The 5 Munger Biases Investors Need to Be Aware Of
- By Rupert Hargreaves
In his famous speech, "The Psychology of Human Misjudgment," Charlie Munger (Trades, Portfolio), the business partner of Berkshire Hathaway (BRK-A)(BRK-B) CEO Warren Buffett (Trades, Portfolio), presented the 25 cognitive biases he believes impact everyone's life, for better and for worse.
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These cognitive biases all have a different impact on human thinking, but they are not separate. Rather, they are interlinked and can influence one another.
For example, deprival super-reaction tendency, which is the tendency for people to strongly prefer avoiding losses to acquiring gains, can influence doubt avoidance tendency, whereby people try to remove any doubt in a decision by making it quickly and without trying to gather all of the relevant information. This, in turn, can be influenced by excessive self-regard tendency, where individuals think they are above average and have overconfidence in their decisions.
All of the cognitive biases interact and can have an effect on how people think, but some are more important for investors to understand the consequences of than others. As a result, I have identified what I think are the five most important cognitive biases for investors to recognize and try to eliminate in day-to-day thinking as a sort of simple and rough guide to investigative cognitive behavior.
This is by no means designed to be a replacement for Munger's full speech, which is highly recommended reading for all investors.
Five cognitive biases
I have already highlighted two of the five most important cognitive biases I think investors should be aware of. Deprival super-reaction tendency and excessive self-regard tendency can both influence investing decisions in negative ways.
Several different studies have been published over the last several decades which show investors tend to have an aversion to loss. They are more likely to let losses run than take money off the table because they are convinced the position is still valid.
More often than not, investors are happy to ignore information that may suggest their original investment thesis is no longer relevant. When blended with excessive self-regard tendency, this can be extremely damaging to investment performance. Value investors need to have a certain degree of extreme self-confidence and need to be prepared to act against the rest of the market.
There also needs to be a degree of humility: Investors need to keep an eye on how the company is evolving and be willing to admit when they are wrong. Balancing the two is difficult. The most successful investors know when to take a loss and give up on a company.
The next cognitive bias I think is significant for investors to consider is inconsistency avoidance tendency. Humans have a natural reluctance toward change, which is bad news for investors. Investing is not a science, it is an art. The business environment is always changing and evolving, so the same strategy will not work in all different environments.
Buffett is a great example of how important it is to adapt an investment strategy as time passes. Over the past several decades, he has evolved from a deep-value investor into a quality investor because he correctly asserted that following a deep-value strategy would have hampered returns.
Investors need to be prepared to change their strategy and evolve with the market if they want to succeed.
Next up is the envy/jealousy tendency. This cognitive bias can be summed up in a quote from Munger:
"Someone will always be getting richer faster than you. This is not a tragedy."
For value investors in particular, it is easy to become envious of growth investors who get rich in bull markets. Envy can cause investors to make silly decisions and impulsive investments. In the long run, these may prove to be a mistake if they have not done their research.
The final cognitive bias I am going to highlight is the social-proof tendency, which is very similar to the envy/jealousy tendency. Humans naturally want to follow the herd, which is a bad trait for value investors to have. Momentum investors, on the other hand, might benefit.
Whatever strategy you follow, it always makes sense to trust your own instincts and not other investors just because you don't want to be left out of the party.
Disclosure: The author owns shares of Berkshire Hathaway.
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This article first appeared on GuruFocus.
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