Multiple Psychological Tendencies

2. MULTIPLE TENDENCIES

When you get two or three of these psychological principles operating together, then you really get irrationality on a tremendous scale.

— Charles Munger

Charles Munger gives an illuminating example on the issue of stealing:

A very significant fraction of the people in the world will steal if (A) it's very easy to do and, (B) there's practically no chance of being caught. And once they start stealing, the consistency principle will soon combine with operant conditioning to make stealing habitual. So if you run a business where it's easy to steal because of your methods, you're working a great moral injury on the people who work for you...

It's very, very important to create human systems that are hard to cheat. Otherwise you're ruining your civilization because these big incentives will create incentive-caused bias and people will rationalize that bad behavior is OK.

Then, if somebody else does it, now you've got at least two psychological principles: incentive-caused bias plus social proof. Not only that, but you get Serpico effects: If enough people are profiting in a general social climate of doing wrong, then they'll turn on you and become dangerous enemies if you try and blow the whistle.

Frank Serpico became known after exposing corruption at the New York Police Department in the 1970s. When Frank Serpico entered the New York Police force in 1960, payoffs and kickbacks were rampant in the department.

When he refused to take money, his fellow officers saw him as a potential danger. Then he blew the whistle on them, and became their enemy. In a 1971 testimony before the Knapp commission, Serpico said: "I hope that police officers in the future will not experience the same frustration and anxiety that I was subjected to for the past five years at the hands of my superiors because of my attempt to report corruption ... We create an atmosphere in which the honest officer fears the dishonest officer, and not the other way around."

John's acquisition experience caused him stress and cost TransCorp money.

John said, "I was dissatisfied having done so little for TransCorp last year. All of the other guys made acquisitions. If I could find a good acquisition, maybe I could move up the ranks. I needed a promotion. I found a good-looking business, and saw the possibility of making TransCorp a lot of money. The CEO of the business was a nice guy and we always met in their relaxing conference room. The asking price was low in relation to past profits. I had experts telling me what a great company it was. I was presented entertaining information on new products. The investment banker did me a favor by bringing the deal and I wanted to reciprocate. The banker told me that other people I admire would jump at the opportunity. I made a commitment to the financiers and told TransCorp's CEO about the deal. I committed myself publicly and felt a need to follow-through. I concentrated my search on evidence that confirmed the greatness of the deal. I denied reality and thought nothing bad could happen. I didn't say what I thought for fear of social disapproval. The CEO of the company I wanted to acquire continuously gave me good reasons to pursue the deal. The more effort I put into the deal, the more I felt I had to do it. I finally signed the papers. When reality kicked in and the deal turned sour, I was in deep trouble. And so was TransCorp."

"I don't want to go against the CEO and risk losing my $250,000 directors fee."

Is the board of directors an effective corrector to deal with CEO mediocrity? Charles Munger says: "The psychological nature of the board of directors system makes it an ideal system for causing people to follow the lead of the CEO."

A board may be a legal creation, but it is a social animal. Warren Buffett says:

When people meet every couple of months and come from different parts of the country – and they have the normal social instincts – they don't like to have rump meetings or sort of talk behind people's backs. So it's very difficult in a group – particularly if it's a group like Charlie described where the directors' fees for a significant number of them are important to their well-being, and they'd love to be recommended for another board and add another $100,000 a year to their income – for someone to lead a charge all of a sudden at a regular meeting or to try to arrange a rump meeting of some sort to say, "We think the guy at the head of the table is no good."

So dealing with mediocrity – or, like I say, a notch above it – is a difficult problem if you're a board member. ... I've been on 19 boards. And I've never seen a director on any of the 19, where the director's fees were important to them, object to an acquisition proposal or a CEO's compensation.

The CEO of TransCorp tells his board: "This is the decision, now let's start the discussion."

Apart from incentive-caused bias, liking and social approval, what are some other tendencies that operate here? Authority – the CEO is the authority figure who directors tend to trust and obey. He may also make it difficult for those who question him. Social proof – the CEO is doing dumb things but no one else is objecting so all directors collectively stay quiet – silence equals consent; illusions of the group as invulnerable and group pressure (loyalty) may also contribute. Reciprocation – unwelcoming information is withheld since the CEO is raising the directors fees, giving them perks, taking them on trips or letting them use the corporate jet. Association and Persian Messenger Syndrome – a single director doesn't want to be the carrier of bad news. Self-serving tendencies and optimism – feelings of confidence and optimism; many boards also select new directors who are much like themselves; that share similar ideological viewpoints. Deprival – Directors don't want to lose income and status. Respecting reasons no matter how illogical – the CEO gives them reasons. Believing first and doubting later – believing what the CEO says even if not true, especially when distracted. Consistency – directors want to be consistent with earlier decisions – dumb or not.

Can we get rid of a bad CEO? Warren Buffett and Charles Munger say:

Buffett: When certain boards consisting of prominent people are embarrassed publicly by the media attention, I think that acts as kind of an early warning signal to some other boards because big shots – and they look for big shots frequently in terms of dressing up boards – do not like to look foolish, at least publicly...

Munger: ...in terms of the director's actually rebelling against the CEO, it tends to happen in one or two cases: One is when they reduce the directors' perks – which most CEOs are wise enough not to do. The other is when the situation gets so bad that it threatens to disgrace the directors. But you rarely see people taking action before they're threatened with disgrace.

Warren Buffett says that we need true independence from directors i.e. a: "willingness to challenge a forceful CEO when something is wrong or foolish." He continues: "In addition to being independent, directors should have business-savvy, a shareholder orientation and a genuine interest in the company."

Charles Munger adds:

The correct system is the Elihu Root System. Elihu Root, who had three different cabinet appointments, if I remember right, said no man was fit to hold public office who wasn't perfectly willing to leave it at any time. And if Elihu Root didn't approve of something the government asked him to do, he could always go back and be the most sought-after lawyer in the world. He had an identity to go back to – so he didn't need the government's salary.

Well, I think that also ought to be more the test in corporate directorships. Is a director really fit to make tough calls who isn't perfectly willing to leave the office at any time? My answer is no.