Yes, you heard it right, the Lollapalooza Effect, and I am sure, many of you have never heard about it. It may sound a bit strange, but it holds much importance for an intelligent investor.

And, you might be surprised, it is an essential ingredient of Warren Buffett’s wealth creation process.

So, what this term means and who popularised it, let’s check out.

The term was first coined by a super American investor and partner of Warren Buffett in Berkshire Hathaway, Charles Thomas Munger aka Charlie Munger.

If you do not know who Charlie Munger is, then here is a little brief about him.

Charlie Munger is a great American investor and is the Vice-Chairman of Berkshire Hathaway. He is considered as Warren Buffett’s right-hand man. Together with their investing intelligence, they created huge wealth for Berkshire Hathaway.

Trained as a meteorologist during World-War II and as a lawyer from Havard before devoting his full time in business. He eventually was drawn towards the study of psychology, economics and different streams of science which helped him in developing systems of “multiple mental models” to navigate problems in various complex social systems. And, one of his models is the Lollapalooza Effect.

It is believed that Charlie Munger has a huge influence on Buffett’s investment philosophy and Buffett himself calls Munger as an investment genius. His investment philosophy is based on the principle of sticking to what you know (area of competence) and acting only when the time is right.

Now, let’s move on to know what the Lollapalooza Effect in investing is.

The Lollapalooza Effect

The term was first coined in 1995 during a Harvard speech on a topic titled “The Psychology of Human Misjudgement“. Since then, it has become an investment jargon.

The lollapalooza effect explains the inherent biases, tendencies and mental models that act in tandem in the same direction towards a particular action. It creates a potentially large scale impact and can lead to either a positive or negative outcome.

He better explains the lollapalooza effect through an open outcry auction system. Following are the typical actions involved in an auction and how human biases work.

Reciprocity

Suppose, you are invited to an auction and as a participant, you’re mentally pushed to bid due to reciprocity. Like “I should place a bid because I’m invited”.

Consistency

I should buy or bid for this product, as I like it very much.

Commitment Tendency

I will continue the bidding process, as I’m already into it.

Social Proof

I know the product is good because others are also bidding for it.

Now, if I put it in a context, remember how Tata Steel acquired the Anglo-Dutch steel-maker Corus. How Tata has to outbid, Brazilian steel-maker CSN. In this process, Tata has to pay almost 34% higher than their original offer. At the time of the acquisition, Tata Steel’s market cap was very less compared to acquisition cost and took huge debt to finance the takeover.

For Tata’s, the acquisition was a huge mistake and to date, they have never recovered fully from it.

The mortgage crisis of 2007-08 is another text-book example of the lollapalooza effect.

The Lollapalooza Effect and Stock Market Investing

The stock market acts like a one big auction house, where you place your bid and ask price for a particular security and millions of such orders are placed simultaneously.

And, compared to the open outcry auction system, where the auctioneer feeds the inherent biases and other tendencies into participants, here in the stock market, the 24/7 media house does that job.

There are numerous developments and motivations in the market, which results in the price movement and volatility in stocks. And, the ability to monitor the security prices in real-time leads to short-termism among investors. Further, it leads to impulsive buying and selling.

Also, social media, too, influences the behaviour of investors, where investors can select to be amongst like-minded people and get social-validation of their investment decision. And, no matter how hard the investor tries to remain neutral, at some point, he/she gets swayed away by biases as it all happens in the subconscious mind.

That’s what Charlie Munger refers to as the lollapalooza effect.

It often leads to human misjudgement and for a successful investor, it is very important to identify and avoid the lollapalooza effect.

The only way to escape is by limiting your exposure to such factors that create biases and influences your decision-making ability.