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:
- 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.
- Psychological denial. The inability of people to accept truths that are too painful to accept.
- Incentive-cause bias, or when the interests of two parties aren’t aligned.
- 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.
- Bias from Pavlovian association, or misconstruing past correlation as a reliable basis for decision-making.
- Bias from reciprocation tendency, including the tendency of one on a roll to act as other persons expect.
- 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.
- “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.
- 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.
- 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.
- 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.
- Bias from envy or jealousy. “It’s not greed that drives the world, but envy.” – Warren Buffett
- Bias caused by chemical dependency, such as drugs or alcohol.
- Bias from a gambling compulsion.
- 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.
- Bias from the non-mathematical nature of the human brain. Letting yourself be fooled by statistical tricks.
- 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.
- 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.
- Other normal limitations of sensation, memory, cognition and knowledge.
- Stress-induced mental changes, small and large, temporary and permanent.
- Mental illnesses and declines, temporary and permanent, including the tendency to lose ability through disuse.
- 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.
- 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.
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