Reviewing Munger's The Psychology of Human Misjudgment

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway (BRK.A). This is part of a series in which we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where Munger describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Part I: Reward and Punishment Tendencies

In this chapter, Munger discusses the super powers of incentives. While he believes everyone understands how important incentives are, he also believes that everyone (including himself) constantly underestimates its powers. Munger takes the reader through examples at several companies (including Fedex, Xerox, GE, and Westinghouse) where aligned (misaligned) incentives powered (impeded) the firm's effectiveness. According to Munger, the most important rule in management is "Get The Incentives Right!"

An important consequence of the power of incentives is human bias caused by the very same incentives. This causes even generous and caring individuals to be able to rationalize to themselves even the most immoral and callous of behaviors. Munger's examples of this "cognitive drift" in action include a doctor murdering his patients, salesmen/brokers selling products their clients don't need, and management consultant reports that conclude with the advice "This problem needs more management consultant services."

Munger suggests some antidotes against falling prey to such bias: fear advice that, if implemented, is good for the advisor, learn the basic elements of your advisors trade, and doublecheck/disbelieve much of what you're told.

As powerful as incentives are, it is a puzzle to Munger that the topic is not discussed in academic textbooks devoted to psychology. Economists have long studied its powers, as incentives form the basis of many economic theories. Economists have also long used the term "agency costs" to describe a firm's costs due to the disconnect between manager and owner incentives. For example, a sales force paid only in commissions may be more efficient than a salaried sales force, but will also be more difficult to keep moral. As such, incentive systems make tradeoffs between costs and efficiency gains.

Part II: Like and Dislike

The 2nd and 3rd tendencies Munger discusses are human tendencies to like and dislike. Certain triggers cause man (and other animals) to like and dislike others. For example, a baby goose will love and follow the first creature that is nice to it, whether it's its mother or a human being.

A consequence of these tendencies is that man will ignore faults of the object of their affection, favour people/products associated with that object, and distort facts to facilitate that love. Conversely, man will ignore virtues in the object of his dislike, dislike people/products associated with that object, and distort facts to facilitate hatred! Munger uses as an example the fact that mediations between Israelis and Palestinians are difficult because the facts on each side overlap very little.

Man also likes being liked, causing man to strive for the devotion and admiration of those around him. Munger also argues that an individual that loves admirable persons with a strong intensity has a great advantage in life. He says that both he and Warren Buffett are so inclined, and they both admired Warren's uncle Fred in this manner.

Part III: Doubt Avoidance

Because it has helped our ancestors survive, humans have a tendency to quickly eliminate doubt by reaching some decision. As an example, Munger notes that the worst thing an animal can do in the face of a predatory species is to take time to deliberate.

This tendency is so strong in humans (and other animals), that man must often force himself to be objective when his natural tendency is not to do so. Judges and jurors are forced to delay decisions exactly for this reason. By taking time to consider all issues, rather than following his gut feelings or initial instincts, man can better work through circumstances in an objective manner.

Munger attributes the success of religion in society to this doubt-avoidance tendency. He argues that although individuals may believe their own faith comes from revelation, this does not explain the seemingly inconsistent faiths of others.

Munger believes this doubt-avoidance tendency is triggered by some combination of puzzlement and stress. An unthreatened man, on the other hand, has no need to rush to a decision and is therefore not forced to remove doubt.

Part IV: Inconsistency Avoidance

Man tends to resist all forms of change. Munger argues that this tendency is what leads to the fact that people have habits, be they good or bad. Furthermore, every man will carry many bad habits despite the fact that he knows that the habits are bad. Since man has this tendency to avoid change, in order to avoid bad habits, prevention is far more effective than cure (i.e. it is easier to prevent a habit than change it).

Also as a result of this tendency, man tends not to change his previous conclusions (even when facing convincing new information to the contrary), human loyalties, and role in civilization. Unfortunately, if a conclusion was reached quickly thanks to the "Doubt Avoidance" tendency previously discussed, this tendency to avoid change will lead to many errors in judgement!

Munger paraphrases from Lord Keynes who argued that it was not the fact that ideas were new that made them difficult to accept, but rather the fact that they were inconsistent with old ideas. In other words, people tend to accumulate a bunch of fixed conclusions over their lifetimes, and those conclusions and attitudes will not be reexamined or changed.

Munger argues that this tendency has also been useful to man in many areas. People are loyal to their roles in life as priests, physicians, solders, spouses etc. Unfortunately, when people learn dubious notions, they are also more prone to carry these notions for the rest of their lives. For this reason, Munger advocates that it is "important not to put one's brain in chains before one has come anywhere near his full potential as a rational person".

Part V: Curiosity and Fairness Tendencies

While all mammals are curious, apes are abnormally more curious than other mammals, and humans are by far the most curious of them all. Munger argues that this curiosity can drive the advancement of knowledge, using examples from Ancient Greece, where much math and science was developed out of pure curiosity. Individuals who are more curious than others also benefit from added wisdom long after their formal education is complete.

Munger also argues that man displays and expects fairness to and from others. Man's tendency towards reciprocity is part of this fairness tendency: when someone does something nice for you, you feel like doing something nice for them.

Sometimes, an individual will do something nice for another even when he knows that person will not have occasion to repay them. Man will allow drivers in front of them on the highway and even allow others to advance when they don't have right-of-way. This behavior pattern may have evolved due to the fact that it makes everybody better off when these acts of indirect reciprocity are performed.

Because fairness has come to be expected, much conflict arises when fairness is expected and not provided!

Part VI: Envy

Envy is fairly commonly understood by humans, yet one will not find it discussed in psychology texts. Munger believes Warren Buffett to be roughly correct when he says "It is not greed that drives the world, but envy." Yet the words 'envy' and 'jealousy' were often absent from the indexes of psychology textbooks Munger has studied.

Munger argues that the origins of envy are the result of a desire for man to acquire scarce resources, and then the feelings of conflict associated with seeing those resources in the hands of others. Munger also notes that jealousy is fiercest among siblings, particularly at younger ages. It is also exaggerated in myth, religion and literature, as in many of those accounts it triggers hatred and injury.

In modern life, jealousy is visible in many forms. University communities are driven to anger when it becomes known that an employee in money management or surgery is given annual compensation far above standard professorial salaries (in order to compete with what the employee could command in private employment). In order to avoid conflicts and hurt feelings, many large law firms will treat all senior partners alike, even if their contributions to the firm coffers are widely different.

Munger also believes this tendency to be a taboo topic, as labelling someone as jealous is considered to be an extreme insult. While this may be an explanation for why the term is absent from psychology textbooks, Munger believes it accounts for so much of man's behavior that it should be regarded as an important topic.

Part VII: Reciprocation

Humans, apes, monkeys, dogs, and other animals all share the tendency to reciprocate. When someone does something nice (mean) to you, you tend to do something nice (mean) to them as well. The tendency fosters cooperation within groups, and also protects groups from the ill-intentioned.

The power of this tendency is strong, and can drive individuals to perform brutal acts. For example, in wars sometimes prisoners are not taken (but rather killed) when one side believes the other side is treating its prisoners unfairly. Non-war examples of disfavourable actions as a result of this tendency are road rage and injury-causing temper tantrums on athletic fields.

Munger notes that, whether good or bad, humans are not programmed to turn-the-other-cheek. The best antidode to falling victim to disfavorable actions resulting from this tendency is to defer reaction. Munger quotes Tom Murphy, whom Buffett has often called one of the best managers alive, who frequently says, "You can always tell the man off tomorrow, if it's such a good idea."

Positive reciprocation is just as strong as well. Marriage and commercial trade are listed as examples where this reciprocation fosters strong relationships. Because it is often a subconscious behavior, one's tendency to reciprocate can also be taken advantage of. For example, when an automobile salesman offers small favors, you are more likely to accept a final sale price that is $500 higher than otherwise. A man who is spending someone else's money (e.g. the manager of a company, a government employee) are more likely to fall into this trap, since he is not the one who has to foot the bill. Sam Walton (the man who started Wal-Mart) recognized this tendency early, causing him to implement a policy disallowing purchase managers from receiving gifts of any kind from vendors.

Part VIII: Influence from association

Humans tend to form judgments based on factors that may be irrelevant. This tendency of humans to be influenced by association is well understood by advertisers. In this way, people can be tricked into believing things that are not true. For example, producers will sometimes charge a higher price for a product only because customers perceive its quality to be higher due to the higher price. The association can even be trivial: if a pretty girl is pictured on the product's packaging, this too can drive buyers to be influenced to purchase.

However, Munger argues that the ramifications of this tendency that are caused by advertising are relatively trivial. The most important miscalculations due to this tendency come from improper associations with past successes, and liking/disliking to the point of ignoring relevant factors.

For example, if a man has success at a casino, he will associate that success with particular behaviors, and believe that his success can be repeated. All too often, he will wager - and lose - far more than his initial gains. Traders who are blessed with early success will often believe they are superior speculators, only to fall victim to their overconfidence. Munger argues two antidotes to combat this improper association: 1) look for accidental, non-causative factors that led to the initial success, and 2) look for dangerous aspects in the new venture that were not present in the old.

When it comes to liking/disliking to the point of ignoring relevant factors, Munger uses the example of man's (un)willingness to listen to bad news. People who "blame the messenger" often find themselves living in realities void of bad news and also void of fact. Munger uses examples from Ancient Persia, two major oil companies, and CBS to illustrate the detriment of ignoring bad news. To counteract this tendency, Munger claims Berkshire has a policy of "Tell us the bad news promptly; the good news can wait."

Part IX: Pain Avoiding Denial

The perfectly sane mother of a soldier who had not been heard from since World War II refused to believe her son was not alive and well. In order to avoid the pain she would feel from acknowledging his death, she distorted the facts in her own mind. This is what Munger refers to as simple, pain-avoiding, psychological denial.

It is difficult to criticize an individual who has used this denial to shield themselves from pain, but Munger finds it an admirable trait that others prefer to live by a different creed: "It is not necessary to hope in order to persevere."

While Munger believes we all use this form of denial at various points in our lives, it is particularly visible when used by those who suffer from some form of chemical dependency. Those under the influence of addiction often believe themselves to be in respectable condition with good prospects, when this is clearly not the case.

Comments

[Ferdinand E...:]

As much as I hate to say it, this Munger person seems to know as much or more about certain topics than yours truly.

But not always. Warren Buffet apparently said that envy is more important than greed, which is true, but whether it "turns the world" doesn't sound right to me. I've lived in two countries - Sweden and Australia - where envy is a crucial social factor, but whether it turns anything is problematical.

Jun 28 09:22 AM

[Mad Hedge F...:]

The hand has turned cold. A lot of people like to follow Warren Buffet’s Berkshire Hathaway (BRK/A) as a leading indicator for the market. What better guide than a portfolio of the best of the best, run by the world’s great investor? Recently the news has not been good. If you wonder what a stock looks like when it is rolling over on diminishing volume, this is it. The only question is how big, how fast. As much as I worship the avuncular, chocolate milkshake loving, Sees Candy eating Oracle of Omaha, memorizing his annual letter to investors and hanging on his every spoken word, he hasn’t been doing that well lately. Since March, his main investing vehicle has only managed a 35% gain, compared to a 40% pop for the S&P 500; despite heavy weightings in such best of breed financials like Goldman Sachs (GS). Better keep his ticker on your desk top, because what BRK/A does, the world will follow.

Jun 28 04:11 PM