Becoming A Better Investor: Contrast-Misreaction Tendency

Legendary investor and former Berkshire Hathaway Chairman Charlie Munger is well-known for his work, Poor Charlie’s Almanac. In it, he highlighted 25 psychological tendencies or biases that he felt governed how humans make decisions. (These are decisions we make in work, life, investing and beyond.) Understanding these tendencies is useful when it comes to investing: because when we recognise and understand the effect of these biases, we can avoid making mistakes while investing and make more rational choices.

This week, we’re analysing the sixteenth tendency, the Contrast-Misreaction Tendency

What is it?

The Contrast-Misreaction Tendency refers to the value we attach to things, based on the reference points to experience we have. Our judgments are shaped more by comparisons than by absolute values, often distorting our perception. Instead of assessing something based on its intrinsic worth, we tend to evaluate it by comparing it to other options or reference points. We tend to overreact to stark contrasts, but underreact to subtle differences.

Munger explains it based on our sense of sight, saying: “The eyes have a solution that limits their programming needs: the contrast in what is seen is registered. And as in sight, so does it go, largely, in the other senses. Moreover, as perception goes, so goes cognition. The result is man’s Contrast-Misreaction Tendency.”

Munger illustrates this further with an example of how salespeople operate. To make a regular price appear like a bargain, vendors often inflate a fake, much higher price — which would never be accepted by the customer — and then present the actual, intended price as a significant discount. This tactic can still be effective even when customers recognise the manipulation. It helps explain the prevalence of such pricing strategies in newspaper advertising and highlights a key insight: simply being aware of psychological tricks doesn’t always protect us from their influence.

How does this tendency play out in the world of investing?

In the world of investing, this tendency may push us to make investments because we perceive them as valuable, and not necessarily because they are fundamentally good.

For example, if the value of a particular company declines, we race to invest in it, not because we believe in the company’s fundamentals, but simply because it is now at a more attractive price point, which we see as a bargain. This bias can also show up in terms of how information is framed. Let’s say we suffer a quarterly loss of 5% on our investments. But because our fund managers tell us the markets have slumped by 10% that quarter, we feel it isn’t such a loss.

So how can we be sure that we are investing for the right reasons, and not because something feels like a bargain?

• Focus on the intrinsic value: Don’t invest based on what something used to be worth. We must ask ourselves what the business is actually worth today, whether the facts and fundamentals are strong, and whether we would invest based on the data, irrespective of the price.
• Stay neutral: Never fall in love with a stock, or the idea of owning a stock. We should avoid emotional reactions to gains and losses, and the rise and fall of the markets. Your investment decisions should be grounded in logic, and the knowledge that gains and losses are part of the game, especially when you are investing for the long-term.
• Take your time: Don’t jump into making an investment because it “looks attractive.” We need to slow down, take our time, look at the company’s filings and reports, remove the assumptions and the influence of contrasts. Would we invest in this company based on the data at hand? That is what we should take into account.

The Contrast Misreaction Tendency may seem innocuous, especially if we are investing when it feels like a bargain. But it can lead to overconfidence, poor judgement, and losses, if we’re not prudent, which is why Munger advises us to be careful and recognise this bias when it creeps in.