Wednesday, 7 September 2016

Lessons from Charlie Munger-XIV

Oct 12, 2012

In the previous article, we discussed the availability-misweighing tendency and elaborated how it has an adverse effect on investments. Today we shall discuss what investors can do to avoid falling prey to this thinking error. 

Playing Charles Darwin

The theory of evolution proposed by Charles Darwin, a 19th century British scientist, revolutionised the way many thought about the natural world. It is worth noting that around the time, a majority Europeans subscribed to the biblical description that the world was created by God in seven days.

Given the vulnerability of the human mind to thinking errors and psychological shortcuts, what led Darwin to think so radically different? As it turns out, the man operated through a mental model that helped steer past several psychological biases. Charlie Munger suggests that taking Darwin's approach could be an effective antidote for availability-misweighing tendency. 

What did Darwin do to eliminate biases? It is said that Darwin was a very strong proponent of objectivity. He was known for playing the devil's advocate to his own ideas and hypotheses. So much so that as soon as he would have an idea, he would try to gather evidence to disconfirm it. In fact, he tended to be even more rigorous in his approach with ideas that were particularly compelling.

Let's try and apply this approach to investing in stock markets. Say for instance, there is a certain stock that your friend has strongly recommended you to consider buying. Suddenly, the stock price goes up following a positive piece of news. What would be your reaction? Your friend is optimistic about the stock. The news is positive. The markets too have cheered the news. Isn't there enough reason to run and call your broker to buy the shares? If you would have done that, you would have quite likely fallen prey to the availability-misweighing tendency. 

A wiser response would have been to do what Darwin always did: Challenge the merit of the idea. Look for potential risks and concerns that could adversely affect the company. Arrive at your independent view only after thoroughly evaluating the potential of the stock. The ultimate investing decision should be based solely on your understanding and insight and not from borrowed optimism. In short, if you come across a stock that appears to be the market's darling with a lot of media attention on it, play the devil's advocate and consider all possible risks and concerns that can derail the investment. If the idea still holds, it is certainly worth investing.

It is observed that a vital quality that is common amongst all great investors is discipline. It is this discipline that helps them overcome the various thinking errors and biases, availability-misweighing tendency being one of them. A practical way to ensure discipline and to avoid falling prey to this tendency is to prepare an investment check list and adhere to the process in a disciplined manner. 

In conclusion, remember what Charlie Munger has said, "An idea or a fact is not worth more merely because it is easily available to you." 

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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