The Psychology of Human Misjudgement – Charlie Munger Full Speech

http://web.archive.org/web/20151004200748/http://law.indiana.edu/instruction/profession/doc/16_1.pdf

By Charlie Munger (Warren Buffett’s partner at Berkshire Hathaway)
Speech at Harvard Law School (1995)

Transcription of The Psychology of Human Misjudgment, comments [in brackets] by Whitney Tilson.  Note from Joshua Kennon: I’ve written a lot about Charlie Munger over the years, especially the influence he has had on my life and how we run my companies by using our own mental models.  This is one of the best speeches Munger ever gave … which may be why my family owns about a dozen copies of various editions of Poor Charlie’s Alamanack, including an autographed first edition that sits in my office.

Charles Munger, Vice Chairman of Berkshire Hathaway

Charlie Munger: Although I am very interested in the subject of human misjudgment — and lord knows I’ve created a good bit of it — I don’t think I’ve created my full statistical share, and I think that o­ne of the reasons was I tried to do something about this terrible ignorance I left the Harvard Law School with.

When I saw this patterned irrationality, which was so extreme, and I had no theory or anything to deal with it, but I could see that it was extreme, and I could see that it was patterned, I just started to create my own system of psychology, partly by casual reading, but largely from personal experience, and I used that pattern to help me get through life. Fairly late in life I stumbled into this book, Influence, by a psychologist named Bob Cialdini, who became a super-tenured hotshot o­n a 2,000-person faculty at a very young age. And he wrote this book, which has now sold 300-odd thousand copies, which is remarkable for somebody. Well, it’s an academic book aimed at a popular audience that filled in a lot of holes in my crude system. In those holes it filled in, I thought I had a system that was a good-working tool, and I’d like to share that o­ne with you.

And I came here because behavioral economics. How could economics not be behavioral? If it isn’t behavioral, what the hell is it? And I think it’s fairly clear that all reality has to respect all other reality. If you come to inconsistencies, they have to be resolved, and so if there’s anything valid in psychology, economics has to recognize it, and vice versa. So I think the people that are working o­n this fringe between economics and psychology are absolutely right to be there, and I think there’s been plenty wrong over the years. Well let me romp through as much of this list as I have time to get through:

24 Standard Causes of Human Misjudgment

1. Under-recognition of the power of what psychologists call ‘reinforcement’ and economists call ‘incentives.’

Well you can say, “Everybody knows that.” Well I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.

One of my favorite cases about the power of incentives is the Federal Express case. The heart and soul of the integrity of the system is that all the packages have to be shifted rapidly in o­ne central location each night. And the system has no integrity if the whole shift can’t be done fast. And Federal Express had o­ne hell of a time getting the thing to work. And they tried moral suasion, they tried everything in the world,
and finally somebody got the happy thought that they were paying the night shift by the hour, and that maybe if they paid them by the shift, the system would work better. And lo and behold, that solution worked .

Early in the history of Xerox, Joe Wilson, who was then in the government, had to go back to Xerox because he couldn’t understand how their better, new machine was selling so poorly in relation to their older and inferior machine. Of course when he got there he found out that the commission arrangement with the salesmen gave a tremendous incentive to the inferior machine.

And here at Harvard, in the shadow of B.F. Skinner — there was a man who really was into reinforcement as a powerful thought, and, you know, Skinner’s lost his reputation in a lot of places, but if you were to analyze the entire history of experimental science at Harvard, he’d be in the top handful. His experiments were very ingenious, the results were counter-intuitive, and they were important. It is not given to experimental science to do better. What gummed up Skinner’s reputation is that he developed a case of what I always call man-with-a-hammer syndrome: to the man with a hammer, every problem tends to look pretty much like a nail. And Skinner had o­ne of the more extreme cases in the history of Academia, and this syndrome doesn’t exempt bright people. It’s just a man with a hammer…and Skinner is an extreme example of that. And later, as I go down my list, let’s go back and try and figure out why people, like Skinner, get man-with-a-hammer syndrome.

Incidentally, when I was at the Harvard Law School there was a professor, naturally at Yale, who was derisively discussed at Harvard, and they used to say, “Poor old Blanchard. He thinks declaratory judgments will cure cancer.” And that’s the way Skinner got. And not only that, he was literary, and he scorned opponents who had any different way of thinking or thought anything else was important. This is not a way to make a lasting reputation if the other people turn out to also be doing something important.

2. My second factor is simple psychological denial.

This first really hit me between the eyes when a friend of our family had a super-athlete, super-student son who flew off a carrier in the north Atlantic and never came back, and his mother, who was a very sane woman, just never believed that he was dead. And, of course, if you turn on the television, you’ll find the mothers of the most obvious criminals that man could ever diagnose, and they all think their sons are innocent. That’s simple psychological denial. The reality is too painful to bear, so you just distort it until it’s bearable. We all do that to some extent, and it’s a common psychological misjudgment that causes terrible problems.

3. Incentive-cause bias, both in o­ne’s own mind and that of o­nes trusted advisor, where it creates what economists call ‘agency costs.’

Here, my early experience was a doctor who sent bushel baskets full of normal gall bladders down to the pathology lab in the leading hospital in Lincoln, Nebraska. And with that quality control for which community hospitals are famous, about five years after he should’ve been removed from the staff, he was. And o­ne of the old doctors who participated in the removal was also a family friend, and I asked him: I said, “Tell me, did he think, ‘Here’s a way for me to exercise my talents’” — this guy was very skilled technically– “‘and make a high living by doing a few maimings and murders every year, along with some frauds?’” And he said, “Hell no, Charlie. He thought that the gall bladder was the source of all medical evil, and if you really love your patients, you couldn’t get that organ out rapidly enough.”

Now that’s an extreme case, but in lesser strength, it’s present in every profession and in every human being. And it causes perfectly terrible behavior. If you take sales presentations and brokers of commercial real estate and businesses… I’m 70 years old, I’ve never seen o­ne I thought was even within hailing distance of objective truth. If you want to talk about the power of incentives and the power of rationalized, terrible behavior: after the Defense Department had had enough experience with cost-plus percentage of cost contracts, the reaction of our republic was to make it a crime for the federal
government to write o­ne, and not o­nly a crime, but a felony.

And by the way, the government’s right, but a lot of the way the world is run, including most law firms and a lot of other places, they’ve still got a cost-plus percentage of cost system. And human nature, with its version of what I call ‘incentive-caused bias,’ causes this terrible abuse. And many of the people who are doing it you would be glad to have married into your family compared to what you’re otherwise going to get. [Laughter]

Now there are huge implications from the fact that the human mind is put together this way, and that is that people who create things like cash registers, which make most [dishonest] behavior hard, are some of the effective saints of our civilization. And the cash register was a great moral instrument when it was created. And Patterson knew that, by the way. He had a little store, and the people were stealing him blind and never made any money, and people sold him a couple of cash registers and it went to profit immediately. And, of course, he closed the store and went into the cash register business…

And so this is a huge, important thing. If you read the psychology texts, you will find that if they’re 1,000 pages long, there’s o­ne sentence. Somehow incentive-caused bias has escaped the standard survey course in psychology.

4. Fourth, and this is a superpower in error-causing psychological tendency: bias from consistency and commitment tendency, including the tendency to avoid or promptly resolve cognitive dissonance. Includes the self-confirmation tendency of all conclusions, particularly expressed conclusions, and with a special persistence for conclusions that are hard-won.

Well what I’m saying here is that the human mind is a lot like the human egg, and the human egg has a shut-off device. When o­ne sperm gets in, it shuts down so the next o­ne can’t get in. The human mind has a big tendency of the same sort. And here again, it doesn’t just catch ordinary mortals; it catches the deans of physics. According to Max Planck, the really innovative, important new physics was never really accepted by the old guard. Instead a new guard came along that was less brain-blocked by its previous conclusions. And if Max Planck’s crowd had this consistency and commitment tendency that kept their old inclusions intact in spite of disconfirming evidence, you can imagine what the crowd that you and I are part of behaves like.

And of course, if you make a public disclosure of your conclusion, you’re pounding it into your own head. Many of these students that are screaming at us, you know, they aren’t convincing us, but they’re forming mental change for themselves, because what they’re shouting out [is] what they’re pounding in. And I think educational institutions that create a climate where too much of that goes o­n are…in a fundamental sense, they’re irresponsible institutions. It’s very important to not put your brain in chains too young by what you shout out.

And all these things like painful qualifying and initiation rituals pound in your commitments and your ideas. The Chinese brainwashing system, which was for war prisoners, was way better than anybody else’s. They maneuvered people into making tiny little commitments and declarations, and then they’d slowly build. That worked way better than torture.

5. Fifth: bias from Pavlovian association, misconstruing past correlation as a reliable basis for decision-making.

I never took a course in psychology, or economics either for that matter, but I did learn about Pavlov in high school biology. And the way they taught it, you know, so the dog salivated when the bell rang. So what? Nobody made the least effort to tie that to the wide world. Well the truth of the matter is that Pavlovian association is an enormously powerful psychological force in the daily life of all of us. And, indeed, in economics we wouldn’t have money without the role of so-called secondary reinforcement, which is a pure psychological phenomenon demonstrated in the laboratory.

Practically…I’d say 3/4 of advertising works o­n pure Pavlov. Think how association, pure association, works. Take Coca-Cola company (we’re the biggest share-holder). They want to be associated with every wonderful image: heroics in the Olympics, wonderful music, you name it. They don’t want to be associated with presidents’ funerals and so-forth. When have you seen a Coca-Cola ad…and the association really works.

And all these psychological tendencies work largely or entirely o­n a subconscious level, which makes them very insidious. Now you’ve got Persian messenger syndrome. The Persians really did kill the messenger who brought the bad news. You think that is dead? I mean you should’ve seen Bill Paley in his last 20 years. [Paley was the former owner, chairman and CEO of CBS; seehttp://www.kcmetro.cc.mo.us/pennvalley/biology/lewis/crosby/paley.htm for his bio.] He didn’t hear o­ne damn thing he didn’t want to hear. People knew that it was bad for the messenger to bring Bill Paley things he didn’t want to hear. Well that means that the leader gets in a cocoon of unreality, and this is a great big enterprise, and boy, did he make some dumb decisions in the last 20 years.

And now the Persian messenger syndrome is alive and well. I saw, some years ago, Arco and Exxon arguing over a few hundred millions of ambiguity in their North Slope treaties before a superior court judge in Texas, with armies of lawyers and experts o­n each side. Now this is a Mad Hatter’s tea party: two engineering-style companies can’t resolve some ambiguity without spending tens of millions of dollars in some Texas superior court? In my opinion what happens is that nobody wants to bring the bad news to the executives up the line. But here’s a few hundred million dollars you thought you had that you don’t. And it’s much safer to act like the Persian messenger who goes away to hide rather than bring home the news of the battle lost.

Talking about economics, you get a very interesting phenomenon that I’ve seen over and over again in a long life. You’ve got two products; suppose they’re complex, technical products. Now you’d think, under the laws of economics, that if product A costs X, if product Y costs X minus something, it will sell better than if it sells at X plus something, but that’s not so. In many cases when you raise the price of the alternative products, it’ll get a larger market share than it would when you make it lower than your competitor’s product. That’s because the bell, a Pavlovian bell — I mean ordinarily there’s a correlation between price and value — then you have an information inefficiency. And so when you raise the price, the sales go up relative to your competitor. That happens again and again and again. It’s a pure Pavlovian phenomenon. You can say, “Well, the economists have figured this sort of thing out when they started talking about information inefficiencies,” but that was fairly late in economics that they found such an obvious thing. And, of course, most of them don’t ask what causes the information inefficiencies.

Well o­ne of the things that causes it is pure old Pavlov and his dog. Now you’ve got bios from Skinnerian association: operant conditioning, you know, where you give the dog a reward and pound in the behavior that preceded the dog’s getting the award. And, of course, Skinner was able to create superstitious pigeons by having the rewards come by accident with certain occurrences, and, of course, we all know people who are the human equivalents of superstitious pigeons. That’s a very powerful phenomenon. And, of course, operant conditioning really works. I mean the people in the center who think that operant conditioning is important are very much right, it’s just that Skinner overdid it a little.

Where you see in business just perfectly horrible results from psychologically-rooted tendencies is in accounting. If you take Westinghouse, which blew, what, two or three billion dollars pre-tax at least loaning developers to build hotels, and virtually 100% loans? Now you say any idiot knows that if there’s o­ne thing you don’t like it’s a developer, and another you don’t like it’s a hotel. And to make a 100% loan to a developer who’s going to build a hotel… [Laughter] But this guy, he probably was an engineer or something, and he didn’t take psychology any more than I did, and he got out there in the hands of these salesmen operating under their version of incentive-caused bias, where any damned way of getting Westinghouse to do it was considered normal business, and they just blew it.

That would never have been possible if the accounting system hadn’t been such but for the initial phase of every transaction it showed wonderful financial results. So people who have loose accounting standards are just inviting perfectly horrible behavior in other people. And it’s a sin, it’s an absolute sin. If you carry bushel baskets full of money through the ghetto, and made it easy to steal, that would be a considerable human sin, because you’d be causing a lot of bad behavior, and the bad behavior would spread. Similarly an institution that gets sloppy accounting commits a real human sin, and it’s also a dumb way to do business, as Westinghouse has so wonderfully proved.

Oddly enough nobody mentions, at least nobody I’ve seen, what happened with Joe Jett and Kidder Peabody. The truth of the matter is the accounting system was such that by punching a few buttons, the Joe Jetts of the world could show profits, and profits that showed up in things that resulted in rewards and esteem and every other thing… Well the Joe Jetts are always with us, and they’re not really to blame, in my judgment at least. But that bastard who created that foolish accounting system who, so far as I know, has not been flayed alive, ought to be.

6. Sixth: bias from reciprocation tendency, including the tendency of one o­n a roll to act as other persons expect.

Well here, again, Cialdini does a magnificent job at this, and you’re all going to be given a copy of Cialdini’s book. And if you have half as much sense as I think you do, you will immediately order copies for all of your children and several of your friends. You will never make a better investment.

It is so easy to be a patsy for what he calls the compliance practitioners of this life. At any rate, reciprocation tendency is a very, very powerful phenomenon, and Cialdini demonstrated this by running around a campus, and he asked people to take juvenile delinquents to the zoo. And it was a campus, and so o­ne in six actually agreed to do it. And after he’d accumulated a statistical output he went around o­n the same campus and he asked other people, he said, “Gee, would you devote two afternoons a week to taking juvenile delinquents somewhere and suffering greatly yourself to help them,” and there he got 100% of the people to say no. But after he’d made the first request, he backed up a little, and he said, “Would you at least take them to the zoo o­ne afternoon?” He raised the compliance rate from a third to a half. He got three times the success by just going through the little ask-for-a-lot-and-back-off.

Now if the human mind, o­n a subconscious level, can be manipulated that way and you don’t know it, I always use the phrase, “You’re like a one-legged man in an ass-kicking contest.” I mean you are really giving a lot of quarter to the external world that you can’t afford to give. And o­n this so-called role theory, where you tend to act in the way that other people expect, and that’s reciprocation if you think about the way society is organized.

A guy named Zimbardo had people at Stanford divide into two pieces: o­ne were the guards and the other were the prisoners, and they started acting out roles as people expected. He had to stop the experiment after about five days. He was getting into human misery and breakdown and pathological behavior. I mean it was…it was awesome. However, Zimbardo is greatly misinterpreted. It’s not just reciprocation tendency and role theory that caused that, it’s consistency and commitment tendency. Each person, as he acted as a guard or a prisoner, the action itself was pounding in the idea. [For more o­n this famous experiment:
http://www.prisonexp.org/]

Wherever you turn, this consistency and commitment tendency is affecting you. In other words, what you think may change what you do, but perhaps even more important, what you do will change what you think. And you can say, “Everybody knows that.” I want to tell you I didn’t know it well enough early enough.

7. Seventh, now this is a lollapalooza, and Henry Kaufman wisely talked about this: bias from over-influence by social proof — that is, the conclusions of others, particularly under conditions of natural uncertainty and stress.

And here, o­ne of the cases the psychologists use is Kitty Genovese, where all these people — I don’t know, 50, 60, 70 of them — just sort of sat and did nothing while she was slowly murdered. Now o­ne of the explanations is that everybody looked at everybody else and nobody else was doing anything, and so there’s automatic social proof that the right thing to do is nothing. That’s not a good enough explanation for Kitty Genovese, in my judgment. That’s o­nly part of it. There are microeconomic ideas and gain/loss ratios and so forth that also come into play. I think time and time again, in reality, psychological notions and economic notions interplay, and the man who doesn’t understand both is a damned fool.

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

Now let’s talk about efficient market theory, a wonderful economic doctrine that had a long vogue in spite of the experience of Berkshire Hathaway. In fact o­ne of the economists who won — he shared a Nobel Prize — and as he looked at Berkshire Hathaway year after year, which people would throw in his face as saying maybe the market isn’t quite as efficient as you think, he said, “Well, it’s a two-sigma event.” And then he said we were a three-sigma event. And then he said we were a four-sigma event. And he finally got up to six sigmas — better to add a sigma than change a theory, just because the evidence comes in differently. [Laughter] And, of course, when this share of a Nobel Prize went into money management himself, he sank like a stone.

If you think about the doctrines I’ve talked about, namely, o­ne, the power of reinforcement — after all you do something and the market goes up and you get paid and rewarded and applauded and what have you, meaning a lot of reinforcement, if you make a bet o­n a market and the market goes with you. Also, there’s social proof. I mean the prices o­n the market are the ultimate form of social proof, reflecting what other people think, and so the combination is very powerful. Why would you expect general market levels to always be totally efficient, say even in 1973-74 at the pit, or in 1972 or whatever it was when the Nifty 50 were in their heyday? If these psychological notions are correct, you would expect some waves of irrationality, which carry general levels, so they’re inconsistent with reason.

8. Nine [he means eight]: what made these economists love the efficient market theory is the math was so elegant.

And after all, math was what they’d learned to do. To the man with a hammer, every problem tends to look pretty much like a nail. The alternative truth was a little messy, and they’d forgotten the great economists Keynes, whom I think said, “Better to be roughly right than precisely wrong.”

9. Bias from contrast-caused distortions of sensation, perception and cognition.

Here, the great experiment that Cialdini does in his class is he takes three buckets of water: o­ne’s hot, o­ne’s cold and o­ne’s room temperature, and he has the student stick his left hand in the hot water and his right hand in the cold water. Then he has them remove the hands and put them both in the room temperature bucket, and of course with both hands in the same bucket of water, o­ne seems hot, the other seems cold because the sensation apparatus of man is over-influenced by contrast. It has no absolute scale; it’s got a contrast scale in it. And it’s a scale with quantum effects in it too. It takes a certain percentage change before it’s noticed.

Maybe you’ve had a magician remove your watch — I certainly have — without your noticing it. It’s the same thing. He’s taking advantage of contrast-type troubles in your sensory apparatus. But here the great truth is that cognition mimics sensation, and the cognition manipulators mimic the watch-removing magician. In other words, people are manipulating you all day long o­n this contrast phenomenon.

Cialdini cites the case of the real estate broker. And you’ve got the rube that’s been transferred into your town, and the first thing you do is you take the rube out to two of the most awful, overpriced houses you’ve ever seen, and then you take the rube to some moderately overpriced house, and then you stick him. And it works pretty well, which is why the real estate salesmen do it. And it’s always going to work.

And the accidents of life can do this to you, and it can ruin your life. In my generation, when women lived at home until they got married, I saw some perfectly terrible marriages made by highly desirable women because they lived in terrible homes. And I’ve seen some terrible second marriages which were made because they were slight improvements over an even worse first marriage. You think you’re immune from these things, and you laugh, and I want to tell you, you aren’t.

My favorite analogy I can’t vouch for the accuracy of. I have this worthless friend I like to play bridge with, and he’s a total intellectual amateur that lives o­n inherited money, but he told me o­nce something I really enjoyed hearing. He said, “Charlie,” he say, “If you throw a frog into very hot water, the frog will jump out, but if you put the frog in room temperature water and just slowly heat the water up, the frog will die there.” Now I don’t know whether that’s true about a frog, but it’s sure as hell true about many of the businessmen I know [laughter], and there, again, it is the contrast phenomenon. But these are hot-shot, high-powered people. I mean these are not fools. If it comes to you in small pieces, you’re likely to miss, so if you’re going to be a person of good judgment, you have to do something about this warp in your head where it’s so misled by mere contrast.

10. Bias from over-influence by authority.

Well here, the Milgrim experiment, as it’s called — I think there have been 1,600 psychological papers written about Milgrim. And he had a person posing as an authority figure trick ordinary people into giving what they had every reason to expect was heavy torture by electric shock to perfectly innocent fellow citizens. And he was trying to show why Hitler succeeded and a few other things, and so this really caught the fancy of the world. Partly it’s so politically correct, and over-influence by authority…

You’ll like this o­ne: You get a pilot and a co-pilot. The pilot is the authority figure. They don’t do this in airplanes, but they’ve done it in simulators. They have the pilot do something where the co-pilot, who’s been trained in simulators a long time — he knows he’s not to allow the plane to crash — they have the pilot to do something where an idiot co-pilot would know the plane was going to crash, but the pilot’s doing it, and the co-pilot is sitting there, and the pilot is the authority figure. 25% of the time the plane crashes. I mean this is a very powerful psychological tendency. It’s not quite as powerful as some people think, and I’ll get to that later.

11. Bias from deprival super-reaction syndrome, including bias caused by present or threatened scarcity, including threatened removal of something almost possessed, but never possessed.

Here I took the Munger dog, a lovely, harmless dog. The o­nly way to get that dog to bite you is to try and take something out of its mouth after it was already there. And you know, if you’ve tried to do takeaways in labor negotiations, you’ll know that the human version of that dog is there in all of us. And I have a neighbor, a predecessor who had a little island around the house, and his next door neighbor put a little pine tree o­n it that was about three feet high, and it turned his 180 degree view of the harbor into 179 3/4. Well they had a blood feud like the Hatfields and McCoys, and it went o­n and o­n and o­n…

I mean people are really crazy about minor decrements down. And then, if you act o­n them, then you get into reciprocation tendency, because you don’t just reciprocate affection, you reciprocate animosity, and the whole thing can escalate. And so huge insanities can come from just subconsciously over-weighing the importance of what you’re losing or almost getting and not getting.

And the extreme business case here was New Coke. Coca-Cola has the most valuable trademark in the world. We’re the major shareholder — I think we understand that trademark. Coke has armies of brilliant engineers, lawyers, psychologists, advertising executives and so forth, and they had a trademark o­n a flavor, and they’d spent the better part of 100 years getting people to believe that trademark had all these intangible values too. And people associate it with a flavor. And so they were going to tell people not that it was improved, because you can’t improve a flavor. A flavor is a matter of taste. I mean you may improve a detergent or something, but don’t think you’re going to make a major change in a flavor. So they got this huge deprival super-reaction syndrome.

Pepsi was within weeks of coming out with old Coke in a Pepsi bottle, which would’ve been the biggest fiasco in modern times. Perfect insanity. And by the way, both Goizuetta [Coke’s CEO at the time] and Keough [an influential former president and director of the company] are just wonderful about it. I mean they just joke. Keough always says, “I must’ve been away o­n vacation.” He participated in every single decision — he’s a wonderful guy. And by the way, Goizuetta is a wonderful, smart guy — an engineer. Smart people make these terrible boners. How can you not understand deprival super-reaction syndrome? But people do not react symmetrically to loss and gain. Well maybe a great bridge player like Zeckhauser does, but that’s a trained response. Ordinary people, subconsciously affected by their inborn tendencies…

12. Bias from envy/jealousy.

Well envy/jealousy made, what, two out of the ten commandments? Those of you who have raised siblings you know about envy, or tried to run a law firm or investment bank or even a faculty? I’ve heard Warren say a half a dozen times, “It’s not greed that drives the world, but envy.”

Here again, you go through the psychology survey courses, and you go to the index: envy/jealousy, 1,000-page book, it’s blank. There’s some blind spots in academia, but it’s an enormously powerful thing, and it operates, to a considerable extent, o­n the subconscious level. Anybody who doesn’t understand it is taking o­n defects he shouldn’t have.

13. Bias from chemical dependency.

Well, we don’t have to talk about that. We’ve all seen so much of it, but it’s interesting how it’ll always cause this moral breakdown if there’s any need, and it always involves massive denial. See it just aggravates what we talked about earlier in the aviator case, the tendency to distort reality so that it’s endurable.

14. Bias from mis-gambling compulsion.

Well here, Skinner made the o­nly explanation you’ll find in the standard psychology survey course. He, of course, created a variable reinforcement rate for his pigeons and his mice, and he found that that would pound in the behavior better than any other enforcement pattern. And he says, “Ah ha! I’ve explained why gambling is such a powerful, addictive force in this civilization.” I think that is, to a very considerable extent, true, but being Skinner, he seemed to think that was the o­nly explanation, but the truth of the matter is that the devisors of these modern machines and techniques know a lot of things that Skinner didn’t know.

For instance, a lottery. You have a lottery where you get your number by lot, and then somebody draws a number by lot, it gets lousy play. You have a lottery where people get to pick their number, you get big play. Again, it’s this consistency and commitment thing. People think if they have committed to it, it has to be good. The minute they’ve picked it themselves it gets an extra validity. After all, they thought it and they acted o­n it.

Then if you take the slot machines, you get bar, bar, walnut. And it happens again and again and again. You get all these near misses. Well that’s deprival super-reaction syndrome, and boy do the people who create the machines understand human psychology. And for the high-IQ crowd they’ve got poker machines where you make choices. So you can play blackjack, so to speak, with the machine. It’s wonderful what we’ve done
with our computers to ruin the civilization.

But at any rate, mis-gambling compulsion is a very, very powerful and important thing. Look at what’s happening to our country: every Indian has a reservation, every river town, and look at the people who are ruined by it with the aid of their stock brokers and others. And again, if you look in the standard textbook of psychology you’ll find practically nothing o­n it except maybe o­ne sentence talking about Skinner’s rats. That is not an adequate coverage of the subject.

15. Bias from liking distortion, including the tendency to especially like o­neself, o­ne’s own kind and o­ne’s own idea structures, and the tendency to be especially susceptible to being misled by someone liked. Disliking distortion, bias from that, the reciprocal of liking distortion and the tendency not to learn appropriately from someone disliked.

Well here, again, we’ve got hugely powerful tendencies, and if you look at the wars in part of the Harvard Law School, as we sit here, you can see that very brilliant people get into this almost pathological behavior. And these are very, very powerful, basic, subconscious psychological tendencies, or at least party subconscious.

Now let’s get back to B.F. Skinner, man-with-a-hammer syndrome revisited. Why is man-with-a-hammer syndrome always present? Well if you stop to think about it, it’s incentive-caused bias. His professional reputation is all tied up with what he knows. He likes himself and he likes his own ideas, and he’s expressed them to other people — consistency and commitment tendency. I mean you’ve got four or five of these elementary psychological tendencies combining to create this man-with-a-hammer syndrome.

Once you realize that you can’t really buy your thinking — partly you can, but largely you can’t in this world — you have learned a lesson that’s very useful in life. George Bernard Shaw had a character say in The Doctor’s Dilemma, “In the last analysis, every profession is a conspiracy against the laity.” But he didn’t have it quite right, because it isn’t so much a conspiracy as it is a subconscious, psychological tendency.

The guy tells you what is good for him. He doesn’t recognize that he’s doing anything wrong any more than that doctor did when he was pulling out all those normal gall bladders. And he believes his own idea structures will cure cancer, and he believes that the demons that he’s the guardian against are the biggest demons and the most important o­nes, and in fact they may be very small demons compared to the demons that you face. So you’re getting your advice in this world from your paid advisor with this huge load of ghastly bias. And woe to you.

There are o­nly two ways to handle it: you can hire your advisor and then just apply a windage factor, like I used to do when I was a rifle shooter. I’d just adjust for so many miles an hour wind. Or you can learn the basic elements of your advisor’s trade. You don’t have to learn very much, by the way, because if you learn just a little then you can make him explain why he’s right. And those two tendencies will take part of the warp out of the thinking you’ve tried to hire done. By and large it works terribly. I have never seen a management consultant’s report in my long life that didn’t end with the following paragraph: “What this situation really needs is more management consulting.” Never once. I always turn to the last page. Of course Berkshire doesn’t hire them, so I o­nly do this o­n sort of a voyeuristic basis. Sometimes I’m at a non-profit where some idiot hires o­ne. [Laughter]

16. Seventeen [he means 16]: bias from the non-mathematical nature of the human brain in its natural state as it deal with probabilities employing crude heuristics, and is often misled by mere contrast, a tendency to overweigh conveniently available information and other psychologically misrouted thinking tendencies o­n this list.

When the brain should be using the simple probability mathematics of Fermat and Pascal applied to all reasonably obtainable and correctly weighted items of information that are of value in predicting outcomes, the right way to think is the way Zeckhauser plays bridge. It’s just that simple. And your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge. Now, you notice I put in that availability thing, and there I’m mimicking some very eminent psychologists [Daniel] Kahneman, Eikhout[?] (I hope I pronounced that right) and [Amos] Tversky, who raised the idea of availability to a whole heuristic of misjudgment. And they are very substantially right.

I mean ask the Coca-Cola Company, which has raised availability to a secular religion. If availability changes behavior, you will drink a helluva lot more Coke if it’s always available. I mean availability does change behavior and cognition. Nonetheless, even though I recognize that and applaud Tversky and Kahneman, I don’t like it for my personal system except as part of a greater sub-system, which is you’ve got to think the way Zeckhauser plays bridge. And it isn’t just the lack of availability that distorts your judgment. All the things o­n this list distort judgment. And I want to train myself to kind of mentally run down the list instead of just jumping o­n availability. So that’s why I state it the way I do.

In a sense these psychological tendencies make things unavailable, because if you quickly jump to o­ne thing, and then because you jumped to it the consistency and commitment tendency makes you lock in, boom, that’s error number o­ne. Or if something is very vivid, which I’m going to come to next, that will really pound in. And the reason that the thing that really matters is now unavailable and what’s extra-vivid wins is, I mean, the extra-vividness creates the unavailability. So I think it’s much better to have a whole list of things that would cause you to be less like Zeckhauser than it is just to jump o­n o­ne factor.

Here I think we should discuss John Gutfreund. This is a very interesting human example, which will be taught in every decent professional school for at least a full generation. Gutfreund has a trusted employee and it comes to light not through confession but by accident that the trusted employee has lied like hell to the government and manipulated the accounting system, and it was really equivalent to forgery. And the man immediately says, “I’ve never done it before, I’ll never do it again. It was an isolated example.” And of course it was obvious that he was trying to help the government as well as himself, because he thought the government had been dumb enough to pass a rule that he’d spoken against, and after all if the government’s not going to pay attention to a bond trader at Salomon, what kind of a government can
it be?

At any rate, this guy has been part of a little clique that has made, well, way over a billion dollars for Salomon in the very recent past, and it’s a little handful of people. And so there are a lot of psychological forces at work, and then you know the guy’s wife, and he’s right in front of you, and there’s human sympathy, and he’s sort of asking for your help, which encourages reciprocation, and there’s all these psychological tendencies are working, plus the fact he’s part of a group that had made a lot of money for you. At any rate, Gutfreund does not cashier the man, and of course he had done it before and he did do it again. Well now you look as though you almost wanted him to do it again. Or God knows what you look like, but it isn’t good. And that simple decision destroyed Jim Gutfreund, and it’s so easy to do.

Now let’s think it through like the bridge player, like Zeckhauser. You find an isolated example of a little old lady in the See’s Candy Company, o­ne of our subsidiaries, getting into the till. And what does she say? “I never did it before, I’ll never do it again. This is going to ruin my life. Please help me.” And you know her children and her friends, and she’d been around 30 years and standing behind the candy counter with swollen ankles. When you’re an old lady it isn’t that glorious a life. And you’re rich and powerful and there she is: “I never did it before, I’ll never do it again.” Well how likely is it that she never did it before? If you’re going to catch 10 embezzlements a year, what are the chances that any o­ne of them — applying what Tversky and Kahneman called baseline information — will be somebody who o­nly did it this o­nce? And the people who have done it before and are going to do it again, what are they all going to say? Well in the history of the See’s Candy Company they always say, “I never did it before, and I’m never going to do it again.” And we cashier them. It would be evil not to, because terrible behavior spreads.

Remember…what was it? Serpico? I mean you let that stuff…you’ve got social proof, you’ve got incentive-caused bias, you’ve got a whole lot of psychological factors that will cause the evil behavior to spread, and pretty soon the whole damn…your place is rotten, the civilization is rotten. It’s not the right way to behave. And I will admit that I have…when I knew the wife and children, I have paid severance pay when I fire somebody for taking a mistress o­n an extended foreign trip. It’s not the adultery I mind, it’s the embezzlement. But there, I wouldn’t do it like Gutfreund did it, where they’d been cheating somebody else o­n my behalf. There I think you have to cashier. But if they’re just stealing from you and you get rid of them, I don’t think you need the last ounce of vengeance. In fact I don’t think you need any vengeance. I don’t think vengeance is much good.

17. Now we come to bias from over-influence by extra-vivid evidence.

Here’s o­ne that…I’m at least $30 million poorer as I sit here giving this little talk because I o­nce bought 300 shares of a stock and the guy called me back and said, “I’ve got 1,500 more,” and I said, “Will you hold it for 15 minutes while I think about it?” And the CEO of this company — I have seen a lot of vivid peculiarities in a long life, but this guy set a world record; I’m talking about the CEO — and I just mis-weighed it. The truth of the matter was the situation was foolproof. He was soon going to be dead, and I turned down the extra 1,500 shares, and it’s now cost me $30 million. And that’s life in the big city. And it wasn’t something where stock was generally available. So it’s very easy to mis-weigh the vivid evidence, and Gutfreund did that when he looked into the man’s eyes and forgave a colleague.

18. Twenty-two [he means 18]: Mental confusion caused by information not arrayed in the mind and theory structures, creating sound generalizations developed in response to the question “Why?” Also, mis-influence from information that apparently but not really answers the question “Why?” Also, failure to obtain deserved influence caused by not properly explaining why.

Well we all know people who’ve flunked, and they try and memorize and they try and spout back and they just…it doesn’t work. The brain doesn’t work that way. You’ve got to array facts o­n the theory structures answering the question “Why?” If you don’t do that, you just cannot handle the world.

And now we get to Feuerstein, who was the general counsel with Salomon when Gutfreund made his big error, and Feuerstein knew better. He told Gutfreund, “You have to report this as a matter of morality and prudent business judgment.” He said, “It’s probably not illegal, there’s probably no legal duty to do it, but you have to do it as a matter of prudent conduct and proper dealing with your main customer.” He said that to Gutfreund o­n at least two or three occasions. And he stopped. And, of course, the persuasion failed, and when Gutfreund went down, Feuerstein went with him. It ruined a considerable part of Feuerstein’s life.

Well Feuerstein, [who] was a member of the Harvard Law Review, made an elementary psychological mistake. You want to persuade somebody, you really tell them why. And what did we learn in lesson o­ne? Incentives really matter? Vivid evidence really works? He should’ve told Gutfreund, “You’re likely to ruin your life and disgrace your family and lose your money.” And is Mozer worth this? I know both men. That would’ve worked. So Feuerstein flunked elementary psychology, this very sophisticated, brilliant lawyer. But don’t you do that. It’s not very hard to do, you know, just to remember that “Why?” is very important.

19. Other normal limitations of sensation, memory, cognition and knowledge.

Well, I don’t have time for that.

20. Stress-induced mental changes, small and large, temporary and permanent.

Here, my favorite example is the great Pavlov. He had all these dogs in cages, which had all been conditioned into changed behaviors, and the great Leningrad flood came and it just went right up and the dog’s in a cage. And the dog had as much stress as you can imagine a dog ever having. And the water receded in time to save some of the dogs, and Pavlov noted that they’d had a total reversal of their conditioned personality. And being the great scientist he was, he spent the rest of his life giving nervous breakdowns to dogs, and he learned a helluva lot that I regard as very interesting.

I have never known any Freudian analyst who knew anything about the last work of Pavlov, and I’ve never met a lawyer who understood that what Pavlov found out with those dogs had anything to do with programming and de-programming and cults and so forth. I mean the amount of elementary psychological ignorance that is out there in high levels is very significant[?].

21. Then we’ve got other common mental illnesses and declines, temporary and permanent, including the tendency to lose ability through disuse.

22. And then I’ve got development and organizational confusion from say-something syndrome.

And here my favorite thing is the bee, a honeybee. And a honeybee goes out and finds the nectar and he comes back, he does a dance that communicates to the other bees where the nectar is, and they go out and get it. Well some scientist who is clever, like B.F. Skinner, decided to do an experiment. He put the nectar straight up. Way up. Well, in a natural setting, there is no nectar where they’re all straight up, and the poor honeybee doesn’t have a genetic program that is adequate to handle what he now has to communicate. And you’d think the honeybee would come back to the hive and slink into a corner, but he doesn’t. He comes into the hive and does this incoherent dance, and all my life I’ve been dealing with the human equivalent of that honeybee. [Laughter] And it’s a very important part of human organization so the noise and the reciprocation and so forth of all these people who have what I call say-something syndrome don’t really affect the decisions.

Shipping slowdown hints at a recession around the corner

( Source : http://www.newstatesman.com/politics/economy/2016/02/global-shipping-slowdown-hints-recession-around-corner )

The global shipping slowdown hints at a recession around the corner

Instability in China and tumbling commodity prices have devastated the world’s freight providers – a strong indicator of trouble to come.

This is beginning to have the feel of 2008 all over again. Policy makers around the world are in denial once again as global stock markets dive. In 2008, the slowing of the world’s biggest economy – the US – sent the global economy into a tailspin. The concern now is that the slowing of the second-largest economy, China, may well have similar global effects. Chinese growth, which averaged 10 per cent for three decades through to 2010, has decelerated for five straight years and in 2015 slowed to 6.9 per cent, its lowest rate in a quarter of a century. The IMF is forecasting that Chinese growth will slow further to 6.3 per cent in 2016 and 6 per cent in 2017, which may well be overly optimistic. There is already speculation that China’s banking system may see losses even larger than those suffered by US banks during the last crisis.

The bad news from China appears to have already spread to the US, which has seen GDP growth slowing sharply in the last quarter of 2015. US industrial production and core retail sales are both falling, and there have been marked contractions in core capital goods shipments and private non-residential construction. Business fixed investment declined nearly 2 per cent last quarter. Despite the bad news, last week Federal Reserve chair Janet Yellen astonishingly claimed that “the US economy is in many ways close to normal”. By contrast, Ruslan Bikbov from Bank of America Merrill Lynch calculates that there is a 64 per cent probability the US is already in recession. My expectation is the next move by the Fed will be to cut rates.

Company profits are tumbling as commodity and oil prices decline. BP reported a $3.3bn fourth-quarter loss last year while Exxon Mobil reported a 58 per cent fall in its quarterly profit. It isn’t just oil companies. Last week, Rio Tinto – the world’s second biggest mining company – reported profits down 51 per cent after commodity prices collapsed amid slowing growth from China. Company profits are also suffering due to a big decline in the amount of freight being moved, especially to and from China. Moeller-Maersk, the Danish conglomerate and the world’s biggest container-ship operator by capacity, last week reported a fourth-quarter net loss of $2.51bn.

DP World, one of the world’s biggest port operators, also says that global volume has slowed sharply. It reported that volumes at its ports rose by 2.4 per cent last year, compared with 8 per cent growth in 2014. Data provider Container Trades Statistics said this week that Asia-to-Europe trade fell nearly 4 per cent last year. Freight rates in 2015 averaged $620 per container on the Asia-to-Europe trade route. Typically, ship operators need more than $1,000 to break even. In February, the cost of moving a container from Shanghai to Rotterdam fell to $431, barely covering fuel costs. Figures released by the Shanghai Shipping Exchange show that the country’s 20 largest container ports grew by 3.7 per cent over 2014, compared to 5.5 per cent the previous year. The Hong Kong Port Development Council reported that throughput at the port of Hong Kong fell by 9.5 per cent in 2015.

The Baltic Dry Index (BDIY) – an index of the price for shipping dry goods such as iron ore and coal (oil is wet) as shown in the chart below – is at a record low of 290. It is down 75 per cent since its recent peak in 2015 and down 98 per cent from its peak of 11,793 points in May 2008. The collapse to 772 by 5 September 2008 (a week before Lehman Brothers failed) presaged the global recession and it is falling again. Capesize vessels, which are too big to get through the Suez or Panama canals, had an average daily hire last week of $1,484, compared with a peak of $233,988 in June 2008. Even though there is an oversupply of ships, global demand is collapsing.

The International Air Transport Association (IATA) released figures for global air freight, showing cargo volumes expanded 2.2 per cent in 2015 compared to 2014. This was a slower pace of growth than the 5 per cent recorded in 2014. This weakness apparently reflects sluggish trade growth in Europe and Asia-Pacific. “2015 was another very difficult year for air cargo,” said Tony Tyler, IATA’s Director General and CEO. “Growth has slowed and revenue is falling. In 2011 air cargo revenue peaked at $67bn. In 2016 we are not expecting revenue to exceed $51bn.”

The current contraction in rail freight is apparently reminiscent of the drop that started at the end of 2008 and carried on into 2009. China’s rail freight volumes fell by a significant amount last year. According to the National Development and Reform Commission (NDRC), volumes fell by 11.9 per cent, a further increase on the 2014 slowdown, when traffic declined by 3.9 per cent.

In the western US farm belt, grain trains are so abundant you can’t give one away. Since the middle of last March, carloads of agricultural products, chemicals, coal, metals, autos and other goods have declined every week. Shipments of US coal, the biggest commodity moved by rail, declined 12 per cent in 2015, according to the Association of American Railroads. The cost of carrying spring wheat from North Dakota to the Pacific coast has dropped by a third in the past two years. In early 2014, grain companies with a train to spare could command $6,000 per car above the official railway tariff, traders say. Today, to avoid hefty contract cancellation fees, they are paying others to use their unwanted trains.

Manufacturing output in the UK fell for each of the last three months and is down 1.7 per cent over the year. The overly optimistic Monetary Policy Committee is forecasting GDP growth of 2.2 per cent (2.4 per cent) in 2016; 2.4 per cent (2.5 per cent) in 2017 and 2.5 per cent (2.4 per cent) in 2018 (the latest, broadly similar, OBR forecasts in parentheses).

So all is well then? Probably not. Mark Carney has run out of ammunition with the Bank Rate at 0.5 per cent, compared with 5.5 per cent in 2008, and has little room to manoeuvre. Negative rates and more quantitative easing, here we come. George Osborne has never explained what he would have done differently in 2008 – his plans for a budget surplus are already in disarray as the economy slows. I am not saying a recession is going to happen any time soon, but it well might.

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The optimal portfolio of risky assets is exactly the same for everyone

The optimal portfolio of risky assets is exactly the same for everyone :

1. Investors should control the risk of their portfolio not by reallocating among risky assets, but through the split between risky and risk-free assets.

2. The portfolio of risky assets should contain a large number of assets – it should be a well diversified portfolio.

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10%= correction, 20%= bear market.

( Source : https://theirrelevantinvestor.wordpress.com/2016/01/12/probably-everything-you-need-to-know-about-bear-markets/ )

stock-market-correction

10%= correction, 20%= bear market.

I know these arbitrary numbers sometimes seem silly, but when looking at the data, you have to draw the line somewhere. Get over it, let’s move on.

The S&P 500 has been in a drawdown for the last eight months. Stocks are currently 9.2% below the highs made in May 2015, just a hair away from official correction territory. Everyone knows this is totally normal, but you might be surprised to know that since 1928, stocks have been in a 10% drawdown 55% of the time. The problem of course is that they never feel normal because we don’t know in real time if this is just a correction or the start of a bear market. And the deeper stocks go, the harder it is to resist fear’s temptation.

In times like this, historical facts don’t provide much comfort and even less of a roadmap, however, hopefully they can provide a little context.

Since 1928, there have been fifteen separate drawdowns of 10%. Before I continue, you might be thinking, “only fifteen corrections, that doesn’t sound right.” Here’s how I look at drawdowns; in my mind, a drawdown is not over until new highs are made. Of these fifteen corrections, ten have turned into a bear market.

Let’s take a closer examination of these 20% declines because not all bear markets are created equal. There are secular bear markets, which by their nature can only be defined after the fact. These are long periods of time in which stocks make little progress. Then there are cyclical bears, which can come in the middle of a long secular bear or even a secular bull. The chart below shows the three secular bears over the last ninety years.

Screen Shot 2016-01-12 at 8.36.44 PM

As you can see, the defining characteristic for secular bears is that stocks make no progress for long periods of time. Even worse, they experience severe declines which can scar an entire generation of investors. The chart below shows the painful drawdowns investors witness during these secular bear markets.

Screen Shot 2016-01-12 at 8.37.59 PM

The frustrating thing about each and every bear is it’s impossible to know how long they will last. Think about the most recent secular bear, which lasted from March 2000 through March 2013 (I think it’s over, though reasonable people can disagree on this). Stocks briefly poked their heads above their 2000 highs in October 2007 before being slammed right back into their decade long range. Investors had a similar experience in 1980; break above the long range for a minute only to be delivered one final gut punch.

Screen Shot 2016-01-12 at 8.38.28 PM

Looking at bear markets over long periods of time might not be as helpful as breaking them down further. Within the three secular bears have been distinct cyclical bears (think the tech bubble of 2000 and credit bubble of 2007). Here is how I’ve compiled the data below; any time there is a 20% rally, the bear market is over. What this does is break up 1929-1954 period into 11 separate bear markets.

The average of these 20 distinct bear markets saw a 36% peak-to-trough decline, lasting just over 52 weeks. The fifth column shows how long each bear was and the the sixth column shows how quickly stocks gained 20% from their lows, resetting the bear market. For instance, the October ’07 peak to the March ’09 lows was 74 weeks. Stocks then rallied 20% in 4 weeks, making 78 weeks the total length of that particular bear market.

Screen Shot 2016-01-12 at 8.38.13 PM

Whether the S&P 500 sees a correction, and whether or not that turns into a bear market, and how deep it might go and how long it might last is anybody’s guess. The only thing in your control is what you choose to do or not do. Making decisions in the heat of the moment is almost never a good idea, which is why having a plan in place is so important. Knowing that you have an answer, whether stocks go up, down or sideways a is really liberating feeling.

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In the stock market, short term trends are mostly random and heavily influenced by luck

(Source :  http://jimoshaughnessy.tumblr.com/post/137235375474/short-term-luck-versus-long-term-skill )

Daniel Kahneman, one of the fathers of behavior economics, said one of his favorite papers was “On the Psychology of Prediction (1973).” He claims in the paper that intuitive predictions are often unreliable because people base their predictions on how well an event fits a story. In behavioral economics, this phenomena is called a judgmental heuristic—representativeness, or how familiar you are personally with the story. This is one of the worst ways to make a forecast, because it uses a highly limited data set and allows the law of small numbers to mislead you and your forecast. For example, one study showed that when a doctor is told that a procedure works 50 percent of the time (essentially a coin toss probability or base rate) he or she could get the majority of patients to undergo the procedure if he or she simply added “The last patient who did this is doing great!” The story of success eliminates consideration of the base rate.

I recommend that to successfully make predictions about the long-term results of something such as an investment strategy or the overall direction of a market, you must consider three things:

1.      The long-term base rate of the success or failure of the strategy you are evaluating;

2.      The tendency of systems where both luck and skill are involved to revert to the mean and;

3.      What happened historically after certain extreme observations.

So, for example, when I wrote the commentary entitled “A Generational Buying Opportunity” in March of 2009, I was not relying on any particular insight that I might have had at the time, but rather on the data available to me about what happens in markets after they reach an extreme infection point.  It’s important to remember that the stock market is a complex, adaptive system with feedback loops that has elements of both luck and skill. Luck, in the stock market, essentially holds sway over the short-term and is a specific chance occurrence that affects the overall market or individual stock or portfolio can be either good or bad. Luck is a residual—it’s what is left over after you subtract skill from the outcome.

How much luck is involved determines the range of outcomes—where little luck is involved, a good process will almost always lead to a good outcome. Where a measure of luck is involved, a good process will usually have a good outcome, but only over longer periods of time. The luck/skill continuum in investing is almost entirely a function of time. Over shorter periods, your results are highly contingent on luck and chance. This is vital to understand because you might see a bad process provide excellent results due entirely to chance and a good process provide poor results for the same reason.

Consider a simple intuitive strategy of buying the 50 stocks with the best annual sales gains. But consider this not in the abstract but in the context of what had happened in the previous five years:

Year                            Annual Return            S&P 500 return

Year one                      7.90%                          16.48%

Year two                     32.20%                        12.45%

Year three                   -5.95%                         -10.06%

Year four                     107.37%                      23.98%

Year five                     20.37%                        11.06%

Five-year

Average Annual

Return                         27.34%                        10.16%

$10,000 invested in the strategy grew to $33,482 dwarfing the same investment in the S&P 500, which grew to $16,220. The three-year return (which is the metric that almost all investors look at when deciding if they want to invest or not) was even more compelling, with the strategy returning an average annual return of 32.90% compared to just 7.39% for the S&P 5000. Also consider that these returns would not appear in a vacuum—if it was a fund it would probably have a five start Morningstar rating; it would probably be featured in business news stories quite favorably and the “long-term” proof would say that this intuitive strategy made a great deal of sense and would attract a lot of investors.

Here’s the catch—the returns shown are from “What Works on Wall Street” and are for the period from 1964 through 1968, when, much like the late 1990s, speculative stocks soared. Investors without access to the very long-term results to this investment strategy would not have the perspective that the longer term brings, and without these tools, might have jumped into this strategy right before it went on to crash and burn. As the data from What Works on Wall Street makes plain, over the very long term, this is a horrible strategy that returns less then U.S. T-bills over the long-term. Had this investor had access to long-term returns, he or she would have seen that buying stocks based just on their annual growth of sales was a horrible way to invest—the strategy returned just 3.88 percent per year between 1964 and 2009! $10,000 invested in the 50 stocks from All Stocks with the best annual sales growth grew to just $57,631 at the end of 2009, whereas the same $10,000 invested in U.S. T-Bills compounded at 5.57 percent per year, turning $10,0000 into $120,778. In contrast, if the investor had simply put the money in an index like the S&P 500, the $10,000 would have earned 9.46 percent per year, with the $10,000 growing to $639,144! An investment in All Stocks would have done significantly better, earning 11.22 percent per year and turning the $10,000 into $1.33 million! What the investor would have missed during the phase of exciting performance for this strategy is that, in the end, valuation matters, a lot.

This is a good example of why Kahneman’s paper is so important—people make forecasts not on the data, but how well the prediction fits their perspective and the story behind it. Extrapolating from a small data set can be disastrous to long-term results. The “Most Dangerous Equation” was derived by Abraham de Moivre and states that the variation of the mean is inversely proportional to the size of the sample. A small sample tells you nothing about the true direction of results. Using a small sample—as we see above—can lead to costly errors over the long term.

What this tells us

 

1.      Investors are well advised to look at short-term performance as a worthless indicator for what will happen over the long-term. Indeed, short-term performance can be among the most misleading to investors and should be heavily discounted. The stock market combines both luck and skill, with luck more pronounced over short time periods, and skill more telling over long periods of time.

2.      Investors should make decisions using the long-term base rates a strategy exhibits—in other words, they should concentrate on what is probable rather than what is possible. If you organized your life around things that might possibly happen to you, you’d probably never leave your house, and when you did, it would only be to buy a lottery ticket. Consider, on a drive to the supermarket, it is highly probable that you will get there, buy your groceries and get back home to unpack them without incident. But what’s possible? Almost anything—it’s possible a plane flying overhead could lose an engine falling directly on your car and instantly killing you. It’s possible another car runs a red light and kills you on impact. It’s possible that you get carjacked and your assailant kills you in the process. You get the point—anything is possible but highly improbable. It’s only when you think in terms of probability that you will get in your car and go, yet few investors do so when making investment decisions. Our brains create cause and effect narratives after something has occurred that seem to make sense, however improbable the event. Witness anyone who invested in the stocks with the highest sales gains after a great short-term run.

3.      In the stock market, short term trends are mostly random and heavily influenced by luck. To succeed, you must ignore them and invest in strategies that have the highest probability (base rate) of succeeding in the future.

4.      You will not win the lottery. Avoid buying tickets and avoid what my son, Patrick O’Shaughnessy, calls lottery stocks.

5.      Over short periods of time, a good investment strategy can lead to poor results just as a poor investment strategy can lead to good results. Do your homework; understand how a strategy performs over long periods of time and stick with it. If you can do just this one thing, you will be ahead of the vast majority of investors over the long-term.

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No surprise, a lot of unicorns are actually donkeys.

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( Source : https://medium.com/@abhasvc/unicorns-vs-donkeys-your-handy-guide-to-distinguishing-who-s-who-f1b30942b2b6 )

I’ve been having this conversation a lot lately:

Friend: “Did you see [startup] just raised at a $1B valuation?”
Me: “Unbelievable.”
Friend: “They’re apparently killing it on [metric that is meaningless without the bigger picture].”
Me: “Yeah, but their [metric that also matters] is struggling.”

I am by no means the unicorn prophet, but here’s how I think about which companies have earned their unicorn status vs. which ones are playing a dangerous game of massive capital needs, sky high valuations, impossible expectations, and deferred judgement days. Hopefully, by the end of this post, you’ll have an intuitive feel for which startups actually have a shot at being unicorns and which ones are probably just donkeys.

The Fundamental Law of Growth

LTV = Lifetime Value of a Customer; CAC = Cost of Acquiring a Customer

Like Newton’s laws of gravity or momentum, most tech startups (see exceptions below*) who sell directly to their customers — both enterprises and consumers — must eventually obey the Fundamental Law of Growth: LTV/CAC > 3. There’s a lot of nuance as to why — a discussion that is better suited for a semester-long class than a blog post — but suffice to say that the LTV/CAC ratio speaks to a startup’s revenue trajectory, capital needs, and in turn, how much “irrational exuberance” is demanded of its investors. The lower the LTV/CAC ratio, the less efficient a company is at deploying capital and the more money it needs to fuel growth; conversely, the higher the LTV/CAC ratio, the more efficient the company is and thus the more value it creates for the same amount of capital. Though this can be derived, many before me have empirically observed that 3x is roughly the threshold needed to build big, sustainable businesses.

Assessing a company’s valuation is a discipline on its own and growth is only one factor in that calculation. However, for simplicity’s sake, one can assume that tech companies who don’t obey the Fundamental Law of Growth will eventually lose access to capital, drastically slow their growth, and watch their valuations plummet — those fabled unicorns will eventually emerge as donkeys. So with that, let’s dig into some examples…

*Companies whose value is not predicated on revenue (e.g., disruptive technologies, monopolies, social networks, intellectual property) as well as companies where revenue is achieved indirectly (e.g., ad-tech networks, certain marketplaces, certain viral growth startups) or discontinuously (e.g., government contractors) typically do not follow this rule


For each example, I’ll make assumptions about the various components of the LTV/CAC ratio (see below); some assumptions are based on publicly available data and others are just gut feels. If it’s the latter, I’ve generally erred on being generous to the startups.

ARPU = Average Revenue Per User

Case Example #1: HelloFresh, Subscriptions Meals

  • Customer Lifetime — in my household, we usually try each meal subscription company for a few weeks then switch it up, but let’s assume the average across all customers is 3 months or 0.25 years
  • ARPU — average revenue is probably 2 people, 3 meals per week, 3 weeks per month, so $60/week x 3 = $180/month or $2160/year
  • Margin % — we know from Mahesh’s excellent IPO filing teardown that their margin is 52% (sign of a strong operating team; that’s higher than I expected for this type of business!)
  • CAC — given the numerous other meal subscription companies, brick and mortar competitors, etc., it feels like the CAC is probably in the hundreds, say $400
LTV/CAC = 0.25 years x $2160/year x 52% / $400 = 0.70x

Under these assumptions, HelloFresh is an incredibly capital intensive company because of the (presumed) low customer lifetime/high churn. We know from the IPO filing that HelloFresh grew its revenue from $77M in 2014 to $290M in 2015 (276% growth), so you can understand why someone would say, “They’re killing it on revenue!”. We also know that the company didn’t report cohort retention data, but as per Mahesh, “they do mention that they achieve 2.8x LTV/CAC after two years.” Hold up, come again?Reporting LTV/CAC for only a subset of customers is disconcerting, and even then, it’s just under 3x; substituting 2 years into the LTV/CAC ratio suggests that the true CAC may be much higher ($800). Other food subscription and even some on-demand meal companies — Blue Apron, Plated, Instacart, Munchery, Sprig, etc. — may similarly have short customer lifetimes/high churn and thus low LTV/CAC ratios, thereby also violating the Fundamental Law of Growth.

Verdict: Donkey Watch

Case Example #2: Evernote, Productivity Software

  • Customer Lifetime — I use Evernote constantly, so I expect if anyone is going to have an extended lifetime, it’s them. But as a rule of thumb, lifetimes >3 years should only be considered in exceptional circumstances
  • ARPU — in most freemium products, paid customers make up only a tiny fraction (<5%). Nevertheless, let’s assume 25% are premium users at $50/year, so a blended ARPU of .25 x $50 = $12.50
  • Margin % — pure SaaS company with no customer service costs should probably achieve 70–90% margins, so let’s go with 90%
  • CAC — freemium models typically land in the $1–$100 CAC range, so let’s assume $20
LTV/CAC = 3 years x $12.50/year x 90% / $20 = 1.69x

Evernote has great customer lifetimes, margins, and low CACs; however, because their pricing is low, their overall LTV is limited and thus results in a low LTV/CAC ratio, again violating the Fundamental Law of Growth. Evernote could compensate by increasing pricing, but with other readily available substitutes (Google Docs, Microsoft OneNote), increased pricing likely increases churn too, so the pressure is on Evernote to then increase ARPU by increasing value (additional products, collaboration tools, AI insights, etc.).

Verdict: Donkey Watch

Case Example #3: Oscar, Health Insurance

  • Customer Lifetime — once you join an insurer, you typically stay with them until you switch jobs/get a job. <1.5 years is probably the average, but let’s use 2 conservatively
  • ARPU — $5000; saw this in an Oscar press release and it’s fairly typical of this market
  • Margin % — healthcare insurers have gross margins in the 5–10% range with a max of 15% as mandated by Obamacare, so let’s go with 15%
  • CAC — this is an expensive product for consumers to purchase and probably requires a light-touch inside sales team, so let’s assume CAC is $800
LTV/CAC = 2 years x $5000/year x 15% / $800 = 1.88x

Similar to HelloFresh, Oscar is posting massive revenue ($200M) and growth rates (135%), so you can again understand the hype around them; however, Oscar fails the Fundamental Law of Growth due to its low gross margins. If the Oscar team can achieve a CAC near $500 — perhaps because they’re the hip/fresh insurer on the block with best-in-class marketing — then maybe the company can still grow a horn, but that’s asking a lot given the inherent complexity and cost of the product. Recently, a number of other companies— Jet.com, Instacart, etc.— have built fast-growing businesses that operate on low margins, but they too are at risk of breaching the Fundamental Law of Growth.

Verdict: Donkey Watch

Case Example #4: ZocDoc, Online Physician Reservations

  • Customer Lifetime—I’ve heard that physicians typically churn after a year once they’ve established a sizable patient base, but let’s assume 2 years
  • ARPU — $3000 (publicly available)
  • Margin % — SaaS company with light-touch customer service should probably achieve 60–80% margins, so let’s assume 80%
  • CAC — Selling to physician practices must be challenging, so like any high-touch inside sales operation, ZocDoc’s CAC is probably in the $1–10K range; let’s assume $3K
LTV/CAC = 2 years x $3000/year x 80% / $3000 = 1.60x

ZocDoc has a good LTV overall, but their CAC is likely a show-stopper. Unfortunately, there’s no getting around that — selling to physicians is tough stuff, just ask Pfizer. Also, as competition increases, customer lifetimes and pricing erode too, further driving down the LTV/CAC ratio. I suspect this is why ZocDoc is shifting sales to hospital system customers (1000x higher LTV and only 20x higher CAC), but hard to know what fraction of their business this constitutes. Although I am not familiar enough with the unit economics of fantasy sports startups, I suspect that FanDuel and DraftKings may similarly be spending heavily on customer acquisition without the supporting customer lifetimes or ARPU needed to satisfy the Fundamental Law of Growth.

Verdict: Donkey Watch


Concluding Thoughts

I hope this framework gives you a better sense of how to evaluate today’s unicorn landscape. The companies above all have impressive, press grabbing growth metrics, but they also fail the Fundamental Law of Growth for different reasons — short customer lifetime, low pricing, low margin, and high CAC — so must be viewed with some skepticism.

The most obvious next question is: if the Fundamental Law of Growth is so simple, why did investors grant $B valuations to these companies and others in the first place? I believe the answer is a combination of downside protections, upside overoptimism, and what can only be described as FOMO.

Downside protections are being prominently discussed now in light of Square’s down round IPO (albeit still in unicorn territory); to put it simply, late stage investors have (smartly) insulated themselves from losses, so they’re willing to give more on valuations. With regards to upside overoptimism, I imagine that when these rounds were executed, both investors and entrepreneurs believed that things would look up — customer lifetimes would extend, ARPU would increase, margins would expand, and CACs would decline. Alas, it doesn’t always pan out that way, which is why we encourage our portfolio companies to stay conservative on valuations: big up rounds can be appealing in the short-term, but when companies stumble (which they often do), the subsequent down rounds can be outright devastating. Zenefits, for example, is likely to feel that pain shortly given their recently exposed stumbles.

Personally, I’m looking forward to a private market correction. I feel my colleagues and I have done a good job building a portfolio of companies with sound fundamentals and well-earned valuations; a return to sanity would be a welcomed change, as it would unlock quality talent that we can then direct to our companies and others who are playing the prudent, long game.

There’s no shortage of lessons for business leaders and trailblazers in these stories and biographies.

Source  : http://www.inc.com/frederic-kerrest/5-must-read-books-on-technology-and-innovation.html

At the beginning of the year, Mark Zuckerberg challenged himself to read a new book every week and welcomed the Facebook community to join him. (I have a feeling he was taking a page from Bill Gates’ book.) In his pledge, Zuck wrote, “books allow you to fully explore a topic and immerse yourself in a deeper way than most media today” and I agree. They offer much more in-depth lessons for readers, especially for business leaders and technologists taking on daunting tasks and impossible adversaries. I learned a good deal about opportunity, innovation, execution and efficiency from these five books–which I highly recommend–and I wanted to share my big takeaways.

1) The Innovators: How a Group of Hackers, Geniuses, and Geeks Created the Digital Revolution, by Walter Isaacson

I came to Silicon Valley to attend Stanford University in 1994, after going to high school in Paris and moving around for most of my young life. When I tell friends, coworkers and acquaintances about how I got here, I usually say “talk about luck–I couldn’t have picked a better time or location.” Technology was just starting to take over the world and Isaacson (who recently spoke at our customer conference) does a great job of capturing the opportunity so many innovators encountered and seized at the time.

The takeaway: Sure, being in the “right place at the right time” plays a role in success, but those who truly succeed are open to opportunities at any time. And they know seizing the moment is as physical as it is mental.

2) Moore’s Law: The Life of Gordon Moore, Silicon Valley’s Quiet Revolutionary, by Arnold Thackray, David Brock and Rachel Jones

This biography of Gordon Moore, co-founder of Intel, focuses on the development of Moore’s Law, detailing how Moore foresaw the potential of silicon transistors to make electronics affordable and immensely powerful. His belief that microchips could double in power, then redouble again like clockwork, was revolutionary at the time. It drove Intel to pioneer new technologies in computer memory, integrated circuits and microprocessor design–technology that made them the giant we all know today.

The takeaway: Since insanity is doing the same thing over and over and expecting different results, we have to learn from the past. Moore’s story and impact offers a history lesson on innovation for all business leaders. If Intel didn’t shift from memory to processors, it would be long forgotten. Now the company has one of the greatest legacies in technology.

3) How to Fly a Horse: The Secret History of Creation, Invention, and Discovery,by Kevin Ashton

Kevin Ashton is best known for coining the phrase “the Internet of Things” and co-founding the Auto-ID Center at MIT, which created a global standard for radio-frequency identification (RFID), the use of sensors to identify and track tags on objects. I was confident the man who recognized the potential of sensors so early would be able to tell a compelling story about innovation and invention, and Ashton didn’t disappoint. From the creation of the Muppets and the Wright brothers’ mission to “fly a horse” to the discovery of DNA, Ashton profiles inventors and their unique journeys to world-changing breakthroughs, showing that innovation can’t simply be “done.”

The takeaway: Your “a-ha” moment isn’t going to challenge the status quo or move the landscape forward. Truly impactful innovation comes with incremental progress and hard work.

4) Zero to One: Notes on Startups, or How to Build the Future, by Peter Thiel (and Blake Masters)

Zero to One is not only a must-read for startup founders, but it also has relevant messages and lessons for business leaders at any stage and in any industry. Not only does Thiel encourage entrepreneurs to think for themselves and do something unprecedented; he also gives practical advice–particularly on sales, which is a topic many authors shy away from–and focused on the importance of daily execution.

The takeaway: If you want the pie in the sky, you need to execute everyday and figure out how your team can best block and tackle.

5) Elon Musk: Tesla, SpaceX, and the Quest for a Fantastic Future, by Ashlee Vance

Like most entrepreneurs and innovators in Silicon Valley, I have a great deal of respect for Elon Musk. He’s taken on momentous challenges–electric cars, spaceships, solar energy–and done it at scale and in parallel. Beyond being the current CEO and Chairman of Tesla, SpaceX and SolarCity, he’s also raising 5 kids (twins and triplets, just for kicks). Vance’s biography showcases how Musk does it: he brings a “think big” approach to everything he does that’s off the charts. And not only does he think big; he does big. So big that he truly believes he can change the world, which is something we can all aspire to.

The takeaway: We can solve the world’s biggest problems if we’re all as efficient as Elon Musk. I’m only partly kidding. What I learned from Vance’s biography is there’s no problem too big to take on, but it has to be tackled will scale and scope in mind.

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Halts Dividends as Miners Face Commodity Fall

Anglo American Plc dropped to a new record low after scrapping its dividend for the first time since 2009 and pledging deeper spending cuts to help the mining company withstand a collapse in commodities. The company will suspend its payouts for the second half of this year and for 2016, it said in a statement Tuesday. Anglo is abandoning its practice of steadily increasing the dividend in favor of a system that allows the payment to rise and fall with the company’s profits, known as a dividend payout ratio. Chief Executive Officer Mark Cutifani is seeking to turn around the company’s fortunes in the face of metalprices at the lowest in about six years and China’s sluggish economic growth.

By the time Anglo suspended its dividend in 1998, the S&P Metals & Mining Index was down 50% from its monthly closing high. In 2008, it was down 67%. Currently, it is down 69%…These dividend suspensions are exactly what potential shareholders should be looking for as a signal that sentiment is nearing a trough.”

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Reflektion om : Sju råd: Så äter du smart för kropp och klimat

Idag skriver SvD :

http://www.svd.se/sa-ater-du-klimat-mat-smartast

Det känns som om SvD har valt att publicera enkla lösningar utan den fördjupning och diskussion som jag vanligtvis förväntar mig av er journalistik. Även om förekomsten av övervikt och kliniska fetma har ökat under de senaste årtionden så har detta hänt samtidigt som det genomsnittliga intaget av kalorier per person faktiskt har reducerats. Våra förfäder som arbetade med kroppen, gick och cyklade för att uträtta ärenden var tvungna att äta mer än vad vi gör idag.   Även om ökad kroppsvikt till viss del kan förklaras av en enkel och god tillgång på välsmakande kaloririka livsmedel som eventuellt kan åsidosätta normala mättnadsmekanismer, så kvarstår faktum att vi som population drastiskt har reducerat fysik aktivitet. Denna stillasittande livsstil är en oberoende faktor som leder till ökad ohälsa, men drar man SvD rekommendation till sin spets bör man inte träna mer eftersom detta skulle leda till att fler kalorier behöver konsumeras.  Det verkar därför på sin plats att istället fundera på hur maten produceras och transporteras.

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