Lessons from Psychology of Human Misjudgement 🧠
Why smart people make dumb decisions
Hi Investor! 👋🏻
Charlie Munger's "The Psychology of Human Misjudgment" explores multiple cognitive biases and tendencies that often lead people to make poor decisions.
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Charlie Munger’s speech elegantly explains practical psychology and why smart people make dumb decisions.
Here is “The Psychology of Human Misjudgement” as a free PDF:
In this article, we will explore 12 lessons from his famous speech.
Here is an overview of all 25 tendencies discussed in the must-read article:
Let’s get into it 👇🏻
1. Reward and Punishment Superresponse Tendency
What: People are heavily influenced by incentives and respond strongly to rewards and punishments. This often leads to irrational behaviors as people pursue incentives even when it leads to negative outcomes.
Investing example: The management team is incentivized to increase the business’ market capitalization and/or revenue instead of increasing the “per share value”. This leads to poor acquisitions and a “growth at all cost” mindset that can be value-destroying for shareholders.
2. Liking/Loving Tendency
What: People tend to favor, make excuses for, and overlook the faults of stocks or people they like, leading to biased judgments.
Investing example: Falling in love with a stock will have you overlook important objective facts about the business that is not aligned with your beliefs. The same can be true for CEOs.
Think about the “Pandemic darlings” that were trading at +100 times earnings. The growth and the narrative around the pandemic made investors blind to the high valuations:
3. Disliking/Hating Tendency
What: The opposite of the liking tendency, where people distort information or act irrationally against things or people they dislike.
Investing example: Rejecting a good investment idea just because it comes from a person you don’t like.
4. Doubt-Avoidance Tendency
What: In uncertain situations, people seek to quickly eliminate doubt, often leading to snap judgments and premature decisions. Stress and pressure make us make decisions that are not rational or objective because we want to avoid the feeling of doubt in our minds.
Investing example: Rushing to sell out of a stock on bad news or during a crisis without understanding the situation.
Think about everyone who sold their equities during March of 2020, only to rebuy into the same assets a few months later:
5. Inconsistency-Avoidance Tendency
What: People resist change and prefer to remain consistent with their past actions, beliefs, and commitments, even when presented with new information.
Investing example: Refusing to change a flawed investment strategy due to previous commitment.
Or even worse, refuse to sell a portfolio darling even though the narrative has changed and fundamentals are deteriorating.
6. Curiosity Tendency
What: A natural tendency to seek knowledge, but this curiosity is often suppressed, leading to missed opportunities for learning.
Investing example: Ignoring new information because it doesn't align with existing beliefs.
Our own beliefs can block us from digging deeper into our curiosity.
7. Kantian Fairness Tendency
What: People are driven by a sense of fairness and reciprocity, but this can lead to irrational behavior if fairness is pursued without considering practical outcomes.
“The world isn’t fair”
Investing example: If I put in the work, I will get what I deserve! (Not necessarily true - the world does not care about how hard you work)
Great article going deeper on Kantian Fairness: Farnman Street
8. Envy/Jealousy Tendency
What: People are often envious or jealous of others' success, leading to destructive behavior or poor decisions.
Investing example: Sabotaging others' success out of envy, even if it offers no personal gain.
We’ve seen many analysts come after Warren Buffett over the years, they try to kick him when he’s down and underperforming. This behavior is rooted in deep-seated envy.
9. Reciprocation Tendency
What: People feel obliged to return favors, which can be exploited to manipulate others.
Investing example: Feeling the need to reciprocate a favor even when it's against one's interests.
For fund managers, this can be the fact that we don’t sell out of a business because the CEO has done so much for us (and we also happen to like the CEO).
10. Influence-from-Mere-Association Tendency
What: People make judgments based on associations and not on objective facts.
Investing example: Trusting the management team because they are associated with a reputable CEO.
Selling a business because it is associated with the coal industry without understanding what the business does. This often leads to cheap quality businesses associated with “dying” industries.
11. Pain-Avoiding Psychological Denial
What: People deny or rationalize away painful realities to avoid discomfort, leading to avoidance of truth or reality.
Investing Example: Ignoring red flags like a poor balance sheet and solvency instead of addressing them in an investment case.
12. Excessive Self-Regard Tendency
What: People tend to overestimate their abilities, intelligence, and morality, leading to overconfidence.
Investing Example: Overestimating one’s investment skills and taking unnecessary risks.
This tendency relates to “The illusion of skill” and “The Dunning Kruger effect”:
That’s it for today, leave a like and a comment if you learned something new!
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This is great, thanks!