Meet Warren Buffett’s mentor

In the midst of market madness it always pays to look for a sober mind. Over the past few weeks, Warren Buffett has been in the news confidently taking large positions, first in Goldman Sachs and then in GE. If he was excited enough to buy last week, how

In the midst of market madness it always pays to look for a sober mind. Over the past few weeks, Warren Buffett has been in the news confidently taking large positions, first in Goldman Sachs and then in GE. If he was excited enough to buy last week, how must he be feeling this week?

You can bet there have been some animated phone calls between Buffett and his old pal Charlie Munger in the past few days. In fact, as Buffett takes such bold steps, those that know something of the relationship between Buffett and Munger will see Munger’s fingerprints all over the Goldman Sachs and GE deals.

In case you have never heard of him, Charlie Munger has long been the “power-behind-the-throne” for Warren Buffett. In fact, Munger is the older of the duo, clocking in at 84 against Buffett’s sprightly 78.

A graduate of Harvard Law School, Munger started his business career as a lawyer in California before becoming a professional money manager. He and Buffett first hooked up informally in the early 1960s and their business relationship still retains an unusual level of informality.

In the mid-1970s Munger became a substantial shareholder in Berkshire Hathaway, with the size of his holding meaning that he has become one of the wealthiest people in the world. But he has earned his money: Munger – a double billionaire – is the man Buffett turns to for advice.

Munger is the ultimate disciplinarian, with his approach to life (and especially investing) perhaps being summed up best by this oft-quoted line; to a man with a hammer, every problem looks likes a nail.

Munger has made it his life’s work to ensure that he always has a range of tools that lets him be honest about the nature of the problem. He has developed the investment world’s biggest toolkit, and right now he will be using every tool in it. (While there are dozens of Buffett books, including the just released 952-page blockbuster Snowball: Warren Buffett and the business of life, Charlie has only graced two covers; Damn Right, behind the scenes with Berkshire Hathaway billionaire Charlie Munger (foreword by Warren Buffett) and Poor Charlie’s Almanack).

Munger draws his tools from a wide variety of sources, ranging from the Greek classics to modern cartoons. One of the most unusual elements of Munger’s approach to investment is his application of human psychology.

Munger was the first big investor to realise the extent of irrationality in the investment markets. In fact, he is often credited with inventing behavioural finance. Munger’s main contribution, which the events of this week in particular reinforce, was to point out the “elephant in the corner” of academic economics; human behaviour often confounds the assumption of rationality. Put simply; people are not rational.

But Munger does not stop at merely realising that people are irrational. He has developed a broad and well-thought out thesis as to why. He calls this thesis the “psychology of human misjudgement”, and it is essentially an ode to irrationality.

Munger boils irrational human behaviour down to 25 “tendencies”, and right now you could do a lot worse than to close your trading screen and instead spend your time learning about these tendencies. Some of the more applicable current tendencies include the “constant-misreaction tendency”, the “pain avoiding tendency” and the “twaddle tendency”. For many of Munger’s tendencies, the titles say it all.

Psychologists always look for empirical, or real-world, evidence to support a theory. In Munger’s textbook, under the heading “Proof that my theory is right”, he could probably just write: “October 2008 (with specific reference to the week beginning October 6… case closed.”

So, if this is a time of mass misjudgement, why specifically are Buffett and Munger buying? Munger’s theory gives us the answer. At the end of Munger’s list of tendencies comes the biggest of them all. He calls it the “lollapalooza tendency”, and it is basically the combined effect of several strands of irrationality all occurring at the same time. The word lollapalooza is in many ways a reference to the size of the profits that can be made when the world goes mad.

If Buffett’s move into Goldman Sachs and GE pays off, the returns will be huge. For Buffett and Munger, this is a time to get to work. Misjudgements are crowding upon misjudgements and things are spiralling seemingly out of control. The world looks like it is about to end. Which is, of course, the biggest irrationality of them all.

That’s why Charlie is whispering a single word to Warren. That word is lollapalooza!

Adrian McMaster is a registered psychologist and financial planner at McMasters. This article first appeared in Business Spectator