Charlie Munger’s speech on The Psychology of Human Misjudgement (1995)

Charlie Munger’s speech on The Psychology of Human Misjudgement (1995)

Charlie Munger has delivered a talk which is titled the ‘Psychology of Human Misjudgement’. Even though Munger is not a clinical psychologist, the talk embedded below is a landmark in the field of Behavioral Investing. For additional clarity, it is essential to read the transcript of the speech, while listening to it. You can do that by clicking Charlie Munger’s speech at Harvard University in June 1995.

The Power of Incentives

Edward Thorndike and B.F. Skinner – Operant Conditioning and the Law of Effect-Reinforcement

Operant conditioning refers to the method of learning that occurs through rewards and punishment. From the time we are born, that’s how all of us learn. The words ‘operant condition’ imply that we tend to make an association between a particular behaviour and the related consequence.

Edward Thorndike was the psychologist who put forward the ‘Law of Effect’. It stated that any behaviour that is followed by a pleasant consequence is likely to be repeated, and any action that results in an unpleasant outcome will be stopped.

B.F.Skinner built on the work of Thorndike. He is regarded as the father of ‘Operant Conditioning’, but he drew on Thorndike’s work on the ‘Law of Effect’. It became clear to Skinner that it made sense to study human behaviour rather than to explore the mind. Instead of expecting people to be intuitive, it made sense to try and control their environment as a means of influencing their behaviour.

Thorndike had proved that pleasant outcomes cause repetitive behaviour and vice-versa. Skinner expanded on the concept and introduced a term called the ‘Law of Effect-Reinforcement’. He concluded that behaviour that is rewarded or reinforced tends to be repeated and behaviour that is not reinforced tends to die out. Skinner conducted most of his experiments on animals and ultimately concluded that humans behave similarly. He drew a parallel between the variable ratio schedule of reinforcement among pigeons and that of the way humans behaved when they gamble using slot machines. In other words, he took the art of ‘pattern recognition’ to a different level altogether.

Skinner identified three types of ‘operant conditions’ or put it in simple terms, three types of behavioural responses. These were:

Neutral Behaviour. The responses from an environment that do not have any effect on the repetitive nature of the behaviour.
Reinforcer Behaviour. These are outcomes that increase the probability of the behaviour being repeated in a similar environment. The resultant behaviour can either be positive or negative.
Punishing Behaviour. Situations wherein similar environments will not cause the behaviour to be repeated. Punishment weakens behaviour.

What Skinner did was not as simple as it sounds. Human Behaviour is notoriously erratic and unpredictable, and there are exceptions. For example, there is a very thin line between what can be construed as a punishment and what can be thought of as negative reinforcement. Also, punishment can have some strange undesirable consequences. For example, depending upon the person:

The punished behaviour is not forgotten, and it returns in the absence of the punishment.
Punishment can result in aggression.
Punishment can create fear or dislike for the person who dishes out the same.
Whereas reinforcements tend to direct us towards a particular behaviour, they are rampantly misused.

Freakonomics and the Power of Incentives

Incentives & Conflict of Interest

Upton Sinclair a famous American novelist has said: ’It is difficult to get a man to understand something when his salary depends on his not understanding it.’ That, in a nutshell, is what conflict of interest is all about. Warren Buffett has famously said” ‘don’t ask a barber whether you need a haircut.’ The official definition is: “A conflict of interest is a set of circumstances that creates a risk that professional judgement or actions regarding a primary interest will be unduly influenced by a secondary interest.”

Dan Ariely – The Price of FREE

Pavlov’s Dogs & Classical Conditioning

In the English language, the words a ‘Pavlovian Response’ is commonly used as a metaphor for an unthinking popular response to stimulus; as a result, the word ‘Pavlovian’ has been divorced in the public consciousness from physical reality.

Pavlovian Responses are commonly seen among those who resort to substance abuse. For example, a drug addict will generally have a specific regular place to consume drugs. A connection is established between the substance abuse and the place at which it takes place. Similarly, when we are not careful, we too can train ourselves into Pavlovian Responses that, at times, can sometimes become dangerous at some later stage. In the stock market, the blue colour generates a Pavlovian reaction, as does the colour red. On Saturdays for example, traders suffer from withdrawal syndrome.

For example, when the Indian cricket team plays Pakistan and wins, it brings about a ‘Pavlovian Response’ among Indian cricket fans. For the most part, a Pavlovian response is a physical, not a psychological, reaction.

Ivan Pavlov was a Russian physiologist (Pavlov was not a psychologist), who won the Nobel Prize for his work in digestive processes in 1904. While studying these processes, he discovered by accident that the dogs whose digestive processes he was studying, would salivate whenever a research assistant of Pavlov entered the room. On further research, he found that dogs could be trained to drool (salivate) in response to other stimuli as well.

As part of his research, Pavlov would measure saliva production when different items were introduced. Salivation is a reflexive process, it occurs automatically in response to a specific stimulus and is not under conscious control. What Pavlov realised was that the dogs would begin to salivate in the absence of food and smell. He concluded that salivation was not an automatic process but in fact a learned response. The dogs were responding to the sight of the research assistants wearing lab coats since they had come to associate the sight of the lab coats with the presentation of food. Pavlov differentiated between, salivation that occurs on the presentation of food as an unconditioned reflex and the salivation that occurs in the expectation of food (lab assistants in lab coats), as a conditioned reflex.

Classical Conditioning as it is now called, involves forming an association between two stimuli resulting in a learned response. It has three parts:

The first part of the classical conditioning process requires a naturally occurring stimulus that will automatically elicit a response – for example, salivating in response to the smell of food. The unconditional stimulus (food), results in an unconditional response (salivation). In other words, there is the unconditioned stimulus (the smell of food makes the dog feel hungry), and there is an unconditioned response (the salivation).
The second part is what is called classical conditioning. At this point, a neutral stimulus that produces no effect (as yet) is introduced. Herein, the hitherto neutral stimulus (ringing a bell) is repeatedly paired with the unconditioned stimulus (the smell of food). As a result, an association develops between what was a neutral stimulus, and the unconditioned stimulus, and it generates a conditioned response.
In the third part, Pavlov observed that once this association has been formed, presenting the conditioned stimulus (which was earlier the neutral stimulus) alone, will evoke the conditioned response.

Pavlov’s research and findings, established beyond doubt that in the real world, all learning happens through interactions with the environment; environment shapes behaviour. Pavlov’s research is being extensively used today by dog trainers and for conditioning other pets. Among human applications, technology companies use these techniques for increasing user engagement. In the world of medicine, therapists use classical conditioning for treating patients with anxieties and phobias by pairing their phobias with relaxation techniques. It is also being used in classroom environments.

Difference Between Operant Conditioning Classical Conditioning

Robert Cialdini – ‘Influence: The Psychology of Persuasion’

Charlie Munger refers to mental models as those that we use to understand the world. Our mental models, in turn, are dependent on our perceptions of reality and our ‘belief system’. To be sure, our decision-making process follows our ‘belief system’ in the following manner:

Each of us lives life using a view of the world and reality
Each of us has our independent version of reality and our views evolve as we get older.
Our version of ‘reality’ keeps changing, and we update our beliefs based on our experiences. For example, as kids, we are taught to pray and have a strong belief in the existence of God. We use ‘God’ as the ‘filter’ for our ‘belief system’ because it makes us happy. We are not interested in reality as long as our current filter makes us happy. As we age, our belief in God fades. We find a new screen (filter) and a new idea (belief) of how the world works; this process continues throughout our lives.
At all times, we assume that our version of reality is correct and all others are wrong. Since we are born with and continue to evolve in this ‘belief system’, it follows that our decision-making is a function of what we believe.

What if someone or something were able to persuade us to change our beliefs? Effectively, that person or thing would be able to ‘influence’ our decision making. Since ‘Persuasion’ is all about using techniques to change peoples minds, it follows that individuals who are persuasive and have mastered the skill of persuasion can be one-up on the rest. History is replete with examples of great leaders who were known for their persuasive skills. In other words, ‘Persuasion’ is a useful ‘filter’ in our behavioural arsenal, (assuming it is not misused).

Robert Cialdini is the author of ‘Influence: The Psychology of Persuasion’ In the book, he talks about the six principles which can be used to persuade others to behave in a way that we want them too. According to Cialdini, we can use these six principles to ’influence’ the ‘decision-making process’. Since the book was published, it has been used by marketers both overtly and covertly; it is now considered a bible in the science of persuasion.

Reciprocity

The ’Principle of Reciprocity’ states that we humans are wired to return favours and pay back our debts. It doesn’t apply just to actual debts, but even debts of gratitude. According to the principle of Reciprocity, we feel obliged to provide concessions to others if we think that we have received the same from them in the past. Why does it work the way it does? Because reciprocity by and of itself is a compellin human emotion. There are two conditions that we should remember while using this principle, these are (a) always be the first to give and (b) there should be a surprise element in our giving. In other words, the idea is to underpromise and then overdeliver at all times.

Commitment

The ’Principle of Commitment and Consistency’ states that it is an inherent part of our self-esteem to be seen as consistent. Hence, once we publicly commit to something or someone, the probability of our delivering on that commitment is higher than it otherwise would have been. In other words, we tend to stay ‘consistent’ with our commitment. If we have agreed and committed to an idea or an act, we have a difficult time breaking that commitment. What happens is that once we have publicly stated our commitment, we inadvertently start identifying our commitment with our self-image. Once that happens, we stay consistent with our commitment. Unbeknownst to us, our prior commitment is the key to our subsequent consistent behaviour. The best antidote is to have strong opinions but to hold them weakly. In other words, we should be willing to rethink and change our views and take the other side of the argument, if we were wrong to start with.

Social Proof

Simply stated we tend to behave in a manner that we observe other people are acting. If we are the only one doing something or behaving in a certain way, we tend to feel inhibited by our behaviour. By being part of a group or cohort, we tend to feel ‘safe’; we not only feel at ease but we also feel reassured that we are making the right decision. Unfortunately, most of us tend to follow what the others are doing blindly; the logic being that if everyone else is doing something, it must be the right ergo the safest thing to do. Why does ‘social proof’ work as a persuasion technique? We tend to assume that if a lot of people are doing something or acting in a certain way, they must know something that we don’t. It works when we are uncertain about something, and we rely on the collective wisdom of the crowd to guide us. Benjamin Graham has famously said: ‘You are neither right nor wrong because the crowd disagrees with you; you are right because your data and reasoning are correct’. In the markets, what seems safe is infinitely dangerous.

The video above is a bit dated. However, human behaviour has remained the same since aeons and there is no reason to believe that technological advances have forced any change. On the contrary, technology has entrenched our behavioural biases and ‘social’ has played a huge role in allowing this to happen. Watch the video below to confirm that social proof still works.

Authority

People are inclined to listen to an authority figure. Moreover, we trust authority figures and abide by their ruling without questioning the sanctity of what is stated or demanded. As a result, the task of persuasion becomes far more manageable. We see this principle being used when we watch advertisements showing us figures of authority endorsing a brand or a product. Cialdini differentiates between someone who is ‘in authority’ and another person who is ‘an authority’. Someone who is ‘in authority’, has a title, ranking or similar trappings of authority. Another person who is ‘an authority’, is more persuasive because he or she has superior knowledge, experience or expertise in the specific area or subject.

The Miligram Experiment

The Milgram Experiment is by far the crudest live experiment conducted to test the efficacy of the Principle of Authority. In World War II, many soldiers and their higher-ups committed atrocities – were they just following orders or were they accomplices of Adolf Hitler? In other words, Milgram was trying to find out whether these soldiers were complicit in the war crimes committed by Adolf Hitler or were they merely following the authority figure and obeying instructions?

Liking

If we like someone, the probabilities of that person influencing our decision making are higher. As a result, when we are asked for a favour, the probabilities of our saying no to a stranger over a friend are higher. This is also the reason why referrals from prior clients tend to bring in new ones. By using referrals to our advantage we can get a ’foot in the door’ at times when it would not have been otherwise possible to do so. In the world of selling and marketing, the idea is to build ‘likability’ by building a rapport with one’s customer.
We see this in the world of finance and investing in an inverse manner. We don’t want to invest with a Promoter who we dislike or we refuse to learn from someone we dislike.
This principle also has another manifestation. Since we are in love with ourselves, we like our ideas and cling on to them. Richard Feynman the famous Physicist has said: ’the first principle is that you must not fool yourself and you are the easiest person to fool’

Scarcity

The value of a product or service becomes more valuable if the supply of the same is perceived as being limited or scarce. In other words, people see that they’ll be missing out on something vital unless they act quickly. Hence, the last day of a shopping festival or a discount bonanza tends to attract the most significant traffic. In reality, all of us know that its a gimmick, yet we fall for it almost every time. Cialdini points out that the scarcity principal trades on our weakness for shortcuts; it hinders our ability to think. We need to ask ourselves the question. ‘and then what’ and ‘think things through’, to mitigate the effects of the scarcity principle.

The Boiling Frog Syndrome

If we put a frog in boiling water, it jumps out. But, if we put a frog in water of normal temperature and then heat the water very slowly, the frog is oblivious to the rise in the temperature of the water; the frog’s body adjusts to the rise in the temperature of the water that surrounds it. However, when the temperature becomes unbearable for the frog, it has lost all its energy in acclimatising itself to the rise in the temperature and is unable to jump, ergo it dies. The behaviour pattern of the frog relates to human behaviour in the following manner:

We tend to tolerate harmful situations or loss-making situations for far longer than we should. The principle is ’what can’t be cured, has to be endured’. It is visible in the world of finance and investing.
Many a time, our emotions come in the way of rational decision-making. Staying wrong is far worse than being wrong. We have to decide when to jump out of our mistakes; else we become ‘boiling frogs’. It is particularly true in the case of our relationships.
In today’s disruptive world, boiling frog syndrome is visible among scores of businesses whose business models have been decimated due to the advent of the internet.

The only way to combat the boiling frog syndrome is to embrace change. The best way of embracing change is to unlearn what we have learnt. Why do we need to unlearn what we have already learnt? The primary reason is technological change. Times have changed, beliefs that were true are now false, routes have changed and so have maps (the old maps are redundant). Apart from the changes brought about by technological innovation, there has also been a change in our environment. Ways and means that worked earlier have stopped working. In other words, those who don’t embrace change are destined to become boiling frogs. Someone has rightly said: change is the most unchanging feature of our lives.

Learning, Unlearning and then Re-Learning

To embrace change, we need to be able to unlearn what we have previously learnt and then re-learn the new stuff to stay up-to-date. John Cage, the famous American artist and philosopher, has said: ’I can’t understand why people are frightened of new ideas, I’m frightened of the old ones’. What the Boiling Frog Syndrome teaches us is that just adding knowledge and being resistant to the changes in our environment is useless. We not only have to add to our understanding almost on a continuous basis, but we also need to learn how to subtract from what we think we know. The problem is that in our minds adding to our knowledge is deeply ingrained. Subtracting from our knowledge is not part of our mindset; we have to learn how to subtract stuff that is already with us; that is not as easy as it sounds. How do we add and subtract at the same time? OR How does one unlearn and adapt to change? The following might help:

Doubt what you know. It would automatically mean getting out of the habit of saying that you know something and embracing the power of saying ‘I don’t know’. The problem is that today everyone knows everything, but very few of us knows things well enough.
Look for validation of the things that you think you know, by asking the question: ‘does my way of thinking or doing things, still work?’
Embrace the latest technological trends and understand how they are disrupting things that you thought you knew. For items that have moved beyond your scope of expertise, embrace the power of ‘I don’t know’ or ‘just move on to something else’. In other words, jump out before it’s too late, you can always jump back in.
The most important thing to remember is that the process of learning, unlearning and then relearning, doesn’t stop just because one has aged. It’s a lifelong process, and one just has to keep updating one’s beliefs, and adapting to the changes.

The New Coke Syndrome

In 1985 The Coca-Cola company introduced a ‘New Coke’ and decided to abandon the old formula by which coke had been prepared. Within three months, they abandoned the ‘New Coke’ and reintroduced the old one. What happened? It seems that Coke as a product/brand mattered in peoples lives. Drinking Coke had become a part of their lifestyle. When it became unavailable, there was a backlash and an adverse reaction. Even the Coca-Cola company didn’t realise the power of their brand.

The following is their version of what went wrong published on their website under the title: What New Coke Continues to Teach Us 30 Years Later:

Safe to say, from this vantage point, that New Coke taught The Coca-Cola Company some valuable lessons. First: don’t mess with something that can’t be improved. Second: the people who enjoy our brands ultimately own them. Many still ask: if we valued the Secret Formula of Coca-Cola enough to keep it in a bank vault, why would we consider changing it? A very good question. Part of the issue was seeing our flagship beverage lose ground in the face of intense competition. Meanwhile, our very extensive and secretive research showed that people preferred the taste of New Coke. The research, however, was based almost entirely on sip tests—a comparison of sips, not entire beverages, which made it deeply flawed. And we failed to understand or factor into our decision-making the intense connections between the people who loved Coca-Cola and the brand itself. When we launched New Coke, our company called it “the boldest single marketing move in the history of the packaged goods business.” Bold, yes. But not well-received. We received 7,000 phone calls of protest, which was a lot of feedback for the times. Imagine if there had been social media: bloggers shouting from the digital rooftops, flash mobs jamming the beverage aisles, our websites melting down. Frankly, we would have deserved it because we drew a moustache on the Mona Lisa. We broke faith with Coca-Cola’s fans. And we will never intentionally do so again. The second lesson becomes more obvious daily. Consumers take their brands personally—and seriously. And now more than ever, our brands are owned by the people who enjoy them. It was a lesson we should have known long before 1985. After all, The Coca-Cola Company didn’t coin the term “Coke.” That name was created by our fans and widely used by 1900. Our ads, meanwhile, urged people not to use nicknames, which could “encourage substitution.” Four decades later, in 1941, our people embraced the term “Coke.” Today, we’re striving to build a consumer-focused mindset across our business.

Mental Models

What is a mental model? Recurring concepts are called mental models. Once you are familiar with them, you can use them to quickly create a mental picture of a situation, which becomes a model that you can later apply in similar situations. Mental models are a tool set that can help you be wrong less by inverting the thinking process. Game Theory, which is the study of strategy and decision making in adversarial situations, is an example of a mental model. Game theory provides several foundational mental models to help you think critically about conflict. Game in this context refers to a simplified version of a conflict, in which players engage in an artificial scenario with well-defined rules and quantifiable outcomes, much like a board game. While constructing and using mental models, we rely on two fundamental human capabilities. These are Abstraction and Analogy. Abstraction is the ability to recognise specific concepts and situations as instances of a more general category. Abstraction is closely linked to analogy making. Analogy making is the ‘perception of common essence between two things’. Analogies, most often made unconsciously, are what underlie our abstraction abilities, and the formation of concepts. As Hofstadter and his coauthor, the psychologist Emmanuel Sander, stated, “Without concepts there can be no thought, and without analogies there can be no concepts.” Our common sense knowledge is governed by abstraction and analogy. What we call common sense cannot exist without these abilities.

How do we use Mental Models to understand and act appropriately in situations that we encounter? We have core knowledge of some concepts and there are others we learn throughout life. Our concepts are encoded in the brain as mental models that we can “run” (that is, simulate) in order to predict what is likely to happen in any situation or what could happen given any alteration we might imagine. Our concepts, ranging from simple words to complex situations, are formed via abstraction and analogy. Let’s use the example of Seeing v/s Observing. Just because you see something doesn’t mean you observe. Observation is more than seeing, its a mental process involving visual and thought. Often observation involves a conscious or unconscious linking to something that we already know, which brings us to an interesting point on how our experiences impact what we deem significant or not. Our experiences filter what we see. In other words, our observations have to be linked to our mental models so that it can lead to second order thinking. The role of the observer is to discriminate. Often the difference between the novice and the expert is the ability to quickly determine what’s relevant and what’s irrelevant, and mental models enable us to quickly ascertain these facts.

How do mental models work? Mental Models are representations of how the world works and they allow you to mentally “simulate” situations. Neuroscientists have very little understanding of how such mental models-or the mental simulations that “run” on them-emerge from the activities of billions of connected neurons. However, some prominent psychologists have proposed that one’s understanding of concepts and situations comes about precisely via these mental simulations-that is, activating memories of one’s own previous physical experience and imagining what actions one might take. Mental models also enable you to imagine what would happen if a particular event were to occur. In other words, mental models let you imagine different possible futures.

What is a Latticework of Mental Models? Mental models are how we understand the world. Based on our understanding of reality, we form connections between what we experience and how it will affect us. Munger encourages everyone to construct a latticework of models so you can effectively solve as many problems as possible. The idea is to fit a model to the problem and not, in his words, to “torture reality” to fit your model. In the words of Charlie Munger: ’Well, the first rule is that you can’t know anything if you just remember isolated facts and try and bang ’em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form. You’ve got to have models in your head. And you’ve got to array your experience both vicarious and direct on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and life. You’ve got to hang experience on a latticework of models in your head.’

How does Charlie Munger use Mental Models? Charlie Munger’s approach to investing is different from what other investors follow. While investing, Munger not only makes a comprehensive assessment of the internal workings of the business that he proposes to invest in, but he also analyzes the larger ecosystem in which the company operates. While doing so, he draws on his immense knowledge of the world at large, for each of which he has a separate mental model. Munger then proceeds to use his skills at pattern recognition to ‘stitch together’ a world view of the business. In this way, Munger combines analysis, tools and anecdotal evidence from a variety of disciplines, before he concludes. In his opinion, one needs to have roughly a hundred mental models to understand how the world works. According to Munger, multiple factors affect any and every business. Similarly, while investing, we must apply a latticework of mental models from a variety of disciplines before we commit to an investment. In other words, Charlie Munger uses a checklist of atypical investment factors from diverse disciplines and thinks that those of us who don’t follow this approach will go through life like the ‘man with the hammer, for whom every problem looks like a nail’. To summarise:

One must know the big ideas from the significant disciplines and use these ideas in conjunction with one another. Just knowing one subject, (for example, Economics) is not enough.
We need to have a separate checklist and different mental models for various companies.
We need to know and understand these mental models well enough to be able to teach them to someone. Just having a preliminary understanding of a discipline is not enough.
Our life experiences teach us many mental models if we are eager to learn. He says that one needs to update one belief system and models on an almost continuous basis. Once we have formed some models and are in the process of creating new ones, we are on our way.
Having done the hard work of forming models, we can now proceed to hang our actual and vicarious experiences on this ‘latticework of models‘ in a way that will enhance our cognitive skills. The word ‘latticework’ is interpreted as providing the context from which one can draw our insights and come to conclusions. The latticework helps in reducing the chaos and confusion of the investing process.

Mental models help us to become rational decision-makers in the following way:

Our ability to recognise and interpret patterns is based on our mental models. Having mental models is crucial for our reasoning abilities.
Mental models enhance second-order thinking; they enable us to differentiate the signal from the noise.
Since most of us specialise in one vocation or another, we tend to develop blind spots. As a result, we look at problems in a one-dimensional manner. If we develop multiple mental models, our blind spot bias is greatly reduced.
The more mental models we have, the easier it will become for us to see and interpret reality.

What is a Lollapalooza Effect?

Charlie Munger was asked which, of all the human biases is the most important one? Munger side-stepped the question, and he answered that when we combine the positive features from a bunch of these biases, we get what he called the ‘Lollapalooza Effect’. Factors that reinforce and amplify each other lead to the ‘Lollapalooza Effect’.

Munger has coined the phrase and he explains it thus: ’I coined it when I realised I didn’t know psychology. I bought three comprehensive psychology textbooks and read through them, and like usual I thought they were doing it all wrong, and I could do it better. When three or four tendencies were operating at once in the same situation, the outcome wasn’t linear, it was straight up. The scholars were ignoring the most important thing in the profession because they couldn’t do experiments with so many variable operating together, and then they didn’t synthesise it with other disciplines, because they didn’t know squat about other disciplines. I am lonely, but I am right.’

In the book, ‘Poor Charlie’s Almanack’, a Lollapalooza effect is defined as: ’Lollapalooza is the critical mass obtained via a combination of concentration, curiosity, perseverance, and self-criticism, applied through a prism of multidisciplinary mental models.’

In other words, the Lollapalooza Effects occur when multiple biases act in unison; in such cases, the outcomes are unique or outstanding, almost abnormal. What Munger is referring to is situations when business outcomes are far greater than the sum of the parts that contribute to the same. In the real world, when several of our biases interact, what happens is that it tends to sway our behaviour one way or another thereby bringing about a very concentrated or coherent outcome. A Lollapalooza Effect can be either positive or negative. To summarise:

When several (two, three or four) mental models combine and are acting in the same direction, they cease to be simple additive forces, they compound. At times, some trade-offs from such combinations are miserable. But considered as a whole, the compromises are benign compared to the critical mass that has been obtained as a result of the combination of several mental models. The outcomes that are derived from Lollapalooza Effects are not linear, and Munger searches for businesses that can benefit from these kinds of effects.
Munger has combined multiple mental models in the way he has led his life and is a living legend, a Lollapalooza if you will. There are four parts to the Munger Operating System as he likes to call it. These are Preparation, Discipline, Patience and Decisiveness. Each of these attributes is lost without the other, but together they form the effective critical mass that results in a cascading of positive effects which Munger calls the Lollapalooza Effect. Similarly for other businesses and mental models, one has to be able to recognise a ‘Lollapalooza’.
Lollapalooza Effects can be positive, or they can be detrimental. If they are positive, they can make you productive, and if they are negative, they can kill you. He gives the example of Coca-Cola as one that has used them positively. What Coca-Cola has done is to combine operant conditioning with classical conditioning (as explained by Skinner and Pavlov). Combining these two techniques, Coca-Cola has managed to obtain and maintain conditioned reflexes which is what Munger calls a ‘Lollapalooza’ result. He cites the success of Coca-Cola beverage as a Lollapalooza outcome from such a process. The New Coke fiasco is a Lollapalooza Effect of the negative sort.
Munger has complained that the academic teaching of psychology lacks intradisciplinary synthesis. According to him, not enough attention is being paid to Lollapalooza Effects that come about as a combination of psychological tendencies.

Lollapalooza Effects & Coca-Cola

Charlie Munger has described how The Coca-Cola company has combined Operant Conditioning and Classical Conditioning to create a Lollapalooza Effect. The thought process behind the Lollapalooza Effects at Coca-Cola is outlined below:

To create and maintain conditioned reflexes, we must combine the features of both these psychological processes (operant and classical) to enhance effects from each of these.
For the operant conditioning part to work, we must (a) maximise rewards from the ingestion of the beverage and (b) minimise the probability that competing products will extinguish these reflexes. How has Coca-Cola done this? By using stimuli such as sugar, flavour, aroma and cooling effects. At the same time, the beverage has to be widely available all over the world to thwart competition.
For the Pavlovian association, Coca-Cola used advertising, and the amounts they spent on advertising were so large that nobody else could afford to match their spend. They created an association in the minds of the user through powerfully targetted advertising. The association so created meant that the mere sight of the product seemed to make one salivate. It created an intense desire to consume Coca-Cola.
Coca-Cola next used ‘social proof’, which Munger calls the ‘monkey-see, monkey-do’ aspect of the human brain. Imitative consumption was used in all their advertising and sales promotion campaigns.
Coca-Cola decided to keep their formula a secret and the hoopla over secrecy indirectly enhanced the Pavlovian effects.
When the Coca-Cola company announced their ‘New Coke’, all of the above worked in reverse and created a negative Lollapalooza Effect that almost threatened their business model. What happened was that the old flavour was so entrenched in the minds of the consumer, they didn’t see any additional benefits from the new one. It was perceived as if they were being deprived of something, which was the old coke flavour. It is described as a ‘deprival super-reaction syndrome’, and it made Coca Cola realise the value of what they had created. It was an irrational reaction, but taking away a perceived benefit tends to produce this kind of a backlash when dealing with the human mind.

Munger has cited Tupperware parties and sessions at the Alcoholics Anonymous groups as those that work by Lollapalooza Effects.