The
Compounding Success Theory
Behavioral Finance Factors that Contribute to the
Successful Investment Decisions made by
Warren Buffett and Charlie Munger
arranged and
edited by Cesar "Bud" Labitan, Jr. MD MBA
Purdue
University
April 29, 2003
Framing in behavioral finance is the choosing of particular words to present a given set of facts. And, framing can influence our choices. Tversky and Kahneman described "Prospect Theory" in 1979 using framed questions. They found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They also found that individuals are much more distressed by prospective losses than they are happy by equivalent gains. Some have concluded that investors typically consider the loss of $1 twice as painful as the pleasure received from a $1 gain. Others believe that this work helps to explain patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty. An increasing body of literature on framing supports a tendency for people to take more risks when seeking to avoid losses as opposed to securing gains. Takemura (1992) showed that the effects of framing are likely to be lower when subjects are warned in advance that they will be required to justify their choices, and when more time is allowed for arriving at their choices.
Buffett and Munger have employed the principles taught by Dave Dodd and Ben Graham. In my view, Buffett and Munger overcome the conventional framing effects thru rational and thorough business analysis. They simply avoid getting into judgments in some fields. In my paper, I presented ten factors for consideration as ones that contribute to the compounding success of the Graham-Dodd-Buffett-Munger investment approach:
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Rational and thorough business analysis, with keen emotional intellects that promote ethical information exchange.
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Wide experience with analyzing and managing numerous different businesses.
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Charlie Munger's Role as (a.) "Devils-Advocate" (Munger as therapist/analyst of investment decisions) and (b.) Munger's role in encouraging further limiting the portfolio towards "wonderful businesses."
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Leverage via a Low Cost of Capital from Insurance Operations
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Disciplined Tracking of Understandable Businesses
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Analysis of Strategic and Sustainable Competitive Advantages of Industries and Businesses. Both men have a variety of operational business experiences.)
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Trustworthy First-Class Managements with proven track records.
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Ben Graham's Mr. Market and search for the Margin of Safety. M.O.S. is the bargain obtained when purchasing at a market price below the intrinsic value estimation. Graham and Dodd taught: "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return."
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Satisfaction: Buffett stated: "Though "working" means nothing to me financially, I love doing it at Berkshire for some simple reasons: It gives me a sense of achievement, a freedom to act as I see fit and an opportunity to interact daily with people I like and trust."
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Learning from Practice, Mistakes, and Experiences: "After many years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them."
Next, I asked myself: Is it the superiority of the decision or the superiority of the analysis that precedes the decision? In my view, the superiority of results achieved by Buffett and Munger are the result of the prudent allocation of capital after careful business, industry, and competitive analysis. From this point forward, proof is given in the words used to illustrate these concepts listed. The text is taken from the publicly available writings of Warren Buffett to the shareholders of Berkshire Hathaway Inc. While attempting to avoid taking ideas out of context, I have condensed and rearranged some of Warren Buffett's sentences to illustrate his and Charlie Munger's behavioral finance factors that contribute to their successful investment decision making process. I have also taken the liberty to rearrange sections into the ten major factor areas. [See http://www.frips.com/cst.htm]
Examples of ideas that illustrate these ten factors are presented in the ten divided sections and additional frames within the body of this document. The ten factors presented were derived from the writings of Warren Buffett. Buffett and Munger have said that their investment behaviors are based on rational and thorough business analysis. In my view, the writings also illustrate their keen emotional intellects and their value of ethical information exchange. Many of the opportunities presented to them were made available through friendships, referrals, and previous business associations. I believe that by looking into the writings of Warren Buffett from his "frame of reference", we gain insights into his and Charlie Munger's successful rational investment decision making processes. In addition, other small "frames" of his thinking were presented for your review. Mr. Buffett once described steps 5-8 as his sequential filter criteria in selecting a company/equity for purchase. Furthermore, a look at factors 3, 6, and 7 illustrates the catalytic effect of Mr. Munger's influence.
Mr. Munger has amplified their success by assisting and influencing Mr. Buffett's selectivity towards focused concentration in higher quality companies called "wonderful businesses". Only Mr. Buffett and Mr. Munger know the validity and weights of this multifactorial proposition or model. However, I contend that this Compounding Success Theory label provides a framework that unifies the ideas of Graham, Dodd, Buffett, and Munger into an academic field worthy of deeper examination.
©
2003 Bud Labitan
Further
Reference
Links to a 9 minute audio summary of my masters paper.
mp3 format: http://www.frips.com/cst.mp3
realmedia format: http://www.frips.com/cst.rm
Contact
Info for Bud Labitan
Author
Email
research tool: http://www.frips.com/ybr.htm
cv: http://www.frips.com/resume.htm
project: http://www.frips.com/cst.htm
ebook: http://www.frips.com/wbbf.htm
poem: http://www.frips.com/poem.htm
workbook: http://www.frips.com/brkiv.xls
