We all know how important an understanding of psychology is to sound investment practices. And when Charlie Munger espouses the virtues of someone he considers a leader in the Psychology field, its well worth taking note of his opinion.
Robert Cialdini is the author of an incredibly insightful book, 'Influence'. Dr. Cialdini has spent his entire career researching the science of Influence, earning him an international reputation as an expert in the fields of persuasion, compliance, and negotiation. He currently holds the position of Professor Emeritus of Psychology & Marketing at Arizona State University.
Upon reading Cialdini's book, Munger was so appreciative of the collected wisdom in Cialdini's work that he sent him a share of Berkshire Hathaway A-stock to thank him.
“I was in my office and went to the mail box and got a big envelope that came from Berkshire Hathaway. Of course I had heard of Berkshire Hathaway, everyone had by that time about 15 years ago. When I opened it, it was a share of Berkshire stock. The letter from Charlie saying ‘this is by way of thanks, Warren and I have read your books, we’ve made hundreds of millions of dollars. This is our way of saying thanks.’” Robert Cialdini
"Academic psychology has some very important merits alongside its defects. I learnt this eventually, in the course of general reading, from a book, 'Influence', aimed at a popular audience, by a distinguished psychology professor, Robert Cialdini… I immediately sent copies of Cialdini's book to all my children. I also gave a share of Berkshire stock [A share] to thank him for what he had done for me and the public." Charlie Munger
"Fairly late in life I stumbled into this book, Influence, by a psychologist named Bob Cialdini.. 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." Charlie Munger
Charlie Munger has been Buffett's business partner for the best part of 50 years. Together they're the world's undisputed Investment Masters. And while it's Buffett who basks in the spotlight, it's Munger who directed Berkshire away from buying companies cheaply to instead focus on buying high quality businesses at reasonable prices.
Munger's forte is mental models, and over the years he has drawn on these to sculpt investment theses that have generated billions of dollars in profits for shareholders. And when it comes to mental models, some of the most powerful are psychological. It is in psychology that Munger credits Dr. Robert Cialdini with filling in a lot of the gaps in his understanding.
Over the years, reading about the businesses that have attracted Buffett and Munger, I've seen the insights of Cialdini permeate through their thought processes. I've often drawn on the lessons in Cialdani's book myself to help understand a company's competitive advantage, why share prices may be acting in a particular way, why a board has engaged in a certain manner or why shareholders or analysts have taken a certain stand.
I was fortunate enough to meet Robert Cialdini in Omaha at the recent Berkshire meeting.
In his best-selling book 'Influence', Cialdini addresses six psychological principles of influencing - Consistency and Commitment, Reciprocation, Social proof, Authority, Liking, and Scarcity. Each principle tends to have a basis as a useful mental short cut which has evolved with human development and aided society's functioning. The book is an easy and enjoyable read, as Cialdini provides vivid and entertaining anecdotes on each.
When it comes to investing, understanding each of these fundamental principles can provide invaluable insights. In this post I'll cover off on the first two principles, 'consistency & commitment' and 'reciprocation', and provide some relevant investment analogies. The other principles will be covered in a later post.
Consistency and Commitment
Humans have evolved to value and desire consistency. Cialdini explains "It is, quite simply, our nearly obsessive desire to be (and to appear) consistent with what we have already done." Inconsistency is commonly thought to be an undesirable personality trait, yet a high degree of consistency is normally associated with personal and intellectual strength.
"It allows us a convenient, relatively effortless, and efficient method for dealing with complex daily environments that make severe demands on our mental energies and capacities. It is not hard to understand, then, why automatic consistency is a difficult reaction to curb. It offers us a way to evade the rigors of continuing thought. And as Sir Joshua Reynolds noted, 'There is no expedient to which a man will resort to avoid the real labour of thinking'." Robert Cialdini
The associated bias is commitment. When we make a commitment to something, we like to remain consistent. As humans, we don't like changing our mind.
"Whenever one takes a stand that is visible to others, there arises a drive to maintain that stand in order to look like a consistent person." Robert Cialdini
The dangerous side-effect for investors of commitment and consistency tendencies lies in situations that are changing or when there is contrary information to our initial assumptions.
"The humankind works a lot like the human egg. When one sperm gets into a human egg, there's an automatic shut-off device that bars any other sperm getting in. The human mind tends strongly toward the same sort of result. And so, people tend to accumulate large mental holdings of fixed conclusions and attitudes that are not often re-examined or changed, even though there is plenty of good evidence that they are wrong." Charlie Munger
Investors often don't change their minds when contradictory evidence makes it obvious they should. As a relevant example, I remember a hedge fund manager who cleaned up in the Financial Crisis. Following this, he made a name for himself as an able short seller and inflows naturally followed. Unfortunately he'd become committed to shorting stocks; never able to take-off the so-called 'bear suit'. As a result he gave back a good portion of his earlier profits.
"Oscar Wilde said that 'consistency' is the last refuge of the unimaginative" Peter Cundill
Even today, I can think of one reasonably well known manager, a true 'perma-bear' in every sense of the word, whose monthly missives have been a cacophony of doom and gloom since 2009. Here's a very small sample ... 'Strenuously Overbought' (2009), 'Don't Take the Bait' (2010), 'Betting on a Bubble, Bracing for a Fall' (2010), 'Reduce Risk' (2011), 'Hard-Negative' (2011), 'Warning: A New Who's Who of Awful Times to Invest' (2012), 'Dancing at the Edge of a Cliff ' (2012), 'The Endgame is Forced Liquidation' (2013), 'A Textbook Pre-Crash Bubble' (2013), 'Market Peaks are a Process' (2014), 'Ingredients of a Market Crash' (2014), 'Fair Value on the S&P 500 Has Three Digits' (2015), 'Warning with a Capital "W"' (2016). While he's maintained his commitment, his fund has delivered -8%pa return over the last 5 years and -6%pa over 10 years. Like a broken clock, you can expect that his bearish thesis will be right one day, but in the meantime he's lost his investors a lot of money.
The Investment Masters recognize the risk of commitment bias. When facts change, you must change. There are numerous techniques to combat this bias. Being a generalist allows you take a wider view of the investment landscape rather than committing to a certain type of investment. By refraining from publicly disclosing an investment idea there is less risk of becoming committed to it. Consider the following from Buffett's lieutenants:
"I never liked talking to my limited partners about ideas I had, because you become somewhat wedded to it, it's harder to change your mind over time, you become pre-committed to your positions and so forth. That's always been my stance" Todd Combs
"If you speak up and put it [investment idea] on record, you end up getting too wedded to your thesis and that's dangerous because everything your'e invested in is a function of the facts and circumstances on a given day, it changes" Ted Weschler
Getting others to continually test your ideas, or appointing a devil's advocate, can help force you to consider alternative theses and help avoid investment mistakes. Writing an investment thesis prior to investing and then regularly re-checking your reasons can help you maintain an unbiased and rational view should developments evolve contrary to your original expectations. Simply asking yourself if you'd buy the stock today if you didn't own it is another good self-check.
"You've made an enormous commitment to something. You've poured effort and money in. And the more you put in, the more that the whole consistency principle makes you think, 'Now it has to work. If I put in just a little more, then it will 'all work'. People go broke that way, because they can't stop, rethink, and say, "I can afford to write this one off and live to fight again. I don't have to pursue this thing as an obsession in a way that will break me." Charlie Munger
Remaining flexible, keeping an open-mind and maintaining a sense of humility is essential. Recognize there are things you can't know. Recognize that you will make mistakes. And when you enter an investment, acknowledge you may be wrong and you'll be far better placed to adjust your thesis if and when required. Remember stocks are just 'three letters' - don't fall in love with ideas.
It's not only investors that get caught in the commitment bias. When a company's management commits to earning guidance or an acquisition policy, they may be inclined to take actions which aren't in the interest of shareholders. The Investment Masters tend to be leery of companies with aggressive growth targets and/or acquisition strategies.
"Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating manoeuvres so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to 'make the numbers'.” Warren Buffett
“Organisations expected to grow rapidly, usually because of pressure from investors, often turn to acquisitions to meet expectations. This may dilute an organizations strategy, by tempting it to extend its reach beyond its area of expertise. At least one research study has called this practice ‘premature core abandonment,’ citing it as one of the primary reasons that an organization’s growth stalls.” James Heskett, 'The Culture Cycle'
"Number's pressure impairs judgement and robs dignity.. [It] makes good, smart people do ethically dumb things and takes them closer toward ethical collapse." Marianne Jennings, 'The Seven Signs of Ethical Collapse'
As humans we have benefited from placing a high value on reciprocation. Our ancestors learned to share their food and their skills in an honored network of obligations. We feel an obligation to give, an obligation to receive and an obligation to repay. This is particularly relevant for things like gifts and favors. And then there are what are known as 'reciprocal concessions'; someone makes a concession to us and we feel obliged to respond in kind.
In business, the implications can be positive. A good example lies in the intangible qualities of culture. They're hard to replicate. When a company looks after it's staff, when it pays them well, values them, trusts them and empowers them, it can provide a significant competitive advantage. A cultural 'flywheel' develops. The company rewards the staff, the staff go the extra mile for customers, the customers reciprocate. Home Depot is a good example, they support their staff and they also support their communities, particularly in times of need.
"Traditionally, we hire the best people in the industry, so they make more money than their counterparts do at our competition. That breeds initial loyalty when they are hired; receiving company stock further deepens that loyalty; and then they fall in love with the way they are treated .. Every associate at Home Depot has an opportunity to be an owner of the company. Everyone has a stake in the company that goes beyond a day's wages. Associates have a real vested interest in cultivating customers and building lifelong relationships with them." Bernie Marcus, Founder - Home Depot
One of the best predictors of a company's performance is when staff work together, which starts with reciprocation. Adam Grant, a professor at the Wharton School of the University of Pennsylvania explains:
"Evidence from studies led by Indiana University’s Philip Podsakoff demonstrates that the frequency with which employees help one another predicts sales revenues in pharmaceutical units and retail stores; profits, costs, and customer service in banks; creativity in consulting and engineering firms; productivity in paper mills; and revenues, operating efficiency, customer satisfaction, and performance quality in restaurants."
Across these diverse contexts, organizations benefit when employees freely contribute their knowledge and skills to others.
While reciprocation tendencies can be positive, they can often lead to sub-optimal investment outcomes.
"Reciprocation tendency subtly causes many extreme and dangerous consequences, not just on rare occasions but pretty much all the time" Charlie Munger
An example may be a corporate acquisition. The seller makes a small concession; drops the price a little, waives a condition or two and then the acquirer feels an obligation to respond in kind. Or consider when a company provides assistance for an analyst report or invites the Wall Street analyst on a company tour; is the analyst more or less inclined to write a favourable report? When so-called 'Independent Experts' are appointed to report on the fairness of takeovers, I've noticed they rarely recommend against a transaction. Ditto auditors on company accounts. On the latter, Buffett has opined 'whose bread I eat, his song I sing.'
“It’s a Wall Street truism that good management is important to any company’s success, but the typical analysts report ignores the subject.” Chris Davis
"Analysts are competent gatherers of facts and figures, but few can be relied upon for much more. Their assessments of managements are superficial and far too uncritical." Ralph Wanger
“Broker/analysts rarely comment on management in any detail and if so they tend not to criticise." Marathon Asset Management
"Wall Street analysts are unlikely to issue sell recommendations due to an understandable reluctance to say negative things, however truthful they may be, about the companies they follow. This is especially true when these companies are corporate-finance clients of the firm." Seth Klarman
"Enron represents another instance, like the dot-coms, where a) most benignly, we’d have to say brokerage house analysts possess little insight and their opinions are of no value, and (b) cynically, it seems they’re not there to help investors as much as their companies’ investment banking efforts.” Howard Marks
Directors fees may be considered another form of reciprocation.
"A director getting $150,000 a year from a company, who needs it, is not an independent director." Charlie Munger
"I’ve been on 19 boards. I have never seen a director, where the directors’ fees were important to them, object to an acquisition proposal, object to a compensation arrangement of the CEO. It’s just never happened." Warren Buffett
"The liberal pay [of boards of directors] is counterproductive to good management of the company. There’s a sort of a reciprocation. You know, “You keep raising me, and I keep raising you.” And it gets very club-like. And I think, by and large, the corporations of America would be managed better if the directors weren’t paid at all." Charlie Munger
You can see, even though I have only addressed two of Cialdini's tenets within this post, that the information is more than just valuable, its invaluable to investors. How many people or companies do you know that blindly follow 'consistency' to their detriment? I love Munger's humility in this - being able to acknowledge that he is able to learn from someone else is remarkable for someone with his track record. And not only did he learn, he turned that knowledge to profit and was able to reward Dr Robert Cialdini for the lessons. And when you consider what that single A Class share is worth today, it may seem a high price to pay for the knowledge. For me, the lesson is perhaps beyond invaluable - $300,000 for a book that earnt Munger's shareholders hundreds of millions of dollars is priceless as far as I'm concerned. So read the book - it may well be the best twenty bucks you'll ever spend.
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