The Psychology of Human Misjudgment by Charlie Munger

This is a great speech given by Charlie Munger. Throughout the speech, Charlie runs through the common causes of human beings to misjudge.

I think it’s important for everyone to understand these concepts, but it’s particularly important for investors. The goal of an investor ought to be to take advantage of human misjudgment. With markets, you’re dealing with the collective judgment of human beings. To make any money, you have to be able to make good decisions and understand why other people are making comparatively bad decisions.

Whenever you find yourself coming to a conclusion about something, I think it’s a good idea to think about this speech and think about whether or not you are succumbing to these common misjudgments.

The common causes that Charlie summarizes in the speech are listed below:

  1. Under-recognition of the power of what psychologists call ‘reinforcement’ and economists call ‘incentives.’ Always think in terms of whether or not someone is gaining from a course of action and whether that lines up with your own goals. “Is my realtor just trying to maximize his commission, or is this house actually a decent value?” Never underestimate the power of incentives.
  2. Psychological denial. The inability of people to accept truths that are too painful to accept.
  3. Incentive-cause bias, or when the interests of two parties aren’t aligned.
  4. Bias from consistency and commitment tendency. This is sticking to your guns over “core beliefs” and refusing to change in the face of evidence to the contrary.
  5. Bias from Pavlovian association, or misconstruing past correlation as a reliable basis for decision-making.
  6. Bias from reciprocation tendency, including the tendency of one on a roll to act as other persons expect.
  7. Lollapalooza: bias from over-influence by social proof. Social proof is your desire to agree with other people for the sake of agreeing. The ultimate examples I can think of are both the real estate bubble and the dot-com bubble of the late ’90s. The prices made no sense, but everyone else was doing it.
  8. “To a man with a hammer every problem looks like a nail”. Economists are cited as an example of loving the efficient market hypothesis because the math was beautiful and that was what they were trained to use even though it was largely useless for the problem that they were tackling.
  9. Bias from contrast-caused distortions of sensation, perception and cognition. In other words, limiting yourself to your own experiences when making decisions instead of looking at the bigger picture.
  10. Over influence by authority. Valuing someone’s opinion more just because they’re an authority figure. Also known as the expert fallacy. You’re more likely to listen to someone in a suit than someone in a t-shirt and jeans.
  11. Bias from deprival super-reaction syndrome, including bias caused by present or threatened scarcity, including threatened removal of something almost possessed, but never possessed. I.e., the reaction of a dog when you try to remove its food or the reaction of the American public when Coca-Cola tried to change the flavor.
  12. Bias from envy or jealousy.  “It’s not greed that drives the world, but envy.” – Warren Buffett
  13. Bias caused by chemical dependency, such as drugs or alcohol.
  14. Bias from a gambling compulsion.
  15. Liking and disliking distortion. This is the tendency to agree with the opinions of someone just because you like them personally. Conversely, there is the same tendency to disagree with the opinions of someone you dislike just because you dislike them. In other words, not analyzing the actual merits of an opinion, but basing your thoughts on your attitude towards the person. You see this a lot in politics. When a President does something that the opposing party dislikes, think of the different reactions that would be caused in the same people if someone from their own party proposed the same course of action.
  16. Bias from the non-mathematical nature of the human brain. Letting yourself be fooled by statistical tricks.
  17. Bias from the over influence of extra vivid evidence. Not looking closely at something because the answer seems obvious. Look closer because the truth isn’t always obvious.
  18. Mental confusion caused by information not arrayed in the mind and theory structures, creating sound generalizations. In other words, you need models to understand the world. Your mind isn’t just randomly collecting scattered facts. They have to exist in some kind of structure to be useful.
  19. Other normal limitations of sensation, memory, cognition and knowledge.
  20. Stress-induced mental changes, small and large, temporary and permanent.
  21. Mental illnesses and declines, temporary and permanent, including the tendency to lose ability through disuse.
  22. Development and organizational confusion from say-something syndrome. In other words, it’s the idea that you feel you have to do or say something for the sake of doing it, not because it will actually achieve anything. Anybody who ever sat in a meeting in corporate America knows this truth. 90% of the people who say something in these meetings have nothing useful to say.
  23. Combinations of these tendencies. Examples cited include Tupperware parties, Alcoholics anonymous and open outcry auctions. All combine several of the psychological biases that Charlie previously described to obtain a result.

Before making a decision, take a step back and think about whether or not any of these biases are at work. The more we can avoid these biases, the better decisions we can make.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

The Price of Politics by Bob Woodward

 

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I recently completed Bob Woodward‘s The Price of Politics.  The book chronicles the debt showdown of 2011 and the lead up to it. I wouldn’t recommend this to anyone who wants to have a positive feeling about the direction of the country or the federal budget, but I would recommend it to anyone who wants a good understanding of where our politics unfortunately rest today.

Background

For those lucky people who don’t remember, in 2011 the United States approached the debt ceiling. The debt ceiling is a limit set in law placing a dollar limit on the total amount that the United States can borrow. Raising the debt ceiling is typically passed as a matter of procedure and occurs without much of a fuss. 2011 was different. To understand why, Woodward recaps the rise of Obama and the Republican controlled Congress.

Obama was elected during the financial crisis. My own view is that the efforts of the Federal Reserve along with TARP prevented a full-scale Depression. In 2008, we faced the exact same situation that the United States faced in 1929, but we avoided a full scale Depression because we didn’t repeat the mistakes that the Federal Reserve made in 1929. We increased the money supply and saved the banks. In the early 1930s, the Fed enabled a decrease in the supply of money and let banks fail. Milton Friedman explains in this video.

Anyway, I am getting off track. While we avoided a Depression, we still had a horrific Recession. The recession greatly limited revenues to the Federal Government. Spending rose in the form of 2009’s $787 billion stimulus bill. As a result, the deficit exploded. Contrary to popular belief, TARP wasn’t the primary cause of the increase in the deficit. In fact, TARP was paid back and the government made a profit from it.

By 2011, the deficit increased from less than 60% of GDP to over 90% of GDP.

With the exploding deficit, the unpopularity of the Affordable Care Act and high unemployment due to the lingering effects of the recession, the Republicans were swept into power in Congress in the 2010 midterm elections.

The Showdown

Once Republicans entered power, a showdown was inevitable. The Republican’s primary goal was to use their Congressional power to address federal spending and the deficit. Their approach to the debt ceiling was rather straightforward: put together a bill that decreases the deficit by the amount that the debt ceiling would be increased.

Throughout the book all of the personalities clash with each other and their own party. Woodward’s book chronicles every wonky detail of the debate. To sum it up: they never really reached a compromise and the US nearly defaulted. The debate was so ugly that it led to a downgrade of US debt.

Woodward details the efforts of the White House and Congress to hammer out a deficit reduction deal to occur alongside the increase in the debt ceiling. A deficit reduction deal was sorely needed (and still is), despite temporary improvements due to an improving economy. There was a constant back and forth between the White House and Congress.

Particularly striking was how disjointed the process was. Obama and Boehner were negotiating separately from Joe Biden and Eric Cantor. All of the top people were out of touch with their own political bases, who would howl wildly at any talk of a deal and spook their leadership. Anger from the bases (Democrats mad about cuts to entitlements, Republicans mad about increased taxes) often spooked the leadership if they were on the brink of a deal. There were a few opportunities for a Grand Bargain which would have significantly reduced the debt. Obama and Boehner point the finger at each other for the failure of the Grand Bargain, but after reading the book I’m convinced that both of them blew it. They both backed away from provisions of the bargain once their base started complaining about it.

The failure of a Grand Bargain is a major lost opportunity of the Obama administration. Only Nixon could go to China and only a Democrat could have reformed our entitlement mess. If Obama were able to sign entitlement reform, the budget outlook of the United States would have been greatly improved for decades.

In a normal political climate, the Democrats would have agreed to some spending cuts that made them uncomfortable and the Republicans would have agreed to some tax increases that made them uncomfortable. In a divided government, neither side can get everything they want. Neither party had complete control of government, but they both acted like they did.

I thought at the time that both sides were simply engaged in political posturing. I figured they would reach a deal because they always reach a deal. However, after reading the book, I came away with the feeling that we really dodged a bullet. Many in each party were actually willing to risk a default because they thought a default would hurt the other side more. There were Democrats who thought that a default would be blamed on the Republicans and there were Republicans who thought it would do more damage to the Obama administration. In other words, elements of both parties toyed with blowing up the US economy in an attempt to do political harm to the other side.

The effects of a default would have been truly horrific. Even though bondholders would still be paid, Tim Geithner lays out the effects of a technical default to the President in one chilling segment. A default on obligations would have permanently rattled markets and bond investors would then demand much higher interest rates on US government debt for decades. A double dip recession would have likely resulted as well. Another recession at this time would have been devastating. In 2011 we had barely recovered from the last Great Recession. The unemployment rate in 2011 was 9% and another recession would have probably pushed this above 15%. Both parties were well aware of this potential catastrophe and yet they both almost let it happen.

Hardcore partisans blame the showdown on the other side. Republicans will point to Obama’s handling of Republicans prior to the 2010 election and his incompetence as commander-in-chief during the negotiation. He even outsourced it to Joe Biden for a period of time. Democrats will say that Republicans were unwavering in their resistance to tax increases and too intimidated by the newly minted Tea Party movement. This approach amounts to two toddlers wrecking a living room and then pointing at each other and saying simultaneously “he started it!”

Conclusion

It’s hard to come away from the book without feeling that our political system is completely and utterly broken. Today’s Democrats look at Republicans as the reincarnation of the Third Reich. Republicans look at Democrats as the reincarnation of the Soviet Union. A simple budget debate that would have been resolved rapidly 30 years ago is now an ideological showdown against the forces of “evil”, depending on your perspective.

My own view is that it’s the fault of baby boomers.  The debt showdown was about simple math in which everyone needs to sacrifice some of their position to hammer out a simple deal. Unfortunately, Washignton is dominated by baby boomers and they are more apt to view the showdown as an ideological showdown between the forces of good and evil.

The roots of baby boomer extremism is in the incredibly intense ideological showdown of the 1960s. It’s shocking to me how much hardcore conservatives and liberals share resemblances to the radical student movements of the 1960s. Unwilling to compromise, convinced that entire institutions are filled with evil and willing to use any means necessary to achieve their ends. It’s not a coincidence that as soon as baby boomers ascended to a majority of Congress in the early 1990s that our politics became increasingly divisive, reaching its apogee of dysfunction during the 2011 debt showdown. Partisanship so extreme that government was almost unable to fulfill the basic function of paying its bills.

There is a reason that the most famous baby boomers have nothing to do with governing or managing. They are interested in tearing things down and building a new. They are wildly creative – giving us people like Stephen Spielberg and Steve Jobs – but the downside to that creativity is that they’re not interested in basic management and maintenance of existing institutions, to the point where our existing institutions become completely dysfunctional. The budget showdown is about simple math and that’s probably how prior generations would have ultimately looked at it. To boomers, the budget showdown is about moral priorities and those who object to their view aren’t just wrong, they’re immoral and possibly evil.

My views on this are fueled by my reading of another book that I’ll have to review at some point on this site, The Fourth Turning by Neil Howe and William Strauss. Ever since I read the book, I find myself looking at current events through a generational perspective and nowhere is this more apparent than in politics.

The good news is that the baby boomers are getting old. Members of Generation X and Millennials are far less ideological than their parents, with roughly double the number of political independents. As the baby boomers leave politics, my expectation and hope is that sanity will return to our politics and showdowns of this magnitude won’t happen again. Our debt problems aren’t going away, but that doesn’t mean they can’t be resolved through arithmetic and rational thinking. It may take a new generation to tackle these problems. It’s too bad that Republicans and Democrats weren’t able to act like adults and take advantage of the unique opportunity that they had in 2011 to resolve this problem.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Ed Thorp: The Man Who Beat Las Vegas and Wall Street

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I just finished Ed Thorp‘s new book, A Man for All Markets, and give it a strong recommendation. Ed Thorp is a genius who mastered card counting, built the first wearable computer to beat roulette and created the first market neutral hedge fund. The book takes the reader on a fascinating adventure through Thorp’s Depression-era childhood, his academic career in mathematics, his successful assault on Las Vegas and his wildly successful career in the financial markets.

Lifelong Learning

One of the things that struck me about Edward Thorp was his enduring lifelong love of learning, which fueled much of his success. Edward Thorp didn’t have a one-dimensional interest in mathematics. He was constantly fascinated by new ideas which likely led him to study unconventional subjects such as gambling. In his childhood he experimented with radio, attempted to win mathematics competitions, conducted funny experiments (such as attempting to create a hot air balloon and playing a prank on a local swimming pool with red dye that turned the entire pool blood-red). These funny pranks and interests show a deeply inquisitive mind willing to learn new things. While few of us are anywhere near the intellect of Ed Thorp, that’s an important lesson to take away. Remaining curious and developing a lifelong love of learning is a positive attribute that we should all strive to achieve.

The Original Black Scholes

I never knew that Thorp developed the original black scholes model, but he developed this and used it to make money for himself in the 1960s. He wrote about it in a 1967 book about it along with other arbitrage strategies, Beat the Market . Thorp was looking for a way to successfully invest his money that he accrued through his gambling activities and best-selling book Beat the DealerHe tried stock picking and wasn’t pleased with it, looking instead for something more precise and scientific. He ended up employing his own brand of convertible arbitrage and his own version of the Black Scholes model, before Fisher Black and Myron Scholes wrote their 1973 paper about it. In 1997, Myron was awarded the Nobel prize for an insight that Thorp discovered first. While Fisher Black and Myron Scholes appeared to have engaged in outright theft of Thorp’s ideas, he is surprisingly cool and level-headed about it. I suppose the lesson of this is that it doesn’t pay to hold grudges and needlessly create enemies. In fact, Thorp maintained a good relationship with them and was pleased that they were able to prove his idea. In any case, Thorp put the ideas to work in the world’s first market neutral hedge fund, Princeton Newport Partners.

A Unique Perspective

Something I thoroughly enjoyed about the book was reading Ed Thorp’s outlook on financial and political issues. What was fascinating to me was how non-ideological Thorp’s approach is. It’s hard to pin him down as a conservative or liberal. He does not subscribe to any kind of orthodoxy. Thorp’s approach is pragmatic and relies primarily on logic.

For instance, when discussing welfare, Thorp isn’t opposed to welfare as would be standard conservative orthodoxy but he also doesn’t subscribe to the standard liberal worldview. Thorp’s attitude is that welfare and unemployment benefits are necessary, but believes that these individuals should be put to work as occurred during the Great Depression’s Works Progress Administration.

Thorp is certainly no friend of Wall Street and takes a critical eye towards the actions of investment banks. A standard liberal response would be to load up Wall Street with as many regulations as possible. A standard conservative response would be that laws created by Washington, DC (such as the community reinvestment act) forced the banks to take unnecessary risks and that they therefore are not directly responsible for the outcome of the crisis. Thorp acknowledges the bad behavior of banks and believes in sensible regulation, but thinks that we would do much better off by enabling shareholders to better combat bad behavior by the management of public companies rather than pursuing excessive regulation.

Thorp also has a very unique perspective on the 1980s junk bond boom. While acknowledging that Michael Milken was responsible for illegally enabling insider trading, he believes that Milken was not a target solely for his illegal acts. Milken’s illegal activity was magnified and pursued by the authorities because Milken financed an assault against the established corporate order. The established corporate order was far more entrenched politically and pleaded with politicians to shut him down. Thorp also has an unfavorable attitude towards Rudy Giuliani, whom he believes pursued these scandals less out of a sense of justice and more for political gain.

He’s also quite critical of the hedge fund industry, arguing accurately that hedge funds rarely deliver returns that justify their high expense ratios. This is quite ironic because Thorp launched one of the first modern hedge funds.

A Wild Trade

One of my favorite stories in the book involves an amazing trade that Thorp came across in 2000 at the height of the internet bubble. It is a story that could come straight out of Joel Greenblatt’s You Can Be a Stock Market Genius. It also gives insight into the level of financial insanity that fueled the internet bubble.

Back in March 2000, 3COM owned Palm Pilot. 3COM spun off 6% of its interest in Palm in an IPO. Due to the mania that was consuming market participants at the time, every technology or internet oriented IPO would immediately be bid up to an insane valuation on the first day of trading. Palm was no exception, but the level it was bid up to was truly absurd. After the first day of trading, the market valued the Palm IPO at $53.4 billion but valued the parent company (that owned the other 94% of Palm) at only $28 billion! In other words, the 6% share of Palm was valued more than the other 94% owned by 3COM plus all of 3COM’s other business interests. Thorp shorted Palm and went long in 3COM, in an incredible trade that would never have been possible if markets were efficient.

Investment Ideas

Thorp is a strong advocate for buying index funds, but he also offers a couple interesting ideas for investors to make above average returns.

The first fascinating idea is taking advantage of Savings & Loans that issue new equity. Thorp will open up a deposit account in a savings & loan that he suspects will eventually take a new equity offering public. Because depositors get a share of any new equity issue, Thorp then applies for a position in the new equity offer which typically sells for nearly double of the original price that Thorp paid for it. If he feels the savings & loan is well-managed, Thorp will hold onto the position for much longer periods of time. Thorp opens up multiple deposits in S&L’s throughout the country and then patiently waits for an equity offer. This was immensely profitable in the run up to the S&L crisis when S&L’s were hungry for new capital. The game has slowed down in recent years, but it sounds like those opportunities can still be identified.

The second idea is buying closed end funds at a discount and shorting closed end funds at a premium. This was an idea I was previously familiar with (Graham was an advocate of the strategy, at least the long portion of it). Closed end funds are publicly traded investment vehicles that can only be redeemed through trading activity. There are fixed number of shares and market participants determine the price. However, like a standard mutual fund, you can easily assign a net asset value to the shares. Unlike a mutual fund, you can’t redeem your investment at NAV, you have to sell it to someone in the open market at whatever they’re willing to pay.

In other words, there is no guesswork involved in determining the value of a closed end fund, but the shares trade openly and the price relative to the NAV frequently changes. Shares of closed end funds frequently trade at a significant discount or premium to their NAV. Efficient market types will say that these price discrepancies occur because the market is speculating on the riskiness or promise of the assets that the closed end fund owns. However, during the financial crisis, Thorp was able to acquire closed end funds that owned nothing but treasuries (an essentially risk free asset) at a substantial discount. Barron’s maintains a nice list of closed end fund NAVs and premium/discount that investors can take advantage of.

Bernie Madoff

A particularly fascinating passage in the book is one in which Thorp uncovers the Madoff scandal all the way back in 1990. While auditing investments for another firm, Thorp investigated Madoff because the firm had investments with Madoff. Thorp at first suspected that Madoff’s slow and steady returns every month (Madoff “earned” 1-2% every single month and never lost) might be fraudulent. Thorp confirmed this suspicion when, after checking with the exchanges, he confirmed that none of Madoff’s alleged trades actually happened. Thorp could have alerted the authorities back then, but he suspects they wouldn’t have done anything about it, so it wasn’t worth getting into the weeds. He’s right, of course. Harry Markopolos came to a similar conclusion and tried to alert the authorities about it and no one would listen (in fact, the SEC investigated and cleared Madoff of wrongdoing), and Harry spent years worrying that Madoff would try to take him out in some way. It sounds like Thorp made the prudent choice without making a big splash: advise his client to get out and lay low about the finding.

Conclusion

Edward Thorp is a living, breathing refutation of the efficient market hypothesis. He’s an iconoclast who refused to accept the conventional wisdom about markets or casinos. He had a lifelong love of learning which he allowed to pursue a fun (and profitable) adventure. His journey is a fascinating one that I thoroughly enjoyed. I recommend the book to anyone interested in a great story about a unique genius.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.