The Psychology of Entrepreneurial Misjudgment, part 1: Biases 1-6

Saturday, March 29th, 2008

If I weren’t already a fan of Charles Munger, then Marc Andreessen’s recent post on The Psychology of Entrepreneurial Misjudgment might make a fan out of me.

“The Psychology of Entrepreneurial Misjudgment” is the name of Munger’s magnum opus speech, included in Poor Charlie’s Almanack, a book inspired by Ben Franklin’s Poor Richard’s Almanack and assembled by a group of Mr. Munger’s friends from his most interesting thoughts and speeches.

In part one of his planned series of posts, Andreessen examines the first six of the 25 “key forms of human behavior that lead to misjudgment and error” that Munger has discovered in his 60 years in business.

Munger feels strongly about the first bias, Reward and Punishment Superresponse Tendency:

I place this tendency first in my discussion because almost everyone thinks he fully recognizes how important incentives and disincentives are in changing cognition and behavior. But this is not often so. For instance, I think I’ve been in the top five percent of my age cohort almost all my adult life in understanding the power of incentives, and yet I’ve always underestimated that power. Never a year passes but I get some surprise that pushes a little further my appreciation of incentive superpower.

…We [should] heed the general lesson implicit in the injunction of Ben Franklin in Poor Richard’s Almanack: “If you would persuade, appeal to interest and not to reason.” This maxim is a wise guide to a great and simple precaution in life: Never, ever, think about something else when you should be thinking about the power of incentives…

One of the most important consequences of incentive superpower is what I call “incentive caused bias.” A man has an acculturated nature making him a pretty decent fellow, and yet, driven both consciously and subconsciously by incentives, he drifts into immoral behavior in order to get what he wants, a result he facilitates by rationalizing his bad behavior [like a salesman who harms her customers by selling them the wrong product because she gets paid more for selling it, versus the right product -- see, e.g., the mutual fund industry].

…Another generalized consequence of incentive caused bias is that man tends to “game” all human systems, often displaying great ingenuity in wrongly serving himself at the expense of others. Antigaming features, therefore, constitute a huge and necessary part of almost all system design.

…Military and naval organizations have very often been extreme in using punishment [the inverse of reward] to change behavior, probably because they needed to cause extreme behavior. Around the time of Caesar, there was a European tribe that, when the assembly horn blew, always killed the last warrior to reach his assigned place, and no one enjoyed fighting this tribe.

Andreessen agrees and believes that stock options make excellent sense for startups:

There is a wrong-headed and dangerous theory afoot that restricted stock (grants of fully in-the-money shares of stock) is a more appropriate motivator of employees of tech companies than stock options. [...] From an incentive standpoint the result of shifting from stock options to restricted stock should be obvious: current employees will be incented to preserve value instead of creating value. And new hires will by definition be people who are conservative and change-averse, as the people who want to swing for the fences and get rewarded for creating something new will go somewhere else, where they will receive stock options — in typically greater volume than anyone will ever grant restricted stock — and have greater upside.

And sure enough, in the wake of shifting towards restricted stock and away from stock options, Microsoft’s stock has been flat as a pancake. The incentive works.

I think it’s a bit facile to attribute Microsoft’s flat stock performance to the move from stock options to restricted stock.

More importantly, employees with restricted stock are not incented to preserve value instead of creating value; they’re incented to both preserve and create value. It’s the employees with stock options who have an incentive to create value without much incentive to preserve value. Options are an incentive to swing for the fences — to go big or go home.

This can make sense, if we think employees are systematically biased against risk, but it’s not the obvious answer.

And let’s not forget that restricted stock in a startup that isn’t worth anything yet is no different from a stock option with a strike price of zero.

Charles Munger on Niederhoffering the Curriculum

Sunday, January 6th, 2008

I’ve already mentioned that Berkshire Hathaway’s Charles Munger gave a speech at UCSB in 2003 that was chock-full of thought-provoking bits — like this bit on Niederhoffering the curriculum:

There was a wonderful example of gaming a human system in the career of Victor Niederhoffer in the Economics Department of Harvard. Victor Niederhoffer was the son of a police lieutenant, and he needed to get A’s at Harvard. But he didn’t want to do any serious work at Harvard, because what he really liked doing was, one, playing world-class checkers; two, gambling in high-stakes card games, at which he was very good, all hours of the day and night; three, being the squash champion of the United States, which he was for years; and, four, being about as good a tennis player as a part-time tennis player could be.

This did not leave much time for getting A’s at Harvard so he went into the Economics Department. You’d think he would have chosen French poetry. But remember, this was a guy who could play championship checkers. He thought he was up to outsmarting the Harvard Economics Department. And he was. He noticed that the graduate students did most of the boring work that would otherwise go to the professors, and he noticed that because it was so hard to get to be a graduate student at Harvard, they were all very brilliant and organized and hard working, as well as much needed by grateful professors.

And therefore, by custom, and as would be predicted from the psychological force called reciprocity tendency, in a really advanced graduate course, the professors always gave an A. So Victor Niederhoffer signed up for nothing but the most advanced graduate courses in the Harvard Economics Department, and of course, he got A, after A, after A, after A, and was hardly ever near a class. And for a while, some people at Harvard may have thought it had a new prodigy on its hands. That’s a ridiculous story, but the scheme will work still. And Niederhoffer is famous: they call his style “Niederhoffering the curriculum.”

(Hat tip to the Photon Courier.)

Charles Munger on Workman’s Comp and Bad Incentives

Saturday, January 5th, 2008

I’ve already mentioned that Berkshire Hathaway’s Charles Munger gave a speech at UCSB in 2003 that was chock-full of thought-provoking bits — like this bit on workman’s comp madness:

Anyway, as the Medicare example showed, all human systems are gamed, for reasons rooted deeply in psychology, and great skill is displayed in the gaming because game theory has so much potential. That’s what’s wrong with the workman’s comp system in California. Gaming has been raised to an art form. In the course of gaming the system, people learn to be crooked. Is this good for civilization? Is it good for economic performance? Hell no. The people who design easily–gameable systems belong in the lowest circle of hell.

I’ve got a friend whose family controls about 8% of the truck trailer market. He just closed his last factory in California and he had one in Texas that was even worse. The workman’s comp cost in his Texas plant got to be about 30% of payroll. Well, there’s no such profit in making truck trailers. He closed his plant and moved it to Ogden, Utah, where a bunch of believing Mormons are raising big families and don’t game the workman’s comp system. The workman’s comp expense is 2% of payroll.

Are the Latinos who were peopling his plant in Texas intrinsically dishonest or bad compared to the Mormons? No. It’s just the incentive structure that so rewards all this fraud is put in place by these ignorant legislatures, many members of which have been to law school, and they just don’t think about what terrible things they’re doing to the civilization because they don’t take into account the second order effects and the third order effects in lying and cheating. So, this happens everywhere, and when economics is full of it, it is just like the rest of life.

The people who design easily–gameable systems belong in the lowest circle of hell.

Charles Munger and Predicting Policy Costs

Thursday, December 6th, 2007

I’ve already mentioned that Berkshire Hathaway’s Charles Munger gave a speech at UCSB in 2003 that was chock-full of thought-provoking bits — like this bit on predicting the cost of Medicare:

Extreme economic ignorance was displayed when various experts, including Ph D. economists, forecast the cost of the original Medicare law. They did simple extrapolations of past costs.

Well the cost forecast was off by a factor of more than 1000%. The cost they projected was less than 10% of the cost that happened. Once they put in place all these new incentives, the behavior changed in response to the incentives, and the numbers became quite different from their projection. And medicine invented new and expensive remedies, as it was sure to do. How could a great group of experts make such a silly forecast? Answer: They over simplified to get easy figures, like the rube rounding Pi to 3.2! They chose not to consider effects of effects on effects, and so on.

Charles Munger and Predicting Policy Costs

Thursday, December 6th, 2007

I’ve already mentioned that Berkshire Hathaway’s Charles Munger gave a speech at UCSB in 2003 that was chock-full of thought-provoking bits — like this bit on predicting the cost of Medicare:

Extreme economic ignorance was displayed when various experts, including Ph D. economists, forecast the cost of the original Medicare law. They did simple extrapolations of past costs.

Well the cost forecast was off by a factor of more than 1000%. The cost they projected was less than 10% of the cost that happened. Once they put in place all these new incentives, the behavior changed in response to the incentives, and the numbers became quite different from their projection. And medicine invented new and expensive remedies, as it was sure to do. How could a great group of experts make such a silly forecast? Answer: They over simplified to get easy figures, like the rube rounding Pi to 3.2! They chose not to consider effects of effects on effects, and so on.

Charles Munger and His Amusing But Aprocryphal Planck Anecdote

Tuesday, December 4th, 2007

I’ve already mentioned that Berkshire Hathaway’s Charles Munger gave a speech at UCSB in 2003 that was chock-full of thought-provoking bits. Here’s an amusing but apocryphal story about Max Planck, the famous physicist:

After he won his prize, he was invited to lecture everywhere, and he had this chauffeur that drove him around to give public lectures all through Germany. And the chauffeur memorized the lecture, and so one day he said, “Gee Professor Planck, why don’t you let me try it as we switch places?” And so he got up and gave the lecture. At the end of it some physicist stood up and posed a question of extreme difficulty. But the chauffeur was up to it. “Well,” he said, “I’m surprised that a citizen of an advanced city like Munich is asking so elementary a question, so I’m going to ask my chauffeur to respond.”

Charles Munger and His Amusing But Aprocryphal Planck Anecdote

Tuesday, December 4th, 2007

I’ve already mentioned that Berkshire Hathaway’s Charles Munger gave a speech at UCSB in 2003 that was chock-full of thought-provoking bits. Here’s an amusing but apocryphal story about Max Planck, the famous physicist:

After he won his prize, he was invited to lecture everywhere, and he had this chauffeur that drove him around to give public lectures all through Germany. And the chauffeur memorized the lecture, and so one day he said, “Gee Professor Planck, why don’t you let me try it as we switch places?” And so he got up and gave the lecture. At the end of it some physicist stood up and posed a question of extreme difficulty. But the chauffeur was up to it. “Well,” he said, “I’m surprised that a citizen of an advanced city like Munich is asking so elementary a question, so I’m going to ask my chauffeur to respond.”

Charles Munger on Side-Stepping the Gangs, Pimps, and Dope-Dealers

Monday, December 3rd, 2007

I’ve already mentioned that Berkshire Hathaway’s Charles Munger gave a speech at UCSB in 2003 that was chock-full of thought-provoking bits. Here’s another such bit:

Berkshire had this former savings and loan company, and it had made this loan on a hotel right opposite the Hollywood Park Racetrack. In due time the neighborhood changed and it was full of gangs, pimps, and dope dealers. They tore copper pipe out of the wall for dope fixes, and there were people hanging around the hotel with guns, and nobody would come. We foreclosed on it two or three times, and the loan value went down to nothing. We seemed to have an insolvable economic problem — a microeconomic problem.

Now we could have gone to McKinsey, or maybe a bunch of professors from Harvard, and we would have gotten a report about 10 inches thick about the ways we could approach this failing hotel in this terrible neighborhood. But instead, we put a sign on the property that said: “For sale or rent.” And in came, in response to that sign, a man who said, “I’ll spend $200,000 fixing up your hotel, and buy it at a high price on credit, if you can get zoning so I can turn the parking lot into a putting green.” “You’ve got to have a parking lot in a hotel,” we said. “What do you have in mind?” He said. “No, my business is flying seniors in from Florida, putting them near the airport, and then letting them go out to Disneyland and various places by bus and coming back. And I don’t care how bad the neighborhood is going to be because my people are self-contained behind walls. All they have to do is get on the bus in the morning and come home in the evening, and they don’t need a parking lot; they need a putting green.” So we made the deal with the guy. The whole thing worked beautifully, and the loan got paid off, and it all worked out.

Charles Munger on Increasing Price to Increase Sales

Friday, November 30th, 2007

Berkshire Hathaway’s Charles Munger gave a speech at UCSB in 2003 that was chock-full of thought-provoking bits, like this:

My fifth criticism is there is too little synthesis in economics. Not only with matter outside traditional economics, but also within economics. I have posed at two different business schools the following problem. I say, “You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes. And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” And there’s this long and ghastly pause. And finally, in each of the two business schools in which I’ve tried this, maybe one person in fifty could name one instance. They come up with the idea that occasionally a higher price acts as a rough indicator of quality and thereby increases sales volumes.

This happened in the case of my friend Bill Ballhaus. When he was head of Beckman Instruments it produced some complicated product where if it failed it caused enormous damage to the purchaser. It wasn’t a pump at the bottom of an oil well, but that’s a good mental example. And he realized that the reason this thing was selling so poorly, even though it was better than anybody else’s product, was because it was priced lower. It made people think it was a low quality gizmo. So he raised the price by 20% or so and the volume went way up.

But only one in fifty can come up with this sole instance in a modern business school — one of the business schools being Stanford, which is hard to get into. And nobody has yet come up with the main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent? (Laughter). Is that going to work? And are there functional equivalents in economics — microeconomics — of raising the price and using the extra sales proceeds to drive sales higher? And of course there are zillion, once you’ve made that mental jump. It’s so simple.

One of the most extreme examples is in the investment management field. Suppose you’re the manager of a mutual fund, and you want to sell more. People commonly come to the following answer: You raise the commissions, which of course reduces the number of units of real investments delivered to the ultimate buyer, so you’re increasing the price per unit of real investment that you’re selling the ultimate customer. And you’re using that extra commission to bribe the customer’s purchasing agent. You’re bribing the broker to betray his client and put the client’s money into the high-commission product. This has worked to produce at least a trillion dollars of mutual fund sales.

This tactic is not an attractive part of human nature, and I want to tell you that I pretty completely avoided it in my life. I don’t think it’s necessary to spend your life selling what you would never buy. Even though it’s legal, I don’t think it’s a good idea.

(Hat tip to the Photon Courier.)