Reflections on the psychology of Warren Buffett
A while ago, a very good New York Times article interviewed Dr. Brent James, a physician at Intermountain Healthcare who's devoted to using statistical and social science methods to improve medicine.
Gary Klein, a cognitive psychologist and researcher, collects examples like these, and one of the most powerful involves a paramedic who, at a family gathering, told her father-in-law that he needed to go the hospital. He said he felt fine. She prevailed on him. The next day, he was undergoing heart-bypass surgery. Like the firefighters and the face readers, the paramedic could not explain her reasoning. She did not know how she knew what she knew. When she was interviewed later, she said that she must have been tipped off by the kind of paleness and swelling that she had seen dozens of times before.
Stories like this one are deeply appealing. They allow us to feel that we are tuned into the mysterious logic of life. Indeed, in many ways we are. The human mind can store huge amounts of knowledge. Intuition is not simply belief; it springs from this knowledge. A doctor making an intuitive diagnosis is doing so on the basis of thousands of hours spent treating patients. The problem, however, is that the mind is not particularly good at sorting through this knowledge and weighing different parts appropriately. We give too much weight to information that confirms our suspicions or that is highly memorable.
Behavioral researchers have come to believe that there is a clear pattern to when intuition works and when it doesn’t. “Intuitive diagnosis is reliable when people have a lot of relevant feedback,” says Daniel Kahneman, a Nobel laureate in economics who recently collaborated on a project about intuition with Klein. People need a great deal of experience, and the feedback from these experiences — whether a treatment is working, say — needs to come quickly and to be clear. “But,” Kahneman adds, “people are very often willing to make intuitive diagnoses even when they’re very likely to be wrong.” When doctors have been asked to estimate the likelihood of a treatment succeeding based on experience, for example, they give wildly divergent answers. Medicine is full of such examples.
James is a voracious consumer of social science, and he likes to frame these issues with opposing concepts: pattern matching and rate estimation. Pattern matching refers to intuition at its best. It is what people can do in those few areas in which they have had vast experience and clear feedback. Rate estimation is a task that people usually do not perform well but that happens to make up a great deal of modern medicine. “When a person says, ‘In my experience,’ what’s actually happening is you’re being dominated by one or two recent cases that you can recall or by some distant case that was either particularly good or particularly bad,” James says. “My first goal for Intermountain is that anytime a physician or nurse says, ‘In my experience’ when they’re talking to a patient, they mean, ‘In my measured experience.’ ”
What's interesting about this is that Warren Buffett is clearly an intuitive investor. He doesn't construct a Morningstar-style discounted cash flow model. He just reads the financials, meets management and pulls the trigger. He seems to be right in his investment decisions far more often than just sheer chance - he seems to have an accurate sense of the fair value of a company.
I think that Warren Buffett is innately very, very good at rate estimation. That's how he differs from most people. And value investing involves a lot of rate estimation, either using one's intuition, or else using explicit methods like constructing a DCF model. No doubt, Buffett had to gain a lot of experience as well. And I believe that people can be trained to improve their pattern matching skills by acquiring experience and some training in statistics. However, there's some folks you just can't match, and Buffett is one.