This is an edited version of a talk I gave at John Mihaljevic’s conference in Zurich in June 2017. All mistakes and errors are my own. – via Philip C. Ordway
“It seems clear to me that I've been wrong for many years in saying that the single greatest challenge for investors is to develop self-control. In fact, the single greatest challenge investors face is to see ourselves as we actually are. What makes Warren Buffett and, perhaps even more, Charlie Munger so remarkable is how honest they are about themselves with themselves.” - Jason Zweig1
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Charlie Munger’s famous speech “The Psychology of Human Misjudgment" has changed my life.2 In that spirit, the goal of this talk is to improve my own understanding of the concepts by updating “The Psychology of Human Misjudgment” with more recent examples and case studies while also incorporating the related work of Kahneman, Tversky, and other prominent researchers. There is no substitute for the original, and this isn’t an attempt to substitute or improve upon it. I highly recommend both the audio recording of the 1995 version and the comprehensive, updated written account in Poor Charlie’s Almanack.
Despite the emphasis on failure and folly, the goal of this talk is not to assign blame or to condemn and ridicule the mistakes; there is no place for schadenfreude here. Learning from the mistakes of others is a very effective and less costly method, but compiling a database of failures – collecting inanities, as Munger would put it – opens us up to accusations of throwing stones in a glass house. To be clear, all of us are prone to these mistakes. By studying failure I’m trying to avoid it myself. An interest in the psychology of human misjudgment is a natural outgrowth from the desire for self-improvement. By seeking an explanation for other people’s mistakes, we can hope to internalize the reasons and improve our own decisions. Just bias from extra-vivid evidence can cause our brains to misfire, the goal in this exercise is to highlight vivid, interesting examples that will sear the misjudgments into our brain. By creating a readily accessible framework for decision-making – by crafting a personal system of psychology – we can all improve our outcomes in life. The idea is to avoid these common psychological traps – to be less stupid – rather than to be brilliant.
I’ve been working on this for quite a while, and it’s an ongoing effort.3 There are sure to be errors and misapplications here, so corrections and suggestions of all kinds are welcome. This essay is also in dire need of good editing, so please forgive its length and loose writing.
Philip C. Ordway
“Man is a rational animal. So at least we have been told. Throughout a long life I have searched diligently for evidence in favor of this statement. So far, I have not had the good fortune to come across it.” ? Bertrand Russell4
Danny Kahneman’s book Thinking, Fast & Slow has filled in a lot of holes in my knowledge, and it is the best collection of thinking on the subject that I’ve found. I had previously listened to a recording of Munger’s “The Psychology of Human Misjudgment” and read the transcript in Poor Charlie’s Almanack and elsewhere. That probably spurred some of my initial interest in the subject, and the combination of Munger’s talk with Kahneman’s research and writing is especially powerful. I think those two books tell you almost everything you need to know about the psychology of investing, and a lot about life in general too.
A special focus here will be business and investing. That is partly because those fields are such a fertile ground for misjudgment, but these lessons apply to almost all areas of life. I didn’t revisit my old college textbook in psychology, either – most or all of these examples were taken from own experiences or from the popular accounts I found online, in the newspaper, etc. over the past few months.
I’m assuming that most people are familiar with the original masterpiece, so I plan to just briefly allude to the “standard causes of human misjudgment” and the original examples so we can spend time on more recent findings and examples. As usual, Munger figured out the important ideas and left very few holes for us to patch, so I’ve tried to take the original material and add one or two new or supplemental topics and a few new examples. As always, the biggest bang for our buck – the lollapaloozas – will be found when the various factors combine and act in concert. “Cherchez la femme” and the combination. We need a working understanding of multiple models and their interaction, and it must be derived individually – it will be different for each circumstance and each person.
A short list of topics that would likely get more attention in “The Psychology of Human Misjudgment 3.0”:
• Baseline information or base rates
• Prospect Theory and loss aversion
• Munger’s “two-track analysis” – first, what are the fundamentals of the situation, rationally judged, and second, what are the subconscious or other psychological factors at play?
• Self-awareness and self-honesty
With that in mind, here are some of standard causes of human misjudgment as illustrated by modern examples.
Under-recognition of the power of reinforcement/incentives.
Munger: “I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.”
Munger’s favorite cases were Federal Express, which was finally able to fix its system by paying night-shift workers by the shift instead of the hour; Xerox, which had commission arrangements that gave an incentive to an older, inferior machine; and B.F. Skinner, the eminent researcher who made many important psychological discoveries (see below).
Update: Later called “Reward and Punishment Superrresponse Tendency.” In Munger’s revision, he added several new examples:
• Mark Twain’s cat that, after sitting on a hot stove, never sat on another stove (hot or cold) ever again;
• Ben Franklin’s maxims that “if you would persuade, appeal to interest and not to reason” and “never, ever, think about something else when you should be thinking about the power of incentives”;
• the Soviet employee’s phrase that “they pretend to pay us and we pretend to work”;
• “Perhaps the most important rule in management is ‘Get the incentives right’”;
• “Another generalized consequence of incentive-caused bias is that man tends to ‘game’ all human systems, often displaying great ingenuity in wrong serving himself at the expense of others. Anti-gaming features, therefore, constitute a huge and necessary part of almost all system design”;
• “Dread, and avoid as much as you can, rewarding people for what can be easily faked. Yet our legislators and judge…often ignore this injunction”;
• “Punishments also strongly influence behavior and cognition, although not so flexibly and wonderfully as rewards.” Price fixing was more common when it was met with fines rather than jail time. A European tribe in the time of Caesar, when the assembly horn blew, always killed the last warrior to reach his assigned place. And George Washington hanged deserters at a great height as an example to others who might think of deserting.
Wells Fargo recently demonstrated the power of incentives with its “fake accounts” scandal. The cause and effect of this situation reads like a script for this talk, with amazing parallels to the Salomon scandal of 1991. The Wells Fargo situation was a straightforward one: the legacy Norwest culture of “cross-selling” had been enormously successful, but the incentives involved got stretched past their breaking point and then denial, more incentive-caused bias, commitment and consistency, Persian messenger syndrome, and social proof, among other tendencies, combined to allow the problem to morph into a true scandal.
At the heart of the issue is that management and the board made efforts – some genuine, some half-hearted – to address the problem before it spread. Numerous employees raised the issue to the head of the community bank, Carrie Tolstedt, and to the company’s senior executives. In almost all cases the evidence was ignored or suppressed. There were massive compliance manuals and plenty of procedures and policies, but culture and leadership trumped the manuals and policies as they often do.
And the problem festered for years. The first signs came as early as 2004 when an internal investigations unit noticed a rise in “sales integrity” issues. The report said, “Whether real or perceived, team members . . . feel they cannot make sales goals without gaming the system. The incentive to cheat is based on the fear of losing their jobs.” And many people did get fired or quit. The sky-high turnover rate (42% in 2012 among all branch and call center employees) was a red flag itself, but it was dismissed internally as “slightly lower than turnover for similar types of roles in the retail industry” (emphasis added). The 2004 report “recommended that Wells consider reducing or eliminating sales goals, as several peer banks had done, and warned that the issue could lead to ‘loss of business and . . . diminished reputation in the community.’” Wells did none of that until 2016, of course. But almost a decade after the first report, a Los Angeles Time story broke the news that the issue had festered and grown over the years. And as several more years went by, management did almost nothing to address the problem or to manage the fallout when the settlement – dismissed as small relative to Wells Fargo’s financial size – was inevitably announced. The Board made some attempts that I believe were more genuine than those often seen in such circumstances, but inertia and Stumpf’s opposition slowed things down.
The parallels to John Gutfreund and the scandal at Salomon Brothers are stark. Gutfreund’s downfall resulted from his response to Paul Mozer’s misdeeds. Had Gutfreund moved aggressive to snuff out the problem, most or all of the damage could have been avoided. But Gutfreund fell victim to reciprocation and the fact that Mozer’s group had made enormous amount of money for Salomon. At Wells, John Stumpf had repeated praised Carrie Tolstedt in public as The Board’s official report spelled it out explicitly: