More Praise for The Warren Buffett Way, First Edition

Outstanding Investor Digest.
“First, what are the factors that really
govern the interests involved, rationally considered. And second, what
are the subconscious inf luences where the brain at a subconscious level is
automatically doing these things—which by and large are useful, but
which often misfunction.”
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B E H AV I O R A L F I N A N C E
In many ways, Charlie Munger is a genuine pioneer. He was thinking
about, and talking about, the psychological aspects of market behavior
long before other investment professionals gave it serious attention. But
that is beginning to change. Behavioral f inance is now an accepted area
of study in the economics department at major universities, including
the work done by Richard Thaler at the University of Chicago.
Observing that people often make foolish mistakes and illogical as-
sumptions when dealing with their own financial affairs, academics, in-
cluding Thaler, began to dig deeper into psychological concepts to explain
the irrationalities in people’s thinking. It is a relatively new field of study,
but what we are learning is fascinating, as well as eminently useful to
smart investors.
Overconfidence
Several psychological studies have pointed out that errors in judgment
occur because people in general are overconf ident. Ask a large sample
of people how many believe their skills at driving a car are above av-
erage, and an overwhelming majority will say they are excellent driv-
ers. Another example: When asked, doctors believe they can diagnose
I came to the psychology of misjudgment almost against my
will; I rejected it until I realized my attitude was costing me a
lot of money.
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C
HARLIE
M
UNGER
, 1995

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T H E W A R R E N B U F F E T T W AY
pneumonia with 90 percent confidence when in fact they are right only
50 percent of the time.
Conf idence per se is not a bad thing. But 
over
conf idence is an-
other matter, and it can be particularly damaging when we are dealing
with our f inancial affairs. Overconf ident investors not only make silly
decisions for themselves but also have a powerful effect on the market
as a whole.
Overconf idence explains why so many investors make wrong calls.
They have too much conf idence in the information they gather and
think they are more right than they actually are. If all the players think
that their information is correct and they know something that others
do not, the result is a great deal of trading.
Overreaction Bias
Thaler points to several studies that demonstrate people put too much
emphasis on a few chance events, thinking they spot a trend. In partic-
ular, investors tend to f ix on the most recent information they received
and extrapolate from it; the last earnings report thus becomes in their
mind a signal of future earnings. Then, believing that they see what
others do not, they make quick decisions from superf icial reasoning.
Overconfidence is at work here; people believe they understand the
data more clearly than others do and interpret it better. But there is more
to it. Overreaction exacerbates overconfidence. The behaviorists have
learned that people tend to overreact to bad news and react slowly to good
news. Psychologists call this 
overreaction bias.
Thus if the short-term
earnings report is not good, the typical investor response is an abrupt, ill-
considered overreaction, with its inevitable effect on stock prices.
Thaler describes this overemphasis on the short term as investor
“myopia” (the medical term for nearsightedness) and believes most in-
vestors would be better off if they didn’t receive monthly statements. In
a study conducted with other behavioral economists, he proved his idea
in dramatic fashion.
Thaler and colleagues asked a group of students to divide a hypo-
thetical portfolio between stocks and Treasury bills. But f irst, they sat
the students in front of a computer and simulated the returns of the
portfolio over a trailing twenty-f ive-year period. Half the students
were given mountains of information, representing the market’s
volatile nature with ever-changing prices. The other group was only

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T h e P s y c h o l o g y o f M o n e y
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given periodic performance measured in five-year time periods. Thaler
then asked each group to allocate their portfolio for the next forty years.
The group that had been bombarded by lots of information, some of
which inevitably pointed to losses, allocated only 40 percent of its
money to the stock market; the group that received only periodic infor-
mation allocated almost 70 percent of its portfolio to stocks. Thaler,
who lectures each year at the Behavioral Conference sponsored by the
National Bureau of Economic Research and the John F. Kennedy School
of Government at Harvard, told the group, “My advice to you is to in-
vest in equities and then don’t open the mail.”
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This experiment, as well as others, neatly underscores Thaler’s no-
tion of investor myopia—shortsightedness leading to foolish decisions.