Premium Value Investing NewsletterDownload Free Issue

Wit, Wisdom, Charlie: Elementary Worldly Wisdom from Charlie Munger (Issue #1)

This post is authored by Puneet Khurana, a Safal Niveshak tribesman.

Are you planning to buy a specific car? Go out and you will start noticing that so many people have the same car. You never noticed it was so damn popular!

Astrology column told you that your lucky number is 999, and miraculously you started seeing that number frequently (house numbers, phone numbers, license plates and even the shares quoting at that price). In fact, you see the number so frequently that you feel the universe is trying to tell you something.

Going through a tough breakup? Sadly, every song on the radio is about heartache. As if somebody told the RJ that you were listening.

Or on a more positive note, you are in love and somehow every song is romantic!

Ever witnessed any of those? If yes, it’s called ‘divine intervention’. Or atleast that’s what we are told most frequently.

On a serious note though, psychologists have a different term for it. It’s called ‘Frequency Illusion’ – the fact that something becomes more frequent in your observation once your mind is introduced to it.

There’s more to it. The phenomenon explained above doesn’t stay in its natural occurrence. Human beings have a natural propensity to take this illusion from its passive existence to an active pursuit and the result is that rather than waiting for things to appear more frequent you start looking for them.

Psychologists call this as Confirmation Bias.

Do you suffer from Confirmation Bias?
Let me explain it a bit more. Even though we like to believe that we are objective human beings with rational thought process, nothing can be far from truth.

Human beings as a species are extremely curious, constantly seeking answers to the puzzles existing in the Universe. But unfortunately, our brain has a very limited circuitry and it’s a natural propensity for us to look for easy answers to complicated questions.

Due to this propensity, the mind has the tendency to jump to conclusions. The first plausible answer that the mind finds to a question becomes the ‘near-truth’ and there is a natural resistance to seek more answers and accept it as a conclusion.

This is popularly known as the ‘first conclusion bias’.

Once this idea/thought/conclusion is accepted by the brain, human beings tend to push aside any other observation which disregards the initial conclusion.

So, if we think about it, our whole thought process since childhood is an outcome of subconsciously seeking out books, writings, evidences in support of the ideas we believed to be true (and disregarding the evidences which oppose it).

Just like a vicious circle, the very act of this selective seeking of supporting evidences makes the initial ideas even more prominent till a point we are absolutely convinced that nothing else is truth.

This is what I introduced above as ‘Confirmation bias’.

Francis Bacon puts it succinctly:

The human understanding when it has once adopted an opinion (either as being the received opinion or as being agreeable to itself) draws all things else to support and agree with it.

Since now you are aware of the two biases, let me come to the big gun.

This one was explicitly mentioned by Munger in his speech – ‘The Psychology of Human Misjudgment’ as ‘Availability-Misweighing’ tendency.

It builds on the two biases explained above and states that the mind, due to its limited capacity, works with what is easily available to it. The things are easily available to mind for variety of reasons.

3 reasons we fall for Availability Bias
Reason #1 – Recent activity: Something which is more recent occupies more recalling power in the brain compared to something that happened long ago and hence we tend to weigh that activity as more important than others.

For example, your tendency to go in a train after a train blast (unless you absolutely have to) is extremely low immediately after a bomb blast.

Similarly our tendencies to avoid areas which had terrorist attacks in recent times despite the fact that the place is safer immediately next day after the blast than let’s say 10 years after it.

Gamblers fallacy is a classic phenomenon explaining this bias because of recent events.

Investopedia defines it this way:

When an individual erroneously believes that the onset of a certain random event is less likely to happen following an event or a series of events. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future.

For example, consider a series of 20 coin flips that have all landed with the “heads” side up. Under the gambler’s fallacy, a person might predict that the next coin flip is more likely to land with the “tails” side up.

Reason #2 – Personal Experience: Something which has happened to us is easy to recall compared to something which has not. Since your all senses are involved in personal experiences, the impression in the memory is significant and hence it’s easily recallable.

Reason #3 – Vividness: The more vivid the thing, the easier it is to recall for the brain. The technique (vividity) which works as a brilliant memory tool, ironically, also acts as an impediment in logical reasoning due to our tendency to overweigh the importance of a vivid event compared to a ‘not-so-vivid’ event.

Add to all the above our tendency to further look for confirming evidences and we have things so strong that they are most often recalled by our brains during the decision making process.

Some of you might be wondering, “Yes, wonderful, very elegant all this is, but can we please switch to investing and stocks? If you haven’t noticed, this site is called Safal ‘Niveshak’!” 🙂

Well, here it is.

Availability bias and investing
First, let’s understand how an investors ‘suffers’ because of this ‘When-I-am-not-near-the-girl-I-love, I-love-the-girl-I-am-near’ fallacy and then see what can be done to avoid it.

The most common behaviour is observed in the panic/euphoric markets. A recent event causing a sudden reaction in the markets, like a terrorist attack causing a crash are the example of this bias.

At times like these, it is imperative for investors to take themselves mentally away from the scene and think objectively as to why the value should be affected.

We all know that value is affected only by two variables – (1) Cash flows and (2) Interest rates.

If there is no reason for these two to change, there is no reason for prices to change. These markets create opportunities for rational investors. Another way this bias affect us is during the evaluation of business prospect. We have a natural tendency to give too much importance to the current or past few quarters.

The reason is simple, the experience of those quarters is very recent and it’s easy for us to recall that straight away. Combine this with the vividness provided by business channels and experts telling you day in and day out what’s great or bad about the company and that makes you overoptimistic or over-pessimistic about the prospects.

Even the contrarian in you sometimes may feel overwhelmed and succumb to “they must know something I don’t” syndrome.

This can be avoided by taking a longer operating history of the business while evaluating it. Almost every prominent investor has emphasized this fact. Look for a long operating history preferably 10 years or more. In a lot many Indian companies, 10 years history may not be available, but take as much as you can and then evaluate the business.

Important: I am not asking you to ignore the recent quarters. The aberration in recent quarter results may or may not be just aberrations.

Structural changes are also very subtle. But the idea is to look the picture from both far off (10 years) and close (recent quarters) without over-emphasizing any view.

Another way in which availability bias impacts investors is the tendency to give too much importance to an idea (let’s take a stock idea for e.g.), the moment it strikes to us.

The sources of the idea may differ. You may have heard about a company from an intelligent friend or a known stock picker or worse, a TV stock expert and you work on it and you agree with the prospect.

Now don’t get me wrong here! It’s good to be excited about something you just ‘discovered’. I am just pointing out to the fact that the tendency is to give too much importance to the one idea. After all, the stock doesn’t know we own it.

Always remember…

An idea or a fact is not worth more merely because it’s available to you.

The examples are many, like:

  • Overoptimistic about upcoming IPO because your previous IPO investment made money, completely disregarding the fact that in general IPOs have been losing propositions for investors.
  • Selling a security just because it has risen up substantially in the recent times without giving the regard to the value-price gap.
  • Buying something just because it has fallen 80% from the peak. (this is also called anchoring bias but I will discuss it later)
  • Giving too much importance to price movement of recent past.
  • Giving too much importance to stocks that are covered by the media and ignoring the ones those are not.

And so on…..

But what can rational investors do to deal with this bias?

The solutions have to be customized according to the investor. But here is a general broad guideline which have helped number of investors and which I have found very helpful personally.

Since most of the biases are psychological, unless you are trained to think about them yourself, a written reminder is of utmost use. Infact, we can almost remove all inefficiencies from our thinking process if we follow written procedures (general guidelines).

This idea has been very well explained by Atul Gawande in his book The Checklist Manifesto and the strong idea of checklists have been used and promoted by very savvy investors including Buffett, Munger, Mohnish Pabrai, and Guy Spier.

As a defense against our cognitive disability of remembering everything, checklists help us avoid first conclusion bias. But always remember, the effectiveness of the checklist will be determined not only by its existence but by its exhaustiveness and its ability to accumulate your learning, be it direct or vicarious.

The checklists differ for different kind of investors and the more you read, the more you will be able to develop one. For me personally, checklists serve two important purposes:

  1. Since mistakes made in recent investment operations are recallable easily but mistakes done few years back are not, a checklist serves as a reminder to avoid the same.
  2. Incorporates not only learning from your own investment operations but also from the other investors’ and hence adds the vicarious learning benefit to your process.

Mistakes are very costly in the markets. There are some mistakes we can’t avoid but some we can. As Buffett have told us a number of times…

An investor needs to do very few things right as long as he or she avoids big mistake.

To do: Don’t do all the mistakes yourself. Learn from others, add to your checklist and follow it religiously. (If possible, I will write a separate post just on checklists considering its importance in the investment process)

Another way of avoiding this bias is not a concrete idea like a checklist but a conscious change in the cognitive thought process.

This is what I learned from Darwin, something he wrote in his autobiography…

I had, also, during many years followed a golden rule, namely, that whenever a published fact, a new observation or thought came across me, which was opposed to my general results, to make a memorandum of it without fail and at once; for I had found by experience that such facts and thoughts were far more apt to escape from the memory than favorable ones.

The idea is extremely powerful and the notion behind it is simple: One can never conclusively prove anything but one can conclusively disprove something.

This is the same idea we use in statistics where our objective is to ‘reject the hypothesis’ or else we ‘fail to reject the hypothesis’. We never accept the hypothesis.

Sighting of 100,000 white swans doesn’t conclusively prove that all swans are white but sighting of one black swan disproves the notion. And hence the idea is to consciously seek disconfirming evidences. As I explained above, it’s our natural tendency to seek out what is consistent with our view. So it becomes absolutely imperative to seek out things which disprove us.

It’s a very powerful idea and so many great investors have made it such a habit that now they do it subconsciously. It becomes the way of operating. And this is not only true for investors, but prominent thinkers, politicians, humanists, businessman and countless successful people.

Some examples where I have used this technique in past:

  • Whenever I have a view on a stock, I don’t read the research reports with the similar conclusions. In fact, if I have a bullish view, I make a point to read all the analyst reports which have a sell on the stock and discuss with them, their viewpoint. Remember, there is no right or wrong, just point of views. Right and wrong are always in hindsight.
  • When I am studying one school of thought, it’s important to understand other school of thoughts to get the complete picture. I am a proponent of Austrian school of economics but it’s imperative not just to read Hayek or other prominent Austrian economists but also to read Keynes, Krugman etc. to get varied point of views and then decide.
  • Don’t assume some strategy work because some investor told you so. More so, why not challenge yourself and read Soros and not just Buffett every time. Or on an unrelated topic, when reading Dawkins work on atheism, you don’t only read Dawkin’s ‘The God Delusion’ but also David Bernilski’s ‘The Devil’s Delusion’.

To do: Have lots of ideas. Have opposite point of views and constantly seek out disconfirming evidence. It’s a very essential trait in a profession where our major enemy against our success is our psychology.

Finally, always remember the wise words of Emile Auguste Chartier…

Nothing is more dangerous than an idea, when it’s the only one you have.

About the Author: Puneet Khurana works with an India focused hedge fund. A student of Prof. Sanjay Bakshi at MDI and a CFA (charter awaited), Puneet is an avid reader of books on investing, finance, psychology, philosophy, physics and various other disciplines.

His investing journey has gone from speculating as a college student to investing based on ‘margin of safety’ principle over a period of 9 years. Currently besides his work, Puneet spends considerable time taking guest lectures in subjects like Investment Management and Business Strategy for MBA students and also training CFA aspirants. He blogs at Pragmatic Investing.

Disclaimer: The views expressed in this post are those of the author only and do not constitute in any way an official position, policy, or pronouncement of his employer.

Print Friendly, PDF & Email

About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. SG Jaclyn says:

    Puneet, that was a well written article. An eye opener for me on some of the points you have covered. Thank you.

  2. Puneet, thought provoking and very well writen article. Thanks

  3. amazing work men, after this, whole night i will be in availability as i will be thinking about it!!!!!!
    it opened level of thinking of my mind, which my bro calls circle of thinking, we will be in same thinking circle unless or until some other ideas comes to our mind which is known as uniform motion
    Newton first law of motion-
    An object that is at rest will stay at rest unless an unbalanced force acts upon it.

    Hope to learn alot by such articles
    Yours thankfully

  4. my personal experience with recency bias
    I watched jim carrey movie The Number 23 with my friend, after movie my friend started calculating everything his name,roll no,time everything by numbers
    The Number 23 is a ,2007 American psychological thriller film written by Fernley Phillips, plot involves an obsession with the 23 enigma, an esoteric belief that all incidents and events are directly connected to the number 23, some permutation of the number 23, or a number related to 23.

  5. Harish Bihani says:

    Thanks Puneet and Vishal. Keep up the good work.

  6. Nice article…

  7. ankur bhatia says:

    Thanks Puneet wonderful article and these principles can be applied in investing but in all our decision making.

    • Agreed. The principles explained by Munger are aimed at improving our general thinking process about everything. Its a path to ‘Worldly’ Wisdom and not only ‘Investing’ wisdom.

  8. Sanjeev Bhatia says:

    Hi Puneet.

    A very well written article, and one with profound lessons. I have been very much interested in “Human” part of investing for quite some time and the way these biases play on the psyche, right since Tulip Mania. As I understand, there are about 13 biases we, as investors, are prone to. It is in light of articles like these which can help us immensely in getting rid of those.

    Thanks for the effort. Keep up the good work.

    • Thanks for the kind words, Sanjeev. Will surely try to cover all the important and lethal biases. There is no end to the list, Munger covers around 25 reasons for human misjudgement in his speech and mentions that there are more. And its not so scientific, I am sure, somewhere in the world somebody while working on his/her Phd is expanding that list 🙂

  9. Sanjeev Bhatia says:

    Was going through the article again, hence this comment 🙂

    A very good way of removing both confirmation and first conclusion bias which I came across recently and trying to implement in my investment process (In fact, I have incorporated a separate excel sheet for this) is to use what is know as “Developing the Bear Case”. Since you are interested in Buying a particular stock, somebody has to Sell it, Right? Developing a bear case implies you become that seller and come up with arguments why you would be SELLING this particular stock. Believe me, this is an eye-opening experience and you come across certain factors which you tend to overlook when you are trying to justify BUYING that stock.

    Answering by using method of elimination is pretty common in Engineering and MBA streams and also where multiple choice questions are asked. Instead of selecting the right answer, you Reject the wrong ones, and the one which is left is the right answer. A very effective technique indeed.

    A couple of points where I differ, though :(:-

    1. ” And this is not only true for investors, but prominent thinkers, politicians, humanists, businessman and countless successful people.”

    Keeping politicians in the same league as Thinkers, Humanists etc. is, to me, an act of sacrilege 😀 .

    2. I, personally, don’t see any harm in “When-I-am-not-near-the-girl-I-love, I-love-the-girl-I-am-near’. Maybe the short term need of the person in question are greater than his long term ones…. ;).

    Happy Investing.

    • Developing a bear case certainly seems to be a very useful approach surely.

      As far as point of differences are concerned:

      1. I have great respect for politicians for their ability to prepare for the unknowns (even if it is for selfish reasons). And to avoid the punishment for the sacrilege, I assure you I am not generalizing it for all politicians but select few. 🙂

      2: Till the point this ‘When-I-am-not-near-the-girl-I-love, I-love-the-girl-I-am-near’ approach stays in personal matters and doesn’t jump to other aspects of your life (especially investing) , even I see no harm in that 🙂

  10. Manish Sharma says:

    Hi, Puneet,

    A detailed article and of course a very well attempt. Anything written and said by Buffett and Munger needs to be read and re-read by lesser mortals like us before the key points get distilled in our philosophy.

    However, towards the end you have used the ‘idea’ quote and I would like to seek your views on the same. I have observed that many a good investors have made money by keeping things simple. They used a few things smartly. Even in the case of professional money managers one can take the example of John Neff who made his career by using the low p/e approach. Ben Graham also advocated the idea of asset values predominantly. Even Buffett talk about the importance of staying with in your circle of competence.
    In this view, i think more than focussing on the idea alone one should also see the practicality of the idea he is pursuing, while concentrating on the value aspects of the stock and investing all the time. Many retail investors may have cognitive dissonance while focussing on many ideas simultaneously that may lead to analysis paralysis. The focus in investing must be to curtail the risk, with risk being permanent loss of capital.

    • Hi Manish,

      Your question reminds me a small story I read somewhere.

      “A plumber comes to a house to repair a faulty waterline. After evaluating the problem for 2 minutes , he bangs a hammer few times on certain areas in the pipe and the fault disappears. When finished, he ask for a $100. The house lady asks, ” Why should I pay you $100 dollars for ‘just banging on the pipe’ few times”. To which the plumber replies, ” Banging the pipe is only $1, knowing where to bang is $99.”

      This, is how it is relevant to your question at least in the context of investing ( The idea itself has much greater relevance)

      You don’t know your circle of competence initially. You have to find it after trying a lot of things. Similarly, you don’t just find one stock and start buying it, you look at a lot of ideas and then zero down to the best ones. So, to find where to expand your knowledge/operations (where to bang) is for where you need lot of ideas.

      After that comes the point of focusing on what you have zeroed down to.That is what you are referring to. When you find what works (for you that is), then you work on that ( with an open mind though and willingness to change again)
      When I say the point of having ‘lots of ideas’, I am not trying or asking you to focus on all. I am just saying that before you focus on select few, you should have a huge arsenal of ideas to select from. So the ideas you focus on are because of ‘choice’ and not because of ‘lack of ideas’.

      Hope it clarifies your doubt. Else , I am willing to explain it further.

      • Anil Kumar Tulsiram says:

        Thanks Puneet

        I have read lot of times in Sanjay Bakshi articles and blog that one should not stick to one investment approach or philosophy at the beginning of one’s investment career. Your points clarifies that point further. Thanks again.

  11. Arun Ramakrishnan says:

    Here is a huge collection of Charlie’s speeches from 1994-2011. Hope everyone will find it useful to pore over them in the context of this article series.

  12. Anil Kumar Tulsiram says:

    Excellent one Puneet

    Whenever I went through presentation slides of Sanjay Bakshi lectures, I always wished if the transcript of his lectures are available. I think my wish has come true. Thanks again for starting this initiation.

    The problem which I am face is inspite of knowing all the flaws, sometimes I still fall for it. Like sometime buying the stock immediately the moment you read about it, because in the past for some stock by the time I completed by research, the stock was already 30-40% up and very little margin of safety was left. Similarly, there was one stock which though was available at below book value, I decided not to buy, as I thought there is a possibility of permanent loss of capital, as in my view operations of this company was more because of bubble in the sector. But within few months, stock went up by 100% and I still regret my times, that I should have bought atleast some shares, as it is not necessary that bubble should burst in next few years.

  13. Hi Puneet,

    Wonderfully written…making it simple enough…for the lay investor to get it. That is what I liked best about your article. I think its a gift to be able to write simple and educate. More power to you and Safal NIveshak tribesmen:)

    Cheers
    Donald

  14. Amit Kinhikar says:

    Hi Puneet,

    Nicely written and explains the biases very well, it would be good to have process that helps to eliminate these biases, the checklist you mentioned is going to play important role, eagerly waiting for your post on checklist 🙂

    Kind regards,
    Amit

  15. Lalaram singh says:

    Hi Puneet,
    Congratulations you for writing in such a lucid and simple way.
    Looking forward to all your future posts.

Trackbacks

  1. […] It’s a conversation between me and my friend (a senior HR manager for a reputed firm and a retail investor), from here on referred to as CM (Curious Manager). I advise you to get your own cup of coffee at this point, as this may go on for long time. CM: Hey, It was nice reading your post on availability bias. […]

  2. […] time. So I thought that once it does its spinoffs I would get a higher price like I did in TV18. Recency bias got into […]

Speak Your Mind

*