Wednesday 22 August 2012

Psychology of Human Misjudgement and Investing - Part 1

I am sure many of you must have heard about Charlie Munger as vice chairman of Berkshire Hathway and astute value investor who is partner of warren buffet in Berkshire Hathaway. Warren buffet has publicly acknowledged the invaluable contribution that Mr.Munger has made towards the success of Berkshire Hathway. In a sense, Mr.Munger was instrumental in shaping Warren Mr.Buffet's philosophy of "paying for the quality". As Warren Buffet has put it, it is better to buy a great business at reasonable price than buying a reasonable business at great price. However in my opinion, Mr.Munger has made even greater contribution to the discipline of value investing by unfurling how  some very prevalent psychological tendencies contribute towards faulty and ill conceived decision making. I have gained immense insights about our psychological fallies  by reading Mr.Munger's transcript of Psychology of Human Misjudgement. In the essay, Mr.Munger has talked about 25 psychological tendencies/biases that is likely to result into human misjudgement. Most of these  misjudgements lead to faulty decision making without even realizing one has made mistake. I would like to talk about 8 such tendencies which are very prevalent and will try to put forward my point of views on how these biases will cause errors in decision making from investment perspectives. In the first part, I will discuss four tendencies namely reward and punishment super response, inconsistency avoidance, influence from mere association and excessive self regard. In the second part, I will focus on deprival superreaction, social proof, contrast misreaction and availability misweighing.

At the outset, I would like to mention that most of the points discussed here not my ideas and are merely my interpretation of Mr.Munger's essay on the subject. I would like to also mention that Prof. Sanjay Bakshi's hugely insightful lecture notes on this subject has contributed immensely to my understanding of the subject.  

Reward and Punishment Super response Tendency: In very simple words Mr.Munger is talking about power of incentives. According to Mr.Munger, incentives or disincentives are the most important in changing cognition and behavior. As he puts it " I have been in top 5% of my age cohort all my adult life in understanding the power of incentives and yet I have always under estimated that power". Out this enormous power of incentives, arises what is called "incentive caused bias" which drives a fairly decent and good intentioned person, consciously or unconsciously driven by incentives, to drift towards immoral/unethical/unprofessional behavior. Not sure how it works? Remember that insurance agent who sold you ULIP/guaranteed return plans laden with hidden charges, large upfront deductions and meagre insurance covers? What drove and still drives most insurance agents is the commission that they get on policy and ostensibly commissions were highest for ULIP plans. So a fairly decent guy i.e. insurance agent was driven by incentive of "maximizing his returns" without worrying about sub par returns to the policy holder! So how is it relevant in making investment decisions? 

My two cents:

  • As Warren buffet puts it, "never ask a barber whether you need haircut". Be wary of trading calls/advise from brokerages/brokers as they would, almost always want you to trade more to earn more brokerage, even in situations when the best action is "no action".
  • Management having high shareholding in the company has natural incentive towards value creation and sharing of value. Hence high management shareholding shall certainly be regarded as "positive" 
Inconsistency Avoidance Tendency: As Mr. Munger puts it, the brain of a man conserves programming space by being reluctant to change , which is a form of inconsistency avoidance. If we look at worldly wisdom, "first impression is the last impression" which is a combination of doubt avoidance tendency (another tendency discussed by Mr.Munger in his essay which leads to our habit of jumping to conclusions) and then ignore all the facts/incidences that are not consistent with the initial opinion formed. As lord Keynes put it " it is not intrinsic difficulty of new ideas that prevented their acceptance. Instead new ideas were not accepted because they were inconsistent with old ideas prevailing".  And Mr. Munger comes up with a wonderful metaphor that human mind works a lot like a human egg. When one sperm gets into human egg, there is an automatic shut off device that bars any other sperm for getting in. For human mind, idea is like a sperm which penetrates human mind and shuts off the mind from any other ideas. 
From these tendencies arises "confirmation bias". We tend to over weigh evidences that confirm with our conclusions and under weigh evidences that counter our conclusions/judgement. So how does it impact investment decisions? 

My two cents: 
  • This is one of the most potent bias that has ability to cause us huge loss  financially! A typical situation would be to clinging on to stock which was   bought in the first places out of "misjudgements" or "mistakes". As time passes, contrary evidences emerge nullifying   one's investment hypothesis. However, driven by confirmation bias, investors under weigh contrary evidences and do not sell such "losers". Not only one suffers from "loss of capital" from such losers but also suffers opportunity loss (sometimes "huge" due to very attractive investment opportunity) from not liquidating such position and reinvesting it in much better opportunity. I. myself, has fallen into this many a times in the past. 
Influence From Mere Association Tendency: There is a typical tendency in most of us to associate one event with the good/bad outcome in spite of no causal link between event and outcome. Mr.Munger talks about this tendency at length giving various examples. Many a times when people are presented with four or five similar purchase, quite a few of them will select the item with highest price associating the "high priced" item with "highest quality" item even though there may be no causal relationship between price and quality. This tendency is also known as pavlovian association. Another typical example of such tendency is looking for patterns and trends where there are no such patterns/trends. Yet another pitfall that we experience is the extrapolating trends into future which is erroneous most of the times especially in predictions related to business/economics. Stereotypes is also the outcome of such tendency where we associate certain traits/observations with a set of people/communities/nationalities where actually there is no causal link between such traits and people/communities/nationalities and observations/traits may apply to only some identified people/communities/nationalities. 

My Two Cents:

  • My hunch is that some good cash bargains  are created arising out of this tendency. A case in point: Piramal healthcare. Market typically views companies that hold large chunk of cash that it received from sale of asset/business/operations very negatively if proceeds from such sale is not fully shared with the shareholders and a large portion is retained with the company to be deployed in the business. This dislike arises from the fact that history is full of examples where in such situation dishonest or incompetent promoters either allocate this extra capital foolishly (by overpaying for acquisitions or unduly expanding aggressively) to generate  mediocre return on capital or stash away money into promoter's account through financial jugglery. However, market treats competent and ethical management (proven through track record) also with same stick and discounts it heavily to the extent that company is available for less than cash on its balance sheet! It is like getting a dollar worth of cash for 80 cents.... This happened with Piramal Helathcare when it sold of its domestic formulation business to Abbott for $3.7 billion by clinching jaw dropping deal. PHL management shared roughly 20% of the sale proceeds with shareholders through buy back program and rest of the proceeds it retained with the company to deploy effectively in existing and new businesses. Piramal management has exemplary track record of capital allocation and integrity over last many years, however market treated PHL in the same way as it would have treated a company of some third rate promoter! At one point in time, PHL was available at 70 cents for a dollar on a balance sheet with all fixed assets and operating businesses coming free on top! So market associated non deployment of cash immediately with "wrong intentions" of the promoter. I am sure if one understands that market has fallen for this "bias", one would be able to use the situation to take a great advantage out of such situations.
  • Another example of such tendency is drop in price of all companies in a particular industry which is surrounded by negative sentiments or is in down cycle even though some the companies in the same industry may not have been impacted negatively and may actually be reaping positive results of such situations. 
Excessive Self Regard Tendency: Mr.Munger points out to the fact that most of us misappraise ourselves on the higher side on many of our abilities than objective assessment will reveal. A typical example he shares is that 90% of Swedish drivers consider their driving skills above average! Similarly, one typically values his/her possession more than realistic estimate of the value of possession. As Mr.Munger points out that man's possessions, once owned, suddenly become worth more to him than what he would pay if they were offered on sale to him and he did not own them! How about lottery ticket? Odds of winning a lottery for a randomly selected number is as good as (or as bad as!) the number "chosen" by the purchaser of the ticket. However, lottery company charges differently for randomly selected number versus a lottery ticket with a number "chosen" by the purchaser! They take take advantage of lottery ticket purchaser's excessive self regard in "choosing" a number which has more probability of winning....

My Two Cents:

  • A typical folly arising out of this tendency is to over estimating the value of our holdings compared to intrinsic value of our holdings. This over estimation of our holding will not allow us to liquidate the position even when the price of the holding has exceeded its intrinsic value. This trap will lead to a situation where one holds on to investments where margin of safety no longer exist and by clinging onto such holdings one is letting go other attractive opportunities. Prof. Bakshi has suggested a wonderful antidote to this folly. Prof. Bakshi suggests that one should periodically liquidate the entire portfolio mentally to reassess whether one will invest in each holdings if it was a fresh investment decision! I have tried doing this, and let me tell you, it is a wonderful technique to avoid commitment/excessive self regard bis. 
  • Most of us believe that we are better at the art of stock picking than our peers. So we will become "active" investors and make stock specific investments. However, if we analyze portfolio returns over a long period of time (which we often don't!),  we may find out that our track record does not support our assumptions of being "above average" stock picker! We may be under performing the index consistently and yet believe that we are good stock pickers! To avoid falling for this bias, one should maintain a close tab on the portfolio returns which if unsatisfactory, shall either resort to index funds or resort to "intelligent" investment adviser (by intelligent i mean an adviser who follows "value based" investment approach)