Latticework of Mental Models: Contrast-Misreaction Tendency

Do you remember my old friend, Mr. Irrational? He made a cameo appearance in Latticework series when we discussed Mean Reversion.

For the uninitiated, he is a figment of my imagination, inspired by Benjamin Graham’s Mr. Market.

One fine day, it so happened that Mr. Irrational was trying on suits in front of a shop’s three-sided mirror. The men’s tailor shop was owned by Sid and Harry. The younger brother, Harry, being less experienced, was sitting at the back of the room with all the design catalogues and price list.

Sid, elder brother and the chief tailor, who seemed to have hearing problems, was helping Mr. Irrational make a choice.

“How does this one look?” asked Mr. Irrational. He liked the dark grey colour but wasn’t sure about the woollen texture of the suit.

“Pardon me Sir. Can you please speak up little louder?” This was the third time that Sid had requested his patron to speak louder.

“I am asking, how does this suit look on me?” Mr. Irrational raised his voice. The extra decibels came with a hint of irritation. After all my friend is a soft spoken guy and shouting is considered rude in his family.

“Aha! You’re looking fabulous in this one sir! Nothing less than a business tycoon.” Sid’s artificial smile bundled with a fake compliment proved that he was a skilful salesman.

“How much does this one cost?” Mr. Irrational asked loudly. He didn’t want to repeat his sentence.

“This one sir? Let me check.” said Sid. He turned towards Harry and shouted at the top of his voice, “Harry, how much for this suit?”

Looking up from his work – Harry called back, “For that beautiful all-wool suit, nine thousand rupees.”

At this point, Sid turned to Mr. Irrational and reported, “He says five thousand rupees.”

Curbing his instincts to correct Sid, Mr. Irrational realized that Sid’s hearing problem had just thrown up an opportunity to grab a nine thousand suit for five thousand. Without even giving a second thought, he hurriedly paid five thousand to Sid and scrambled out of the shop with his “expensive means good” bargain before poor Sid could discover the “mistake”.

My question to you is this – do you think Mr. Irrational exploited Sid’s disability?

What if I told you that there is a twist in the tale? What if Sid didn’t really have a hearing problem?

As it turned out that it was an elaborate scam and Mr. Irrational was manipulated.

Sid and Harry knew something important about human behaviour: humans rarely choose things in absolute terms. We don’t have an internal value meter that tells us how much things are worth. Rather, we focus on the relative advantage of one thing over another, and estimate value accordingly.

This human behavioural bias is called Contrast-Misreaction Tendency. And that’s our mental model for today.

Contrast-Misreaction Tendency (CMT)
I’ll take Charlie Munger’s help in defining this behavioural anomaly. This an excerpt from his famous lecture on psychology of human misjudgement –

.. human nervous system can’t naturally measure in absolute scientific units, it must instead rely on something simpler. The eyes have a solution that limits their programming needs: the contrast in what is seen is registered. And as in sight, so does it go, largely, in the other sense. Moreover, as perception goes, so goes cognition. The result is man’s Contrast-Misreaction Tendency.

In the image here, the two inner rectangles are exactly the same shade of grey, but the right one appears to be a lighter grey than the left one due to the background provided by the outer rectangles. It’s the result of contrast effect.

Mr. Irrational, who was uninformed about suit business, had no clue about the value of the suit until he heard from Harry, who shouted “nine thousand rupees”. In that moment Harry had deliberately planted a price anchor in his customer’s mind. The very next moment, when Sid said “five thousand rupees”, Mr. Irrational found the suit cheap in contrast to price anchor.

Sid and Harry made their moolah even as the customer thought he got a ‘great’ deal! Unfortunately, almost every one of us, knowingly or unknowingly, has fallen for such scams in our lives.

Peter Bevelin describes the idea eloquently in his book Seeking Wisdom –

We judge stimuli by differences and changes and not absolute magnitudes. For example, we evaluate stimuli like temperature, loudness, brightness, health, status, or prices based on their contrast or difference from a reference point (the prior or concurrent stimuli or what we have become used to). This reference point changes with new experiences and context….This means that how we value things depend on what we compare them with.

If Mr. Irrational looked like a sitting duck then let me warn you that Sid and Harry aren’t the only ones who understand the importance of CMT.

Exploiters of CMT
Is it possible to influence customer’s decisions by manipulating the available options?

The answer is a resounding yes.

Consider this experiment where a group of people was asked to choose between $6 cash and an elegant pen. Most choose the cash. Another group of people was asked to choose between $6 cash, the elegant pen, or an inferior pen. Most choose the elegant pen. Why?

By adding an inferior option, a decoy if you will, which nobody chooses, people are subtly nudged towards the option (the elegant pen in this case) which can be compared to the inferior choice.

Bevelin quotes the example of real estate where this bias is a standard tool of persuasion –

Mary is looking at houses. The real estate broker knows that the house he is trying to sell Mary is in poor shape and a bad area. He starts by showing Mary bad properties in an ugly neighbourhood. Afterwards, he takes her to the house he wanted to sell all along. Suddenly this house and the area seem great in comparison to the other house she saw.

This tendency is routinely used to exploit customers buying merchandise and services.

The story isn’t much different when we end up buying that overpriced ₹25,000 leather accessory merely because the price is so low compared to our concurrent purchase of a ₹5 lacs car.

Even when people know that this sort of customer manipulation is being attempted, it will often work to trigger buying, which demonstrates that being aware of psychological ploys is not a perfect defence.

In fact the ‘predictability about our irrational behaviour’ was the premise on which Dan Ariely wrote his entertaining book, Predictably Irrational. In the following talk, Dan shows you some optical illusions to bring home the point that awareness about human biases doesn’t necessarily make you immune to them.

On a lighter note, Rolf Dobelli suggests that if you are seeking a partner, never go out in the company of your supermodel friends. People will find you less attractive than you really are. Go alone or, better yet, take two ugly friends. I haven’t validated this trick, so goes without saying –“try it at your own risk!” 🙂

There is another aspect of CMT which makes it very interesting. If we fail to perceive the change, due to small contrast, the mis-reaction may not trigger at all. For example, our kids grow up right in front of our eyes but we notice the change only when we look at old pictures.

Contrast, the Invisible Killer
Contrasts makes us blind to slow change until it’s too late. The reality around us seems pretty much constant, although it’s continuously changing. The change in a stimulus has to cross a certain threshold before our awareness can register it.

It’s worth mentioning here a tremendously useful mental model from Charlie Munger’s Latticework called boiling frog syndrome, described by Prof Bakshi in this wonderful blog post. He explains –

Small incremental changes tend to go unnoticed…If you put a frog in hot boiling water, he will instantly leap out of the pan and be never seen again. But, if you put a frog in a pan with room temperature water and slowly turn up the heat, he wouldn’t be able to tell the tiny incremental changes. He will boil and die.

Charlie Munger once said that many businesses die just like the boiling frog. Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny. He further warns –

When a man’s steps are consecutively taken toward disaster with each step being very small, the brain’s Contrast-Misreaction Tendency will often let the man go too far toward disaster to be able to avoid it. This happens because each step presents so small a contrast from his present position.

To a small stimulus, only a small amount must be added. To a larger stimulus, a large amount must be added.

Warren Buffett says –

One of the problems in society is that the most important issues are often these incremental type things…But, if you keep doing it over time, the incremental problems are hard to attack because that one extra piece of pie doesn’t really seem to make a difference…but the cumulative effects of them will make a huge difference over time, just like overeating will make a huge difference over time. The time to attack those problems is early.

Sometimes it is the small, gradual, invisible changes that harm us the most.

Contrast Effect in Investing
The whole idea behind systematic investment plan (SIP) is that a small outgo (as compared to the whole salary) every month from our paycheque doesn’t pinch.

As we have seen contrast is a two sided sword, and its ill effects show up in investing also.

Have you heard of “Big Bath” accounting? For the uninitiated it’s an accounting jugglery to “manage” a company’s earnings. Sometimes, to fool the shareholders, a particular year’s poor income statement is made to look even worse by increasing expenses and selling assets.

As a result, the subsequent years, especially the very next, appear much better in contrast.

Satyam’s case is another example which shows how big accounting scams are created.

Here is what Ramalinga Raju’s aides at Satyam must have told him before the scam came to light – “If we slowly and gradually over time manipulate the numbers, the auditors won’t notice it.”

Incidentally, in this case, even the auditors were involved! But the Satyam scam did not come to light till Raju confessed of riding a tiger.

You see, contrasts may blind us to change until it’s too late. For example, we often don’t notice the bad behaviour of others (like we ignore “small” accounting manipulations at companies) if it goes sour gradually over time. Often we see reality as constant, although it gradually changes.

Similarly, we fail to notice how our money disappears. It constantly loses its value, but we do not notice because inflation happens over time. If it were imposed on us in the form of a brutal tax (and basically that’s what it is), we would be outraged.

Another area where CMT can harm is our fixation on the stock price. When you are analysing a business, it becomes extremely hard to overcome the temptation to ignore the past stock price trends. If a stock has risen recently, our subconscious screams that the stock has become expensive. A recent fall in price triggers the CMT which convinces us that the stock has become cheaper.

My advice? Don’t look at the stock price until you have analysed the business and worked out some valuation. For that matter, if you can’t avoid price based screeners, use them carefully.

Conclusion
Understand that CMT is everywhere, and that we view our world through its lens – rose coloured or otherwise.

Few psychological tendencies do more damage to correct thinking than CMT. Warren Buffett was probably referring to contrast bias when he said –

Chains of habit are too light to be felt until they are too heavy to be broken.

It’s interesting that most bad habits are formed because of this tendency but fortunately this bias, if used intelligently, can help us form good habits too. John Wooden, one of the most successful coaches in the history of basketball, observed –

When you improve a little each day, eventually big things occur … Don’t look for big, quick improvement. Seek the small improvement one day at a time. That’s the only way it happens and when it happens, it lasts.

I wanted to tell my friend, Mr. Irrational, that he was taken for a ride by his tailors but then I thought to myself, “Let me keep the poor kid happy.” After all he still believes that he stole a great deal.

But you don’t forget to include CMT in your mental model checklist. And at the same time don’t forget to make use of it for creating good habits.

Take care and keep learning.

PS: The tailor shop example was taken from Robert Cialdini’s book Influence: The Psychology of Persuasion.