Alex Tabatabai is Co-founder of Fernbank Partners (http://www.fernbankpartners.com). In this video he talks about why every entrepreneur should understand the psychology of human misjudgment. Moreover, these tips will help entrepreneurs when interacting with people on a daily basis.
- Charlie Munger, author: "The Psychology of Human Misjudgment"
- Misinterpreting past correlation
- Bias related to incentives
- Envy of those with greater status & wealth
- Disproportionate amount of reciprocation
- Valuation distortion due to contrasts
- Bias based on associated emotions
- Blindly accepting the influence of authority
- Deprival super reaction
- Lollapalooza effect: multiple factors coming together
One of my favorite areas of investing in all of business is a discipline called the psychology of human misjudgment. Sometimes you'll see this in the area of behavioral finance but I think there’s value for it for anybody in business.
One of my favorite top leaders on the subject is Charlie Munger who Warren Buffet's business partner. He has written a wonderful paper on it which you can find just doing a simple Google search. I'm going to cover a couple of the key human misjudgments. There are many of them.
One is reinforcement and misconstruing past correlations. In our business we see this with a technical analysis type day trading. People try to chart the pattern of a stock and where it's going and it's silly. I mean you really need to study the intrinsic value of a business before making an investment not study some arbitrary chart.
Another human misjudgment is incentive cost biases. Think about how much subconsciously incentive drives our behavior. If we knew a certain action i going to get us a certain incentive we subconsciously tend to gravitate toward that which is why it's so important to make sure incentives are aligned for participants in a business transaction or business.
Another great one is envy. We are envious beings. We tend to want what other people are doing and it's a good thing to be calling this enough and know when you're participating in an envious behavior and just not do it. You'll save yourself a lot of heartache.
Another human misjudgment is reciprocation tendency. This is the tendency we have from evolutionary stand point to want to give back when somebody gives us something. Now if it's in proportion -- it's proportionally done its fine but a lot of times it's done in a manner that people try to get us to reciprocate disproportionally higher and that causes us financial loss.
Another human misjudgment is contrast cause distortions. The best way to sum this up is when you go buy a car, you pay $40,000. You have or go for it. You get the price maybe down 35 and then they hit with you with these options and from a psychological stand point you think you're spending all these money. What's another $1000 in navigation and all the radio and that's actually where they make their money.
Another misjudgment is like, dislike bias. Just think about somebody you like. You tend to like the things associated with them or if there's somebody you don't like. You tend to dislike the things disassociated with them. When this is really not logical behavior you should judge the things associated with them on their own individual merits.
Another human misjudgment is over influence by authority. A lot of times when you see people in positions of authority we give them automatic difference. We are tribal creatures to look to an authority figure and we really need to question authority. We really need to make independent thoughtful analysis of -- is what the authority figure saying actually makes sense? Should we follow it or not?
Another human misjudgment is deprival super reaction. If I tell you I'm going to give you $100 tomorrow, show up at this coffee shop. Show up at the coffee shop I'll only give you $50. You'll probably feel upset and feel like you should have got $100 when in reality you just got a free $50 but this is how us humans are wired.
And to sum it all up, there is something which one of my favorite people Charlie Munger calls the lollapalooza effect. When you have 2 or more of this human misjudgment working in concert, you got a perfect storm. There are some really good or really bad things that can happen. The recent financial crisis was a lollapalooza effect. You got a couple of these things coming together and things happen exponentially quicker and more impactfully.
So, to recap psychology of human misjudgment is so important. There is so many psychological aspects of human behavior that are overlooked in business and I highly encourage every business owners to really dig into this field.