“The simple truth is that we aren’t adapted to face the world as it is today. We evolved in a very different environment, and it is that ancestral evolutionary environment that governs the way in which we think and feel. We can learn to push our minds into alternative ways of thinking, but it isn’t easy as we have to overcome the limits to learning posed by self-deception. In addition, we need to practice the reframing of data into more evolutionary familiar forms if we are to process it correctly.”
- James Montier
“Sometimes heuristics are good for making decisions, while at other times heuristics are bad for making decisions. The reason for this mixed or nuanced answer is namely heuristics act faster than rational deliberation, but precisely because of their speed, heuristics can mislead us into systematic errors in making decisions”.
-Huang
All of us behave irrationally at times. One of the best explanations of human irrationality is Charlie Munger’s seminal talk on The Psychology of Human Misjudgment. For the uninitiated, Munger is the Vice Chairman of Berkshire Hathaway and longtime partner of legendary Warren Buffett. In this talk, (given in 1995, transcript, video) Munger lists the human tendencies that lead us to be irrational and make wrong decisions. He calls these misjudgements (I somehow prefer to call them biases). I came across this talk in 2008 and have been reading and re-reading it very frequently. Since I find it very useful, I have tried to summarize the talk in a way I can relate to things we come across in our lives. I find this useful to make a mental model or a checklist of items while observing human behaviour on a daily basis. I have also included current and recent examples of the biases in action. There have been various books, websites and notes referred to for completing this piece. I do not claim this to be my (original) work - this is more of a compilation. Notable among the many references I have used are (all references have been attributed wherever used):
1. Reward and Punishment Super-response Tendency (Incentives are Superpowers)
Charlie is continuously amazed by the response to awards and punishment. He says "Never, ever, think about something else when you should be thinking about the power of incentives." and the most important rule in management is "Get the incentives right." Charlie also says “Well I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.” He thinks that "Incentives are superpowers." Incentives can lead to behavior changes.
“Incentive Induced Bias” is another major fallout of this. "Man driven both consciously and subconsciously by incentives, drifts into immoral behavior in order to get what he wants, a result he facilitates by rationalizing his bad behavior." Charlie also says that “Widespread incentive-caused bias requires that one should often distrust, or take with a grain of salt, the advice of one's professional advisor, even if he is an engineer.”
The general antidotes to Incentive Induced Bias are:
(1) especially fear professional advice when it is especially good for the advisor;
(2) learn and use the basic elements of your advisor's trade as you deal with your advisor; and
(3) double check, disbelieve, or replace much of what you're told, to the degree that seems appropriate after objective thought.
Agency cost is another concept where employees end up putting their own interests before that of the firm or the shareholders.
My Notes:
Psychologists call incentives ‘reinforcements’ and economists call incentive induced bias as ‘agency cost’.
Incentives cannot be your only tool to understand psychology or drive results in an organization. Like a man with only a hammer to whom everything seems like a nail, do not be a man with a single hammer (rewards) trying to smoothen any nail. Try to understand the interplay of other tendencies with incentives. Money is the basic incentive in life as it can be traded for a lot of other physical things. However, in addition to money, people also change their behavior and cognition for recognition, sex, friendship, companionship, advancement in status and other non-monetary items.
In most cases, employees decide how much work they are willing to put up with so that they can align the incentives they get from their employment to their output. That is why getting the incentives right is a fundamental job of management. Remember that incentives are not only monetary – they can be status, respect, etc. Since we need to consider not only the first level of incentives but also the second and third order consequences of any incentive (see the cobra example in my notes), creating any effective incentive systems in an organization is very hard. It is also probably one of the most underrated items and is mostly an afterthought or a reaction.
In a startup, getting equity distribution done correctly among the (co)founders is a major determinant of success - so much so that notable startup accelerator YCombinator recommends splitting equity equally among co-founders irrespective of who brought the idea, what stage each of the founders joined, how long one co-founder took salary while another one did not and so on.
Prompt, severe and exemplary punishment of undesired and immoral behavior is fundamental to the success of the society. One key point to keep in mind is that punishments work best when we want to avoid action while incentives are useful when we prefer people to act. In my understanding, punishments should not be used to trigger actions as this goes against the basic psychology of incentives.
Don’t forget to look at the antidotes to “Incentive Induced Bias” as mentioned above - this is a very important bias in good people who we trust and are our well-wishers. Watch out for this one all the time when interacting with professionals - doctors, financial advisors, real estate agents etc.
Examples:
Liking/Loving Tendency
Disliking/Hating Tendency
Doubt Avoidance Tendency
Inconsistency Avoidance Tendency (Resistance to Change/Confirmation Bias)
Curiosity Tendency
Kantain Fairness Tendency
Envy/Jealousy Tendency
Reciprocation Tendency
Influence from Mere Association Tendency
Simple Pain Avoiding Psychological Denial
Excessive Self Regard Tendency
Over-Optimism Tendency
Deprival Super-Reaction Tendency
Social Proof Tendency (Herd Mentality)
Contrast Misreaction Tendency (Anchoring Bias)
Stress Influence Tendency
Availability Misweighing Tendency (Availability Bias)
Use it or Lose it Tendency
Drug Misinfluence Tendency
Senescence-Misinfluence Tendency
Authority-Misinfluence Tendency
Twaddle Tendency
Reason-Respecting Tendency
Lollapalooza Tendency - Extreme Consequences from Confluences of Psychological Tendencies Acting in Favor of a Particular Outcome
Many thanks to Anshul Khare, Vikas Kasturi and Prashanth Jnanendra for reading drafts of this and valuable suggestions.
- James Montier
“Sometimes heuristics are good for making decisions, while at other times heuristics are bad for making decisions. The reason for this mixed or nuanced answer is namely heuristics act faster than rational deliberation, but precisely because of their speed, heuristics can mislead us into systematic errors in making decisions”.
-Huang
All of us behave irrationally at times. One of the best explanations of human irrationality is Charlie Munger’s seminal talk on The Psychology of Human Misjudgment. For the uninitiated, Munger is the Vice Chairman of Berkshire Hathaway and longtime partner of legendary Warren Buffett. In this talk, (given in 1995, transcript, video) Munger lists the human tendencies that lead us to be irrational and make wrong decisions. He calls these misjudgements (I somehow prefer to call them biases). I came across this talk in 2008 and have been reading and re-reading it very frequently. Since I find it very useful, I have tried to summarize the talk in a way I can relate to things we come across in our lives. I find this useful to make a mental model or a checklist of items while observing human behaviour on a daily basis. I have also included current and recent examples of the biases in action. There have been various books, websites and notes referred to for completing this piece. I do not claim this to be my (original) work - this is more of a compilation. Notable among the many references I have used are (all references have been attributed wherever used):
- The archive of Marc Andreessen’s Blog (referenced further as “(Marc)”) – available at multiple places on the web – gives a good insight on Munger’s tendencies applied to entrepreneurship and startups, though it only covers six out of 25 misjudgment tendencies.
- Munger’s Psychology based tendencies on Capital Ideas
- Cialdini’s Six Principles: Reciprocation, Social Proof, Commitment and Consistency, Liking, Authority and Scarcity.
- Other sources like Farnam Street, videos of Charlie and Warren annual meetings were also very helpful for this compilation. Farman Street (referenced further as FS) is a very good compilation of a lot of thinking about misjudgment and a recommended source.
- Peter Bevelin’s book “Seeking Wisdom – from Darwin to Munger” was a useful source.
- Value Research (VR) also has a good collection at 25 ways to (Not) make mistakes
Munger gave this talk in 1995 – since then Kahneman and Tversky have come up with definitions and explanations of various biases like confirmation, anchoring, overconfidence, fundamental attribution, etc. Whatever Munger is talking here is so useful and simple to apply from a practical standpoint - even if you skip Kahneman’s work (which incidentally won him a Nobel Prize), you can still cover a lot of ground in daily life with what Munger has talked about here. When I mention an action to be performed by ‘you’, it really means it’s a note for my own self, not necessarily for the reader.
I will publish these articles one by one listing each bias as a separate blog post. Once I have covered all of them, I will include a personal summary of my “Learnings” on these tendencies and a sample checklist for daily use (which I find useful).
I will publish these articles one by one listing each bias as a separate blog post. Once I have covered all of them, I will include a personal summary of my “Learnings” on these tendencies and a sample checklist for daily use (which I find useful).
Charlie is continuously amazed by the response to awards and punishment. He says "Never, ever, think about something else when you should be thinking about the power of incentives." and the most important rule in management is "Get the incentives right." Charlie also says “Well I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.” He thinks that "Incentives are superpowers." Incentives can lead to behavior changes.
“Incentive Induced Bias” is another major fallout of this. "Man driven both consciously and subconsciously by incentives, drifts into immoral behavior in order to get what he wants, a result he facilitates by rationalizing his bad behavior." Charlie also says that “Widespread incentive-caused bias requires that one should often distrust, or take with a grain of salt, the advice of one's professional advisor, even if he is an engineer.”
The general antidotes to Incentive Induced Bias are:
(1) especially fear professional advice when it is especially good for the advisor;
(2) learn and use the basic elements of your advisor's trade as you deal with your advisor; and
(3) double check, disbelieve, or replace much of what you're told, to the degree that seems appropriate after objective thought.
Agency cost is another concept where employees end up putting their own interests before that of the firm or the shareholders.
My Notes:
Psychologists call incentives ‘reinforcements’ and economists call incentive induced bias as ‘agency cost’.
Incentives cannot be your only tool to understand psychology or drive results in an organization. Like a man with only a hammer to whom everything seems like a nail, do not be a man with a single hammer (rewards) trying to smoothen any nail. Try to understand the interplay of other tendencies with incentives. Money is the basic incentive in life as it can be traded for a lot of other physical things. However, in addition to money, people also change their behavior and cognition for recognition, sex, friendship, companionship, advancement in status and other non-monetary items.
In most cases, employees decide how much work they are willing to put up with so that they can align the incentives they get from their employment to their output. That is why getting the incentives right is a fundamental job of management. Remember that incentives are not only monetary – they can be status, respect, etc. Since we need to consider not only the first level of incentives but also the second and third order consequences of any incentive (see the cobra example in my notes), creating any effective incentive systems in an organization is very hard. It is also probably one of the most underrated items and is mostly an afterthought or a reaction.
In a startup, getting equity distribution done correctly among the (co)founders is a major determinant of success - so much so that notable startup accelerator YCombinator recommends splitting equity equally among co-founders irrespective of who brought the idea, what stage each of the founders joined, how long one co-founder took salary while another one did not and so on.
Prompt, severe and exemplary punishment of undesired and immoral behavior is fundamental to the success of the society. One key point to keep in mind is that punishments work best when we want to avoid action while incentives are useful when we prefer people to act. In my understanding, punishments should not be used to trigger actions as this goes against the basic psychology of incentives.
Don’t forget to look at the antidotes to “Incentive Induced Bias” as mentioned above - this is a very important bias in good people who we trust and are our well-wishers. Watch out for this one all the time when interacting with professionals - doctors, financial advisors, real estate agents etc.
Examples:
- During the British rule over India, due to concerns about the number of venomous snakes, monetary rewards were offered to help eliminate unwanted snakes by making a payoff for each dead snake. Initially, this was a successful strategy as large numbers of snakes were killed for the reward. Eventually, however, Indians began to breed cobras for the income. When this was realized the reward was cancelled, but then the cobra breeders set the snakes free and the wild cobras thus multiplied. The apparent solution for the problem made the situation even worse, a classic case of misunderstanding the power of incentives (or not using a counter goal – see the next point).
- For every goal you put in front of someone, you should also put in place a counter-goal to restrict gaming of the first goal. So, for example, if you are incenting your recruiters on the number of new employees recruited and hired, you need to also give them a counter-goal (and tie it to their compensation) that measures the quality of the new hires three months in. Otherwise, the recruiters are guaranteed to give you what you don’t want: a lot of mediocre new hires. (Marc)
- In the book, Pebbles of Perception, Laurence Endersen writes: “Good incentives acknowledge recognition, public perception, and the value of pursuing work that we can be proud of. So yes, if we want to persuade, we should appeal to interests not reason. But when it comes to interests, appeal not just to the net worth but also to self-worth.”
- Requiring people to have very complex passwords for security can be a perverse incentive. When faced with this complexity we simply write down our passwords somewhere “safe”, defeating the whole purpose of a complex password in the first place.
- This is why stock options work so well in startups —the fewer people in a startup, the better stock options work, since when there are only a few people in a company, it’s usually crystal clear to each person how her work will impact the value of the company. (Marc)
- Incentivize engineers based purely on a ship date, and you’ll get a shipping product with lots of bugs. Incent based on number of bugs fixed, and you’ll never get any new features. And so on. (Marc)
- “It is difficult to get a man to understand something when his salary depends upon his not understanding it.” — Upton Sinclair
- Most doctors end up advising you to buy more of their services even if you do not require them in the first place – an example of incentive induced bias. They are able to rationalize that they are doing the right thing for the patient and helping the patient by doing this. A large number of C-section births in India is a case in point – many of the doctors who are doing it are not immoral but biased.
- Egalitarian or equal sharing systems are mostly a failure as there are no incentives for anyone to do better than average (for example communism) - this is also called ‘tragedy of commons’.
- Financial Crisis of 2008 - a lot of subprime mortgages were sold by people genuinely believing that they were doing a good job selling homes to people with no ability to pay. It’s a classic case of incentive induced bias. There are many other such examples where people who had incentives to achieve certain sales or achievement targets ended up acting immorally leading to huge scandals and even complete ruin.
- Many of us invest into financial products (or real estate) recommended to us by our family relations or friends who are also sales agents of the same products. We end up purchasing believing that the advice we receive is good for us - after all these people are our well wishers. These friends and relations may be perfectly moral and upright (we can happily marry our daughters into their families). The issue here is that we did not watch out for incentive induced bias - these people in their hearts genuinely believe that what they are offering us to buy is the best for us because they are incentivised for it. The sad truth is that in many cases their advice is not the best instrument we can get.
Liking/Loving Tendency
Disliking/Hating Tendency
Doubt Avoidance Tendency
Inconsistency Avoidance Tendency (Resistance to Change/Confirmation Bias)
Curiosity Tendency
Kantain Fairness Tendency
Envy/Jealousy Tendency
Reciprocation Tendency
Influence from Mere Association Tendency
Simple Pain Avoiding Psychological Denial
Excessive Self Regard Tendency
Over-Optimism Tendency
Deprival Super-Reaction Tendency
Social Proof Tendency (Herd Mentality)
Contrast Misreaction Tendency (Anchoring Bias)
Stress Influence Tendency
Availability Misweighing Tendency (Availability Bias)
Use it or Lose it Tendency
Drug Misinfluence Tendency
Senescence-Misinfluence Tendency
Authority-Misinfluence Tendency
Twaddle Tendency
Reason-Respecting Tendency
Lollapalooza Tendency - Extreme Consequences from Confluences of Psychological Tendencies Acting in Favor of a Particular Outcome
Many thanks to Anshul Khare, Vikas Kasturi and Prashanth Jnanendra for reading drafts of this and valuable suggestions.
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