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Charlie Munger on investing biases

Almost 20 years ago, Berkshire Hathaway (NYSE: BRK-B) vice-chairman Charlie Munger gave a talk called “The psychology of human misjudgement” at Harvard. He’s given dozens of talks since, but I don’t think any match its wisdom and usefulness.

I recently came found the talk on video. For the impatient, the talk discusses about 18 separate biases that cause people to fool themselves and make bad decisions. I’ve summarised the first nine here, along with a few comments from Munger. I’ll bring you the final nine next week.

1. Under-recognition of the power incentives

“I think 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. Never a year passes that I don’t get some surprise that pushes my limit a little farther.”

2. Simple denial

“If you turn on the television you find the mothers of the most obvious criminals that man could ever diagnose and they all think their sons are innocent. The reality is too painful to bear so you just distort it until it’s bearable. We all do it to some extent. It’s a common psychological misjudgement that causes terrible problems.”

3. Incentive-caused bias

“Both in one’s own mind and that in one’s trusted advisor… It causes perfectly terrible behaviour. Take sales presentations of brokers of commercial real estate businesses. I’m 70 years old and I’ve never seen one that I thought was even within hailing distance of objective truth.”

4. Bias from consistency and commitment tendency

“The human mind is a lot like the human egg, in that the human egg has a shut-off device. One sperm gets in, it shuts down so that the next one can’t get in. The human mind has a big tendency of the same sort… According to Max Plank, the really innovative and important new physics was never really accepted by the old guard. Instead, a new guard came along that was less brain-blocked by its previous conclusions. And if Max Plank’s crowd had this consistency and commitment tendency that kept their old conclusions intact despite disconfirming evidence, you can imagine what the crowd that you and I are a part of behaves like… What people are shouting out they are pounding in.”

5. Bias from Pavlovian association

“Practically three-quarters of advertising works on pure Pavlov. Just think how pure association works. Take Coca-Cola (NYSE: KO), where we’re the largest shareholder. They want to be associated with ever-wonderful images — heroics, the Olympics, music, you name it. They don’t want to be associated with presidents’ funerals. The association really works… at a subconscious level, which makes it very insidious. The Persians really did kill the messenger that brought the bad news. Do you think that is dead?”

6. Bias from reciprocation tendency

“The human mind, on a subconscious level, can be manipulated and you don’t know it. I always use the phrase, ‘You’re like a one-legged man in an ass-kicking contest.’… A guy named Zimbardo had people at Stanford divide into two pieces: one were the guards and the other were the prisoners. And they started acting out roles as people expected. He had to stop the experiment after about five days. He was getting into human misery and breakdown and pathological behaviour … What you think may change what you do, but perhaps even more important, what you do will change what you think.”

7. Bias from over-influence by social proof

“Big-shot businessmen get into these waves of social proof. Do you remember some years ago when one oil company bought a fertiliser company, and every other major oil company practically ran out and bought a fertiliser company? And there was no more damned reason for all these oil companies to buy fertiliser companies, but they didn’t know exactly what to do, and if Exxon was doing it, it was good enough for Mobil, and vice versa. I think they’re all gone now, but it was a total disaster.”

8. Bias from contrast-caused distortions of sensation, perception, and cognition

“In my generation, when women lived at home until they got married, I saw some perfectly terrible marriages made by highly desirable women because they lived in terrible homes. And I’ve seen some terrible second marriages which were made because they were slight improvements over an even worse first marriage. You think you’re immune from these things, and you laugh, and I want to tell you, you aren’t.”

9. Bias from over-influence by authority

“They don’t do this in aeroplanes, but they’ve done it in simulators. They have the pilot to do something where an idiot co-pilot would know the plane was going to crash, but the pilot’s doing it, and the co-pilot is sitting there, and the pilot is the authority figure. Twenty-five per cent of the time, the plane crashes. I mean this is a very powerful psychological tendency.”

Munger is one of the sharpest minds in investing – and when he talks, investors would be well to listen… especially when it comes to the biases that we’d otherwise overlook.

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A version of this article, written by Morgan Housel, originally appeared on fool.com.

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