Charlie Munger and the Psychology of Human Misjudgment


If you know Berkshire Hathaway (NYS: BRK.B) , then you probably know its vice chairman, Charlie Munger -- Buffett's right-hand man. Munger's book, Poor Charlie's Almanack, collects his speeches and musings, including his intriguing thoughts on the 25 tendences that lead us humans to make really bad decisions. For your benefit and mine, this series will review each of those ill-fated impulses, the errors they create, and the antidotes that can help make us better investors.

Today, we'll start at the top with tendency No. 1: reward and punishment superresponse.

The carrot and the stick, on steroids
Incentives play a very important role in our lives. From our upbringing as children to our work lives as adults, various incentives dictate how we behave. The power of incentives is so great that if not properly addressed, it can and will produce less-than-desirable behavior.

Munger uses the example of the Xerox (NYS: XRX) salesman who pushes the inferior of two products on his customers. Because of a poorly arranged incentive structure, the salesman has a strong (albeit selfish) reason to push the shoddier product, since it benefits him with better compensation. Of course, the customers end up losing: They buy a lousy product. Ultimately, if this tendency isn't corrected, Xerox loses, too, as people flee to other suppliers with better offerings.

What does this have to do with investing?
Of the many ways this lesson can relate to stocks, I keep coming back to how incentives apply to a company's management. When management's compensation structure is flawed, expect unproductive behavior to follow.

You needn't look far down the Dow Jones Industrial Average (INDEX: ^DJI) to find examples. Bank of America (NYS: BAC) and JPMorgan Chase (NYS: JPM) found themselves at the center of the storm when the financial crisis hit, and critics ultimately questioned both companies' compensation practices. Even today, they continue to fight the public perception that their executive pay policies reward short-term thinking with excessive generosity.

And what have we learned?
I can sum up my greatest takeaway from this tendency with a quote from the book: "Never, ever, think about something else when you should be thinking about the power of incentives." In other words: Be careful what you ask for. You just might get it.

At the time thisarticle was published

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