Charlie Munger on Human Misjudgments

Charlie Munger gave an insightful speech on “24 Standard Causes of Human Misjudgment,” which has powerful implications for investors. Whitney Tilson summarizes some key points and provides a link to the speech, so you can read for yourself.

By Whitney Tilson

Published on the Motley Fool web site, 8/21/02

Behavioral finance — which examines how people’s emotions, biases, and misjudgments affect their investment decisions — is one of the least discussed and understood areas of investing. Yet I believe it’s critically important — so important, in fact, that I covered it in my very first column (in September 1999, which seems like an investing lifetime ago, doesn’t it?).

Behavioral finance recently reappeared on my radar screen when I came across an 80-minute recording of a speech given by Berkshire Hathaway (NYSE: BRK.A) Vice  Chairman Charlie Munger, Warren Buffett’s right-hand man and a genius in his own right. It’s a brilliant, powerful, and compelling tour de force.

In it, Charlie Munger highlights what he calls “24 Standard Causes of Human Misjudgment,” and then gives numerous examples of how these mental weaknesses can combine to create “lollapalooza” effects, which can be very positive — as in the case of Alcoholics Anonymous — or frighteningly negative, such as experiments in which average people end up brutalizing others.

I’d like to highlight some of Munger’s most important lessons, especially as they relate to investing.

Psychological denial

Munger notes that sometimes “reality is too painful to bear, so you just distort it until it’s bearable.” I see this all the time among investors — both professionals and average folks. Think of all the people who simply have no business picking stocks, such as the “bull market geniuses” of the late 1990s, whose portfolios have undoubtedly been obliterated in the bear market of the past two and a half years.

You’d think these people would’ve recognized by now that whatever investment success they had in the late ‘90s was due solely to one of the most massive bubbles in the history of stock markets, and that they should get out while they still have even a little bit of money left. I’m sure some are doing so, but many aren’t because they’d have to acknowledge some extremely painful truths (e.g., they should not, and should never have been, picking stocks; they speculated with their retirement money and frittered most of it away, and so on).

Instead, I’m still getting emails like this one, from people who, I suspect, are in serious psychological denial:

Why isn’t anyone suggesting WorldCom as an investment possibility? Assuming WorldCom survives, and assuming they reach a third of their highest stock value prior to the decline, why not buy shares at $0.19 (as listed now) [they’re now down to $0.124] and hold them for a few years? If WorldCom manages to make it back to $10.00 a share, the profit for a small investor would be more than satisfactory. What am I missing here? It seems like another chance to ‘get in on the ground floor.’

The answer is that WorldCom equity is almost certain to be worthless, and the only sane people buying the stock right now are short-sellers covering their very profitable shorts.

Bias from consistency and commitment tendency Munger explains this bias with the following analogy: “The human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in.” In other words, once people make a decision (to buy a stock, for example), then it becomes extremely unlikely that they will reverse this decision, especially if they have publicly committed to it.

See full document on Charlie Munger’s Greatest Hits, 1994-2011 in PDF format here.

via valueplays