Dealing with it - a lesson from Munger and Buffett

The chief criticism leveled at behavioral economics is that this body of knowledge "does not help us."  To some the principles of behavioral economics seem unrelated or unstructured, thereby offering no assistance in the world of economics.  That may be true on a macroeconomic scale. Behavioral economics as a field of study is new and much more study is needed to apply it to the economy as a whole. But that argument does not refute the legitimacy of the principles that have been discovered, it just says we haven't yet melded them together into a unified theory. True and we may never do so. It may be on a macro level all BE does is supplement or adjust economic theory.

The foregoing, in my view does not apply to micro-economic theory, and by this reference, I mean to restrict my comments to individual financial decisions and the decision making process. Here I am not sure a unified theory is possible given the vast differences individuals possess. That does not mean behavioral economic principles are not useful for those of us that deal with individuals or their financial matters.They are very important. Why? Because although our psychological machinations often help us out in life they almost always cause us to make poor economic decisions including decisions about our investments and portfolios. 

I promised you in my November 15, 2009 Observation that I would tell you how I thought you might deal with these frailties. Here is how:

(1) learn what they are,(2) realize that your clients will be subject to them and (3) steer your clients away from them. Its not possible to do that entirely but it is possible to do a pretty good job of it and thereby benefit your clients.

Two guys who have figured this out are Warren Buffett and his partner Charlie Munger. Portions of a magazine article and a speech will help prove my point.

Carol Loomis, the author of an article in the April 1988 edition of Fortune Magazine, entitled "The Inside Story of Warren Buffett," writes:

Last year at a Los Angeles party, Munger's dinner partner turned to him and coolly asked,  "Tell me, what one quality most accounts for your enormous success?"  Recalling this delicious moment later, Munger said, "Can you imagine such a wonderful question? And so I looked at this marvelous creature -- whom I certainly hope to sit by at every dinner party -- and said, I'm rational. That's the answer. I'm rational.''

The article can be found at: 

http://money.cnn.com/magazines/fortune/fortune_archive/1988/04/11/70414/index.htm

Mr. Munger knows all about human psychological frailty when it comes to finance, in fact he gave a speech about it at his law school Alma mater. I reproduce part of the transcript of that speech:

THE PSYCHOLOGY OF HUMAN MISJUDGMENT

By Charlie Munger (Warren Buffett's partner at Berkshire Hathaway)

From a Speech at Harvard Law School (1995)

[The moderator of the program introduced the subject of Mr. Munger's talk and after being introduced Mr. Munger began:]

When I saw this patterned irrationality, which was so extreme, and I had no theory or anything to deal with it, but I could see that it was extreme, and I could see that it was patterned, I just started to create my own system of psychology, partly by casual reading, but largely from personal experience, and I used that pattern to help me get through life. Fairly late in life I stumbled into this book, Influence, by a psychologist named Bob Cialdini, who became a super-tenured hotshot on a 2,000-person faculty at a very young age. And he wrote this book, which has now sold 300-odd thousand copies, which is remarkable for somebody. Well, it's an academic book aimed at a popular audience that filled in a lot of holes in my crude system. In those holes it filled in, I thought I had a system that was a good-working tool, and I'd like to share that one with you.

And I came here because behavioral economics. How could economics not be behavioral? If it isn't behavioral, what the hell is it? And I think it's fairly clear that all reality has to respect all other reality. If you come to inconsistencies, they have to be resolved, and so if there's anything valid in psychology, economics has to recognize it, and vice versa. So I think the people that are working on this fringe between economics and psychology are absolutely right to be there, and I think there's been plenty wrong over the years. Well let me romp through as much of this list as I have time to get through:

The link to a transcript of the original speech is:

http://vinvesting.com/docs/munger/human_misjudgement.html

Mr. Munger revised and edited the transcript of his original 1995 speech in 2005. The revision, he dubbed the "long talk," can be found at:

http://www.jeremybroomfield.com/munger2.pdf

In his long talk Mr. Munger describes and illustrates over twenty human mental frailties.  Two he identified are:

Doubt-Avoidance Tendency

The brain of man is programmed with a tendency to

quickly remove doubt by reaching some decision. It is

easy to see how evolution would make animals, over the

eons, drift toward such quick elimination of doubt. After

all, the one thing that is surely counterproductive for

a prey animal that is threatened by a predator is to take a

long time in deciding what to do. And so man’s Doubt

Avoidance Tendency is quite consistent with the history

of his ancient, nonhuman ancestors.

  at page 9

Inconsistency-Avoidance Tendency

The brain of man conserves programming space by being

reluctant to change, which is a form of inconsistency

avoidance.  And so, people tend to accumulate large mental

holdings of fixed conclusions and attitudes that are not

often reexamined or changed, even though there is

plenty of good evidence that they are wrong.

at page 10

I do not cite these two principles because they are any more important than others but just to show that Mr. Munger observed them occur in life and avoided them in order to be successful. In my view a large part of any effort to manage your risk successfully and distinguish yourself favorably from your peers is to follow the example of Mr. Munger.

Recognize that these frailties exist, learn what they are and steer yourself and your clients away from them. That is in essence what Buffet and Munger did first with their hedge funds and now with Berkshire Hathaway. That is how you and your clients can "be rational." I am not suggesting that you mimic Buffet and Mungers' style of investing just that you mimic their acknowledgement of behavioral economic principles and their dogged determination to avoid the traps these principles describe.

So, maybe Spock is not such a bad guy after all. Can you imagine what McCoy's investment portfolio looks like?  Live long and prosper probably doesn't describe it.

While I was an in-house counsel I distributed Observations which discussed principles of behavioral economics.  I will revisit these principles in some of my future Observations.

- Why? (pay attention to this behavioral economics stuff anyway)

In reading Justin Fox's The Myth of the Rational Market, I ran across several passages which are in part humorous and taken together make a great point for me. Chapter 11 begins:

In the spring of 1979, just after the publication of their "Prospect Theory” article, Daniel Kahneman and Amos Tversky visited Richard Thaler at the University of Rochester. Thaler arranged a dinner for his guests and, somewhat mischievously, seated Tversky next to efficient markets apostle Michael Jensen [of the Jensen index or "Alpha"]. The exchange that resulted, recalled Thaler's Rochester colleague Hersh Shefrin, who was also at the table, “kind of set the tone for the debate over the next fifteen years.

The psychologist could not resist springing one of his quizzes on the finance professor. Tversky asked Jensen to describe how his wife made decisions. Jensen regaled him with tales of her irrational behavior. Tversky asked Jensen what he thought of President Jimmy Carter. An idiot, Jensen said. And what about the policies of the Federal Reserve chairman? All wrong. Tversky continued listing decision makers of various sorts, all of whom Jensen found wanting. “Let me see if I've got this straight,” Tversky finally said. “When we talk about individuals, especially policy makers, they all make major errors in their decisions. But in the aggregate, they all get it right?

Jensen's response was [according to those present - but not Jensen] ' Well Amos, you just don't understand.' Errors and irrationalities of the sort Tversky asked about simply didn't matter. It was the market as a whole that got things right, not its individual participants.

At page 289 the author continues:

When it came to the study of individuals and the decisions they make, this behaviorist updating of equations was an unalloyed success. Most economists and finance scholars had never disputed that people sometimes made weird choices. The issue was that finance professors in particular could not see why it mattered. They studied prices not people.

The book goes on to state that this priority had to be modified. In the 1970s most pensions were defined benefit plans. The investments in those plans were made by professional fund managers without the input or even knowledge of the pension beneficiaries. With the enactment of ERISA, the death of the defined benefit plan and most importantly the rise (to virtual exclusivity) of the 401(k), all of us including our clients were thrown (whether we liked it or not) into the investment arena.

This shift meant that individuals were now in charge of their own financial destinies, including tax deferred and non tax deferred assets.

Mr. Fox continues on page 289 to state what may be obvious but immensely important:

“It [individual assumption of control over their financial destiny] also opened up a staggering new set of opportunities for poor financial decisions.”

My point:

Even finance professors from the “Chicago” school of finance acknowledge that individuals can and often do make poor financial decisions. The professors deal with markets and prices and not with individual lives.

You do.

In managing your risk you may wish to consider how you are going to deal with the aspects of human nature our psychologist friends are pointing out to us. I will have more to say on how you might later.

For those of you in the dispute resolution business, an examination of these same aspects of human nature may present entirely new and different explanations for what transpired or perhaps shed some light on what operative facts actually transpired.



-11/13/2009

Bounded Rationality

Took third in the 1957 Belmont Stakes. Not really but it is a good name for a thoroughbred and maybe someday.

“Bounded Rationality” is a term used in academic circles* as a short form description for the reason or reasons why we do not make optimal economic decisions. The term can be more easily understood and its concept more easily digested when it is compared against the concept of “unbounded” or unlimited rationality, meaning Spock-like (as in Star Trek) reasoning. If unbounded rationality is pure logic then bounded rationality is something short of that, in other words, rationality within limits or boundaries, hence the term itself.

Recall that classic economic theory assumes that individual economic decision makers have unbounded rationality. They will unfailingly maximize their utility at the least possible personal cost. While useful as an analytical tool this view does not reflect the real world.

In his 1982 book Models of Bounded Rationality and Other Topics In Economics, Herbert Simon (Nobel Laureate) describes three unavoidable constraints under which we make economic decisions. The first is that we are given limited and often unreliable (or inaccurate) information with which to make our decision. The second is that our mind has a limited capacity to evaluate and process the available information and finally, we only have a limited amount of time to make that decision. These constraints function as boundaries on our ability to be “rational.”

Dr. Simon and other commentators came to describe the real world quality of economic decisions of individuals as “satisficing”, meaning satisfactory (as opposed to rational or optimal). One example of the sub-optimal approach in making a decision is our use of rules of thumb. Others would be the use of judgmental heuristics, some of which I have discussed in past Observations and no doubt will discuss in the future.

What this all means is that we have to take into account the unavoidable limits on rationality clients encounter when asked to solve economic dilemma and the mental tools (heuristics) they use to do so, that is, if we want to intelligently manage risk. Except, of course, for those of you who deal with Mr. Spock. In which case, live long and prosper. Now for the rest of us “Scotty! (this is sub-optimal) I need more power!” To which Scotty replies...

*Academics (or Academicians if you will), their studies and writings serve an invaluable purpose in expanding our understanding of our environment. Nevertheless some of these folks apparently don't get out much and do have a tendency to use what I think are non-descriptive terms for their concepts and often write in a fashion which lay people might just consider, shall we say, obtuse. If asked I would say to them -you don't have to give us the answer but at least let us figure out what the question is.

This Observation should be considered in conjunction with my Observation of September 30, 2009. If you did not receive a copy of that Observation and would like to receive one just let me know.