Wednesday, 7 September 2016

Lessons from Charlie Munger-XI

Mar 1, 2012

In the previous article, we discussed the social proof tendency in day-to-day life and also explained why corruption in India is so deeply rooted. Today, we shall discuss the social proof tendency in the context of business and finance. 

The Institutional Imperative

Many of us may think of corporate leaders and managers as highly qualified, intelligent and experienced people who would be making rational business decisions. Even the legendary investor Warren Buffett had the same notion when he entered the world of business. But through time and experience, he realised that more often than not, despite all the qualifications and experience, it was not the case. A deadly force which he calls the 'institutional imperative' often hinders rational decision making and at times, even destroys businesses. 

What does institutional imperative mean? The Oracle of Omaha explains the institutional imperative as that need for managers to act and do like their peers no matter how irrational it may seem. A simpler term that comes to mind is peer pressure. However surprising it may seem, even CEOs are subject to this pressure which forces them to make stupid mistakes. 

The evidence is almost everywhere. Say for instance, if some companies in a certain sector go on a capacity expansion spree, others are quite likely to follow, even though the overall economic situation may be hinting otherwise. What is the excuse such companies provide when the initiative goes for a toss? It's not difficult to guess- 'Everybody was doing that'. 

From his own mistakes, Buffett realised how important it was to not fall victim to this force. As an antidote to this problem, he introduced a technique at Berkshire Hathaway that has been quite effective in dealing with institutional imperative. To idea is simple- Have the management act as if they were the owners. What happens when managers start thinking like owners? They think very differently. They think twice if their own money is at stake. 

The tendency to fall prey to the social proof tendency is also seen among investors. Stock market booms, bubbles and eventual crashes clearly show how investors succumb to peer pressure and end up burning their fingers. What should investors do to avoid such mistakes? Buffett has a solution for this as well. He says, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." It may sound simple but it's indeed a very powerful way to guard yourself against the social proof tendency. 

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

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