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Lessons from Charlie Munger-IX

Dec 29, 2011

In the previous article, we had discussed how a simple emotion like jealousy could prompt you into making irrational investment decisions. Today, we shall discuss our innate tendency to be over-optimistic and how it affects our view of the economy and the stock markets. Our aim is to help you understand the workings of your mind better so that you do not let your biases and thinking errors jeopardise your investments.

Over-optimism tendency

It is indeed commendable how humans and other creatures have evolved and survived over millions of years of evolution. Forget millions of years. Just look at all that has happened in the last 100 years, a period which saw two major world wars and a series of economic and political crises across the globe. Yet we continue to look forward to a better future. What is it that allows man to endure the many trials and tribulations that life presents? Hope, isn't it?

Charlie Munger shares a very interesting perspective in this regard. He opines that an excess of optimism is the normal human condition. And this tendency to be over-optimistic not only manifests when man is in pain, but also when he is doing well and there is no threat of pain whatsoever. A famous Greek orator by the name of Demosthenes is known to have said these very fitting lines more than 2,000 years ago-"What a man wishes, that also will he believe."

Over-optimism tendency in stock markets

It is not at all difficult to understand how this tendency drives not just stock markets but the entire world of finance and economics. Why otherwise would we have booms and bubbles with such amazing regularity? Why do people continue to flock to the financial markets despite the regular crises and busts that torment the markets? In fact, all the malaise troubling the global economy today, from the debt crises in the developed economies to the high inflation and slowing growth in emerging economies like India, do have roots in excessive optimism. The problem is that when things are good, we expect them to get better and better in a linear fashion. And even when things are bad and getting worse, we often expect that the situation will turn good again sometime in the future.

This tendency is so often displayed by company managements. During good times, they tend to get over-optimistic and take up massive debt-funded expansion plans by way of capacity additions or wasteful mergers and acquisitions. When the cycle turns and things turn sour, you see red ink all over their financial statements. What is surprising is that even in bad times, a lot of companies are extremely shy to admit that things are not going too well. They tend to project and hope only what they wish to see and not what there is really.

As investors, the best way to deal with this bias is to acknowledge that it exists in the first place. That is half solution done because most of the times we are not aware of our own biases. Then a very effective antidote to over-optimism is to challenge your views by asking yourself as many questions as possible. If your views cannot stand the attack of reason, you know which tendency is to be blamed.

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.

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