Contrast-Misreaction Tendency(CMT)

Charlie Munger once said that many businesses die just like the boiling frog. Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny. He further warns When a mans steps are consecutively taken toward disaster with each step being very small, the brains Contrast-Misreaction Tendency will often let the man go too far toward disaster to be able to avoid it. This happens because each step presents so small a contrast from his present position.To a small stimulus, only a small amount must be added. To a larger stimulus, a large amount must be added.Warren Buffett says One of the problems in society is that the most important issues are often these incremental type thingsBut, if you keep doing it over time, the incremental problems are hard to attack because that one extra piece of pie doesnt really seem to make a differencebut the cumulative effects of them will make a huge difference over time, just like overeating will make a huge difference over time. The time to attack those problems is early.Sometimes it is the small, gradual, invisible changes that harm us the most.

Contrast Effect in InvestingThe whole idea behind systematic investment plan (SIP) is that a small outgo-SLOWLY (as compared to the whole salary) every month from our paycheque doesnt pinch.As we have seen contrast is a two sided sword, and its ill effects show up in investing also.Have you heard of Big Bath accounting? For the uninitiated its an accounting jugglery to manage a companys earnings. Sometimes, to fool the shareholders, a particular years poor income statement is made to look even worse by increasing expenses and selling assetsSatyams case is another example which shows how big accounting scams are created.Here is what Ramalinga Rajus aides at Satyam must have told him before the scam came to light If we slowly and gradually over time manipulate the numbers, the auditors wont notice it.

Similarly, we fail to notice how our money disappears. It constantly loses its value, but we do not notice because inflation happens over time. If it were imposed on us in the form of a brutal tax (and basically thats what it is), we would be outraged.Another area where CMT can harm is our fixation on the stock price. When you are analysing a business, it becomes extremely hard to overcome the temptation to ignore the past stock price trends. If a stock has risen recently, our subconscious screams that the stock has become expensive. A recent fall in price triggers the CMT which convinces us that the stock has become cheaper.My advice? Dont look at the stock price until you have analysed the business and worked out some valuation. For that matter, if you cant avoid price based screeners, use them carefullyConclusionUnderstand that CMT is everywhere, and that we view our world through its lens rose coloured or otherwise.Few psychological tendencies do more damage to correct thinking than CMT. Warren Buffett was probably referring to contrast bias when he said Chains of habit are too light to be felt until they are too heavy to be broken.Its interesting that most bad habits are formed because of this tendency but fortunately this bias, if used intelligently, can help us form good habits too. John Wooden, one of the most successful coaches in the history of basketball, observed When you improve a little each day, eventually big things occur Dont look for big, quick improvement. Seek the small improvement one day at a time. Thats the only way it happens and when it happens, it lasts.I wanted to tell my friend, Mr. Irrational, that he was taken for a ride by his tailors but then I thought to myself, Let me keep the poor kid happy. After all he still believes that he stole a great deal.But you dont forget to include CMT in your mental model checklist. And at the same time dont forget to make use of it for creating good habits.