Charlie Munger’s cognitive biases for investment

Asefa Hafeez

2 years ago

Table of Contents

Charlie Munger is a man with many hats. Before joining Warren Buffett and managing the conglomerate Berkshire Hathaway, he was a real estate attorney after graduating from Harvard Law School and before that he was an Army meteorologist during world war 2.

Apart from that he studied psychology extensively and wrote books on them. One of his books, The psychology of human misjudgment talks about various unconscious biases that humans have which affect their decision-making process.

In this article, we are going to look at some of these biases and see how these biases can affect your investing decisions. Let’s start:

Bias 1 — Over-Optimism Tendency

This bias shows that we tend to be more optimistic in any situation than we have reasons to be. In the world of investment, this is a common bias where investors believe that their investments will recover once the market starts going up but that doesn’t happen. The term ‘bull trap’ is a perfect example of this.

It happens when a share is declining in value and then shows some signs of improvement and optimist investors think that it is going upward and start investing in it only to find out that it’s a temporary improvement and they got tricked.

Bias 2 — Social Proof Tendency

You look at other people, their status, and their group to think and act as they do.

Social proof is a powerful bias in all aspects of life. We are always looking around us to see what others are doing and also to validate our own decision-making.

Investment intrinsically is personal, your financial needs, goals, and background is not the same as others and therefore looking at how other people are investing can lead to wrong decisions and losses. Many investors fall victim to this bias and experience losses.

Bias 3 — Stress-Influence Tendency

We will act faster and get more extreme reactions if adrenaline is running through our bodies. Stress can cause us to take unwise and unnecessary decisions. And since the world of investment is so heavily influenced by external factors, the stress in investment can be significant.

This can cause many investors to take the wrong decision. Managing stress and panic is a crucial part of a successful investment journey.

Bias 4 — Excessive Self-Regard Tendency

We all think we’re above average. We’re smarter, more attractive, and more persuasive than we really are. This is where overconfidence comes from. And overconfidence makes us take decisions that we know might not be wise.

There are many examples of investors who lost a great deal of money because they did not act according to the market and had complete confidence in their analysis of the market.

Bias 5 — Inconsistency and Avoidance Tendency

We have the reluctance to change ourselves and our habits. Our brain tries to conserve energy by being reluctant to change, which is a way of avoiding inconsistency.

In investing this can mean not learning about the newer forms of investments and various ways you can save taxes by investing in them. This can also mean being stubborn in old ways of investing even though they are not helpful anymore.

Being flexible is also a crucial part of investing.

Bias 6 — Liking and Loving Tendency

We ignore the faults and flaws of people or products if we like or love them. Even if the mistake is unforgivable, we’re easier to accept it if it’s done by our favorite brand or an attractive person.

This is very common in the world of investing, we see a person/founder/CEO that we like and invest in their company/brand. We also might see a finance influencer talk about something and because we like the, we might want to invest in the same things that they have.

Bias 7 — Disliking and Hating Tendency

We ignore the virtues and positive aspects of people we dislike. This is the opposite of the above. We might not like a person for any number of reasons and because of that, we might avoid investing in places or ways that they have invested. This can gain lead to unwise investing decisions.

Bias 8 — Doubt and Avoidance Tendency

We hate uncertainty. If we are unsure about a decision, we try to quickly remove any doubt by making a hasty decision so that we could be certain again. And the stock market is inherently uncertain. Many people do not invest because they don’t like the uncertain aspect of it.

Bias 9 — Deprival-Superreaction Tendency

This is loss aversion. You much rather prefer to avoid losing something than gain something.

This is the main reason why many Indians don’t invest. The fear of experiencing financial loss is greater than the prospect of wealth building and this stops them from investing.

Conclusion

Biases are everywhere but understanding psychological biases can help you identify them and prevent you from making biased decisions.

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