Is Berkshire Hathaway Really a Psychology Experiment?

Warren Buffett and Charlie Munger are known for many things, yet one important aspect of their success is often overlooked: they are conducting Corporate America’s longest running applied psychology experiment.

Buffett and Munger have often discussed the importance of understanding oneself and others in making decisions, but their methods have, strangely, not been copied widely, despite their long-term and outsized success.  This is largely because it is simple to hear and understand the principles they teach, but it goes against human nature – human psychology – to apply them.

So most of us construct logical reasons why applying their ideas are not practical, or because their situation is different, or for any number of other reasons.  Ultimately, most of these arguments are justifications for not doing things that run counter to our own psychological tendencies.  Investors, as a group, largely validate the saying that “man is a rational animal, he can rationalize anything.”

In areas ranging from corporate governance to conducting research and making investment decisions, they do things differently, and better, than 99% of corporate America.

Here are a few examples and some of the psychology behind them:

Incentive-Caused Bias:   Berkshire directors are required to own a significant amount of stock, and, uniquely in Corporate America, the board does not carry Directors’ and Officers’ liability insurance.  This structure elegantly solves the problem of incentive-caused bias – the tendency to believe as correct the outcome that is most beneficial to the decision maker. 

Berkshire directors, who are representatives of the shareholders, are also actual owners, with a material investment at stake.  They sit in the shoes of owners because they are owners.  So at the very least, when they disagree with each other, they know that everyone has Berkshire’s best interests at heart.  This improves their ability to reconcile differences and make tough decisions.

Boards often suffer from mis-aligned incentives because many directors haven’t bought stock in the open market, or are dependent on the board fees for their living expenses, or want to be liked by the management and other board members so they are asked to join other boards.  Together, these problems create a fragile board, with conscious and subconscious biases working against directors making decisions in the best interests of shareholders.

Anchoring Bias:  Anchoring is the bias to overweight the first piece of information found versus other, potentially more important information.   

When Buffett starts to learn about a stock, he begins by learning about the company.  He reads the annual reports and other industry information to form an opinion about the company’s intrinsic value and the durability of its competitive advantages.  He doesn’t look at the stock price, and the implied valuation of the company, until after he has done his own work and made an estimate of what the company is worth.  Buffett’s approach avoids the powerful psychological bias of anchoring to a price first, and then trying to move away from it as he learns more about the company.  

Commitment and Consistency Bias:   Buffett and Munger learned early in life that much of the activity in business is driven by a pressure to act, and they have avoided many bad decisions by resisting this urge.  Uncertainty creates a sense of discomfort, and to resolve this tension our brains make fast decisions.  Once a decision is made to do something, the bias to be consistent with an already made decision comes into play.  This desire to act catalyzes the commitment and consistency bias, causing us to make quick, potentially poor decisions, and being reluctant to changing our minds and reconsidering.

Upshot?  This is the most difficult thing to calculate – the value created by systematically avoiding making a decision unless it is an obvious no-brainer.  And it is a bit confusing, as they are famous, both for being patient, and for acting quickly when a great opportunity presents itself, but in reality, the two go hand-in-hand.  They have become very good at saying no to investment opportunities, and therefore they are well equipped to recognize a great deal – it looks obvious when compared to all the things they turned down – and they have the capital to act.  Neither the context nor the capital might be available if they had acted sooner.

Lollapalooza Effect.  Charlie Munger popularized this term to mean the extraordinary impact that occurs when several of these tendencies for miscognition – Munger’s preferred term – come together.  They potentiate and catalyze each other in ways that are significant, but sometimes difficult to understand. 

By applying the lessons of human psychology, Berkshire Hathaway is the product of the lollapalooza effect of avoiding poor decisions and the conditions that lead to them.

Kenneth Shubin Stein, MD, CFA, is Founder & Portfolio Manager of Spencer Capital Management and the Chairman of Spencer Capital Holdings. He teaches as an adjunct professor at the Columbia University Graduate School of Business.  Before 2000, Shubin Stein pursued a simultaneous career in medicine, having graduated from the Albert Einstein College of Medicine after completing a 5-year medical and research program with a focus on molecular genetics.   

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8 Responses

  1. Guy Spier says:

    “It is simple to hear and understand the principles they teach, but it goes against human nature to apply them”. This is true, but that is not to say that there is not a small, but growing group in the United States and around the world who have every intent to copy these principles.

    And that group includes: Ken Shubin Stein, not to mention Mohnish Pabrai, John Mihaljevic and various others.

  2. Matt says:

    Very interesting, Ken. I’d be interested to know if you think that learning about and understanding these biases helps people avoid them, or if the ability to avoid them is to some significant degree independent of knowing about them (even tacitly, perhaps.) I can imagine that, for some people, knowing of the biases might make them _more_ likely to fall prey to them, because knowing about them makes them _think_ they are avoiding them, even though they are not, but I don’t know of any study on this. Do you know if there is good work done one questions of this sort?

  3. Ken Shubin Stein says:

    Matt,

    Great question – you focused in on one of the toughest aspects of innate and acquired cognitive biases. Knowing about them, even studying them deeply, does not completely immunize a person from their influence. There are a number of studies, some even on psychology PhD students, where the experimenter tells the subjects that they are being tested for a certain bias, and the subjects still exhibit the bias.

    In my experience the only things that partially work are: 1) behavioral changes designed to avoid the stimuli that would cause the bias response – such as not going to an open outcry auction, or aligning compensation in the same direction for all stakeholders; or 2) building tools to help mitigate the biases impact and allow the slower, more rational part of the brain to get involved – checklists, re-framing exercises, breaks of time and place before decision making, etc.

    A few resources I found helpful are: Influence by Cialdini, Thinking Fast and Slow by Khaneman, and The Checklist Manifesto by Gawande.

  4. Although the second title is well known, just in case (typo): Daniel Kahneman.

  5. Ken Shubin Stein says:

    Another resource that has great re-framing tools in it is a de-classified CIA document: The Psychology of Intelligence Analysis by Richards Heuer.

    https://www.cia.gov/library/center-for-the-study-of-intelligence/csi-publications/books-and-monographs/psychology-of-intelligence-analysis/PsychofIntelNew.pdf

    We use some of his tools at our firm and in our class, and a few members of the US intelligence community recently told me that they regularly use his techniques for decision making when facing difficult choices.

  6. Great article! Charlie Munger has not been shy to include such authors as Robert Cialdini among his favorites, and it seems Buffett and Munger ascribe an increasing portion of their success to rationality over time.

    As young investors, we tend to believe that success is due to some superior analytical or information-gathering ability. Over time, most of us tend to realize that, to the extent we have been successful as investors, it is because we have kept a cool head when the world was panicking.

    I would argue that people like Ken Shubin Stein, Guy Spier and Mohnish Pabrai have set up their investment businesses in ways that maximize avoidance of psychological errors. They have copied aspects of Berkshire Hathaway even in the context of privately managed investment firms. The positive effects of the right structure may still be underappreciated in the investment world, but they deserve to be studied and emulated.

  7. Great read, enjoyed reading it.

  8. Amar Sendro says:

    Great read indeed. Re. WB and anchorin: http://www.youtube.com/watch?v=sLXNn-im4ec

    (at the 2.25 min mark)