The great investor Charlie Munger is known for his mastery of “the art of worldly wisdom,” which combined with his “latticework of mental models” has helped craft his overwhelming success. Part of that includes his lessons on behavioral psychology, as he shared in a famous speech to Harvard University students.
This speech by Charlie Munger was called “The Psychology of Human Misjudgment” and was based heavily on the influential book called Influence by Robert Cialdini.
In this speech, Munger shares what he calls “24 Standard Causes of Human Misjudgment”. Many of these are fascinating, and you can read the entire list by parsing through various transcripts you can find easily online.
For this post, let’s take some of the most helpful lessons from Charlie Munger’s speech and apply them to the average investor.
Hopefully we can learn a thing or two, and apply it to find better performance in the stock market and our overall investment portfolios.
You can’t start a conversation about investing and Wall Street without mentioning incentives. It’s no secret that one of the biggest problems about Wall Street is that many of the advice-givers and advice-takers have interests (incentives) that are not aligned.
This conflict of interest can cause the advice-taker to earn very suboptimal results, and it can happen naturally because of misaligned incentives rather than overt malicious behavior.
One easy example of the insidious nature of incentives on Wall Street is the world of hedge fund managers and their “2-and-20” fee structure.
In the “2-and-20”, fund managers are paid 2% of a client’s assets and also get 20% of the profits.
Where these incentives break down is in the risk-reward profile of both fund manager and client.
By getting an annual 2% fee from the customer regardless of performance, the fund manager essentially has all of his downside capped while the client takes 100% of the risk. Worse yet, the fund manager gets to participate in 20% of the upside, without taking any percent of the downside risk.
This means that a manager with questionable morals could quite easily see the logic in taking huge risks with other people’s money, without broadly challenging his own livelihood (all of his 2% fees).
Or, the manager could see clients as orchestrated bets, taking concentrated risks and needing just one to payout immensely in order to amass massive wealth, staying unscathed even as all the others blow up catastrophically.
Charlie warns of how powerful incentives are in shaping human behavior in the speech:
“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.”
2—Pavlov and Accounting
The popular experiment by Pavlov and his dogs has vast implications on several levels for both investors and the underlying businesses in the stocks they own.
The Pavlov experiment was simple—Pavlov would feed dogs directly after ringing a bell. Once this behavior was subconsciously ingrained, Pavlov would simply have to ring the bell to get the dogs to salivate, before even bringing any food out.
The funny thing is that humans behave much in the very same way.
Munger uses an example of a company called Westinghouse which lost billions of dollars in bad loans to developers. In this case, there was an accounting system which incentivized salespeople to make decisions which in the end led to the billion dollar+ disaster.
Just as incentives can help shape behavior, the rewards (money or “esteem”) which come from a particular scoring system such as you see with accounting can encourage people to continue in their behaviors—regardless of if these behaviors are ultimately good or bad in the long term.
That’s the philosophy anyway, and while it does make humans sound primitive; that is the overarching message of Munger’s speech.
Not to degrade anyone, but simply to say that we should all be aware of our innate human tendencies and work to improve and be aware of them, particularly if we want to be good investors.
Another term for this whole phenomenon is “operant conditioning”, and Charlie gives a great example to summarize these conclusions:
“If you carry bushel baskets full of money through the ghetto, and made it easy to steal, that would be a considerable human sin, because you’d be causing a lot of bad behavior, and the bad behavior would spread. Similarly an institution that gets sloppy accounting commits a real human sin, and it’s also a dumb way to do business, as Westinghouse has so wonderfully proved.”
It adds credence to the idea that as investors, we could start by looking how management at a company is compensated, which could indicate if a system is in place to align management incentives with the interests of shareholders, or whether there’s a potential conflict.
3—Consistency and Commitment Tendency
This might be the most powerful bias out of the whole speech for investors. In effect, the human mind shuts down and closes itself to conflicting ideas from formed beliefs.
What’s particularly interesting about the way Charlie presented this bias was how he mentioned that the more that someone would act or speak about their belief, the more ingrained this tendency became. In other words, the more someone would commit to this belief.
There’s many examples we could use to explain this bias, and how it could be combined with others.
I like the one where in a controlled experiment, an expert tells a person to cause pain to another individual behind the glass. But instead of doing this immediately, the expert sort-of eases the person into it, starting with smaller commitment “asks” before progressing to causing serious pain to the other person.
Where this hits home with investors is in the ways we all talk about investments and investing strategies.
If you commit to preferring a particular style of investing—whether that’s growth investing, value investing, technical analysis, or something else—you are less likely to change your mind about it the more and more you’ve outwardly committed to that belief, even if you can be ultimately and objectively proven wrong.
That can be a big problem with investing if you are following a bad strategy, or have the wrong details about a belief, or a misjudgment of the facts.
Keynes once said “when the facts change, I change my mind”.
In the case of stubborn investors with consistency and commitment tendency, they are likely to NOT change their mind even if the facts change—which can leave them in the dust particularly in the fast moving and changing stock market.
That’s not to say that we should constantly change our strategies at the slightest hint of underperformance; rather we should constantly challenge our beliefs over time and work to constantly improve our circle of competence, and slowly evolve our strategies and mindsets over time if the facts overwhelmingly show that we are actually wrong.
I love the way that both Charlie Munger and Warren Buffett talk about constantly staying curious and expanding that circle of competence, as this can keep you attuned to changes in the market and economy while also showing you where you might be ignorant.
Like the many brilliant pieces of the speech, this one summarizes the point nicely:
“Well what I’m saying here is that the human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in. The human mind has a big tendency of the same sort.”
This one has two sides of it; really, all of us can get affected by social proof in all aspects of life.
The idea of social proof is simple—we tend to believe an idea or think something is good just because a lot of other people think so as well.
Walking by a restaurant, we are more likely to dine at the packed one instead of the empty one; after all, so many people can’t possibly be wrong, right?
We follow the crowd, because not following the crowd with every little decision would be incredibly time consuming and probably unproductive.
That said, social proof can be extremely detrimental when blindly followed.
Munger used the example of oil companies buying fertilizer companies. Basically it just started with one oil major buying a fertilizer company until all of its peers also did the same. Looking from the outside-in, there wasn’t much logic for the oil company to make this acquisition; certainly there was no other obvious reason all of the peers followed suit other than because the first oil major did.
It might be easy to think of social proof in this way as: “well they did it so should we”.
As investors, or shareholders in businesses who exhibit this behavior, we could find much pain if we (or the companies) are jumping off the cliff because our friends next to us are too.
This is where evaluating capital allocation decisions by management can really help investors in separating the wheat from the chaff—the companies who are adept at managing capital and those who are wasteful because they simply follow the crowd.
But it’s not just managements who are susceptible to social proof.
Investors can get extremely heavy doses of social proof when they buy stocks which rocket higher. The idea of a rising stock is an extreme form of social proof because it is instantly confirming that many other people (the market) agree with you.
Taken to the extreme, you could either get addicted to the dopamine from this feeling and/or base future decisions off recent social proof events.
Just because the market agrees with you over a given period of time doesn’t mean you are necessarily right or skilled.
It takes the self-aware investor to shed the positive (and negative) emotions that come from positive or negative social proof from the stock market, and truly evaluate themselves objectively. By doing this, an investor can more easily spot weaknesses and improve in mindset, knowledge, and/or strategy.
5—Pulling It All Together
Perhaps the greatest takeaway from Charlie Munger’s fantastic speech on human psychology was not any one individual bias. Rather, it was that in many cases, four or five (or more) biases can all be operating at the same time to completely influence behavior. And in most cases we don’t even realize it.
For us to benefit from this newly acquired knowledge, it might not be enough to vigilantly shield against social proof, or consistency tendency, or any single bias…
Instead it might be better for us to recognize that these things will inherently affect us in one way or the other.
It’s probably impossible to avoid all of them, even if we are aware of them, as Charlie admits himself,
“Now, I knew I was being manipulated and that she’d done this before, and I just loved it. I never see this woman without a little lift in my spirits. By the way, I told her I was rational. You’ll have to judge yourself whether that’s true. I may be demonstrating some psychological tendency I hadn’t planned on demonstrating.”
If someone as brilliant and studied as Charlie Munger can fall victim to a psychological tendency even as he is aware that it is happening—then most of us investors probably don’t stand a chance.
You can then bet that the rest of the business world, stock market, and other parts of the economy are susceptible to these things too. There were many examples in the speech where behavioral biases have very observably led to huge influences on human behavior—whether talking about the wildly successful Tupperware parties or the healing and recovery capabilities of Alcoholics Anonymous.
Maybe the best that we can do is catch ourselves when we can, and through better awareness become better at stopping these hurtful tendencies before they happen.
Or, perhaps we can use these tidbits from Charlie to embark down a more serious path of understanding—and seeing the world for what it TRULY is.
Unfortunately, our dear friend Charlie Munger did not answer the question crisply for us, as I will not either; just leaving his final words of the speech as follows:
“The final question is if the thought system indicated by this list of psychological tendencies has great value not widely recognized and employed, what should the educational system do about it? I am not going to answer that one now. I like leaving a little mystery.”