Munger on Why Economics Needs Psychology

In his 2000 speech at the Philanthropy Roundtable, legendary investor Charlie Munger introduced some interesting concepts, such as the concept of “febezzle,” which we explored in the previous blog. Febezzle or functionally equivalent bezzle (a contraction of embezzlement), is described as the illusion of wealth created by rising asset prices and wasteful financial practices.

While criminal embezzlement is more tangible, febezzle occurs as a result of self-delusion, rising bull markets, or irrational institutional behaviour that leads to bad-decision making. The underlying theme in much of Munger’s work, including this speech, is the role psychology plays in investing. And he reiterates that in this speech, talking about why economics needs psychology.

Why psychology cannot be ignored

In his speech, Munger says, “Your mistaken professors were too much influenced by ‘rational man’ models of human behaviour from economics and too little by ‘foolish man’ models from psychology and real-world experience.” He argues that economic theory often starts with the assumption that the investor or decision-maker is completely rational, while in real life, people are influenced by emotions, incentives, social pressure, overconfidence, and fear. He says there are a number of ways psychology influences investment decisions.

• Rationality cannot be assumed: Economic models often rely on assumptions about how people should behave when making financial decisions, when in reality, decisions are rarely straightforward. Investors may buy an asset because its price has been rising, sell it because everyone else is selling, or spend more simply because their investment portfolio increases in value. People often spend more in response to a psychological sense of greater wealth, when the actual value generated isn’t much. Munger says these behaviours need to be taken into account because they are a fundamental part of how markets work.
• Smart people can (and do) make bad decisions: Psychology doesn't just affect inexperienced investors. Munger's concept of “crowd folly,” discussed in the previous blog, highlights how even the most intelligent people make poor decisions when they are influenced by the behaviour of the people around them. Institutional investors, for example, may feel pressure to follow conventional investment practices because being different from everyone else can pose a professional risk.
• Incentives also shape behaviour: Munger also highlights the importance of incentives in understanding financial behaviour. An investment manager who earns fees for managing money has an incentive to keep managing money. Similarly, investors may also have incentives to chase recent performance, switch managers or adopt increasingly complicated investment strategies. These incentives may look attractive on paper, but when you take it as a whole, they can produce outcomes that aren't necessarily in the best interests of investors.

The enduring lesson…

Munger isn’t saying that economics and numbers don’t matter, but that numbers alone cannot explain an economy that’s run by human beings. Markets are ultimately driven by people, and people are influenced by psychology and emotions. They can become overconfident, follow the crowd, have knee-jerk reactions to incentives and market movements, and confuse rising prices for genuine wealth — all of which can lead to poor decision-making.

This is why Munger advocates using different “thinking tools” to navigate complex problems. Economics is one tool, and psychology another. Using both is what leads to understanding the complete picture and making better investment decisions.