Charlie Munger breaks down the interplay between psychology and business from the perspective of his expert investment acumen.
At one time or another, business magnate, Warren Buffett, has been nicknamed the “Wizard,” “Sage” or “Oracle” for his incredible investment savvy, and as Berkshire Hathaway executives, he and Charlie Munger have long made names for themselves as the gurus of business.They’ve both influenced one another greatly over the course of the six decades they’ve spent as business partners and friends.
“Every time I’m with Charlie,” Buffett said during a joint CNBC interview with Munger, “I get at least some new slant on an idea that causes me to rethink certain things.” Munger has a deep comprehension of the role that psychology plays in enterprise and entrepreneurship, and that may very well be the reason why he and Buffett are so hand-in-glove.
Munger held several speaking engagements in the early ‘90s wherein he discussed the overlap of psychology and economics.One speech in particular that he delivered at Harvard University stated that it cost him “a lot of money” to not realize the connection between the two modes of thought.He unfurled some 24 psychological predispositions that he takes into consideration whenever he makes corporate decisions or career choices.
The speech was received by the business world as being of such insight that Tiny Capital, an investment firm, collaborated with Thinko, an animation studio, to create a cartoon that firmly encapsulated Munger’s expressed ideas.Munger joined psychological phenomena to various business examples as a way to illustrate how economic decision making goes hand-in-hand with psychology.
One of the principles that Munger applies in business is Pavlov’s theory of classical conditioning.He explains never having taken a course in either psychology or economics, but he learned plenty about the Russian physiologist during a high school biology class and retained it.
Pavlov examined whether or not the digestive process could be initiated by way of external stimuli during the late 19th century, and to observe this, he rang a metronome immediately before giving his dogs food on a regular basis, presumably without fail.Pavlov’s dogs eventually came to associate the sound of the metronome with the idea of food, so they would salivate at the sound as opposed to the sight or smell of actual food.Pavlov referred to this process of training his dogs to respond to a bell with their digestive processes as “conditioning.”
“Well, the truth of the matter is that Pavlovian association is an enormously powerful psychological force in the daily life of all of us,” Munger explains. “And, indeed, in economics we wouldn’t have money without the role of so-called secondary reinforcement.” He continues by saying that three quarters of advertisement is only effective based on this very concept of classical conditioning.He provides the example of Coca-Cola, a company that has been legendary at times for its commercial advertising.
“They want to be associated with every wonderful image: heroics in the Olympics, wonderful music, you name it,” Munger says. “They don’t want to be associated with presidents’ funerals and so forth.”
Both Buffett and Munger have also repeatedly spoken out in public against the market efficiency theory—the idea that companies cannot beat the market by way of stock picking.Munger’s speech addressed this directly as he brags about how many holes they poked in that theory, referring to it as “a wonderful economic doctrine that had a long vogue” in lieu of Berkshire Hathaway ignoring it and succeeding consistently.
Munger used the concepts of social proof and the bystander effect to illustrate his point and show how investors are often just followers.Psychology Today defines the latter as follows: “The bystander effect occurs when the presence of others discourages an individual from intervening in an emergency situation.” This was an increasingly popular idea in the Cold War era when Kitty Genovese, a 28-year-old bar manager in Queens, New York, was murdered in 1964.It was reported as a stabbing outside her home wherein several bystanders were present to observe the incident yet none acted.
This is the kind of situation that best exemplifies the bystander effect, but it is also the kind of situation in which said bystanders exhibit what’s called social proof.The handbook, Social Psychology, defines social proof as the instance in which “we conform because we believe that others’ interpretation of an ambiguous situation is more accurate than ours and will help us choose an appropriate course of action.” In other words, it’s when people simply copy the behavior of others because they do not trust their own reactions to be appropriate.
“Now, one of the explanations is that everybody looked at everybody else and nobody else was doing anything,” Munger said during his speech, alluding to so-called “big-shot businessmen” who only make the investments that others are making without ever exhibiting an original thought, making their own investment decisions or taking their own risks, “and so there’s automatic social proof that the right thing to do is nothing.”
There are microeconomic ideas and gain/loss ratios and so forth that also come into play,” Munger explained. “I think time and time again, in reality, psychological notions and economic notions interplay, and the man who doesn’t understand both is a damned fool.”