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Brian Flores
Brian Flores
Articles (126)  | Author's Website |

Building On Munger's 2-Track Analysis

Here is my thesis of what 2 renowned psychologists have in common with Charlie Munger

July 05, 2016

You have probably heard it before. It is one of Charlie Munger (Trades, Portfolio)'s most famous quotes:

"Personally, I've gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things which by and large are useful but often malfunction?"

I certainly heard it before, but it was only after re-reading it that something clicked, most importantly, for the second part of the analysis. What Munger tries to teach us is to be aware of the mental and emotional biases that affect our decision making, before we just assume that something fits into our model to reach a conclusion.

In order to do this, we need to add certain building blocks to identify what affects us at a subconscious level to reduce the mistakes we make. For this, I recommend two books: "Thinking, Fast and Slow" by Daniel Kahneman and "Influence" by Robert Cialdini. These two books provide, in an entertaining and accessible manner, some of the tools that we can incorporate to understand our decision making and the mistakes that we could generally fall into. Here are some of the most relevant factors.

For us readers and investors, it is quite fascinating to discover that 1) we are not alone and 2) most of the mistakes we make have names and consequences already identified.

  • Reciprocity: Our subconscious desire to correspond an action, sometimes in disproportionate ways.
  • Social proof: As we developed and evolved as social creatures, we understood the importance of following the crowd in order to survive. However, this instinct can lead us to suboptimal decisions creating a herding effect.
  • Consistency: Have you seen how many people stay attached to their initial hypotheses in spite of disconfirming information? This is because we want to be consistent with our self-image. This can also lead to bad investment decisions if we are not flexible and open to new ideas/information.
  • Authority: We are used to following authorities; it has helped us maintain order in our society. However, in investing, it can make us blindly follow advice because it was provided by a respected entity.
  • Liking/confirmation: When building our hypotheses, we avoid looking for information that is contrarian to our beliefs. That pain it causes is called "cognitive dissonance," and this can lead to missing some factors that could be relevant to our case.
  • Scarcity: The need to obtain something because we perceive it as scarce. Does "limited-time offer" ring any bells?
  • Availability: We tend to place more importance on the latest information that we recall, overlooking other information.
  • Mean reversion: We tend to believe that what is far from the mean could be a potential buy/sell opportunity. However, in finance, we must remember that means can move, and the new average could be higher/lower.
  • Endowment: We place more emotional value to objects that were passed on to us, such as an inheritance.
  • Framing: We tend to reach different conclusions based on how the information is framed. Studies demonstrate that we are loss averse, not risk averse. That is, the pain we encounter from losing money is far greater than the satisfaction of winning the same amount.

While Cialdini and Kahneman both discuss some of the subconscious factors that lead us to suboptimal decision making, Kahneman expands on the two levels at which the mind works, calling them System 1 and System 2. Mainly, and in order to be the most efficient it can be, the brain operates in System 1, making intuitive decisions instead of allocating time and energy to think rationally.

Connecting this to what Munger suggests, by understanding these biases and how they affect our decision making, the probability of making a mistake gets reduced. Adding these blocks to our array of mental models can lead not only to better investment results, but generally a better understanding of our surroundings and why the market acts so irrationally at times.

What do you think?

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About the author:

Brian Flores
"I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you." - Charlie Munger

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Frationuder - 4 years ago    Report SPAM

Looks like you got the re-reading of this idea from Farnam Street (see: Charlie Munger: A Two-Step Process for Making Effective Decisions and Improving Your Thinking), why didn't you source them?

Brian Flores, CFA
Brian Flores, CFA - 4 years ago    Report SPAM
I cited, just like the guys at Farnam Street, the original source, which is Charlie Munger (Trades, Portfolio). Farnam Street did not comment on the biases separately (as I did), and that is why I did not cite them as the source for this article.

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