Behavioural Finance 101– Investing Rationally

If you ask the average person, they would say that finance and investing is driven by numbers and analysis. Unfortunately, we are all fallible and vulnerable to numerous inherent psychological biases that 1) are documented and repeatable, 2) can completely overwhelm “rational” analysis even when you are aware of the biases, and 3) are compounded by the fact that most people simply do not acknowledge that this happens. When it comes to investing, if these human misjudgements are ignored it will lead to underperformance or even disaster. And even if you are aware you are still vulnerable but at least you have a chance to self-correct.

So here at Canadian Value Investors we are happy to learn from others who have spent the time to understand and document their experiences. Our goal here is to create a list of biases and also relevant case studies that is easy to review and can be used as a checklist/reminder list. We plan to expand this over time.

Charlie Munger’s Standard Causes of Human Misjudgement

Our initial summary here is from Charlie Munger, the Vice-Chairman of Berkshire Hathaway and Warren Buffett’s right hand man, and primarily from a speech he gave at Harvard in 1995. It is a fantastic listen that can typically be found on YouTube, Poor Charlie’s Almanack and there are transcripts floating around as well. We have aimed to condense the talk that was over an hour into the key points to allow for easy referencing and review (that said, you should watch the original at least once as Charlie is very entertaining). We have also selected only key examples.

Charlie Munger - “When I saw this patterned irrationality, which was so extreme, and I had no theory or anything to deal with it, but I could see that it was extreme, and I could see that it was patterned, I just started to create my own system of psychology, partly by casual reading, but largely from personal experience, and I used that pattern to help me get through life.”

1. Under-recognition of the power of what psychologists call ‘reinforcement’ and economists call ‘incentives.’

Well you can say, “Everybody knows that.” Well 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. And never a year passes but I get some surprise that pushes my limit a little farther.

Example: Joe Wilson of Xerox, examined why their better, new machine was selling so poorly in relation to their older and inferior machine. The commission arrangement with the salesmen gave a tremendous incentive to the inferior machine.

2. Simple psychological denial.

The reality is too painful to bear, so you just distort it until it’s bearable.

Example: This first really hit me between the eyes when a friend of our family had a super-athlete, super-student son who flew off a carrier in the north Atlantic and never came back, and his mother, who was a very sane woman, just never believed that he was dead.

3. Incentive-cause bias, both in one’s own mind and that of ones trusted adviser, where it creates what economists call ‘agency costs.’

Example: Doctor in Lincoln, Nebraska, who took out completely healthy gull bladders for years. And one of the old doctors who participated in the removal was also a family friend, and I asked him: I said, “Tell me, did he think, ‘Here’s a way for me to exercise my talents’” -- this guy was very skilled technically-- “’and make a high living by doing a few maimings and murders every year, along with some frauds?’” And he said, “Hell no, Charlie. He thought that the gall bladder was the source of all medical evil, and if you really love your patients, you couldn’t get that organ out rapidly enough.”

4. Bias from consistency and commitment tendency, including the tendency to avoid or promptly resolve cognitive dissonance. This includes the self-confirmation tendency of all conclusions, particularly expressed conclusions, and with a special persistence for conclusions that are hard-won.

Well what I’m saying here is that the human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in. The human mind has a big tendency of the same sort… And of course, if you make a public disclosure of your conclusion, you’re pounding it into your own head.

Example: Max Planck noted that innovative and new physics were not accepted by the old guard as consistency and commitment tendency kept their old inclusions intact in spite of disconfirming evidence… If this can happen in science it can happen anywhere.

#2 The Chinese brainwashing system for prisoners of war maneuvered people into making tiny little commitments and declarations, and then they’d slowly build into large commitments including treason.

5. Bias from Pavlovian association, misconstruing past correlation as a reliable basis for decision-making.

Practically...I’d say 3/4 of advertising works on pure Pavlov, example being Coca-cola’s approach to try to be seen only seen in positive wonderful images (heroic Olympics, music, etc) and as often as possible.

Example 2: Persian messenger syndrome, Persians really did kill the messenger. Bill Paley (former owner/chairman and CEO of CBS) refused to hear bad news and his staff learned to not deliver any leading to a cocoon of unreality and bad decisions.

Take Westinghouse, which blew two or three billion dollars pre-tax at least loaning developers to build hotels, and virtually 100% loans? Now you say any idiot knows that if there’s one thing you don’t like it’s a developer, and another you don’t like it’s a hotel. And to make a 100% loan to a developer who’s going to build a hotel…That would never have been possible if the accounting system hadn’t been such but for the initial phase of every transaction it showed wonderful financial results

6. Bias from reciprocation tendency, including the tendency to act as other persons expect.

It is so easy to be a patsy for what Cialdini calls the compliance practitioners of this life. At any rate, reciprocation tendency is a very, very powerful phenomenon, and Cialdini demonstrated this by running around a campus, and he asked people to take juvenile delinquents to the zoo. And it was a campus, and so one in six actually agreed to do it. And after he’d accumulated a statistical output he went around on the same campus and he asked other people, he said, “Gee, would you devote two afternoons a week to taking juvenile delinquents somewhere and suffering greatly yourself to help them,” and there he got 100% of the people to say no. But after he’d made the first request, he backed up a little, and he said, “Would you at least take them to the zoo one afternoon?” He got three times the success by just going through the little ask for a lot and back off…Wherever you turn, this consistency and commitment tendency is affecting you. In other words, what you think may change what you do, but perhaps even more important, what you do will change what you think. And you can say, “Everybody knows that.” I want to tell you I didn’t know it well enough early enough.

7. Bias from over-influence by social proof -- that is, the conclusions of others, particularly under conditions of natural uncertainty and stress. (A lollapalooza example, originally from Henry Kaufman).

Big-shot businessmen get into these waves of social proof. Do you remember some years

ago when one oil company bought a fertilizer company, and every other major oil

company practically ran out and bought a fertilizer company? And there was no more

damned reason for all these oil companies to buy fertilizer 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.


If you think about the doctrines I’ve talked about, namely, one, the power of reinforcement after all you do something and the market goes up and you get paid and rewarded and applauded and what have you, meaning a lot of reinforcement, if you make a bet on a market and the market goes with you. Also, there’s social proof. I mean the prices on the market are the ultimate form of social proof, reflecting what other people think, and so the combination is very powerful… If these psychological notions are correct, you would expect some waves of irrationality.

8. What made these economists love the efficient market theory is the math was so elegant.

And after all, math was what they’d learned to do. To the man with a hammer, every problem tends to look pretty much like a nail. The alternative truth was a little messy, and they’d forgotten the great economists Keynes, whom I think said, “Better to be roughly right than precisely wrong.”

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

Cialdini cites the case of the real estate broker. And you’ve got the rube that’s been transferred into your town, and the first thing you do is you take the rube out to two of the most awful, overpriced houses you’ve ever seen, and then you take the rube to some moderately overpriced house, and then you stick him. And it works pretty well, which is why the real estate salesmen do it. And it’s always going to work. And the accidents of life can do this to you, and it can ruin your life. 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.

10. Bias from over-influence by authority.

You get a pilot and a co-pilot. The pilot is the authority figure. They don’t do this in airplanes, but they’ve done it in simulators. They have the pilot do something where the co-pilot, who's been trained in simulators a long time -- he knows he’s not to allow the plane to crash -- 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. 25% of the time the plane crashes…this is a very powerful psychological tendency.

11. Bias from deprival super-reaction syndrome, including bias caused by
present or threatened scarcity including threatened removal of something almost
possessed but never possessed.

Here I took the Munger dog, a lovely, harmless dog. The only way to get that dog to bite you is to try and take something out of its mouth after it was already there. And you know, if you’ve tried to do takeaways in labor negotiations, you’ll know that the human version of that dog is there in all of us.

I mean people are really crazy about minor decrements down. And then, if you act on them, then you get into reciprocation tendency, because you don’t just reciprocate affection, you reciprocate animosity, and the whole thing can escalate. And so huge insanities can come from just subconsciously over-weighing the importance of what you’re losing or almost getting and not getting.

And the extreme business case here was New Coke. Coca-Cola has the most valuable trademark in the world. We’re the major shareholder -- I think we understand that trademark. Coke has armies of brilliant engineers, lawyers, psychologists, advertising executives and so forth, and they had a trademark on a flavor, and they’d spent the better part of 100 years getting people to believe that trademark had all these intangible values too. And people associate it with a flavor. And so they were going to tell people not that it was improved, because you can’t improve a flavor. A flavor is a matter of taste. I mean you may improve a detergent or something, but don’t think you’re going to make a major change in a flavor. So they got this huge deprival super-reaction syndrome.

12. Bias from envy/jealousy.

Those of you who have raised siblings you know about envy, or tried to run a law firm or investment bank or even a faculty? I’ve heard Warren [Buffett] say a half a dozen times, “It’s not greed that drives the world, but envy.”

13. Bias from chemical dependency.

Well, we don’t have to talk about that. We’ve all seen so much of it, but it’s interesting how it’ll always cause this moral breakdown if there’s any need, and it always involves massive denial.

14. Bias from mis-gambling compulsion.

For instance, a lottery. You have a lottery where you get your number by lot, and then somebody draws a number by lot, it gets lousy play. You have a lottery where people get to pick their number, you get big play. Again, it’s this consistency and commitment thing. People think if they have committed to it, it has to be good. Then if you take the slot machines, you get bar, bar, walnut. And it happens again and again and again. You get all these near misses. Well that’s deprival super-reaction syndrome, and boy do the people who create the machines understand human psychology.

15. Bias from liking distortion, including the tendency to especially like oneself, one’s own kind and one’s own idea structures, and the tendency to be especially susceptible to being misled by someone liked. Disliking distortion, bias from that, the reciprocal of liking distortion and the tendency not to learn appropriately from someone disliked.

Now let’s get back to B.F. Skinner, man-with-a-hammer syndrome revisited. Why is man- with-a-hammer syndrome always present? Well if you stop to think about it, it’s incentive- caused bias. His professional reputation is all tied up with what he knows. He likes himself and he likes his own ideas, and he’s expressed them to other people -- consistency and commitment tendency. I mean you’ve got four or five of these elementary psychological tendencies combining to create this man-with-a-hammer syndrome. Once you realize that you can’t really buy your thinking -- partly you can, but largely you can’t in this world -- you have learned a lesson that’s very useful in life. There are only two ways to handle it: you can hire your advisor and then just apply a windage factor, like I used to do when I was a rifle shooter. I’d just adjust for so many miles an hour wind. Or you can learn the basic elements of your advisor's trade. You don’t have to learn very much, by the way, because if you learn just a little then you can make him explain why he’s right. And those two tendencies will take part of the warp out of the thinking you’ve tried to hire done. By and large it works terribly. I have never seen a management consultant’s report in my long life that didn’t end with the following paragraph: "What this situation really needs is more management consulting." Never once.

16. Bias from the non-mathematical nature of the human brain in its natural state as it deals with probabilities employing crude heuristics, and is often misled by mere contrast, a tendency to over-weight conveniently available information and other psychologically misrouted thinking tendencies on this list.

When the brain should be using the simple probability mathematics of Fermat and Pascal applied to all reasonably obtainable and correctly weighted items of information that are of value in predicting outcomes, the right way to think is the way Zeckhauser plays bridge. It’s just that simple. And your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge.

I mean ask the Coca-Cola Company, which has raised availability to a secular religion. If availability changes behavior, you will drink a helluva lot more Coke if it’s always available. I mean availability does change behavior and cognition.

.. All the things on this list distort judgment. And I want to train myself to kind of mentally run down the list instead of just jumping on availability. So that’s why I state it the way I do.

Example - here I think we should discuss John Gutfreund. This is a very interesting human example, which will be taught in every decent professional school for at least a full generation. Gutfreund has a trusted employee and it comes to light not through confession but by accident that the trusted employee has lied like hell to the government and manipulated the accounting system, and it was really equivalent to forgery. And the man immediately says, “I’ve never done it before, I’ll never do it again. It was an isolated example.” And of course it was obvious that he was trying to help the government as well as himself, because he thought the government had been dumb enough to pass a rule that he’d spoken against, and after all if the government’s not going to pay attention to a bond trader at Salomon, what kind of a government can it be? At any rate, this guy has been part of a little clique that has made, well, way over a billion dollars for Salomon in the very recent past, and it’s a little handful of people. And so there are a lot of psychological forces at work, and then you know the guy’s wife, and he’s right in front of you, and there’s human sympathy, and he’s sort of asking for your help, which encourages reciprocation, and there’s all these psychological tendencies are working, plus the fact he’s part of a group that had made a lot of money for you. At any rate, Gutfreund does not fire the man, and of course he had done it before and he did do it again. Well now you look as though you almost wanted him to do it again. Or God knows what you look like, but it isn’t good. And that simple decision destroyed John Gutfreund, and it’s so easy to do.

17. Bias from over-influence by extra-vivid evidence.

Here’s one that...I’m at least $30 million poorer as I sit here giving this little talk because I once bought 300 shares of a stock and the guy called me back and said, “I’ve got 1,500 more,” and I said, “Will you hold it for 15 minutes while I think about it?” And the CEO of this company -- I have seen a lot of vivid peculiarities in a long life, but this guy set a world record; I’m talking about the CEO -- and I just mis-weighed it. The truth of the matter was the situation was foolproof. He was soon going to be dead, and I turned down the extra 1,500 shares, and it’s now cost me $30 million. And that’s life in the big city.

18. Mental confusion caused by information not arrayed in the mind and theory structures, creating sound generalizations developed in response to the question “Why?” Also, mis influence from information that apparently but not really answers the question “Why?” Also, failure to obtain deserved influence caused by not properly explaining why.

And now we get to Feuerstein, who was the general counsel with Salomon when Gutfreund made his big error, and Feuerstein knew better. He told Gutfreund, “You have to report this as a matter of morality and prudent business judgment.” He said, “It’s probably not illegal, there’s probably no legal duty to do it, but you have to do it as a matter of prudent conduct and proper dealing with your main customer.” He said that to Gutfreund on at least two or three occasions. And he stopped. And, of course, the persuasion failed, and when Gutfreund went down, Feuerstein went with him. It ruined a considerable part of Feuerstein’s life.

Well Feuerstein, [who] was a member of the Harvard Law Review, made an elementary psychological mistake. You want to persuade somebody, you really tell them why. And what did we learn in lesson one? Incentives really matter? Vivid evidence really works? He should’ve told Gutfreund, “You’re likely to ruin your life and disgrace your family and lose your money.” And is Mozer worth this? I know both men. That would’ve worked. So Feuerstein flunked elementary psychology, this very sophisticated, brilliant lawyer.But don’t you do that. It’s not very hard to do, you know, just to remember that “Why?” is very important.

19. Other normal limitations of sensation, memory, cognition and knowledge.

20. Stress-induced mental changes, small and large, temporary and permanent.

Here, my favorite example is the great Pavlov. He had all these dogs in cages, which had all been conditioned into changed behaviors, and the great Leningrad flood came and it just went right up and the dog’s in a cage. And the dog had as much stress as you can imagine a dog ever having. And the water receded in time to save some of the dogs, and Pavlov noted that they’d had a total reversal of their conditioned personality.

21. Other common mental illnesses and declines, temporary and permanent, including the tendency to lose ability through disuse.

22. Development and organizational confusion from say-something syndrome.

And here my favorite thing is the bee, a honeybee. And a honeybee goes out and finds the nectar and he comes back, he does a dance that communicates to the other bees where the nectar is, and they go out and get it. Well some scientist who is clever, like B.F. Skinner, decided to do an experiment. He put the nectar straight up. Way up. Well, in a natural setting, there is no nectar where they’re all straight up, and the poor honeybee doesn’t have a genetic program that is adequate to handle what he now has to communicate. And you’d think the honeybee would come back to the hive and slink into a corner, but he doesn’t. He comes into the hive and does this incoherent dance, and all my life I’ve been dealing with the human equivalent of that honeybee. And it’s a very important part of human organization so the noise and the reciprocation and so forth of all these people who have what I call say-something syndrome don’t really affect the decisions.

23. When these combine they create a Lollapalooza effect (a term coined by Charlie) where it greatly increases their power to change behaviour. Examples being:


  • Tupperware parties. Tupperware’s now made billions of dollars out of a few manipulative psychological tricks.
  • The Milgrim shock experiment where he got students to induce heavy shocks through: 1) “We need this to look for scientific truth,” (authority), worked them up from tiny to increasingly larger (commitment, consistency, and contrast) – four different psychological tendencies combining.
  • McDonald-Douglas airliner evacuation disaster – One of my favorite cases. The government requires that airliners pass a bunch of tests, one of them is evacuation. It’s some short period of time. The government has rules, make it very realistic, so on and so on. You can’t select nothing but 20-year-old athletes to evacuate your airline. So McDonald-Douglas schedules one of these things in a hangar, and they make the hangar dark and the concrete floor is 25 feet down, and they’ve got these little rubber chutes, and they’ve got all these old people, and they ring the bell and they all rush out, and in the morning, when the first test is done, they create, I don’t know, 20 terrible injuries when people go off to hospitals, and of course they scheduled another one for the afternoon.. what do they do? They do it again in the afternoon. Now they create 20 more injuries and one case of a severed spinal column with permanent, unfixable paralysis. These are engineers, these are brilliant people; this is thought over through in a big bureaucracy. Again, it’s a combination of psychological tendencies: Authorities told you to do it and told you to make it realistic. You’ve decided to do it. You’d decided to do it twice. Incentive-caused bias. If you pass you save a lot of money. You’ve got to jump this hurdle before you can sell your new airliner. Again, three, four, five of these things work together and it turns human brains into mush. And maybe you think this doesn’t happen in picking investments? If so, you’re living in a different world than I am.
  • The open-outcry auction. Well the open-outcry auction is just made to turn the brain into mush: you’ve got social proof, the other guy is bidding, you get reciprocation tendency, you get deprival super-reaction syndrome, the thing is going away… I mean it is just absolutely is designed to manipulate people into idiotic behavior.
  • Finally the institution of the board of directors of the major American company. Well, the top guy is sitting there, he’s an authority figure. He’s doing asinine things, you look around the board, nobody else is objecting, social proof, it’s okay? Reciprocation tendency, he’s raising the directors fees every year, he’s flying you around in the corporate airplane to look at interesting plants, or whatever in hell they do, and you go and you really get extreme dysfunction as a corrective decision-making body in the typical American board of directors. They only act, again the power of incentives, they only act when it gets so bad it starts making them look foolish, or threatening legal liability to them. That’s Munger’s rule. I mean there are occasional things that don’t follow Munger’s rule, but by and large the board of directors is a very ineffective corrector if the top guy is a little nuts, which, of course, frequently happens.
  • When I was young there was a whodunit hero who always said, “Cherche la femme.” [In French, "Look for the woman."] What you should search for in life is the combination, because the combination is likely to do you in.

Practical examples of minimizing these psychological tendencies in a positive way through the creation of systems:

•       The system of Alcoholics Anonymous: a 50% no-drinking rate outcome when everything else fails? It’s a very clever system that uses four or five psychological systems at once toward, I might say, a very good end.

•       Karl Braun’s communication practices. He designed oil refineries with spectacular skill and integrity. He had a very simple rule. Remember I said, “Why is it important?” You got fired in the Braun company. You had to have five Ws. You had to tell Who, What you wanted to do, Where and When, and you had to tell him Why. And if you wrote a communication and left out the Why you got fired, because Braun knew it’s complicated building an oil refinery. It can blow up...all kinds of things happen. And he knew that his communication system worked better if you always told him why. That’s a simple discipline, and boy does it work.

•       The use of simulators in pilot training. Here, again, abilities attenuate with disuse. Well the simulator is God’s gift because you can keep them fresh.

•       Clinical training in medical schools: here’s a profoundly correct way of understanding psychology. The standard practice is watch one, do one, teach one. Boy does that pound in what you want pounded in. Again, the consistency and commitment tendency. And that is a profoundly correct way to teach clinical medicine.

•       The rules of the U.S. Constitutional Convention: totally secret, no vote until the whole vote, then just one vote on the whole Constitution. Very clever psychological rules, and if they had a different procedure, everybody would’ve been pushed into a corner by his own pronouncements and his own oratory and his own... And no recorded votes until the last one. And they got it through by a whisker with those wise rules. We wouldn’t have had the Constitution if our forefathers hadn’t been so psychologically acute. And look at the crowd we got now.

•       The Harvard Business School’s emphasis on decision trees. When I was young and foolish I used to laugh at the Harvard Business School. I said, “They’re teaching 28-year-old people that high school algebra works in real life?” We’re talking about elementary probability. But later I wised up and I realized that it was very important that they do that, and better late than never.

•       The use of granny’s rule. I love this.. Now granny’s rule is you don’t get the ice cream unless you eat your carrots. Well granny was a very wise woman. That is a very good system. A very eminent psychologist runs around the country telling executives to organize their day so they force themselves to do what’s unpleasant and important by doing that first, and then rewarding themselves with something they really like doing.

•       The use of post-mortems at Johnson & Johnson. At most corporations if you make an acquisition and it turns out to be a disaster, all the paperwork and presentations that caused the dumb acquisition to be made are quickly forgotten. You’ve got denial, you’ve got everything in the world. You’ve got Pavlovian association tendency. Nobody even wants to even be associated with the damned thing or even mention it. At Johnson & Johnson, they make everybody revisit their old acquisitions and wade through the presentations. That is a very smart thing to do. And by the way, I do the same thing routinely.

•       The great example of Charles Darwin is he avoided confirmation bias. Darwin probably changed my life because I’m a biography nut, and when I found out the way he always paid extra attention to the disconfirming evidence and all these little psychological tricks.

•       Walmart and Sam Walton’s purchasing agents: And you can know these psychological tendencies and avoid being the patsy of all the people that are trying to manipulate you to your disadvantage, like Sam Walton. Sam Walton won’t let a purchasing agent take a handkerchief from a salesman. He knows how powerful the subconscious reciprocation tendency is. That is a profoundly correct way for Sam Walton to behave.

•       Then there is the Warren Buffett rule for open-outcry auctions: don’t go.



What special knowledge problems lie buried in the thought system indicated by the list?

•       One is paradox. The granny’s rule, when you apply it to yourself, is sort of a paradox in a paradox. The manipulation still works even though you know you’re doing it. And I’ve seen that done by one person to another.

How can you relate these principals to investing?

Well of course an investment decision in the common stock of a company frequently involves a whole lot of factors interacting. Usually, of course, there’s one big, simple model, and a lot of those models are microeconomic. And I have a little list of -- it wouldn’t be nearly 24, of those -- but I don’t have time for that one.

What rule is most important?

I would say the one thing that causes the most trouble is when you combine a bunch of these together, you get this lollapalooza effect. And again, if you read the psychology textbooks, they don’t discuss how these things combine, at least not very much.


Suggested Readings

·      Robert Cialdini’s book, Influence – Highly recommended by both us and Charlie Munger.

·      Poor Charlie’s Almanack.

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