This classic Whitney Tilson investing article was originally published on Aug. 21, 2002. Some of the information has been updated.

Behavioral finance -- a field that examines how people's emotions, biases, and misjudgments affect their investment decisions -- is one of the least discussed and most poorly understood areas of investing. Yet I believe it's a critically important area -- so important, in fact, that I covered it in my very first Fool column back in September 1999. Seems like an investing lifetime ago, doesn't it?

Behavioral finance recently reappeared on my radar when I came across an 80-minute recording of a speech from Berkshire Hathaway (NYSE:BRK-A) vice-chairman Charlie Munger, Warren Buffett's right-hand man and a genius in his own right. It's a brilliant, powerful, and compelling tour de force.

In the speech, Munger highlights what he calls "24 Standard Causes of Human Misjudgment." He then gives numerous examples of how these mental weaknesses can combine to create "lollapalooza" effects, which can be very positive in what they offer, as in the case of Alcoholics Anonymous, or frighteningly negative, such as experiments in which average people end up brutalizing others.

I'd like to highlight some of Munger's most important lessons, especially as they relate to investing.

Psychological denial
Munger notes that, sometimes, "reality is too painful to bear, so you just distort it until it's bearable." I see this all the time among investors -- both professionals and average folks. Think of all the people who simply have no business picking stocks, such as the "bull market geniuses" of the late 1990s, whose portfolios were undoubtedly obliterated in the bear market that followed.

You'd think these people would've recognized that whatever investment success they had in the late '90s was due solely to one of the most massive bubbles in the history of the stock market, and that they should have gotten out while they still had even a little bit of money left. I'm sure some did, but many didn't, because that would have meant acknowledging some extremely painful truths: They should never have been picking stocks, they speculated with their retirement money and frittered most of it away, and so on.

Instead, I remember seeing emails like this one, from people who, I suspect, were in serious psychological denial:

Why isn't anyone suggesting WorldCom as an investment possibility? Assuming WorldCom survives, and assuming they reach a third of their highest stock value prior to the decline, why not buy shares at $0.19 [as listed at the time of this email] and hold them for a few years? If WorldCom manages to make it back to $10.00 a share, the profit for a small investor would be more than satisfactory. What am I missing here? It seems like another chance to "get in on the ground floor."

The answer is that WorldCom equity is almost certain to be worthless, and the only sane people buying the stock right now are short-sellers covering their very profitable shorts. [Editor's note: Whitney was right, of course: WorldCom filed for Chapter 11 bankruptcy in July 2002.]

Bias from consistency and commitment tendency
Munger explains this bias with the following analogy: "The human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can't get in." In other words, once people make a decision (to buy a stock, for example), it becomes extremely unlikely that they will reverse this decision, especially if they have publicly committed to it.

This is true even if overwhelming evidence emerges indicating that the initial decision was disastrously wrong. Have you ever bought a stock such as Lucent, Enron, or WorldCom, then seen your original investment thesis so badly torn to shreds by subsequent developments that you would never consider buying more of the stock, despite the lower price -- yet still failed to sell your shares? I've written twocolumns on this common, painful mistake.

Overinfluence by social proof
Human beings have a natural herding tendency, innately preferring to look at what everybody else is doing and do the same, however insane that behavior might be. Munger gives a classic example from Corporate America:

Big-shot businessmen get into these waves of social proof. Do you remember some years ago, when one oil company bought a fertilizer company, and every other major oil company practically ran out and bought a fertilizer company? And there was no more damned reason for all these oil companies to buy fertilizer companies, but they didn't know exactly what to do, and if Exxon was doing it, it was good enough for Mobil, and vice versa. I think they're all gone now, but it was a total disaster.

Similar behavior led to the tech-stock bubble of the late 1990s. For more on this topic, see my column "The Cocktail-Party Test," in which I argue: "Following the crowd and investing in what is fashionable is a recipe for disaster. Instead, look for solid companies with strong balance sheets that are either out of favor with Wall Street or, better yet, not even on Wall Street's radar screen."

Other questions Munger answers
I've cited only a few examples of Munger's powerful observations, and the answers he gives to a range of perplexing questions, such as:

  • Why are boards of directors so consistently dysfunctional, unable to rein in even the most egregious behavior by CEOs?

  • Why was Coca-Cola's (NYSE:KO) introduction of New Coke almost one of the costliest business blunders of all time?

  • Why didn't Salomon CEO John Gutfreund or General Counsel Donald Feuerstein immediately turn in rogue employee Paul Mozer -- a failure of judgment that cost both men their careers and nearly put Salomon out of business?

  • How did Joe Jett lose $210 million for Kidder Peabody (and parent company General Electric (NYSE:GE))?

  • How did FedEx (NYSE:FDX) solve the problem of processing all of its packages overnight?

  • Why wouldn't Wal-Mart (NYSE:WMT) founder Sam Walton let his purchasing agents accept even the tiniest gift from a salesperson?

  • How does Johnson & Johnson (NYSE:JNJ) ensure that it evaluates and learns from its experience in making acquisitions?

  • How has Tupperware (NYSE:TUP) "made billions of dollars out of a few manipulative psychological tricks"?

  • Why do bidders consistently overpay in "open-outcry" actions?

  • Why is a cash register "a great moral instrument"?

  • Why would it be evil not to fire an employee caught stealing?

  • Why might raising the price of a product lead to greater sales?

  • Why do some academicians continue to cling to the Efficient Market Theory?

  • Why are people who grow up in terrible homes likely to marry badly? And why is it so common for a terrible first marriage to be followed by an almost-as-bad second marriage?

  • How can real estate brokers manipulate buyers?

  • How do lotteries and slot machines prey on human psychology?

  • Why should we be grateful that our founding fathers were "psychologically astute" in setting the rules of the U.S. Constitutional Convention?

There is no space here to even begin to summarize Munger's answers to these questions. However, the speech is available in his book Poor Charlie's Almanack.

If you find his thinking and the field of behavioral economics as fascinating as I do, I suggest reading Influence by Robert Cialdini, Why Smart People Make Big Money Mistakes by Gary Belsky and Thomas Gilovich, and, for the definitive work on Munger himself, Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger by Janet Lowe.

FedEx is a Motley Fool Stock Advisor recommendation. Tupperware and Johnson & Johnson are Motley Fool Income Investor picks, and Wal-Mart and Coca-Cola are Motley Fool Inside Value selections. All of our investing newsletters come with a free 30-day trial.

Fool contributor Whitney Tilson is the founder and managing partner of T2 Partners LLC. He owned shares of Berkshire Hathaway at the time of publication. To read his previous columns for The Motley Fool and other writ ing s, visit The Motley Fool is investors writing for investors.