And the Risk

Charlie Munger, Vice Chairman of Berkshire-Hathaway, suggests that “instead of filling your ranks with lawyers and compliance people, hire people that you actually trust and let them do their job.” A radically simple idea – and a good one.

He noted that, “By the standards of the rest of the world, we overtrust. So far it has worked very well for us. Some would see it as weakness.” But the key to understanding his point is understanding trust.

First of all it’s not simply being naïve. It’s not closing your eyes and falling backwards into the arms of a stranger. In every case it involves an informal version of what lawyers refer to a due diligence, looking into a person’s history of being reliable and responsible, examining what you already know about the person.

That doesn’t mean interviewing their associates or poring over their financial records. But it does mean making an assessment based on your experience of them and that, in turn, requires being clear-eyed as you size up the person’s capacity to be honest and truthful. The work involves not only being vigilant about the other person’s history, but, even more important, monitoring your own desire to trust the person or your inclination to give them the benefit of a doubt because they remind you of someone emotionally close to you like a parent or a brother.

What do you really know about them? What are your doubts and fears? Munger said: “We just try to operate in a seamless web of deserved trust and be careful whom we trust.” The operative word here is “deserved.”

In its story, The New York Times noted: “A widely circulated study by two professors at the University of Zurich supports Mr. Munger’s thesis: ‘Conventional wisdom suggests more monitoring and sanctioning of management. We argue that these efforts will create a governance structure for crooks,’ wrote the professors, Margit Osterloh and Bruno S. Frey. “Instead of solving the problem, they make it worse. Selfish extrinsic motivation is reinforced.”

One reason for that is that formal procedures and investigations lead you to doubt or minimize your own more subjective intuitions. But, more importantly, they act as challenges to competitive, over-achievers to find the chinks in your armor, the loopholes through which they will drive their trucks. This is, no doubt, what the Zurich professors concluded. For competitive investors it becomes a game, like the hedge managers, seeking new ways to defeat the rules designed by regulators to level the playing field.

Mr. Munger, in a previous annual meeting, contended that the best way to hold managers accountable is to make them eat their own cooking. (See, “Berkshire’s Radical Strategy: Trust.”) That’s a homely analogy, suitable to Omaha. Wall Street bankers might need a stronger punishment than indigestion.a

Warren Buffett, Berkshire-Hathaways’ CEO, has been known to be slow to change his mind, and that can be a problem. If you take the time and make the personal investment to trust the people you do business with, you get involved. It’s harder to change your mind and walk away. And it should be. An honest mistake is no reason to conclude that someone is not to be trusted.