didn’t know exactly what to do, and if Exxon was doing it, it was good enough for Mobil, and vice versa. I think they’re all gone now, but it was a total disaster” http://www.rbcpa.com/Mungerspeech_june_95.pdf
16. Contrast-Mis-reaction Tendency
“Because the nervous system of man does not naturally measure in absolute scientific units, it must instead rely on something simpler. The eyes have a solution that limits their programming needs: the contrast in what is seen is registered. And as in sight, so does it go, largely, in the other senses. Moreover, as perception goes, so goes cognition. The result is man’s Contrast-Mis-reaction Tendency. Few psychological tendencies do more damage to correct thinking. Small-scale damages involve instances such as man’s buying an overpriced $1,000 leather dashboard merely because the price is so low compared to his concurrent purchase of a $65,000 car. Large-scale damages often ruin lives, as when a wonderful woman having terrible parents marries a man who would be judged satisfactory only in comparison to her parents. Or as when a man takes wife number two who would be appraised as all right only in comparison to wife number one.” Poor Charlie’s Almanack
Here is a blogger’s interpretation of this tendency:
“‘Contract-Misreaction’ causes people to take actions which are potentially detrimental, because they appear insignificant or appear positive when compared to other actions. Munger uses an analogy of the human eyes to illustrate how this tendency works: humans only see items which contrast with their environment. In the same way, humans find it difficult to differentiate perceptions where there is little in the way of contrast. For example, a man may buy a $1,000 leather dashboard, even if overpriced, when considered in combination with the fact that the vehicle cost is a much larger $65,000.
While the above example is a relatively minor one, Munger points to some examples where this tendency can have detrimental and long-lasting effects. In business, Munger has seen marketers use this practice to their advantage. Real-estate brokers may show clients awful properties at inflated prices for the purpose of closing a sale on merely a bad property at a merely partially inflated price. This practice is also seen frequently in mainstream advertising, with service/product providers asserting a phony price for a product and then promptly offering a ‘discount’ to a lower price. Munger argues that even though consumers recognize this practice, it still works! Therefore, being aware of psychological ploys does not prove to be a perfect defense!” http://www.barelkarsan.com/2009/07/psychology-of-human-misjudgement_12.html
17. Stress-Influence Tendency
Munger thinks people under stress can make big mistakes as well as have life altering experiences:
“Here, my favorite example is the great Pavlov. He had all these dogs in cages, which had all been conditioned into changed behaviors, and the great Leningrad flood came and it just went right up and the dog is in a cage. And the dog had as much stress as you can imagine a dog ever having. And the water receded in time to save some of the dogs, and Pavlov noted that they’d had a total reversal of their conditioned personality.” http://www.rbcpa.com/Mungerspeech_june_95.pdf
18. Availability-Misweighing Tendency
“The great algorithm to remember in dealing with this tendency is simple: An idea or a fact is not worth more merely because it is easily available to you.” http://markettorrent.com/topic/8171?page=9
A blogger describes the problem here:
“When making decisions, people tend to be influenced by what can be readily remembered. Vivid, much-publicized events are easily recalled. Stock market crashes are vivid, highly publicized events. Long periods of steady market advance are less vivid and less publicized. The result is that people over-emphasize crashes and exaggerate risk. An adviser can provide more balanced information in order to overcome negative perceptions arising from the availability bias.” http://www.fpanet.org/journal/BetweentheIssues/LastMonth/Articles/ABehavioralViewofHowPeopleMakeFinancialDecisions/
19. Use-It-or-Lose-It Tendency
“All skills attenuate with disuse. I was a whiz at calculus until age twenty, after which the skill was soon obliterated by total nonuse.” Poor Charlie’s Almanack
This one is pretty simple. Skill degrades unless it is practiced. For example, flying an airplane is not something you want to do once in a while. If you are not flying often or sting in a simulator often, you should not be flying.
20. Drug-Misinfluence Tendency
This tendency is self-explanatory. Everyone makes mistakes, but Munger has said often that staying away from the really big mistakes like cocaine is vital.
“We’ve all seen so much [drug abuse], but it’s interesting how it’ll always cause this moral breakdown if there’s any need, and it always involves massive denial.” http://www.rbcpa.com/Mungerspeech_june_95.pdf
21. Senescence-Misinfluence Tendency
This is another self-explanatory tendency. Senility happens, but you can slow it with activity. Munger:
“some people remain pretty good in maintaining intensely practiced old skills until late in life, as one can notice in many a bridge tournament…. Continuous thinking and learning, done with joy, can somewhat help delay what is inevitable.” Poor Charlie’s Almanack
22. Authority-Misinfluence Tendency
People tend to follow people who they believe are authorities. Munger cites the Nazi madness as an example. Then there are the Milgram experiments in which people are told to shock others and they comply since they person giving the command is wearing a lab coat and looks official.
Munger gives this example of the tendency :
“You get a pilot and a co-pilot. The pilot is the authority figure. They don’t do this in airplanes, but they’ve done it in simulators. They have the pilot do something where the co-pilot, who’s been trained in simulators a long time — he knows he’s not to allow the plane to crash — they have the pilot to do something where an idiot co-pilot would know the plane was going to crash, but the pilot’s doing it, and the co-pilot is sitting there, and the pilot is the authority figure. 25% of the time the plane crashes. I mean this is a very powerful psychological tendency.” http://www.rbcpa.com/Mungerspeech_june_95.pdf
23. Twaddle Tendency
The definition of “twaddle” is: “speech or writing which is silly or not true; nonsense.” What Charlie is saying here is that people tend to spend a lot of time on meaningless activities that accomplish little or nothing. In Munger’s view people too often confuse twaddle with importance and value. Here’s one example from Munger:
“The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle. It’s convenient for a bunch of pension fund consultants to get fees prattling about and a way for one adviser to distinguish himself from another. But, to me, all intelligent investing is value investing – acquiring more than you are paying for. You must value the business in order to value the stock.” http://www.ticonline.com/archives_quotes.html
Most of the talking heads on financial TV are dishing out twaddle. Of course, the hardest thing is to spot when you are telling yourself twaddle since the easiest person to fool is yourself.
24. Reason-Respecting Tendency
What Munger calls “compliance professionals” know that it is possible to get people to act against their interest as long as they are given a reason even if it is silly. Munger:
“Unfortunately, Reason-Respecting Tendency is so strong that even a person’s giving of meaningless or incorrect reasons will increase compliance with his orders and requests. This has been demonstrated in psychology experiments wherein “compliance practitioners” successfully jump to the head of the lines in front of copying machines by explaining their reason: “I have to make some copies.” This sort of unfortunate byproduct of Reason-Respecting Tendency is a conditioned reflex, based on a widespread appreciation of the importance of reasons. And, naturally, the practice of laying out various claptrap reasons is much used by commercial and cult “compliance practitioners” to help them get what they don’t deserve.” Poor Charlie’s Almanack
25. Lollapalooza Tendency – The Tendency to Get Extreme Confluences of Psychological Tendencies Acting in Favor of a Particular Outcome
All of the tendencies described above interact with each other in ways that can make the whole of the effect greater than the sum of the parts. This is a classic signature of complex adaptive systems. What asked what caused “the current economic mess” Munger replied:
“It was a lollapalooza event – a confluence of causes that is how complex systems work.” http://www.valueplays.net/wp-content/uploads/The-Best-of-Charlie-Munger-1994-2011.pdf
Sometimes this lollapalooza tendency can be used for good purposes. As Munger points out:
“The system of Alcoholics Anonymous: a 50% no-drinking rate outcome when everything else fails? It’s a very clever system that uses four or five psychological systems at once toward, I might say, a very good end.” http://www.tilsonfunds.com/mungerpsych
But of course an evil cult can use the same techniques.
Another example Munger cites of a lollapalooza tendency involves open outcry auctions:
“Well the open-outcry auction is just made to the brain into mush: you’ve got social proof, the other guy is bidding, you get reciprocation tendency, you get deprival super-reaction syndrome, the thing is going away… I mean it just absolutely is designed to manipulate people into idiotic behavior.” http://www.valueinvestingworld.com/2010/02/psychology-at-home-auction.html
Buffett’s advice for these open outcry auctions is simple: “Don’t go”.
Charlie believes that this lollapalooza tendency is often encountered in investing:
“An investment decision in the common stock of a company frequently involves a whole lot of factors interacting … the one thing that causes the most trouble is when you combine a bunch of these together, you get this lollapalooza effect.” http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htm
In the book Poor Charie’s Almanack Munger describes an airline manufacturer that ran tests that resulted in numerous injuries which were a classic example of lollapalooza tendency. Munger:
“… it’s a combination: authorities told you to do it. He told you to make it realistic. You’ve decided to do it. You’d decided to do it twice. Incentive-caused bias. If you pass you save a lot of money. You’ve got to jump this hurdle before you can sell your new airliner. Again, three, four, five of these things work together and it turns human brains into mush. And maybe you think this doesn’t happen in picking investments? If so, you’re living in a different world than I am.” http://www.tilsonfunds.com/mungerpsych
Perhaps the best way to sum up Munger’s view of these tendencies, is to just quote Charlie responding to people who think that economists can assume that people are rational:
“How could economics not be behavioral? If it isn’t behavioral, what the hell is it?” https://twitter.com/mungerisms/status/154735076549201920
P.s., I am not sure where I will take this series of blog posts on Munger from here. I might cover a few specific topics of interest to Charlie. Or not. TBD.