Charlie Munger, the notoriously wise partner of Warren Buffett and author of Poor Charlie’s Almanack, gave a speech to Harvard University students in June of 1995 on the psychology of human misjudgment.
You can pull the transcript here or listen to the speech on YouTube (no visual – appears to have just been an audio recording).
In this speech, Munger lays out a 24-point framework for decision making and factors contributing to misjudgment (the 24-point framework is also below).
Now those of you who know Charlie Munger know that he’s not a psychologist. He’s an attorney by trade and better known for teaming up with Warren Buffett at Berkshire Hathaway as Vice Chairman of the Board.
So why study psychology?
Munger believes that understanding behavior is the number one factor to investing success. For Munger, figuring out why humans do the things they do and figuring out how to temper one’s own tendency towards irrational behavior is paramount to success investing.
His big influence in this field was Robert Cialdini and his book, Influence. Munger brings up Cialdini many times throughout his speech and heaps praise on his work on the topic of biases.
Munger also knows that he’s not above getting caught up in these behaviors. After all, he is human and susceptible to human behavior…right? But knowing the biases which we all succumb is half the battle.
Are you biased?
We can illustrate this with Munger’s 4th point below, bias from consistency and commitment tendency. Once you commit to something – say an idea – you will discount opposing views and seek views that align with your idea.
As an example, if you believe investing in bitcoin is sure to pay off big, you’re more likely to read articles on how great bitcoin is versus any opposing view. If you’ve really studied bitcoin and then came to your conclusion, you’re likely to be even more biased. You may even be angered by anti-bitcoin viewpoints because your bias is so strong.
I displayed this sort of bias when I first started investing. I’d buy a stock. Then I would follow everything that came out on this stock (bad idea by the way). If an article came out that said this stock was overpriced and management was a bunch of clowns, I’d discount it: “This author doesn’t know what he’s talking about.” On the other hand, if a positive article came out on the stock, I’d be quick to praise the author: “What a smart analyst!”
When you figure out that this happens all the time, you start to really question things objectively instead of being biased.
Someone who exhibits strong biases and doesn’t know it will not be successful in investing.
It happened because of X
Another strong bias that we all have is the Pavlovian association bias: misconstruing past correlation as the basis for decision making (#5 below).
When a stock you buy increases, you’re rewarded. You may have done your research on this stock and have come to some sort of conclusion. The stock goes up. You make another stock buying decision based on the conclusion of the first stock. You’re rewarded again with the 2nd stock increasing. What no one told you is that the stocks simply increased because the market increased, not because of your well thought out conclusion.
Pavlov’s bell is to dog food, as your conclusion is to the increased stock price.
You now have two biases working against you in this case: commitment tendency and misconstruing past association with outcomes.
You can start to see the power of biases in investing here. You made a decision to buy (commitment tendency) and the stocks you buy increase because of what you thought even though it was a false correlation (misconstruing past association).
Behavior Is Your Biggest Liability and Asset
What stands out among the world’s best investors like Warren Buffett and Charlie Munger is their behavior.
When they buy into a stock, they’re taking ownership of a company, holding it for a very long time, and keeping in check the biases that are laid out below.
They understand that all market participants do not act the same way. To the dismay of many academics, there is an inefficient market and they stand ready to take advantage of it.
That’s why I think behavior is the number one factor to investing success. Do you get skittish when price of your assets goes down? Do you let your investing decisions be driven by your biases?
Knowing these biases will help you succeed in investing:
- You’ll be more likely to cut your losers and keep your winners.
- You’ll understand that you can take advantage of the market’s wild swings instead of being fearful.
- You’ll have a better understanding of why investors get caught up in “hot” stocks and be better equipped to avoid them.
- You’ll learn that you have tendency to defend your book of stocks instead of objectively analyzing them; you can overcome this.
- You’ll trade less frequently because you realize it doesn’t pay to get in and out of the market (time in the market is of greater importance than timing the market).
- There are many other things that you can learn from Munger’s framework that will help you succeed in investing.
Psychology of Human Misjudgment – 24-point Framework from Charlie Munger
- Under recognition of the power of what psychologists call ‘reinforcement’ and economists call ‘incentives.’
- Simple psychological denial
- Incentive-caused bias
- Bias from consistency and commitment tendency – Once you think or say something, you’re bias toward it going forward.
- Pavlovian association – Misconstruing past correlation as a reliable basis for decision-making
- Reciprocation tendency, including the tendency of one on a roll to act as the other person
- Over-influence by social proof – that is, the conclusions of others, particularly under conditions of natural uncertainty and stress.
- What made these economists love the efficient market theory is the math was so elegant.
- Bias from contrast-caused distortion in perception, sensation, and cognition
- Over-influence by authority – Going against one’s better judgment because an authority tells you to.
- Deprival super-reaction syndrome
- Bias from envy/jealousy
- Bias from chemical dependency
- Bias from mis-gambling compulsion
- Liking distortion
- Disliking distortion
- Bias from the non-mathematical nature of the brain and its tendency to get probability wrong
- Bias from over influence from extra-vivid evidence
- Mental confusion caused by information not arrayed in the mind and theory structures, creating sound generalizations developed in response to the question “Why?”
- Mis-influence from information that apparently but not really answers the question “Why?”
- Other normal limitation of sensation, memory, cognition, and knowledge
- Stress induced mental changes, small and large, temporary and permanent
- Common mental illness and declines
- Say-something syndrome