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Why were Warren Buffett and his creation, Berkshire Hathaway, so unusually successful?
In 2007 Wesco Annual Meeting, someone asked the above question from Charlie Munger. He replied –
If that success in investment isn’t the best in the history of the investment world, it’s certainly in the top five. It’s a lollapalooza.
Lollapalooza in the conventional sense means something outstanding of its kind. A person, a thing or an event that is particularly impressive, or extraordinarily attractive. But being multidisciplinary learners, we shouldn’t be satisfied with the conventional definitions, should we? Moreover, Charlie Munger doesn’t use lollapalooza just for its dictionary meaning.
Here’s the definition of Lollapalooza taken from the book Poor Charlie’s Almanack –
Lollapalooza is, as personified by Charles Munger, the critical mass obtained via a combination of concentration, curiosity, perseverance, and self-criticism, applied through a prism of multidisciplinary mental models.
When Charlie Munger uses the word lollapalooza, he often attaches the word “effects” (as in “lollapalooza effects”) which means that multiple factors are acting together in ways that are feeding back on each other.
In simple words, lollapalooza effect is an outcome which is far bigger than the sum of the parts. Using this mental construct of lollapalooza, one can explain the cause-effect relationship behind extreme events in the world. Not only explain, but Lollapalooza helps us understand the workings of this complex world so that we can leverage that for our own benefit.
In 2017 Daily Journal (DJCO) annual meeting, Munger said –
I coined it when I realized I didn’t know psychology. I bought three comprehensive psychology textbooks and read through them, and like usual I thought they were doing it all wrong, and I could do it better. When three or four tendencies were operating at once in same situation, the outcome wasn’t linear, it was straight up. The scholars were ignoring the most important thing in profession, because they couldn’t do experiments with so many variable operating together, and then they didn’t synthesize it with other disciplines, because they didn’t know squat about other disciplines. I am lonely, but I am right.
Lollapalooza is a great problem-solving tool. When you learn the important mental models and start applying them for problem-solving, you will realize that multiple models seem to converge in one direction and together they form the critical mass for a cascading of positive effects – a lollapalooza. It simplifies your decision making tremendously.
According to Munger, a majority of the worldly problems would be no-brainers if you look at them through the lens of lollapalooza.
To wrap our head around Munger’s idea of lollapalooza effect, let’s explore two cases studies which exemplify this concept.
Tupperware parties and open outcry auctions.
These examples highlight the situations where human irrationality, under the spell of Lollapalooza, becomes an uncontrolled freight train ripping apart every decision on its way.
Lollapalooza and Tupperware Parties
A Tupperware party, according to Munger, is the best example of Lollapalooza effect because multiple psychological biases work in the same direction and push people towards irrational decisions.
Famous psychologist Robert Cialdini, in his book Influence, has written extensively about how the structure of Tupperware parties is designed to exploit many of the human biases.
A Tupperware party takes advantage of four weapons of influence, i.e., reciprocity, liking bias, social proof, and confirmation bias.
Here’s a crash course on these biases.
Reciprocity is the deep-seated urge to return a favour. When someone does something nice for you, it sows the seed to reciprocate. This feeling of obligation to repay is what’s known as reciprocation bias. Even if we didn’t need the initial favour in the first place, it’s hard to get rid of the feeling that you have to return the favour in some form. This urge to reciprocate may lead us to do things which we wouldn’t have done otherwise.
Liking bias explains why people prefer to do business with people they like rather than people they don’t like. And who do we like? Those who are similar to us, who cooperate with us, who makes us feel special. Especially our friends and neighbours. We find it hard to refuse a request that comes from such people.
Social proof is a way to deal with uncertainty. When we’re in doubt we often make decisions by imitating what others are doing. Humans find great comfort in social validation. Following others usually serves well under normal circumstances but social proof can lead us astray when making crucial decisions.
Commitment and consistency bias is when we resist changing our views even if we’re wrong. Once we’ve taken a stand on something, it’s cognitively tough to change it even when we’re shown evidence that counters our original beliefs. The more we affirm our past decisions the stronger we believe in them.
Back to Tupperware party.
The invite for the Tupperware party comes from someone you like — a friend, a colleague, a neighbour or a relative. Liking bias at play. The party then starts with a game where everyone is allowed to win a prize. Winning “prizes” invokes the force of reciprocation. You want to pay back those who gave you the free items. Then old customers are asked to share the benefits of the Tupperware products. This unleashes the commitment bias. Then you see other people at the party buying items and that triggers the social validation — since other similar people want the product; it must be good. Social proof bias at work.
Combine these effects, and it’s not hard to see why many people try to avoid going to a Tupperware party in the first place, because they know that once they are there, they will buy something.
Lollapalooza and Auctions
In 2007 Tata Steel acquired Corus group – an Anglo-Dutch steel major. The acquisition happened through a competitive open-outcry auction. Tata Steel submitted a proposal with an initial bid of 455 pence a share. Soon CSN a Brazilian competitor chimed in with an offer of 475 pence. In response, Tatas upped the bid to 500 pence a share. Then CSN raised the bid to 515 pence. After a long drawn bidding war, Tata group eventually won with a bid of 608 pence a share. That was 34 percent higher than Tata’s original proposal. The total payment was $12.1 billion (Rs. 53,580 crores at the then exchange rate) of which $6 billion was debt. At that time Tata Steel’s market cap was less than Rs. 30,000 cr.
By 2014, Tata Steel’s debt had ballooned to more than $13 billion. They never recovered from this mistake.
Social psychology experiments show that bidders in auctions often get carried away and end up bidding far more than the underlying value of the auctioned objects. Such outcomes are almost always the result of the combination of multiple forces working in the same direction.
In his famous lecture title Psychology of Human Misjudgment, Charlie Munger says –
…the open-outcry auction is just made to turn the brain into mush: you’ve got social proof, the other guy is bidding, you get reciprocation tendency, you get deprival super-reaction syndrome, the thing is going away… I mean it just absolutely is designed to manipulate people into idiotic behavior.
The list of cognitive biases that are at play in an auction is just mind-boggling. It starts with greed and envy but doesn’t stop there.
- Commitment Bias: Every bid and its escalation is a public commitment. It reinforces and justifies the bidder’s belief that his bid price is right.
- Social Proof: You’re in close contact with other people who are all providing social validation that the sale item is valuable.
- Low Contrast Effect: Every successive bid is only a tiny increment over the previous one.
- Loss Aversion: As the auctioneer starts the countdown on the competitive bid it intensifies the feeling that you’re being deprived of something which was almost yours.
- Authority Bias: The auctioneer is seen as a symbol of authority because he certifies the authenticity of the auctioned object. He also announces an initial bidding price which serves as an “anchor.”
- Incentive Bias: The incentives of the auctioneer are directly attached to the final price. Higher the winning-price more the commission for the auctioneer.
- Scarcity Bias: Auction items are scarce because only one person can have it, and after the bids are finished, you’ve lost your chance.
Do you see what happens to people who get into open-outcry, auction-like situations? That’s why Warren Buffett and Charlie Munger have a rule when they get invited to auction situations.
The rule is: Don’t Go.
Lollapalooza and the Stock Market
So how does lollapalooza play out in the stock market?
If you think about it, you will arrive at the same conclusion as I did. The stock market is either one big Tupperware party or a giant auction room or both.
The environment in which a typical stock market investor operates today is the breeding ground for many psychological biases — all acting in the same direction. And when forces act in the same direction, as we’ve learnt from Munger, it’s an invitation to lollapalooza.
With the advent of social media, everyone has the power to shout their opinions openly. Publicly voicing your views triggers a strong commitment and consistency effect. Irrespective of how many people actually listen to you, the mere fact that you’ve spoken about a stock openly, engraves those existing beliefs deeper into your own psyche.
The same social media becomes the source of social validation too. When you see hundreds of people talking about an obscure company, it’s difficult to fight the urge to follow the herd. This effect is more pronounced during rapidly falling or rising stock prices.
The incessant noise from the TV channels, financial newspapers, WhatsApp groups and free stock tippers, aggravates the recency bias in an investor’s mind.
And then the mother of all biases – incentive bias.
“I think I’ve been in the top 5 percent of my age cohort all my life in understanding the power of incentives,” says Charlie Munger, “and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther…Never ever think about something else when you should be thinking about incentives.”
The train of financial industry chugs on the rails of incentives. As a result, the incentive bias among the sellers of financial products creates a moral hazard for the small investors.
“All commissioned salesmen,” said Charlie Munger in 1988 Wesco Financial annual meeting, “have a tendency to serve the transaction instead of the truth.”
To invest in the stock market, a new investor cannot avoid contact with the so-called relationship managers of large financial institutions (banks, brokerage houses, mutual funds, etc.) This customer facing army is equipped with weapons of persuasion to be deployed against the innocent retail investors.
Unfortunately, even after knowing about the power of persuasion principles, it’s hard to resist giving in to the requests coming from these people. They are sharply dressed, they look confident, they are articulate, and sound very convincing. Can you imagine what a gullible investor, who has neither heard of Cialdini’s work nor the workings of Tupperware parties, gets sucked into?
Mr. Market – Benjamin Graham’s figment of imagination – is like the Tupperware hostess who would invite you every day to join the party. He’s also like the auctioneer who wants you to jump into the adrenaline-filled bidding war.
Remember the rule? Don’t go.