I make it a point to re-watch this video of a speech Charlie Munger originally gave at Harvard in 1995. Charlie was a master when it came to thinking about how we, well, think. In this speech, Charlie talks about the biases we all have that we may not be aware of. In order to think clearly, you must first be aware of what’s clouding your thoughts.
The above video was created by Pasquale D’Silva for Andrew Wilkinson who is also a big fan of Charlie Munger.
The biases that cost investors the most
Munger’s most dangerous bias has an unglamorous name: reward super-response tendency. People, he says, will do almost anything, including things they know are foolish, when the incentives point that way. For investors this is the whole game in miniature. Fund managers churn portfolios to justify fees. Analysts recommend stocks their employers underwrite. And individual investors chase whatever paid off last quarter, because the market rewards the appearance of action. Whenever you catch yourself reaching for an investment, Munger would ask you to check who is being paid to make you reach.
Then there is social proof, the tendency to follow the herd because the herd feels safe. Munger considered it one of the most powerful forces in human behavior, and markets are where it does its worst damage. Bubbles are social proof with a ticker symbol: everyone buying because everyone is buying. The antidote is not intelligence. Plenty of brilliant people rode the dot-com bubble all the way down. The antidote is the willingness to look foolish for a while, which is why Munger prized temperament over IQ.
Deprival super-reaction is the one that explains panic selling. Losing something you have hurts roughly twice as much as gaining the same thing feels good, so investors cling to losers too long and sell winners too early, exactly backwards. Munger watched this destroy more portfolios than bad analysis ever did. His remedy was brutal and simple: think in terms of opportunity cost. Every dollar sitting in a mediocre investment is a dollar not working in a great one, and sentimentality about the past is the most expensive emotion in finance.
The lollapalooza effect is what happens when several biases fire at once, and Munger said it produces consequences out of all proportion to any single cause. The 2008 crisis was a lollapalooza: easy money plus social proof plus reward super-response plus the comforting authority of AAA ratings, all pointing the same way. For the individual investor, the lesson is defensive. You cannot eliminate your biases, but you can build systems that assume they exist: automatic contributions, diversified index funds, and a written plan for what you will do when the market drops 30 percent, made before it drops.
If you enjoyed the video, you may also like the web version of Poor Charlie’s Almanack created by the talented folks at Stripe. Prefer the analog version? You can find it for around $80 on Amazon.
Enjoyed this video? If so, you may also enjoy Peter Lynch’s fantastic 1994 lecture as well.
Winchell House 
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