Mar 1, 2012|
Lessons from Charlie Munger-XI
In the previous article, we discussed the social proof tendency in day-to-day life and also explained why corruption in India is so deeply rooted. Today, we shall discuss the social proof tendency in the context of business and finance.
The Institutional Imperative
Many of us may think of corporate leaders and managers as highly qualified, intelligent and experienced people who would be making rational business decisions. Even the legendary investor Warren Buffett had the same notion when he entered the world of business. But through time and experience, he realised that more often than not, despite all the qualifications and experience, it was not the case. A deadly force which he calls the 'institutional imperative' often hinders rational decision making and at times, even destroys businesses.
What does institutional imperative mean? The Oracle of Omaha explains the institutional imperative as that need for managers to act and do like their peers no matter how irrational it may seem. A simpler term that comes to mind is peer pressure. However surprising it may seem, even CEOs are subject to this pressure which forces them to make stupid mistakes.
The evidence is almost everywhere. Say for instance, if some companies in a certain sector go on a capacity expansion spree, others are quite likely to follow, even though the overall economic situation may be hinting otherwise. What is the excuse such companies provide when the initiative goes for a toss? It's not difficult to guess- 'Everybody was doing that'.
From his own mistakes, Buffett realised how important it was to not fall victim to this force. As an antidote to this problem, he introduced a technique at Berkshire Hathaway that has been quite effective in dealing with institutional imperative. To idea is simple- Have the management act as if they were the owners. What happens when managers start thinking like owners? They think very differently. They think twice if their own money is at stake.
The tendency to fall prey to the social proof tendency is also seen among investors. Stock market booms, bubbles and eventual crashes clearly show how investors succumb to peer pressure and end up burning their fingers. What should investors do to avoid such mistakes? Buffett has a solution for this as well. He says, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." It may sound simple but it's indeed a very powerful way to guard yourself against the social proof tendency.
We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.
||Ankit Shah (Research Analyst) is the editor for Equitymaster Insider and Vivek Kaul's Inner Circle. A journalism graduate turned Research Analyst, Ankit joined Equitymaster when he was just 23 years old, right after getting his MBA from NMIMS, Mumbai. Having been an avid reader of Equitymaster's research through his college years, Ankit knew he would fit right in!
In his seven years with Equitymsater, Ankit rose quickly, leaving his mark on almost everything from: Travelling thousands of miles to find the next small cap stock, as part of the Hidden Treasure team... Designing Equitymaster's Secrets, an online value investing course based on the company's 20-year journey... Bringing global investing ideas to Indian readers through Vivek Kaul's Inner Circle... Right to launching his brand-new service, Equitymaster Insider.
Ankit is a firm believer in Charlie Munger's multidisciplinary approach on juggling between various disciplines...He is not just a research analyst, but also a voracious reader and an avid traveler...Born and brought up in Mumbai, he now prefers to keep away from the noisy megapolis as much as possible. In any given month, you could find him exploring the ancient ruins of South America, the beaches of South East Asia, or the organic cafes of Pondicherry.
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