Part three of a short series on Charlie Munger’s Human Misjudgment Revisited:

 

“The sensation apparatus of man is over-influenced by contrast – it has no absolute scale but it has a contrast scale. And it’s a scale with quantum effects too – it takes a certain percentage chance before it’s noticed. Here the great truth is that cognition mimics sensation. People are manipulating you all day with contrast. If it comes to you in small pieces you’re likely to miss it.” – Charlie Munger

Psychological distortions caused by sensation, perception, and cognition are some of the most dangerous in the investment (and real) world because they are so difficult to see initially. Even correct decisions may be influenced by these factors. For example, spending an extra $1000 on a new card to buy an add-on just because the $1000 seems insignificant to the purchase price of $50,000.

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Charlie Munger Contrast-Caused Misperceptions
By Nick (Charlie Munger) [CC BY 2.0], via Wikimedia Commons
These contrast-caused misperceptions are rife in investing. Probably the most common mistake is valuing a company relative to its peers. How many times have analysts issued the mantra “it’s cheap compared to the rest of the sector.” If the rest of the sector is overvalued compared to the wider market, is the cheap company undervalued or is it just appropriately valued? What happens when the rest of the industry re-rates? Philip Ordway used a similar example in his text but related to the corporate bond market:

“Relative valuation – fixed income as priced over Treasurys, or a Triple-A tranche against a triple-BBB tranche. Who cares if the relative valuation is correct if the absolute valuation is garbage? Is an extra 40 bps of spread worthwhile when comparing a Treasury and a structured subprime RMBS?”

Contrast-Caused Misperceptions In Investing

Another cause of misconception cited in the piece is that of non-GAAP accounting. The term "non-GAAP" appeared in 58% of proxy filings for S&P 500 companies reporting so far in 2016, up from 27% of those same S&P 500 constituents five years ago. If you’re valuing a company based on non-standard metrics, which are ultimately designed to present the best view possible of the business, how can you possibly expect to establish an accurate valuation? Once again, just because everyone else is using the same misleading process does not mean that it’s right and in the words of Warren Buffett, “only when the tide goes out do you discover who's been swimming naked."

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Anchoring to recent market prices can be another source of misconception. I’m sure almost every investor has experience of this, looking at a chart and thinking “that the stock looks cheap compared to where it was five years ago.” There’s usually a reason why the shares have declined, and there’s never any guarantee that the price will return to previous levels. Warren Buffett never looks at the market price until he has his own opinion of valuation. Stock splits also make investors think differently about valuation even though nothing has fundamentally changed with the business.

Ordway offers an interesting solution to the problem of anchoring and contrast-caused misperceptions in his text. While no guarantee that this valuation adjustment will remove the cognitive biases completely, it does help to remove issues surrounding stock prices:

One way to avoid some contrast-related problems of cognition in investing is to focus on market capitalization and enterprise value, not the stock price. One of my favorite tests to see whether a person is really thinking like an owner of the price or a predictor of the stock price is when I hear someone start pitching an idea – usually with multiple references to current, past and future stock prices along the way – I’ll let him go for a while and then casually ask what the market cap is. I would say at least half the time the stock pitcher has no idea, and in about half of those cases they stumble for a bit before offering a number that isn’t even in the right ballpark. That’s the worst case – it’s one thing not to know, but it’s a whole other thing to not know and try to fake it.”