How to Avoid psychological biases when investing

The following is a guest post by Sajid Karsan. Sajid regularly writes for Barel Karsan, a site dedicated to discussing value investments and avoiding psychological biases when investing.

While mutual funds can serve as a useful mechanism to get returns on one’s capital, many individuals prefer to invest directly in the stock market. Unfortunately, there are many psychological tendencies humans have which prevent them from obtaining the best returns possible. While investors like Warren Buffett and Mohnish Pabrai have already mastered the psychology behind investing, the rest of us would do well to learn them ourselves to improve our investment returns.

Charlie Munger is Warren Buffett’s right hand man at Berkshire Hathaway. In this post, we’ll discuss a psychological tendency Munger has termed “Contrast-Misreaction”, as by understanding human tendencies, we better equip ourselves to avoid psychological biases when investing.

“Contrast-Misreaction” causes people to take actions which are potentially detrimental, because they appear insignificant or appear positive when compared to other actions. Munger uses an analogy of the human eyes to illustrate how this tendency works: humans only see items which contrast with their environment. In the same way, humans find it difficult to differentiate perceptions where there is little in the way of contrast. For example, a man may buy a $1,000 leather dashboard for a car, even if overpriced, when considered in combination with the fact that the vehicle cost is a much larger $65,000.

While the above example is one with relatively minor effects, Munger points to some examples where this tendency can have detrimental and long-lasting problems. In business, Munger has seen marketers use this practice to their advantage. For example, real-estate brokers may show clients awful properties at inflated prices for the purpose of closing a sale on merely a bad property at a merely partially inflated price. This practice is also seen frequently in mainstream advertising, with service/product providers asserting a phony price for a product and then promptly offering a ‘discount’ on that price. Munger argues that even though consumers recognize this practice, it still works! Therefore, being aware of psychological ploys does not prove to be a perfect defense!

While a minor mistep caused by this tendency is on its own not disastrous, Munger argues that a series of seemingly minor misteps can lead to disaster. This can occur because each step represents only a minor deviation (i.e. low contrast) from the current situation. Munger uses the example of the live frog that boils to death because it never jumps out of a pot of slowly heated water, not realizing that the temperature is changing because the changes are minute.

Ben Franklin said that a small leak will sink a great ship. Munger argues that this is due to the fact that the brain often misses the small leak in the large ship.

If you enjoyed this post, you may be interested in reading some of the other human tendencies that Munger has discussed. You may also subscribe to the Barel Karsan blog if you prefer to read about these tendencies in your RSS reader!

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