22 biases leading to human misjudgements: Charlie Munger

Gyan on Treadmill dated 06-Apr-2018

In his speech given at Harvard Law School in Jun 1995, Charlie Munger laid out 22 standard causes of human misjudgement. While we have discussed behavioral biases in the Google Talks by Prof.Sanjay Bakshi, in the speech by Prof.Sanjay Bakshi at IFA Galaxy Global Summit 2015 and the in the book 'Value Investing and Behavioral Finance' by Parag Parikh, this is the motherhood list. Almost all identifiable biases have been identified and discussed by Mr.Munger.

Charlie Munger

Why is understanding of this very important? Two reasons, one, it will help you understand the root cause of the problem and design optimum solutions and two, it reduces one's ability to help others. 

Here is the link to the speech (audio)

The 22 Causes are:

1. Under-recognition of the power of incentives: Incentives have power to alter behaviour. When you look at a behaviour, we need to understand the incentives for their behaviour. For example, in India, insurance salesmen gets higher commission if they sell endowment plans at the expense of term plans, even though latter one is cheaper for the customer. If the customer do not understand the power of this incentive, they will end up buying expensive plans. 

2. Psychological denial: Sometime we tend to deny reality even though it is right in front of us. For example, the company we work for may be against our values, but we deny these concerns. 

3. Incentive - caused bias: People with a vested interest in something will tend to guide you in the direction of their interest. Real estate agents always try to sell you the house, even when they know that rental is cheaper for the customer. This is why insurance sales person tend to sell endowment plans at the expense of term plans, eventhough the latter is cheaper and better for the customer

4. Consistency and commitment tendency: There are multiple aspects to this bias. We tend to resolve issues even when they work against us, because looking for a solution means that we have to accept that we were wrong. Another aspect of this bias is the self-confirmation bias, where we commit to a position that is verbalized or when it is hard won. For example, many investors lost money during the 2008 bear market, because they kept on believing it as a 'bull market correction'.

5. Pavlovian association, misconstruing past correlation as a basis for future decision making: In the famous Pavlovian experiment on classical conditioning, Pavlov rang a bell and gave a reward to the dog. At the sight of the reward, the dog started salivating. Over a period of time, the association between the bell and the reward became so close that the dog started salivating at the sound of the bell itself !!. By associating their products with positive memories, advertisers are working on the principles of classical conditioning above.

Another type of conditioning is called operant conditioning. In this case the animal is given a reward once it performs some activities. Initially the animal do not realize the cause and effect linkage. However over a period of time, it catches on, and a clear linkage is established between the behavior and the reward. We see this happen in many situations. 

6. Reciprocation tendency: This is also called 'ask-for-a-lot-and-backoff'. If you ask someone to do something difficult and then modify the request by reducing a bit of difficulty, you can increase the compliance rate significantly, even when doing any part of the task is against their best interests. Part of the reciprocation tendency is the role theory, where people behave the way society expects them to do. In one experiment, people were made to role play 'Cops and Robbers'. Over a few days, the people who played Cops started acting the part and inflicting tortures on the people who were playing robbers. You see this play out regularly in India where girls are expected to 'play their part'.

7. Bias from over-influence by social proof: You tend to do what others are doing because it gives your behaviour a social acceptance. In one real life scenario, one lady was brutally murdered in the public square with so many people watching. Silence of others gave others the social acceptance not to do anything. You see this playing out very regularly in stock market where mutual fund managers do not take any risks and only buy stocks that other managers are buying.

8. Bias of numbers: This is simple. Anything expressed in numbers or statistics is accepted without much of analysis. 

9. Contrast-caused distortions of sensation, perception and cognition: This is the progressive acceptance of a bad situation. Examples abound in real life, like ignoring progressively worsening health signs, staying in a progressively worsening relationship etc. The positive aspects of this are also equally striking. Writing one page a day may not be a big deal, but over a year you have written a book !!

10. Over-influence of authority figures: This is the famous Milgram's experiment. It reflect almost everyday when we take investment decisions based on expert's comments on the TV

11. Deprival super-reaction syndrome: This is the famous loss avoidance. We tend to value a loss of something we own significantly higher than the gain from something we own. As per research, the sadness we feel from a loss in our equity investment is three times higher than the happiness we feel from a gain of the same amount. You see this every day in flights when someone occupies a seat next to you which you thought was empty. 

12. Envy / jealousy: No need of any explanation. These two animals often cloud our judgement. 

13. Bias from Chemical dependency (drugs)

14. Bias from Mis-gambling compulsion: This is the idea that you control the odds if you are a part of the decision making process in any step of gambling. For example, those who picked their own numbers felt that their odds of winning are higher in a lottery. This is the illusion of control. By varying the reinforcement rate, you can strengthen the behaviour. Casinos use this very effectively when they give you occasional win which will motivate you to continue playing. The so called 'beginner's luck' is nothing but mis-gambling compulsion in action.

15. Liking distortion and its opposite disliking distortion: Tending to accept suggestions from someone we like (including ourselves) and rejecting suggestions from people we don't like.

16. Tendency to over-weigh conveniently available information: This is the so called availability bias. This is also related to recency bias and vividness bias. We tend act based on easily available information that is recent and which is vivid. Examples abound. We buy or sell stocks based on their most recently available results, especially if they are significantly different from estimates (vividness), people tend to buy earthquake insurance 'after' an earthquake etc. 

17. Over-influence of vivid information (Vividness bias). This is explained in the point 16 above. 

18. Not having clarity on 'Why': This is the bias of taking decisions based on sketchily available information without asking the 'Why' question till we get the real problem that we are trying to solve. As an ERP consultant, I see this bias play out everyday. We tend to provide solutions to non-existent problems. We tend to buy stocks on tips without going deeper into understanding about the business etc.  

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

20. Stress-induced mental changes: Stress can cause one to behave differently in any situation than one normally would. 

21. Tendency to lose ability through disuse: You tend to lose capabilities by not using them regularly. You do not realize that and tend to misjudge your capability. For example a man who used to do competitive racing in the past, would misjudge that he will be able to do it after 30 years, even though he has not had any practice in between. Identifying and continuously honing your skillset is very, very important for any person.

22. Say-something syndrome: This idea that you are contributing something in a meeting just because you made some point. We all want to contribute in decision making, but some time, the best contribution is to remain silent. 

After reading this list, it is difficult not to come to the conclusions that we are 'NOT' in control of ourselves, and that we are living with an 'Illusion of Control'. Our judgements are subject to so many biases that it is a surprise that we make good decisions on a regular basis at all !!!

Update: Jana Vembunarayan has created a mindmap of these biases in his wordpress blog. You can check it out HERE. It is very good