Hello friends, thanks for the overwhelming response to my last article in which we have discussed what The Lollapalooza Effect is. Anything could be the impact, negative or positive, of this type of phenomenon on the market. In this article, we are going to discuss, How it is involved in the market and what is the solution?
The term was first coined by a super American investor and partner of Warren Buffett, Charlie Munger. If you do not know who Charlie Munger is, then here is a little brief about him.
Charlie Munger is a great American investor and is the Vice-Chairman of Berkshire Hathaway. He is considered Warren Buffett’s right-hand man. Together with their investing intelligence, they created huge wealth for Berkshire Hathaway. Trained as a meteorologist during World War II and as a lawyer from Havard before devoting his full time to business. Eventually, he studied psychology, economics and various streams of science, which helped him develop a system of “multiple mental models” for navigating problems in various complex social systems. And, one of his models is the Lollapalooza Effect.
It is believed that Charlie Munger has a huge influence on Buffett’s investment philosophy, and Buffett himself calls Munger an investment genius. His investment philosophy is based on the principle of sticking to what you know (area of competence) and acting only when the time is right.
Now, let’s move on to know what the Lollapalooza Effect in investing is?
The lollapalooza effect explains the inherent biases, tendencies and mental models that act in tandem in the same direction towards a particular action. It creates a potentially large scale impact and can lead to either a positive or negative outcome.
We can better explain the lollapalooza effect through an open outcry auction system. Following are the typical actions involved in an auction and how human biases work.
Reciprocity: Suppose you are invited to an auction as a participant, so you are mentally motivated to bid due to reciprocity. Like “I should place a bid because I’m invited”.
Consistency: I should buy or bid for this product, as I like it very much.
Commitment Tendency: I will continue the bidding process, as I’m already into it.
Social Proof: I know the product is good because others are also bidding for it.
Auctions are the worst example of the Lollapalooza Effect.
Do you remember how Tata Steel acquired the Corus? How Tata has to outbid Brazilian steel-maker CSN. In this process, Tata has to pay almost 34% higher than their original offer. Tata Steel took huge debt to finance the takeover.
For Tata’s, the acquisition was a huge mistake, and to date, they have never recovered fully from it.
How does The Lollapalooza Effect work in Stock Market Investing?
The process of buy and selling the stock in the market is just like one big auction house, where you can bid and ask price for a particular security, and millions of such orders are placed simultaneously. And, compared to the open outcry auction system, where the auctioneer feeds the inherent biases and other tendencies into participants, here in the stock market, the 24/7 media house does that job.
There are numerous developments and motivations in the market, which results in the price movement and volatility in stocks. And, the ability to monitor the security prices in real-time leads to short-termism among investors. Further, it leads to impulsive buying and selling.
Social media, too, influences the behaviour of investors, where investors can select to be amongst like-minded people and get social validation of their investment decision. And, no matter how hard the investor tries to remain neutral, at some point, S/he gets swayed away by biases, as it all happens in the subconscious mind. That’s what Charlie Munger refers to as the lollapalooza effect.
It often leads to human misjudgement, and for a successful investor, it is important to identify and avoid the lollapalooza effect. The only way to escape is by limiting your exposure to such factors that create biases and influences your decision-making ability.
The Lollapalooza Effect causes millions of investors to buy one sector, sell off another one, and act as a “herd.” This herd mentality is the worst enemy for an Investor. After all, if you sell when everyone else is selling, then you’re probably eating huge losses. If you do the opposite and buy when everyone else is selling, then you’re likely getting bargain prices for your shares. So, before you invest, it’s wise to think about how different psychological factors might be causing an irrational reaction in the market?
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Let us focus on the solution. Before discussing read this
The Pope: “Tell me the secret of your genius. How have you created the statue of David, the masterpiece of all masterpieces?”
Michelangelo: “It’s simple. I removed everything that is not David.”
That is very simple to say but very tough to follow. For removing everything, that is not David, first of all, we should know David thoroughly, then only we can judge what is not David. The same approach is required while investing in building a sustainable portfolio.
Why do we choose one behaviour over another, and why are we biased in our thinking? Mental models can determine why this happens?
First of all, we have to understand what is mental models are?
Mental models are nothing but our brain’s environment, which presents a way of perceiving and reacting to the world. These tools are the basis for our psychological tendencies, which determine why we choose one behaviour over another and why we are inherently biased.
While the recognition of our psychological tendencies is in itself a step forward, developing new mental models – no matter how difficult – is like developing a new way of thinking. It is reformed thinking which can guide us to strategise and make better decisions.
Munger, while explaining the faults in our thinking, invokes the following quote: “To the man with only a hammer, every problem looks like a nail” and recommends the development of a “latticework of mental models”, which can prevent us from solely blindly wielding a hammer. The quest must instead be to explore our minds for greater success.
The most dreadful example of “social proof” and succumbing to authority (“authority mis-influence”) has been the Milgram experiment where participants were instructed to administer electric shocks to “learners”. The experiment found that the participants, although reluctantly, agreed to the inhumane task and led the scientific community to draw parallels between this exercise and the holocaust.
It is clear that our psychological tendencies and biases play a big role in how we lead our lives, but now that we are armed with this rare awareness, can we use it to change our thinking for betterment in life and work?
Mental Model #1: Using “Social Proof” to your benefit:
This can also be called the herd instinct, where you think and act like others around you. In a workplace, herd instinct leads to uninspiring, run-of-the-mill thinking that doesn’t help the company.
If you’re following the herd instinct, you’re not thinking for yourself and are instead blindly following the social norm and practices. When businesses have to grow, herd instinct is a confirmed dampener. It must be each of our pursuits to ensure that we use our time, not to parrot other people’s views, but develop original, insightful analyses that can help our progress at the workplace.
However, it’s worth noting that herd might not be all bad. There are communities, such as Alcoholics Anonymous, where being part of them and using our tendency of imitating others can help us live more valuable lives.
Mental Model #2: Using First Principles:
Write down your goals to understand where you want to go.
Elon Musk, James Clear writes, ran into a major challenge while forming his company SpaceX: the astronomical cost of purchasing a rocket. Instead of giving in, he looked at first principles and decided to build a rocket from scratch. Today, other companies are 3D printing entire rockets to bring costs down even further. This is, in fact, a result of First Principles thinking.
What first principles thinking suggests is that we must dig deeper till we are left with the foundational truths of the problem.
To accomplish first principles thinking in day-to-day life, one must look beyond acknowledging the problems and ask: What is the core issue? What is my goal? Why does it matter?
Mental Model #3: Ditching Confirmation Bias, Embracing Rationality:
The problem, however, is that we ignore the ‘why’ and disconfirm available evidence. This means that we develop a bias so strong that any contrary information is automatically filtered out. Just like how we are behaving while discussing on SIP.
Our failing to evaluate an unbiased position leads to what should be a carnal business sin, irrationality.
Charles Darwin, for example, trained himself to consciously pay attention to any evidence that would disprove what he had worked on so far. He did, which was the opposite of confirmation bias. In fact, he particularly paid more attention to the corollaries the better he thought his hypothesis was. Warren Buffett, much to Munger’s delight, is credited with similar psychological insight.
Therefore, mental models, although difficult to follow, have the potential to change our minds. We might all suffer from cognitive faults and shortcomings, but a conscious effort to reject biases and adopt rationality can effectively transform how we think and act in life.
Next week we will discuss “How The Lollapalooza Effect is working in SIP Marketing.“
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