Lessons from Charlie Munger

https://www.equitymaster.com/detail.asp?date=12/29/2010&story=6&title=Lessons-from-Charlie-Munger--I&utm_source=archive-page&utm_medium=website&utm_campaign=sector-info&utm_content=story

In the previous article, we had discussed the influence of incentives at the level of individual firms and some antidotes for investors. In this article, we'll discuss the power of incentives in the context of economic systems.

We all are part of various systems or groups- from a micro-system like a family to a macro-system like an economy. If you rip apart any system and look at its core design, you will find mainly two things: incentives and disincentives. They may be in the form of rules, regulations, norms, customs, traditions, mores or ethics. And you see them everywhere, don't you? Be it religion, politics or economics, every system is made up of these elements.
We'd like to point out to you how the success or failure of any economic system depends on how incentives and disincentives are designed. Let us explain.

What made the free-market economy work?

The success of the free-market system as an economic system comes from its inherent reward-punishment mechanism. Owners have a strong incentive to prevent all waste in operations. Their businesses will perish in the face of brutal competition if they are not efficient. Replace such owners by salaried government employees and you will normally get a substantial reduction in overall efficiency.

Communism has failed due to the absence of exactly those incentives that have motivated private enterprises to flourish in democracies. The fall of the Soviet communists is a glaring example of wrong system design. But one may also point the knife at the US- the epitome of free-market economy, for bringing in one of the worst financial crises ever. What really went wrong? Well, there is not just one simple answer to this. But we'll restrict our discussion to the main theme of the article.

The US financial crisis: an outcome of wrong incentives and absence of disincentives
It is fashionable to bash up the US Fed and the big investment banks for all the menace they created. But blaming them alone would do us more harm than good; because the crisis was a failure of the entire system and not the outcome of a few crooks alone. In one part, the financial crisis was a result of a series of incentives that induced unscrupulous behaviour across the entire system. The other major mishap was a complete dearth of penalties for wrong behaviour. Looking back, the evidence comes out pouring, often overwhelming.

Though it is not widely discussed, the original subprime lenders of the 1990s had already gone bust by turn of the century. A child could point and say, "Don't make loans to people who can't repay them." Simple. But amusingly and frighteningly, the lesson learnt was a bit complicated: "Keep making such loans; just don't keep them on your books." The lenders made the loans, and then sold them off to the fixed income departments of big Wall Street investment banks. These investment banks in turn packaged them into bonds and sold them off to investors. So the originator of loans had little incentive to bother at all about creditworthiness. On the other hand, there was hardly any penalty to curb his recklessness. As Mr. Raghuram Rajan, a leading economist who saw the crisis unfolding as early as 2005 noted, "Incentives were horribly skewed in the financial sector, with the workers reaping rich rewards for making money but being only lightly penalized for losses."

Also, the problem was not that no one warned about the dangers. It was that those who benefited from an over-heated economy- which included a lot of people- had little incentive to listen. So everyone enjoyed this "passing the parcel (read atom bomb)" game as long as the music played. And we all know what happened after the music stopped.

India 2010: A carnival of scams

We just emphasised the omnipotence of incentives and how a flawed reward-punishment mechanism can bring about the collapse of a giant system. It is quite clear that man responds more often and more easily to incentives than to reason and conscience. Didn't we see this axiom crystallizing before our own eyes with the cracking of a series of scams last year? Again, we will not arrive at an effective solution if the issue is not addressed at the most fundamental level. Firstly, we have to accept that man is fallible and corruptible, if the situation so allows. So the solution does not lie in moralising individuals alone, but more importantly, in creating robust systems that reward fair and ethical behaviour and deter deceitful practices.

https://www.equitymaster.com/detail.asp?date=1/13/2011&story=5&title=Lessons-from-Charlie-Munger--III

Lessons from Charlie Munger- IV

In the previous article, we had discussed how a wrong set of incentives across the entire economic system was responsible for the US financial crisis. Today, please do not panic, for we are going to talk about love.

Liking and loving tendency

Love is one of the most basic of emotions. The very first manifestation of it is between a mother and the new-born child. For a child, this earliest experience has far reaching effects. The child learns to love and to be loved in return. It becomes a kind of a programming device. And it extends not only towards people, but also towards things, ideas and concepts. Of course, the child learns to dislike and hate as well. But we'll limit this piece to our tendency to love and to like.

This tendency to love has its own set of side effects. It acts as a conditioning device and often distorts our perceptions. To make it simple, think of someone you love- your spouse, your kid, your favourite actor or cricketer. You could also think of any idea or belief that is very dear to you. Now ask yourself these questions:

Do you tend to ignore their faults? Do you readily comply with their wishes?
Do you favour people, products, and actions merely associated with them?
Do you distort any unpleasant facts about them?

Now why are we talking about all this? Has it got anything to do with investments and stocks? Most certainly yes! We are firmly of the belief that being a successful investor requires discipline and a sound emotional make-up.

Have a look at your stock portfolio. There is one very common error that most investors do with stocks that they own. Once they have bought a stock, they automatically start developing a feeling of affection towards it. Don't we often hear people raving about certain blue chips with an admiration that borders around reverence? Any negative comment about them will either be ignored, dismissed or defended. It almost seems like a marriage brimming with loyalty and affection. Take the so-called "hot" sector stocks. Don't they often cause many a feeble hearts to melt? And what happens to all thoughts about business and valuation? Well, well, well... You know best. We dislike challenging and reasoning with things and ideas that we love.

Our bottom line is this. Do fall in love, but not with your stocks. Love your capital and do the best you can to protect it and to help it grow. And what better of doing that than being a disciplined value investor!

https://www.equitymaster.com/detail.asp?date=3/3/2011&story=6&title=Lessons-from-Charlie-Munger--IV

Lessons from Charlie Munger-V

In the previous article, we had discussed how loving your stocks too much can distort your perception and in turn be a threat to stock investing. Today, we shall discuss the other extreme of the emotional spectrum: how feelings of dislike and hatred too can derail your investments.

Disliking and hating tendency

Take the recent Cricket World Cup. Rewind back to the semi-final match between India and Pakistan. Was it a cricket match? Or was it war? War it was! The high-voltage match that ended with India beating Pakistan saw our feelings of patriotism and national pride touch the sky. But it's not pride for India alone that makes us so jingoistic. There's also an intense hatred towards Pakistan that equally nourishes that feeling. So we get back to where we started- emotions and biases.

From the time we are born, we learn to dislike and hate the same way as we develop tendencies to like and love. The history of human evolution boasts of almost continuous wars. Neither religion, nor advancements in civil life have done much to change the basic savage instinct. And wars are not the only way in which hatreds find expression. In more sophisticated societies, hatreds and dislikes find expression in more non-lethal things such as elections, sports and even stock markets.

Charlie Munger has very aptly explained how the "disliking & hating tendency" acts as a conditioning device:

We ignore virtues in the object of dislike
We dislike people, products, and actions merely associated with the object of dislike
We even tend to distort other facts so as to justify our hatred.

Do you recall a promising stock that you had fallen for faltering miserably? There may have been some unfortunate event or probably a cyclical downturn. Maybe your timing wasn't right. Or maybe, the markets were just too pessimistic and overreacting at that moment. But your instinctive reaction could have been that of disappointment and anger. In your fury, you may have even decided never to put money in such a money-sucking monster.

This kind of biased approach to investing could be very detrimental to your stock portfolio. While negative events should be viewed diligently, you will be better off if you fairly consider the pros and cons of every situation. You never know, your blind dislike for a certain stock or sector could destroy a potential multibagger

https://www.equitymaster.com/detail.asp?date=4/7/2011&story=2&title=Lessons-from-Charlie-Munger-V

Lessons from Charlie Munger-VI

In the previous article, we had discussed how the 'disliking and hating' tendency can be a threat to your investments. Today, we shall discuss a very important human tendency that every investor should undoubtedly not avoid.

Doubt-avoidance tendency

The name itself is quite self-explanatory. Doesn't our mind often display a tendency to steer clear of doubts to quickly reach a decision or conclusion? It surely does, and at times to our own disadvantage. Charlie Munger presents an evolutionary perspective about how this tendency must have developed in humans from their non-human ancestors. He asserts that it would be suicidal for a prey animal threatened by a predator to take a long time to decide what to do. The development of this tendency has come as a survival tactic in times of stress and confusion. Much of religious propaganda has in fact taken advantage of this tendency. How otherwise would you explain the immense faith displayed by people in religious decrees that will otherwise find difficulty to get past the check-post of logic?
So the evolutionary justification of this tendency is reasonable. But the problem with any kind of psychological tendency or mental programming is that it doesn't work well in all situations. Say, a person who is neither under pressure nor threatened should ideally not be prompted to remove doubt through rushing to some decision. Yet, more often than not we find ourselves doing exactly the opposite.

Doubt-avoidance tendency in stock markets

Have you observed the doubt-avoidance tendency manifesting itself in the stock markets? The answer is a loud 'yes' in our view. How often do you trade on impulse without asking the right questions? How open are you to hear negative things about stocks that you are very optimistic about? When a person comes to the stock markets with a bag full of money to invest, he is usually inclined to fall in love with any stock that seems promising. The boredom and pain that is usually part of a thorough scrutiny and analysis of a stock is often avoided. Quick conclusions and quick decisions are often preferred instead of the burden of doubts and ambiguity.

Without any exaggeration, we strongly believe that if you learn how to reign over the doubt-avoidance tendency while you conduct your business in the stock markets, there is little that can stop you from becoming a successful investor.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

https://www.equitymaster.com/detail.asp?date=09/29/2011&story=2&title=Lessons-from-Charlie-Munger-VI

Lessons from Charlie Munger-VII

In the previous article, we had discussed the roots and the consequences of the 'doubt-avoidance' tendency. Today, we shall discuss another extremely important human tendency that every serious investor should be well aware of.

Inconsistency-avoidance tendency

Imagine what it would be like if you woke up every day and had to learn all the physical and mental tasks from scratch. It's impossible to even imagine such a situation. Thanks to the human brain, we don't have to bother about most tasks every single day. Through countless sets of programs, the human brain ensures our smooth and consistent functioning. Habits, which are patterns of behaviour which routinely repeat themselves subconsciously, are also a result of this process. While habits can be good, and good habits doubly so, there are several disadvantages as well. Habits often come in the way of any kind of change or transformation. As Charlie Munger puts it very aptly, "People tend to accumulate large mental holdings of fixed conclusions and attitudes that are not often reexamined or changed, even though there is plenty of good evidence that they are wrong."

This brings us to the inconsistency-avoidance tendency which is very rampant amongst human beings. In simple words, we filter away any piece of information which may be inconsistent to our ideas and beliefs. You may have read as students how many great scientists and discoverers were often discredited and ridiculed for their so-called lunacies. Many were acknowledged for their great work only after their death. Do you see how the inconsistency-avoidance tendency works? Not just history, even our day-to-day life is filled with such stories.

Inconsistency-avoidance tendency in stock markets

Our aim is not to profess psychology for its own sake but to attempt to relate it to human behaviour in the stock markets. Stock markets are largely driven by sentiment. So you must do your best to be as objective as you can and guard yourself from the lures of greed and fear.

Getting back to inconsistency-avoidance tendency, can you remember instances when you have used this tendency to your own peril? We'll point out a few for your benefit:

Have you lost money on your favourite stock that had once been an outperformer? The company's prospects may have changed, it may no longer be worth putting your money into, but you still couldn't let go of it. Why? Because letting go of it would be inconsistent with your original beliefs about it. So you did everything to console and convince yourself that nothing was wrong. But your portfolio losses have a different story to say, don't they?

Each investor will have innumerable such instances to share. Now the more important question, how exactly do you get rid of this tendency? There are several ways to do that, but more than anything else, you need to be very disciplined with your approach.

One great way is to play the devil's advocate. If you find a prospective company very compelling, first start with rejecting the hypothesis. In other words, try to gather facts and arguments that will prove that the stock is a bad investment. After all your analysis, if you arrive at the conclusion that the stock is still good, then it has passed the bar.
You can also take a good lesson from the court of law. Law courts have processes and procedures in place that tend to minimise hasty and biased decision-making, which can cost someone's life. As investors, you must learn not to be hasty. Adjourn your stock purchases till you're not clear in your mind.

Always remember, stock markets will always keep swinging higher and lower. Investing opportunities will be there. We can assure you that if you can tackle with your inconsistency-avoidance tendency, money will consistently keep pouring into your bank accounts.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

https://www.equitymaster.com/detail.asp?date=12/08/2011&story=5&title=Lessons-from-Charlie-Munger-VII

Lessons from Charlie Munger-VIII

In the previous article, we had discussed how you can make consistent stock returns by understanding and avoiding the trap of inconsistency-avoidance tendency. Today, we shall discuss a very basic tendency that often drives our thoughts and actions and is very relevant to our behaviour in stock markets. And in doing so, our aim is to help you identify dysfunctional behaviour patterns and thinking errors that may be hampering your stock market investments.

Envy / jealousy tendency

What do the words envy and jealousy bring to mind? Whatever they bring to mind, we often try our best to dissociate ourselves from them. Such is the taboo attached to these emotions that we do not want to link our behaviour and actions with them. Yet these very emotions are so innate to human nature that it is almost impossible to get rid of them. More importantly, given the crucial role that these emotions play in the human world, you could risk ignoring them at your own peril.
So let's ponder a bit about the roots of envy and jealousy. Charlie Munger gives a very interesting evolutionary perspective on this, "A member of a species designed through evolutionary process to want often-scarce food is going to be driven strongly toward getting food when it first sees food. And this is going to occur often and tend to create some conflict when the food is seen in the possession of another member of the same species. This is probably the evolutionary origin of the envy/jealousy tendency that lies so deep in human nature." If these lines sound very geeky and clinical, let us elaborate in simple words. Food is very basic to the survival of any life-form. Without nutrition, no life can exist. So the chief life-long struggle of any creature is about securing the supply of food. Throughout history, the availability of food has dictated the survival or extinction of species. Given the utmost importance of this vital resource, a creature will be instinctively driven to possess the food the moment it notices it. The conflict arises when it sees food in the possession of another creature. This explanation, though difficult to verify accurately, does broadly explain the origin of envy and jealousy. And it extends to all other things other than food as well.

Envy and jealousy tendency in stock markets

It is often said that stock markets are driven by greed and fear. Sounds pretty neat, isn't it? But legendary investor and Charlie Munger's 'Siamese twin,' Warren Buffett, has an important interruption to make here. He very wisely points out, "It is not greed that drives the world, but envy."A patient contemplation of this sentence will reveal to you its utmost significance. While 'greed' refers to an excessive desire to possess something, 'envy' is a desire to possess what the other person is possessing. And more often than not, greed is fuelled by envy. A lot of times, we desire something simply because we see someone else enjoying it. Such human tendency of envy and jealousy is very well orchestrated in the stock markets, albeit in overwhelming proportions. Everyone is here not just to make money, but to make more money than what the next person is making. Comparison and competition is intense, creating a perfect recipe for jealousy tendency. Let us give you a couple of examples to elaborate our point:

a) Mr Gupta made 25% annual gain on his stock portfolio in 2007. He is quite satisfied. But then he learns that his colleague Mr Agarwal made a whopping gain of 300% that same here. Now Mr Gupta is distressed and feeling left out. His 25% gain now looks paltry in comparison to Mr Agarwal's triple-digit gains. He gets desperate to replicate his friend's success. In his frenzy, he ends up playing some stupid bets and loses quite a lot of money.

b) Mr Rao has made a lot of money on certain stocks in recent times. Mr Desai, whose portfolio hasn't fared too well, is secretly disturbed, or in other words, jealous of his friend's prosperity. He decides to do exactly as his friend does, so that he would be as successful as him. Around this time, Mr Trivedi is extremely bullish on silver and places big bets on silver futures. Mr Sharma is tempted to copy. Despite not being in a very sound financial position, he jumps on the bandwagon and ends up burning his fingers.

It is clear that it was jealousy that motivated wrong behaviour in both these cases. The list of such cases is long. The important point to take home is to not let such negative emotions affect your investment decisions. But isn't it a little too difficult to not feel bad if your friends and colleagues make a lot more money than you do? It is indeed difficult. So the best antidote in such a case is to avoid discussions that would trigger feelings of jealousy. In fact, some of the best investors in the world keep extremely low profile and keep their discussions limited to stock ideas and business fundamentals. In the absence of such external disturbances, they are able to make more rational investment decisions.
We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

https://www.equitymaster.com/detail.asp?date=12/15/2011&story=1&title=Lessons-from-Charlie-Munger-VIII

Lessons from Charlie Munger-IX

In the previous article, we had discussed how a simple emotion like jealousy could prompt you into making irrational investment decisions. Today, we shall discuss our innate tendency to be over-optimistic and how it affects our view of the economy and the stock markets. Our aim is to help you understand the workings of your mind better so that you do not let your biases and thinking errors jeopardise your investments.

Over-optimism tendency

It is indeed commendable how humans and other creatures have evolved and survived over millions of years of evolution. Forget millions of years. Just look at all that has happened in the last 100 years, a period which saw two major world wars and a series of economic and political crises across the globe. Yet we continue to look forward to a better future. What is it that allows man to endure the many trials and tribulations that life presents? Hope, isn't it?

Charlie Munger shares a very interesting perspective in this regard. He opines that an excess of optimism is the normal human condition. And this tendency to be over-optimistic not only manifests when man is in pain, but also when he is doing well and there is no threat of pain whatsoever. A famous Greek orator by the name of Demosthenes is known to have said these very fitting lines more than 2,000 years ago-"What a man wishes, that also will he believe."

Over-optimism tendency in stock markets

It is not at all difficult to understand how this tendency drives not just stock markets but the entire world of finance and economics. Why otherwise would we have booms and bubbles with such amazing regularity? Why do people continue to flock to the financial markets despite the regular crises and busts that torment the markets? In fact, all the malaise troubling the global economy today, from the debt crises in the developed economies to the high inflation and slowing growth in emerging economies like India, do have roots in excessive optimism. The problem is that when things are good, we expect them to get better and better in a linear fashion. And even when things are bad and getting worse, we often expect that the situation will turn good again sometime in the future.

This tendency is so often displayed by company managements.

During good times, they tend to get over-optimistic and take up massive debt-funded expansion plans by way of capacity additions or wasteful mergers and acquisitions. When the cycle turns and things turn sour, you see red ink all over their financial statements.
What is surprising is that even in bad times, a lot of companies are extremely shy to admit that things are not going too well. They tend to project and hope only what they wish to see and not what there is really.

As investors, the best way to deal with this bias is to acknowledge that it exists in the first place. That is half solution done because most of the times we are not aware of our own biases. Then a very effective antidote to over-optimism is to challenge your views by asking yourself as many questions as possible. If your views cannot stand the attack of reason, you know which tendency is to be blamed.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

https://www.equitymaster.com/detail.asp?date=12/29/2011&story=4&title=Lessons-from-Charlie-Munger-IX

Lessons from Charlie Munger-X

In the previous article, we had discussed how our tendency to be over-optimistic distorts our view of reality and as a result, we often end up making wrong investment decisions. Today, we shall discuss a very important human tendency which is prevalent in all walks of our social life and has a tremendous influence on how we think and behave. Our aim is to help you understand the workings of your mind better so that you do not let your biases and thinking errors jeopardise your investments.

Social proof tendency

We would like you to contemplate a bit about the below questions before we share our views on them:

Have you ever commuted on Mumbai's local trains? If you have, you will most certainly agree about how a harmless looking gentleman can so quickly transform into a savage beast to plough his way into the train and onto a seat.
What causes riots? How are terrorists created? What do you think prompts an otherwise normal person to pick up weapons and brutalise unarmed strangers?
What was the reason for the success of Anna Hazare's movement against corruption? Why did an otherwise indifferent middle class go all out in support of Team Anna, sometimes even referring to the episode as India's second freedom struggle?
Why are Indians cleaner and more disciplined abroad than at home?

Though there may be other reasons as well, but the one important common thread among all these is the social proof tendency. What is social proof tendency? Well, it is an automatic tendency to think and act the way people around you are thinking and acting.

In the first instance, an otherwise gentleman turns rash in a Mumbai local train. Since everyone is doing the same, it seems socially acceptable to him. While he may not display that kind of behaviour in most other places, pushing and suffocating others in a local train appears pardonable to him. At least that is what it seems to him from the behaviour of others. Meaning, there is social proof.

The social proof tendency works in both positive and negative situations. Be it riots and terrorists. Or be it the massive support that came in for Anna Hazare. This tendency most readily occurs in the presence of puzzlement or stress, or both.

Social proof tendency and corruption in India

Charlie Munger points out one interesting aspect of the social proof tendency which very well explains why corruption in India is so deeply rooted. The "Serpico Syndrome" is named in the memory of Frank Serpico who once entered a highly corrupt New York police division. Unlike others, he resisted to be consumed by the contagion of corruption. And for that resistance, he was almost about to lose his life. Isn't this reminiscent of the many Indian films wherein the protagonist is the honest police officer who challenges the corrupt system? In the film, of course, the good cop reigns over his adversaries. In real life, however, that is seldom the case. As it is evident, the evil of corruption continues to persist in our country because of this very Serpico Syndrome, which is created by the social proof tendency and the power of incentives.

Akin to the other spheres of life, social proof tendency is present in overwhelming proportions in the world of business and finance. It dominates how investors behave in stock markets, how company managements do business and so on. We will discuss this is more detail in the next article of this series.

https://www.equitymaster.com/detail.asp?date=01/05/2012&story=4&title=Lessons-from-Charlie-Munger-X

Lessons from Charlie Munger-XI

In the previous article, we discussed the social proof tendency in day-to-day life and also explained why corruption in India is so deeply rooted. Today, we shall discuss the social proof tendency in the context of business and finance.

The Institutional Imperative

Many of us may think of corporate leaders and managers as highly qualified, intelligent and experienced people who would be making rational business decisions. Even the legendary investor Warren Buffett had the same notion when he entered the world of business. But through time and experience, he realised that more often than not, despite all the qualifications and experience, it was not the case. A deadly force which he calls the 'institutional imperative' often hinders rational decision making and at times, even destroys businesses.

What does institutional imperative mean? The Oracle of Omaha explains the institutional imperative as that need for managers to act and do like their peers no matter how irrational it may seem. A simpler term that comes to mind is peer pressure. However surprising it may seem, even CEOs are subject to this pressure which forces them to make stupid mistakes.

The evidence is almost everywhere. Say for instance, if some companies in a certain sector go on a capacity expansion spree, others are quite likely to follow, even though the overall economic situation may be hinting otherwise. What is the excuse such companies provide when the initiative goes for a toss? It's not difficult to guess- 'Everybody was doing that'.

From his own mistakes, Buffett realised how important it was to not fall victim to this force. As an antidote to this problem, he introduced a technique at Berkshire Hathaway that has been quite effective in dealing with institutional imperative. To idea is simple- Have the management act as if they were the owners. What happens when managers start thinking like owners? They think very differently. They think twice if their own money is at stake.

The tendency to fall prey to the social proof tendency is also seen among investors. Stock market booms, bubbles and eventual crashes clearly show how investors succumb to peer pressure and end up burning their fingers. What should investors do to avoid such mistakes? Buffett has a solution for this as well. He says, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." It may sound simple but it's indeed a very powerful way to guard yourself against the social proof tendency.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

https://www.equitymaster.com/detail.asp?date=03/01/2012&story=8&title=Lessons-from-Charlie-Munger-XI

Lessons from Charlie Munger-XII

In the previous article, we discussed the social proof tendency and explained how often company managements and investors get bitten by the bug of' institutional imperative'. Today we shall discuss another important psychological tendency that often causes massive misjudgments and bad investment decisions.

Contrast Misreaction tendency

How do we really perceive things? For instance, how does our brain figure that an elephant is a big fat creature? Or, how do we know that a tortoise is very slow? The answer to both these questions is relative comparison. We perceive everything in relative terms. That is, an elephant seems big in comparison to our own selves and most other creatures. A tortoise seems to be moving slower when compared to a hare. Of course, this mode of perception is not just restricted to how we look at animals. But it extends to all things in life, and very evidently in investments and stock markets. It influences how we think about economic news and information, corporate performance, stock prices, and so on.

The reason why we tend to perceive things in relative terms is that it is impossible for the human nervous system to measure everything in absolute scientific units. So we use our senses to identify things by comparing them with other things. It is the relative contrast that gives things their specific characteristics. This is a simple program that the human mind follows. But like all psychological processes, if a mental program is allowed to run without due diligence, it can cause thinking errors and misjudgements. In this specific case, it can lead to contrast misreaction tendency.

What is contrast misreaction tendency? Contrast misreaction causes people to make wrong judgments based on misleading contrasts between two or more things and situations. Charlie Munger cites an interesting example where this tendency is often misused- A person is shifting to another city and looking for a new house for his family. To get some quick help, he goes to a real estate broker. First, the salesman takes him around and shows him some really terrible homes for insanely high prices. Then, he takes the person to a merely bad house at a slightly lower price. Need we mention what happens next! What exactly went amiss in this case? How did the home buyer fall into the saleman's psychological trap? Blame it on the contrast misreaction tendency. When the person was shown the last property, he compared the house and its price to the horrible ones he saw before. Because of this comparison, he was ready to buy the not-so-good-house at a pretty high price.

Contrast misreaction tendency in the stock markets

Do investors also make wrong investment decisions because of the contrast misreaction tendency? The answer is yes, very often. The following instance will explain how investors enter this psychological trap.

Expensive at 140, attractive at 300!

Mr Chandra was an active investor. He was suggested by a friend to buy shares of XYZ Ltd when the stock price was Rs 90 per share. Instead of buying immediately, he decided to wait for some time. But in just a matter of few weeks the stock price mounted to Rs 140 per share. That was a whopping rise of nearly 56%. Obviously, Mr Chandra was very distressed. He cursed himself for not buying when the stock was trading at Rs 90. But now, he couldn't get himself to invest in the stock. It's way too expensive, he thought.

In the meanwhile, the stock continued to rally. In just a few months, the stock price was hovering around Rs 400. Mr Chandra had never felt so miserable. He had missed such a big opportunity. But then the stock price faced some selling pressure and corrected by about 25%. At Rs 300, what do you think Mr Chandra must have done? He invested heavily into the stock.

Why did he not buy the stock at Rs 140? What forced him to buy the same stock at Rs 300? The answer in both cases is contrast misreaction tendency. Rs 140 seemed very expensive in contrast to Rs 90, the price at which his friend had suggested. However, Rs 300 seemed cheaper relative to the high of Rs 400 that the stock had witnessed.

A similar mistake also occurs with valuation multiples. For instance, if a stock has commanded a price to earnings (P/E) multiple of 50 times in the past, it doesn't mean that a P/E of 30 times is a lucrative buying opportunity.

How can investors avoid such thinking errors? We believe the principles of value investing are a perfect antidote for the contrast misreaction tendency. Never judge the value of a company based on its past stock price performance or P/E multiples. Look at the company's business fundamentals and its past financial track record. How are the future growth prospects? What are the risks and opportunities to the business? Do the company's managers behave like owners? Valuing the company based on such important parameters will help you avoid false comparisons.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

https://www.equitymaster.com/detail.asp?date=03/30/2012&story=8&title=Lessons-from-Charlie-Munger-XII&utm_source=archive-page&utm_medium=website&utm_campaign=sector-info&utm_content=story

Lessons from Charlie Munger-XIII

In the previous article, we discussed the contrast misreaction tendency and elaborated how it has an adverse effect on investments. Today we shall discuss yet another erroneous psychological tendency that causes investors to misinterpret information, resulting in wrong investing decisions.

Availability-misweighing tendency

The first thing many people do after they wake up in the morning is grab the newspaper. Reading the paper gives us a sense of what's going around in the real world. The same is true for television news channels. Based on what is served to us by the news media, we build our mental model of what the real world outside is like.

But does this mean that the news stories presented by the media are the most important and legitimate issues concerning us? What about issues that don't make it to the newspaper or the TV but still could be very relevant and vital? This discrepancy often leads us into a distorted view of reality. What appears more often and more prominently around us assumes a lot more importance than it may deserve. On the other hand, issues that may not be discussed could be disregarded as trivial.

This brings us to availability-misweighing tendency. What does it mean? Charlie Munger explains it very aptly quoting a song: "When I'm not near the girl I love, I love the girl I'm near." The human mind has a tendency to focus on what's easily available. And in doing so, often tends to give undue importance to it. On the other hand, the significance of things and events that are not easily accessible could be undermined.

Availability-misweighing tendency in the stock markets

Business fundamentals and earnings drive stock prices over the long term. However, on a day-to-day basis, it is the relentless flow of news and information that sends markets up and down. Owing to this intricate relationship with news, the stock market is one place that most easily falls prey to the availability-misweighing tendency. Isn't it often observed that news items that are prominently projected in the media elicit substantial response from the stock markets? In other words, the markets are ready to react to any information that is made available to them. This also means that important matters that are not covered by the news media may be ignored by the stock markets.
Take for instance, the recent slew of economic reforms announced by the government. The initiative has been covered extensively by the media. Though most of these reforms are not very significant and are unlikely to have any major positive impact on India's economic growth in the near future, the sentiment on the Indian bourses has suddenly turned optimistic.

The case of individual investors is also very similar. Stocks that are most widely talked about in the media often make an easy entry into the stock portfolio. Many companies tend to use this tendency to prop up their share prices. Using their PR machinery, companies bombard the media with press releases, interviews and news reports about every trivial development and achievement, many of which may not have any major impact on earnings. But in the absence of other relevant information, investors often end up giving undue importance to such insignificant matters.

In the next article, we will discuss what investors can do to avoid falling prey to this think error.

https://www.equitymaster.com/detail.asp?date=10/05/2012&story=6&title=Lessons-from-Charlie-Munger-XIII

Lessons from Charlie Munger-XIV

In the previous article, we discussed the availability-misweighing tendency and elaborated how it has an adverse effect on investments. Today we shall discuss what investors can do to avoid falling prey to this thinking error.

Playing Charles Darwin

The theory of evolution proposed by Charles Darwin, a 19th century British scientist, revolutionised the way many thought about the natural world. It is worth noting that around the time, a majority Europeans subscribed to the biblical description that the world was created by God in seven days.

Given the vulnerability of the human mind to thinking errors and psychological shortcuts, what led Darwin to think so radically different? As it turns out, the man operated through a mental model that helped steer past several psychological biases. Charlie Munger suggests that taking Darwin's approach could be an effective antidote for availability-misweighing tendency.

What did Darwin do to eliminate biases? It is said that Darwin was a very strong proponent of objectivity. He was known for playing the devil's advocate to his own ideas and hypotheses. So much so that as soon as he would have an idea, he would try to gather evidence to disconfirm it. In fact, he tended to be even more rigorous in his approach with ideas that were particularly compelling.

Let's try and apply this approach to investing in stock markets. Say for instance, there is a certain stock that your friend has strongly recommended you to consider buying. Suddenly, the stock price goes up following a positive piece of news. What would be your reaction? Your friend is optimistic about the stock. The news is positive. The markets too have cheered the news. Isn't there enough reason to run and call your broker to buy the shares? If you would have done that, you would have quite likely fallen prey to the availability-misweighing tendency.

A wiser response would have been to do what Darwin always did: Challenge the merit of the idea. Look for potential risks and concerns that could adversely affect the company. Arrive at your independent view only after thoroughly evaluating the potential of the stock. The ultimate investing decision should be based solely on your understanding and insight and not from borrowed optimism. In short, if you come across a stock that appears to be the market's darling with a lot of media attention on it, play the devil's advocate and consider all possible risks and concerns that can derail the investment. If the idea still holds, it is certainly worth investing.

It is observed that a vital quality that is common amongst all great investors is discipline. It is this discipline that helps them overcome the various thinking errors and biases, availability-misweighing tendency being one of them. A practical way to ensure discipline and to avoid falling prey to this tendency is to prepare an investment check list and adhere to the process in a disciplined manner.

In conclusion, remember what Charlie Munger has said, "An idea or a fact is not worth more merely because it is easily available to you."

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

https://www.equitymaster.com/detail.asp?date=10/12/2012&story=3&title=Lessons-from-Charlie-Munger-XIV

Lessons from Charlie Munger-XV

In the previous article, we discussed how investors can avoid falling prey to the availability-misweighing tendency. Today we shall discuss another important tendency which is not just crucial to investing but almost everything you do in your life.

Use-it-or-lose-it tendency

The name is quite self-explanatory. If you don't use a certain skill, you tend to lose it gradually. The most common example that we all grow up hearing is about our tail bone. Human beings, in their evolution from apes, lost their tails as they stopped using it over time. The same holds true for the various mental and physical skills that we possess.

You may recollect that when you were younger, there were many things you could do very well. But as time passed and you lost touch with those things, the skills have either diminished or have been forgotten completely.

Often, you may not immediately notice that a skill is attenuating. For instance, say a person excelled in Science and Sanskrit when he was in school or college. But on account of a marketing job, he made little use of his knowledge in those subjects. Slowly, over time these skills shimmered away. Each of us can name several such instances.

What can one do to avoid such loss of useful skills? The only way to keep such skills alive is to use them regularly. The importance of regular practice is especially very vital in skills of a very higher order. For example, a Polish pianist called Paderewski once admitted that if he did not practice even a single day, he could notice some deterioration in his performance. And if he did not practice for as long as one week, the audience would also be able to notice the difference.

Similar is the case with aircraft pilots. It is crucial that they remember all the necessary skills that are required while flying, though all of them may not be frequently used. Any deterioration in vital skills can result in destruction of people and property.

Charlie Munger suggests using something that is a functional equivalent of the aircraft simulator employed in pilot training. While investing is not a rocket science, there is no reason to take it too casually. Many people take investing as a side business which can be done without putting in too much time and effort. And that is one of the biggest fallacies. Legendary investors such as Warren Buffett, Charlie Munger and Peter Lynch did not create great fortunes out of thin air. They are known to be rigorous practitioners of their art. They all read extensively and spend a huge amount of their daily routine analysing companies. In other words, by using their mental skills meticulously, they have become successful pilots of the investing world.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

https://www.equitymaster.com/detail.asp?date=12/14/2012&story=3&title=Lessons-from-Charlie-Munger-XV

Lessons from Charlie Munger-XVI

In the previous article, we discussed the importance of use-it-or-lose-it tendency for investors. Today we shall discuss another psychological tendency which is pertinent to investors of all age groups.

Senescence-misinfluence tendency

The word 'senescence' may not seem familiar. It derives its roots from the Latin word 'senescere' which means 'to grow old'. So effectively, senescence-misinfluence refers to the cognitive decay and mental limitations on account of biological aging. Of course, the aging process may differ from person to person in terms of the time it commences and the pace at which it progresses. But, by and large, old people have difficulty acquiring new skills. As such, the probability of learning complex new skills is practically zilch.

But here is an interesting twist. Though acquiring new skills may be challenging, the good news is that some people very well manage to retain old skills that they have practiced intensely over the years. In fact, there is a long list of people who have achieved great feats despite their old age. Benjamin Franklin, who has been Charlie Munger's personal hero, helped frame the US Constitution at the age of 81 years. At the age of 76 years and 340 days, a Nepalese gentleman by the name of Min Bahadur Sherchan became the oldest person to climb Mount Everest, the world's tallest mountain. Age did not hinder the famous deafblind American author and political activist from writing a book called 'Teacher' at the age of 73 years. Across the world and across fields there is long list of such achievers who have seldom let old age get in their way.

What does senescence-misinfluence tendency have to do with investing?

You may be wondering why we are discussing old age in the context of investing. Let us explain a bit and you will see the connection.

Our financial needs change with the various phases of our life. Given that the topic under discussion concerns old age, let us focus on a person's financial needs post retirement. At this age, you may not have the burden of educating and marrying your kids. You may also not have to worry about buying a home. With all major investments and expenses behind you, you may be relatively relieved.

But you may have several other expenses. For instance, your healthcare expenses could be significantly higher. You may also want to fulfil all the dreams that you may have sacrificed in your youth. And so on. The point is that you are going to need a good deal of money irrespective of your age.
But would your pension income be enough to take care of your post-retirement needs? And wouldn't you want to avoid depending on your kids for money? At an age when you may not be in the best physical frame to travel distances and perform demanding tasks, what could you do for an alternative source of income? The answer is investing.

Some may counter with the usual argument that investing in stocks is risky. Of course, there is no denying that there is an inherent risk. But the real risk of significant losses lies in speculative short-term trading. If you choose the path of long term value investing, you will not only live with minimal risk, but the chances of immense profits will be significantly high. Remember, in the long run, equities tend to outperform all major asset classes.

But it would be a big mistake if you wait until retirement to start investing actively. The preparation has to start much earlier. When you are relatively young, invest time regularly to educate yourself about value investing. Let this be a life-long process of learning and investing. In this way, you will be very well-equipped to deal with your investments in your latter years.

But wouldn't old age hinder your thinking abilities and decision making? Your greatest inspirations could be Warren Buffett (82 years) and his so-called Siamese twin Charlie Munger (89 years). What is the secret behind their outstanding thinking prowess and investing acumen even at this age? The answer is simple. If you develop useful skills early in your life and practice them rigorously over the years, you could manage to retain those skills for a much longer period, despite the aging process.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

https://www.equitymaster.com/detail.asp?date=01/18/2013&story=5&title=Lessons-from-Charlie-Munger-XVI

Lessons from Charlie Munger-XVII

In the previous article, we discussed how the ageing process could weaken your thinking capacity and ways that could help you to retain your mental prowess in old age. Today we shall discuss a psychological tendency that is very dominant in all spheres of our lives and often misleads investors into making poor decisions.

Authority-misinfluence tendency

In his bestselling psychology book Influence, renowned author Robert Cialdini tells an interesting and funny story. A man complaining of earache goes to visit the doctor. The doctor diagnoses an ear infection and prescribes ear drops for him. On the prescription, he writes, "Place drops in R ear." Given that doctors are usually in a rush, he abbreviated "Right" with R.

What do you think the trained nurse must have done? She followed the instructions obediently and interpreted it as 'rear' instead of 'right ear'. Very dutifully, the nurse asked the patient to turn over and placed the prescribed number of drops in the patient's anus. Yes, what you just read is true!

Now, you don't have to be a trained medical practitioner to realise that an ear infection is unlikely to be cured by placing the drops in your rear. It is interesting to note here that neither the nurse nor the patient doubted the sanity of the prescription. Why? Simply because it came from an authority!

Errors owing to the misinfluence of authority are found across all spheres of human life. In some cases, the results tend to be very tragic. A classic case that shows the powerful influence of an authority figure is the Holocaust. What else do you think could have motivated Nazis to ruthlessly slaughter millions of innocent Jews?

Charlie Munger recalls an incidence from World War II wherein a new pilot was very eager to please the general. Sitting besides the general in the copilot's seat, he misinterpreted a minor shift in the general's position as a direction to do something absolutely foolish. Without a moment's doubt, he did it and this resulted in a plane crash.

Why is man innately wired to follow authority? What causes man to submissively bow down to authority even if it may seem wrong and unreasonable?

The answer probably lies in the way we have evolved over the ages. All our ancestors lived in dominance hierarchies. Dominance hierarchy is a social living group with a ranking system based on power. Owing to competition over limited resources and mating opportunities, relative relationships are developed between members of the same gender. This results in the creation of a social order. The social order undergoes changes only when a dominant animal is overpowered by a subordinate one.

Human societies have followed a similar path. History has been largely shaped by few men at the helm, while the majority of humanity has simply followed orders. This explains why following authority is a very automatic tendency of man.

Following authority is not a flaw in itself. In several cases, it is quite crucial. For instance, think about the fate of a military operation where each member refuses to take orders without questioning. On the other hand, follow-the-leader tendency can be very dangerous at times as the examples above suggest.

In our next article of this series, we will analyse how the authority-misinfluence tendency could be causing you to make investment mistakes in the stock markets. We will also discuss ways that could help investors minimise the ill-effects of this tendency.

https://www.equitymaster.com/detail.asp?date=03/07/2013&story=6&title=Lessons-from-Charlie-Munger-XVII

Lessons from Charlie Munger-XVIII

In the previous article, we discussed how humans have a natural tendency to submissively follow authority and how in some cases it can have tragic consequences. Today, we shall discuss this psychological tendency in the context of stock markets and how investors can wean themselves off this thinking error.

Authority-Misinfluence tendency in stock markets

Uncertainty and risk have a big influence on how independently people take their decisions. The greater the risk and uncertainty, the greater is the tendency to seek guidance and conformation from an authority figure. This makes the stock market a place that is incurably afflicted by the authority-misinfluence tendency.

Just spare a moment and ponder about how exactly you decide when to buy or sell a stock. Do you invest based on 'hot tips' shared by 'influential' friends? Do you avidly track the portfolio of successful investors/ fund managers and try to mimic them? Do you invest based on the advice given by stock experts who appear on television? Do you blindly follow the advice of your broker or any other advisor?

If your answer is a 'yes' to any one of these, then here are some more questions. What makes you follow these experts? Do you ever question or challenge their opinions? Do you trust them simply because they are in a position of authority? Is it convenient for you to follow them blindly so that you can escape the blame in case things go wrong?
If you honestly reflect over these questions you will see that your decisions are seldom your own. In fact, it is not just small investors who fall prey to the wrong influence of authority. Even experts do, a lot of times.

You will recall that just prior to the stock market crash of 2008 most analysts had given a thumbs-up to an unreasonably expensive big ticket IPO of a famous corporate house. The IPO was oversubscribed a whopping 73 times! And then, not very surprisingly, the stock tanked after listing. In fact, it's been over five years since the stock listed and it is still down nearly 68% from its listing day closing price. This is what happens when one indiscriminately gives in to follow-the-leader tendency.

Of course, we are by no means suggesting that you should switch yourself off from all external help. This would be a stupid thing to do. Listening to views and opinions from experts is quite valuable. But there is difference between listening to experts with discretion and blindly following them. It is important that you exercise your own independent judgment to the opinions of others.

'Mr Market' is there to serve you, not to guide you

In an abstract sense, 'Mr Market' (as referred to the stock market by value investing genius Benjamin Graham) is a representation of an authority figure. People pay excessive attention to where the markets are going. But you must remember that 'Mr Market' is a fickle leader and often deviates away from the rational path.

The greatest investors in the world are those who do not give in to the moods of 'Mr Market'. In fact, in his Letter to Shareholders in 1987, legendary investorWarren Buffett put down some very important lessons that he had learned from his Columbia Business School professor. Ben Graham had taught him to look at the market quotations as if they were coming from an emotionally troubled fellow called 'Mr Market'. The poor guy often goes through periods of euphoria followed by periods of gloom. But the good thing is that 'Mr Market' does not mind if you ignore him. His only job is to come up with a new quote every day, every few seconds.

So if you learn to command this peculiar gentleman, you can take advantage when he is gloomy and rack up great businesses at depressed prices. On the other hand, when 'Mr Market' is euphoric, you can simply ignore him. The most important thing to remember is to let the 'Mr Market' serve you, not to influence your investing decisions.

https://www.equitymaster.com/detail.asp?date=03/14/2013&story=5&title=Lessons-from-Charlie-Munger-XVIII

Lessons from Charlie Munger-XIX

In the previous article, we discussed how investors often make wrong investing decisions due to misguided influence from authority figures. Today we shall discuss yet another human tendency that often leads us into unproductive behaviour.

Twaddle tendency

All creatures survive in groups. And the one factor that connects creatures of a species is communication. It goes without saying then that communication has been one of the most critical tools in the evolution and survival of all species. Broadly, communication facilitates sharing of information about food, attracting a mate, signaling danger and so on.

One of the things that differentiate human beings from other animals is our ability to think. The relatively larger size of our cerebral cortex is the reason for our creativity, language and logical deduction. As such, we have a highly advanced and complex language at our disposal.

But do we always make the most rational and productive use of words? The answer seems to be no. And this is where the 'twaddle tendency' fits in. An online dictionary defines 'twaddle' as silly, trivial or pretentious talk or writing. Being a social animal, man often indulges in petty small talks and chatter. No wonder the celebrity rumour and gossip pages are often the most widely viewed amongst all other news and editorial content!

Twaddle or nonsense talks are not such a bad thing by themselves. They only become a nuisance when they come in the way of some serious work that is in progress. And this is what we need to keep a check on. Charlie Munger relates an interesting experiment on honeybees which can be used as an analogy to show how the twaddle tendency can lead to unproductive results. For those not very well-read in biology, honeybees have a peculiar dance language that they use to indicate to their fellow mates where the food is. After returning to the honey comb with pollen or nectar, the worker bee performs a dance with particular movements. Through this, it communicates to the other bees both the distance and the location of the food. The other worker bees then follow the directions suggested and set out to gather pollen and nectar.

A certain scientist was curious to know how the honeybees would respond if the nectar was placed in an unusual position. So he placed the nectar in a straight-up position at a significant height. As you would have guessed, no nectar exists in such a position in a natural setting. So, this baffles the honeybee. It does not have a genetic program that is capable of communicating this new position.

According to you, what should the honeybee ideally do in such a situation? It should just go back to the hive and pick a quiet corner, shouldn't it? But the honeybee does not do that. Instead, it comes back and attempts a dance. But the dance turns out to be incoherent. Just like twaddle!

Can this behavioural tendency of the honeybee also apply to human beings? In our next article of this series, we will analyse the twaddle tendency in human beings, particularly in the context of the stock markets and the economy. We will also discuss ways that could help investors to filter away all the useless twaddle.

https://www.equitymaster.com/detail.asp?date=03/20/2013&story=3&title=Lessons-from-Charlie-Munger-XIX

Lessons from Charlie Munger

Tan KW

Publish date: Wed, 07 Sep 2016, 03:05 PM

Tan KW

Lessons from Charlie Munger- I

The Multi-disciplinarian

Lessons from Charlie Munger- II

Lessons from Charlie Munger- III

Lessons from Charlie Munger- IV

Lessons from Charlie Munger-V

Lessons from Charlie Munger-VI

Lessons from Charlie Munger-VII

Lessons from Charlie Munger-VIII

Lessons from Charlie Munger-IX

Lessons from Charlie Munger-X

Lessons from Charlie Munger-XI

Lessons from Charlie Munger-XII

Lessons from Charlie Munger-XIII

Lessons from Charlie Munger-XIV

Lessons from Charlie Munger-XV

Lessons from Charlie Munger-XVI

Lessons from Charlie Munger-XVII

Lessons from Charlie Munger-XVIII

Lessons from Charlie Munger-XIX

More articles on Gurus

Discussions

Post a Comment

Featured Posts

Latest Videos

Apps

Top Articles

Hot Stocks Today >

Daily Stocks

MQ Trading Signals

Featured Advertisers / Partners

Top Brokers >

Books Review >

Welcome! Select a username of your choice.

Lessons from Charlie Munger

Tan KW

Publish date: Wed, 07 Sep 2016, 03:05 PM

Tan KW

Lessons from Charlie Munger- I

The Multi-disciplinarian

Lessons from Charlie Munger- II

Lessons from Charlie Munger- III

Lessons from Charlie Munger- IV

Lessons from Charlie Munger-V

Lessons from Charlie Munger-VI

Lessons from Charlie Munger-VII

Lessons from Charlie Munger-VIII

Lessons from Charlie Munger-IX

Lessons from Charlie Munger-X

Lessons from Charlie Munger-XI

Lessons from Charlie Munger-XII

Lessons from Charlie Munger-XIII

Lessons from Charlie Munger-XIV

Lessons from Charlie Munger-XV

Lessons from Charlie Munger-XVI

Lessons from Charlie Munger-XVII

Lessons from Charlie Munger-XVIII

Lessons from Charlie Munger-XIX

More articles on Gurus

Discussions

Post a Comment

People who like this

Featured Posts

Latest Videos

Apps

Top Articles

Hot Stocks Today >

Daily Stocks

MQ Trading Signals

Featured Advertisers / Partners

Top Brokers >

Books Review >