Warren Buffett’s Interview with the Financial Crisis Inquiry Commission (2010)

Some key excerpts from the interview:

[Answering a question on asset bubbles]

There’s a really interesting aspect of this which will take a minute or two to explain, but my former boss Ben Graham in an observation 50 or so years ago told me that really stuck in my mind and now I’ve seen elements of it. He said you can get in a whole lot more trouble in investing with a sound premise than with a false premise. If you have some premise that the moon is made of green cheese or something, you know, it’s ridiculous on its face.

So after a while the original premise which becomes sort of the impetus for what later turns out to be a bubble is forgotten and the price action takes over. Now we saw the same thing in housing. It’s a totally sound premise that houses will become, worth more over time because the dollar becomes worth less. It isn’t because, you know, construction costs go up. And it isn’t because houses are so wonderful it’s because the dollar becomes worth less that a house that was bought 40 years ago is worth more today than it was then.

And since 66% or 67% of the people want to own their home and because you can borrow money on it and you’re dreaming of buying a home, if you really believe that houses are going to go up in value you buy one as soon as you can. And that’s a very sound premise. It’s related of course, though, to houses selling at something like replacement price and not [unintelligible] of stripping inflation.

So the sound premise it’s a good idea to buy a house this year because it will probably cost more next year and you’re going to want a home and the fact that you can finance it gets distorted over time if housing prices are going up 10% a year and inflation is a couple of percent a year. Soon the price action, or at some point the price action takes over and you want to buy three houses and five houses and you want to buy with nothing down and you want to agree to payments that you can’t make and all of that sort of thing because it doesn’t make any difference, it’s going to be worth more next year.

[On what made this bubble different]

And for some reason it gets to a critical mass, this critical point where price action alone starts dominating people’s minds. And when your neighbor has made a lot of money by buying internet stocks, you know, and your wife says that you’re smarter than he is and he’s richer than you are, you know, so why aren’t you doing it. When that gets to a point, when day trading gets going, all of that sort of thing, very hard to point to what does it. I mean, it, you know, we’ve had hula hoops in this country, we’ve had pet rocks, I mean, you know, and this is the financial manifestation of, you know, a craze of sorts. And I, it’s very hard to tell what got the—all the, you can name a lot of factors that contribute to it but to say what is the one that this time was different that made, why it didn’t catch fire earlier, I can’t give you the answer.

[Another example]

That doesn’t mean that your time is wasted or anything. Understanding, you know, the pathology of bubbles is not an unimportant–we had one that was more severe, in fact there was an article in the Omaha World Herald about three months ago that described how it was more severe, we had a bubble in the Midwest in the early ‘80s in farmland that created much more financial dislocation, but it was limited to the farm belt than this particular bubble has which has not hit as hard in terms of housing in the Midwest.

So Nebraska was much harder hit in the farmland bubble. And the farmland bubble had the same logic to it. Inflation was out of control, Volcker hadn’t really come in with his, with his meat axe to the economy and people said, you know, you’re not making more farmland, there are going to be more people eating, farmland gets more productive by the years, we learn more about it, fertilizers and all that sort of thing.

And cash is trash so you should go to, and own something real which was a farm. And I bought a farm from the FDIC and well, no, it was the FDIC I think. They took over a bank 30 miles from here, I bought up a farm for $600 an acre that the bank had lent $2,000 an acre against. And the farm didn’t know what I’d paid for it or the other guy had paid, or lent on it. And that farm had a productive capacity of probably $60 an acre in terms of what corn soybeans were selling for. To lend $2,000 against it when interest rates were 10% was madness. And both the banks in [unintelligible] and Nebraska went broke because they went insane.

 

The Endowment Effect

The endowment effect states that people ascribe more value to things merely because they own them.

An example and experiment conducted by Ziv Carmon and Dan Ariely  found that participants’ hypothetical selling price for NCAA final four tournament tickets were ten times higher than their hypothetical buying price.

From Ariely’s book, “Predictably Irrational“:

There are three fundamental quirks of human nature. We fall in love with what we already have. We focus on what we might lose, rather than what we might gain. We assume that other people will see the transaction from the same perspective as we do.

The value of what you’ve spent so far on a service, product, or relationship — in effort or money — is probably far less than you think. Be willing to walk away.

Once you’ve bought something, never rely on your internal judgment to assess its value, because you’re too close to it now.

Originally, the endowment effect was thought to be explained by loss aversion but further studies indicated that it was mainly driven by a sense of ownership. Businesses use this to a large degree with changing rooms (customers are more likely to purchase clothing once they have tried it on [one step closer to ownership], free samples/trials and coupons.

Diderot Effect

Denis Diderot was an 18th century writer who wrote a short piece called “Regrets for my old Dressing Gown”. You can read it here:

https://www.marxists.org/reference/archive/diderot/1769/regrets.htm

This led to what is known today as the Diderot effect which is defined in Wikipedia as:

The Diderot effect is a social phenomenon related to consumer goods which either posits that form culturally defines groups that are considered cohesive or refers to a process of spiralling consumption resulting from dissatisfaction induced by a new possession.

Which is basically saying, you buy or get something nice and now you feel an urge to upgrade other things in your life. How many of us are guilty of that?

Here’s my favourite quote from the piece:

I was absolute master of my old dressing gown, but I have become a slave to my new one.”