In 1995, Charlie Munger made a fantastic speech at Harvard University.
His speech was about cognitive biases, the reasons why our brain tricks itself into making the wrong decisions
He breaks them down in a little less than 20 biases, giving vivid examples in each case.
You can listen to this speech below.
If you enjoy these principles, I recommend that you read two books :
- Poor Charlie’s Alamanack: a great journey into the words and wisdoms of Charlie Munger.
- Robert B. Cialdini’s Influence : The psychology of Persuasion.
These two books will change the way you think about the world and interact with people and situations, trust me they are invaluable reads.
So let us dive into that “system of psychology” as Charlie Munger puts it.
These biases are patterns that have helped him get through life, and I believe a good number of them apply to traders and investors in the way they approach the world and markets.
Standard causes of Human Misjudgement, a list of the most common psychological biases
Bias #1: Psychological Denial
Sometimes the reality is too difficult to bear so we just distort it until it is bearable. A common misjudgment.
Bias #2: Agency cost
Depending too much on an adviser’s knowledge while he often has a ghastly bias to give you a particular advice.
You need to factor that in with a « windage factor » or learn the basic elements of your advisor’s trade.
An interesting article expanding on Agency Cost.
Bias #3: Consistency & Commitment Tendency
This bias consists in being brainwashed by previous conclusions.
This article also explores the Consistency bias and tries to understand why, as creatures of habit, it is so difficult to change our mind.
If you’re interested, this book by Evan Wilhelms goes much more in depth in the Frontiers of Cognitive Psychology and delves in Neuroeconomics, Judgment, and Decision Making.
Bias #4: Pavlovian Association
Misconstruing past correlation as a reliable basis for decision making. An enormously powerful force. 90% of advertising works with Pavlovian association. For example raising the price of a product sometimes gives it a larger market share than dropping it.
Bias #5: Reciprocation tendency
This is the bias that makes us act as another person expects.
Or, as this article explains, when receiving a favor we feel an immense need, almost an obligation, to pay it back in kind.
Bias #6: Social proof
One common form is the Over-influence from the conclusions of others, particularly under conditions of uncertainty and stress.
To the man with a hammer, every problem pretty well looks like a nail.Charlie Munger
Bias #7: Contrast-Caused distorsion
This means a distorsion of sensation, perception and cognition. The sensation apparatus of man is overinfluenced by contrast, it has no absolute scale. Widely used by magicians or real estate agents who take you first to the most horrible over-priced property while touring you around.
Bias #8: Over-influence by Authority
A famous experiment shows how ordinary people can be led to administer deadly electric shocks to other people from the simple power of a third party Authority
Bias #9 : Deprival Super-Reaction Syndrome
Caused by present or threatened scarcity. Usually the only way to get bitten by a dog is to get a bone out of his mouth.
Bias #10: Bias from Envy : Jealousy
Warren Buffett famously said «it’s not greed that drives the world but envy »
Bias #11: Chemical Dependency
Dependency to any form of drug, usually generating massive denial and moral breakdown if there’s any need.
Bias #12: Misgambling compulsion
Take deprival super reaction syndrome with slot machines for example
Bias #13: Liking Distortion
Including the tendency to like oneself and one’s own idea structures and to be especially susceptible to be misled by someone like.
Bias #14: Other normal limitations of Sensation, Memory, Cognition & Knowledge
Bias #15: Stress-induced mental changes
The total reversal of condition personality induced by stress. This list has immense value. It should definitely be tought by the education system. Tell me what you think about these biases, are any of these familiar ?
Here are the full Cognitive Biases in an infographic
Books to take things further
If you’re interested in these Cognitive biases and want to take things a little further, here are a couple of recommended reads, including books on Charlie Munger :