Charlie Munger: The Psychology of Human Misjudgment

This is a continuation from Page 1 here (due to page length limits, sorry!)

In a sense, these psychological tendencies make things unavailable ’cause if you quickly jump to one thing and then because you’ve jumped to it, the consistency and commitment tendency makes you lock in, boom, it’s there. Number one.

Or if something is very vivid, which I’m going to come to next, that will really pound in. And the reason that the thing that really matters is now unavailable and what’s extra vivid wins is … the extra vividness creates the unavailability. So I think it’s much better to have a whole list of things that cause you to be less like Zeckhauser than it is just to jump on one factor.

Here, I think we should discuss John Gutfreund. This is a very interesting human example, which will be taught in every decent professional school for at least a full generation. Gutfreund has a trusted employee, and it comes to light not through confession but by accident that the trusted employee has lied like hell to the government and manipulated the accounting system and was really the equivalent to forgery. The man immediately says, “I’ve never done it before. I’ll never do it again. It was an isolated example.” Of course, it was obvious that he was trying to help the government as well as himself ’cause he thought the government had been dumb enough to pass a rule that he’d spoken against. And after all, if a government’s not gonna pay attention to a bond trader at Salomon, what kind of a government can it be?

At any rate, and this guy has been part of a little clique that has made way over a billion dollars for Salomon in the very recent past, and it’s a little handful of people. So there are a lot of psychological forces at work. You know the guy’s wife, he’s right in front of you, and there’s human sympathy, and he’s sort of asking for your help, which is the form which encourages reciprocation, and there are all these psychological tendencies are working. Plus the fact he’s part of a group that has made a lot of money for you.

At any rate, Gutfreund does not cashier the man, and of course, he had done it before, and he did do it again. Well now you look as though you almost wanted him to do it again or God knows what you look like, but it isn’t good. And that simple decision destroyed John Gutfreund.

It’s so easy to do. Now let’s think it through like the Bridge player, like Zeckhauser. You find an isolated example of a little old lady in the See’s candy company, one of our subsidiaries, getting into the till, and what does she say? “I never did it before. I’ll never do it again. This is gonna ruin my life. Please help me.” And you know her children and her friends, and she’s been around 30 years and standing behind the candy counter with swollen ankles. In your old age, isn’t that glorious a life? And you’re rich and powerful and there she is. “I never did it before, and I will never do it again.”

Well, how likely is it that she never did it before? If you’re gonna catch ten embezzlements a year, what are the chances that any one of them, applying what Tversky and Kahneman called baseline information, will be somebody who only did it this once? And the people who have done it before and are gonna do it again, what are they all gonna say?

Well in the history of the See’s candy company, they always say, “I never did it before, and I’m never gonna do it again.” And we cashier them. It would be evil not to because terribly behavior spreads. … You let that stuff … you’ve got social proof, you’ve got incentive caused bias, you got a whole lotta psychological factors that will cause the evil behavior to spread, and pretty soon the whole damn … your place is rotten, the civilization is rotten. It’s not the right way to behave, and …

I will admit that I have … when I knew the wife and children, I have paid severance pay when I fire somebody, for taking a mistress on a extended foreign trip. It’s not the adultery I mind. It’s embezzlement. But there, I wouldn’t do it where Gutfreund did it, where they’d been cheating somebody else on my behalf. There I think you have to cashier, but if they’re just stealing from you and you get rid of them, I don’t think you need the last ounce of vengeance. In fact, I don’t think you need any vengeance. I don’t think vengeance is much good.

Now we come bias from over-influence by extra vivid evidence. Here’s one … I’m at least $30 million poorer as I sit here giving this little talk because I once bought 300 shares of a stock, and the guy called me back and said, “I got 1500 more.” I said, “Will you hold it for 15 minutes while I think about it?” In CEO of this company, I’ve seen a lot of vivid peculiarities in a long life, but this guy set a world record. I’m talking about the CEO, and I just mis-weighed it. The truth of the matter is his situation was foolproof. He was soon gonna be dead. I turned down the extra 1500 share, and it’s now cost me $30 million, and that’s life in the big city.

It wasn’t something where the stock was generally available, and so it’s very easy to mis-weigh the vivid evidence. Gutfreund did that when he looked into the man’s eyes and forgave the colleague.

22. Stress-induced mental changes, small and large, temporary and permanent. Oh no, no no, I’ve skipped one.

Mental confusion caused by information not arrayed in the mind and theory structures creating sound generalizations, developed in response to the question why. Also mis-influence from information that apparently but not really answers the question why. Also, failure to obtain deserved influence caused by not properly explaining why.

Well we all know people who’ve flunked, and they try and memorize, and they try and spout back, and they just … doesn’t work. The brain doesn’t work that way. You’ve got to array facts on theory structures answering the question of why. If you don’t do that, you cannot handle the world.

Now we get to Feuerstein, who was the general counsel of Salomon when Gutfreund made his big error. And Feuerstein knew better. He told Gutfreund, “You have to report this as a matter of morality and prudent business judgment.” He said, “It’s probably not illegal. There’s probably no legal duty to do it, but you have to do it as a matter of prudent conduct and proper dealing with your main customer.” He said that to Gu-

… and proper dealing with your main customer. He said that to Gutfreund on at least two or three occasions, and he stopped. And, of course, the persuasion failed, and when Gutfreund went down, Feuerstein went with him. It ruined a considerable part of Feuerstein’s life. Well Feuerstein, was a member of the Harvard Law Review, made an elementary psychological mistake. You want to persuade somebody, you really tell them why. And what did we learn in lesson one? Incentives really matter. Vivid evidence really works. He should have told Gutfreund, “You’re likely to ruin your life and disgrace your family and lose your money.” And is Mozer worth this? I know both men. That would’ve worked. So Feuerstein flunked elementary psychology, this very sophisticated, brilliant lawyer. But don’t you do that. It’s not very hard to do, you know, just to remember that “Why?” is terribly important.

Other normal limitations of sensation, memory, cognition and knowledge. Well, I don’t have time for that. Stress-induced mental changes. Here, my favorite example is the great Pavlov. He had all these dogs in cages, which had all been conditioned into changed behaviors, and the great Leningrad flood came, and it just went right up. The dog’s in a cage, and the dog had as much stress as you can imagine a dog ever having. The water receded in time to save some of the dogs, and Pavlov noted that they’d had a total reversal of their conditioned personality. Well, being the great scientist he was, he spent the rest of his life giving nervous breakdowns to dogs, and he learned a hell of a lot that I regard as very interesting. I have never known any Freudian analyst who knew anything about the last work of Pavlov, and I never met a lawyer who understood that what Pavlov found out with those dogs had anything to do with programming, and de-programming, and cults and so forth. …

Then, we’ve got other common mental illnesses and declines, temporary and permanent, including the tendency to lose ability through disuse. Then I’ve got mental and organizational confusion from the say-something syndrome. Here, my favorite thing is the bee, a honeybee. A honeybee goes out and finds the nectar, and he comes back, and he does a dance that communicates to the other bees where the nectar is, and they go out and get it. Well, some scientist who was clever, like B.F. Skinner, decided to do an experiment. He put the nectar straight up. Way up. Well, in a natural setting, there is no nectar way the hell straight up, and the poor honeybee doesn’t have a genetic program that is adequate to handle what he now has to communicate.

You’d think the honeybee would come back to the hive and slink into a corner, but he doesn’t. He comes into the hive and does this incoherent dance, and all my life I’ve been dealing with the human equivalent of that honeybee. And it’s a very important part of human organization to set things up so the noise, and the reciprocation and so forth of all these people who have what I call say-something syndrome don’t really affect the decisions.

Now, the time has come to ask two or three questions. This is the most important question in this whole talk. What happens when these standard psychological tendencies combine? What happens when the situation, or the artful manipulation of man, causes several of these tendencies to operate on a person toward the same end at the same time? The clear answer is the combination greatly increases power to change behavior, compared to the power of merely one tendency acting alone. Examples are: Tupperware parties. Tupperware has now made billions of dollars out of a few manipulative psychological tricks. It was so schlock that directors of Justin Dart’s company resigned when he crammed it down his board’s throat. And he was totally right, by the way, judged by economic outcomes.

Moonie conversion methods. Boy, do they work. He just combines four or five of these things together. The system of Alcoholics Anonymous. A 50% no-drinking rate outcome when everything else fails? It’s a very clever system that uses four or five psychological systems at once toward, I might say, a very good end. The Milgrim experiment. See, Milgrim … It’s been widely interpreted as mere obedience, but the truth of the matter is that the experimenter who got the students to give the heavy shocks in Milgrim, he explained why. It was a false explanation. “We need this to look for scientific truth,” and so on. That greatly changed the behavior of the people. And number two, he worked them up, tiny shock, a little larger, a little larger. So commitment and consistency tendency and the contrast principle were both working in favor of this behavior. So again, it’s four different psychological tendencies.

When you get these lollapalooza effects you will almost always find four or five of these things working together. When I was young, there was a whodunit hero who always said cherchez la femme. What you should search for in life is the combination, because the combination is likely to do you in. Or, if you’re the inventor of Tupperware parties, it’s likely to make you enormously rich if you can stand shaving when you do it. One of my favorite cases is the McDonald-Douglas airliner evacuation disaster. The government requires that airliners pass a bunch of tests. One of them is evacuation. Get everybody out, I think it’s 90 seconds or something like that. It’s some short period of time. The government has rules, make it very realistic, so on, and so on. You can’t select nothing but 20-year-old athletes to evacuate your airline.

So McDonald-Douglas schedules one of these things in a hangar, and they make the hangar dark. The concrete floor is 25 feet down, and they got these little rubber chutes, and they got all these old people. They ring the bell, and they all rush out. In the morning when the first test is done, they create, I don’t know, 20 terrible injuries. People go off to hospitals. Of course, they scheduled another one for the afternoon. By the way, they didn’t meet the time schedule either, in addition to causing all the injuries. So what do they do? They do it again in the afternoon. Now, they create 20 more injuries and one case of a severed spinal column with permanent, unfixable paralysis. They’re engineers. These are brilliant people. This is thought over through in a big bureaucracy. … Authorities told you to do it. He told you to make it realistic. You’ve decided to do it. You’d decided to do it twice. Incentive-caused bias. If you pass, you save a lot of money. You’ve got to jump this hurdle before you can sell your new airliner.

Again, three, four, five of these things work together, and it turns human brains into mush. And maybe you think this doesn’t happen in picking investments. If so, you’re living in a different world than I am. Finally, the open-outcry auction. Well, the open-outcry auction is just made to turn the brain into mush. You get 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.

Finally, the institution of the board of directors of a major human, American company. Well, the top guy is sitting there. He’s an authority figure. He’s doing asinine things. You look around the board, nobody else is objecting. Social proof, it’s okay. Reciprocation tendency, he’s raising the director’s fees every year. He’s flying you around in the corporate airplane to look at interesting plants, or whatever in hell they do, and you go and you really get extreme dysfunction as a corrective decision-making body in the typical American board of directors. They only act, again the power of incentives, they only act when it gets so bad that it starts making them look foolish, or threatening legal liability to them. That’s Munger’s rule. I mean, there are occasional things that don’t follow Munger’s rule, but by and large the board of directors is a very ineffective corrector if the top guy is a little nuts, which, of course, frequently happens.

The second question. Isn’t this list of standard psychological tendencies improperly tautological compared with the system of Euclid? That is, aren’t there overlaps, and can’t some items on the list be derived from combinations of other items? The answer to that is, plainly, yes.

Three. What good, in the practical world, is the thought system indicated by the list? Isn’t practical benefit prevented because these psychological tendencies are programmed into the human mind by broad evolution so we can’t get rid of them? Broad evolution, I mean the combination of genetic and cultural evolution, but mostly genetic. Well, the answer is the tendencies are partly good and, indeed, probably much more good than bad, otherwise they wouldn’t be there. By and large these rules of thumb, they work pretty well for man given his limited mental capacity, and that’s why they were programmed in by broad evolution.

At any rate, they can’t be simply washed out automatically and they shouldn’t be. Nonetheless, the psychological thought system described is very useful in spreading wisdom and good conduct when one understands it and uses it constructively.

Here are some examples.

Karl Braun’s communication practices. He designed oil refineries with spectacular skill and integrity. He had a very simple rule. Remember I said, “Why is important?” You got fired in the Braun company. You had to have five Ws. You had to tell who, what you wanted to do, where and when, and you had to tell him why. If you wrote a communication and left out the why, you got fired, because Braun knew it’s complicated building an oil refinery. It can blow up. All kinds of things happen, and he knew that his communication system worked better if you always told him why. That’s a simple discipline, and boy does it work.

Two, the use of simulators in pilot training. Here, again, abilities attenuate with disuse. Well, the simulator is God’s gift because you can keep them fresh. Three, the system of Alcoholics Anonymous. That’s certainly a constructive use of somebody understanding psychological tendencies. I think they just blundered into it, as a matter of fact, so you can regard it as kind of an evolutionary outcome. But, just because they blundered into it doesn’t mean you can’t invent its equivalent when you need it for a good purpose. Clinical training in medical schools. Here’s a profoundly correct way of understanding psychology. The standard practice is to watch one, do one, teach one. Boy does that pound in what you want pounded in. Again, the consistency and commitment tendency. That is a profoundly correct way to teach clinical medicine.

The rules of the U.S. Constitutional Convention, totally secret, no vote until the final vote, then just one vote on the whole Constitution. Very clever psychological rules, and if they had a different procedure, everybody would have been pushed into a corner by his own pronouncements and his own oratory and his own … and no recorded votes until the last one. And they got it through by a whisker with those wise rules. We wouldn’t have had the Constitution if our forefathers hadn’t been so psychologically acute, and look at the crowd we got now.

Six, the use of granny’s rule. I love this. One of the psychologists who works with the center gets paid a fortune running around America, and he teaches executives to manipulate themselves. Now granny’s rule is you don’t get the ice cream unless you eat your carrots. Well, granny was a very wise woman. That is a very good system. So this guy, a very eminent psychologist, he runs around the country telling executives to organize their day so they force themselves to do what’s unpleasant and important by doing that first, and then rewarding themselves with something they really like doing. He is profoundly correct.

Seven, the Harvard Business School’s emphasis on decision trees. When I was young and foolish, I used to laugh at the Harvard Business School. I said, “They’re teaching 28-year-old people that high school algebra works in real life?” We’re talking about elementary probability. But later, I wised up and I realized that it was very important that they do that, and better late than never.

Eight, the use of post-mortems at Johnson & Johnson. At most corporations, if you make an acquisition and it works out to be a disaster, all the paperwork and presentations that caused the dumb acquisition to be made are quickly forgotten. You’ve got denial, you’ve got everything in the world. You’ve got Pavlovian association tendency. Nobody even wants to even be associated with the damned thing, or even mention it. At Johnson & Johnson, they make everybody revisit their old acquisitions and wade through the presentations. That is a very smart thing to do. By the way, I do the same thing routinely.

Nine, the great example of Charles Darwin is he avoided confirmation bias. Darwin probably changed my life because I’m a biography nut, and when I found out the way he always paid extra attention to the disconfirming evidence, and all these little psychological tricks, I also found out that he wasn’t very smart by the ordinary standards of human acuity, yet there he is buried in Westminster Abbey. That’s not where I’m going, I’ll tell you. And I said, “My God, here’s a guy that, by all objective evidence, is not nearly as smart as I am and he’s in Westminster Abbey? He must have tricks I should learn.” And I started wearing little hair shirts like Darwin to try and train myself out of these subconscious psychological tendencies that cause so many errors. It didn’t work perfectly, as you can tell from listening to this talk, but it would’ve been even worse if I hadn’t done what I did. And you can know these psychological tendencies and avoid being the patsy of all the people that are trying to manipulate you to your disadvantage, like Sam Walton. Sam Walton won’t let a purchasing agent take a handkerchief from a salesman. He knows how powerful the subconscious reciprocation tendency is. That is a profoundly correct way for Sam Walton to behave.

Then, there’s the Warren Buffett rule for open-outcry auctions: don’t go. We don’t go to the closed-bid auctions too because they … that’s a counter-productive way to do things ordinarily for a different reason, which Zeckhauser would understand.

Fourth, what special knowledge problems lie buried in the thought system indicated by the list? Well, one is paradox. Now, we’re talking about a type of human wisdom that the more people learn about it, the more attenuated the wisdom gets. That’s an intrinsically paradoxical kind of wisdom. But, we have a paradox in mathematics and we don’t give up mathematics. I say damn the paradox. This stuff is wonderfully useful.

By the way, the granny’s rule, when you apply it to yourself, is sort of a paradox in a paradox. The manipulation still works even though you know you’re doing it. I’ve seen that done by one person to another. I drew this beautiful woman as my dinner partner a few years ago, and I’d never seen her before. Well, she’s married to prominent Angelino. She sat down next to me, and she turned her beautiful face-up and she said, “Charlie,” she said, “What one word accounts for your remarkable success in life?” Now, I knew I was being manipulated and that she’d done this before, and I just loved it. I never see this woman without a little lift in my spirits. By the way, I told her I was rational. You’ll have to judge yourself whether that’s true. I may be demonstrating some psychological tendency I hadn’t planned on demonstrating.

How should the best parts of psychology and economics interrelate in an enlightened economist’s mind? Two views. That’s the thermodynamics model. You know, you can’t derive thermodynamics from plutonium, gravity, and laws of mechanics, even though it’s a lot of little particles interacting. And here is this wonderful truth that you can sort of develop on your own, which is thermodynamics. Some economists and I think Milton Friedman is in this group, but I may be wrong on that, sort of like the thermodynamics model. I think Milton Friedman, who has a Nobel prize, is probably a little wrong on that. I think the thermodynamics analogy is over-strained. I think knowledge from these different soft sciences have to be reconciled to eliminate conflict. After all, there’s nothing in thermodynamics that’s inconsistent with Newtonian mechanics and gravity, and I think that some of these economic theories are not totally consistent with other knowledge, and they have to be bent. And I think that these behavioral economics, or economists, are probably the ones that are bending them in the correct direction.

Now, my prediction is when economists take a little psychology into account that the reconciliation will be quite endurable. Here, my model is the procession of the equinoxes. The world would be simpler for a long-term climatologist if the angle of the axis of the Earth’s rotation, compared to the plane of the Euclyptic, were absolutely fixed. But it isn’t fixed. Over every 40,000 years or so there’s this little wobble, and that has pronounced long-term effects. Well, in many cases, what psychology is going to add is just a little wobble, and it will be endurable. Here, I quote another hero of mine, who of course is Einstein, where he said, “The Lord is subtle, but not malicious.” And I don’t think it’s going to be that hard to bend economics a little to accommodate what’s right in psychology. The final question is if the thought system indicated by this list of psychological tendencies has great value not widely recognized and employed, what should the educational system do about it? I am not going to answer that one now. I like leaving a little mystery.