Wit, Wisdom, Charlie: Elementary Worldly Wisdom from Charlie Munger (Issue #9)

This post is authored by Puneet Khurana, a Safal Niveshak tribesman.

Imagine the following scenario. You are sitting at your work desk sipping your coffee when your boss comes and offers you the following deal.

He offers you a fixed bonus of Rs 1 crore for the year. Besides this, he offers you a variable bonus. For the variable bonus, he asks you to either take another fixed Rs 50 lac or flip a coin. If it’s heads, you get Rs 1 crore and if its tails, you get zero.

Which of the options will you chose?

Now consider this.

This time he offers you a fixed bonus of Rs 2 crore for the year. From this Rs 2 crore, you can either give him Rs 50 lac back, no questions asked, or you can flip a coin.

If it’s heads, you ‘give back Rs 1 crore’ and if it’s tails, you don’t have to give back anything.

Now if you chose the fixed Rs 50 lac in Deal 1 and the coin flip in Deal 2, you have displayed what economists refer to as ‘Loss aversion’.

The idea here is that people are more prone to avoiding losses. As you can see, the expectancy in both the cases is of Rs 1.5 crore. But the quantity of pleasure from gaining is less than the displeasure of losing the similar amounts.

This tendency of disproportionate reaction to losses is described by Munger as…

Deprival Super-Reaction Syndrome (DSRS)
The loss aversion does have certain positive aspects. It usually brings out the best in people when people go to extreme to avoid losses.

A very prominent field where I think it is best visible is that of ‘competitive sports’.

There have been studies that show that a golfer performs far better when he is putting to save par than to make a birdie. The similar reaction is valid in other sports too.

Generally, in life too, it’s often observed that people do things which they never thought they were capable of, when something is taken away from them or is threatened.

But this tendency comes with its own set of biases and irrational behaviors.

Let us first examine the reason for the extreme reactions against losses.

The ‘super-reaction’ is often caused in two different cases.

First, when something you possess, cherish and love is taken away from you. What is interesting is that in case of a loss, the reactions are very extreme for even the smallest and insignificant possessions.

This extreme reaction is also because of the psychological tendency to value something more when it’s no longer in possession or is under the threat of loss.

It’s very common to see such extreme reactions of lovers in love affairs and is equally common in case of other human relationships but it is, by no means, restricted to that.

On numerous occasions, scarcity of things increases their perceived values and also the reaction to the possible loss.

The Black Friday sales in US give you the glimpse of it below (or watch here).

Marketers use this tendency of loss avoidance and reaction to scarcity in numerous ways.

It is very common nowadays to impose limits on the quantity available of products to create an ‘exclusive’ feeling which increase its perceived value and desperation of people to get it.

They offer various ‘limited period offers’ and occasional freebies with the product are well deployed to invoke the DSRS in people.

Real estate builders have even started offering free ‘cars’ with flats so that people feel they are ‘missing’ out on a car if they don’t book the flat with this developer.

In Negotiation & Marketing classes, it is often taught to use this tendency. If one is trying to persuade someone for a deal, a purchase etc., it is often advised to tell the other party (vividly if possible) about what they will lose if they don’t go ahead with the deal rather than telling them what they will gain. The sense of losing on to something makes them more inclined to agree.

Various opportunities have their own perceived value and they seem more valuable when there is limited availability. Anyone who has passed out of their graduation/post graduation in recession years will automatically relate to what I am saying.

The jobs and profiles which were ‘untouchable’ a year or two before become the ‘dream profiles’ for the students during the placement session.

The second type of scenario that triggers the ‘super-reaction’ is when something you love is ‘almost’ with you, but is taken away at the last moment.

This case, according to me, is more dangerous. A big reason for that is the natural impulse to repeat activities which ends with near misses.

Anybody who bets on horse racing will understand this very easily. Since the margin of defeat amongst the top few horses is very small, there is an illusion of a ‘higher probability’ of things going in one’s favour the next time.

In casinos, this psychological tendency is exploited by having slot machines that gives ‘near misses’. There is a good chance that you will play the slot game again if your last attempt ends like this.

Usually, higher occurrences of such near misses act as a positive reinforcement to gamble further.

Another instance where DSRS comes into picture is in the setup of an open-outcry auction.

The social proof that other person is also bidding along with the possibility of losing the item causing DSRS brings out the idiotic behavior in people.

The wise men, Buffett and Munger, have the best antidote to such auction like scenarios – “Don’t go”

For investors, I find this tendency playing a very important role in their psychology. Consider this hypothetical scenario.

You have a Jewellery retailer company’s stock or a niche pharma company in ‘radar’ or ‘watchlist’ but you are not convinced enough to buy it at current price…and then it goes up by 100% in a very short period of time.

There is a natural impulse to buy this ‘obvious’ brilliant company and ‘correct’ your ‘mistake’. (Even though at half the price you were not willing to buy it!)

Another very prominent and, in my understanding, the most crucial mistake in investing triggered by DSRS is to hold on to losing stocks with the expectation of ‘getting even’.

This inability to take losses has caused many investors to lose a lot of money which they would have otherwise saved by taking losses and deploying the remaining capital in better ideas. Commitment bias and DSRS cause a lot of investors to lose a lot of money.

Another area where I find DSRS affecting investors is the ‘curse in disguise’ of social forums.

The nexus of investors on social forums with few investors post their big ideas and people tend to spend a considerable amount of time on all the ideas (which if combined makes a huge list) without realizing the importance of value investing clichés of ‘sticking to circle of competence’ and ‘building high conviction in the ideas’ etc.

Investors don’t want to miss the next Infosys, Titan or HDFC.

So here is how I ‘try to’ tackle the above issues.

I do go through the ideas of various smart investors in my network and eliminate the one which are not from a sector of my comfort. While constantly improving upon the analytical skills and quantitative assessments of business, I try to reject the ‘not very attractive’ ideas after looking only at quantitative data which takes less time than going into qualitative details and if and only if a company meets the major criteria, a detailed study of the company is undertaken.

It’s important to stick to industries one understands because conviction can’t be developed without knowledge and one won’t be able to bet big or average down with declining stock prices without the conviction in the idea and hence won’t make big money.

Always remember – In investing, the error of omission is better than the error of commission.

And lastly and crucially, I feel it’s absolutely imperative to fight the urges to rationalize the reasons to hold on to the losing stocks and to learn to keep them only for strong reasons. Holding on to the losers to get even is a very bad idea.

It reminds me of Sanjay Bakshi Sir quoting Robert Heinlein in his lectures – “Man is not a rational animal, he is a rationalizing one.”

Any past experiences where you have been either a victim of this syndrome or a beneficiary of this psychological tendency? Do share in the Comments below.

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About the Author: Puneet Khurana works with an India focused hedge fund. A student of Prof. Sanjay Bakshi at MDI and a CFA (charter awaited), Puneet is an avid reader of books on investing, finance, psychology, philosophy, physics and various other disciplines.

His investing journey has gone from speculating as a college student to investing based on ‘margin of safety’ principle over a period of 9 years. Currently besides his work, Puneet spends considerable time taking guest lectures in subjects like Investment Management and Business Strategy for MBA students and also training CFA aspirants. He blogs at Pragmatic Investing.

Disclaimer: The views expressed in this post are those of the author only and do not constitute in any way an official position, policy, or pronouncement of his employer.