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STOCK IDEAS
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Behavioural finance -- which examines how people's emotions, biases, and misjudgments affect their investment decisions -- is one of the least discussed and understood areas of investing. Yet I believe it's critically important -- so important, in fact, that I covered it in my very first column (in September 1999, which seems like an investing lifetime ago, doesn't it?). Behavioural finance recently reappeared on my radar screen when I came across an 80-minute recording of a speech given by Berkshire Hathaway (NYSE: BRK.A) Vice Chairman Charlie Munger, Warren Buffett's right-hand man and a genius in his own right. It's a brilliant, powerful, and compelling tour de force. In it, Munger highlights what he calls "24 Standard Causes of Human Misjudgment," and then gives numerous examples of how these mental weaknesses can combine to create "lollapalooza" effects, which can be very positive -- as in the case of Alcoholics Anonymous -- or frighteningly negative, such as experiments in which average people end up brutalizing others. I'd like to highlight some of Munger's most important lessons, especially as they relate to investing. Psychological denial You'd think these people would've recognized by now that whatever investment success they had in the late '90s was due solely to one of the most massive bubbles in the history of stock markets, and that they should get out while they still have even a little bit of money left. I'm sure some are doing so, but many aren't because they'd have to acknowledge some extremely painful truths (e.g., they should not, and should never have been, picking stocks; they speculated with their retirement money and frittered most of it away, and so on). Instead, I'm still getting emails like this one, from people who, I suspect, are in serious psychological denial: Why isn't anyone suggesting WorldCom as an investment possibility? Assuming WorldCom survives, and assuming they reach a third of their highest stock value prior to the decline, why not buy shares at $0.19 (as listed now) [they're now down to $0.124] and hold them for a few years? If WorldCom manages to make it back to $10.00 a share, the profit for a small investor would be more than satisfactory. What am I missing here? It seems like another chance to 'get in on the ground floor.' The answer is that WorldCom equity is almost certain to be worthless, and the only sane people buying the stock right now are short-sellers covering their very profitable shorts. Bias from consistency and commitment tendency This is true even if overwhelming evidence emerges indicating the initial decision was disastrously wrong. Have you ever bought a stock such as Lucent, Enron, or WorldCom, seen your original investment thesis torn to shreds by subsequent developments -- such that you would never consider buying more of the stock (despite the lower price), yet you didn't sell? I've written two columns on this common, painful mistake. 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 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. Similar behaviour led to the tech stock bubble of the late 1990s. For more on this topic, see my column The Cocktail-Party Test, in which I argue, "Following the crowd and investing in what is fashionable is a recipe for disaster. Instead, look for solid companies with strong balance sheets that are either out of favor with Wall Street or, better yet, not even on Wall Street's radar screen." Other questions Munger answers There is no space here to even begin to summarize Munger's answers to these questions, so I transcribed his speech and posted it here. I urge you to read it. If you find his thinking and the field of behavioral economics as fascinating as I do, I suggest reading Influence, by Robert Cialdini, Why Smart People Make Big Money Mistakes, by Gary Belsky and Thomas Gilovich and, for the definitive work on Munger himself, Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger, by Janet Lowe. Guest columnist Whitney Tilson is managing partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Berkshire Hathaway at the time of publication. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com. The Motley Fool is investors writing for investors.
Munger notes that sometimes "reality is too painful to bear, so you just distort it until it's bearable." I see this all the time among investors -- both professionals and average folks. Think of all the people who simply have no business picking stocks, such as the "bull market geniuses" of the late 1990s, whose portfolios have undoubtedly been obliterated in the bear market of the past two and a half years.
Munger explains this bias with the following analogy: "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." In other words, once people make a decision (to buy a stock, for example), then it becomes extremely unlikely that they will reverse this decision, especially if they have publicly committed to it.
Human beings have a natural herding tendency -- to look at what everybody else is doing and do the same, however insane that behaviour might be. Munger gives a classic example from corporate America:
I've cited only a few examples of Munger's powerful observations and the answers he gives to a range of perplexing questions, such as: