Issue No. 22: Munger's Psychology of Human Misjudgement, A Bridge in Detroit (Lessons in Capex Discipline),
Psychological tricks to help deal with your own helplessness, A lesson in the positive personal benefits of rent seeking.
Once a year I try to revisit Charlie Munger’s talk on the Psychology of Human Misjudgement (audio link - text link). The benefits of doing so are both offensive and defensive in nature. For better or worse I work as one of the ‘compliance practitioners’ Munger warns of below - that is to say as a salesperson. As much as it may be uncomfortable to hear and know, successful sales is a series of psychological biases playing out over the course of an interaction. Making the sales experience successful, and indeed helpful, for clients is about appealing to the very imperfect human psyche. Defensively, the benefits of being reminded of one’s blind spots should be self evident. The quintessential human delusion is in thinking we aren’t prone to the subtle manipulations that others fall prey to. The truth of the matter is: you are not.
As far as investments go, the same aspects apply. In choosing investments we are all equally likely to fall into varying degrees of misjudgement. Awareness of these is a call to action. On one hand we can remove ourselves from environments that aren’t to our advantage - or that at least are not to our disadvantage. On the other hand, we can be aware of the opportunities brought on by the misjudgements of others. There are, after all, reasons why equities (and other investment vehicles) become attractively priced from time to time. Equally, the circumstances that propel some companies to enormous success and others to mediocrity and tragedy can be explained by the presence of, or the lack thereof, a number of concurrent psychological biases running together.
Munger opens the talk with:
I am very interested in the subject of human misjudgement, and Lord knows I’ve created a good bit of it. I don’t think I’ve created my full statistical share, and I think that one of the reasons was I tried to do something about this terrible ignorance I left the Harvard Law School with. When I saw this patterned irrationality, which was so extreme, and I had no theory or anything to deal with it, but I could see that it was extreme, and I could see that it was patterned, I just started to create my own system of psychology, partly by casual reading, but largely from personal experience, and I used that pattern to help me get through life.
Below is a curated list of psychological biases I think are most useful:
Incentives and reinforcement:
First. Under recognition of the power of what psychologists call reinforcement and economists call incentives. Well you can say, “Everybody knows that.” Well I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes, but I get some surprise that pushes my limit a little farther.
I certainly agree with the Mungerism that incentives should not be underestimated. I have noticed this in myself and you’d be surprised too at how flexible your take on certain courses of actions can be given the correct stimuli. It’s often the reason for the stunningly illogical actions of others - or that is to say your interpretation of what is illogical. Incentive structures always change someone’s own personal risk/reward profile - and acting in accordance with that is an act of reason.
Denial:
My second factor is simple 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 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 misjudgement that causes terrible problems.
Incentive-caused Bias:
Third. Incentive-cause bias, both in ones own mind and that of ones trusted advisor, where it creates what economists call agency costs. Here, my early experience was a doctor who sent bushel baskets full of normal gallbladders down to the pathology lab in the leading hospital in Lincoln, Nebraska. And with that quality control for which community hospitals are famous, about five years after he should’ve been removed from the staff, he was.
And one of the old doctors who participated in the removal was also a family friend, and I asked him, I said, “Tell me, did he think, here’s a way for me to exercise my talents,” this guy was very skilled technically, “And make a high living by doing a few maimings and murders every year, along with some frauds?” And he said, “Hell no, Charlie. He thought that the gallbladder was the source of all medical evil, and if you really love your patients, you couldn’t get that organ out rapidly enough.”
Commitment and Consistency:
Fourth, and this is a superpower in error-causing psychological tendency, bias from consistency and commitment tendency, including the tendency to avoid or promptly resolve cognitive dissonance. Includes the self-confirmation tendency of all conclusions, particularly expressed conclusions, and with a special persistence for conclusions that are hard-won.
And of course, if you make a public disclosure of your conclusion, you’re pounding it into your own head. Many of these students that are screaming at us, you know, they aren’t convincing us, but they’re forming mental change for themselves, because what they’re shouting out they’re pounding in. And I think educational institutions that create a climate where too much of that goes on are in a fundamental sense, they’re irresponsible institutions. It’s very important to not put your brain in chains too young by what you shout out.
Commitment and consistency is a reason not to openly discuss one’s investments (and there are other good reasons for this too). Likewise, the artful use of this bias is an absolute killer sales tactic. Sun Tzu might have said that ‘The supreme art of war is to subdue the enemy without fighting’ - but the supreme art of sales is to have the prospect sell you.
All successful companies have a distinctive, and in some cases very intense culture. This is seen in the repetition of slogans, and of the automatic refrain to courses of action under unclear scenarios (‘keep the customer in the car’ to quote Credit Acceptance). Sometimes this also manifests in unusual levels of loyalty to a leader. Successful Generals like Caesar often arranged for their men to chant their name. These are all examples of C&C being used toward an effective, if not always moral, end.
Pavlovian Reaction:
Sixth. Bias from Pavlovian association, misconstruing past correlation as a reliable basis for decision-making. I never took a course in psychology, or economics either for that matter, but I did learn about Pavlov in high school biology. And the way they taught it, you know, so the dog salivated when the bell rang. So what? Nobody made the least effort to tie that to the wide world. Well the truth of the matter is that Pavlovian association is an enormously powerful psychological force in the daily life of all of us. And, indeed, in economics we wouldn’t have money without the role of so-called secondary reinforcement, which is a pure psychological phenomenon demonstrated in the laboratory.
Another refrain to Caesar. He would pay his men after a battle was fought. His enemy Pompey, paid his men before. While the Caesarian’s had no choice but to win battles, their opponents often had other options.
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