Are Investors, Illogical by nature?

Are Investors, Illogical by nature?

In 2015, Tren Griffin published a book titled “Charlie Munger: The Complete Investor” and as I was about to leave for a vacation at the time, I decided to buy it and read it over the next few days. It’s an easy read and a relatively short book. To be honest, I don’t think there’s anything brilliant about this book. A lot of the concepts presented are very basic and it sometimes feels more as a collection of quotes and references to other books and articles rather than an original piece of work. However, there are two concepts explained in the book which are unique to Charlie Munger and are worth exploring further.

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Worldly wisdom

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Charlie is a big believer in what he calls “worldly wisdom”. In simple terms, his idea is that, if you want to successfully analyse an issue, you can’t focus on one specific discipline such as psychology, history, mathematics, or biology. You can’t simply use isolated facts or frameworks and apply these to whatever situation you’re facing. You have to be able to recognize how different disciplines might be involved when conducting your analysis and how interconnected they are. With this notion of worldly wisdom comes the underlying concept of “latticework of mental models” developed by Munger and which basically explains more specifically how to approach worldly wisdom. Munger has come to the conclusion that if you wish to make the best possible decisions in business and in life, you have to master the core principles of several disciplines and merge them together in a web of interconnected theories in order to have them in a usable form. The reason why this concept is so powerful is that if you consider anything around you, which is not man-made, it basically works that way. Take the human body for example. When studying the body, it would be a big mistake to consider one organ or another in isolation. This is also why we still have very little understanding of the human body because we study it in pieces – neurology, optometry, gynecology, and so on. But we are slowly finding out, for example, that the brain and the digestive system are strongly related. The issue is that since childhood, this is not how we have been thought to approach problems. From kindergarten to university, we split up the world into different disciplines and try to frame the reality to fit into these different areas because we know no better, which leads us to the wrong conclusions. And there is no class showing us how to integrate everything we learn. We therefore oversimplify systems so that it fits what we know and forget to connect the dots. It can also lead us to misinterpret causes and effects or when faced with a butterfly effect type of situation, we might conclude that the first or second level is the ultimate cause to the issue, which might be totally wrong.

The next question is: in practice, how do you apply the concept of worldly wisdom? Well… again, it’s simple but not always easy. Similar to Leonardo da Vinci or Galileo, Charlie Munger is an incredible polymath. Unfortunately, it doesn’t mean we’re all polymath geniuses, however we can all try to improve ourselves (and grow our snowball :P). And don’t forget that this is a lifelong project, so it won’t happen overnight – it’s a way of approaching life. According to Munger, with about 80 to 90 important models you’ll be able to cover about 90% of what you need to know to be a worldly wise person. These models usually reflect what you would learn in “101” courses of each major discipline (but that you might have forgotten). Here are a few examples: in terms of numeracy you will find concepts such as algebraic equivalence, randomness, compounding, and normal distribution. In physics, for example, you will have the laws of thermodynamics, reciprocity, and velocity. You might already know many of these, but the key here is how you use these models and how you make the connection between each of these when applied to different situations. One relatively new field which is trying to connect different disciplines is behavioural finance. It mainly merges behavioural and cognitive psychological theories with conventional economics and finance to explain how people take financial decisions. To get better at worldly wisdom, you absolutely need a growth mindset and to stay flexible and open to new ideas. You need to learn all the time and one way to do this is to read a lot. Charlie Munger is an avid reader, which has certainly contributed tremendously to his success. At the end of the day, if you are investing or doing business just for the money, you won’t get really far, but if you use this as a medium to understand the world better and enrich yourself and others, this is certainly a step in the right direction.

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The psychology of human misjudgement

Coming back to the book “Charlie Munger: The Complete Investor”, Chapter 4 presents Munger’s concept of the psychology of human misjudgement. Most of which was explained by Munger himself during a famous lecture he gave at Harvard in 1995. During his speech, he presented 25 standard causes of human misjudgement, which can all be applied to business and investment (or other fields). These misjudgements are born out of our tendency to take shortcuts in our thought process. Shortcuts can often be very helpful, however in many circumstances we end up with the wrong conclusion because the wrong shortcut was used and we didn’t think rationally enough.

“Bias [arises] from the nonmathematical nature of the human brain in its natural state as it deals with probabilities employing crude heuristics, and is often misled.”

– Charlie Munger, Harvard University, 1995

Here is the list of the 25 causes of human misjudgement:

1-      Reward and punishment superresponse tendency

2-      Liking/loving tendency

3-      Disliking/hating tendency

4-      Doubt-avoidance tendency

5-      Inconsistency-avoidance tendency

6-      Curiosity tendency

7-      Kantian fairness tendency

8-      Envy/jealousy tendency

9-      Reciprocation tendency

10-   Influence-from-mere-association tendency

11-   Simple, pain-avoiding psychological denial

12-   Excessive self-regard tendency

13-   Over-optimism tendency

14-   Deprival super-reaction tendency

15-   Social-proof tendency

16-   Contrast-misreaction tendency

17-   Stress-influence tendency

18-   Availability-misweighing tendency

19-   Use-it-or-lose-it tendency

20-   Drug-misinfluence tendency

21-   Senescence-misinfluence tendency

22-   Authority-misinfluence tendency

23-   Twaddle tendency

24-   Reason-respecting tendency

25-   Lollapalooza tendency

For the sake of clarity, let’s have a look at two of these misjudgements. Take #2 for example: “Liking/loving tendency”, Munger explains that people tend to ignore or deny the faults of people they love and also tend to distort facts to facilitate that love. We all do it. We do it with family, friends, favourite sport teams, our country, and so on. Obviously, there is a place for love and care, but it can rarely be applied to investment and money. If you ever consider loaning money to a loved one, you better consider it as a gift right from the start. #25 “the lollapalooza tendency (with its funny name) happens not only when you have a combination of different misjudgements coming together, but when the effect of all these is compounded exponentially. For example, Munger sees the Great Financial Crisis of 2008 as a lollapalooza effect.

The usefulness of these tendencies becomes evident when you are fully aware of them and can avoid falling into their traps, not only as an investor, but simply as a person. In addition, to avoid these, you have to be fully self-aware and know your weaknesses. We are all prone to some of these misjudgements more than others. A useful way to get better at this is to constantly ask yourself questions. Don’t assume anything and try to fight your misconceptions.

To learn more about these 25 factors, I would strongly recommend you to visit the following sites:

  • Youtube video – Summary: Charlie Munger: The Psychology of Human Misjudgement
  • Transcript: 1995 Harvard University lecture

What is really interesting when reading about Charlie Munger is that you realize that he hasn’t invented anything new during his extremely long career. Instead, he has focused on understanding our world as it exists and his brilliance lies into how he was able to organize all of this information and act on it, in this case through investing. His attitude towards investing and life in general has been key. Patience, discipline, and rationality have all been of paramount importance.

Featured image: Your lattice of mental models should look something like a spider web… Source: National Geographic

Embedded image: Charlie Munger: The Complete Investor by Tren Griffin

Keep growing your snowball!

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