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The Investor's Podcast (We Study Billionaires) - The Investor’s Podcast Network
TIP739: The Psychology Of Human Misjudgement
01:09:28
Kyle discusses Charlie Munger’s legendary speech, The Psychology of Human Misjudgment.
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Tip
You're listening to Tip.
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Kyle Grieve
Charlie Munger wasn't just Warren Buffett's partner. He was a towering intellect who profoundly influenced how countless people think about decision making, investing, and life. While he's primarily known for helping to build Berkshire Hathaway into the giant that it is today, I think Charlie's real legacy was his clarity of thought, which was portrayed exquisitely in one speech he gave titled the Psychology of Human Misjudgment. In this episode, we're looking at one of Charlie's greatest contributions to the world, a framework for understanding the psychological traps that lead otherwise smart and successful people to make dumb decisions. We'll unpack all 25 of his tendencies, starting with how incentives shape behavior, often more powerfully than we even realize, and how misaligned incentives can create disastrous outcomes. We'll look at how our affection for a company, products, or even a person can blind us to incredibly obvious facts, and why emotional attachment can be very, very dangerous. We'll also look at why our brains crave certainty and consistency, even when staying flexible and open minded would serve us much better. Then we'll transition and look at the powerful pull of the crowd and why investors must learn to stand apart from the herd. And lastly, we're going to look at probably one of my favorite tendencies, which is when multiple biases combine to produce extreme outcomes that can cause massive successes or or crushing busts. Now, Charlie truly believed that avoiding stupidity was more critical than seeking cleverness. And by understanding how to avoid mistakes, by recognizing these misjudgments, we would have no choice but to improve at investing and in life itself. These tools are truly timeless, practical, and deeply rooted in human psychology. So if you're an investor looking to sharpen your mind and add a few new tools to optimize your thinking, a business leader striving for improved judgment, or simply someone trying to make fewer dumb decisions, this episode is for you. Now let's get right into this week's episode on the psychology of human misjudgment. Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Kyle Grieve. Foreign welcome to the Investors Podcast. I'm your host, Kyle Grieve, and today we're discussing one of my favorite chapters from one of my favorite books, Poor Charlie's Almanac. And specifically we're going to look at the chapter on the psychology of human misjudgment. Yes, we're only going to cover a single chapter from the book just because I think it alone contains just a wealth of incredibly, incredibly valuable information. And to be honest, while prepping for this, I probably could have even dove a little deeper into each of these tendencies. But for the sake of time, I think you'll enjoy exactly how I weave this into both investing and how to use and think about these misjudgments in that light. So let's jump right into it. So the first one we're going to cover is a reward and punishment super response tendency. I'm just going to kind of basically go in order and connect a few of these as we go along. So Charlie Munger may have put this one first because he thinks everyone just underestimates its power. More so than some of the other misjudgments on his list. Munger said that he always believed that he was in the top 5% of his age cohort in understanding the power of incentives. And even then, he still felt like he always underestimated its power. So what exactly is this tendency? It's simply understanding the strengths of incentives. Whether incentives reward agents or punish them, they can be used both ineffectively and effectively. Let's go over examples of each in the investing world. So the first one I'd like to cover is Salomon brothers in the 1990s. So the incentive program at Salomon was part of the reason that I think many of its bond traders took risk, and it was part of the reason why it was so successful as well. So one of these bond traders, Paul Moser, took a risk specifically by buying a disproportionately large share of treasury bonds, effectively squeezing the market and reaping a very quick and large profit. Unfortunately, this just wasn't part of the deal that Solomons had with the US Treasury. And Salomon was promptly banned from bidding. For a time, Bowser was incentivized to maximize profits, but he achieved this goal in a manner that was considered unethical. While I think maximizing profits is a good incentive, and that's what I look for in a lot of the businesses that I own or am researching, it only really works when there's also safeguards against breaking the rules. This is an example, I think, of an ineffective incentive program because it lacked some of these guardrails. Now how can a business establish guardrails? Interestingly, Buffett tried with Solomon. Once he took over as a CEO for a limited period of time, he established a system that was based on returns on invested capital. Now, a company that I think has done an excellent job on aligning incentives between managers of the company and shareholders is Constellation Software a business that we've spoken about a lot on this show. Now, to unlock incentives, managers at Constellation Software essentially have to earn a return above their cost of capital. So this means that management can invest in software and in pretty much any area that they want, but it has to generate returns above a specific hurdle rate. Now, to make the System Even better, 50 to 75% of that bonus must be used to purchase shares of Constellation Software on the open market. And then to make it even better, the shares that are purchased on the open market are then held in escrow for three to five years. So this really, really aligns management with shareholders very well and has some really good guardrails in place because the managers aren't incentivized to really take risks just to do well in the short term. Otherwise they're likely to, you know, make a mistake that could theoretically hurt the long term view of the business, which then would make it so that their shares that are held in escrow become less valuable over time. So a corollary of this tendency is called incentive caused bias. And this is essentially just when you're biased in a way, because it helps obtain your incentive, you may even drift into immoral behavior to get what you want and rationalize even bad behavior. I think a really good example of this is analyst reports. So these reports are supposed to be unbiased, but if the analyst works for a business, that can cause the firm to lose out on deals or maybe impair a key relationship, they can be fired. So for this reason, they may paint a rosier picture than reality as they're incentivized to, you know, keep people buying a specific stock rather than selling it. So research indicates that over 50% of analyst reports carry a buy rating. I assume that's why people like, you know, Buffett and Munger just don't choose to place any weight on relying on analyst reports for information. Now, the next tendency is the liking and loving tendency. This one's pretty simple. We are predisposed to favor people, ideas, or objects that we like or love, and we often overlook faults and make irrational decisions. Munger gives a really good example of how, you know, when a mouse is born, the mother instantly falls in love with her baby mouse, But a single gene can be deleted which can eliminate this loving behavior. So to Munger, this suggests the existence of a triggering gene. Now, this is a great tendency to Understand, because in many cases we must actively fight the tendency to to like or love things to make better decisions. If we succumb to the loving tendency to ignore faults, play favors or distort facts, we're going to make some horrible, horrible decisions. And investing this is readily apparent, we may spend a lot of time on an idea and begin to fall in love with it. Perhaps we even own it and its price has increased significantly, which only further enhances our passion for the idea. Now, if we allow ourselves to ignore faults in our hypothesis, we may end up forfeiting all those gains if we choose to be blind to obvious facts that might indicate a significant flaw in our thesis. Now, to counter this, you must continually re evaluate your hypothesis. You have to know what to look for that might tell you that your thesis is cracking. And you must make deals with yourself to exit an idea. Once these factors become reality, the key is to avoid distorting reality to fit your narrative. Now, the antithesis of the liking loving tendency is the disliking and hatred tendency. And this is just the opposite of the previous one. It's also a conditioning device which Charlie says makes the disliker hater tend to 1, ignore virtues in the object of the dislike, 2 dislike people, products and actions merely associated with the object of his dislike, and three, distort other facts to facilitate hatred. Now, it's pretty easy to see how this bias works, especially in things such as politics. Now, I'm not going to get into any of that because that's not what this show is about, but I think you can easily put two and two together to just see how divisive politics can really be. When one side dislikes or hates the other, it can be very tough to come to a consensus. The inability to show empathy to the opposite side really just limits the opportunity to come together and work together to come to better solutions. Now, the disliking tendency is excellent for investors that are willing to harness its power, though entire industries or sectors of the market often fall into the state of being hated or unloved. But the market frequently overshoots these sentiment swings. For instance, in 2008, the Western World just did not enjoy stocks that were domiciled in China. And you know, I don't think that's too different today. However, at this time, the same issues arose. You know, the state had too much power and valuations were unlikely to reach a premium due to that uncertainty. But Charlie Munger used this to make one of his greatest investments of his life in a company called BYD. When Charlie began buying BYD, its shares were trading around 10 times earnings, which is a very reasonable multiple for a business that was growing very strongly and had an absolutely exceptional leader. Had the company been loved, as it has been for much of the last decade since he's bought in it, he wouldn't have earned anywhere close to the returns that he made for Berkshire, which was about a 32% compounded annual growth rate between 2008 and 2021. So if you can actively use the disliking tendency, you'll never run out of potential investment ideas because there's always an area of the market that is heavily out of favor. And this is how people like Munger and Buffett built up much of Berkshire Hathaway. Now, the next misjudgment that I want to go over is known as the doubt avoidance tendency. Munger said, quote, the brain of man is programmed with a tendency to quickly remove doubt by reaching some decision. Munger argues that this is an artifact of evolution. If we were to imagine an animal that was subject to being eaten, they would need to make decisions very, very quickly or risk losing their life. Doubt avoidance tendency has two triggers, 1, puzzlement and 2 stress. When we are faced with an unknown situation that requires a decision, we exhibit this tendency the most. In investing, we are constantly bombarded with information. Our general mood as well as the information itself can easily increase or decrease our stress levels. Then when you add in the fact that the market does some very puzzling things like moving up and down for no apparent reason, we are apt to become very, very puzzled. This may be one reason why investors tend to make poor knee jerk decisions. If you think you have a history of making these types of decisions, then creating a barrier is a very, very smart move. In investing, if you see something that puzzles you while you're stressed, it's essential to take some time to just think about that decision and avoid becoming a victim of this tendency. Let's suppose a news release or earnings report comes out that you maybe don't like or weren't expecting. In that case, it might be better, as long as the information isn't a complete thesis breaker, to just take a few days, digest the information and make sure that you're coming to a rational decision before making any trades. Another example are IPO investors. It's important to remember that doubt avoidance means that we prefer an incorrect conclusion rather than having no conclusion at all. We avoid ambiguity. In an ipo, there is often very little information available to base the future economics of a business going public, you may know a little bit about the company, you might go through the prospectus, but I think unfortunately a lot of investors just skip the prospectus, which can easily run 200 plus pages, and just ride with the narrative. In this case, any doubt that you'd find from doing all that hard work is going to be erased by the attractiveness of that story. However, in the case of IPOs such as Rivian, Robinhood, Snowflake, doubt probably should not have been avoided and investors would have saved a significant sum of money had they done the necessary work. Now, doubt avoidance has many similarities with the next tendency, which is called the inconsistency avoidance tendency. Another way to think about this is in terms of consistency bias. So humans tend to be very set in their ways. We avoid changing our beliefs, habits and identities once they've been formed, even in the face of new evidence. The evolutionary reasons for this tendency are very powerful. When you had a view based on survival, it probably had some sort of validity to it which would further improve your chances for survival and the survival of your offspring. If you had consistent roles and behavior, it made group cohesion even better and smoother. Now, being part of that group when you're thinking about survival is a lot stronger than just being a lone wolf out there by yourself trying to survive. And finally, the brain requires a lot of energy, so sticking to your guns requires less energy than trying to find new and novel solutions. There are a few great examples of inconsistency avoidance tendency in the market. So the first one here is stating your stance on a stock publicly, which may limit your ability to exit a position when your identity is tied very, very closely to that particular idea. Think of being well known for an idea on something like Twitter and having a lot of people know you for that exact idea. I think this can cloud your judgment if you find contrary evidence that makes you want to exit that idea. Additionally, when you have an idea and you're part of some sort of larger community that also likes that idea, your ability to actively search for disconfirming evidence becomes less of a focus because everyone's just bullish along with you. Now how can you fight the inconsistency avoidance tendency? You can play the devil's advocate and search for opposing views. You can have open minded role models. People like Charlie Munger or Charles Darwin are the two that come to mind, and people who I think are very, very big role models for myself. And lastly, you can periodically revisit your thesis and test it against some objective measure. You know, think margins, profits, capital, efficiency, etc. One of Charlie's best traits was his curiosity. Which brings us to our next tendency, the curiosity tendency. This has a very brief explanation, but it's simply that humankind is just innately curious. We want to understand how the world works and why it functions in a certain way. Curiosity is interesting because there are certain cultures which foster curiosity, whereas others actually suppress it. Munger notes that the Greeks utilized education and culture to foster curiosity and advance human knowledge. They helped invent many aspects of math and science purely out of curiosity. However, when looking at the Romans, they were just as powerful as the Greeks, but they actually made minimal contribution to either math or science. If we view investing as a subset of worldly culture, even within that, some subsets foster curiosity while others suppress it. For instance, you know, followers of Munger are likely to be curious individuals, have curious, invested friends, and enjoy thinking critically about problems. If you're a person who follows someone who's just trying to sell you something, like maybe a course on the Internet that claims to have some sort of secret, you may be disinterested in figuring things out on your own. Given that I'm doing a podcast on Munger, you can probably guess which group I put myself into. But I think I can harness curiosity even better. You know, Munger's breadth of knowledge was truly awe inspiring and something that I deeply admire. And I think it's a great lesson that we can learn from nearly any discipline if we decide to intentionally think about solving problems in one subject that can be applied to several different domains. One investor besides Munger, who I think embodies curiosity, is Peter Lynch. So lynch found the idea for Legs while shopping at the grocery store with his wife. So legs were basically these pantyhose that were sold in these egg shaped plastic containers. So instead of, you know, what probably 99% of people did, which was just brush this item off that was being sold next to things like potato chips. Peter lynch asked why it was being sold here and if it was actually selling well. So lynch discovered that the product was absolutely flying off the shelves and that the leg's owner, Haynes, had tapped into a previously untapped market. A combination of convenience, brand recognition and impulse buying. Haynes turned out to be a six bagger for Peter lynch before it was bought out. Curiosity is beneficial in investing because there are numerous products and services that we use daily that we either need or want. If you're curious enough to dive into your own psychology and find out why you feel that way, you might find a great investing Idea. Next up is the Kantian fairness tendency. So Munger points out that Kant was famous for his categorical imperative, which is often referred to as a type of golden rule. Essentially, it states that humans follow specific behavior patterns that, if followed by others, make surrounding systems work best for everybody. Picture, you know, just waiting in a line. Everyone understands that if you stay in a line like everyone else, you'll eventually get to the front of it. When you're in traffic, you will do things like allowing other vehicles to turn into your lane simply because you'd expect similar treatment in return. Munger also claims that Kantian fairness tendency resulted in things like the abolishment of slavery. Buffett has acted in perfect alignment with, I think, the Kantian fairness tendency. In Buffett's annual letters to Berkshire shareholders, he wrote, our goal is to communicate with you in a manner that we would wish you to use if our positions were reversed. That is, if you were Berkshire CEO while I and my family were passive investors trusting you with our savings. Buffett runs much of his life this way. Suppose you've read his annual letters or the compilation of them in the excellent book the Essays of Warren Buffett. In that case, you probably realize that he believes that companies should be run specifically for the benefit of shareholders and not for the benefit of the individual insiders inside of a business. The Kantian fairness tendency is why you see many angry shareholders. When business executives do silly things such as, you know, make poor capital allocation decisions that maybe work well for getting their own short term incentive, but not for creating long term shareholder value, you might see executives that are just getting paid too much and not delivering any shareholder value. And you might also look at businesses or executives that buy back stock at the worst possible times. You know, you go back in time and they're buying their stock repeatedly at 52 week highs and never at 52 week lows. So essentially, you just want executives who would do things in a way that if they were in the investor's place, they would be happy to switch. Buffett is one of the finest examples of this action in the history of business. And if you can find someone who acts similarly, consider partnering with them for a very, very long time. Along similar lines is the envy jealousy tendency. This is one of the most potent and destructive biases of all. It's based around the human condition of wanting what others have, even when we don't necessarily need or want it ourselves. For the parents out there, I'm sure you've witnessed it in your children. My son will have a playdate with a friend and they'll start playing with a toy that my son hasn't touched in six months that he'll get upset that somebody else is playing with the toy. It would be great to say that this bias only applies to toddlers, but unfortunately that would be incorrect. Adults envy many, many things in life, but Munger points out that it's very insulting to call someone envious, which is why you don't hear people accusing one another of it very often. Let's take a quick break and hear from today's sponsors.
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Kyle Grieve
My favorite example of this in the markets is simply the action of investors during short periods of euphoria. Name any bubble in history and you'll note the appearance of sophisticated and intelligent individuals who willingly take part in that bubble at overly inflated prices because they just can't stand that family, friends and colleagues are getting rich while they aren't. So a case study that I continually think about is Isaac Newton's involvement in the South Sea bubble. So Newton had already actually sold a large share of his stock at a significant profit in that business as the bubble began forming. But as it started climaxing, he actually reentered the position and saw a large portion of his fortune come crashing down once that bubble popped. Here you have just one of the most intelligent humans in history, and he's actively taking part in a bubble because he had fomo. So how do we fight this bias? To be honest, I'm not sure we really can. But we can make an effort to limit its influence as much as possible. So doing things such as, you know, focusing less on other results and more on your own process is a great start. Recognizing that there will always be someone out there with better returns is another key consideration. And just because that is reality, it doesn't mean that we should strive to change what we're doing if it's already working really, really well. And then I think just understanding that just because a part of the market is going through a bubble doesn't mean we need to partake to meet our financial goals. As a matter of fact, participating in the bubble has a better chance of ensuring you never actually achieve your financial goals, rather than getting you there faster. So transitioning here to one of my favorite tendencies is a reciprocation tendency. Why do I say it's one of my favorites? Because I've given it a lot of thought and it's so powerful and pervasive. The reciprocation tendency is the automatic tendency to reciprocate both favors and disfavors. This tendency can have both creative and destructive effects. It's also important to understand that reciprocation is particularly strong when it facilitates cooperation for the benefit of community members. Unfortunately, this means that there have been many wars where hatred between two sides reaches such high levels that people are willing to do just horrible things to one another. But Munger points out that this tendency isn't limited to humans. For instance, ants and other organisms do some horrific things to one another as well to protect their colonies. Reciprocation can be an excellent tool for marketers. If they know they can upsell you on a product by giving you something small, such as, you know, a pen or a cup of coffee, Then they know that even if the gift doesn't work specifically on one or two people, it will end up paying itself off if somebody else decides to spend a few extra hundred dollars on whatever it is that they're selling. My favorite example in the book was regarding how employers should avoid all Reciprocation between employees and suppliers. If a supplier does a favor for somebody engaged in purchasing, they are more likely to continue doing business with that supplier, even if they aren't getting the best terms. So Sam Walton, the founder of Walmart, knew this. So he wouldn't allow purchasing agents to accept anything from vendors. And this helped ensure that Walmart purchasing agents were out there trying to, you know, get the best possible deal for Walmart rather than trying to reciprocate a favor from a supplier. So reciprocation tendencies are just all over financial markets. The more time I spend learning about the markets and business, the more I see how much of successful business just really comes down to being good at sales. If you have friends in the industry who might be willing to provide an analyst report or spend some time helping you understand an idea or an industry, you may feel the need to reciprocate. So when the same analyst comes to you with an idea, you may be more willing to buy into that idea if they're trying to sell you on something. If the same idea came to you from someone else who never did a favor to you, you'd be less likely to be biased. So things that you can do to fight this bias include things like a no gift policy, which is very smart in certain areas where the reciprocation tendency can actively harm you. You can be proactive in other ways as well. You can conduct your own independent research, use checklists, and avoid forming personal relationships with management teams, brokers or analysts. You want to remain as objective as possible to avoid bias. It's not an easy task, but we must all try to handle it to the best of our abilities. Perhaps this is why Buffett preferred to work with minimal help. Now, one bias that you see all the time in the business world is influence from mere association tendency. So this one refers to our subconscious tendency to associate feelings, whether that's positive or negative, with unrelated things simply because they appear together. The key mechanism here is conditioning through proximity and not logic. I think this is most prevalent in the power of certain brands. Coca Cola is a prime example. They spent a lot of money over many decades associating their brand with things like happiness, fond memories, and joyful experiences. And this is all intentional because they know know that when someone is thinking of consuming a beverage, looking at a can of Coke will evoke all sorts of positive emotions in their imagination. And Coke takes it even further because they know that their product evokes these emotions in their customers. They know that they don't necessarily have to compete with their competitors on price. Their competitors products just don't provide the same feelings to their customers. And this means that Coke can charge a higher and does charge a higher price while still selling larger and larger volumes of its product. However, if we examine certain high priced products like Louis Vuitton, it's evident that they're selling a product that is a luxury good. So when you see their advertising or walk past their store, they've really dressed up their product to be associated with a high price and high status. However, the association tendency can have some deleterious effects as well. For instance, people can engage in behavior where the chances of success is low but end up with a positive outcome. For example, let's say someone begins trading stocks using margin and find some early success. They'll then have a positive association with using margin to buy stocks and attempt to try it again. And unfortunately, if they don't realize they're playing a suckers game, they'll end up losing all their money. Now this tendency really reminds me of a book I'm reading right now about Texas wildcatters. So one wildcatter was named Roy Cullen and he achieved significant success drilling wells and had a few massive, massive winners. So in his early days he had to have early investors help him fund these early ventures. But to be honest, the base rates on success weren't very high. He might drill, you know, 100 holes and find one. So you had to be very, very lucky to hit it big. However, what would happen is he would find a gusher well that would be really, really good and return a lot of oil, lots of, you know, who know, billions of barrels of oil. And then he'd, you know, go out and try to repeat that again and again. So what essentially would happen would be he'd hit one gusher, get a bunch of investors, decide that he want to do it again, and then he'd end up just losing a ton of money trying to reproduce that same result. So you know, I think some ways that this tendency affects investors include liking a stock because maybe you like the CEO or a specific brand, mistaking past successes as causation for future outcomes, buying high priced stocks and assuming the premium is deserved for the high quality of a business, or even misjudging competitors because you associate them negatively with the business that you like. So I think your best tool for fighting this is just to focus on what has caused past successes and failures. You also need to accept that past results might be a result of luck. If you compare your results to base rates and See that your strategy worked because of maybe a very unsustainable strategy, then you just accept that luck played a role in your success there, and it probably won't happen again. So maybe you shouldn't partake in that exact same strategy again. Now, Mugger's next tendency is what he calls pain avoiding psychological denial. This is our tendency to just avoid unbearable pain. He mentioned that this tendency is often mixed with love, death, and chemical dependencies. Munger points this tendency out in parents who, you know, can't admit that their child is gone or that their child is a criminal in the face of overwhelming evidence. He mentions how he knew a perfectly sane woman who just refused to believe that her son had perished in the Atlantic Ocean during World War II. In terms of chemical dependency, it shows up when people with an addiction have issues admitting they're addicted to. And this usually results in an expedited pace of deterioration. You can see this in drug and alcohol dependency. Now, how does this exactly affect investors? I think it's very much so. Psychological denial is just a form of denial that rejects reality. And in investing, the goal isn't to warp reality to fit into your narrative. It's to match your narrative with reality to make the best possible decision. But as anyone who follows psychology knows, confirmation bias is arguably the most powerful tendency out there. So we are wired to confirm the world to our reality. In investing, it manifests itself when investors do things such as ignore disconfirming or negative information about their holdings. They cling to unrealistic expectations about deteriorating investments, or they rationalize weakening fundamentals rather than confront the painful reality of admitting that they were wrong. And, you know, doing this, unfortunately results in compounding your mistakes, painful losses, and irrational decision making. I really think you just have to attempt to find the underlying truths, even if they disagree with your thesis. And this is why I like things like kill criteria. So if you set a kill criteria out and stay disciplined, you're going to get ideas that unfortunately get triggered by your kill criteria which tell you to sell them. So, you know, if you're undisciplined, you may ignore those kill criteria. And this is a good example of just being in denial, because you aren't listening to the signals that you specifically created. So the one part of the kill criteria that I think is important is to really crank up the pain that's necessary to sell. You can create both easy and difficult kill criteria. So let's say there's a business that maybe you want to have a longer leash. You think it has a really, really positive long term outlook. In that case you might extend the date of the kill criteria to be over multiple years. But maybe there is a business that you like for the short term, maybe it's a cyclical and in that case you might just give it a year. You can really get creative with both the timelines and what the kill criteria are. So I'd like to touch here on a variation of confirmation bias. And that's Charlie Munger's next misjudgment which he calls the excessive self regard tendency. So this one is relatively straightforward. We tend to just overestimate our abilities. A notable example of this is a well known study that was conducted in Sweden about how people rate themselves as drivers. So 88% of Americans and about 77% of Swedes rated themselves as above average drivers. Now obviously 50% of people will be above average and 50% of people will be below average. Therefore, this research clearly shows that we have an excessive self regard of our skill set. Another subcategory that Munger discusses is the endowment effect. This one is often cited in economic psychology because it's vital and very powerful. So the endowment effect states that people tend to assign greater value to items simply because they own them, often irrationally above their actual market value. For instance, if we buy something for 20 bucks, we will automatically perceive it as being worth more than $20 after we make the purchase and to part ways with it, even if it's, you know, right after we buy it, we might need to be paid something like call $25. This tendency is very, very dangerous though. I was thinking about this the other day. So every time we put a dollar into the market, specifically into individual stocks, what we're really doing is telling ourselves that we can beat the market. And even if we didn't believe that, then if we're speaking in rational terms, we would just put all of our capital into an index fund and call it a day. Yes, I realize there's more to it than that. For instance, we might derive pleasure from the investment process. But you know, if we're speaking strictly in a rational manner, I think the statement still stands. And if we appraise ourselves to be higher skilled than 50% of the market, then that means that we should be able to outperform the average investor. But the problem is that more than 50% of the market participants own individual stocks, which strengthens the case for excessive self regard tendency. Now I mentioned base rates a little earlier and I think this is another good opportunity to consider them as they're very instrumental. So there was a study by Dalbar where they looked at the average retail investor and so they looked at their results over a 20 year period. So the average retail investor underperformed the S&P 500 by 6.1% annually over a 20 year period with a 5.5% gap in 2023, which was higher than the gap in 2022. And this shows that bull markets often do not actually reward investors in the way that it's perceived. So if you're a retail investor, consider these base rates. Because the 20 year return of the S&P 500 is approximately 10.36%, this means that the average retail investor's returns are around 4 to 5%. Oof. Yikes. So if you are highly rational, you might take the time to invest in individual stocks, observe your performance and then decide whether or not you're successful. The bar for being an above average investor is pretty low at 5% per annum. But even if you can beat the average retail investor doesn't necessarily mean you should invest your own money in an index fund. This is why most institutions use a benchmark to compare themselves with. It clearly shows that investing with a specific fund manager is more or less valuable than investing on your own or in an index fund. Munger mentions the best way to avoid excessive self regard tendency. So the best antidote to the folly of an excessive self regard is just force yourself to be more objective when you are thinking about yourself, your family, your friends, your property and the value of your past and future activity. This isn't easy to do well and won't work perfectly, but it'll work much better than simply letting psychological nature take its normal course. We're up to number 13 now. The next one is called the over optimism tendency. Munger summed it up well from a quote by Demosthenes from over 1700 years ago. What a man wishes that also he believe. Munger suggests that humans are inclined to believe things that will turn out well, perhaps even better than what is rational, simply because we want them to. And we do this while denying stress or pain so that we can maintain that belief. If you think about this for a second, it's pretty apparent that it's true. I can tell you from personal experience that I'd prefer to believe that outcomes will be positive rather than negative. The problem is that we don't want to delude ourselves completely. There are three pernicious effects of the over optimism tendency in investing. The first one here is that investors overestimate returns and underestimate risk. For instance, investors may believe that a stock may be the next winner, while overlooking the fact that its balance sheet is in tatters or that it lacks any competitive advantages. The second one is narratives. When investors combine the over optimism tendency with loving tendency and consistency avoidance tendency, they can become emotionally connected to an idea. And this does things like distort any negative aspects of their thesis, which can then lead them to take larger and larger risks. The third one here is speculative booms. These create lollapalooza effects, bringing in multiple tendencies simultaneously, such as reward response, mirror association, and social proof, which causes investors to become just completely detached from reality. Now, being an optimist is, I think, a positive trait. But there's a fine line between being an optimist and being an over optimist. We must balance our thinking to maybe lean slightly to the optimistic side while not putting the blinders on ourselves against reality. The next tendency is one that every investor listening will be able to resonate with. And this is what Munger refers to as a deprivation super reaction tendency, or what Kahneman and Tversky would call loss aversion. It's simple, losses hurt more than gains. For instance, if we were to win $100, we wouldn't derive the same quantity of displeasure as a $100 loss. Munger expands the deprivation super reaction tendency also to include the tendency for humans to overreact to the sudden loss of something. For instance, he says that many of Berkshire Hathaway's shareholders have held their stock simply because they can't stand the thought of having a smaller holding in Berkshire, which has grown significantly over the years. One area of his talk that really stood out to me concerned business executives. So Munger points out that deprival super reaction tendency mixed with inconsistency avoidant tendency is an especially dangerous concoction of misjudgments. In this case, a manager will covet and use their assets to recover from a bad deal. One could argue this is precisely what Buffett did with Berkshire Hathaway, the textile mill. He thought he had a great idea when buying it, and he shared that idea with partners, friends and family. This created an inconsistency avoidance that Buffett had to live with, although I believe he handled it perfectly. Buffett likely delayed shutting down Berkshire for a significantly longer period than necessary because he viewed the business as undervalued, which is where the deprival super reaction tendency comes into play. Luckily for Berkshire shareholders, Buffett had a great strategy to reduce the impact of this painful duo. Of misjudgments. For instance, he refused to invest capital into Berkshire and then gradually liquidated the textile assets to provide himself even more cash to put into opportunities that offered high returns. But the sad fact is that 99% of CEOs won't act in this fashion, so make sure that you heed Warren's advice. If you find yourself on a sinking ship when you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks. Part of the reason that getting off a sinking ship can be so tricky is that we often just surround ourselves with others who have similar beliefs, and this transitions well to the next tendency, which is social proof tendency. This tendency guides us towards thinking and acting as we observe others around us doing the exact same. As an evolutionary tool, it's incredibly powerful. If someone in a tribe a few thousand years ago was maybe hungry, they could simply eat what others in the tribe were eating, as they would have a very high certainty that it was safe to consume. If they went against what everyone was eating, there would be a chance that maybe they would eat something that was poisonous and could end their life. But today, social proof has multifaceted impacts that affect both positively and negatively. Let's focus on the positive first. I think you'll see this happen in communities, sports clubs, groups, and other similar settings. This is where individuals feel closer to a subset of people and can foster, you know, a very good sense of community and relationship, which obviously can have excellent beneficial effects. But the negative side is that the people that you surround yourself with also exert their influence on you in ways that you can't even actually imagine. So Munger points out a study where 10 actors in an elevator face the back of the elevator. When a test subject gets on the elevator, they end up facing the same direction, which is the wrong direction as everybody else. So I observed this phenomenon in investing with groups of people, particularly on platforms such as Twitter or other small community platforms. Let's take a quick break and hear from today's sponsors.
- [41:29]
Tip
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- [45:03]
Kyle Grieve
The owners of a stock will often boast about how good their pick is and they will attract other investors into that same business. Then you get influenced by these people in interesting ways. For instance, if they like a stock, they may continue talking it up, ignoring some of the warning signs that might tell a rational person that the company is just no longer worth talking up. And if you succumb to social proof, you might hold a sinking ship to the very bottom of the ocean. The key to battling this tendency is to be perfectly fine having a view that's just different than the consensus. Munger said it's crucial to ignore examples from others when they're wrong. He went so far as to say there are very few other skills worth having over this one skill. Another area to focus on is to be skeptical of whatever is popular. Just because new investors are jumping on board an idea doesn't make the idea superior. Make sure you're watching the fundamentals of a business to note any large cracks before the herd and you're going to do all right in the markets. Now let's take out what I think is another highly dangerous bias, which is the contrast misreaction tendency. This tendency is for humans to think in terms of contrast rather than on an absolute basis. For instance, in Internet marketing, you may notice some people will carry a variety of different products or services at various price points. They may have one product that is just ridiculously priced and they know will never sell. And this is done purposely. It basically contrasts the cheapness of their more reasonably priced products. You'll see this on platforms like Gumroad, which sell a variety of courses to people. You might see a course on learning how to grow your social media following for 300 bucks. Then they'll have a consulting package for $5,000. The consulting package will never sell, but it makes the course seem more affordable in comparison. My favorite use case for this model is when comparing businesses in similar industries. Look, you know industries like sentiment is completely cyclical. If you compare one company with another where the entire business is loved by the market, you're probably going to be succumbing to the contrast misreaction tendency. So let's say you found some sort of AI play and maybe you decide to compare it to some of the business in the top of the S&P 500 that are somewhat related to AI, such as, you know, Nvidia, Broadcom, Oracle, Tesla, Meta and Alphabet. So you might look at the earnings of each of these businesses. You might see Nvidia trading at 51 times earnings, Broadcom at 100 times earnings, Oracle at 51 times earnings, Tesla at 150 times earnings, and Meta and Alphabet around 20 times earnings. You then contrast your AI play with each of these and see that they're trading at an average of around 65 times earnings. You then apply that metric to your future evaluation of the business that you're looking at. But the question that you should be asking is, are these multiples likely to sustain for the duration of your holding period? Because if you're comparing multiples to an overheated market that I think we're probably in right now to some degree, then your normalized number is probably going to be closer to that of something like a meta and Alphabet, which is around 20 times. And then you're putting yourself at just a considerable risk of losing money. If you were wrong about the multiple and it goes from, let's say 65 times to 20 times, the value that you are ascribing could decrease significantly even if you're actually spot on on the per share earnings or cash flow growth. So let's say you think that earnings per share is going to go from $2 to $4 over the next five years. The price difference in that five year period is $260, that $65 times earnings and only $80 at 20 times earnings. That's a massive range in value. So the value investor inside me would probably want to use that more Conservative Number of 20 for my evaluation purposes. And alternatively, if you want to be a little more aggressive, maybe you would consider examining the 10 year averages of your competitors and then use the average of those numbers. Now, to combat this bias, consider things in absolute terms and be cautious of relative framing. Now, being in the digital world we're in now creates an extraordinary and novel environment. One of the second order effects of that environment is that many of the actions we take serve to increase our stress levels. This is exhibited in Munger's next bias, the stress influence tendency. Heavy stress loads can have a range of unintended influences on us. Munger's points on this tendency are that through stress, the actions of organisms can rapidly reprogram an organism's brain and it can be nearly impossible to reprogram once the damage is done. This makes me think of a concept that William Green shared with a richer, wiser, happier masterclass. This is an idea called intentional disconnection. It's a process where you intentionally disconnect yourself from specific sources of stress to improve your daily environment. This can serve as a tool to reduce your ability to be programmed in a way that you just don't want to be programmed. The tool can be used to promote clarity as well, while avoiding noise. In the name of preventing myself from exposure to undue stress and noise, I have inadvertently used this tool since I started investing. So a few examples include things such as I don't watch any investing news on television, I check my portfolio performance only once a quarter, I place a premium on my company's abilities to increase earnings and cash flows over increasing its stock price, and I don't bother having an opinion on 99.99% of stocks out there. Now the next bias relates to our ability to work with information that is most easily available. This generally means we overweight information that we've come across recently or information that is associated with especially vivid imagery. This misjudgment is called the availability misweighing tendency. This bias is used extensively by the average investor in both bear and bull markets. So let's imagine yourself during a bear market. You have multiple positions that are down 30% or more with each passing day. You look at your portfolio in disgust as you see your net worth just evaporate in front of you. You might have imagined yourself retiring in a few years, but now, given the state of your portfolio, retirement is starting to look further and further away. Now the availability of that information is going to be top of mind and it will cause you to overweight this evidence, which will cause you to make poorer decisions. Some of these poor decisions might show themselves as you being less likely to deploy cash into cheap stocks. Or maybe in order to get back to break even, you increase your risk by using something like leverage to get back now let's look at a raging bull market. Now imagine you have multiple positions that are up 30% or higher for the year. Every day you look at your portfolio and you just admire it. You can see your net worth climbing into the stratosphere when you plug numbers into a compounding calculator. You're just amazed at what your net worth will be if you can continue compounding at this number endlessly into the future. Of course this is a complete fiction because nobody's going to compound 30% a year forever. But now you're more likely to think very, very highly of your skills. And this is excessive self regard tendency. It's working in full force. You think everything that you find turns to gold. Businesses trading at 15 times earnings you thought were interesting before are now interesting at 30 times earnings. Now you can see the contrast between the two scenarios. And to fight this tendency, Munger has some excellent pieces of advice. So his advice is to underweight the most vivid evidence and overweight the less vivid. Or better yet, focus on disconfirming evidence or find skeptics with whom you can discuss a topic to advocate for opposing views from your own. Let's see how the average investor could use this advice to make better decisions. In the case of a bear market, investors may realize that they have lost their money and obviously that still hurts. But instead of focusing on the fact that they're now poor, they can focus on all the juicy opportunities that are available there for them. Instead of selling their losers because they can't sign inside of them, they can use the cash they do have to add to their positions that are now most attractively priced. Now moving on to the next tendency. It's going to be very familiar to anyone who's ever lifted weights in the hopes of gaining muscle. And that's the use it or lose it tendency. So Munger states that all skills attenuate with disuse, just like a muscle will shrink if not put under stress. This is a great topic to discuss because it directly affects our ability to improve at using these misjudgments that we're talking about on problems that we will 100% encounter in life. Since there are numerous skills we learn and can become proficient in throughout life, we must select and cultivate those skills that we want to develop and maintain. If we want to improve at something, such as using these psychological misjudgments to think more effectively, we have to practice using them regularly. And I think Charlie was just a master at this, which is why he was so proficient at using them. If you just, you know, spend a week thinking about these misjudgments, then just toss them away for a year, chances are you're not going to get anything out of them. You need daily practice, so something like keeping a daily journal can be helpful. You can do something like, you know, quickly define a misjudgment, apply it to an observation in your life, then discuss how you would improve upon a problem once you face it again. And you can do this in a couple minutes. A day. I enjoy doing this and applying it to what's happening in the markets or based on decisions that I made in my portfolio. Here's what Munger said about skill acquisition. If a skill is raised to fluency instead of being crammed in briefly to enable one to pass some tests, then the skill will be lost more slowly and will come back faster when refreshed with new learning. These are not minor advantages, and a wise man engaged in learning some important skill will not stop until he's really, really fluent in it. If we are to think clearly, we must ensure that our cognitive abilities aren't impaired. And one way to guarantee impairment is through the consumption of drugs. Munger calls it the drug influence tendency. He devotes only one paragraph in Poor Charlie's Almanac to the topic, stating that everything you need to know can be found in the discussion on psychological denial tendency. But I think it's worth adding a little more color. Now, I don't want to bastardize a tendency, but you could also attribute this to alcohol. Regarding both, Munger once said, I've never seen somebody whose life was better by including drugs and alcohol on them. And so it's like, well, what are the things that I could do to destroy my life? Well, if I got really into drugs and really alcohol, that would be something that would now, the key here isn't necessary that you must fully abstain from alcohol. After all, unlike Warren, Charlie enjoyed wine. But the point is not to get consumed by alcohol where it takes over your life, causing you to live in denial or have some sort of dependency problem. I won't comment on whether or not you should consume either chemicals or alcohol. Still, I will say if you want to avoid misinfluence, you should avoid any dependency issues on both of these substances. There is a different kind of misinfluence that unfortunately, we cannot really choose to take part in, and that's the effects of aging. Charlie calls it the senescence misinfluence tendency. This tendency is more of a biological fact than a psychological one. As we age, humans suffer from cognitive decay. The severity and onset of this decay is entirely individual, and a lot of it can be attributed to just plain old good or bad luck. As we age, it becomes increasingly difficult to learn new and complex skills, but Charlie makes the point that it's possible to sustain the skills that we do have by upkeeping practice. He makes the point that if you were to go to a bridge tournament, a large percentage of the competitors would be older than, say, an Olympic event. This tendency is A tough one to game plan for. You know, Charlie and Warren have suffered very slight cognitive declines, but neither of them suffered from significant declines such as, you know, dementia or Alzheimer's that can really, unfortunately expedite these declines. The key here is to focus on Munger's emphasis on practice, skill development and I think, maintenance. If there are skills that you think are vital to your long term success, develop them as soon as possible, because you likely won't be able to create them as well as you can now in say, 20 to 30 years. And borrowing from Nick Sleep's concept of destination analysis, I think you can think about the skills that you want when you are 60, 70, 80 years old, then just work backwards and develop those skills now so you can maintain them later in life at a very high level. I've noticed this a lot in myself as I've aged. There isn't much that I'm good at now that I haven't been practicing very regularly. Things I used to love growing up, like hockey or playing basketball, I would probably suck at today. Whereas a sport like Jiu Jitsu, which I've been practicing regularly for over 10 years, I'm pretty decent at. And then in the thinking forum, keeping these psychological misjudgments and mental models top of mind and using them regularly is a skill that I know I want to develop for the remainder of my life. However, this is going to require daily practice to build and maintain. Otherwise it just becomes an interesting, you know, talking point with very little real world utility. Just like aging can cause all sorts of misinfluence, who we listen to and respect can also influence us in damaging ways. This is a good segue into our next misjudgment, which is the authority misinfluence tendency, or as I've always called it, the appeal to authority bias. This bias makes us unthinkingly follow perceived authority figures even when their guidance is flawed, harmful or absurd. Perceived authority figures is a broad term that can apply to just many, many different types of people. It can apply to people like our bosses. It can apply to CEOs of a business. It can apply to talking heads on tv. It can apply to writers. It can apply to nearly anyone who has a platform and followers who listen to them. A great example of this is a talking heads you might find on something like MSNBC or other financial news outlets. These actors become celebrities with large followings of people who follow and cling to their every word. Their disciples will even make significant financial decisions based on advice that these so called Gurus will dispense. Problems here are pretty obvious. If you're creating content for the sake of creating content, your advice should not be taken as financial advice, but as a form of entertainment. This is why it's so important to use critical thinking. It's perfectly fine to disagree with someone that you highly respect. And I would encourage you to actively seek dissenting opinions simply to help keep you thinking at a high level and avoid any bias that you might be getting from an authority figure. One part of investing that I think I've exhibited this tendency is when speaking to management. So management are great salesmen and they know how to effectively promote their product or service to entice people, including investors, to think very, very positively about it. While they might not be doing it in any nefarious way, you really have to question some of their assumptions. I recall, you know, for instance, one CEO posting growth of over 100% per year in his investor deck mainly due to a couple strong quarters. While I agreed with his growth forecast, I can only assume that many other investors clung to his assumptions and purchased a significant amount of that company's stock as a result. Now, that stock eventually fell by over 50% and his growth projections were nowhere close to reality. I unfortunately lost a chunk on that investment and it wasn't very fun. Therefore, you know, it's essential to challenge the assumptions of people that you respect to make the highest quality decisions. If you skip doing that, you open yourself up to a lot of potential pain and risk. We are now down to the final three misjudgments that Charlie outlined. So twaddle tendency is the next one I want to cover. This bias refers to the human propensity for engaging in meaningless talk or thought, or what Munger calls twaddle or prattle, which can interfere with serious thinking or decision making. Munger has an outstanding example of a Honeybee experiment by B.F. skinner, who was one of the most important scientists in the subject of behaviorism. So he put nectar up high, vertically, much higher than would ever happen in nature. Then he just observed a bee attempting to use a dance to explain the location of this nectar to other bees. And the dance was completely incoherent. No, they couldn't understand what the bee was trying to communicate. To put it even more simply, I think his tendency is just simply to waste time on things that don't matter. And that one sentence has a very crucial consequence in basically everything that we do. There are three areas of investing I think this tendency is especially active. The first one is following fads over fundamentals, the second one prioritizing eloquence over evidence, and third is mistaking verbosity for insight. What it comes down to is getting to the essence of something and trying to avoid excessive complexity. The financial markets love complexity because it can be used as a weapon to confuse people. But as Buffett says, we get paid not for jumping over seven foot bars but for stepping over one foot bars. If something is overly complex, you can easily choose not to pursue it and instead find something simpler. These points on simplicity and confusion are essential to understand. If someone is trying to communicate something like a stock idea to you, are they saying it in words that you can understand? Or are they intentionally trying to make it overcomplicated to maybe hide something from you? This is a good transition into the next bias, the reason respecting tendency, which posits that humans have a natural inclination toward accurate cognition and pleasure in its pursuit. This means when we're taught something or pitched a new investing idea, we will learn it and understand it better if we know the reasoning behind it. For instance, if someone starts telling me about a ticker and I ask why it's interesting and they reply with to the moon. Well, that doesn't help me understand the reasoning behind why I should invest in it. If someone tells me about an idea and we can have an intelligent conversation about what the business does, why do they have a sustainable business model where their customers are located? How long is their growth Runway? What kind of returns do they expect out of the investment? What needs to happen to achieve those returns? Why does the opportunity exist today? Then I'm going to have a much better understanding of the business and can make more intelligent decisions. If someone just says to buy it because their uncle told them it would be a good investment, that's a red flag that signals that I should probably tune out most of what they're going to say regarding that idea. Charlie said, in general, learning is most easily assimilated and used when lifelong people consistently hang their experiences, actual and vicarious, on a latticework of theory. Answering the question why? Indeed the question why is a sort of Rosetta Stone opening up the major potentiality of mental life. Now we come to the final psychological misjudgment, which may be the most important one to understand in his entire list. And this is called the Lollapalooza effect. This is a tendency to get extreme consequences from a confluence of tendencies acting in favor of a particular outcome. One important thing to contemplate is that the Lollapalooza effect can be both positive and Negative what might a Lollapalooza Effect Be? Most listeners will be familiar with the brand Tupperware. So Tupperware is so prodigious today that food storage, regardless of if it's the Tupperware brand or something else, is just called Tupperware. There was a time when people would have these Tupperware parties and be sold on the product while having a good time. As Munger said, these parties turn their brain to mush. They are highly effective due to multiple psychological tendencies. So the first one is social proof. When all your friends are psyched about a product, you're more likely to feel the same just to fit in with that social group. The second reciprocation, because you're offered food, drinks and company, you're more likely to want to pay it back by buying Tupperware. The third is loving liking. Since you're invited to the gathering, there's a good chance that you probably like the person who's hosting it, which can cause you to have positive feelings toward them. The fourth here is commitment and consistency. Since you showed up, you're more likely to participate since the act of showing up is an implicit form of commitment. And last is the incentive cause bias. Since the seller of Tupperware is incentivized to sell it, they're going to speak positively about the product regardless of any potential defects that they might know about. Now, to conclude this episode, I'll share an example of an adverse Lollapalooza effect that I think happened to me. It happened on a business I own called Aritzia. Now, since I've owned it, it has had three separate 40% drawdowns. I've never sold a share. It's also my biggest winner. But the Lollapalooza effect that I want to share opened up an opportunity. And this was in the fall of 2023. So for context, the business reported an EPS of about $0.63 for the quarter ended in November of 2022. But for the quarter ending on August of 2023, the EPS was negative $0.05. So there were a number of reasons this happened that intertwined with psychological misjudgments that I think create a Lollapalooza effect that I was able to take advantage of. So the first one was that the business was having supply chain issues like many other industries. And I think this is the availability mis weighing tendency at work. Since many investors held businesses that were having supply chain issues and observed firsthand how much that damage could do to a business's margins, they made very quick decisions once they saw Aritzia going through the same scenario. The second one here is that free cash flow was crushed. I think this was because the company invested significantly into growth capex to upgrade one of their distribution centers. And obviously as we know investors love consistency, but this inconsistency in cash flows caused them to rethink the business due to the inconsistency avoidance tendency. If Aritzia wasn't going to consistently produce cash flow, many investors lost interest in owning the company even though the capex was specifically outlined to support future growth. And the last one here is the hating disliking tendency. So once the business went through points one and two it was put into the penalty box. Lucky for me it was pretty short lived. Management indicated that inflationary pressures would subside which would help with margins, but the market which had been burned by the stock didn't seem to put much stock into management which I had no reason to mistrust. And then interestingly, the business has markedly improved since this time. The March 2025 quarter had an EPS of $0.85 and now the company is back in investors good books and it is in loving liking territory by the market. Now I actually have to prepare for any potential downsides that might arise with improved expectations. And with its shares trading around 42 times earnings, any hiccups will likely cause a short term hit to the share price. Now to sum up this episode, the two words that really come to mind to combat many of these tendencies is just critical thinking. Regardless of how we feel about something or other people or what they do or say, we must continually challenge our assumptions. And that starts with yourself. You have to challenge your own assumptions as well. It's really easy to rely on our lazy System one, which really just prefers to stick with the assumptions that we already have. But if we want to optimize our decision making, you must use System two Thinking to think critically about your base assumptions to come to the best possible solution. Charlie was just a master at this, and while it's unlikely we see another Charlie Munger anytime soon, you can still put in work to try to use his systems to improve the quality of your thinking. Good luck. That's all I have for you today. If you want to interact with me on Twitter, please follow me at irrational mrkts or on LinkedIn under Kyle Grieve. If you enjoy my episodes, please don't hesitate to let me know how I can improve your listening experience. Thanks again for tuning in. Bye bye. Thank you for listening to tip. Make sure to follow we study billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to theinvestorspodcast.com this show is for entertainment purposes only. Before making any decision, consult a professional. 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