www.ThinkMentalModels.com How people like US get really smart
“The better decision maker has at his/ her disposal repertoires of possible actions; checklists of things to think about before he acts; and he has mechanisms in his mind to evoke these, and bring these to his conscious attention when the situations for decision arise.” !
1
Herbert Simon, Nobel Laureate
Behavior Models!
9
Availability !
9
Fool Yourself Tendency !
10
Habit!
11
Human Action!
13
Negotiation!
14
Operant Conditioning!
15
Pain - Pleasure !
16
Pavlovian Conditioning!
17
PLAGGES - 7 Sins!
18
Reader or Listener?!
19
Science of Achievement!
20
Behavior - Influence Models!
21
Authority!
21
Commitment & Consistency!
22
Deprival Syndrome !
23
Framing the Issue!
24
Incentive-Cause Bias!
25
Liking!
26
Reciprocation!
27
Scarcity !
28 2
Social Proof!
29
Big Thinking Models!
30
As Simple As Possible !
30
Big Picture Math!
32
Deduction or Induction?!
35
Disconfirming Evidence !
36
Game Theory !
37
Getting to Why !
39
Ideas!
40
Incentives !
42
Information!
43
Invert!
44
Marginal Thinking!
45
Metaphors!
46
Opportunity Costs!
48
Probabilistic Thinking!
49
Reductionism!
52
Scientific Method!
53
Spend - Conserve!
54
Systems Thinking!
56
The Argument!
57 3
Unintended Consequences !
59
80:20 Rule!
61
Business Models!
62
Arbitrage!
62
Brand!
63
Business Model!
64
Core Competency!
66
Cost Leader!
68
Culture!
69
Disruptive Innovation!
70
Entrepreneurship!
71
GRICS (Retailers)!
72
Key Factors for Success !
73
Management Fanaticism!
74
Network Effect!
76
Porterʼs 5-forces!
77
Pricing Ability!
78
Protective Moat!
79
Scale !
80
Specialization!
82
Standardization!
83 4
Surf a Wave!
84
Technology !
85
Business - Financial Models!
86
Bob-around Earnings!
86
Business Metrics!
87
Intrinsic Value!
88
Mr. Market!
90
Reversion-to-mean!
91
Scandal!
92
The Magic Formula !
93
Business - Goodsʼ Models!
94
Diminishing Utility!
94
Nature of Goods!
95
Maslowʼs Triangle!
96
Total Utility!
97
Value !
98
Decision Models!
99
Margin of Safety!
99
Pr O A C T!
100
Process v Outcome!
101
5
The Agency Problem!
102
Trade-offs!
103
Your Circle of Competence!
104
Decision - Common Mistakesʼ Models!
105
Anchor Effect!
105
Bayes Theorem!
106
Contrast Principle !
107
Correlation or Causation!
108
Doubt Avoidance!
109
Extrapolation!
110
False Mental Accounting!
111
Groupthink!
112
Ideology !
113
Information Bias !
114
Over-optimism!
116
Overweighting Numbers!
117
Statistics!
118
Economic Models!
119
Animal Spirits!
119
Asymmetric Information!
121
Bubbles!
122 6
Comparative Advantage!
124
Creative Destruction!
125
Diminishing Returns!
127
Equilibrium!
128
Externalities!
129
Markets!
130
Moral Hazard!
131
Price Discrimination!
132
Property Rights!
133
Public/Private Goods!
134
Sunk Costs!
135
Switching Costs!
136
Transaction Costs !
137
System Models!
138
Back-up/Redundancy!
138
Bottlenecks !
139
Complex Adaptive Systems!
140
Evolution!
142
Feedback Loops !
144
Momentum!
145
Newtonʼs Laws!
146 7
Power Law!
147
Reflexivity!
148
Six Degrees!
149
System Boundary!
151
Thermodynamics!
153
8
Behavior Models Availability
A Behavior Changer If a product or service is widely and conveniently available, consumers are less likely to try the competition. Further, the consumer may change his/her behavior in order to take advantage of the easily available product/service. This idea plays to the concept of scale, whether it be in terms of physical presence or intense distribution. Think Starbucks, where being everywhere links to the creatures of habit principle, reducing the need to try other coffee establishments; and consider how people have adapted their behavior to take advantage of Starbucks’ many locations social gatherings, business meetings, study areas etc. Another behavior changer could be a dominant local supermarket that encourages consumers to increase shopping frequency, as a result of its convenient location, opening hours and fresh daily produce.
9
Fool Yourself Tendency
I Think She Really Likes Me Cognitive Dissonance: When feelings and facts are in opposition, people will find, or invent, a way to reconcile them.
Richard Feynman stated it more memorably: "The first rule is not to fool yourself, and you are the easiest person to fool."
Eric Beinhocker in ‘The Origin of Wealth’ expands on the idea: People have a general bias toward spinning their reality in positive ways and ignoring uncomfortable facts. It takes a real jolt to make them see that everything is not O.K. [Experts] refer to such optimism in the face of countervailing facts as delusional optimism. Jack Welch was infamous for popping the unduly optimistic bubbles of his people, and one of his dicta was that managers must ‘face reality [and] see things as they are… not the way they wished it would be.’
10
Habit
My Burger Habit The difficulty of getting consumers to change their behavior cannot be underestimated. It is one aspect of human behavior that can lead to outsize profits for companies. Humans have a tendency to habituate to any unpleasant stimulus, from pain and sorrow to a persistent car alarm.
The idea is explained in ‘Value Investing’ by Bruce Greenwald et al: In an open and competitive economy, there are only a limited number of ways in which customer behavior leads to captivity. Habit, usually associated with high frequency purchase, is probably the most powerful. For a soda company to compete with Coca-Cola, it must induce Coca-Cola drinkers to stop drinking their favorite beverage. This is no easy task. Consumer studies and historical experience suggest that Coke drinkers are fiercely attached to their Cokes. By comparison, the attachment to Budweiser, another leading beverage brand, is weaker. When diners go to Chinese, Japanese, or Mexican restaurants, they are not reluctant to ordering a beer from that country, but the chances that they will ask for a local cola are slim.
11
The tendency for people to stay with the status quo has produced the ‘default’ behavior option. Thaler and Sunstein describe this idea in ‘Nudge’. For lots of reasons, people have a more general tendency to stick with their current situation. This phenomenon... dubbed the ‘status quo bias’, has been demonstrated in numerous situations. Most teachers know that students tend to sit in the same seats in class, even without a seating chart. Status quo bias is easily exploited (Examples include never-changing asset allocations in 401(k) plans; automatic renewals of subscriptions on credit cards etc.). One of the causes of status quo bias is a lack of attention. Many people adopt what we will call the ‘yeah, whatever’ heuristic. A good illustration is the carryover effect in television viewing. The combination of loss aversion with mindless choosing implies that if an option is designated as the ‘default’, it will attract a large market share. Default options thus act as powerful nudges. In many contexts defaults have some extra nudging power because consumers may feel, rightly or wrongly, that default options come with an implicit endorsement from the default setter, be it the employer, government, or TV scheduler.
12
Human Action
A Vision of a Better State
Ludwig von Mises, in 'Human Action', describes the conditions necessary for a person to act: ! ! !
[1. Unease or dissatisfaction with the present state of affairs] [2. A vision of a better state] [3. Belief that they can reach the better state]!
! Acting man is eager to substitute a more satisfactory state of affairs for a less satisfactory one. His mind imagines conditions which suit him better, and his action aims at bringing about this desired state. The incentive that impels a man to act is always some uneasiness. A man perfectly content with the state of his affairs would have no incentive to change things. He would have neither wishes nor desires; he would be perfectly happy. He would not act; he would simply live free from care. ! But to make a man act, uneasiness and the image of a more satisfactory state alone are not sufficient. A third condition is required: the expectation that purposeful behavior has the power to remove or at least to alleviate the felt uneasiness. In the absence of this condition no action is feasible. ! Action is not simply giving preference. Man also shows preference in situations in which things and events are unavoidable or are believed to be so. Thus a man may prefer sunshine to rain and may wish that the sun would dispel the clouds. He who only wishes and hopes does not interfere actively with the course of events and with the shaping of his own destiny. But acting man chooses, determines, and tries to reach an end. Of two things both of which he cannot have together he selects one and gives up the other. Action therefore always involves both taking and renunciation.
13
Negotiation Roger Fisher & William Ury outline their methods for principled negotiation in 'Getting To Yes': ... in contrast to positional bargaining, the principled negotiation method of focusing on basic interests, mutually satisfying options, and fair standards typically results in a wise agreement. The method permits you to reach a gradual consensus on a joint decision efficiently without all the transactional costs of digging in to positions only to have to dig yourself out of them. People: Separate the people from the problem. Interests: Focus on interests, not positions. When you do look behind opposed positions for the motivating interests, you can often find an alternative position which meets not only your interests but theirs as well. The Egyptian-Israeli peace treaty blocked out at Camp David in 1978 demonstrates the usefulness of looking behind positions. Israel's interest lay in security; they did not want Egyptian tanks poised on their border ready to roll across at any time. Egypt's interest lay in sovereignty; the Sinai has been part of Egypt since the time of the Pharaohs. At Camp David, President Sadat of Egypt and Prime Minister Begin of Israel agreed to a plan that would return the Sinai to complete Egyptian sovereignty and, by demilitarizing large areas, would still assure Israeli security. Options: Generate a variety of possibilities before deciding what to do. Criteria: Insist that the result be based on some objective standard. An episode during the Law of the Sea Conference illustrates the merits of using objective criteria. At one point, India, representing the Third World bloc, proposed an initial fee for companies mining in the deep seabed of $60 million per site. The United States rejected the proposal, suggesting there be no initial fee. Both sides dug in; the matter became a contest of will. Then someone discovered that the Massachusetts Institute of Technology (MIT) had developed a model for the economics of deep-seabed mining. This model, gradually accepted by the parties as objective, provided a way of evaluating the impact of any fee proposal on the economics of mining. BATNA: What is your BATNA - your Best Alternative To a Negotiated Agreement? That is the standard against which any proposed agreement should be measured. That is the only standard which can protect you both from accepting terms that are too unfavorable and from rejecting terms it would be in your interest to accept.
14
Operant Conditioning
Killing the Messenger
Operant conditioning is discussed by author B.F. Skinner in 'About Behaviorism': A behavior is followed by a consequence, and the nature of the consequence modifies the organism's tendency to repeat the behavior in the future. The behavior is said to be strengthened by its consequences, and for that reason the consequences themselves are called 'reinforcers'. The probability of behavior depends upon the kind or frequency of reinforcement in similar situations in the past. The things which make us happy are the things which reinforce us, but it is the things, not the feelings, which must be identified and used in prediction, control, and interpretation.
In ‘The Origin of Wealth’, Eric Beinhocker talks of Freud and Skinner : Preferences are a psychological phenomenon. Freud postulated that our material needs are driven by the animal needs of our id and kept in check by our superego - thus, our economic preferences are the result of battles between ‘I really want that expensive car now!’ and ‘But I need to save for my children’s education!’ B.F. Skinner, on the other hand, thought that preferences were essentially learned. So, a Skinnerian might say that we want the fancy car because we have learned from society that fancy cars are desirable, and the maker of the car has taught us to want it by exposing us to alluring marketing messages.
15
Pain - Pleasure
Pain or Pleasure?
The sovereign masters that determine what people will do are not pleasure and pain, but fallible memories of pleasure and pain. Real pleasure is derived from experiences over physical goods, pastimes over knick-knacks, and doing over having.
Anthony Robbins describes the principle in 'Awaken the Giant Within': What is this force that is controlling you even now and will continue to do so for the rest of your life? PAIN and PLEASURE! Everything you and I do, we do either out of our need to avoid pain or our desire to gain pleasure. ! 'If you are distressed by anything external, the pain is not due to the thing itself but to your own estimate of it; and this you have the power to revoke at any moment.' - Marcus Aurelius The truth is that we can learn to condition our minds, bodies, and emotions to link pain or pleasure to whatever we choose. By changing what we link pain and pleasure to, we will instantly change our behaviors. ! 'I conceive that pleasures are to be avoided if greater pains be the consequence, and pains to be coveted that will terminate in greater pleasures.' Michel De Montaigne
16
Pavlovian Conditioning Time to Get a Beer
Conditional reflexes that are taught or learnt sub-consciously.
The application is discussed in 'Poor Charlie's Almanack', by Charles Munger: ! Pavlov's most famous experiment showed that dogs tend to salivate before food is actually delivered to their mouths. This result led him to a long series of experiments in which he manipulated the stimuli occurring before the presentation of food. He thereby established the basic laws for the establishment and extinction of what he called 'conditional reflexes', later mistranslated from the original Russian as 'conditioned reflexes'. [Charles Munger describes a hypothetical situation in which the Pavlovian conditioning concept could have been used as someone was dreaming-up Coca-Cola] ! In Pavlovian conditioning, powerful effects come from mere association. The neural system of Pavlov's dog causes it to salivate at the bell it can't eat. And the brain of man yearns for the type of beverage held by the pretty woman he can't have. And so... we must use every sort of decent, honorable Pavlovian conditioning we can think of. For as long as we are in business, our beverage and its promotion must be associated in consumer minds with all things consumers like or admire. ! Such extensive Pavlovian conditioning will cost a lot of money, particularly for advertising. We will spend big money as far ahead as we can imagine. But the money will be effectively spent. As we expand fast in our new-beverage market, our competitors will face gross disadvantages of scale in buying advertising to create the Pavlovian conditioning they need. ! Moreover, Pavlovian effects from mere association will help us choose the flavor, texture, and color of our new beverage. Considering Pavlovian effects, we will have wisely chosen the exotic and expensive-sounding name 'Coca-Cola', instead of a pedestrian name like 'Glotz's Sugared, Caffeinated Water'. For similar Pavlovian reasons, it will be wise to have our beverage look pretty much like wine instead of sugared water. And so, we will artificially color our beverage if it comes out clear. And we will carbonate our water, making our product seem like champagne, or some other expensive beverage.
17
PLAGGES - 7 Sins
Naughty but Nice
PRIDE - excessive belief in one's abilities or vanity LUST - inordinate craving for a person or thing ANGER - individual opting for fury GREED - desire for material gain or wealth GLUTTONY - desire to consume more than that which one requires ENVY - desire for others' traits, status, abilities, or situation SLOTH - avoidance of physical/mental work
'The Moral Animal', by Robert Wright: ! What the theory of natural selection says, rather, is that people's minds were designed to maximize fitness in the environment in which those minds evolved... the 'ancestral environment'... the question, properly put, is always whether a trait would be in the 'genetic interest' of someone in the [ancestral environment]. Only traits that would have propelled the genes responsible for them through the generations in our ancestral social environment should, in theory, be part of human nature today. ! ... there are recurring themes among contemporary hunter-gatherer societies, and they suggest that some features probably stayed fairly constant during much of the evolution of the human mind. For example: people grew up near close kin in small villages where everyone knew everyone else and strangers didn't show up very often. ! ... whatever the ancestral environment was like, it wasn't much like the environment we're in now. We aren't designed to stand on crowded subway platforms, or to live in suburbs next door to people we never talk to, or to get hired or fired...
18
Reader or Listener?
Do I Need to Spell it Out?
Peter Drucker presents this concept in 'Management Challenges for the 21st Century': ! The first thing to know about how one performs is whether one is a reader or a listener. Yet very few people even know that there are readers and there are listeners, and that very few people are both. ! When he was Commander-in-Chief of the Allied Forces in Europe, General Dwight Eisenhower was the darling of the press, and attendance at one of his press conferences was considered a rare treat. These conferences were famous for their style, for Eisenhower's total command of whatever question was being asked and, equally, for his ability to describe a situation or to explain a policy in two or three beautifully polished and elegant sentences. Ten years later, President Eisenhower was held in open contempt by his former admirers. They considered him a buffoon. He never, they complained, even addressed himself to the question asked, but rambled on endlessly about something else. And he was constantly ridiculed for butchering the King's English in his incoherent and ungrammatical answers. Yet Eisenhower had owed his brilliant career in large measure to a virtuoso performance as a speechwriter for General MacArthur, one of the most demanding stylists in American public life. ! The explanation: Eisenhower apparently did not know himself that he was a reader and not a listener. When he was Commander-in-Chief in Europe, his aides made sure that every question from the press was handed in, in writing, at least half an hour before the conference began. And then Eisenhower was in total command. ! [on the other hand] Roosevelt knew himself to be so much of a listener that he insisted that everything first be read out loud to him - only then did he look at anything in writing.
19
Science of Achievement
A Big Hairy Audacious Goal - BHAG
The science of taking ideas, and dreams, and making them happen is generally considered as: 1. Setting a goal. 2. Creating a written plan to reach the goal within a certain timeframe. 3. Taking action by implementing the plan. 4. Getting feedback from actions - negative and positive - and making changes, if necessary.
The process is underpinned by a strong 'self-concept' as described in 'Maximum Achievement' by Brian Tracy The access ports to your subconscious are both internal and external. Internally, you are affected by your thoughts, your mental pictures or imagination and your feelings. Externally, you are influenced by your suggestive environment, by everything that registers on your conscious mind. The thoughts you think, the images you hold, the feelings you experience trigger words and actions consistent with them. Every attitude, behavior, value, opinion, belief and fear you have today has been learned. Therefore, if there are elements of your self-concept that do not serve your purposes, you can unlearn them.
20
Behavior - Influence Models Authority
Don't Challenge Authority
The concept is explained by Robert Cialdini, in his book 'Influence Science and Practice': ! The strength of this tendency to obey legitimate authorities comes from systematic socialization practices designed to instill in members of society the perception that such obedience constitutes correct conduct. In addition, it is frequently adaptive to obey the dictates of genuine authorities because such individuals usually possess high levels of knowledge, wisdom, and power. For these reasons, deference to authorities can occur in a mindless fashion as a kind of decision-making shortcut. ! The worrisome possibility arises, then, that when a physician makes a clear error, no one lower in the hierarchy will think to question it - precisely because, once a legitimate authority has given an order, subordinates stop thinking in the situation and start reacting. Mix this kind of click, whirr response into a complex hospital environment and mistakes are inevitable. Indeed, a study by the U.S. Health Care Financing Administration shows that, for patient medication alone, the average hospital has a 12 percent daily error rate.
21
Commitment & Consistency
Very Public Commitment
The concept is explained by Robert Cialdini, in his book 'Influence Science and Practice': ! ! Once we make a choice or take a stand, we will encounter personal and interpersonal pressures to behave consistently with that commitment. Those pressures will cause us to respond in ways that justify our earlier decision. ! Indeed, we all fool ourselves from time to time in order to keep our thoughts and beliefs consistent with what we have already done or decided. ! For instance, suppose you wanted to increase the number of people in your area who would agree to go door-to-door collecting donations for your favorite charity. You would be wise to study the approach taken by social psychologist Steven J. Sherman. He simply called a sample of Bloomington, Indiana, residents as part of a survey he was taking and asked them to predict what they would say if asked to spend three hours collecting money for the American Cancer Society. Of course, not wanting to seem uncharitable to the surveytaker or to themselves, many of these people said that they would volunteer. The consequence of this subtle commitment procedure was a 700 percent increase in volunteers when, a few days later, a representative of the American Cancer Society did call and ask for neighborhood canvassers. ! ...he did something that fits perfectly with the commitment/consistency principle you talk about. He told his receptionists to stop saying, "Please call us if you change your plans," and to start asking, "Will you please call us if you change your plans," and to wait for a response. His no-show rate immediately dropped from 30 percent to 10 percent. ! In all, it seems that active commitments give us the kind of information we use to shape self-image, which then shapes future actions, which solidify the new self-image. ! Commitments are most effective when they are active, public, effortful, and viewed as internally motivated (not coerced).
22
Deprival Syndrome
Ready for Any Takeaway
Charles Munger, in 'Poor Charlie's Almanack', describes the concept: ! The quantity of man's pleasure from a ten-dollar gain does not exactly match the quantity of his displeasure from a ten-dollar loss. That is, the loss seems to hurt much more than the gain seems to help. ! A man ordinarily reacts with irrational intensity to even a small loss, or threatened loss, of property, love, friendship, dominated territory, opportunity, status, or any valued thing. ! Deprival-Superreaction Tendency has ghastly effects in labor relations. Most of the deaths in the labor strife that occurred before World War I came when employers tried to reduce wages. Nowadays, we see fewer deaths and more occasions when whole companies disappear, as competition requires either takeaways from labor - which it will not consent to - or death of the business. Deprival-Superreaction Tendency causes much of this labor resistance, often in cases where it would be in labor's interest to make a different decision.
'Why Smart People Make Big Money Mistakes and How to Correct Them', by Gary Belsky & Thomas Gilovich: Behavioral economists describe the takeaway idea as the 'endowment effect'. Businesses understand this effect - once you take a product home and use it, there's a strong chance that the endowment effect will kick in; whatever value you might have placed on, say, a stereo at a store will likely be increased once it sits in your den for a few weeks.
23
Framing the Issue
Necessary or Welfare?
'If you would persuade, appeal to interest and not to reason' - Ben Franklin
Robert Rubin describes, 'In an Uncertain World': I learned through this episode that from the moment a President presents an important proposal to the nation, he has to spend time painting a picture of it his way. Otherwise, his opponents will color it their way and put him on the defensive. Our opponents went right to work casting our plan as a tax increase - a grave distortion in relation to the majority of taxpayers, who saw no increase in their income taxes and a gas tax estimated at only $36 a year for an average family of four. We, on the other hand, spent little time explaining how few people were affected by the tax increase or, more important, painting our own picture of the program as a restoration of fiscal discipline to create jobs, increase standards of living, and promote economic growth.
24
Incentive-Cause Bias
Potential for Bad Behavior
Charles Munger, in 'Poor Charlie's Almanack', describes the concept: ! One of the most important consequences of incentive superpower is what I call 'incentive-caused bias'. A man has an acculturated nature making him a pretty decent fellow, and yet, driven both consciously and subconsciously by incentives, he drifts into immoral behavior in order to get what he wants, a result he facilitates by rationalizing his bad behavior. ! Widespread incentive-caused bias requires that one should often distrust, or take with a grain of salt, the advice of one's professional advisor, even if he is an engineer. The general antidotes here are: 1) fear professional advice when it is especially good for the advisor; 2) learn and use the basic elements of your advisor's trade as you deal with your advisor; and 3) double check, disbelieve, or replace much of what you're told, to the degree that seems appropriate after objective thought. ! The inevitable ubiquity of incentive-caused bias has vast, generalized consequences. For instance, a sales force living only on commissions will be much harder to keep moral than one under less pressure from the compensation arrangement. On the other hand, a purely commissioned sales force may well be more efficient per dollar spent. Therefore, difficult decisions involving trade-offs are common in creating compensation arrangements in the sales function.
25
Liking
Easy to Like
The concept is explained by Robert Cialdini, in his book 'Influence Science and Practice': ! People prefer to say yes to individuals they know and like. Recognizing this rule, compliance professionals commonly increase their effectiveness by emphasizing several factors that increase their overall attractiveness and likability. ! Physical attractiveness seems to engender a halo effect that extends to favorable impressions of other traits such as talent, kindness, and intelligence. As a result, attractive people are more persuasive both in terms of getting what they request and in changing others' attitudes. ! A second factor that influences liking and compliance is similarity. We like people who are like us, and we are more willing to say yes to their requests, often in an unthinking manner. ! "It's gotten to the point now where I hate to be invited to Tupperware parties. I've got all the containers I need; and if I wanted any more, I could buy another brand cheaper in the store. But when a friend calls up, I feel like I have to go. And when I get there, I feel like I have to buy something. What can I do? It's for one of my friends."
26
Reciprocation
Just Reciprocating
The concept is explained by Robert Cialdini, in his book 'Influence Science and Practice': ! According to sociologists and anthropologists, one of the most widespread and basic norms of human culture is embodied in the rule for reciprocation. The rule requires that one person try to repay, in kind, what another person has provided. This sense of future obligation within the rule makes possible the development of various kinds of continuing relationships, transactions, and exchanges that are beneficial to society. Consequently, all members of the society are trained from childhood to abide by the rule or suffer serious social disapproval. ! I know of no better illustration of the way reciprocal obligations can reach long and powerfully into the future than the perplexing story of $5,000 of relief aid that was exchanged between Mexico and Ethiopia. In 1985, Ethiopia could justly lay claim to the greatest suffering and privation in the world. Under these circumstances, I would not have been surprised to learn of a $5,000 relief donation from Mexico... I remember my feeling of amazement, though, when a brief newspaper item I was reading insisted that the aid had gone in the opposite direction. ! Fortunately, a journalist who had been as bewildered as I by the Ethiopians' actions had asked for an explanation. The answer he received offered eloquent validation of the reciprocity rule: Despite the enormous needs prevailing in Ethiopia, the money was being sent to Mexico because, in 1935, Mexico had sent aid to Ethiopia when it was invaded by Italy.
27
Scarcity
Now She Really Wants It
The concept is explained by Robert Cialdini, in his book 'Influence Science and Practice': ! According to the scarcity principle, people assign more value to opportunities when they are less available. The use of this principle for profit can be seen in such compliance techniques as the 'limited number' and 'deadline' tactics, wherein practitioners try to convince us that access to what they are offering is restricted by amount or time. ! According to psychological reactance theory, we respond to the loss of freedoms by wanting to have them (along with the goods and services connected to them) more than before. ! The scarcity principle is most likely to hold true under two optimizing conditions. First, scarce items are heightened in value when they are newly scarce. That is, we value those things that have become recently restricted more than those that were restricted all along. Second, we are most attracted to scarce resources when we compete with others for them. ! People seem to be more motivated by the thought of losing something than by the thought of gaining something of equal value. For instance, college students experienced much stronger emotions when asked to imagine losses as opposed to gains in their romantic relationships or in their grade point averages. Especially under conditions of risk and uncertainty, the threat of potential loss plays a powerful role in human decision making.
28
Social Proof
Do They Know Something?
The concept is explained by Robert Cialdini, in his book 'Influence Science and Practice': ! We view a behavior as correct in a given situation to the degree that we see others performing it. Whether the question is what to do with an empty popcorn box in a movie theater, how fast to drive on a certain stretch of highway, or how to eat chicken at a dinner party, the actions of those around us will be important guides in defining the answer. ! Social proof is most influential under two conditions. The first is uncertainty. When people are unsure, when the situation is ambiguous, they are more likely to attend to the actions of others and to accept those actions as correct. The second condition under which social proof is most influential is similarity: People are more inclined to follow the lead of similar others. ! Advertisers love to inform us when a product is the 'fastest-growing' or 'largestselling' because they don't have to convince us directly that the product is good; they need only say that many others think so, which seems proof enough. ! The best illustration I know, however, comes from Singapore, where a few years ago, for no good reason, customers of a local bank began drawing out their money in a frenzy. The run on this respected bank remained a mystery until much later... an unexpected bus strike had created an abnormally large crowd waiting at the bus stop in front of the bank that day. Mistaking the gathering for a crush of customers poised to withdraw their funds from a failing bank, passersby panicked and got in line to withdraw their deposits, which led more passersby to do the same. Soon after opening its doors, the bank was forced to close to prevent a complete crash.
29
Big Thinking Models As Simple As Possible
As Simple As Possible, But No Simpler
The process requires asking why, why and why until one can go no further essentially trying to reduce to a more fundamental body of knowledge.
In 'No Ordinary Genius', Richard Feynman discusses his ability to simplify: But the game is to try to figure a thing out, with what we know is possible. It requires imagination to think of what’s possible, and then it requires an analysis back, checking to see whether it fits, whether it’s allowed, according to what is known. When you explain a ‘why’ you have to be in some kind of framework where you allow something to be true, otherwise you are perpetually asking ‘why?’ Learn by trying to understand simple things in terms of other ideas – always honestly and directly. What keeps clouds up, why do colors appear on oily water, etc. Look about you and think of what you see there. It was my father who got me into this business of having to imagine things all the time. Things like, if a Martian landed wouldn’t they ask: ‘Why does everyone go to sleep every night?’ For example, Aunt Minnie is in hospital. Why - Because she slipped on the ice and broke her hip. That satisfies people. But it wouldn’t satisfy someone who came from another planet.
30
Occam's Razor provides another approach to the 'as simple as possible' approach. William of Occam, a 14th century philosopher, said, 'Non sunt entia multiplicanda oracter necessitatem,' which translates to, 'Hypotheses should not be multiplied without reason.' In other words, look for the simplest answer possible.
In 'The Nature of Science', James Trefil, the author, explains it this way:
For example, suppose that someone sees a bright and unexpected light in the night sky, a UFO. One explanation is that this person has seen the lights of a spacecraft piloted by extraterrestrials. This explanation requires many of Occam's superfluous 'hypotheses' - the existence of extraterrestrials, their ability to build interstellar ships, their interest in Earth, their inability to avoid detection, and so on. But there are many other, simpler explanations for lights in the sky - airplanes, the planet Venus (the number one explanation for 'UFOs'), weather balloons, and so on. Each of these explanations requires a relatively small number of hypotheses.
31
Big Picture Math
Nobody Compounds Better
Using elementary math to quickly appraise a situation. Here, the idea is to use numbers to evaluate the big idea in the argument, to see whether or not it makes sense. A widely used rule of thumb is compounding - Think of 72 Compounding has only half-jokingly been referred to as the eighth wonder of the world. The rule of '72' provides a handy calculation tool. If $10,000 were invested in an account yielding 7%, it would double about every 10 years (72 divided by 7 equals 10, the doubling period). So after 20 years, the $10,000 investment will be $40,000. At 15%, the $10,000 would double about every 5 years (72 divided by 15 equals 5, the doubling period).
Another Big Picture approach, described by Peter Drucker in ‘The Practice of Management’. Instead of forecasting the future, this method focuses on past events - events which, however, have not yet expressed themselves economically. Instead of attempting to guess economic conditions, this method tries to find the ‘bedrock’ underlying economic conditions. [For example]... the bedrock underlying the economy, namely, the pattern of family formation and population structure that had emerged in the United States between 1937 and 1943.
32
Whilst there isn’t a formula set for Big Picture Math, the following examples highlight the methodology of looking for the big part of the argument.
In ‘Poor Charlie’s Almanack’, Charles Munger provides this piece of numerical reasoning as he discusses the potential of a hypothetical Cola company: We can guess reasonably that by 2034 there will be about eight billion beverage consumers in the world. On average, each of these consumers will be much more prosperous in real terms than the average consumer of 1884. Each consumer is composed mostly of water and must ingest about sixty-four ounces of water per day. This is eight, eight-ounce servings. Thus, if our new beverage, and other imitative beverages in our new market, can flavor and otherwise improve only twenty-five percent of ingested water worldwide, and we can occupy half of the new world market, we can sell 2.92 trillion eight-ounce servings in 2034. And if we can then net four cents per serving, we will earn $117 billion. This will be enough, if our business is still growing at a good rate, to make it easily worth $2 trillion.
Alfred Rappaport and Michael Mauboussin get to the heart of the rollout success of McDonald’s in ‘Expectations Investing’: The world's leading fast food purveyor, McDonald's, is an illustration of how fixed-capital investment efficiency can add value. Through standardization, global sourcing, and purchasing power, McDonald's trimmed its average U.S. unit development costs significantly in the early 1990s. Notably, expected sales and operating profit margins from these units did not diminish. The improved efficiency translated directly into higher cash flows and shareholder value.
McDonaldʼs Investment per Unit ($ 000ʼs) 1994
1993
1992
1991
1990
Land
317
328
361
433
433
Building
483
482
515
608
720
Equipment
295
317
361
362
403
Avge. Cost
$1,095
$1,127
$1,237
$1,403
$1,556
33
The last example of math reasoning is taken from a ‘Heard on the Street’ article in the Wall Street Journal: Washington's "cash for clunkers" isn't just a way of getting you to buy a car you didn't know you wanted. The administration also touts its green credentials. Assume 250,000 vehicles are exchanged, with the new ones getting 9.6 miles more per gallon. Based on each driving 12,000 miles a year, that equates to almost 200 million gallons of fuel saved every day. Sounds big, but the U.S. burns that much every 22 seconds. Every gallon of gasoline burned emits about 19 pounds of carbon dioxide. Say the old cars would have been driven another five years without the clunkers subsidy. The implied saving is about 3.5 million tons of carbon dioxide. Even apportioning only half of the $1 billion cost of the subsidy to carbon reduction works out at $144 a ton - about seven times what carbon permits trade for in Europe. As a cost-effective green initiative, "clunkers" emit a fair amount of hot air.
34
Deduction or Induction?
Elementary My Dear Watson Latin roots of the two words mean: ‘leading from’ and ‘leading in’. Deduction forms the basis of classical logic, while induction is the foundation of scientific method.
Deductive reasoning begins with a general truth/hypothesis and leads to a knowledge of a particular instance of it. The classic form is a SYLLOGISM, in which a necessary conclusion is derived from two accepted premises.
‘If all cows are ruminants, and Bossy is a cow, it follows that Bossy chews her cud.’
Induction begins with the particular and moves to the universal (a generalization that accounts for other examples of the same category or class). It relies on observation and experimentation.
‘In the case of Bossy, it can be demonstrated that she digests by rumination; if all the other cows we observe do likewise, we can declare, if not a certainty then a high probability, that cud chewing is a distinguishing feature of all cows.’
35
Disconfirming Evidence
A Disconfirming Figure
The tendency to rationalize preconceived ideas and not look for disconfirming evidence.
Described in 'Decision Traps', by Edward Russo and Paul Schoemaker: Most of us seem to possess a built-in tendency to favor data that support our current beliefs and to dismiss evidence that upsets them. This can lead large organizations far off-course because often a diligent search can turn up hundreds of pieces of evidence that seem to confirm a hypothesis even though the hypothesis isn't true. Most of us favor confirming evidence even when the search for confirming evidence has clearly become unhelpful. Confirming evidence gives us a mental reward. Every shred says: 'You're on the right track... You're doing a good job.' Disconfirming evidence, on the other hand, says: 'Your idea wasn't as good as you thought.' In short, confirmation feels good and disconfirmation feels (at least momentarily) painful. Thus people tend to neglect evidence that might undermine their ideas. ! Moral: Have the discipline to seek information that might disconfirm your opinions. If you look for it and can't find it, then you have reason to be confident. One way to look for it is to generate an alternative hypothesis and test both. The human understanding when it has once adopted an opinion draws all things else to support and agree with it. And though there be a greater number and weight of instances to be found on the other side, yet these it either neglects and despises, or else by some distinction sets aside and rejects, in order that by this great and pernicious predetermination the authority of its former conclusion may remain inviolate. - Francis Bacon
36
Game Theory A framework for studying situations in which decisions are influenced by the choices of others. Consider, for example a new company that wishes to enter a market segment against the industry leader. How should the new company set its prices? Should it go in with its original pricing scheme, or does it go in lower judging that the leader will lower prices to drive out the new entrant? The matrix outlines the possibilities:
Leader Lower Lower
Maintain 0
0
A
B
0 New Company
1
Maintain
1
1
C 0
D 1
Box A: If both the new company and leader adopt lower prices, they both lose (score = 0) as profits are lower all around. Box B: If the new company goes lower price, but the leader maintains, then the new company is likely to gain market share (score = 1). Box C: If the new company maintains its price, but the leader opts for a low price strategy then the new company is unlikely to get a foothold in the leader’s market. Box D: If they both maintain pricing, they will both be better off as profits are maximized. From this basic analysis the best and worst joint scenarios are clear. However, for the leader the best choice is the least worst option. Since it is already the leader if it chooses the lower price strategy, it may win (Box C) or at the worst (Box A) it will prevent the new company from gaining an advantage.
37
From 'The Moral Animal', by Robert Wright: Game theorists, then, may want to follow a few simple rules when applying their tools to human [behavior]. First, the object of the game should be to maximize genetic proliferation. Second, the context of the game should mirror reality in the ancestral environment, an environment roughly like a hunter-gatherer society. Third, once the optimal strategy has been found, the experiment isn't over. The final step - the payoff - is to figure out what feelings would lead human beings to pursue that strategy. Those feelings, in theory, should be part of human nature; they should have evolved through generations and generations of the evolutionary game. !
'Thinking Strategically', by Avinash Dixit and Barry Nalebuff: Everyone’s best choice depends on what others are going to do, whether it’s going to war or maneuvering in a traffic jam. These situations, in which people’s choices depend on the behavior or the choices of other people, are the ones that usually don’t permit any simple summation. Rather we have to look at the system of interaction. Your Rival’s Response – Look Ahead, Reason Back Use decision trees to think through alternatives. Reason back from outcomes to determine initial strategy. A player has a Dominant Strategy when he has one course of action that outperforms all others no matter what the other players do. (Prisoner’s Dilemma – players follow their dominant strategy but the outcome is jointly worse) When leading it may be better to copy those against whom you are competing in order to guarantee staying ahead. Sometimes moving first can be a disadvantage. Credibility 1.! Establish and use a reputation (threats/promises must be credible) 2.! Write contracts 3.! Burn bridges behind you 4.! Employ mandated negotiating agents Unpredictability - Acting randomly, deliberately. The most widespread use of randomized strategies in business is to motivate compliance at a lower monitoring cost. Slippery Slope Continual small steps and lack of focus on overall package can start one on slippery slope and then one cannot back out: Auctions; trade arguments; military arguments.
38
Getting to Why In 'The New Rational Manager', Charles Kepner and Benjamin Tregoe, outline their approach to solving problems. Their framework targets the gap - deviation - between expected and actual outcomes. What is the TROUBLE STATEMENT? What is wrong with what: 1. Object - 1. Defect/Fault IS
IS NOT
WHAT
WHAT
What object or group of objects are you having trouble with? What is wrong with the object or objects - (Defect/ Fault)?
What object(s) could you be having trouble with but are not? What else could be wrong with the object/s but is not?
WHERE
WHAT
Where is the object when the defect is noticed (Geographic Location)? Where is the defect/fault located on the object?
Where could the defective object be observed but is not? Where could the defect/fault be located on the object but is not?
WHEN
WHEN
When was the defect/fault first noticed (Date & Time)? When has the defect/fault been noticed since (Pattern)? When in the life cycle of the object was the defect/fault first noticed?
When could the defect/fault have been first noticed but was not? When could the defect/fault have been noticed since but was not? When in the life cycle could the defect/fault have been noticed but was not?
EXTENT/SIZE
EXTENT/SIZE
How many defective objects are there? What is the size of the defect/fault on the object? How many defects/faults are on any one object? What is the trend?
How many defective objects could there be, but are not? What could the size of the defect/fault be, but is not? How many defects/faults could there be but are not? What could the trend be, but is not?
The analysis can then start by asking what, if anything, is distinctive about the 'is' from the 'is not' for each parameter. Since people tend to think 'what is' rather than 'what is not', the Kepner Tregoe approach helps target the 'what is not' deficiency.
39
Ideas
A Good Idea?
James Webb Young describes the process from an advertising perspective in 'A Technique for Producing Ideas': What is most valuable to know is not where to look for a particular idea, but how to train the mind in the method by which all ideas are produced and how to grasp the principles which are at the source of all ideas. An idea is nothing more nor less than a new combination of old elements. The second important principle involved is that the capacity to bring old elements into new combinations depends largely on the ability to see relationships. 1. Gather new material. The materials which must be gathered are of two kinds: they are specific and they are general. In advertising, the specific materials are those relating to the product and the people to whom you propose to sell it. General materials come from being intensely curious about all manner of things. Extensive browsing produces this general data bank. 2. In advertising an idea results from a new combination of specific knowledge about products and people with general knowledge about life and events. 3. Then really work these materials over in your mind. Trying first to fit one way and then looking from another angle, or trying to combine in a different way. Mindset: To be constantly pre-occupied (with its brooding quality) with the possibilities of new combinations. 4. Then incubate, by letting the conscious mind think about something completely different. This will aid the synthesis process. 5. Once the ‘eureka’ moment has arrived and the idea given birth, review it in the cold light of day so that it can take its final shape and form, helping to overcome those last minute doubts as to its usefulness.
40
In 'why not?' the authors Barry Nalebuff and Ian Ayres describe four tools for generating good ideas: What would Croesus do? Since Croesus was the supremely rich king of Lydia (modern day Turkey), the question is what would you do if money wasn't an issue? If money was not a problem, you would use your own private plane to jet around the world. So how, more realistically, can you get your own jet? Enter the business model that is now known as fractional jet ownership - first conceived by NetJets. Why don't you feel my pain? In addition to watching what consumers do well, it is also useful to pay attention to what they do wrong. In other words, how do the incentives cause them to behave in the 'wrong' way? Busy highways full of no passenger cars, at peak hours, have led many states to introduce car pool lanes in an attempt to provide the correct incentive. Perhaps tolls could be used, based on the number of passengers (the greater the number, the lower the toll), to reinforce this incentive. Where else would it work? You've come up with a great solution. What other problems does it solve? The idea of self-checkout at the supermarket has now been adapted to self-checkin airline counters, automated library checkouts and self-service post office kiosks. Would flipping it work? Sometimes flipping things around provides a powerful new solution. In South Africa, as most other places, the utility provides electricity and then bills you for the amount used. You consume and then pay. But what if you pay first and then consume? This was the scheme devised by Eskom, the electricity utility, as it provided electricity to crowded black townships. Consumers bought prepaid electricity cards and inserted them into their meters to 'turn-on the lights'.
41
Incentives
Say No More Incentives drive behavior. Self-interest makes the world go round. Consider the total utility of the given incentive when predicting behavior.
This incentive story is recounted by Charles Munger in 'Poor Charlie's Almanack': ! From all business, my favorite case on incentives is Federal Express. The heart and soul of its system - which create the integrity of the product - is having all its airplanes come to one place in the middle of the night and shift all the packages from plane to plane. If there are delays, the whole operation can't deliver a product full of integrity to Federal Express customers. And it was always screwed up. They could never get it done on time. They tried everything moral suasion, threats, you name it. And nothing worked. Finally, somebody get the idea to pay all these people not so much an hour, but so much a shift - and when it's all done, they can go home. Well, their problems cleared up overnight.
42
Information
Important & Knowable
Is it important? If it's not important then it can be discarded. But if it is important, is it knowable?
'In Seeking Wisdom', the author Peter Bevelin quotes Warren Buffett: There are two questions you ask yourself as you look at the decision you'll make. A) is it knowable? B) is it important? If it is not knowable, as you know there are all kinds of things that are important but not knowable, we forget about those. And if it's unimportant, whether it's knowable or not, it won't make any difference. We don't care. But there are enough things that are knowable and important that we focus on those things. And everything else, we forget about.
43
Invert
Who ʻWouldaʼ Thought?
Often when trying to solve a difficult problem, it is wise to concentrate on the outcome that you do not want and thereby avoid it to reach the desired result. ! In every business deal or transaction, identify the worst thing that can possibly go wrong, and then make sure it doesn't happen - John Paul Getty
Charles Munger, in 'Poor Charlie's Almanack', highlights the point: ! ! The great algebraist, Jacobi... was known for his constant repetition of one phrase: 'Invert, always invert.' It is in the nature of things, as Jacobi knew, that many hard problems are best solved only when they are addressed backward.
A further Charles Munger explanation is given in 'Seeking Wisdom', by Peter Bevelin: ! The mental habit of thinking backward forces objectivity - because one of the ways you think through backward is you take your initial assumption and say, 'Let's try and disprove it.' ! That is not what most people do with their initial assumption. They try and confirm it. It's an automatic tendency in psychology - often called 'first-conclusion bias'. But it's only a tendency. You can train yourself away from the tendency to a substantial degree. You just constantly take your own assumptions and try to disprove them.
44
Marginal Thinking
The Cost of an Extra Passenger
Rational people can make better decisions by thinking at the margin. For example: Although the average cost of flying a passenger may be $500, the marginal cost is merely the extra bag of peanuts and a drink. As long as the marginal passenger pays more than the marginal cost, selling him a ticket is profitable.
'The Economic Way of Thinking' by Paul Heyne: Economic analysis is basically marginal analysis. Marginal means additional. Economic theory is marginal analysis because it assumes that decisions are always reached by weighing additional costs against additional benefits. Nothing matters in decision making except marginal costs and marginal benefits.
45
Metaphors
Politics Loves Metaphors
It’s often difficult to tell whether similarities between a familiar and an unfamiliar problem are deep or superficial. People facing choices can improve their odds of using analogies well by following these 4 steps:
SOURCE PROBLEM Apparently similar problem from another context
TARGET PROBLEM
!" Recognize the analogy and identify its purpose
Your company’s problem
Understand the source. Actively search for differences between the source and the target; and assess similarities. Find the solution, and adjust for glaring differences. Source Problem
Target Problem
Candidate Solution
Your Solution Translate, decide & adapt Application
46
The method is illustrated as follows: Source Problem: The business and high-value checking customers of a well known local bank had been complaining about branch service. They said teller waiting times were unacceptable and that personal bankers were hardly ever available to deal with important issues. Candidate Solution: The bank reviewed every single account and applied a cost to it based on customer transactions per year, for a 3-year period. It then decided to transfer all the small accounts of its least profitable customers to an internet only account. Some of these customers decided to close their accounts. The majority, however, remained. After six months an independent branch survey showed a high degree of satisfaction among business and high-value checking customers. Target Problem: The international airline has been slipping recently and business customers, its most profitable passengers, have been complaining. The airline has decided to adapt the local bank strategy. It already knows that business class passengers generate the bulk of its profits, whilst economy passengers are barely profitable. The airline reviews all the costs associated with its economy passengers and decides that extra baggage and on-board drinks represent significant 'hidden' costs. Your Solution: The airline will therefore reduce its baggage allowance for economy passengers, and will further ask them to pay for on-board drinks. The additional income will be used to improve food and beverage service in business class.
47
Opportunity Costs The cost of any action is the value of the opportunity forgone by taking that action.Resources have other opportunities for their employment. Hence to acquire them one must 'crowd out' the next best application. Only actions have costs. One must do something to incur the cost. And costs are always to someone.
This is the 'broken window' concept as described by Henry Hazlitt in 'Economics in one Lesson': " A young hoodlum, say, heaves a brick through the window of a baker’s shop. The shopkeeper runs out furious, but the boy is gone. A crowd gathers, and begins to stare with quiet satisfaction at the gaping hole in the window and the shattered glass over the bread and pies. After a while the crowd feels the need for philosophic reflection. And several of its members are almost certain to remind each other or the baker that, after all, the misfortune has its bright side. It will make business for some glazier. As they begin to think of this they elaborate upon it. How much does a new plate glass window cost? Two hundred and fifty dollars? That will be quite a sum. After all, if windows were never broken, what would happen to the glass business? Then, of course, the thing is endless. The glazier will have $250 more to spend with other merchants, and these in turn will have $250 more to spend with still other merchants, and so ad infinitum. The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be, if the crowd drew it, that the little hoodlum who threw the brick, far from being a public menace, was a public benefactor. ! Now let us take another look. The crowd is at least right in its first conclusion. This little act of vandalism will in the first instance mean more business for some glazier. The glazier will be no more unhappy to learn of the incident than an undertaker to learn of a death. But the shopkeeper will be out $250 that he was planning to spend for a new suit. Because he has had to replace a window, he will have to go without the suit (or some equivalent need or luxury). Instead of having a window and $250 he now has merely a window. Or, as he was planning to buy the suit that very afternoon, instead of having both a window and a suit he must be content with the window and no suit. If we think of him as a part of the community, the community has lost a new suit that might otherwise have come into being, and is just that much poorer. " The glazier’s gain of business, in short, is merely the tailor’s loss of business. No new “employment” has been added. The people in the crowd were thinking only of two parties to the transaction, the baker and the glazier. They had forgotten the potential third party involved, the tailor. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye.
48
Probabilistic Thinking
Whatʼs the Chance?
Robert Rubin describes the decision by probabilities mindset in 'In an Uncertain World': All decisions are about probabilities. For me, probabilistic thinking has long been a highly conscious process. I imagine the mind as a virtual legal pad, with the factors involved in a decision gathered, weighed, and totaled up. To describe probabilistic thinking this way does not, however, mean that it can be reduced to a mathematical formula, with the best decision jumping automatically off a legal pad. Sound decisions are based on identifying relevant variables and attaching probabilities to each of them. That’s an analytic process but also involves subjective judgements. The ultimate decision then reflects all of this input, but also instinct, experience, and ‘feel’. All the time bearing in mind that reality is always more complex than concepts and models. A true probabilistic view of life quickly leads to the recognition that almost all significant issues are enormously complex and demand that one delve into those complexities to identify the relevant considerations and the inevitable trade-offs. With an enormous number of competing considerations, the key to reaching the best possible decision is to identify all of them and decide what odds and import to attach to each.
49
A widely used tool for probabilistic thinking is decision tree analysis. For example, consider a company that wishes to conduct a 10,000 piece test marketing campaign and must decide between mail and email. The company obtains pricing from its vendor for both options - $4,000 for mail campaign and $1,500 for email. The company then asks its vendor what the average, best case and worst case orders would be in each case. The vendor is confident of its mail figures due to a large body of prior experience and the nature of delivery (physical address); and therefore informs the company that the average rate is 3%, best case would be 8% and worst case 0.25%. The vendor feels that email is much more unpredictable due to spam filters and the quality of the email list; and therefore informs the company that the average order rate is 1%, best case would be 10% and worst case 0.25%.
50
In 'Take The Risk', Dr. Ben Carson illustrates his approach to probabilistic thinking: " Being successful is simply a matter of making good choices by using our incredibly sophisticated brains. We all have the means to analyze risks and decide which are worth taking and which should be avoided. That’s a simple but powerful prescription for life, love and success. ! With respect to the best/worst analysis, when wrestling with an important decision, ask yourself these four questions:
!
What is the best thing that can happen if I do this?
!
What is the worst thing that can happen if I do this?
"
What is the best thing that can happen if I don’t do it?
"
What is the worst thing that can happen if I don’t do it?
51
Reductionism From 'An Introduction to General Systems Thinking', by Gerald Weinberg. Reductionism - Getting Your Hands Around It. … it is his chosen task to understand the simplifying assumptions of a science… those ‘objects of interest’ and ‘well-defined conditions’ that delimit its domain of application and magnify its power of prediction.
The concept is further explored in 'Consilience The Unity of Knowledge', by Edward O. Wilson: ! Here is how reductionism works most of the time, as it might appear in a user's manual. Let your mind travel around the system. Pose an interesting question about it. Break the question down and visualize the elements and questions it implies. Think out alternative conceivable answers. Phrase them so that a reasonable amount of evidence makes a clear-cut choice possible. If too many conceptual difficulties are encountered, back off. Search for another question. When you finally hit a soft spot, search for the model system – say a controlled emission in particle physics or a fast breeding organism in genetics – on which decisive experiments can be most easily conducted. Become thoroughly familiar with the system; love the details. Design the experiment, so that no matter what the result, the answer to the question will be convincing. Use the result to press on to new questions, new systems.
In 'More Than You Know', author Michael Mauboussin, explains the limits to reductionism: ! Reductionism is the cornerstone of discovery in the Newtonian world, the basis for much of science's breathtaking advance in the seventeenth through nineteenth centuries. As scientist John Holland explains, 'The idea is that you could understand the world, all of nature, by examining smaller and smaller pieces of it. When assembled, the small pieces would explain the whole.' In many systems reductionism works brilliantly. ! But reductionism has its limits. In systems that rely on complex interactions of many components, the whole system often has properties and characteristics that are distinct from the aggregation of the underlying components. Since the whole of the system emerges from the interaction of the components, we cannot understand the whole simply by looking at the parts. Reductionism fails. ! When a system has low complexity and we can define interactions linearly, reductionism is very useful. Many engineered systems fit this bill.
52
Scientific Method
A Very Scientific Approach
Observe & Impartially Consider Data Look for Regularities in Understanding Develop Hypothesis Hypothesis cannot be verified, only falsified. Predict Unobserved Phenomena Using observed initial conditions and hypothesis Review Hypothesis Are the observed final conditions explained by the hypothesis, or has the hypothesis been falsified.
‘The Meaning Of It All’ by Richard Feyman ! ...science as a method of finding things out. This method is based on the principle that observation is the judge of whether something is so or not. All other aspects and characteristics of science can be understood directly when we understand that observation is the ultimate and final judge of the truth of an idea. " Or, put another way, ‘The exception proves that the rule is wrong.’ That is the principle of science. If there is an exception to any rule, and if it can be proved by observation, that rule is wrong. ! So the more specific the rule, the more powerful it is, the more liable it is to exceptions, and the more interesting and valuable it is to check. " The method is ‘Try it and see’… and accumulate the information and so on. And so the question ‘If I do it what will happen?’ is a typically scientific question.
53
Spend - Conserve
Abundant Information
The concept of spending abundances to conserve scarcities is described by George Gilder in a 'Gilder Technology Report' from January, 2000: Every new era is marked and measured by key abundances and scarcities. They shape the field of economics, the substance of business, the fabric of culture, and the foundation of life. As Japanese futurist Taichi Sakaiya has written: 'Survival dictates that human beings... develop an ethics and aesthetics that favor exploiting fully those resources that exist in abundance and economizing on items that are in short supply'. That is how we exist. Economists have traditionally focused on scarcity. Abundances tend to end in a near zero price and thus escape economics altogether. As the price declines and their role in the economy becomes more vast and vital, their role in economic analyses diminishes. When they are ubiquitous, like air and water, they are invisible... 'externalities'. Every economic era has a defining abundance, a critical resource or technology that is expanding in production and plummeting in price so rapidly that it appears virtually free when compared to an array of competing critical resources for which it can be substituted. These abundances come to define the very character of their age, whether an age of 'steam' or 'oil' or an age of 'information'.
54
During the pre-industrial era in America, the scarcity was horsepower and the abundance was land. In the industrial age, horsepower - physical force, translated eventually into watts, or kilowatt-hours - abounded while land grew relatively scarce. Between 1660 and 1950, the cost of an effective kilowatt-hour dropped from thousands of dollars to some seven cents. We splurged on cheap horsepower - to clear farmland, to refine ores, to manufacture goods etc. Over the last 30 years... transistors became asymptotically costless. On a computer memory chip the price of a transistor, with support circuits, dropped from some seven dollars to a few millionths of a cent. An era's defining abundances relieve its critical scarcities. We use transistors to compensate for a shortage of human servants and... broadband communications capacity. But abundances can also create new scarcities. The plethora of cheap fuel created a dearth of roads and a need for pollution controls. The more recent glut of transistors led to a shortage of the very communications capacity it was meant to enhance.
(Simon, H. A. (1971), 'Designing Organizations for an Information-Rich World', in Martin Greenberger, Computers, Communication, and the Public Interest, Baltimore, MD: The Johns Hopkins Press, p. 40-41). '...in an information-rich world, the wealth of information means a dearth of something else: a scarcity of whatever it is that information consumes. What information consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention and a need to allocate that attention efficiently among the overabundance of information sources that might consume it.'
55
Systems Thinking
A Systematic Thinker
From 'An Introduction to General Systems Thinking', by Gerald Weinberg: The Three Great Questions of Systems Thinking Why do I see what I see? Why do things stay the same? Why do things change? All general systems thinking starts with one of the three and pursues it until forced to move to another. Law of Large Numbers The larger the population, the more likely we are to observe values that are close to the predicted average values. Randomness One suggestive phrase is that statistical mechanics deals with ‘unorganized complexity’ that is, systems that are complex, but yet sufficiently random in their behavior so that they are sufficiently regular to be studied statistically. Law of Medium Numbers For medium number systems, we can expect that large fluctuations, irregularities, and discrepancy with any theory will occur more or less regularly. Stability When we speak of stability, we are speaking of two things: a set of acceptable behaviors of the system and a set of expected behaviors of the environment. Principle of Invariance We understand change only by observing what remains invariant, and permanence only by what is transformed. Count-to-Three Principle If you cannot think of three ways of abusing a tool, you do not understand how to use it.
56
The Argument
Letʼs Debate
In 'Asking the Right Questions', the authors Neil Browne and Stuart Keeley, lay out a framework for critical thinking: What are the issue and the conclusion? Finding an author's main point is the first step in deciding whether you will accept or reject that main point. What are the reasons? Reasons are beliefs, evidence, metaphors, analogies, and other statements offered to support or justify conclusions. Reasons are the why. Which words or phrases are ambiguous? You can be certain you have identified an especially important unclear term by performing the following test If you can express two or more alternative meanings for a term, each of which makes sense in the context of the argument, and if the extent to which a reason would support a conclusion is affected by which meaning is assumed, then you have located a significant ambiguity. Thus, a good test for determining whether you have identified an important ambiguity is to substitute the alternative meanings into the reasoning structure and see whether changing the meaning makes a difference in how well a reason supports the conclusion...
57
Consider the following paragraph: ! The quality of education at this university is not declining. In my interviews, I found that an overwhelming majority of the students and instructors responded that they saw no decline in the quality of education here. ! The 'quality of education' is obviously the key point, but does it refer to grade point average, the starting salary of graduating students, a third party ranking etc.
What are the assumptions? Descriptive assumptions are beliefs about the way the world is. By value assumption we mean a taken-for-granted belief about the relative desirability of certain competing values. Keep asking, 'How do you get from the reason to the conclusion?' Ask, 'If the reason is true, what else must be true for the conclusion to follow?' And, to help answer that question, you will find it helpful to ask, 'Supposing the reason(s) were true, is there any way in which the conclusion nevertheless could be false?' How good is the evidence: Intuition, appeals to authority, and testimonials? Other examples of evidence include personal observation, analogies and the validity of presented statistics. Are there rival causes? Is there a plausible interpretation, different from that argued, that can explain the outcome? This is one reason why control samples are used in science. What significant information is omitted? When an author is trying to persuade you of something, he or she often leaves out important information. This information is often useful in assessing the worth of the argument. By explicitly looking for omitted information, you can determine whether the author has provided you with enough information to support the reasoning.
58
Unintended Consequences
Not So Fast
The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups; and to think of primary and secondary consequences. To see the problem as a whole and not in individual fragments. Consequences: Everybody looks to extra-vivid, observable evidence. But also consider what cannot be seen, or what never came into existence because of a particular course of action.
In 'Applied Economics' by Thomas Sowell, the author applies the 'And then what..' framework. As he explains When I was an undergraduate studying economics under Professor Arthur Smithies of Harvard, he asked me in class one day what policy I favored on a particular issue of the times. Since I had strong feelings on that issue, I proceeded to answer him... "And then what will happen?" he asked. The question caught me off guard. However, as I thought about it, it became clear that the situation I described would lead to other economic consequences, which I then began to consider and to spell out. "And then what will happen after that?" Professor Smithies asked. As I analyzed how the further economic reactions to the policy would unfold, I began to realize that these reactions would lead to consequences much less desirable than those at the first stage, and then I began to waver somewhat. "And then what will happen?" Smithies persisted. By now I was beginning to see that the economic reverberations of the policy I advocated were likely to be pretty disastrous - and, in fact, much worse than the initial situation that it was designed to improve.
59
Warren Buffett gives an example of this analysis (Originally in Outstanding Investor Digest, but quoted from 'Seeking Wisdom', by Peter Bevelin): ! The key thing in economics, whenever someone makes an assertion to you, is to always ask, "And then what?" Actually, it's not such a bad idea to ask it about everything. But you should always ask, "And then what?" So when you read that the merchandise trade deficit is $9 billion, what else does that mean? It means that somehow we must also have traded $9 billion of capital assets - (future) claims on our production - and given them to somebody else in the world. So they have to invest. They don't have a choice. And when somebody says, "Won't it be terrible if the Japanese sell all of their government bonds?" Well, they can't without getting another American asset in exchange. There's simply no other way to do it. They could sell it to the French, but then the French have the same problem. So trace through the transactions on the circle whenever you talk about any specific action in economics.
60
80:20 Rule The 80/20 Principle was discovered in 1897 by Italian economist Vilfredo Pareto. It simply maintains that a minority of causes, inputs, or effort usually lead to a majority of the results, outputs, or rewards. Whilst the exact split may not be 80/20, a significant imbalance is often found in a myriad of situations. In part this is explained by the nature of feedback loops and the idea of tipping points.
'The 80/20 Principle', by Richard Koch, develops numerous applications of the concept. The author's top 10 business uses of the 80/20 Principle are ! ! ! ! ! ! !
Strategy Quality Cost reduction and service improvement Marketing Selling Information technology Decision making and analysis
Considering the 80/20 idea forces one to look for the biggest issue, or the point of greatest leverage. This is illustrated in the following approach by Bill Gates: 1. Determine a Goal 2. Find the ‘highest-leverage approach’ 3. Discover the ideal technology for that approach 4. In the meantime, make the smartest application of the technology that you already have. For example, consider the AIDS epidemic: 1. To end the disease 2. Prevention is the highest leverage approach 3. Vaccine for a lifetime 4. Get people to avoid risky behavior
61
Business Models Arbitrage A process for identifying market inefficiencies. The classic idea is that of buying an item in one place and selling it in another. For example buying gold in London at $900 and selling it in New York at $910. But the mis-pricing mindset can apply just as well in business. Outsourcing, for example, is the buying of labor in one location for sale in another.
In the 1988 Berkshire Hathaway Annual Report, Warren Buffett discusses arbitrage: Once, the word applied only to the simultaneous purchase and sale of securities or foreign exchange in two different markets. The goal was to exploit tiny price differentials that might exist between, say, Royal Dutch stock trading in guilders in Amsterdam, pounds in London, and dollars in New York. Some people might call this scalping; it won’t surprise you that practitioners opted for the French term, arbitrage. Since World War I the definition of arbitrage - or “risk arbitrage,” as it is now sometimes called - has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc. In most cases the arbitrageur expects to profit regardless of the behavior of the stock market. The major risk he usually faces instead is that the announced event won’t happen. Some offbeat opportunities occasionally arise in the arbitrage field. I participated in one of these when I was 24 and working in New York for Graham-Newman Corp. Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted LIFO inventory valuation in 1941 when cocoa was selling for 50 cents per pound. In 1954 a temporary shortage of cocoa caused the price to soar to over 60 cents. Consequently Rockwood wished to unload its valuable inventory - quickly, before the price dropped. But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds. The 1954 Tax Code came to the rescue. It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporation’s business. Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to that activity. Accordingly, the company offered to repurchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share. For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts. The profits were good and my only expense was subway tokens.
62
Brand
Difficult to Reproduce
Thomas Sowell, 'Basic Economics': ! Brand names are not guarantees. But they do reduce the range of uncertainty. Since brand names are a substitute for specific knowledge, how valuable they are depends on how much knowledge you already have about the particular product or service. Someone who is very knowledgeable about photography might be able to get a bargain on an off-brand camera or lens, or even a second-hand camera or lens. But the same person might be well advised to stick with well known brands of new stereo equipment, if his knowledge in that field falls far short of his expertise in photography.
The importance of brands as an intangible asset is described in 'The Little Book That Builds Wealth', by Pat Dorsey: ! The bottom line is that brands can create durable competitive advantages, but the popularity of the brand matters much less than whether it actually affects consumers' behavior. If consumers will pay more for a product - or purchase it with regularity - solely because of the brand, you have strong evidence of a moat. But there are plenty of wellknown brands attached to products and companies that struggle to earn positive economic returns. ! Popular brands aren't always profitable brands. If a brand doesn't entice consumers to pay more, it may not create a competitive advantage.
63
Business Model
The Oldest Business Model
Discussed in 'The Practice of Management', by Peter Drucker: "
‘What business are we in?’; 'What business SHOULD we be in?'
The emphasis of defining and thinking about the business from the customer's perspective is further highlighted in 'Marketing Myopia', by Theodore Levitt, a Harvard Business Review article. ! Always ask where the competition might come from; and examine substitutable products. The customer group often never articulates their greatest unsatisfied need. " Do not focus on the product, rather keep focusing on the people who consume it (or don’t consume it) and their changing needs and desires, remembering that the consumer always buys to accomplish something. ! If you weren't already in this business would you enter it today? If not, what are you going to do about it?
Linked to the process is the idea of business model - as described by Joan Magretta in 'What Management Is': ! A business model is a set of assumptions about how an organization will perform by creating value for all the players on whom it depends, not just its customers. [It] is a story of how an enterprise works. Like all good stories, a business model relies on the basics of character, motivation, and plot. For a business, the plot revolves around how it will make
64
money. The characters must be precisely delineated, their motivations must be plausible, and the plot must turn on an insight about value. ! Underpinning every successful organization - whether the people who run that organization know it or not - is a business model that any sensible person can understand after the fact. We see who the characters are, why they will behave as they do, and the underlying economic logic that drives the plot and makes a self-sustaining system of the whole.
Strategy is another representation of this idea. The following extract is taken from 'Winning', by Jack Welch: ! ... I do want to disagree with the scientific approach to strategy... It is taught in many business schools, peddled by countless consulting firms, and practiced in far too many corporate headquarters. ! It's just so unproductive! If you want to win, when it comes to strategy, ponder less and do more. " First, come up with a big ‘aha’ for you business - a smart, realistic, relatively fast way to gain sustainable competitive advantage. ! Look, what is strategy but resource allocation? When you strip away all the noise, that's what it comes down to. Strategy means making clear-cut choices about how to compete. You cannot be everything to everybody, no matter what the size of your business or how deep its pockets.
65
Core Competency
An Engine for Both of Your Cars
As a company moves along a product (or process) path, knowledge is accumulated. Since most innovation is a rearrangement of existing knowledge units, the company is able to further innovate, and therefore move quicker, along this chosen path. Companies that have developed a knowledge base valued by customers in their industry make it more difficult for a new entrant to compete.
Consider Toyota in this description of how a process was studied from a Fortune Magazine article: Explicit specification of how work is going to be done before it is performed – coupled with testing work as it is being done. Hence any discrepancy between what is and what was expected immediately becomes evident. Tests of causal relationships: Stating the observed problem; the root cause suspected; the change proposed; the countermeasure’s actual effect on performance. Understand how the process works – and perhaps more importantly how the process was studied and improved. A series of experiments, performed simply and quickly to address observed problems.
So, it may be that Toyota's proprietary learning curve is its thinking and implementation culture, and high quality is the result? Similarly, we might ask what is about Honda that has led to its core competency in engines? Or why does Virgin seem to be further along the learning curve of setting up successful entrepreneurial businesses?
66
The idea of a 'core competency' in a company is outlined in 'Competing for the Future' by Gary Hamal and C.K. Prahalad: ! A competence is a bundle of skills and technologies rather than a single discrete skill or technology... [it] represents the sum of learning. Thus, a core competence is very unlikely to reside in its entirety in a single individual or small team. ! What is visible to the customers is the benefit, not the technical nuances, of the competence that underlies that benefit. Questions to answer include: What is the customer actually paying for? Why is the customer willing to pay more or less for one product or service than another? ! For example, while SKF, the world's leading manufacturer of roller bearings, might be tempted to define its core competence as bearings, such a definition would be unnecessarily limiting in terms of providing access to new markets. The company's growth need not be totally dependent on finding new uses for roller bearings because, when SKF moves away from a product-based view of its competencies to a skill-based view, new opportunities quickly emerge. SKF has competencies in anti-friction (understanding how different materials work together to either generate or reduce friction), in precision engineering (it is one of a very few European companies that can machine hard metals to incredibly tight tolerances), and in making perfectly spherical devices. ! A core competence is, most decidedly, a source of competitive advantage in that it is competitively unique and makes a contribution to customer value or cost. To better consider potential competencies, one can think in terms of physical and social (methods for organizing people) technology classifications: Matter
Energy
Information Production Service Delivery
Store
Supporting Management Systems
Process Transport
Business Design Strategy
Physical Technology Classification: Prof. Rias J. van Wyk (University of Cape Town)
Social Technology Classification: Prof. Norman Faull (University of Cape Town)
67
Cost Leader
The Absolute Cost Leader Since there can only be one cost leader, this is a powerful position for any company to hold. As the product tends to commodity status, with price becoming the major issue for the buyer, the competitive position of the cost leader improves. There are several areas to look for a cost advantage - cost of goods sold, cost of funds, distribution, research and development, marketing reach etc. But does the company have the discipline to maintain its relentless focus on cost leadership? Will it keep its simple low-cost message in the future? Or could the company drift?
68
Culture A superstar manager will likely provide exceptional company performance only whilst at the helm, but the underlying attributes of a company's culture should be more enduring.
Warren Buffett, 2007 Berkshire Hathaway Chairman's Letter: ! ...these managers... have exactly the job they want for the rest of their working years. At almost any other company, key managers below the top aspire to keep climbing the pyramid. For them, the subsidiary or division they manage today is a way station - or so they hope. Indeed, if they are in their present positions five years from now, they may well feel like failures. ! Conversely, our CEOs' scorecards for success are not whether they obtain my job, but instead are the long-term performances of their businesses. Their decisions flow from a here-today, here-forever mindset. I think our rare and hard-to-replicate managerial structure gives Berkshire a real advantage.
'Competitive Advantage Through People', by Jeffrey Pfeffer: ! There are several problems with seeking competitive advantage through investments in process technology. First, little of that technology is proprietary - the people who sell you robots or point-of-sale terminals or software to analyze production or service delivery will sell the robots, terminals, and software to your competitors. Your ability to obtain the benefits of, let alone get any advantage from, this technology - which is often widely available and readily understood - depends on your ability to implement it more rapidly and more effectively. This almost inevitably involves the skill and motivation of the work force. Sixteen Practices for Managing People [and creating a successful culture] Employment Security ! ! Selectivity in Recruiting! ! High Wages! ! ! ! Incentive Pay!! ! ! Employee Ownership! ! Information Sharing! ! ! Participation and Empowerment! Teams and Job Redesign! !
! ! ! ! ! ! ! !
Training and Skill Development Cross-Utilization and Cross-Training Symbolic Egalitarianism Wage Compression Promotion from Within Long-Term Perspective Measurement of the Practices Overarching Philosophy
69
Disruptive Innovation
Disruptive Technology On The Way
'The Innovator's Dilemma', by Clayton Christenson, outlines how even the greatest firms can get caught out by disruptive technology: ! What all sustaining technologies [the concept of technology can also encompass marketing, investment, and managerial processes] have in common is that they improve the performance of established products, along the dimensions of performance that mainstream customers in major markets have historically valued. When faced with sustaining technology change that gave existing customers something more and better in what they wanted, the leading practitioners of the prior technology led the industry in the development and adoption of the new. ! Disruptive technologies bring to a market a very different value proposition than had been available previously. Disruptive technologies typically enable new markets to emerge. And products that seriously underperform today, relative to customer expectations [functionality, reliability, convenience, price] in mainstream markets, may become directly performance-competitive tomorrow. Established Technology! !
!
Silver halide photographic film! ! Offset printing! ! ! ! Credit decisions based on judgement! Electric utility! ! ! ! !
Disruptive Technology Digital photography Digital printing Automated decisions based upon credit scores Distributed power generation
70
Entrepreneurship In 'Innovation and Entrepreneurship', Peter Drucker outlines six recurring patterns of success: Unexpected Successes and Failures. Analyze both unexpected successes and failures, by asking ‘what does it mean if this is exploited?' Incongruities. Think ‘what is it at the moment’ and ‘what should it be’. The gap between these two is the opportunity. For example, people are seeking more leisure pursuits yet cinema audiences are going down. Why? Be ready to challenge the most basic industry assumptions. Process Need. Look hard for the ‘weak link’ within a self-contained process. You should be struck by the realization of ‘there should be a better way’. Industry/Market Changes. See the value migrating within the industry, by spotting commoditization or changing technologies or society changes. For example, from computer hardware to software, from big steel mills to mini-mills or from public to private medicine. Demographics. Are the demographics of your market changing? Clearly the population of Japan is aging, what opportunities does this create? The young urban population of many middle-eastern countries provides different opportunities. Mood/Perception. Take advantage of changing tastes within society. Timing is crucial, as those who move too early on a change often meet with disaster. Some recent changes include wildlife conservation, healthy eating, women in the workplace and holidays abroad. New Knowledge. The advent of a new technology or new knowledge can create opportunities. This need not be in your direct market in order to affect you. Technology/knowledge scanning across industry segments can be useful.
71
GRICS (Retailers)
Selection Selection Selection
A Warren Buffett model: Better Gross Margins Than Competition Large Product Range Rapid Inventory Turns Low Operating Costs Shrewd Buying
Nelson Peltz (Fortune Magazine Article): His lieutenants prepare detailed comparisons on margins, the percentage of sales spent on marketing, ‘deals and allowances’ paid to retailers, and growth in overhead versus sales. They worship free cash flow, and believe it’s more efficient to revitalize a great brand than to try to build one from scratch. He also loves exploring what grabs the public taste – "I try to figure out the marketing puzzle."
72
Key Factors for Success
Not a ʻBig Box Retailerʼ Business success through extreme maximization or minimization of one or two variables (A Charles Munger observation). Or a firm may simply be very good across a wide range of operating variables.
Kenichi Ohmae, in 'The Mind of the Strategist', illustrates how the important variables to be maximized or minimized are determined. Here the author recounts a conversation with the director of a major lumber company: I asked him,"What are the key factors for success in the lumber industry?" To my surprise, his answer was immediate: "Owning large forests and maximizing the yield from them." The first of those key factors is a relatively simple matter: the purchase of forest land. But his second point required further explanation. Accordingly, my next question was: "What variable or variables do you control in order to maximize the yield from a given tract?" He replied: "The rate of tree growth is the key variable. As a rule, two factors promote growth: the amount of sunshine and the amount of water. Our company doesn't have many forests with enough of both."
73
Management Fanaticism
A Fanatical JOB ‘Managers acting as owners’ is a Warren Buffett prerequisite. In his observations, management requires superior capital allocation skills, a desire for outstanding performance and a singular focus on lowering costs and improving productivity. But the grand overlord of management excellence may be fanaticism. Success from obsessive - bordering on unreasonable - entrepreneurs consumed by their business.
Here’s what it takes as described in ‘Sam Walton: Made in America’: As I mentioned, I found out early that one of my talents is remembering numbers. I can't recall names and a lot of other things as well as I would like to. But numbers just stick with me, and always have. That's why I come in every Saturday morning usually around two or three [am], and go through all the weekly numbers. I steal a march on everybody else for the Saturday morning meeting. I can go through those sheets and look at a store, and even though I haven't been
74
there in a while, I can remind myself of something about it, the manager maybe, and then I can remember later that they are doing this much business this week and that their wage cost is such and such. I do this with each store every Saturday morning. It usually takes about three hours, but when I'm done I have as good a feel for what's going on in the company as anybody here - maybe better on some days.
This extract from a letter to his store managers illustrates entrepreneur Les Schwab’s intense focus, as described in ‘Pride in Performance, Keep it Going!’ This I vow... WE ARE GOING TO HAVE A SUPER MARKET TIRE STORE IN EVERY TOWN THAT WE HAVE A LES SCHWAB TIRE CENTER. I hate to use threats, it’s against my policy entirely, but you can visualize what is going to happen in your town if you don’t RUN A SUPER MARKET TIRE STORE, because I’m going to have it regardless of cost, hurt feelings. A Super Market tire store has tires displayed, a clean showroom, tires waxed, appealing appearance... hell, you know by now what a Super Market tire store should look like. If you don’t take a trip to Hermiston, it could be the most important day of your life. I sincerely hope I have made myself very clear. I Love You, But I Love a Super Market Tire Store Even More. ! ! ! ! ! ! ! ! ! ! ! Les
75
Network Effect
♥ Ur Network
The Network effect results from positive feedback, where success begets success and economies of scale undermine the competition. The effect can be observed with Ebay, Microsoft, or even the largest local newspaper. Once Ebay had established itself as the site to visit in order to sell things, this attracted even more sellers as they realized it had the largest audience. So why bother to list on another site? The process snowballs and provides a barrier to competition. Microsoft has network economies with both the Windows operating system and Microsoft Office. In addition, complementary products provide an important reinforcement to the network. For example, a video game producer will obviously want to develop the program for Windows and if the game is a hit, this provides the end-user with another benefit from the Windows platform. This powerful network effect was encapsulated by Bob Metcalf, the inventor, of Ethernet. He stated that if there are n people in a network, and the value of the network to each of them is proportional to the number of other users, then the total value of the network (to all the users) is proportional to n*(n-1) = n2 - n. If the value of a network to single user is $1 for each other user on the network, then a network of size 10 has a total value of roughly $100. In contrast, a network of size 100 has a total value of roughly $10,000. A tenfold increase in the size of the network leads to a hundredfold increase in its value.
'The Little Book That Builds Wealth', by Pat Dorsey: ! ! The bottom line is that you're most likely to find the network effect in businesses based on sharing information, or connecting users together, rather than in businesses that deal in rival (physical) goods... this is not exclusively the case, but it's a good rule of thumb.
76
Porter’s 5-forces A widely used model for diagnosing industry structure, developed by Prof. Michael Porter.
Issues to Consider: Economies of Scale Proprietary Product Differences (Trademarks, Patents) Brand Identity Switching Costs Capital Requirements Access to Distribution Absolute Costs Advantages Proprietary Learning Curve Access to Necessary Inputs Regulations Decision Makers' Incentives Industry Headwinds or Tailwinds Bankruptcy Laws Is Competition Rational?
77
Pricing Ability
Time to Raise the Price
A company that can raise prices, relatively easily, is likely to have some kind of enduring competitive advantage. This may be the result of no, or few, product/service substitutes: It may be due to patent protection; A trademark, in association, with powerful brand attributes could be a cause; Or, perhaps, an exclusive franchise of some kind. The ideal investment contains hidden pricing power - examples include retailers renewing leases in a recessionary environment; operators with a ‘back-catalogue’ that can be exploited through new technologies; and companies with an underexploited brand.
78
Protective Moat
Hard to Replicate
This is a metaphor used by Warren Buffett: So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn't necessarily mean the profit will be more this year than it was last year because it won't be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that's tenuous in any way - it's just too risky. We don't know how to evaluate that. And, therefore, we leave it alone. We think that all of our businesses - or virtually all of our businesses - have pretty darned good moats. And we think the managers are widening them.
The idea of the moat is further discussed in 'The Warren Buffet CEO: Secrets From the Berkshire Hathaway Managers', by Robert Miles: Build the brand, build the brand and build the brand. Invest, as much as possible, in the customer relationship. Focus on building for the long term, even if that means taking shortterm hits. Plan ahead. Search for ways to keep building the competitive advantage – distribution, manufacturing, branding, acquisitions etc. Dominate, profitably, the markets you are in. It’s not necessary to do extraordinary things to make extraordinary profits. It is necessary to do the basics extraordinarily well.
'The Little Book That Builds Wealth', by Pat Dorsey: The company with the moat is worth more today because it will generate economic profits for a longer stretch of time. When you buy shares of the company with the moat, you're buying a stream of cash flows that is protected from competition for many years. It's like paying more for a car that you can drive for a decade versus a clunker that's likely to conk out in a few years.
79
Scale
A Big Distribution Advantage
In 'The Little Book That Builds Wealth', author Pat Dorsey, discusses another scale advantage: ! Although building and operating the delivery network is an expensive proposition for a base level of service, the incremental profit on each item that the truck fleet delivers is enormous. Think about it - once the fixed costs are covered, delivering an extra item that is on a delivery route is extremely profitable because the variable cost of making an extra stop is almost nothing. ! Now imagine that you need to try to compete with a company that has an established distribution network. It has likely covered its fixed costs and is making large incremental profits as it delivers more stuff, while you'll need to take on large losses for a time until (if) you gain enough scale to become profitable.
But scale can also work against you as discussed in 'Six Degrees, The Science of A Connected Age', by Duncan Watts: ! In slowly changing environments in which generic products appeal to large numbers of consumers and the range of competing choices is limited, economies of scale are optimal. But in [a] rapidly globalizing world... with uncertain economic and political forecasts... and with increasingly heterogeneous tastes of consumers... uncertainty, ambiguity, and rapid change favor flexibility and adaptability over sheer scale.
80
Scale advantage is also constrained to particular niches as explained in 'Competition Demystified', by Bruce Greenwald and Judd Kahn: ! ...pure size is not the same thing as economies of scale, which arise when the dominant firm in a market can spread the fixed costs of being in that market across a greater number of units than its rivals. It is the share of the relevant market, rather than size per se, that creates economies of scale. ! The relevant market is the area - geographic or otherwise - in which the fixed costs stay fixed. In the case of a retail company, distribution infrastructure, advertising expenditures, and store supervision expenses are largely fixed for each metropolitan area or other regional cluster. If sales are added outside the territory, fixed costs rise and economies of scale diminish. " The same conditions apply when the relevant geography is a product line rather than a physical region. Research and development costs, including the start-up costs of new production lines and product management overhead, are fixed costs associated with specific product lines. Though IBM’s total sales dwarf those of Intel, its research and development expenses are spread over a far greater range of products. In CPU development and production, which has its own particular technologies, Intel enjoys the benefits of economies of scale. ! Although it may seem counterintuitive, most competitive advantages based on economies of scale are found in local and niche markets, where either geographical or product spaces are limited and fixed costs remain proportionately substantial. [The authors highlight their thinking with Wal-Mart] " The superior efficiencies Wal-Mart achieved in these three functions - inbound logistics, advertising, and executive supervision - taken together, gave the company an operating margin advantage of 4-5 percent of net sales. Wal-Mart’s total advantage was only around 3 percent. Because the lower prices it charged pushed up Wal-Mart’s purchases, in percentage terms, various operating savings could account for more than the entire difference in margins. " The superior efficiencies in these three functions were due to local economies of scale. The relevant localities are the areas in which Wal-Mart and its competitors had their stores, their warehouses, their advertising campaigns, and their managers. It made no difference that Kmart’s total sales were three times those of Wal-Mart in these years (1984-85).
81
Specialization The concept of Adam Smith's pin factory, as described in 'The Wealth of Nations': ! To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it... I have seen a small manufactory of this kind where ten men only were employed... But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about [forty-eight thousand] pins in a day. ! In every other art and manufacture, the effects of the division of labour are similar to what they are in this very trifling one; though, in many of them, the labour can neither be so much subdivided, nor reduced to so great a simplicity of operation. The division of labour, however, so far as it can be introduced, occasions, in every art, a proportionate increase of the productive powers of labour.
The idea of specialization and greater productivity is further detailed by Thomas Sowell in 'Basic Economics': ! The perennial desire to 'eliminate the middleman' is perennially thwarted by economic reality. The range of human knowledge and expertise is limited for any given person or for any manageably-sized collection of people, so that only a certain number of links in the great chain of production and distribution can be mastered and operated efficiently by the same set of managers. Beyond some point, there are other people who can perform the next step in the sequence more cheaply or more effectively - and, at that point, it pays a firm to sell its output to some other businesses that can carry on the next part of the operation more efficiently. ! Despite superficially appealing phrases about 'eliminating the middleman', middlemen continue to exist because they can do their phase of the operation more efficiently than others. It should hardly be surprising that people who specialize in one phase can do that phase better than others.
82
Standardization
Japanese Production Line
The aim here is higher productivity (doing more with less) - a good example being standard designs and processes for home building; and McDonalds’ production system for hamburgers.
The following ideas are more fully developed in 'Lean Thinking' and 'The Machine That Changed the World', by James Womack and Daniel Jones. Eliminate Muda Muda is the Japanese term for waste. Specifically any human activity which absorbs resources but creates no value: mistakes which require rectification, production of items no one wants so that inventories and remaindered goods pile up, processing steps which aren't actually needed, movement of employees and transport of goods from one place to another without any purpose, groups of people in a downstream activity standing around waiting because an upstream activity has not delivered on time, and goods and services which don't meet the needs of the customer. Design Pull Letting the customer 'pull' the product to them. This means order then manufacture, as opposed to the 'push' system that has manufacture, inventory and then sale. The Process Applicable for both manufacturing and service industries. 1.! Place linked processes near one another 2.! Standardize procedures 3.! Eliminate loop-backs 4.! Setting a common tempo 5.! Balancing loads 6.! Segregating complexity 7. Posting performance results - including customer focused metrics.
83
Surf a Wave
Too Big to Surf
The idea of a large business force that developed, which a company was able to ride. The metaphor is explained in 'Poor Charlie's Almanack', by Charles Munger: ! There's a tire store chain in the Northwest that has slowly succeeded over the last fifty years, the Les Schwab tire store chain. It started competing with the stores that were owned by the big tire companies that made all the tires, the Goodyears and so forth. And, of course, the manufacturers favored their own stores. Their 'tied stores' had a big cost advantage. Later, Les Schwab rose in competition with the huge price discounters like Costco and Sam's Club and before that Sears, Roebuck and so forth. And yet, here is Schwab now, with hundreds of millions of dollars in sales. How did he do it? Well, let's think about it with some microeconomic fluency. ! Is there some wave that Schwab could have caught? The minute you ask the question, the answer pops in. The Japanese had a zero position in tires, and they got big. So this guy must have ridden that wave some in the early times. So, he had to get a wave in Japanese tire invasion, the Japanese being as successful as they were. And then a talented fanatic had to get a hell of a lot of things right and keep them right with clever systems.
Steve Jobs', Fortune Magazine, On catching tech's next wave: ! These waves of technology, you can see them way before they happen, and you just have to choose wisely which ones you're going to surf. If you choose unwisely, then you can waste a lot of energy, but if you choose wisely, it actually unfolds fairly slowly. It takes years. One of our biggest insights [years ago] was that we didn't want to get into any business where we didn't own or control the primary technology, because you'll get your head handed to you. We realized that for almost all future consumer electronics, the primary technology was going to be software. And we were pretty good at software.
84
Technology Technology’s doubled edged sword is described by Charles Munger in 'Poor Charlie's Almanack': ! The great lesson in microeconomics is to discriminate between when technology is going to help you and when it's going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does. ! For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles, which are a real commodity product. And one day, the people came to Warren and said, 'They've invented a new loom that we think will do twice as much work as our old ones.' And Warren said, 'Gee, I hope this doesn't work because if it does, I'm going to close the mill.' And he meant it. ! What was he thinking? He was thinking, 'It's a lousy business. We're earning substandard returns and keeping it open just to be nice to the elderly workers. But we're not going to put huge amounts of new capital into a lousy business.' ! And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners. ! That's such an obvious concept - that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that's still going to be lousy. The money still won't come to you. All of the advantages from great improvements are going to flow through to the customers. ! Conversely, if you own the only newspaper in Oshkosh and they were to invent more efficient ways of composing the whole newspaper, then when you got rid of the old technology and get new, fancy computers and so forth, all of the savings would come right through to the bottom line. The need for continuing technology investment just to stand still is a component of maintenance capital expenditures. As technologies progress, the major trends seem to be
increasing increasing increasing increasing increasing increasing
efficiency capacity compactness accuracy size range complexity
85
Business - Financial Models Bob-around Earnings Since most companies do not have an enduring competitive, investors have to get a picture of normalized earning power. For these companies growth that consumes additional capital may not add economic value.
The idea of 'normalized' has been translated into 'bob-around' by Warren Buffett. This explanation is recounted in 'Seeking Wisdom from Darwin to Munger', by Peter Bevelin: ! A few years ago the conventional wisdom held that a newspaper, television or magazine property would forever increase its earnings at 6% or so annually and would do so without the employment of additional capital, for the reason that depreciation charges would roughly match capital expenditures and working capital requirements would be minor. Therefore, reported earnings (before amortization of intangibles) were also freely-distributable earnings, which meant that ownership of a media property could be construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next, that a discount rate of 10% was used to determine the present value of that earnings stream. One could then calculate that it was appropriate to pay a whopping $25 million for a property with current after-tax earnings of $1 million [1/0.1-0.06]. ! Now change the assumption and posit that the $1 million represents 'normal earning power' and that earnings will bob around this figure cyclically. A 'bob-around' pattern is indeed the lot of most businesses, whose income stream grows only if their owners are willing to commit more capital (usually in the form of retained earnings). Under our revised assumption, $1 million of earnings, discounted by the same 10%, translates to a $10 million valuation. Thus a seemingly modest shift in assumptions reduce the property's valuation to 10 times after-tax earnings. ! Dollars are dollars whether they are derived from the operation of media properties or of steel mills. What in the past caused buyers to value a dollar of earnings from media far higher than a dollar from steel was that the earnings of a media property were expected to constantly grow (without the business requiring much additional capital), whereas steel earnings clearly fall in the bob-around category. Now, however, expectations for media have moved toward the bob-around model.
86
Business Metrics
Logisticsʼ Benchmark Setting and measuring the appropriate metrics to drive the company forward profitably. Benchmarking within the industry, and outside of it, in order to obtain productivity information.
Carly Fiorina recently stated: ! "Michael Dell needs to focus on leading indicators. They are customer satisfaction, the rate of innovation, diversity of the management team. If you look at those indicators, you can predict what happens to Dell."
In ‘The Origin of Wealth’, Eric Beinhocker discusses metrics and context : " One mistake many companies make is applying the same performance metrics to all their businesses and strategic experiments. The logic is usually driven by a desire to please the financial markets… but these measures tend to be more appropriate for later-stage, mature businesses and may not give an appropriate picture of newer, more experimental ventures. " In such businesses, milestone measures such as hiring a key executive, winning early customers, and meeting budget targets may be more appropriate. Second, financial measures are often lagging indicators of the market’s feedback. Other, more operational measures, such as customer satisfaction, assembly time, sales per square foot, employee turnover, and rework time, when added to financial data, may provide a more complete, realtime picture...
87
Intrinsic Value
Whatʼs It Worth?
'Security Analysis', 1940 Edition, by Benjamin Graham and David Dodd: We must recognize, however, that intrinsic value is an elusive concept. In general terms it is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses. It is not sufficient to know what the past earnings have averaged, or even that they disclose a definite line of growth or decline. There must be plausible grounds for believing that this average or this trend is a dependable guide to the future. Experience has shown only too forcibly that in many instances this is far from true. The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequate e.g., to protect a bond or to justify a stock purchase - or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight. ... figures alone are not sufficient; they may be completely vitiated by qualitative considerations of an opposite import. A security may make a satisfactory statistical showing, but doubt as to the future or distrust of the management may properly impel its rejection. Again, the analyst is likely to attach prime importance to the qualitative element of stability, because its presence means that conclusions based on past results are not so likely to be upset by unexpected developments. It is also true that he will be far more confident in his selection of an issue if he can buttress an adequate quantitative exhibit with unusually favorable qualitative factors.
88
From 'Valuation, Measuring and Managing the Value of Companies', by T. Copeland, T. Koller & J. Murrin: The value of operations equals the discounted value of expected future free cash flow. Free cash flow is equal to the after-tax operating earnings of the company, plus non-cash charges, less investments in operating working capital, property, plant and equipment, and other assets.
This is the discounted cash flow model, where factors of inherent stability allow one to use past and current data as a guide to future business prospects. The major problem occurs when there's a secular change, where the fundamental economics of the business, or the industry, are changing. Alternatively, one can think of valuation in terms of the replacement cost of assets. For example, a mobile phone company could be worth the cost of building its network and acquiring its customers; remembering, of course, that what was recently created is often most easily reproduced. The Austrian School of Economics, however, states that the value of an asset is determined solely by the quality of plans for its use.
89
Mr. Market
Buying a Great Business
From 'The Intelligent Investor' by Benjamin Graham: ! Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. ! If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise? ! You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
90
Reversion-to-mean There is a strong tendency in many areas of the financial market, due to the action of economic forces, for results to revert to their long-term mean. If a certain company, or industry, earns large profits for a period of time, then more companies, or capital, will enter and the increased competition will likely drive the exceptional profits down to a lower level. If a certain commodity goes up in price, producers will be encouraged to produce, or find, more and the extra supply will drive the price down. The Dow's historical return on equity has been around 11% and book value growth in the order of 5%. Will the future be significantly better, or worse? The $24 real estate investment by the Dutch to buy the island of Manhattan would today, by some estimates, be roughly equivalent to $3 trillion. Over 378 years, that's about a seven percent annual compound rate of return.
This reversion-to-mean explanation is given in ‘Value Investing’ by Bruce Greenwald et al: In the entire world there are few brand names as widely recognized as Mercedes-Benz. It is universally associated with a superior product that is high in quality and prestige. By all rules of product differentiation, Mercedes-Benz ought to enjoy a strongly protected market position and, as a consequence, high profitability. Yet for the years 1995 to 1997, before the company acquired Chrysler, Daimler’s pretax return on identifiable assets in its automotive business averaged 7.2%. The history of the automotive industry explains why Mercedes does not have a profitable franchise. In the late 1960s, the luxury car market in general and Daimler in particular enjoyed abnormally high profits. Seeking to benefit from this situation, other European luxury car makers, such as BMW, Jaguar, Rover, Citroen, and Peugeot, all expanded aggressively. In the 1980s, the Japanese car makers - first Acura (Honda), then Lexus (Toyota), and finally Infiniti (Nissan) - all entered the market. The results turned out exactly as theory predicts; more competition meant a substantial erosion of profit margins. They shrunk for Mercedes in Europe and for Lincoln and Cadillac in the United States. Globalization of the luxury car market proved to be profitability’s foe. Both in theory and in practice, product differentiation and a strong brand are not the same as a profitable franchise.
91
Scandal
A Great Brand Survives
Warren Buffett has used this model for American Express (salad oil scandal), GEICO and more recently USG (asbestos litigation). Essentially, there is a big, onetime mess of some kind, but the enduring competitive advantage of the underlying business is still in tact.
The idea is explained by Warren Buffett, in a 'Berkshire Hathaway Chairman’s Letter': !! Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact. ! GEICO may appear to be an exception, having been turned around from the very edge of bankruptcy in 1976. It certainly is true that managerial brilliance was needed... ! But it is also true that the fundamental business advantage that GEICO had enjoyed an advantage that previously had produced staggering success - was still intact within the company, although submerged in a sea of financial and operating troubles. ! GEICO was designed to be the low-cost operation in an enormous marketplace (auto insurance) populated largely by companies whose marketing structures restricted adaptation. Run as designed, it could offer unusual value to its customers while earning unusual returns for itself. For decades it had been run in just this manner. Its troubles in the mid-70s were not produced by any diminution or disappearance of this essential economic advantage. " GEICO’s problems at that time put it in a position analogous to that of American Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies, temporarily reeling from the effects of a fiscal blow that did not destroy their exceptional underlying economics. The GEICO and American Express situations, extraordinary business franchises with a localized excisable cancer (needing, to be sure, a skilled surgeon), should be distinguished from the true ‘turnaround’ situation in which the managers expect - and need - to pull off a corporate Pygmalion.
92
The Magic Formula
It Really Is Magic
The concept of earnings yield and return on capital is explained in 'The Little Book That Beats The Market', by Joel Greenblatt. A website www.magicformulainvesting.com accompanies the book: The magic formula ranks companies based on two factors: return on capital and earnings yield. 1. Return on Capital = EBIT/(Net Working Capital + Net Fixed Assets) Return on capital is measured by calculating the ratio of pre-tax operating earnings (EBIT) to tangible capital employed (Net Working Capital + Net Fixed Assets). 2. Earnings Yield = EBIT/Enterprise Value Earnings yield is measured by calculating the ratio of pre-tax operating earnings (EBIT) to enterprise value (market value of equity + net interest-bearing debt). We need to plug in estimates for earnings in a normal year (i.e. when nothing extraordinary or unusual is happening within the company, its industry, or the overall economy). Earnings could have been higher than normal due to extraordinarily favorable conditions that may not be repeated in most years. Alternatively there may have been a temporary problem with the company’s operations. Then we want both a high earnings yield and a high return on capital - based on normal earnings. In addition, we need to assess how confident we were in our estimates and make a judgment on whether those earnings are likely to grow in the future (as well as whether there was an honest management team that would reinvest those profits wisely).
93
Business - Goods’ Models Diminishing Utility
The First One Tasted Best People will progressively place a lower value to each additional unit of something that they have in increasing abundance.
In 'Against the Gods', the author Peter Bernstein describes Daniel Bernoulli's development of this concept: ! 'the utility... is dependent on the particular circumstances of the person making the estimate... There is no reason to assume that... the risks anticipated by each [individual] must be deemed equal in value.' To each his own. ! Once Bernoulli has established his basic thesis that people ascribe different values to risk, he introduces a pivotal idea: '[The] utility resulting from any small increase in wealth will be inversely proportionate to the quantity of goods previously possessed.' ! The hypothesis that utility is inversely related to the quantity of goods previously possessed is one of the great intellectual leaps in the history of ideas. In less than one full printed page, Bernoulli converts the process of calculating probabilities into a procedure for introducing subjective considerations into decisions that have uncertain outcomes.
94
Nature of Goods
A Complementary Good
GOODS, according to the 'Austrian School of Economics', require the following: 1. Human Need 2. Causal connection between the good and a need satisfaction 3. Human knowledge of that causal connection 4. Require complementary goods
'Principles of Economics', by Carl Menger: It has been shown that the existence of human needs is one of the essential prerequisites of goods-character, and that if the human needs with whose satisfaction a thing may be brought into causal connection completely disappear, the goods-character of the thing is immediately lost unless new needs for it arise.
95
Maslow’s Triangle
Self – Actualization (Truth, justice, wisdom & meaning)
Esteem Wants (Self-respect, achievement, attention, recognition, reputation, knowledge & aesthetics)
Social Needs (Friendship, group belonging, giving & receiving love)
Safety Needs (Free from the threat of physical & emotional harm)
Physiological Needs (Air/water/food/sleep)
For any business, consider whether its product/service acts as a painkiller or as a vitamin tablet.
96
Total Utility
A Utility Vehicle
Everyone tries to maximize his utility, i.e. get most bang for buck. This may include money, time, physical effort, social reward, pleasure reward, satisfaction reward etc.
But it is also important to remember, as discussed in 'Thinking & Deciding' by Jonathan Baron: ! Our memories of the quality of experiences are essentially influenced by their endings and by their best/worst points. We tend to ignore duration. Hence the judgement from which we infer utility is not the same as the utility itself.
Herbert Simon adapts the utility model in 'Models of My Life': " By the age of twenty-five, I had already had ample experiences in life to understand the limits of the economists’ framework of maximizing subjective expected utility as applied to actual human behavior. " [I developed the idea of] satisficing - searching for ‘good enough’ actions rather than optimal ones. [Indeed] natural selection only predicts that survivors will be fit enough, that is, fitter than their losing competitors; it postulates satisficing, not optimizing. " How do human beings reason when the conditions for rationality postulated by neoclassical economics are not met? The central concept is bounded rationality, a label for the computational constraints on human thinking. When people don’t know how to optimize, they may very well be able to satisfice, to find good enough solutions. And good enough solutions can often be found by heuristic search through the maze of possibilities.
97
Value
A Great Value
Value in Use & Value in Exchange - As explained by Adam Smith: ! The things that have greatest value in use have frequently little or no value in exchange. Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.
In the 'Principles of Economics', author Carl Menger discusses the value concept: The value of goods arises from their relationships to our needs, and is not inherent in the goods themselves. With changes in this relationship, value arises and disappears. It is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being. 1. Goods have only imputed value. It is the importance of satisfactions of needs that gives a good value. 2. Satisfactions, and therefore goods, have differing levels of importance – [Basically according to Maslow’s Triangle]. 3. The value of a good is equal to the least important of the satisfactions assured by the whole available quantity. 4. Consumers desire less of that good they already have.
98
Decision Models Margin of Safety "
"
"
A Small Margin This model is based on the idea that the future is uncertain and, therefore, if one makes a choice with a sufficient margin of safety, then even if the outcome is not as predicted it should still be satisfactory. Hence it has broad application.
From 'The Intelligent Investor' by Benjamin Graham: ! Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.
'Security Analysis', 1940 Edition, by Benjamin Graham and David Dodd: ! Of more practical importance is the question whether or not investment can be successfully carried on in common stocks that appear cheap from the quantitative angle and that - upon study - seem to have average prospects for the future. ! Securities of this type can be found in reasonable abundance, as a result of the stock market's obsession with companies considered to have unusually good prospects of growth. Because of this emphasis on the growth factor, quite a number of enterprises that are longestablished, well financed, important in their industries and presumably destined to stay in business and make profits indefinitely in the future, but that have no speculative or growth appeal, tend to be discriminated against by the stock market - especially in years of subnormal profits - and to sell for considerably less than the business would be worth to a private owner. ! We incline strongly to the belief that this last criterion - a price far less than the value to a private owner - will constitute a sound touchstone for the discovery of true investment opportunities in common stocks.
99
Pr O A C T
Another Easy Decision
From 'Smart Choices', by J. Hammond, R. Keeney & H. Raiffa Pr: Define the problem What's my decision problem? What, broadly, do I have to decide? What specific decisions do I have to make as a part of the broad decision? O: Clarify your real objectives What are my fundamental objectives? Have I asked 'Why' enough times to get to my bedrock wants and needs? A: Develop a range of creative alternatives What are my alternatives? Can I think of more good ones? C: Understand the consequences of your decision What are the consequences of each alternative in terms of the achievement of each of my objectives? Can any alternatives be safely eliminated? T: Make appropriate trade-offs among conflicting objectives What are the trade-offs among my more important objectives? Where do conflicting objectives concern me the most? The correct mindset when approaching a problem is essential. a negative one will unnecessarily exclude a lot of options. Deal sensibly with uncertainties. Take account of your risk-taking attitude. Plan ahead for decisions linked over time.
100
Process v Outcome
Good Judgement
You just made a great decision, but was the outcome due to... Luck Skill Judgement Review the decision making process, as that is the thing which can be controlled. Often the outcome is out of our hands.
Robert Rubin describes the idea of Process v Outcome in 'In an Uncertain World': Unfortunately, Washington - the political process and the media - judges decisions based solely on outcomes, not on the quality of the decision making, and makes little allowance for the inevitability of some level of human error. This can easily lead to an undue risk aversion on the part of public officials. My experience in Washington strongly reinforced my view that good process makes good policy. And a fair, open process is more likely to result in participants buying into decisions with which they may differ. At Goldman, our decisions were driven much more by analysis. We always tried to think of everything that could possibly go wrong with a deal and then tried to evaluate how much weight to accord to such risks in our analysis. Someone who had been to business school would have recognized the charts I made on my yellow pad as expected-value tables, used to calculate the anticipated outcome of a transaction. After a while, organizing my analysis according to these tables became second nature and I’d do them in my head. But I still constantly scribbled notes and numbers on a legal pad - a lifelong habit with me.
101
The Agency Problem
My Brokerʼs Yacht
A conflict of interest may arise when participants in a business have different incentives. Consider, for example, the potential conflicts between long-term shareholders and management, as a result of different incentives.
Charles Munger illustrates the point in 'Poor Charlie's Almanack': ! This professor gave a test involving two unworldly old ladies who had just inherited a New England shoe factory making branded shoes and beset with serious business problems described in great detail. ! In response to the answers, the professor next gave every student an undesirable grade except for one student who was graded at the top by a wide margin. What was the winning answer? ! It was very short and roughly as follows: 'The business field and this particular business, in its particular location, present crucial problems that are so difficult that unworldly old ladies can not wisely try to solve them through hired help. Given the difficulties and unavoidable agency costs, the old ladies should promptly sell the shoe factory, probably to the nearest competitor who would enjoy the greatest marginal-utility advantage.
102
Trade-offs
The Late-night TV Trade-off Decisions require trading off one goal against another. Classic trade-offs include guns or butter, efficiency or equity, work or leisure, spending or saving etc. Because people face trade-offs, making decisions requires comparing the costs and benefits of alternative courses of action. When there are no painful trade-offs to consider, then there are idle, wasted resources, those that yield no value in return for what they cost. However, tradeoffs can be moving targets, shifting and changing, often with great speed.
Trade-offs can occur on every dimension, as explained here in 'Executive Economics', by Shlomo Maital: ! At this second-to-last meeting of his third-year course in legal tactics and ethics, [Alan Dershowitz] sketches the simple diagram that captures the essence of this course... he draws two vertical lines in chalk, marking the left one 'E', for ethics, and the right one 'T' for tactics. ! The left-hand line represents the scale of a lawyer's possible ethical standards, from 1 to 5 (1 being least ethical, 5 being most); the right-hand line stands for the possible range for tactics, up to the hardball maneuvers - say, badgering a rape victim about her sexual history - represented by 'T-5'. Tactics and ethics form, in his view, the pivotal trade-off facing any criminal lawyer, and therefore any client in search of a lawyer.
103
Your Circle of Competence
Hitting Within the Circle
This concept, often referred to by Warren Buffett, proposes that an individual think about his/her areas of understanding and try to remain within them when making judgements.
From the 1999 Berkshire Hathaway Chairman's Letter: " If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. If others claim predictive skill in those industries — and seem to have their claims validated by the behavior of the stock market — we neither envy nor emulate them. Instead, we just stick with what we understand. If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality. Fortunately, it’s almost certain there will be opportunities from time to time for Berkshire to do well within the circle we’ve staked out.
This idea is explained in a slightly different way by Ludwig von Mises in 'Human Action': ! The engineer, on the other hand, knows everything that is needed for a technologically satisfactory solution of his problem, the construction of a machine. As far as some fringes of uncertainty are left in his power to control, he tries to eliminate them by taking safety margins. ! The engineer knows only soluble problems and problems which cannot be solved under the present state of knowledge. He may sometimes discover from adverse experience that his knowledge was less complete than he had assumed and that he failed to recognize the indeterminateness of some issues which he thought he was able to control. Then he will try to render his knowledge more complete. Of course he can never eliminate altogether the element of gambling present in human life. But it is his principle to operate only within an orbit of certainty. He aims at full control of the elements of his action.
104
Decision - Common Mistakes’ Models Anchor Effect
Weʼre Not Dropping the Price The anchor effect is commonly observed in real estate and the stock market. Consider how many people tend to negotiate around the listed price of a house, or cling to the original price of a stock purchase as a benchmark, when neither price may have been established on an objective basis.
This concept is described in 'Why Smart People Make Big Money Mistakes and How to Correct Them', by Gary Belsky & Thomas Gilovich: ! Anchoring is really just a metaphoric term to explain the tendency we all have of latching on to an idea or fact and using it as a reference point for future decisions. Amos Tversky and Daniel Kahneman, for example, asked participants in one study to estimate the percentage of African nations in the United Nations. First, a wheel of fortune numbered 1 through 100 - was spun in the presence of the experimental participants, who were subsequently asked whether their answer was higher or lower than the number that had just been spun on the wheel. Amazingly, given that the number was so obviously a matter of chance, the participants' answers were strongly influenced by the wheel's location. 'For example,' wrote Kahneman and Tversky, 'the median estimates of the percentages of African countries in the United Nations were 25 and 45 for groups that received 10 and 65, respectively, as starting points.'
105
Bayes Theorem The conditional probability of the event A given that the event B has occurred is described by Bayes Theorem (first developed by the English Reverend Thomas Bayes): Pr (A \ B) = The probability of A, given that B has occurred:
!
=
Pr (B \ A) * Pr (A) Pr (B \ A) * Pr (A) + Pr (B \ not A) * Pr (not A)
An example from 'IntroSTAT' by Les Underhill and Dave Bradfield: You feel ill at night and stumble into the bathroom, grab one of three bottles in the dark and take a pill. An hour later you feel really ghastly, and you remember that one of the bottles contains poison and the other two aspirin. Your handy medical text says that 80% of people who take the poison will show the same symptoms as you are showing, and that 5% of people taking aspirin will have them. Let B be the event 'having the symptoms' Let A be the event 'taking the poison' Then 'not A' is the event 'taking aspirin' What is the probability that you took the poison given that you have got the symptoms? i.e. what is Pr (A \ B) From the information supplied by the handy medical text ! Pr (B \ A) = 0.8 and Pr (B \ not A) = 0.05 From our groping round in the dark, we conclude that ! Pr (A) = 1/3 and Pr(not A) = 2/3 Thus Pr(A \ B) = {0.8 * 1/3} divided by {0.8 * 1/3 + 0.05 * 2/3} = 0.89 We recommend that you call the doctor!
106
Contrast Principle
Contrasting Principles
The concept explained by Robert Cialdini, in his book 'Influence Science and Practice': ! [The Contrast] principle accounted for, among other things, the tendency of a man to spend more money on a sweater following his purchase of a suit than before: After being exposed to the price of the larger item, he sees the price of the less expensive item as appearing smaller by comparison. ! In the same way, the larger-then-smaller request procedure uses the contrast principle to make the smaller request look even smaller by comparison with the larger one. If I want you to lend me $5, I can make the request seem smaller than it is by first asking you to lend me $10. One of the beauties of this tactic is that, by first requesting $10 and then retreating to $5, I will have simultaneously engaged the force of both the reciprocity rule and the contrast principle. Not only will my $5 request be viewed as a concession to be reciprocated, it will also look like a smaller request than if I had just asked for $5 straightaway.
107
Correlation or Causation
Correlated to, Or Caused By...?
'Asking The Right Questions', by Neil Browne and Stuart Keeley discusses this problem: ! We have an inherent tendency to 'see' events that are associated, or that 'go together', as events that cause one another. That is, we conclude that because characteristic X (e.g., amount of TV viewing) is associated with characteristic Y (e.g., performance in school), that X therefore causes Y. The following are examples of such reasoning: 1. States with low speed limits tend to have a lower rate of highway death than states with higher speed limits; thus, low speed limits deter highway death. 2. Absence of a father in the home occurs at a higher rate with juvenile delinquents than with non-delinquents; thus, father absence is a cause of juvenile delinquency. When we think this way, we are, however, often very wrong. Why? Usually, because multiple hypotheses can explain why X and Y 'go together'.
108
Doubt Avoidance
No Doubt
This model is taken from 'Poor Charlie's Almanack', by Charles Munger: ! The brain of man is programmed with a tendency to quickly remove doubt by reaching some decision. It is easy to see how evolution would make animals, over the eons, drift toward such quick elimination of doubt. After all, the one thing that is surely counterproductive for a prey animal that is threatened by a predator is to take a long time in deciding what to do. And so man's Doubt-Avoidance Tendency is quite consistent with the history of his ancient, non-human ancestors. ! So pronounced is the tendency in man to quickly remove doubt by reaching some decision that behavior to counter the tendency is required from judges and jurors. Here, delay before decision making is forced. And one is required to so comport himself, prior to conclusion time, so that he is wearing a 'mask' of objectivity.
109
Extrapolation People have a tendency to take the most recent, or the most easily available information and project the 'trend' into the future in a linear fashion extrapolation. Extrapolation is a dangerous game. Consider the following examples:
The volume of subprime loan originations had a 'straight line fit' from 2003 to 2006.
A linear extrapolation in 2004 of the global creditdefault swap market would have missed the subsequent exponential rise.
110
False Mental Accounting
Letʼs Spend It
From 'Why Smart People Make Big Money Mistakes and How to Correct Them', by Gary Belsky & Thomas Gilovich: ! This idea, developed and championed by the University of Chicago's Richard Thaler, underlies one of the most common and costly money mistakes - the tendency to value some dollars less than others and thus to waste them. More formally, mental accounting refers to the inclination to categorize and treat money differently depending on where it comes from, where it is kept, or how it is spent. ! The notion of mental accounts is anathema to traditional economics, which holds that wealth in general, and money in particular, should be 'fungible'. Fungibility, at its essence, means that $100 in roulette winnings, $100 in salary, and a $100 tax refund should have the same significance and value to you, since each [dollar could buy the same thing]. ! ... the easiest-to-explain instance of mental accounting's harmful effects is the different value people place on earned income as opposed to gift income. That is, we'll spend $50 from Mom with less thought than $50 we've earned on the job. ! Imagine that you go to a store to buy a lamp, which sells for $100. At the store you discover that the same lamp is on sale for $75 at a branch of the store five blocks away. Do you go to the other branch to get the lower price? ! Now imagine that you go to the same store to buy a dining room set, which sells for $1,775. At the store you discover that you can buy the same table and chairs for $1,750 at a branch of the store five blocks away. Do you go to the other branch to get the lower price? ! Credit card dollars are cheapened because there is seemingly no loss at the moment of purchase, at least on a visceral level. Think of it this way: If you have $100 cash in your pocket and you pay $50 for a toaster, you experience the purchase as cutting your pocket money in half. If you charge that toaster, though, you don't experience the same loss of buying power that emptying your wallet of $50 brings.
111
Groupthink
Groupthink
Gentlemen, I take it we are all in complete agreement on the decision here... Then I propose we postpone further discussion of this matter until our next meeting to give ourselves time to develop disagreement and perhaps gain some understanding of what the decision is all about. - Alfred P. Sloan, Jr.
In 'Thinking and Deciding', by Jonathan Baron, the major errors that can arise from Groupthink are highlighted The Group overestimates its abilities ! Because there is an illusion of invulnerability ! Due to a belief in the inherent morality of the group The Group is Closed-Minded ! Because there is a collective rationalization ! Members hold stereotypes of out-groups There is Pressure(s) Toward Uniformity ! Self-censorship of members ! There is an illusion of unanimity ! Direct and indirect pressure is applied to dissenters The behavior of a group may be completely different from the traits of the individuals comprising the group. By contrast, when good thinking occurs in groups, there is a commitment of the group to a friendly (and sometimes not so friendly) interchange of arguments pro and con, not to a decision already tentatively made. Loyalty to the group is defined in terms of loyalty to the process of making the best decision, not loyalty to a decision already made.
112
Ideology
A Matching Ideology A tendency to ignore facts and dismiss analyses that do not conform to a political viewpoint. The judgement is often reinforced by the 'commitment and consistency' principle, especially when made in the presence of others.
113
Information Bias
Available, Vivid & Recent There is a strong tendency to overweigh the first piece of information that one comes across (recency bias). A further bias is the tendency to overweigh information because we are familiar with the source - Home Bias - or worse still, because we like the source (liking tendency).
'Thinking and Deciding' by Jonathan Baron: ! Such an effect is called a primacy effect, because the first piece of evidence is weighed more heavily than it should be. One explanation of the primacy effect is that the initial evidence leads to an opinion, which then biases the search for subsequent evidence, as well as the interpretation when it is found. In conjunction with this bias, are the ones that overweigh information that is easily available, or that is extra-vivid.
Charles Munger, in 'Poor Charlie's Almanack': ! The main antidote to miscues from Availability-Misweighing Tendency often involve procedures, including use of checklists, which are almost always helpful. ! The great algorithm to remember in dealing with this tendency is simple: An idea or a fact is not worth more merely because it is easily available to you.
114
Nassim Nicholas Taleb, in 'Fooled by Randomness' illustrates another information bias - survivorship: ! The mistake of ignoring the survivorship bias is chronic, even (or perhaps especially) among professionals. How? Because we are trained to take advantage of the information that is lying in front of our eyes, ignoring information that we do not see. ! ... we tend to mistake one realization among all possible random histories as the most representative one, forgetting that there may be others. In a nut-shell, the survivorship bias implies that the highest performing realization will be the most visible. Why? Because the losers do not show up. [The author later goes on to quote from a paper analyzing trading strategies] " Suppose that, over time, investors have experimented with technical trading rules drawn from a very wide universe - in principle thousands of parameterizations of a variety of types of rules. As time progresses, the rules that happen to perform well historically receive more attention and are considered ‘serious contenders’ by the investment community, while unsuccessful trading rules are more likely to be forgotten... If enough trading rules are considered over time, some rules are bound by pure luck, even in a very large sample, to produce superior performance even if they do not genuinely possess predictive power over asset returns. Of course, inference based solely on the subset of surviving trading rules may be misleading in this context since it does not account for the full set of initial trading rules, most of which are unlikely to have underperformed.
115
Over-optimism
Yes, Iʼm a Very Good Driver
From 'Why Smart People Make Big Money Mistakes and How to Correct Them', by Gary Belsky & Thomas Gilovich: ! The core idea... is not particularly uplifting: You're probably not as smart as you think you are. Overconfidence is pervasive, even among people who presumably have good reason to think highly of themselves. ! The classic example of this tendency is a 1981 survey of automobile drivers in Sweden, in which 90 percent of them described themselves as above average drivers. Clearly a large number of the respondents were giving themselves the benefit of what should have been a very large doubt. ! ... what research psychologists have discovered about overconfidence is that most people - those with healthy egos and those in the basement of self-esteem - consistently overrate their abilities, knowledge, and skill, at whatever level they might place them. ! ... one financial consequence of overconfidence [is] under-preparedness. Another is the willingness with which most people spend large amounts of money for products and services about which they know very little. ! To quote Odean and Barber: 'We argue that the well-documented tendency for human beings to be overconfident can best explain the high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth.'
116
Overweighting Numbers
But, Counting is Easier
Not everything that can be counted counts, and not everything that counts can be counted. - Albert Einstein A widely used management phrase is 'if you can measure it you can manage it'. There is, however, a tendency to attach too little importance to things that cannot be measured. In part this can be attributed to the 'man with a hammer syndrome' - if the only tool that a man has is a hammer, then every problem will look like a nail. So, for example, an individual with great proficiency in numbers will tend to bias an analysis towards data and its subsequent manipulation. And numbers may not be the heart of the issue.
This example by Charles Munger is recounted in 'Seeking Wisdom', by Peter Bevelin: ! The water system of California was designed looking at a fairly short period of weather history. If they'd been willing to take less perfect records and look an extra hundred years back, they'd have seen that they weren't designing it right to handle drought conditions which were entirely likely. ! You see that again and again - that people have some information they can count well and they have other information much harder to count. So they make the decision based only on what they can count well. And they ignore much more important information because its quality in terms of numeracy is less - even though it's very important in terms of reaching the right cognitive result.
117
Statistics
In a normal distribution, the data is distributed around the mean and 68% of the observations fall within 1 standard deviation of the mean, 95% fall within 2 standard deviations and 99.7% within 3 standard deviations.
A series of numbers can be represented by the mean (average), the mode (most frequent) and the median (middle number). The mean is the most commonly used everyday statistic, but sometimes the median provides greater insight. For example, the median house price is a better gauge than the average price as the nature of housing stock units across the whole economy tends to remain the same and therefore the middle number better represents the state of housing. The normal distribution is the most important distribution in statistics. This distribution called the 'central limit theorem', states that if a random variable X is the sum of a large number of random increments, then X has the normal distribution. Consider the examples The daily turnover of a large store is the sum of the purchases of all the individual customers. The height of a 50-year old oak tree can be thought of as the sum of each year's growth - which itself is a variable affected by sunshine, temperature, rainfall, etc. So one expects the heights of 50-year old oak trees to obey a normal distribution. Similarly, an examination mark is the sum of the scores in a large number of questions. Thus, by the central limit theorem, one expects daily turnover, the heights of trees and examination marks (approximately, at least) to be normally distributed.
118
Economic Models Animal Spirits
Just a Question of Confidence
The prerequisite of animal spirits to enable business risk-taking was first described in 'The General Theory of Employment Interest and Money', by John Maynard Keynes The considerations upon which expectations of prospective yields are based are partly existing facts which we can assume to be known more or less for certain, and partly future events which can only be forecasted with more less confidence. The state of confidence, as they term it, is a matter to which practical men always pay the closest and most anxious attention. But economists have not analyzed it carefully and have been content, as a rule, to discuss it in general terms. If human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation. Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits - of a spontaneous urge to action rather than in action, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.
119
... individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death. In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.
The idea is further developed and its impact on the broader economy discussed by George A. Akerlof and Robert J. Shiller in 'Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism ' ... there have been no principles in conventional economic theories regarding animal spirits. Conventional economic theories exclude the changing thought patterns and modes of doing business that bring on the crisis. They even exclude the loss of trust and confidence. They exclude the sense of fairness that inhibits the wage and price flexibility that could possibly stabilize an economy. They exclude the role of corruption and the sale of bad products in booms, and the role of their revelation when the bubbles burst. They also exclude the role of stories that interpret the economy. All of these exclusions from conventional explanations of how the economy behaves were responsible for the suspension of disbelief that led out to the [2007 to 2009] crisis.
120
Asymmetric Information
Itʼs a Lemon When one party to a transaction has more relevant information than the other. For example: The insurance deductible is a tool for teasing out private information.
Charles Wheelan, in his book 'Naked Economics' discusses the principle of asymmetric information: Markets tend to favor the party that knows more. But if the imbalance, or asymmetry of information, becomes too large, then markets can break down entirely. This was the fundamental insight of 2001 Nobel laureate George Akerlof... his paper entitled 'The Market for Lemons' used the used-car market to make its central point. Any individual selling a used car knows more about its quality than someone looking to buy it. Thus, used-car buyers anticipate hidden problems and demand a discount. But once there is a discount built into the market, owners of high-quality cars become even less likely to sell them - which guarantees the market will be full of lemons.
121
Bubbles
A Bubble Prayer
The recurring nature of market extremes provide some examples - Japanese real estate and stocks in the 1980s; the internet mania of 1999 & 2000; and more recently global property markets.
In 'Manias, Panics, and Crashes', Charles Kindleberger & Robert Aliber, outline the model: ! ... a bubble is an upward price movement over an extended period of fifteen to forty months that then implodes. Someone with 'perfect foresight' should have foreseen that the process was not sustainable and that an implosion was inevitable. ! A model developed by Hyman Minsky... [he] believed that pro-cyclical increases in the supply of credit in good times and the decline in the supply of credit in less buoyant economic times led to fragility in financial arrangements and increased the likelihood of financial crisis. ! The boom in the Minsky model is fueled by an expansion of credit. Minsky argued that the growth of bank credit has been very unstable; at times the banks as lenders have become more euphoric and have lent freely and then at other times they have become extremely cautious and let the borrowers 'swing in the wind'. ! Minsky argued that the events that lead to a crisis start with a 'displacement', some exogenous, outside shock to the macroeconomic system. If the shock was sufficiently large and pervasive, the economic outlook and the anticipated profit opportunities would improve in at least one important sector of the economy. Business firms and individuals would borrow to take advantage of the increase in the anticipated profits associated with a wide range of investments. The rate of economic growth would accelerate and in turn there might be a
122
feedback to even greater optimism. It's 'Japan as Number One' or the 'East Asian Miracle' or 'The New American Economy' - a new sense of more profound optimism about the economic environment. ! Minsky noted that 'euphoria' might develop at this stage. Investors buy goods and securities to profit from the capital gains associated with the anticipated increases in the prices of these goods and securities. The authorities recognize that something exceptional is happening in the economy and while they are mindful of earlier manias, 'this time it's different', and they have extensive explanations for the difference. ! A follow-the-leader process develops as firms and households see that others are profiting from speculative purchases [and the envy principle goes to work]. More and more firms and households that previously had been aloof from these speculative ventures begin to participate in the scramble for high rates of return. Making money never seemed easier. ! If the eagerness of the outsiders to buy is stronger than the eagerness of the insiders to sell, the prices of the assets or securities continue to increase. In contrast if the sellers become more eager than the buyers, then the prices will decline. ! As the buyers become less eager and the sellers become more eager an uneasy period of 'financial distress' follows... ! As the decline in prices continues, more and more investors realize that prices are unlikely to increase and that they should sell before prices decline further; in some cases this realization occurs gradually and in others suddenly. The race out of real or long-term financial securities and into money may turn into a stampede. ! The specific signal that precipitates the crisis may be the failure of a bank or of a firm, the revelation of a swindle... or a sharp fall in price. Magazine covers are a useful money-management tool because they indicate the point in time when public awareness of a financial subject has reached maximum saturation – and by extension, the point in time when prices within the subject market are likely to be at, or near, a major extreme.
123
Comparative Advantage
Heʼd Like to Trade
Comparative advantage is doing that in which one has an advantage compared to all other skills that one possesses. It is comparative advantage – the relative advantage resources have, in given uses, over resources in other uses – that determines the most efficient way to employ one’s resources.
The example is given in 'The Wealth of Nations', by Adam Smith: ! ! It is a maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes but employs a tailor. The farmer attempts to make neither the one nor the other, but employs those different artificers. All of them find it for their interest to employ their whole industry in a way in which they have some advantage over their neighbours, and to purchase with a part of its produce, or what is the same thing, with the price of part of it, whatever else they have occasion for. The same concept applies to nations and the trade between them. For example, a rich developed country may want to sell computers to a less developed country, which in turn may want to sell it fruit. Of course it may be that the developed country could allocate resources and grow its own fruit, but by doing so it will likely take resources from even more productive activities. This is the reason why, in general, trade makes everyone better off. Trade allows individuals and countries to specialize in what they do best and thus be more productive by leveraging their comparative advantage.
124
Creative Destruction Creatively Destroying
In 'The Science of Success', the author Charles Koch, describes the importance of creative destruction in his thinking and quotes Joseph Schumpeter: “The... process of industrial mutation... incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of creative destruction is the essential fact of capitalism. It is not [price and output] competition which counts, but competition from the new commodity, the new technology, the new source of supply, the new type of organization.” [He then adds] To drive the process of creative destruction internally, nothing can be immune to challenge. Each of us must help foster an open environment that invites challenge and embraces change. If you find that your views are rarely challenged, or that you rarely challenge the views of others, something is wrong. It may be the lack of entrepreneurial drive, the culture, or perhaps the incentives. Whatever the problem, it must be addressed lest it imperil the business. It is natural to think that if customers don't complain, they are satisfied. But thinking this way can lull us into complacency and make us vulnerable to creative destruction. Customers seldom know what they will value until they see it. This essential insight is fundamental to success.
'More Than You Know' - Michael Mauboussin Just to give you some sense of how much change we've seen in the past hundred years or so, take a gander at the first list of industrial stocks Charles Dow assembled in May 1896: American Cotton Oil ! American Tobacco ! ! Chicago Gas !! !
U.S. Rubber! ! ! North American! ! Tennessee Coal & Iron!
125
Distilling and Cattle Feeding U.S. Leather General Electric! !
Andy Grove in 'Only the Paranoid Survive’, describes creative destruction as a recurring set of strategic inflection points: So how do you know whether a change signals a strategic inflection point? Ask these questions to attempt to distinguish signal from noise. Is your key competitor about to change? When the answer to this question stops being as crystal clear as it used to be and some of your people direct the silver bullet to competitors who didn't merit this kind of attention previously, it's time to sit and pay special attention. When the importance of your competitors shifts, it is often a sign that something significant is going on. In an analogous fashion, you should ask, is your key complementor about to change? [He further dissects the potential turning point] My point is that you can't judge the significance of strategic inflection points by the quality of the first version. You need to draw on your own experience. Perhaps you remember your reaction to the first PC you ever saw. It probably didn't strike you as a revolutionary device. So it is with the Internet [Note: this was written in 1996]. Now, as you stare at your computer screen that is connected to the Internet, waiting for a World Wide Web page to slowly materialize, let your imagination flow a bit. What might this experience be like if transmission speed doubled? Or better yet, if it were improved by "10 X"? What might the content look like if professional editors rather than amateurs create it, not as a sideline but as their main occupation? You might extrapolate the evolution of this phenomenon by remembering how rapidly PCs evolved and improved. As you consider this or any new device, your answer may be that, even if it were "10 X" better, it would not interest you as a consumer. Even if a company actually supplied it, it wouldn't change the silver bullet test and it wouldn't rearrange your complementors. Life would go on as before, just with one more gadget. But if your instincts suggest that a "10 X" improvement could make this capability exciting or threatening, you may very well be looking at the beginning of what is going to be a strategic inflection point. Consequently, you must discipline yourself to think things through and separate the quality of the early versions from the longer-term potential and significance of a new product or technology.
126
Diminishing Returns
Already On The Other Corner After grabbing the low hanging fruit, things tend to get more difficult. Capital, in particular, is subject to diminishing returns. As the amount of capital rises, the return from additional units tends to fall. The principle applies equally to other factors - for example, one more production employee in a small manufacturing company will have a different impact to one more production employee at Toyota. Berkshire's past record can't be duplicated or even approached. Our base of assets and earnings is now far too large for us to make outsized gains in the future. ! ! ! ! ! ! ! ! ! ! - Warren Buffett
127
Equilibrium
Perfect Equilibrium
From 'The Nature of Science' by James Trefil: ! ! Equilibrium is the state of a system when the forces acting on it are in balance. Equilibrium can be stable, unstable, or neutral. ! It can be applied to any system, from a planet circling its star to the population of fish in a tropical lake. In mechanics, a system is in equilibrium if all the forces on it balance, canceling one another out. If you are sitting in a chair and reading this book, for example, the downward force of gravity on your body is being canceled by the upward force exerted on you by the chair. You neither fall nor rise - you are in equilibrium. ! Consider, for example, the relation between predator and prey in an ecosystem. The numbers of predator and prey will come to an equilibrium - so many foxes for so many rabbits, for example. If for some reason the equilibrium number of prey is disturbed (e.g., by rabbits having a successful breeding season) then the number of predators will increase and drive the rabbit population down again. Although these aren't physical forces, they are still forces, in a broader sense of the term, operating in the ecosystem to drive it back toward equilibrium following a disturbance.
128
Externalities
A Negative Externality Sometimes our actions do not have costs. These actions can affect others and yet we do not suffer any consequences. A good example of just such a negative externality would be pollution - the pollution from a car, or even noise pollution from loud music. On the other hand, an externality could be positive. If the exterior of a house is particularly beautiful, both passersby and neighbors alike will receive a benefit from its appearance. The inability to charge for externalities (positive and negative) may be a problem and is therefore an opportunity for better resource allocation.
129
Markets The Market Looks Great Today
Markets allow exchange which creates value for both parties; they encourage participants to bring information that can be of value to everyone; and, of course, allow prices to balance supply with demand. Markets can efficiently sort through vast amounts of information from large numbers of people and arrive at an aggregate view of what that information means.
From 'The Undercover Economist' by Tim Harford: ... you can't get more efficient than a perfectly competitive market. And it all follows perfectly naturally from the truth contained in the price system: prices are true representations of cost to firms, and also true representations of value to customers. Market failures can result from scarcity power, missing information and externalities, among other things. At these times government interventions can sometimes improve market outcomes.
In 'The Origin of Wealth', Eric Beinhocker, describes the market in an evolutionary context: ... we can reinterpret markets as an evolutionary search mechanism. Markets provide incentives for the deductive-tinkering process of differentiation. They then critically provide a fitness function and selection process that represents the broad needs of the population (and not just the needs of a few Big Men [authoritarians etc.]). Finally, they provide a means of shifting resources toward fit [business] modules and away from unfit ones, thus amplifying the fit [business] modules' influence. In short, the reason that markets work so well comes down to what evolutionary theorists refer to as Orgel's Second Rule, which says, 'Evolution is cleverer than you are'. Even a highly rational, intelligent, benevolent Big Man would not be able to beat an evolutionary algorithm in finding peaks in the economic fitness landscape. Markets win over command and control, not because of their efficiency at resource allocation in equilibrium, but because of their effectiveness at innovation in disequilibrium.
130
Moral Hazard
Moral Hazard Approaching
Describes a situation where one party does not bear the true costs associated with its actions, and is therefore likely to behave in a reckless fashion. Moral Hazard issues can occur at any level - for example, government insurance subsidies allowing homeowners to build near vulnerable coastlines; a teenager's car insurance incorporated under the parent's accident free policy etc.
Robert Rubin - 'In an Uncertain World' - describes moral hazard problems at the macro economic level: ! In contemplating such a package, we did worry about the 'moral hazard' problem that had gotten so much attention during the Mexican Peso crisis. There were actually two separate moral-hazard issues. The first pertains to countries. Do large rescue packages encourage countries to borrow unwisely or adopt unsound policies? I didn't worry so much about that because, as this crisis itself would show, countries and their political leaders pay a high price for financial missteps. ! The other kind of moral hazard, the kind that affects creditors and investors, was a more serious concern: insulation from loss can sow the seeds of future crises. Part of the issue in Thailand had clearly been excessive and undisciplined investment from the developed world. 'Rescuing' these investors, especially in a relatively small economy like Thailand's, could encourage lenders and investors to give insufficient weight to risk in pursuit of higher yield in other developing countries and undermine the discipline of the marketbased system. In supporting an IMF rescue program, we would be interfering with the free play of market forces. As a result, investors would escape some of the burden of problems they had helped create.
131
Price Discrimination
So, How Much Did You Pay?
Illustrated in 'The Economic Way of Thinking' by Paul Heyne: The ability to discriminate: to charge high prices for units that are in high demand and lower prices for units that would not otherwise be purchased. To be successful, the seller must be able to 1) Distinguish between buyers with different elasticities of demand 2) Prevent low-price buyers from reselling to high-price buyers 3) Control resentment
132
Property Rights Our Fish
Property rights control the way in which particular resources will be used and help to assign the resulting costs and benefits.
Consider the parable of the Tragedy of the Commons, as explained in 'Principles of Economics' by Greg Mankiw: ! Consider life in a small medieval town. Of the many economic activities that take place in the town, one of the most important is raising sheep. As our story begins, the sheep spend much of their time grazing on the land surrounding the town, called the Town Common. No family owns the land. ! As the years pass, the population of the town grows, and so does the number of sheep grazing on the Town Common. With a growing number of sheep and a fixed amount of land, the land starts to lose its ability to replenish itself. Eventually, the land is grazed so heavily that it becomes barren. With no grass left on the Town Common... the town's once prosperous wool industry disappears. ! What causes the tragedy? The reason is that social and private incentives differ. Avoiding the destruction of the grazing land depends on the collective action of the shepherds. If the shepherds acted together, they could reduce the sheep population to a size that the Town Common can support. Yet no single family has an incentive to reduce the size of its own flock because each flock represents only a small part of the problem. ! This lesson has been known for thousands of years. The ancient Greek philosopher Aristotle pointed out the problem with common resources: 'What is common to many is taken lest care of, for all men have greater regard for what is their own than for what they possess in common with others.' In another interesting idea, Hernando de Soto in his book, 'The Mystery of Capital', argues that a lack of property rights in developing countries is a major drag on their respective economies. Since many dwellings are not recognized, the owners are unable to borrow against them and thus capital is locked-up that would otherwise be accessible under a system of property rights.
133
Public/Private Goods
A Public Good
Public Goods are available to everyone and people cannot easily be prevented from using them. Examples include clean air and the protection of the Military. Using a Public Good does not hinder, or diminish, another's access to that good. Public Goods can have the problem of the Free Rider - a person who receives the benefit of a good but avoids paying for it. Private Goods, on the other hand, can be charged for.
134
Sunk Costs
No Good Crying Now
This concept is explained in 'The Economic Way of Thinking', by Paul Heyne: ! When you pass through the cafeteria line, pick up the tuna lasagna, and pay the cashier $1.90, you incur a cost: the value of whatever opportunity you will have to forgo because you've spent $1.90. Then you take your first bite and suddenly wish you hadn't selected this item. What will be the cost to you of leaving the lasagna on your plate? ! It will not be $1.90 - or $1.80, if we assume your first bite consumed about ten cents' worth of tuna lasagna. That cost is history. The cost of leaving the lasagna on your plate will be the value of whatever opportunity you forgo by doing so. Do you have a dog that would enjoy pasta with tuna? If so, the cost of leaving the lasagna is the opportunity you forgo (by not asking for a doggie bag) to see your dog's eyes light up and its tail wag. ! The price you paid is what economists dismiss as a sunk cost. Sunk costs are irrelevant to economic decisions. Bygones are bygones. The proper stance for making cost calculations is not looking back to the past, but forward to the future. ! Of course, we must be certain that a cost is really sunk, or fully sunk, before we decide to regard it as irrelevant to decision making.
135
Switching Costs High Switching Cost
It can seldom be right to sacrifice a present benefit for a doubtful advantage in the future. Moreover it is not sufficient that the state of affairs which we seek to promote should be better than those that previously existed; it must be sufficiently better to make up for the evils of the transition - Edmund Burke
The cost of switching from one service/product provider to another can be a factor in a myriad of situations. In 'Information Rules' by Carl Shapiro and Hal Varian, the authors describe how customer lock-in works: Type of Lock-In!
!
!
!
Contractual commitments Durable purchases ! ! ! !
!
Switching Costs
!Compensatory or liquidated damages
! !
! !
! !
Replacement of equipment - tends to decline as the durable ages
Brand-specific training!! ! ! ! ! ! ! ! !
! ! !
! !
Learning a new system, both direct costs and lost !productivity - tends to rise over time
Information and databases! ! ! ! !
! !
! !
Converting data to new format - tends to rise over time as collection grows
Specialized suppliers! ! ! ! ! ! ! Search costs! ! ! ! ! ! ! !
! ! ! ! ! !
! ! ! ! ! !
! ! ! ! ! !
Funding of new supplier - may rise over time if capabilities are hard to find or maintain Combined buyer and seller search costs; includes learning about quality of alternatives
Loyalty programs! ! ! ! ! ! !
! ! !
! ! !
! ! !
Any lost benefits from incumbent supplier, plus possible need to rebuild cumulative use
136
Transaction Costs
George Makes It Easy
Every exchange incurs some kind of transaction cost. Consider electronic share trading, which has sharply lowered the cost of buying and selling shares, both in terms of commissions and the spread between bid and offer. But money may not be the only consideration. Time is also a component in a transaction. The large range of products under one roof in a supermarket is a convenience for many people as it reduces the time transaction costs associated with buying groceries and household essentials. On a macro level, transaction costs can play an even bigger role: The time to set up a business corporation; to prepare and file taxes; the costs in resolving business contract disputes etc.
Days to Register a New Company 2008 (Source: The Economist) Highest
Lowest
1
Suriname
694
1
Australia
2
2
Guinea-Bissau
233
2
Canada
3
3
Haiti
203
3
Denmark
5
Iceland
5
United States
5
4
Laos
163
6
Singapore
6
5
Congo
155
7
Puerto Rico
7
137
System Models Back-up/Redundancy
A Design of the Worst Case
The idea of back-up, or redundancy, thinking is common in engineering: Designing bridges with a safety factor that can comfortably handle the maximum volume of traffic, high winds etc.; Building a power grid that can safely handle the peak load; Using preventative maintenance - replacing/servicing components within their predicted lifespan - to ensure that aircraft do not fail in flight, using the meantime-between-failure (MTBF) benchmark; Using data back-up systems
Back-ups and redundancy are required because systems have break points and limits. Peter Bevelin describes the idea in 'Seeking Wisdom': ! At a certain scale, a system reaches a critical mass or limit where the behavior of the system may change dramatically [an example would be a spring that, if stretched too far, merely deforms rather than returning to its original position]. ! Small interactions over time slowly accumulate into a critical state - where the degree of instability increases. A small event may then trigger a dramatic change like an earthquake. A web of cracks over time may increase vibrations that cause an accident. The underlying process may be simple and easy to understand but still remain unpredictable.
138
Bottlenecks
System Speed Equals Bottleneck Speed
Theory of Constraints - first find the system/process constraint and then maximize.
In 'The Goal', the author Eliyahu Goldratt outlines his method: Look at the system when demand exceeds capacity and identify the bottleneck. This bottleneck will determine the throughput rate of the system. Fully utilize the bottleneck point Increase its capacity, if possible. Minimize its downtime. If non-bottlenecks work considerably faster than the bottleneck, then inventory increases, not productivity. Decide - 'What to change?', 'What to change to?', and 'How to cause the change?' The bottleneck may not be at a fixed point in the system and so the process may need to be repeated. A system comprises a set of dependent events and therefore one must think cause and effect - 'If the hypothesis is right then logically another fact must also exist?' Measures Throughput is the rate at which the system generates money through sales. Inventory is all the money that the system has invested in purchasing things which it intends to sell. Operational expense is all the money the system spends in order to turn inventory into throughput.
139
Complex Adaptive Systems
Natural Complexity In systems such as economies, stock markets etc., behavior often changes as a result of the behavior of others and experiential learning (feedback loop). These systems therefore become difficult to predict as unexpected (emergent) properties may emerge. A complex system involves large numbers of interacting elements. Interactions are non-linear. Consider a steady stream of sand grains that randomly pile up on top of each other. At some point the pile of sand reaches a critical state. The next grain of sand causes the pile to topple over and one has to start again. In this way, the sand grains are similar to a number of other systems, in that when they have reached the critical state the slightest change (shock) will cause the system to malfunction. Further, the smallest change can produce the most radical malfunction and this change may be unavoidable and unforeseeable. The system is dynamic, the whole is greater than the sum of its parts, and solutions can't be imposed; rather they arise from the circumstances emergence. The system has a history, and the past is integrated with the present; the elements evolve with one another and with the environment; and evolution is irreversible. Though a complex system may, in retrospect, appear to be ordered and predictable, hindsight does not lead to foresight because the external conditions and systems constantly change.
140
In ‘The Origin of Wealth’, Eric Beinhocker contrasts the ‘complex’ view of economics with traditional economic approach :
Complexity Economics
Traditional Economics
Dynamics
Open, dynamic, nonlinear systems, far from equilibrium
Closed, static linear systems in equilibrium
Agents
Modeled individually; use inductive rules of thumb to make decisions; have incomplete information; are subject to errors and biases; learn and adapt over time
Modeled collectively; use complex deductive calculations to make decisions; have complete information; make no errors and have no biases; have no need for learning or adaptation (are already perfect)
Networks
Explicitly model interactions between individual agents; networks of relationships change over time
Assume agents only interact indirectly through market mechanisms (e.g., auctions)
Emergence
No distinction between micro- and macroeconomics; macro patterns are emergent result of micro-level behaviors and interactions
Micro- and macroeconomics remain separate disciplines
Evolution
The evolutionary process of differentiation, selection, and amplification provides the system with novelty and is responsible for its growth in order and complexity
No mechanism for endogenously creating novelty, or growth in order and complexity
141
Evolution
The Explanation? If some individuals have a trait that allows them to better compete in a given environment, then they are more likely to survive into adulthood and produce offspring. And the offspring are likely to carry the same trait. The organism acts, and has evolved, to further the interests of its genes.
The idea of evolution by natural selection - as per 'The Origin of Species', by Charles Darwin: ! If during the long course of ages and under varying conditions of life, organic beings vary at all in the several parts of their organization, and I think this cannot be disputed; if there be, owing to the high geometric powers of increase of each species, at some age, season, or year, a severe struggle for life, and this certainly cannot be disputed; then, considering the infinite complexity of the relations of all organic beings to each other and to their conditions of existence, causing an infinite diversity in structure, constitution, and habits, to be advantageous to them, I think it would be a most extraordinary fact if no variation ever had occurred useful to each being's own welfare, in the same way as so many variations have occurred useful to man. But if variations useful to any organic being do occur, assuredly individuals thus characterized will have the best chance of being preserved in the struggle for life; and from the strong principle of inheritance they will tend to produce offspring similarly characterized. This principle of preservation, I have called, for the sake of brevity, Natural Selection.
142
Success by mutual cooperation is explained in 'Darwin's Blind Spot', by Frank Ryan. ! Besides the law of mutual struggle there is in Nature the law of mutual aid, which, for the progressive evolution of the species, is far more important than the law of mutual contest. The intimate cooperation between wholly different life forms - plants and fungi - is not only an amazing biological phenomenon but also a vitally important factor in the diversity of plant life on Earth. This evolutionary force that derives from the interaction of different species is Symbiogenesis - the creative force is not natural selection but the act of symbiotic union. Changes in species over time, arising from multifactorial forces that often include symbiotic mechanisms. This does not mean that symbiosis is the sole mechanism of evolutionary change, any more than Darwinian gradualism is. Once the symbiosis is established, each partner is likely to show resistance to further selection pressures because individual change could upset the equilibrium of the symbiotic whole.
'The Origin of Wealth', by Eric Beinhocker places evolution into an economic context: ! We are accustomed to thinking of evolution in a biological context, but modern evolutionary theory views evolution as something much more general. Evolution is an algorithm; it is an allpurpose formula for innovation, a formula that, through its special brand of trial and error, creates new designs and solves difficult problems. Evolution can perform its tricks not just in the ‘substrate’ of DNA, but in any system that has the right information-processing and information-storage characteristics. In short, evolution’s simple recipe of ‘differentiate, select, and amplify’ is a type of computer program - a program for creating novelty, knowledge, and growth. Because evolution is a form of information processing, it can do its order-creating work in realms ranging from computer software to the mind, to human culture, and to the economy.
143
Feedback Loops
Too Much Feedback Feedback loops at the systemic level can be positive, or negative. The system is likely to continually adjust to the loop, but may reach a critical state - a tipping point - and then fundamentally change (consider the metaphor of a spring stretched to deformity). With respect to human behavior, experiential learning causes a feedback loop. It is unlikely therefore that history will exactly repeat itself as participants will have modified their prior behavior. Though the emotions of fear and greed will not have changed.
In 'The Education of a Speculator', Victor Niederhoffer describes feedback loops Homeostatic Functions: One of the common features that all life possesses is a mechanism for maintaining orderly conditions. The tendency is called homeostasis. It is generally achieved through feedback loops.
144
Momentum
This Momentum Thing is Fun
Linear Momentum of an Isolated System is Conserved Momentum = Mass x Velocity (vector quantities with size and direction)
From 'The Nature of Science', by James Trefil: When two pool balls heading toward each other on a straight line collide, several things happen. The balls rebound from each other, they flex slightly during the impact, and some of their kinetic energy is converted to heat. But whatever else happens, we know that the total momentum of the system will be zero. If we see one ball moving off at a given speed in a given direction after the collision, we can say with certainty that the other is moving at the same speed in exactly the opposite direction.
145
Newton’s Laws
Equal and Opposing Forces
James Trefil explains Newton's Laws of Motion in 'The Nature of Science': There is an attractive force - gravity - between each and every pair of objects in the universe. An object moving in a straight line will continue to do so, unless acted upon by an external force. ! It tells us that if we see a change in the motion of an object, there must be a force causing that change. The acceleration of an object is proportional to the applied force and inversely proportional to the object's mass ! ! ! Force = mass * acceleration ! If body A exerts a force on body B, then body B will exert an equal and opposite force on body A. ! The operation of a rocket illustrates all three of Newton's laws of motion. Once launched, the rocket will keep going (first law), it will keep accelerating as long as it burns its fuel (second law), and its forward motion is a reaction to the gases blasting out in the opposite direction (third law).
146
Power Law Mark Buchanan, describes how some systems can be represented by the Power Law in his book 'Ubiquity - why catastrophes happen': In terms of energy, it turns out that the Gutenberg-Richter law boils down to one very simple rule: If earthquakes of type A release twice the energy of those of type B, then type A quakes happen four times less frequently. Double the energy, that is, and an earthquake becomes four times as rare. This simple pattern - a power law - holds for quakes over a tremendous range of energies. ! Remarkably, Bak and his colleagues found a similar relationship for avalanches in the sandpile game. Counting up how frequently avalanches of each size happened, they found that avalanches toppling anything from a few up to a few million grains follow a regular pattern: Double the number of grains involved, and the avalanche becomes just a bit more than twice as unlikely (more precisely, about 2.14 times as unlikely). ! ...their data for 4,284 fires on U.S. Fish and Wildlife Service lands between 1986 and 1995 reveals a remarkably strong power law. Once again we find the same geometric pattern: double the area covered by a fire, and it becomes about 2.48 times as rare, and the pattern holds for fires varying in size by a factor of a million. In other words, despite the immensely complex picture of how fires spread, a startlingly simple pattern emerges when you look at how often you find fires of different sizes - a kind of Gutenberg-Richter law for ecological conflagration. ! Using data for the twenty-four hundred largest cities in the United States, Zanette and Manrubia counted up how many cities there are with populations of around one hundred thousand, two hundred thousand, three hundred thousand, and so on... The numbers reveal that for every city such as Atlanta, Georgia, population four million, there are four cities having populations half that size. Cincinnati, Ohio, is one such city, and for every Cincinnati there are in turn four cities just half as large again, and so on down the line. This perfect geometrical pattern continues down to the smallest cities of just ten thousand people or so. ! Things that live in critical states tend to show similar kinds of organization, and this organization arises not from specific details of those systems and the elements that make them up, but from the far deeper skeleton of basic geometry and logic behind these details. The critical form wells up in things regardless of what they are. When something is recognized to be in a critical state, its essential character can be understood even by ignoring most of the details.
147
Reflexivity Interacting Observers
A model identified with George Soros and explained in his book 'The Alchemy of Finance': The concept of reflexivity is very simple. In situations that have thinking participants, there is a two-way interaction between the participants’ thinking and the situation in which they participate. On the one hand, participants seek to understand reality; on the other, they seek to bring about a desired outcome. The two functions work in opposite directions: in the cognitive function reality is the given; in the participating function, the participants’ understanding is the constant. The two functions can interfere with each other by rendering what is supposed to be given, contingent. I call the interference between the two functions ‘reflexivity’. I envision reflexivity as a feedback loop between the participants’ understanding and the situation in which they participate, and I contend that the concept of reflexivity is crucial to understanding situations that have thinking participants. Reflexivity renders the participants’ understanding imperfect and ensures that their actions will have unintended consequences. When we act as outside observers we can make statements that do or do not correspond to the facts without altering the facts; when we act as participants, our actions alter the situation we seek to understand. … markets are almost always wrong but their bias is validated during both the self-fulfilling and self-defeating phases of boom/bust sequences. Only at inflection points is the prevailing bias proven wrong. The major insight I gained from the theory of reflexivity and what I now call the human uncertainty principle is that all human constructs (concepts, business plans or institutional arrangements) are flawed. The flaws may be revealed only after the construct has come into existence. That is the key to understanding reflexive processes. Recognizing the flaws that are likely to appear when a hypothesis becomes reality puts you ahead of the game.
George Soros adds in 'Money Masters of Our Time' by John Train: The outstanding feature of my predictions is that I keep on expecting developments that do not materialize... In part because markets can influence the events that they anticipate... reflexive processes do not have a predetermined outcome: The outcome is determined in the course of the process.
148
Six Degrees
Just Six Steps Away
‘Six Degrees, The Science of a Connected Age’, by Duncan J. Watts: ! ... the science of networks has taught us that distance is deceiving. That two individuals on the opposite sides of the world, and with little in common, can be connected through a short chain of network ties - through only six degrees. ! The explanation derives from the existence of social connections that span long distances, and from the fact that only a few such ties can have a big impact on the connectedness of the whole world. ! The origin of these long-distance links resides in the multidimensional nature of social identity - we tend to associate with people like ourselves, but we have multiple independent ways of being alike. People know each other because of the things they do, or more generally the contexts they inhabit. Being a university professor is a context, as is being a naval officer. Flying frequently for business is a context... ! And because we know not only who our friends are, but also what kind of people they are, even very large networks can be navigated in only a few links. Social identity is what leads networks to be searchable. [In parallel, the author explores the cascade model] ! What all cascades have in common is that once one commences, it becomes selfperpetuating; that is, it picks up new adherents largely on the strength of having attracted
149
previous ones. Hence, an initial shock can propagate throughout a very large system, even when the shock itself is small. ! As a result, the primary feature of the cascade model - that apparently stable systems can suddenly exhibit a very large cascade - can also be interpreted as a statement about the inherent fragility of complex systems, even those that seem robust. [Alternatively this sudden change of state can be imagined as...] ! Phase transition - driven by the addition of a small number of links right near the critical point that have the effect of connecting many very small clusters into a single giant component, which then proceeds to swallow up all the other nodes until everything is connected. [Bringing these two concepts together one can see, as the author explains, how...] " In 1997, the decoupling of the Thai bhat from the U.S. dollar triggered a real estate crisis in Thailand that led to the collapse of its banking system... within months, financial distress had spread to the other ‘Asian Tigers’ prompting a depression in the prices of commodities. Russia, meanwhile, was heavily dependent on its oil exports. A Russian budgetary crisis ensued, and the government was forced to default on its sovereign debt... the shock to the world debt markets caused investors to flee bonds of any kind other than those of the U.S. government. [Thus completing the link from the distressed Thai real estate investor to the holder of U.S. treasuries.]
150
System Boundary
Redrawn System Boundary
The idea of drawing a system boundary around the area to be studied is not only valid in engineering, but also in business. The most common boundary is that of the organization, which is represented by the company's profit/loss; but the boundary could be drawn around all the companies from the raw material to the final customer, which would represent the profit/loss of the supply chain; or, alternatively, the boundary could be drawn around the individual production process within the company to determine the product's profit/loss.
'An Introduction to General Systems Thinking', by Gerald Weinberg: The idea of clean separation of one part from another is so deeply ingrained that we have confidence that we can always separate inside from outside, even though it may take much mental effort. By analogy, we apply this concept to all our systems, using the term 'system' to mean the inside and 'environment' to mean 'outside'. By the principle of indifference, we might imagine that we can call either one 'the system', for one man's system may be another man's environment. ... when we choose boundaries, we are powerfully influenced by easily recognized physical features. A place where sharp color change is seen, where difference in texture is felt, where solid meets liquid or liquid meets gas - all these and many more make popular boundary choices. On the other hand, we hesitate to define a boundary between two solid bodies rigidly attached so that they always move together.
151
We commonly consider hair to be part of the body, because it is attached to it. When we are thinking of thermal problems, parasite problems, or swimming problems, it is useful to consider the hair in such a way. But this accepted mode of thought blinds us to the possibility that, for some purposes, hair is better thought of as being outside of the body. Unlike the material in body cells, material once secreted into the hair no longer participates in the body's physiological processes. Since material in the hair was once inside the body's physiological system and is now outside, it is useful for the physiologist to think of hair as excrement - just like perspiration, urine, feces, and, for that matter, toenails. These examples could be multiplied endlessly to demonstrate how our built-in notions of 'natural' boundaries may make a difference in the effectiveness of our thought.
152
Thermodynamics
Impromptu Cooling
'The Nature of Science' by James Trefil: 1. In an isolated system - total energy remains constant (Energy of motion and position) ! This means that the total amount of energy in an isolated system cannot change, even though the form it takes can vary. ! It turns out that if, for example, we burn coal to produce electricity, fully two-thirds of the energy in the coal is lost to the environment. This is why the most striking feature of modern generating plants are huge cooling towers - this is where the waste heat is being returned to the environment. 2. HEAT flows from HOT to COLD ! We can easily see why things happen this way by looking at how [an] ice cube and air interact on the molecular scale. We know that temperature is related to the speed of molecules in an object - the faster they move, the higher the object's temperature. This must mean that the molecules in the air are moving faster than the molecules in the ice cube. When a molecule in the air collides with a water molecule at the surface of the cube, our experience tells us that, on average, the fast molecule will slow down and the slow molecule will speed up. The molecules in the ice will thus move faster and faster or, equivalently, the temperature of the cube will increase.
153
3. Transfer occurs by CONDUCTION; CONVECTION (movement of matter); and RADIATION (wavelengths). ! Convection is the transfer of heat by the bulk motion of matter. Material absorbs heat in one place and then moves to another place, carrying the heat with it. This is in contrast to conduction, in which the medium remains stationary while heat is transferred through it. ! Every object with a temperature above absolute zero radiates energy into its environment. This notion is part of of our common experience - a piece of metal in a blacksmith's forge will first glow orange, then red, then white-hot as its temperature changes. This is an indication that as the temperature of the object increases, so too does the frequency of the radiation it emits.
A number of these points are also described in 'A Matter of Degrees', by Gino Segre: ! [He] tells how the great Eddy Merckx, five-time winner of the Tour, fared in a lab experiment in which he rode only a stationary bike. The man who could ride up and down hills day after day for six hours at at time collapsed in a pile of sweat after a single hour in a breezeless indoor gym. Why? ! During the twenty-two-day Tour de France race, the cyclists neither gain nor lose weight, so what happens to the energy? Only 25 percent of it goes into the mechanical work of overcoming air drag and propelling the bicycle and racer forward. A full 75 percent is dissipated as extra body heat - so much heat that the racer needs ten quarts of water to evaporate from his skin each day of the race in order to stay at constant temperature. This requires continual drinking, but the racer also needs a strong breeze to help evaporation; speeding along at twenty-five miles an hour or more provides this breeze. No breeze means saturated vapor pressure, no evaporation, and heat buildup. The result is that the Eddy Merckx who can ride at top speed for eight hours falls off a stationary bike in a state of total exhaustion after sixty minutes.
154
