My timing was impeccable. A full exit from a (not very extravagant) bitcoin position that I had been gradually whittling down with each big move over the last year or two — at first coupled with some elation from only just beating a major drop, followed by a more significant dismay as the price has more than doubled in the time since. There’s a certain adrenaline rush from a volatile market that only experienced traders and risk-takers can ever grow accustomed too, and I hardly consider myself part of that number. In fact the only appropriate adjective for my personal philosophy would be passive. The clarity and simplicity of an indexing strategy has always appealed to the engineer in me (although I’ve always considered myself open to other tactics for cases of an (elusive) ‘edge’). But even the simplicity of indexing leaves some room for interpretation, one key one being the extent of diversification across asset classes. Warren Buffett has recommended that the majority of investors would be best off in a low-cost S&P500 index fund (or more specifically a 90/10 mix of an S&P500 index and short term government bonds), and you know what for the sophistication of the majority of retirement savers I fully agree (you should see my parents for instance). Perhaps its ego but I do consider myself at least a little sophisticated in the investing realm, and so I haven’t shied from a few deviations from the simplest tactics, the most notable of which in recent time has been a venture into cryptocurrencies.
I’m not sure exactly when I first came across Charlie Munger’s speech “The Psychology of Human Misjudgment,” one originally given in 1992 followed by a few revisions thereafter. I may have seen it online as I went a phase of following pretty closely a few investing blogs (a thank you is owed to Barry Ritholtz for sparking some early enthusiasm in this period). At some point I’m sure I came across Marc Andreessen’s essay “The Psychology of Entrepreneurial Misjudgment” which is an excellent adaption of this work applied to the startup realm. But eventually found my way to buying the authoritative work, Poor Charlie’s Almanack, a beautifully presented collection of Munger’s most important talks as well as some biographical treatment. I remember that while reading through the transcripts in this almanack I kept seeing Munger refer back to psychological factors and checklists for decision-making, and I grew frustrated because in all of the Munger book recommendations I found online, there was very little in the way of psychology (other than Robert Cialdini’s excellent Influence). And then I finally got to the final talk in this book and figured out why. Munger was so dissatisfied with those psychology references he had found that he basically wrote one of his own, in which he presents a list of common thinking tendencies that in isolation or conjunction could be responsible for all kinds of errors of judgment. The idea is that prior to some crossroads, one can work through this checklist of psychological tendencies to identify any potential causes of misjudgment for a sounder basis of decision. These tendencies are all evolution derived and thus definitely contain merit, so the goal is not to simply dismiss their signals, however by consciously and systematically inspecting each we can hopefully objectively evaluate for determination of cases where our natural tendencies and heuristics might be leading us astray.
This post will use the checklist framework provided by Munger’s talk to weigh a pressing decision I am now facing, whether to reinvest in bitcoin or continue allocating any free capital elsewhere. I hope to use this exercise to search for any bias that may be clouding my judgment in this matter. Munger has identified 25 psychological tendencies and I’ll walk through each. I expect that some will be more relevant than others, and several probably won’t apply at all. Also note that the goal here is not to provide a comprehensive overview of these tendencies — Munger handles that better than I ever could, in fact my strong recommendation is that to get full value out of this post a reader should pause here and listen to (or read) Munger’s talk in full before proceeding. Seriously, go ahead, it’s that good. Just remember to like this post before leaving so you’ll be able to find again when you’re ready to return.
Transcript also available from Farnam Street.
Well hope you enjoyed the talk, and thanks for returning. Again the hope here is that by the conclusion of this post I will have identified any potential sources of error in my thinking about bitcoin investment by walking through the psychological factor checklist framework as provided by Munger. And without further ado:
1. Reward and Punishment Superresponse Tendency
The idea here is that man is driven by incentives, and that we can overreact to experiencing rewards or punishment, which can lead to the infamous ‘man-with-a-hammer syndrome’ (to a man with a hammer, every problem looks like a nail (resisting the urge for a John Henry pun here)). Such incentives driven bias are always a good reason to question professional advise when the advisor stands to gain — the proverbial asking a barber whether you need a haircut.
In the Bitcoin realm, I’ve seen first hand people who have reaped very real and significant trading profits adopt the man-with-a-hammer mentality, and turn to an always buy never sell mentality. Evaluating the most high-profile of these advocates’ buy recommendations should always be tempered with the realization that they do benefit from wider adoption, they’re ‘talking their book’, which assuming a wide enough audience can actually turn into a very real investing edge (just look at how investors pile onto each announced Berkshire transaction for this behavior’s potential taken to an extreme).
Munger gives some very rich examples in this section, and I’ll mention a few. The story is told of Westinghouse in the 90’s throwing accounting standards to the wind as they ventured far outside of their circle of competence for construction lending (and as a result getting bought out by the industrial conglomerate Siemens in the process) — the incentives of misrepresenting credit risk costing them billions. Those looking to place sizable bets on speculative cryptocurrencies would be wise to take an honest assessment of their own circle of competence. Early success in a position can easily fool one to a false belief that the nature of a risk is understood.
Munger also offers a hero of the incentive game, John Henry Patterson, the founder of the National Cash Register Company. Patterson was an evangelist and salesman and hugely influential to the retail industry adopting this novel form of collecting payments. The heroism comes from the technological elimination of several perverse incentives that can lead to dishonest behavior at large scale. Bitcoin has its own hero, the so far anonymous ‘Satoshi Nakamoto’ who, assuming he is only one person, was responsible for the original architecture and rollout of the bitcoin protocol (and remains the largest currency holder by far). It is certainly possible that bitcoin will one day have as transformative an impact on transactions (financial or otherwise) as the cash register, and even if not bitcoin itself certainly some version of blockchain enabled cryptocurrency technology will.
A final example from this section of the checklist I find both relevant and kind of humorous. Munger sites that a monkey can be trained to seek and work for an intrinsically worthless token if the token is routinely exchangeable for a banana — thus demonstrating that even in primitive brains the liquidity of an arbitrary instrument allows a value be derived and a currency to be accepted. The implications for bitcoin are obvious.
2. Liking / Loving Tendency and 3. Disliking / Hating Tendency
These are actually two distinct items on the checklist, but I’ll address them both here since I believe they have limited relevance to my circumstances. The idea is that we have tendencies to favor (disfavor) things that bear some connection to the object of our affection (ire). If I was dating a girl who made her living in bitcoin for instance I might pay more attention here, but my exposure to the field is primarily found through the osmosis of a tech heavy twitter feed or daily browsing of Hacker News, so I don’t expect there to be much potential for emotional conflation with bitcoin.
4. Doubt-Avoidance Tendency
This tendency is all about how we may seek to remove doubt by rushing to some decision, often triggered by puzzlement or stress. For me, the decision to fully exit from my bitcoin position was largely influenced by a recent failure of the platform’s miners to follow through on a prior intent to expand the block size capacity, a technical challenge that has been nagging the platform with slow transaction times and high fees for too long — a larger block size being technical necessity for the throughput for bitcoin to function as any true payment platform on large scale. Given the scale effects of mass adoption by speculators, I had always assumed that this liquidity would give bitcoin the ability to maintain a market dominating position verses others — after all any better mousetrap demonstrated by some new cryptocurrency can always be adopted by bitcoin to maintain their leading position. However the stalemate around block sizes has demonstrated in my mind that the governance of bitcoin (by miner majority) is dysfunctional to the point that even obvious to a layperson like me improvements are deferred for status quo or forks. When the internet was founded and the protocol wars were conducted between corporations and the volunteer governed Internet as we know it, it was the volunteer community ability to act nimbly that allowed it to dominate.
Munger offers that in the legal system, judges and juries are forced to delay decisions with a mask of objectivity. It is true that my decision to exit from holdings was rash and there probably was some of this doubt-avoidance tendency at play, however the hope is that this exercise will belatedly offer some more objectivity to the analysis.
5. Inconsistency-Avoidance Tendency
This tendency suggests that once we have reached some conclusion, we are prone to maintain that conclusion, thus exasperating any rash decisions as engendered by Doubt Avoidance for instance (Munger also extends this tendency beyond conclusions to behaviors such as habits, loyalties, identity, commitments, etc).
AlphaGo, Google Deepmind’s go playing reinforcement learning engine, has been recently revamped to learn gameplay completely from scratch (unlike the first iteration’s sampling of human gameplay to get it started). It is trained off of a reinforcement learning utilizing a Monte Carlo tree search for exploring potential moves as it experiments with gameplay to hone in on strategy. One of the several novel features of this revamped model is the extent to which it is designed to intentionally explore novel terrain of gameplay. Compare this to Charles Darwin, who Munger sites as having a habit of intentionally considering evidence tending to disconfirm any hypothesis, even more intensely if he thought the hypothesis was a good one. This challenging of a theory helps us to consider a wider field of the state space for our own explorations of theory, and who knows perhaps even identify some disconfirming evidence that we might have missed otherwise. The goal is to remain open minded even after reaching some initial conclusion, to not just allow for consideration of discomfiting evidence but to intentionally seek it out.
6. Curiosity Tendency
Of the tendencies included here, curiosity appears to be the only one that Munger doesn’t find potential for harm. In fact he finds this as a resource to help mitigate consequences from other tendencies in the checklist.
I expect it would take several years (or if you’re gifted at least several dedicated months) to become an expert in bitcoin and cryptocurrency field as it exists today, but the rub is that by the time that expertise is achieved everything will have already changed. The cryptocurrency space is large and growing, but if you can develop a skill for directing your curiosity at areas of importance or significance, or at least novel terrain, you stand a chance of developing actionable insights, whether as an investor, entrepreneur, or in my case as a lowly blogger.
7. Kantian Fairness Tendency
Munger describes a certain evolved innate sense of fairness that can cause even strangers to willingly share in unexpected good (and bad) fortunes. I’m definitely an outsider to the bitcoin community, so am curious to what extent those that have realized these windfalls have become more generous as a result. I’m sure there’s some good stories out there, if you know any feel free to share in the comments (lol jk no one reads these things).
8. Eny/Jealousy Tendency
Munger offers a Buffett quote here: “It is not greed that drives the world, but envy.” I’m not sure the two concepts are orthogonal.
9. Reciprocation Tendency
The reciprocation tendency can be dangerous when we are negotiating with a counter-party for instance. Munger calls for procurement departments to follow Sam Walton’s lead and abstain from accepting even a hint of favors, gifts, meals, etc — this all seems like good advice (which I’ll follow seeing as how I work in a procurement department). In the bitcoin world on the other hand, we are dealing with transactional counterparts in an anonymous market, and so I don’t see as much potential for this tendency. I expect if current trends of broader public adoption continue there could arise a whole class of “cryptocurrency financial advisors” that will look to exploit this tendency — my nose is shriveling just thinking about it.
10. Influence-from-Mere Association Tendency
Just like that man whose first visit to a casino randomly results in a jackpot payout, we have to be careful that we don’t assign any early success in bitcoin holdings to some talent that we have the ability to predict markets. There is now big money trading this market with big-money resources. Consider this a word of caution.
11. Simple, Pain-Avoiding Psychological Denial
This is an extreme case which can present coupled with tragic or traumatic experiences (love, death, chemical dependency). Not extremely relevant to this case but certainly worth note to the field of psychology.
12. Excessive Self-Regard Tendency
This tendency has potential for real mischief in the bitcoin realm. One implication is that after we have made some trade or entered some position, we will subsequently believe even stronger in the merits of that bet. But to complicate matters further, as institutional money backed by sophisticated algorithms finds its way into bloating the bitcoin pool, we are no longer merely playing against other speculators, we’re now like the weekend golfer entering a match play tournament against Tiger Woods. Recognizing our limitations and extent of our competencies requires intentional objectivity.
13. Overoptimism Tendency
The overoptimism tendency is not limited to periods of obstacles and rejections, it even extends to times when we are succeeding. Might mass optimism turn into a self-fulfilling property for bitcoin appreciation? The answer is it will until it won’t.
14. Deprival Superreaction Tendency
This tendency relates to some research by behavioral economists such as Kahneman and Tversky, who demonstrated in their prospect theory that people judge gains and losses on a different scale, carrying an added aversion to losses. Munger warns of the tendency for gamblers to double down on losses with a passion to get even, a desire that grows even stronger with subsequent losses. If Bitcoin does turn its volatility in other directions, well it would be wise not to latch onto any breakeven point and instead evaluate any position based on current conditions, not where we were.
15. Social-Proof Tendency
Just as each of these other tendencies, social proof can be a useful signal and is in general useful. If a majority of people are buying bitcoin, well there is probably a good reason for that. The key is to be vigilant for any kind of phase change, when a majority’s trend has transitioned into a herd mentality. I once had a Florida realtor friend in 2005 enthusiastically lecture me about how Florida home prices could never go down, that it was literally impossible because of the constant influx of new residents. I find these type of blind faith messaging my own kind of flashing yellow lights.
16. Contrast-Misreaction Tendency
Not many of us would consider buying a $2,000 stereo system upgrade, but in the context of a $35,000 electric car perhaps it would be an easier sell — one classic example of the contrast-misreaction tendency at work. Anytime you have a exponential appreciation in an asset, it’s easy to get lost in dollar values when what we should be looking at instead are the underlying metrics. People talk about $10,000 bitcoins or even the (admittedly not outside of the realm of) possibility that a coin could reach $100,000 one day. But a bitcoin isn’t like a BRK.A share, you can easily buy fractional shares of any demarcation you please, so the “price of one bitcoin” is a totally arbitrary unit of measurement — especially considering that there are no earnings per share to go along with that unit. I find a much more useful metric of bitcoin values to be the total market cap of collective bitcoins in circulation, which I’ve seen a recent estimate of around $278B USD at time of this writing. The Federal Reserve reports that there are about $1.59T of USD currency currently in circulation to give you a basis of comparison.
17. Stress-Influence Tendency
So far the biggest stress I’ve been able to identify in bitcoin realm is of the FOMO variety (Fear of Missing Out). Stress is a good thing, it sharpens the mind. It’s the heavy stress variety that this can be a problem, I don’t see that being an issue at this time.
18. Availability-Misweighing Tendency
This is particularly a problem as we each recede into our respective social media echo chambers. Munger prescribes a few antidotes, including emphasizing disconfirming evidence, surrounding ourselves with skeptics who can advocate alternate positions, and even intentionally underweighting that evidence that is most visible. Incorporating diversity into a twitter feed can help here I expect.
19. Use-It-or-Lose-It Tendency
There’s been a distinct trend away from active investing over the last decade or so, as Vanguard’s index rolls have swelled. Might this be causing the retail investor to lose whatever semblance of a trader’s edge he ever had? I think you could probably debate whether any such edge ever existed in the first place. However I suspect that those who have been exclusively offloading their savings to indexing vehicles are the least equipped to deal with such a volatile instrument as bitcoin.
20. Drug-Misinfluence Tendency
For any other security I would dismiss this influence pretty quickly, however it’s easy to forget that bitcoin’s first primary use case was for elicit transactions. Might there still be elements of this aspect at play? Probably not at the scale where it would impact appreciation rates of recent times.
21. Senescence-Misinfluence Tendency
Regarding age-related deterioration, well although parts of my beard are starting to take on decidedly gray undertones, I think I still have a ways before would be considered a white beard. Game on.
22. Authority-Misinfluence Tendency
This is one area where Bitcoin has an advantage. Being built off of a completely decentralized network, there is no charismatic CEO to distract from the fundamentals of the platform. In fact the decentralized nature of bitcoin I would consider both its greatest strength and its greatest weakness. Because it is distributed, any questions of motives or agenda is settled to the openly debated majority rule of miners, however it is that same governance structure that makes steering course a slow and cumbersome process.
23. Twaddle Tendency
This is one area where we have to be vigilant as we let our curiosity take us forth amongst the collective din of bitcoin evangelists and wanna be analysts. Munger tells of a scientific experiment where scientists place a nectar source high above a beehive. When some lucky honeybee returns from this discovery to tell his kin via interpretive dance, well he just doesn’t have the vocabulary to communicate what’s going on, none of them do, and he just dances around like a buffoon. It remains an open question whether bitcoin is some new nectar source from a direction we are unaccustomed to, whether we lack sufficient vocabulary to accommodate a new investing vehicle. My take is that we mostly do have vocabulary for what is going on. A bubble is what happens when speculation causes security prices to significantly exceed that as would be suggested by fundamentals. For most securities these fundamentals constitute future cash flows. Lacking this feature, I just can’t think of bitcoin as an investment vehicle, at best it is a protocol for digital transactions with artificial scarcity that bears resemblance to commodities. The word tulips gets thrown around a lot and I think there are some similarities to this kind of mania in the present conditions — where it differs is the potential for incorporation into a whole slew of use cases which will could lead to transaction volumes far exceeding those of the speculative market. Without the future cash flows as a metric, transaction volume is the closest thing I can find for a fundamental feature which we can use to derive a valuation. If bitcoin becomes the backbone of the financial internet, then valuations even exceeding the present day may be one day justified. But the simple fact is that we are at present far removed from any use case other than speculation, and although bitcoin certainly has the scale advantage, I expect that it’s dysfunctional governance (try googling the scalability problem for instance) is the biggest obstacle to that kind of success. If the bitcoin protocol of today were sufficient to back the financial system of the future, then I think we could go ahead and proclaim them the winner now. I don’t consider myself an expert, but as the miners (who collectively have huge sunk costs in hardware infrastructure) are the ones making the decisions I expect there will continue to be a bias to status quo. The word nimble is not in the vocabulary.
24. Reason-Respecting Tendency
The key point here is that even a person given meaningless or incorrect reasons will increase compliance with suggestions. For example it’s entirely possible that my rationale given in preceding section was nothing but twaddle, I am an outsider and I do not follow this space very closely. These are just impressions that I have picked up upon the way. Frankly, the ability to vocalize a rationale is not as important as the ability to get results — you’re much better off throwing your lot in with a proven risk-taker than a Harvard professor ‘lecturing birds on how to fly’ as Nassim Taleb is known to say.
25. Lollapalooza Tendency — The Tendency to Get Extreme Confluences of Psychological Acting in Favor of a Particular Outcome
I’ll now try to wrap things up by listing the confluence of factors impacting the bitcoin mania. Here goes nothing:
The Reward and Punishment Superresponse Tendency is causing those who received some early success in bitcoin appreciation to adopt it as their global solution for investment, exasperated by an Inconsistency-Avoidance Tendency preventing them from considering when an appropriate time is for exit. As others discover the success from the early adopters, Eny/Jealousy Tendency drives them to seek to duplicate, and like a man who get’s lucky on his first trip to a casino, Influence-from-Mere Association Tendency converts them as well, after which Excessive Self-Regard Tendency and Overoptimism Tendency reinforces their position, after all with so much Social-Proof what could possibly go wrong?