Saturday, June 27, 2009

The Psychology of Human Misjudgement: Influence From Association

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Humans tend to form judgements based on factors that may be irrelevant. This tendency of humans to be influenced by association is well understood by advertisers. In this way, people can be tricked into believing things that are not true. For example, producers will sometimes charge a higher price for a product only because customers perceive its quality to be higher due to the higher price. The association can even be trivial: if a pretty girl is pictured on the product's packaging, this too can drive buyers to be influenced to purchase.

However, Munger argues that the ramifications of this tendency that are caused by advertising are relatively trivial. The most important miscalculations due to this tendency come from improper associations with past successes, and liking/disliking to the point of ignoring relevant factors.

For example, if a man has success at a casino, he will associate that success with particular behaviours, and believe that his success can be repeated. All too often, he will wager - and lose - far more than his initial gains. Traders who are blessed with early success will often believe they are superior speculators, only to fall victim to their overconfidence. Munger argues two antidotes to combat this improper association: 1) look for accidental, non-causative factors that led to the initial success, and 2) look for dangerous aspects in the new venture that were not present in the old.

When it comes to liking/disliking to the point of ignoring relevant factors, Munger uses the example of man's (un)willingness to listen to bad news. People who "blame the messenger" often find themselves living in realities void of bad news and also void of fact. Munger uses examples from Ancient Persia, two major oil companies, and CBS to illustrate the detriment of ignoring bad news. To counteract this tendency, Munger claims Berkshire has a policy of "Tell us the bad news promptly; the good news can wait."

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