Taking a break away from Charlie Munger and his Misjudgment of the Human Behavior, I thought it would be a refreshing change to touch on something simpler. Something most of us can identify with... something to do with a beer. Still, this has to do with my pet topic on financial pyschology. Let me elaborate.
You are at the Beach. The sun is hot and it is a great day. But you are now so thirsty and dying for a cold beer. Your friend volunteered to go to the nearby Hotel resort to buy a beer for you but wanted to know what would be the maximum price that you would pay for the beer. He will not buy the beer if the price is higher than your price (maximum). What will be your maximum price?
Now, in another scenario, supposing you are at the beach, and still dying for a beer etc but your friend now volunteers to buy the same beer at the nearby convenience store, our friendly neighbourhood store. What is your maximum price?
Are the 2 prices different? Why? By pure economic theory, the two prices should be the same, as the ultility derive ie. the joy of the quenched thirst is the same. There should be no difference as we have assumed it to be the same beer. Or is it? Did the fact that one was purchased at the Hotel and the other at the neighbourhood store affect our decision making? Why did it affect our decision?
From this simple exercise, Behaviorists began to postulate that the old classical theories may be inadequate. Fairness, in this case, has changed the outcome. The sense of fairness, is also applicable in employment and other macro situations. In short, decision making is more complex than originally thought... Emotions play a role.
Are there other emotions that play a role? There certainly are many others... Can you name some?
Saturday, October 17, 2009
Wednesday, October 7, 2009
The Human Misjudgment (2)
Below is the continuation of Charlie Munger's 24 causes of misjudment.
Fourthly, the bias from consistency and commitment tendency. For example, after a hard-won conclusion, our human minds shut off. Similarly, being so resistant to change, the laws of physics were never changed until the old guards have mostly passed on. In behavioral Finance, this is called Conservatism.
Fifthly, we often misconstrue past correlation as a reliable basis for decision making. Charlie Minger referred to this as the "Pavlovian" effect, where our minds works on association. For example, Coca Cola is often assocated with heroics at the Olympics, but never a funeral. Similarly, in Accounting, sloppy accounting allowed Institutions to book profits, and because nothing "bad" happened, theaccounting gets sloppier untl the bad behavior spreads.
Sixthly, there is bias from reciprocation tendency. This is a powerful phenomenon. Essentially, the human mind can be manipulated. Often we get better results, when we "ask for a lot, then back off" approach, because the human mind is influenced by the way how it thinks other people expects of you.
Seventhly, there is the Lollapalooza effect, the bias caused from over-influence by social proof. In other words, the conclusion of others (often of higher hierachy) having an impact on you. In Finance, there are stories of a large oil company buying fertilizer plants, which in turn influenced other oil companies into buying fertilizer plants too, without exactly knowing why (which were a disaster). To Charlie, the markets are living examples of bias from social proof as prices reflect what others think, and in turn affecting how we think... recipes for bubbles? Behaviorists have called this herd instinct, mania, positive extrapolitive thinking etc.
Wow. This is really Charlie Munger, the Psychologist. Explicitly, he acknowledged that markets are driven by psychology and in fact, he has rejected the Efficient Market Hypothesis Theory. But can Investors replicate the sort of discipline required by Charlie? Well another 17 points to go... Happy reading !
Fourthly, the bias from consistency and commitment tendency. For example, after a hard-won conclusion, our human minds shut off. Similarly, being so resistant to change, the laws of physics were never changed until the old guards have mostly passed on. In behavioral Finance, this is called Conservatism.
Fifthly, we often misconstrue past correlation as a reliable basis for decision making. Charlie Minger referred to this as the "Pavlovian" effect, where our minds works on association. For example, Coca Cola is often assocated with heroics at the Olympics, but never a funeral. Similarly, in Accounting, sloppy accounting allowed Institutions to book profits, and because nothing "bad" happened, theaccounting gets sloppier untl the bad behavior spreads.
Sixthly, there is bias from reciprocation tendency. This is a powerful phenomenon. Essentially, the human mind can be manipulated. Often we get better results, when we "ask for a lot, then back off" approach, because the human mind is influenced by the way how it thinks other people expects of you.
Seventhly, there is the Lollapalooza effect, the bias caused from over-influence by social proof. In other words, the conclusion of others (often of higher hierachy) having an impact on you. In Finance, there are stories of a large oil company buying fertilizer plants, which in turn influenced other oil companies into buying fertilizer plants too, without exactly knowing why (which were a disaster). To Charlie, the markets are living examples of bias from social proof as prices reflect what others think, and in turn affecting how we think... recipes for bubbles? Behaviorists have called this herd instinct, mania, positive extrapolitive thinking etc.
Wow. This is really Charlie Munger, the Psychologist. Explicitly, he acknowledged that markets are driven by psychology and in fact, he has rejected the Efficient Market Hypothesis Theory. But can Investors replicate the sort of discipline required by Charlie? Well another 17 points to go... Happy reading !
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