TMFJMo (73.95)

Philosophy of Charlie Munger

March 04, 2011 – Comments (1)

Upon the advice of my Foolish friend blesto, I am posting this from my Rising Stars portfolio discussion board. Just to give a quick background, I put out a weekly update every Friday on the board and Tweet it out too. What follows here is my first in a series of updates where I am taking a look at Charlie Munger's take on the psychology of human misjudgment. There are 25 tendencies and I will cover one per week over the coming weeks. I started a few weeks ago, so I will post the others I've already done over here in order to "catch up." From there I'll post them as I get them out each week. The point of this is to think and (hopefully) discuss how this can relate to investing, so don't be scared to throw down some thoughts here...after all that's what a blog is for, right?

Dear Fools,

If you know Berkshire Hathaway then you probably know the name Charlie Munger, Buffett’s right-hand man and Vice Chairman of Berkshire. Mr. Munger has a book called Poor Charlie’s Almanack, a collection of speeches and musings from Charlie himself; life lessons and perspective from a man who’s done a lot of living.

Toward the end of the book Mr. Munger offers his take on the psychology of human misjudgment. He breaks this down into 25 tendencies, the errors that come from these tendencies and antidotes to remedy them. For my benefit (and hopefully yours), I am going to revisit each one on a weekly basis.

Tendency #1 – Reward and Punishment Superresponse Tendency

Incentives play a very important role in our lives. From when we are raised as children to our work lives as adults, incentives in one form or another dictate how we behave. And the power of incentives is so great that if not properly addressed, they can and will produce less-than-desirable behavior. Munger uses the example of the Xerox salesman who pushes the inferior of two products on his customers. Because of a poorly arranged incentive structure, the salesman has good (albeit selfish) reason to push the inferior product as he benefits from better compensation. Of course the customers end up losing because they buy an inferior product. Ultimately, if not corrected, Xerox loses as people flee to other suppliers with better products.

The most important takeaway from this lesson as quoted from the book is: “Never, ever, think about something else when you should be thinking about the power of incentives.” Another one I like that we probably all say at some point is, “Be careful what you ask for, you might just get it.”

We can relate this to investing in a number of ways. But the one that continues to come back to me is to keep in mind incentives when we are assessing management. When management’s compensation (read: incentive) structure is flawed, less-than-desirable behavior will more often than not be the result.

Foolishly,

Jason (TMFJMo)