Colleagues ask how does behavioral economics help investors make money or how does it help investors pick the right stocks or make them better investors? Why can’t we just ignore this discussion about emotional biases and heuristics?
During the Berkshire Hathaway 2017 annual meeting Q&A session, Charlie Munger says:
“I think we have one other advantage. A lot of other people are trying to be brilliant, and we’re trying to stay rational… and… it’s a big advantage!”
Staying rational takes conscience effort and it doesn’t come naturally. Without knowing our biases, we can’t be rational, or as Charlie eloquently puts it:
‘You’re a one-legged man in an ass-kicking contest’
Another investor whom I respect, Allan Mecham of Arlington Value Capital, in a wonderful interview with the Manual of Ideas talks about using a two-track analysis when looking for investment opportunities:
‘It’s important to keep the litany of subconscious biases in mind when investing. Charlie Munger talks about using a two-track analysis when looking at ideas. I think that’s an extremely valuable concept to implement when looking at investment opportunities. You have to understand the nature and facts governing the business/idea and, equally important, you need to understand the subconscious biases driving your decision making — you need to understand the business, but you also need to understand yourself!’
In an experiment (by Dan Ariely, Drazen Prelec, and George Lowenstein), college students in a classroom are shown a few random items. A handout with the items listed is given to each student. Students are asked to write their last two digits of their SSN# on top of the page. The random items are: a box of chocolates, a cordless keyboard and mouse, a trackball, a bottle of rare wine, a bottle of average wine, and a design book.
Students are then asked to write their last two digits of their SSN# next to each of the items on the list and add a dollar sign turning it into a price. Then the students are asked to bid for each of the items and write a price they’re willing to pay for each item.
When asked by the researchers, did the last two digits of your SSN# have any effect on the amount you bid? They reply was of course NOT!!
Take a second and think….. What do you think happened?
It turns out that, on average, those with SSN# ending with 80 – 99 bid more for the items, and those SSN# ending with 01 – 20 bid less for the items. Top 20% avg $56 and bottom 20% avg $16. A 350% difference.
Does this sound rational to you? Do you think you or I are immune?
In this experiment, the SSN# was the anchor. Had the researchers used the students’ shoe size or the current temperature, the results would vary accordingly. Beware of anchoring or – as it’s known by behavioral economists – Arbitrary Coherence.
Could it be that the intricate lives we have carefully crafted are largely a product of arbitrary coherence?
The Dan Ariely series are inspired by:
John Mihaljevic of the Manual of Ideas. John Mihaljevic, CFA, is author of The Manual of Ideas, the bestselling book on value investing.Manual of Ideas.John is also founder of MOI Global, an invitation-only membership community of intelligent investors. It publishes the Manual of Ideas, “the very best investing newsletter” (Pabrai). John is also a managing director of ValueConferences, the series of fully online investment conferences for sophisticated investors. He has also served as managing partner of investment firm Mihaljevic Capital Management LLC since 2005. He is a member of Value Investors Club, an exclusive community of top money managers, and has won the club’s prize for best investment idea. John is a trained capital allocator, having studied under Yale University chief investment officer David Swensen, and served as research assistant to Nobel Laureate James Tobin. John holds a BA in economics, summa cum laude, from Yale and is a CFA charterholder.
Dan Ariely of Duke University. Dan is the James B. Duke Professor of Psychology and Behavioral Economics at Duke and a founding member of the Center for Advanced Hindsight. Dan’s books, Predictably Irrational, The Upside of Irrationality, The Honest Truth About Dishonesty, are NY Times best sellers. Dan also has a podcast “Arming the Donkeys”. A new book by Dan and Jeff Kreisler is expected to go on sale November 11 2017 titled Dollars and Sense.