Mental Models, Investing, and You

TABLE OF CONTENTS INTRODUCTION 4 SECTION 1: PSYCHOLOGY 17 Chapter 1: The Two Systems of Thinking 18 Chapter 2: Va...

Author: Vishal Khandelwal | Anshul Khare

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TABLE OF CONTENTS INTRODUCTION

4

SECTION 1: PSYCHOLOGY

17

Chapter 1: The Two Systems of Thinking

18

Chapter 2: Variable Reinforcement

25

Chapter 3: Kantian Fairness Tendency

32

Chapter 4: Contrast Mis-reaction Tendency

41

Chapter 5: Deprival Super Reaction Syndrome

50

Chapter 6: Do Something Bias

58

Chapter 7: Pavlovian Conditioning

66

Chapter 8: Framing Effect

73

Chapter 9: Status Quo Bias

80

Chapter 10: Twaddle Tendency

89

Chapter 11: Reciprocation Tendency

96

Chapter 12: Gambler’s Fallacy

104

Chapter 13: Mental Accounting

111

Chapter 14: Social Proof

119

Chapter 15: Reason Respecting Tendency

127

Chapter 16: Bystander Effect

134

Chapter 17: Liking Bias

142

Chapter 18: Winner’s Curse

150

SECTION 2: STATISTICS

158

Chapter 19: Mean Reversion

159

Chapter 20: Law of Small Numbers

166

Chapter 21: The Power Law

175

SECTION 3: SOCIAL SCIENCES

182

Chapter 22: Tragedy of Commons

183

Chapter 23: Externalities

192

www.safalniveshak.com

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TABLE OF CONTENTS | Mental Models, Investing, And You Chapter 24: Complex Adaptive Systems

198

Chapter 25: Moral Hazard

205

SECTION 4: ECONOMICS

213

Chapter 26: Matthew Effect

214

Chapter 27: Game Theory

222

Chapter 28: Gresham’s Law

229

Chapter 29: Law of Diminishing Marginal Utility

236

Chapter 30: Pari-mutuel System

244

SECTION 5: PHYSICS

253

Chapter 31: Thermodynamics

254

Chapter 32: Feedback Loops

262

SECTION 6: DECISION MAKING

271

Chapter 33: Occam’s Razor

272

Chapter 34: Checklist

279

Chapter 35: Loser’s Game

288

SECTION 7: BUSINESS

294

Chapter 36: Switching Costs

295

Chapter 37: Network Effects

303

Chapter 38: Float

311

Chapter 39: Arbitrage

322

Chapter 40: Surfing

330

SECTION 8: ENGINEERING

339

Chapter 41: Redundancy

340

Chapter 42: Critical Mass

347

Chapter 43: Theory of Constraints

355


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TABLE OF CONTENTS | Mental Models, Investing, And You

SECTION 9: MATHEMATICS

363

Chapter 44: Inversion

364

Chapter 45: Permutations and Combinations

372

Chapter 46: Bayes Theorem

379

Chapter 47: Alternative Histories

390

SECTION 10: LITERATURE

399

Chapter 48: Journaling

400

Chapter 49: Active Reading

409

Chapter 50: Storytelling

416

EPILOGUE

423

ACKNOWLEDGEMENT

427

BIBLIOGRAPHY

428

ABOUT THE AUTHORS

432


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Introduction The world around us is changing pretty fast and the modern computers are becoming cheaper, faster and more intelligent than ever which means they are ready to replace a large part of human workforce. The day is not far where our work and skills will be threatened by an artificial intelligence. To stay relevant, we need to make sure that we remain valuable to the society in a way which can’t be substituted by a robot. So it’s time that we recognize not just the importance but the urgency of the need to become a learning machine.

Charlie Munger

Image Source: Poor Charlie’s Almanack Charlie Munger, the inimitable partner of Warren Buffett, has been saying the same thing for years – I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning


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Introduction | Mental Models, Investing, And You machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you. The question is where do we begin? We often go through each day without questioning our perception of the world. We seldom stop to wonder whether the world we perceive matches the real world outside. Most of the time, that’s fine…because our perceptions serve us quite well. In fact, our perception is good enough to guide us through a very complex world with few problems. But because it serves us so well, it’s easy to forget how limited perception really is. And one reason for inadequacy of human perception is that it has to deal with an enormously complex real world. We live in a world that is not only complex but vastly older and bigger than we are. To think we can fit it all into our heads is a logical absurdity. At same time, our world and life is full of opportunities, disguised as problems and challenges, which need to be either pursued or avoided. You don’t want to spend a disproportionate amount of time analysing a single problem. Instead the strategy should be to race through numerous problems and quickly identify the solvable ones. How do you do that? By learning the mental models.

Mental Models What’s a mental model? A mental model is a representation, inside your head, of an external reality. Mental models are the basic units which construct a person’s world view. It is the representation that a person has in his mind about the object he is interacting with. It is the way the person thinks about what it is they are doing or dealing with. Mental


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Introduction | Mental Models, Investing, And You models shape our actions as to how we act or behave in a particular situation. They define what people will pay attention to and how they approach and solve problems. Mental models are tools for the mind. The more models you have from outside your discipline and the more you iterate through them when faced with a challenge in a checklist sort of fashion, the better you’ll be able to solve problems. While thinking about a problem, mental models provide you a map with which you can quickly course correct your line of inquiry. These models are additive. Like LEGO. The more you have the more things you can build, the more connections you can make between them and the more likely you are to be able to determine the relevant variables that govern the situation. And when you learn these models you need to ask yourself under what conditions will this tool fail? That way you’re not only looking for situations where the tool is useful but also situations where something interesting is happening that might warrant further attention. It won’t be an overstatement if we call these list of mental models as a cheat sheet which allows us to better understand when to follow and when to reject the conventional wisdom. So it’s very important to have the right models in your head. And how do you build these models? You don’t have to build them all on your own. According to Munger, the most efficient way to learn is vicarious learning. He says – I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.

Vicarious Learning Vicarious learning is a very intelligent form of learning. Even the great scientist Isaac Newton once acknowledged, “If I have seen further than others, it is by standing upon


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Introduction | Mental Models, Investing, And You the shoulders of giants.” Newton wasn’t just being humble, he actually left a very important clue about how he learned things and became one of the greatest thinkers and scientists the world has ever seen. A wide array of mental models already exists in form of big and important ideas in every discipline. These big ideas have been developed over past hundreds of years by influential thinkers who have done the hard work of thinking and framing the knowledge in form of these models. By learning the big ideas from multiple disciplines we are allowing ourselves to stand on the shoulders of giants. People who have come before us and developed useful ideas in different subjects have already done the groundwork required for improved thinking. What remains to be done on our part is to learn these ideas, master them and begin using them in our decision making process. Learning mental models is vicarious learning i.e., learning from other people’s mistakes. Vicarious learning becomes supremely important when it comes to figuring out what not to do. “After all you don’t have to pee on an electric fence,” quips Munger, “to know that it’s dangerous.” You must have heard the following saying – “More the sweat in training, less the blood in war.” So training here is akin to learning the mental models and getting adept in their usage. This training will make sure that you get hurt less in making real life decisions. That’s the beauty of vicarious learning.

Man with Hammer It’s completely fine to use one model to understand the idea, and another to work out the details. But life becomes difficult when we think there’s only one way to approach it.


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Introduction | Mental Models, Investing, And You Munger prescribes You must know the big ideas in the big disciplines, and use them routinely — all of them, not just a few. Most people are trained in one model — economics, for example — and try to solve all problems in one way. You know the old saying: to the man with a hammer, the world looks like a nail. This is a dumb way of handling problems. What Munger is suggesting is that one shouldn’t try to solve problems with the only tool he or she possess. When you’re trying to make sense of the world around you, don’t try to explain things by thinking of one reason and then latching on to it. Big outcomes are rarely caused because of one reason. Ask “what else can cause this outcome.” Get more tools. Learn various mental models. Worldly wisdom requires the use of multiple mental models to understand the real life experiences. It’s said that there is nothing more dangerous than a man with an idea especially if it’s the only idea he has. So instead of swinging your single hammer in every direction, you should learn to rely on your toolbox containing multiple instruments i.e., metal models).

Jumping Jurisdictional Boundaries Having diverse mental models in your head is the true multidisciplinary way of learning. To think in a multidisciplinary way, you have to stop sweating the small ideas in your own discipline and reach out for big ideas in other disciplines. Stepping into different disciplines expands your mind’s ability to experience radically different thoughts, perceptions, and ideas. Paul Graham, founder of YCombinator and a very successful venture capitalist, says-


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Introduction | Mental Models, Investing, And You Studying things from unrelated subjects (multidisciplinary learning) is a lot like yoga for brain. You don’t actually get anywhere when you do yoga. You stand in one place and bend yourself in various shapes. But it makes you more flexible, so when you go out and do walk around, you can walk better. That’s why learning the fundamental ideas from major disciplines like physics, biology, math, psychology, history and economics and then remembering them in form of mental models will give you the highest return on investment (of your time and effort). You don’t really have to become an expert in every field. You merely have to learn the fundamental principles – what Munger calls the big ideas – and learn them so well that they are always with you. When you develop a knack for jumping over jurisdictional boundaries of multiple disciplines, you will be richer – both financially and intellectually.

Mental Models Are Contradictory As you start learning these mental models, you’ll find that some of these ideas are contradictory. But isn’t that the nature of truth? It not only feels contradictory but sometimes it looks outright paradoxical. An elephant is a great metaphor for the complex problems we encounter in the real world. It’s like six blind men trying to describe an elephant by grabbing on to different parts of elephant’s body. And we don’t want to be like those blind men who are looking at the problem from a single dimension.


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Introduction | Mental Models, Investing, And You

Image Source: From the book Graphic Presentation by Willard C. Brinton (1939)

Just like a carpenter’s toolbox contains tools to break things and also instruments to join them back, a multidisciplinary thinker’s mental toolbox contains tool of thinking which may sometimes point in different directions. The key to learn is how and when to use a particular tool, which can only come by practicing and implementing the mental models. In that sense multidisciplinary thinking is also an art which becomes more and more useful as you start using it. One goal to learn different mental models from multiple disciplines is to learn how problems can be transformed. Remember that painting of the old lady and young woman? Look at it again –


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Image Source: Perceptual Ambiguity Do you see both? Once you can see both of them it’s easy to switch between them. That’s the beauty of multidisciplinary thinking. The more models you have available, the bigger and clearer is your windshield through which you can observe the problems. We hope these mental models help you cut through the optical illusion around you and you start seeing many young and old ladies – metaphorically.

Independent Thinking Today our world is multidimensional and our problems are complicated. The superfluity of communication and information is drowning us in massive noise. Which means better decisions aren’t necessarily the result of having all the information. Most of the things that we read, listen or watch is dimly understood unless we have the right tools to detangle the balderdash from the core ideas. So in today’s world of information equality, what separates you from the crowd is your ability to generate unique insights using the same information that everyone has. Multidisciplinary education enables you to look at the problem from a variety of perspectives and increase the odds to arrive at a better solution and superior insights.


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Introduction | Mental Models, Investing, And You Becoming a sensible investor is a byproduct of learning to make better decisions. You can’t make better decision by thinking the same thoughts that everybody is thinking and doing the things which everybody is doing. And that’s why independent thinking is so important.

The Latticework In his 1994 speech to business school students, titled Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business, Charlie Munger said What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ‘em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form. You’ve got to have models in your head. And you’ve got to array your experience — both vicarious and direct — on this latticework of models. Learning the mental models is just the first step. The second and more important step is to have these models available in a usable form. How do we do that? We have to learn to integrate it into our existing knowledge. That’s what ‘hanging the facts’ means. You use this Latticework — a scaffolding — to hang your experiences and facts. Herb Simon, Nobel Laureate and author of the brilliant book Models of My Life, writes– 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


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Introduction | Mental Models, Investing, And You to evoke these, and bring these to his conscious attention when the situations for decision arise. This ‘mechanism of mind’ is what the metaphor of Latticework all about. To be able to use those mental models effectively, one has to work on building his or her own latticework based on knowledge and experience. You may have noticed students who just try to remember and pound back what is remembered, writes Charlie, “Well, they fail in school and in life. You’ve got to hang experience on a latticework of models in your head.” Having the big ideas in usable form is how you begin to achieve worldly wisdom. This way of interacting with the world is supremely efficient. It makes you a better thinker, decision maker and gives you a tremendous edge in navigating the world around you. Even people with ordinary intelligence can outthink the smartest people if they develop certain thinking habits. Building a latticework of mental models is an ongoing process of, first, acquiring the significant concepts – the models – from many areas of knowledge and then, second, learning to recognize patterns of similarity among them. The first is a matter of educating yourself; the second is a matter of learning to think and see differently. Creating this latticework is about the ability of seeing patterns – how ideas and things relate and hang together. Knowledge that can be used in a variety of situations. Building a latticework of mental models will require you to embrace differences, ambiguity, conflict, and tension. Consider them signposts to better solutions and better problems.

Sharpening the Axe We think what Abraham Lincoln said is a great metaphor for lifelong learning. He said-


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Give me six hours to chop down a tree and I will spend the first four sharpening the axe. Spending a lot of time on a single problem is akin to struggling with a single tree with a blunt axe. Learning multi-disciplinary ideas and building a latticework of mental models is akin to sharpening your axe. Axe sharpening doesn’t necessarily mean that you have to build a super smart brain or develop an IQ of 180. You just have to devote some time in learning the ideas that matter – the true wisdom. Wisdom that can help you cut through the crap and directly see the core. And Latticework of Mental Models is that sharp axe. So the idea is to spend more time constructing, overhauling, fine tuning and maintaining your Latticework. Building your own Latticework of mental models is a tremendously useful way to evaluate and upgrade the fabric of your worldview.

To Learn Better, Teach Aristotle saidFor the things we have to learn before we can do them, we learn by doing them. This means we need to practice what we have learnt in various situations. These mental models and multidisciplinary ideas do no good sitting inside your head like artifacts in a museum for they need to be taken out and played with. Once you learn a model, the question that you should ask yourself is – where can I find a practical implication of this?


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Introduction | Mental Models, Investing, And You Another way to crystallize your learning is to teach it. As they say, “Tell me and I forget, teach me and I may remember, involve me and I learn.” Teaching is one of the most effective (and largely ignored) hack for learning. So start implementing what you learn and the first step to implementing any kind of knowledge is to teach it to someone else. When you read something interesting, don’t just forward the link to others, make efforts to explain the idea in your words, in your own unique way. When you are teaching to somebody else, it reveals the gaps in your own understanding. You will be surprised with the kind of insights that pop up in your head while you’re explaining new ideas to other people. So don’t just read, get involved. Don’t just learn, go out and teach. We urge you to find few friends and partners with whom you can share these ideas. And if nobody wants to listen to you, sit in front of the mirror and assume you’re talking to your sibling and share your knowledge. When we write about mental models, we imagine ourselves sitting in front of you and having this conversation face to face. That creates a fear in our minds that we might not be able to answer your doubts and questions. This subconscious fear makes us think hard before writing. Can you guess who benefits the most from this process? We. According to Charlie Munger, the best thing a human being can do is help another human being know more. And as they say charity begins at home, so we are constantly trying to help ourselves know more. So let us say this again - it might look like we are trying to spread the knowledge here but honestly our ulterior motive here is to solidify our own learning. And as a spillover effect, if just one more person benefits from our efforts, we would consider that we paid off a small percentage of the debt that we owe to Charlie Munger. And all we ask from you is to Pass it on.


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Before We Start According to one statistics, only 10 percent of the people read past the first two pages of a book they start. So if you’ve read this far, we can say you’re already ahead in the game. Not the game of “who knows more” but the game where knowing few essential ideas go a long way in reducing errors and increasing the quality of life. According to Mr. Munger, there are about 100 or so models across the disciplines of microeconomics, physiology, psychology, elementary mathematics, hard science and engineering that carry about 90% of the freight in making you a worldly-wise person. And, of course, it’s not possible to learn all of them in day or a week or even in a single year. It’s a long term proposition and will require serious efforts. But when you’ve committed yourself to a lifelong journey for seeking worldly wisdom, it’s a small price to pay. Are you ready to pay that price? Did you just say “Yes”? We think we heard that. In this book, we have compiled a list of 50 mental models arranged by fields of study, which can serve as a good starting point for you to create your own “latticework of mental models”. The book is a collection of essays that were published in past one year as part of Safal Niveshak’s Latticework series. Use these ideas as a springboard for further useful discovery. One last warning - Anything that you read “rewires” a part of your brain. The brain you have now; you don’t get that brain back after learning the mental models. We are sincerely hoping that the trade-off is worth it. With respect, Anshul & Vishal Note: In many of the places in the book we have used “I”. Although we haven’t specifically mentioned who that “I” refers to. It was intentional to keep the reader’s flow uninterrupted. If you have questions on specific chapters, you can always email us at vishal[at]safalniveshak[dot]com or anshul[at]safalniveshak[dot]com.


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SECTION 1: PSYCHOLOGY One of the most important node in Charlie Munger’s Latticework is this idea of behavioural economics. It’s the intersection of economics and psychology. In his book Thinking Fast and Slow, Daniel Kahneman, a Nobel Laureate who is also considered the father of behavioural finance, writes – A remarkable aspect of your mental life is that you are rarely stumped … The normal state of your mind is that you have

intuitive

feelings

and

opinions

about

almost

everything that comes your way. You like or dislike people long before you know much about them; you trust or distrust strangers without knowing why; you feel that an enterprise is bound to succeed without analyzing it. This overconfidence in our intuitive abilities for making crucial decisions in work and life can do us in. The fact is you’re probably not as effective at making decisions as you could be. Nobody is. But we can get better by learning about human behavioural quirks that can bring down the quality of our decisions. Behavioural finance, the place where psychology meets money, is increasingly becoming a very important subject for everybody. It’s no more a thing of academic interest for scientists. It’s mainstream now. The day isn’t far when awareness about human behavioural biases would become as essential as driving a car or using a computer. Awareness about behavioural biases doesn’t necessarily make us immune to them, however what we can attempt to do is to minimize their effect and increasingly make better choices. I would recommend that you start this section by reading Chapter 1 first because it will set the stage for subsequent ideas that are discussed in Psychology section. Rest of the sections and chapters can be read in any order.


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Chapter 1 The Two Systems of Thinking “What’s 2 + 2?” You can’t help but think of the answer instantly. Your mind throws the number “4” on your thought screen. It’s actually impossible to not think of the answer here, unless you haven’t learnt to count to ten. The answer is almost like a reflex. It was an instance of fast thinking. In fact, you don’t even need to consciously think about it. It just happens to you. This is the result of what scientists call reflexive brain. Now if I ask you, “What’s 38 multiplied by 27?” For most of you, except if you’re a math wizard, your brain goes blank. It doesn’t give you any instant answer. You’ll have to take a pause and calculate the answer with some efforts, and if you’re like me you won’t be able to do it without pen and paper. Here you have to involve a part of your brain which is known as the reflective brain. You experience a slow mode of thinking as you proceed through a sequence of steps to solve this multiplication problem. Reflexive brain is quick and it tends to jump to conclusion. Reflective brain is much slower, requires effort, it’s logical and, as we’ll see later, less prone to error. Daniel Kahneman, a Nobel laureate who is also known as the founding father of modern behavioural economics, in his book Thinking Fast and Slow, has termed these two modes of thinking as System 1(reflexive) and System 2 (reflective).


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Chapter 1 - The Two Systems of Thinking | Mental Models, Investing, And You System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control. System 2 allocates attention to the effortful mental activities that demand it, including complex computations. The operations of System 2 are often associated with the subjective experience of agency, choice, and concentration. In other words, System 1 and System 2 modes of thinking can be imagined as intuitive and deliberate thought respectively. So these two don’t really exist physically inside your skull. They are mere representation of the way to understand how human brain carries out the task of thinking. Consider these two systems as agents within the mind, with their individual personalities, abilities, and limitations. “Systems 1 and 2 are both active whenever we are awake”, says Kahneman, “System 1 runs automatically and System 2 is normally in a comfortable low-effort mode.”

So for most of our routine tasks like walking, talking, reading, driving, etc., System 1 is engaged in helping us make quick and efficient decisions. System 1 is the first layer of thinking that any problem is delegated to by our brains. System 2 comes into picture


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Chapter 1 - The Two Systems of Thinking | Mental Models, Investing, And You only when a question arises for which System 1 does not offer an answer, as probably happened to you when you encountered the multiplication problem 38 × 27. The arrangement works well most of the time because System 1 is generally very good at what it does. But things aren’t as perfect as they seem. Our hero, i.e. System 1 is an overconfident guy. And under many specific conditions, which should ideally be delegated to System 2, our System 1 insists on making a decision and ends up creating systematic errors. These systematic errors from System 1 are called psychological biases. Here’s a simple example. Look at the image below. There are three sentences inside the triangles. Read them out loudly.

Did you notice the mistake? Don’t feel bad if you didn’t because most people fail to notice the error. In the first sentence, word “the” appears twice before the word “spring”. Same with the third sentence. And similarly in the second sentence the word “a” repeats. So what really happened?

Impatient System 1 Reading is pretty much an effortless activity (as far as understanding the literal meaning of the sentence is concerned) which is done by System 1. So in a hurry to make sense of the things, System 1 does these optimizations on its own level and hence


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Chapter 1 - The Two Systems of Thinking | Mental Models, Investing, And You these small inconsistencies remain invisible to us because of shortcuts taken by System 1. You may say that it was a case of an optical illusion, so here’s another example which doesn’t involve any images. This is a very simple math problem. Instead of trying to solve it, just observe the first intuitive answer that comes to your mind because that will give you a clue to workings of System 1. •

The total cost of Bat and a Ball is 110 rupees.

•

The cost of Bat is 100 rupees more than the Ball.

•

How much does the Ball cost?

If you’re in a hurry you would quickly conclude that “the ball costs 10 rupees” which is a wrong answer. If you do the math little slowly (using System 2), you’ll realize that the right answer is – ball costs 5 rupees and the bat costs 105 rupees. In all such situations you must pay attention, and you will perform less well, or not at all, if you are not ready or if your attention is directed inappropriately. Use of System 2 requires attention and its operation is disrupted when the attention is taken away. The sloppiness of System 1 is what creates cognitive biases. And that makes System 1 a very interesting subject of study. The whole field of behavioural economics stems out from the need to understand the peculiar characteristics of System 1. So let’s see how did this dude called System 1 come to be.

Origins of System 1 The System 1 thinking or the reflexive brain is a gift from evolution. Our ancestors were hunter gatherers and lived in jungles where there was a constant threat of being eaten by a wild beast. So when they sensed a movement in the bushes it was probably


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Chapter 1 - The Two Systems of Thinking | Mental Models, Investing, And You a predator about to jump on them. The only way our ancestors could survive was to run at any such signs. These reflexes or instincts, to run away from a potential danger, created a strong evolutionary advantage for homo sapiens and resulted in the development of reflexive brain. Imagine if I was in the same situation and upon sensing the movement in the bushes, instead of running, I pulled out my smart phone and started googling – “what does noise from bushes mean?” – by the time google gives me an answer I would be a dead meat. Now the process of evolution is slow. So those instincts, which our ancestors developed during the human evolution history of 2.5 million years, are still present in us. Our bodies and minds haven’t changed much in last few thousand years but the environment in which we live in has changed dramatically. The threat of being attacked by a wild beast isn’t there anymore, unless of course you decide to jump inside the cage of a lion in a zoo. Many of these instincts aren’t very useful in present day. But they do influence of our decision making. In the modern world these biases cause us to make big mistakes particularly in the financial markets.

In Investing When it comes to money and investing, presence of System 1 makes our brains illequipped to handle the situations. Investing is an area which presents many situations where reliance on System 1 gets us fooled into making very serious errors of judgment. Many psychological biases (we are going to see some of them in later chapters) are brainchild of System 1. Some of them are – Anchoring Effect, Overconfidence Bias, Confirmation Bias, Scarcity Bias, Authority Bias, Social Proof (Chapter 14), Base Rate Neglect, Liking Bias etc.


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Chapter 1 - The Two Systems of Thinking | Mental Models, Investing, And You Anchoring effect happens when people get hung up on the stock prices instead of the quality of the underlying business. System 1 thinking compares the current price to the recent high-low prices (anchor) and jumps to faulty conclusions. Confirmation bias is that property of System 1 which makes it prone to remain consistent with its earlier decisions or commitments. System 1 selectively seeks only that information which is consistent to its beliefs and discards any disconfirming evidence. When we see someone dressed as doctor on the TV, we assume that he knows what he’s talking about. Similarly, when a stock market expert (suit-tie wearing talking heads who like to show off their financial jargon vocabulary) forecasts the market movements and the macroeconomic shifts, System 1 falls for the Authority Bias and believes him. Liking bias (Chapter 17) makes us prone to favour those whom we like. It’s very common for people to get duped into buying useless financial products because the so called financial advisor (a salesman) comes across as a likeable person because of his or her pleasant personality and extraordinary communication skills. Base rate neglect is another such erroneous thinking where System 1 ignores the underlying base rate of success. If someone claims that his grandfather was a chain smoker and lived up to a ripe age of 95, he’s ignoring the statistics. Base rate says that statistically a chain smoker is unlikely to live a long life. Grandfather was an exception, an outlier and you can’t make your decisions based on such anecdotal evidences. But Systems 1 tends to fall for such misleading stats. Everyone knows some friend of a friend who made lot of money in an IPO. But don’t forget that the base rate of making money in IPOs is very poor. All these biases of System 1 can wreak havoc and cause serious damage to our financial wellbeing. So how do you fight with System 1?


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Chapter 1 - The Two Systems of Thinking | Mental Models, Investing, And You Turns out that it’s not that easy. It’s quite stubborn. System 1 operates automatically and cannot be turned off at will, errors of intuitive thought are often difficult to prevent, writes Kahneman, “Biases cannot always be avoided, because System 2 may have no clue to the error.” But let’s say you learn to reject the first intuitive response in every situation and call upon System 2 to find the more calculated and rational answer. Would that help? According to Kahneman, it would be an overkill. He writes – As a way to live your life, however, continuous vigilance is not necessarily good, and it is certainly impractical. Constantly questioning our own thinking would be impossibly tedious, and System 2 is much too slow and inefficient to serve as a substitute for System 1 in making routine decisions. The best we can do is a compromise: learn to recognize situations in which mistakes are likely and try harder to avoid significant mistakes when the stakes are high. Notice the point – when the stakes are high. So when you’re making an investment, it’s a high stake situation. But if you’re buying a toothpaste, you can give System 2 some rest and go with System 1.

Conclusion System 1 Vs System 2 is a brilliant mental model to explain the machinery of thought. And when it comes to the subject of thinking, Daniel Kahneman’s book is a bible. You can’t call yourself a serious student of behavioural economics if you haven’t read Daniel Kahneman’s book.


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Chapter 2 Variable Reinforcement It’s not often that you would find me exercising my thumb muscles with a TV remote but it so happened that on a Saturday afternoon while killing time in front of the idiot box, an unsettling thought caught me off guard. I realized that I had been surfing through the TV channels for the past hour without really spending more than a minute on any single channel. This habit is not uncommon but the unusual thing was, once I had looped through all the channels a couple of times and found that there was nothing interesting on TV, I still kept changing the channels without getting bored. So what was keeping me hooked? As a flash of insight the answer that my mind threw at me was an uncomfortable one. It wasn’t the content in the TV which was keeping me engaged. It was the excitement of unknown that existed for those short moments between channel switches. The moment I decided to flick the channel, for a millisecond my mind wouldn’t know what was going to appear next on the TV screen. My above hypothesis wasn’t entirely correct but I knew I was on to something. For few minutes, I even day dreamed about winning the next Nobel prize for a path breaking discovery in human behaviour! Please don’t laugh as that dream was soon shattered by Mr. Google. A little googling revealed an important mental model from the field of psychology. It’s called Variable Reinforcement.

What’s Variable Reinforcement? A response or action is called reinforced response if it generates a reward i.e., a person will be motivated to repeat a response if he or she gets a reward for the same. That’s


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Chapter 2 - Variable Reinforcement | Mental Models, Investing, And You the well-known theory of motivation. However, when a response is reinforced after an unpredictable number of tries, it generates a high and steady rate of response. Which means, when you receive the reward with irregular or unpredictable frequency, your behavior is reinforced even more strongly. Take a moment and think about the following questions. What’s your first instinct when you hear your phone ring? What’s the first thought when you see an incoming phone call from an unknown number? Is it easy to ignore and forget about a WhatsApp buzz or an unread message icon in your mailbox? Personally, my first instinct is to immediately answer the unknown call or read that unopened message. And my rationalizing mind justifies this urge with questions like – What if it’s an emergency? What if there’s a surprise for me? The situation described above is nothing but variable reinforcement in disguise. Psychologists have done elaborate experiments to prove that the effect of variable enforcement is pretty strong on human behaviour. Let’s take a look at one such empirical study.

Skinner’s Experiments In 1950s, a scientist called B.F. Skinner validated the reinforcement theory by conducting experiments on mice. He observed that mice responded most voraciously to random rewards. In one of his experiments, he selected two mice and fed them little differently. The first mouse was treated with same amount of food every time it pressed a lever. However, to the second mouse, the supply of food was irregular and uneven. When this second mouse would press a lever, it would sometimes get a small reward, other times a large one, and sometimes nothing at all.


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Chapter 2 - Variable Reinforcement | Mental Models, Investing, And You What Skinner observed that the second mouse pressed the lever compulsively when the food was given at irregular intervals. That established the theory of variable reinforcement. Nir Eyal, author of the book Hooked: How to Build Habit-Forming Products, writesHumans,

like

the

mice

in

Skinner’s

box,

crave

predictability and struggle to find patterns, even when none exist. Variability is the brain’s cognitive nemesis and our minds make deduction of cause and effect a priority over other functions like self-control and moderation. Variable rewards hook up our brains and keep it occupied. They sometimes create a trance like state for our minds. Variable reinforcement is used by a lot of sales and marketing people to keep you and me engaged with their products. This mental model appears at variety of places in the real world.

In Gambling Have you ever wondered why is gambling an addiction? Especially in casinos you will find people glued to slot machines pulling the lever compulsively. It’s been predicted by studies that even if some of those people end up winning the jackpot, they would prefer spending all that money back into slot machine. Interesting, isn’t it? Slot machine players have no way of knowing how many times they have to play before they will win. All they know is that eventually a player will win. This is why slot machines are so effective and players are often reluctant to quit. There is always the possibility that the next coin they put in will be the winning one. Like the skinner’s rat, they keep pulling the slot machine lever. A horrific finding claims that many slot machine addicts wear adult diapers because they don’t want to get up even to answer the nature’s call.


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Chapter 2 - Variable Reinforcement | Mental Models, Investing, And You It would be naive to think that those slot machines offer a fair play. These machines are designed to exploit the variable reinforcement inherent in human behaviour. The machine doles out rewards in a very unpredictable (which might seem totally random to untrained eyes but it’s not) fashion. Now that we are talking about slot machines, it’s worth mentioning an intelligent aspect of slot machine design called “calibrated near misses”, which exploits another behavioural quirk called Deprival Super Reaction Syndrome. We’ll discuss that in Chapter 5.

In Daily Life It’s common for most people to give in to the urge to take a phone call from an unknown caller or to check your email/mobile phone every few minutes. What we don’t realize that we have limited supply of willpower and attention in a day. When we spend our mental resources (cognitive fuel) attending to these small insignificant attention grabbing events, we are foregoing a chance to engage in deep thinking or doing any other important tasks (like reading a book). Another personal observation – with smartphones and digital devices powered with fast Internet, any song or music in the world is just a few seconds away from you. Then why do people still listen to radio? It’s because radio offers the element of unexpected and novel experience with irregular interval (those annoying radio ads can go on for a long time before the next song is played on air). And you can’t know beforehand which music is going to be played while you’re driving back home. Similarly, many companies use this trick to motivate people. Call centers often offer random bonuses to employees. Workers never know how many calls they need to make in order to receive the bonus, but they know that they increase their chances the more calls or sales they make.


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Chapter 2 - Variable Reinforcement | Mental Models, Investing, And You Video games is another such example which engages people and can lead to addiction. In case you don’t know – the video gaming industry is bigger than movies and music industry combined (worldwide). Surprising, right? Remember Farmville and Angry Bird games? The Twitters and Facebooks of the world are creating new habits by running users through a series of addictive products fueled by variable rewards.

In Investing There are ample evidences to show that a buy and hold strategy triumphs over frequent trading for majority of investors. Then why do people still get into frequent trading, hoping to make sustainable profits? Prof. Sanjay Bakshi compares these short-term speculators to butterflies jumping from one flower to the next. In a recent article, he wrote …reason why people resemble butterflies is because of the presence of a pleasure chemical called dopamine in our brains. The more the dopamine the more the pleasure. And novel experiences (imagine bungee jumping or a one-night stand) deliver enormous amounts of dopamine to the brain.

The

other

thing

that

delivers

dopamine

is

unexpected, pleasant surprises. And day traders get a lot of small, but pleasant surprises just like kids who are hooked to gaming. It gets addictive, this dopamine business. The more you get the more you crave for. If you put a day trader who just had a winning bet in a fMRI machine and compare him with a cocaine addict, the doctors can’t tell the difference. Their brains look just the same. Behaving like a butterfly increases the probability of


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Chapter 2 - Variable Reinforcement | Mental Models, Investing, And You novel experiences. It increases the probability of small, unexpected surprises [variable reinforcements]. Warren Buffett has written that for many “investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be.” He is clearly on to something. Similarly, checking your portfolio constantly is a type of addiction. Because of the inherent volatility of stock prices, there will be times when your portfolio will show profits (and sometimes it will be in red too). Every time you see a paper profit it releases a small quantity of dopamine, the feel good hormone, in your brain and your action (checking the portfolio) is reinforced. The notional increase in your portfolio value is a source of variable reinforcement. Now you know why we aren’t very different from rats when it comes to variable reinforcement.

Antifragility Meets Variability I am an admirer of Nassim Taleb’s ideas. Antifragility is one of his ideas that I found very insightful. It basically says that we should arrange our affairs in such a manner that the uncertainties of life should benefit us instead of causing a harm. So let me speculate a bit about reinforcement in the context of antifragility. Knowing that variable rewards induce addiction, can we design an environment for ourselves where variations (the stimuli which create everyday experience) increase the quality of our life? The idea is to bring in the element of pleasant uncertainty. How about doing something wacky which has the potential of creating a totally unexpected and new experience? Like wearing different coloured sock on each leg? Or parting your hair the other way? Hey! I am just suggesting. By the way I tried the hair


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Chapter 2 - Variable Reinforcement | Mental Models, Investing, And You trick and it freaked my wife big time. But guess what? It became a memorable day and she now calls me Mr. Wacky. Vishal, on his trip to Varanasi, roamed the city’s streets wearing the traditional Indian dhoti-kurta and found passersby amused at his attire. But as he tells me, it was one of his most memorable days in life and he would like to return to Varanasi soon and roam the streets wearing that dress again. A wise man said – “Life is not number of days you live but number of days you remember.” Perhaps this explains the behaviour of those crazy adventure junkies. They are addicted to creating unique moments even if it means frequently putting their life at risk. So a word of caution - taking this idea to extreme may backfire too. Please use common sense and please don’t break the law! Too much wackiness on a consistent basis can end up creating unmanageable mess.

Conclusion Variable reinforcement is a powerful force that focuses attention, provides pleasure, and infatuates the mind. Next time when you see people getting addicted in an environment or to some product, pull out the variable reinforcement mental model from your latticework toolbox. It may give you some useful insights.


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Chapter 3 Kantian Fairness Tendency I was almost at the end of a beautiful evening drive. Refreshing cold breeze gently blowing on my face through the car windows. The relatively less traffic on the road was like heaven on earth. Sporting an ear-to-ear smile I felt confident that nothing in the world had the power to take away my inner peace at that moment. But, as usual, my faithful and ever reliable nemesis, the chaos-monkey, had different plans for me that evening. Just when I was about to take a smooth turn on a closing traffic signal, a taxi cut me off while overtaking my car. The surprising rash maneuver from the taxi called for sudden brakes and by that time signal had turned red. As a result, I missed my turn because of the insensitive driving by the taxi driver. In the next few seconds, my Buddha smile turned into an angry frown and I was thrown out of my “appreciating the good things in life” mode. Why did I feel so agitated? Well, for one, I was ahead of the taxi and it was me who was supposed to cross the signal first. I felt as if the taxi guy had brutally robbed off my well-deserved right to take the turn before him. You might find it amusing but the incident costed me a whopping two minutes of extra wait for the traffic signal to turn green again and of course my inner peace. May be I am exaggerating and unnecessarily using strong words to describe a petty incident. But how could I take it easy? It was absolutely unfair! Do unto others as you would have done unto you. Sounds familiar? Well I would never have done the same thing (it’s pretty close to encroachment in my dictionary) to anybody else.


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Chapter 3 - Kantian Fairness Tendency | Mental Models, Investing, And You Probably the taxi driver didn’t really think it was unfair. Perhaps he’d been at the receiving end of the same treatment many times in the past that he now considered it fair to pass the buck. Or maybe he was just too busy marveling at his own driving skills. Who knows what he was thinking! Well, before you lose interest and stop reading, let me put an end to my rant about traffic etiquettes and being a victim of unfair treatment. Let me ask you this. Have you ever experienced this feeling of being treated unfairly? May be in some small way like when one of your utterly undeserving colleague got promoted before you. Ouch, I’ve been there!

Kantian Fairness Tendency Why is the human psyche so obsessed with the idea of fairness? Actually, it’s not just humans. Even monkey business (literally) isn’t immune to this tendency. Watch this video, which proves that the tendency to seek fairness in all transactions is not an invention of modern man, but the behaviour has been tattooed at a much deeper level by evolutionary process.

Image Source: YouTube.


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Chapter 3 - Kantian Fairness Tendency | Mental Models, Investing, And You The theory about human rationality takes the view that people would accept any offer made to them as long as they were better off. But we know that humans are anything but rational and many studies have shown that people will reject offers they view as unfair. Our ape just validated this hypothesis in the video. This is the matter of discussion in this chapter. Exploring the idea of what Charlie Munger calls Kantian Fairness Tendency. Although we’ve put this mental model under Psychology, it’s one of the big ideas from Philosophy. Let’s define fairness first. The basic idea is that we have devised certain rules that, when followed by everyone, result in a pretty smooth life for all involved. The key is that everyone needs to follow along. This unsaid understanding about ‘following along’ few ‘socially acceptable guidelines for conduct’ is what constructs the framework for fairness. When a behaviour doesn’t fall (or doesn’t seem to fall) in this framework, we label it as unfair. From Charlie’s talk, it’s not entirely clear why he has used the word Kantian but let me still take a stab at it. The word refers to the philosophical framework created by eighteenth century German philosopher Immanuel Kant. Kant’s ethics are founded on his view of rationality as the ultimate

good

and

his

belief

that

all

people

are

fundamentally rational beings. (Source: Wikipedia) According to Kant, an individual’s rights and duties are the foundation for defining morality and fairness. Passing a judgment on ‘what is fair’ seems pretty simple when you are the subject matter i.e., when you are evaluating the fairness in matters involving you. What about the case when you have to take a decision about ‘what is fair’ for a third person?


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Chapter 3 - Kantian Fairness Tendency | Mental Models, Investing, And You

Image Source: Imgur. I have borrowed a lot of ideas in this chapter from Prof. Sanjay Bakshi’s blog post on this topic. His discussion about ‘the law of higher good’ is another mental model that you need to be aware of.

Fairness and Envy If you look at the monkey’s behaviour in the above video, it’s clear that the reward for performing a task was acceptable to the monkey until he saw that his other monkey friend (I am just making a guess about their friendship; they could have been professional rivals too) is getting a better reward for the same task. Of course, at this point, the first monkey goes berserk. He just can’t believe it. He is boiling with anger. A complete pandemonium follows in his cage. My guess is that this extreme reaction against lack of fairness is because of envy, another mental model which we will discuss in detail some other time. However,


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Chapter 3 - Kantian Fairness Tendency | Mental Models, Investing, And You Kantian Fairness Tendency limits the behaviour to accepting or rejecting the offered deal, whereas envy takes it to the next level (i.e., the emotional outburst) which could, and definitely would, get you into trouble. You could say that a distorted worldview about fairness becomes the precursor to envious behaviour. That explains where the roots of envy lie.

Seeking Fairness In the TV news when you see a guy robbing a lady, the obvious first thought is to seek punishment for the culprit. But soon the news reporter reveals that the thief’s mother was ill and he needed money for her treatment. Does this justify robber’s act as fair? May be yes. But then, is it fair to the society as a whole that anybody who needs money for a genuine cause is allowed to rob strangers? As usual, Charlie Munger has some insights to deal with such situations. He has spoken about man’s over love of fairness in his UCSB talk. He said – It is not always recognized that, to function best, morality should sometimes appear unfair, like most worldly outcomes. The craving for perfect fairness causes a lot of terrible problems in system function. Some systems should be made deliberately unfair to individuals because they’ll be fairer on average for all of us. I frequently cite the example of having your career over, in the Navy, if your ship goes aground, even if it wasn’t your fault. I say the lack of justice for the one guy that wasn’t at fault is way more than made up by a greater justice for everybody when every captain of a ship always sweats blood to make sure the ship doesn’t go aground. Tolerating a little unfairness to some to get a greater fairness for all is a model I recommend to all of you. But again, I wouldn’t put it in your assigned


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Chapter 3 - Kantian Fairness Tendency | Mental Models, Investing, And You college work if you want to be graded well, particularly in a modern law school wherein there is usually an over-love of fairness-seeking process. Looking at the idea of fairness in isolation is akin to saying that a surgeon should refuse to operate on a patient because it will cause pain to him. Of course, an operation will cause pain (after the anesthesia wears out) and few days of inconvenience, but eventually it will prove to be a beneficial act for the patient. So, may be, seeking fairness isn’t always wrong. What you have to know is – at what level are you seeking fairness? At an individual level, or at a group level, or at some other level altogether. Answering that question would bring some clarity on what is fair and what isn’t. I suggest you watch this lecture from Michael Sandel who is a professor in Harvard University. Some of the thought experiments that he discusses in his lecture are so unsettling that it seriously challenged my long held notions about morality and fairness. The following story is from an article I read in Wall Street Journal – During the middle ages in Europe when the court couldn’t determine if a defendant was guilty they would offer him an option. The option was to either accept the punishment for their crime or put their hand in boiling water. The idea was that God, who knew the truth, would miraculously save any suspect who had been wrongly accused. The trick however was that a guilty person and an innocent one often respond differently to the same incentive. Typically, a guilty would choose to accept the punishment instead of sacrificing his hand. An innocent who believed in God would daringly agree for boiling water test.


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Chapter 3 - Kantian Fairness Tendency | Mental Models, Investing, And You In the ideal scenario, nobody really goes through the boiling water test, because the defendants are proven guilty/innocent based on their intentions only. But if nobody was ever made to go through the boiling water test in front of the crowd, the trick will lose its effectiveness. People need to at least see some defendants suffering the boiling water torture to believe in the authenticity of the test. Which means some innocent people will have to go through the torture and it would be unfair to them. In order to keep the sanity and order in society few innocents will end up being victim of unfair play. In other words, to make an omelet you need to break some eggs.

In Investing One of the ways this bias comes into play in investing is when people expect that they should make the money in the same way they lost it, i.e., they focus on individual stocks to make money for them. Of course, that’s what the idea is when you choose the stock to begin with. But expecting fairness in returns from the stock is a fallacy. Instead, you should make sure that you don’t lose money overall on your portfolio of stocks. No matter how much margin of safety and rigorous analysis you employ, you are bound to find (time to time) few losers in your portfolio. A natural reaction is to say, “It’s not fair. I have put in so much effort, analysis and money in this stock. It shouldn’t lose money.” Being aware of Kantian Fairness Tendency can save you some unwanted heartache. Now consider, for instance, a company that has historically paid good dividends to shareholders. As time goes on, if the company continues to grow and perform well, shareholders may rightly expect that their dividend should grow, too. But what if it doesn’t? What if something changes, maybe a slowdown in growth, or pressure on cash


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Chapter 3 - Kantian Fairness Tendency | Mental Models, Investing, And You flows? And what if the company decides to cut back on dividends to preserve cash for future expansion? See what happened when Hawkins Cookers cut its dividend from Rs. 60 per share in FY14 to Rs. 45 in FY15 due to slowdown in growth and pressure on cash flows. “It’s unfair! We paid 60X for this.” People who invested in this stock cried. And, when a lot of investors start singing the unfair song, this is what happens to the stock –

On the surface, this may seem fair on the part of the management, who wants to protect precious cash that would help them tide over the immediate slowdown in business. And given the management of Hawkins, it surely seems to be thinking long term. But to most people who bought the stock with unfair expectations, it’s the management and the business that now looks unfair to them!

Conclusion Life isn’t fair, but many can’t accept this. Tolerating a little unfairness should be okay if it means a greater fairness for all. But ‘what is truly fair for all’ isn’t an easy question to answer.


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Chapter 3 - Kantian Fairness Tendency | Mental Models, Investing, And You

Some of my thoughts in this chapter have been a result of my speculation about the utility of Kantian Fairness Tendency. There is a non-zero possibility that my arguments and conclusions are flawed, so instead of taking them at face value, please consider them as starting points to stimulate your own independent thought process.


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Chapter 4 Contrast-Misreaction Tendency Let me introduce you to my friend, Mr. Irrational. He is a figment of my imagination, inspired by Benjamin Graham’s Mr. Market. One fine day, it so happened that Mr. Irrational was trying on suits in front of a shop’s three-sided mirror. The men’s tailor shop was owned by Sid and Harry. The younger brother, Harry, being less experienced, was sitting at the back of the room with all the design catalogues and price list. Sid, elder brother and the chief tailor, who seemed to have hearing problems, was helping Mr. Irrational make a choice. “How does this one look?” asked Mr. Irrational. He liked the dark grey colour but wasn’t sure about the woolen texture of the suit. “Pardon me Sir. Can you please speak up little louder?” This was the third time that Sid had requested his patron to speak louder. “I am asking how does this suit look on me?” Mr. Irrational raised his voice. The extra decibels came with a hint of irritation. After all my friend is a soft spoken guy and shouting is considered rude in his family. “Aha! You’re looking fabulous in this one sir! Nothing less than a business tycoon.” Sid’s artificial smile bundled with a fake compliment proved that he was a skillful salesman. “How much does this one cost?” Mr. Irrational asked loudly. He didn’t want to repeat his sentence.


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Chapter 4 - Contrast-Misreaction Tendency | Mental Models, Investing, And You “This one sir? Let me check.” said Sid. He turned towards Harry and shouted at the top of his voice, “Harry, how much for this suit?” Looking up from his work – Harry called back, “For that beautiful all-wool suit, nine thousand rupees.” At this point, Sid turned to Mr. Irrational and reported, “He says five thousand rupees.” Curbing his instincts to correct Sid, Mr. Irrational realized that Sid’s hearing problem had just thrown up an opportunity to grab a nine thousand suit for five thousand. Without even giving a second thought, he hurriedly paid five thousand to Sid and scrambled out of the shop with his “expensive means good” bargain before poor Sid could discover the “mistake”. My question to you is this – do you think Mr. Irrational exploited Sid’s disability? What if I told you that there is a twist in the tale? What if Sid didn’t really have a hearing problem? As it turned out that it was an elaborate scam and Mr. Irrational was manipulated. Sid and Harry knew something important about human behaviour: humans rarely choose things in absolute terms. We don’t have an internal value meter that tells us how much things are worth. Rather, we focus on the relative advantage of one thing over another, and estimate value accordingly. This human behavioural bias is called Contrast-Misreaction Tendency.

Contrast-Misreaction Tendency (CMT) I’ll take Charlie Munger’s help in defining this behavioural anomaly. He writes -


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Chapter 4 - Contrast-Misreaction Tendency | Mental Models, Investing, And You .. human nervous system can’t naturally measure in absolute scientific units; it must instead rely on something simpler. The eyes have a solution that limits their programming needs: the contrast in what is seen is registered. And as in sight, so does it go, largely, in the other sense. Moreover, as perception goes, so goes cognition. The result is man’s Contrast-Misreaction Tendency. In the image here, the two inner rectangles are exactly the same shade of grey, but the right one appears to be a lighter grey than the left one due to the background provided by the outer rectangles. It’s the result of contrast effect.

Image Source: Wikipedia. Mr. Irrational, who was uninformed about suit business, had no clue about the value of the suit until he heard from Harry, who shouted “nine thousand rupees”. In that moment Harry had deliberately planted a price anchor in his customer’s mind. The very next moment, when Sid said “five thousand rupees”, Mr. Irrational found the suit cheap in contrast to price anchor.


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Chapter 4 - Contrast-Misreaction Tendency | Mental Models, Investing, And You Sid and Harry made their money even as the customer thought he got a ‘great’ deal! Unfortunately, almost every one of us, knowingly or unknowingly, has fallen for such scams in our lives. Peter Bevelin describes the idea eloquently in his book Seeking Wisdom – We judge stimuli by differences and changes and not absolute magnitudes. For example, we evaluate stimuli like temperature, loudness, brightness, health, status, or prices based on their contrast or difference from a reference point (the prior or concurrent stimuli or what we have become used to). This reference point changes with new experiences and context…. This means that how we value things depend on what we compare them with. If Mr. Irrational looked like a sitting duck, then let me warn you that Sid and Harry aren’t the only ones who understand the importance of CMT.

Exploiters of CMT Is it possible to influence customer’s decisions by manipulating the available options? The answer is a resounding yes. Consider this experiment where a group of people was asked to choose between $6 cash and an elegant pen. Most choose the cash. Another group of people was asked to choose between $6 cash, the elegant pen, or an inferior pen. Most choose the elegant pen. Why? By adding an inferior option, a decoy, which nobody chooses, people are subtly nudged towards the option (the elegant pen in this case) which can be compared to the inferior choice.


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Chapter 4 - Contrast-Misreaction Tendency | Mental Models, Investing, And You

Bevelin quotes the example of real estate where this bias is a standard tool of persuasion – Mary is looking at houses. The real estate broker knows that the house he is trying to sell Mary is in poor shape and a bad area. He starts by showing Mary bad properties in an ugly neighbourhood. Afterwards, he takes her to the house he wanted to sell all along. Suddenly this house and the area seem great in comparison to the other house she saw. The story isn’t much different when we end up buying that overpriced ₹25,000 leather accessory merely because the price is so low compared to our concurrent purchase of a ₹5 lacs car. Even when people know that this sort of customer manipulation is being attempted, it will often work to trigger buying, which demonstrates that being aware of psychological ploys is not a perfect defense. In fact the ‘predictability about our irrational behaviour’ was the premise on which Dan Ariely wrote his entertaining book, Predictably Irrational. In the following talk, Dan shows you some optical illusions to bring home the point that awareness about human biases doesn’t necessarily make you immune to them. On a lighter note, Rolf Dobelli suggests that if you are seeking a partner, never go out in the company of your supermodel friends. People will find you less attractive than you really are. Go alone or, better yet, take two ugly friends. I haven’t validated this trick, so goes without saying – “try it at your own risk!” There is another aspect of CMT which makes it very interesting. If we fail to perceive the change, due to small contrast, the mis-reaction may not trigger at all. For example, our kids grow up right in front of our eyes but we notice the change only when we look at old pictures.


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Contrast, the Invisible Killer Contrasts makes us blind to slow change until it’s too late. The reality around us seems pretty much constant, although it’s continuously changing. The change in a stimulus has to cross a certain threshold before our awareness can register it. It’s worth mentioning here a tremendously useful mental model called boiling frog syndrome, described by Prof Bakshi in this wonderful blog post. He explains – Small incremental changes tend to go unnoticed…If you put a frog in hot boiling water, he will instantly leap out of the pan and be never seen again. But, if you put a frog in a pan with room temperature water and slowly turn up the heat, he wouldn’t be able to tell the tiny incremental changes. He will boil and die. Charlie Munger once said that many businesses die just like the boiling frog. Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny. He further warnsWhen a man’s steps are consecutively taken toward disaster with each step being very small, the brain’s Contrast-Misreaction Tendency will often let the man go too far toward disaster to be able to avoid it. This happens because each step presents so small a contrast from his present position. Warren Buffett says – One of the problems in society is that the most important issues are often these incremental type things…But, if you


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Chapter 4 - Contrast-Misreaction Tendency | Mental Models, Investing, And You keep doing it over time, the incremental problems are hard to attack because that one extra piece of pie doesn’t really seem to make a difference…but the cumulative effects of them will make a huge difference over time, just like overeating will make a huge difference over time. The time to attack those problems is early. Sometimes it is the small, gradual, invisible changes that harm us the most.

In Investing The whole idea behind systematic investment plan (SIP) is that a small outgo (as compared to the whole salary) every month from our paycheque doesn’t pinch. As we have seen contrast is a two sided sword, and its ill effects show up in investing also. Have you heard of “Big Bath” accounting? For the uninitiated it’s an accounting jugglery to “manage” a company’s earnings. Sometimes, to fool the shareholders, a particular year’s poor income statement is made to look even worse by increasing expenses and selling assets. As a result, the subsequent years, especially the very next, appear much better in contrast. Satyam’s case is another example which shows how big accounting scams are created. Here is what Ramalinga Raju’s aides at Satyam must have told him before the scam came to light – “If we slowly and gradually over time manipulate the numbers, the auditors won’t notice it.” You see, contrasts may blind us to change until it’s too late. For example, we often don’t notice the bad behaviour of others (like we ignore “small” accounting manipulations at companies) if it goes sour gradually over time. Often we see reality as constant, although it gradually changes.


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Similarly, we fail to notice how our money disappears. It constantly loses its value, but we do not notice because inflation happens over time. If it were imposed on us in the form of a brutal tax (and basically that’s what it is), we would be outraged. Another area where CMT can harm is our fixation on the stock price. When you are analysing a business, it becomes extremely hard to overcome the temptation to ignore the past stock price trends. If a stock has risen recently, our subconscious screams that the stock has become expensive. A recent fall in price triggers the CMT which convinces us that the stock has become cheaper. My advice? Don’t look at the stock price until you have analysed the business and worked out some valuation. For that matter, if you can’t avoid price based screeners, use them carefully.

Conclusion Understand that CMT is everywhere, and that we view our world through its lens – rose coloured or otherwise. Few psychological tendencies do more damage to rational thinking than CMT. Warren Buffett was probably referring to contrast bias when he said – Chains of habit are too light to be felt until they are too heavy to be broken. It’s interesting that most bad habits are formed because of this tendency but fortunately this bias, if used intelligently, can help us form good habits too. John Wooden, one of the most successful coaches in the history of basketball, observed – When you improve a little each day, eventually big things occur … Don’t look for big, quick improvement. Seek the


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Chapter 4 - Contrast-Misreaction Tendency | Mental Models, Investing, And You small improvement one day at a time. That’s the only way it happens and when it happens, it lasts. I wanted to tell my friend, Mr. Irrational, that he was taken for a ride by his tailors but then I thought to myself, “Let me keep the poor kid happy.” After all he still believes that he stole a great bargain. But you don’t forget to include CMT in your mental model checklist. And at the same time don’t forget to make use of it for creating good habits. PS: The tailor shop example was taken from Robert Cialdini’s book . Influence: The Psychology of Persuasion


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Chapter 5 Deprival Super Reaction Tendency In Chapter 2 when we discussed the Variable Reinforcement mental model, there was a brief mention about casino slot machines. Let me pull out that text for you – Now that we are talking about slot machines, it’s worth mentioning another extremely intelligent aspect of slot machine

design

called calibrated

near

misses, which

exploits another behavioural quirk called Deprival Super Reaction Tendency. Those calibrated near misses is going to be subject of investigation in this chapter. If you buy a ticket for the lottery that has the number 49 on it and the number 48 is drawn, you think, “I was so close…” BUT were you really? No you weren’t. If you have read the basics of statistics, you would know that the numbers in lottery are supposed to be random and the probability of each number is ideally same. So you weren’t anymore closer (or farther) from winning as you would have been if the number you got was 1. However, that’s not how the gambling systems are designed. In casinos, some slot machines receive better results (for the casino owner, not the gambler) than other machines based on the same payouts, same locations, same design, etc. How come? The difference between the two slot machines is this – even though the overall probability of winning or losing is the same in both, one machine has a lot more “near


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Chapter 5 - Deprival Super Reaction Tendency | Mental Models, Investing, And You misses” than the other one. This keeps gamblers hooked because it makes them think, “Oh! I was so close to winning. How could I miss it. Let me try again.” The gambler tends to play more, which translates into more collections for the casino from the “doctored” machine. Psychology of the near miss is particularly well known in the casino industry. The “near miss” potential is very reinforcing and makes people want to try again. In fact, gaming commissions, the regulatory bodies which control the casinos, are aware about this irregularity and they even allow slot machines to have unusually large number of “near misses” calibrated in the design. Here’s another interesting video where a slot machine designer explains how intelligent design and human psychology is used to make the activity an addiction. Now, why am I talking about gambling and slot machines? Because I want to tell you about …

Deprival Super Reaction Tendency This irrational response to “near miss” or “almost there” is what Charlie Munger has dubbed as “Deprival Super Reaction Tendency”. It’s another super critical mental model from the field of psychology. Let’s use the acronym DSRT because it saves screen space, computer memory, internet congestion, and my keyboard strokes. Another reason for using acronym is that it creates an impression in reader’s mind that the author is smart. You can call DSRT a flavour of loss aversion bias, which states that the quantity of man’s pleasure from a ten-rupee gain is significantly lower than the quantity of his displeasure from a ten-rupee loss. However, the irrational reaction to loss in this scenario (taking away the almost possessed reward) is little more intense.


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Chapter 5 - Deprival Super Reaction Tendency | Mental Models, Investing, And You

Image Source: Dilbert.com Peter Kaufman writes in Poor Charlie’s Almanack – If a man almost gets something he greatly wants and has it jerked away from him at the last moment, he will react much as if he had long owned the reward and had it jerked away. I include the natural human reactions to both kinds of loss experience – the loss of the possessed reward and the loss of the almost-possessed reward – under one description, Deprival Super Reaction Tendency. It’s no wonder that this tendency isn’t just limited to humans. Evolution has ingrained this anomaly in animals also. Kaufman adds – The Mungers once owned a tame and good-natured dog…There was only one way to get bitten by this dog. And that was to try and take some food away from him after he already had it in his mouth. If you did that, this friendly dog would automatically bite. He couldn’t help it. Nothing could be more stupid than for the dog to bite his master. But the dog couldn’t help being foolish…He had an automatic Deprival-Superreaction tendency in his nature. You should read about Prof. Sanjay Bakshi’s tryst with DSRT, in his own words.


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DSRT in Real World It’s not just money that triggers the DSRT. Taking away people’s freedom, status, love, friendship, opportunity, dominated territory or anything they value will results in DSRT. Charlie Munger explains – Deprival-Superreaction

Tendency

often

protects

ideological or religious views by triggering dislike and hatred directed toward vocal non-believers…because the ideas of nonbelievers, if they spread, will diminish the influence of views that are now supported by a comfortable environment

including

a

strong

belief-maintenance

system…University liberal arts departments, law schools, and business organizations all display plenty of such ideology-based

groupthink

that

rejects

almost

all

conflicting inputs. Centuries ago, DSRT was so strong that it wasn’t uncommon to subject the heretics to extreme torture and brutal death. Coca Cola, one of the most celebrated and profitable brands in the world, was almost brought down to its knees by DSRT. In 1985, they launched a ‘New Coke’ which had different taste from the original Coke. The response was something they didn’t expect at all. Coke was a birthright that everyone, from farmers to presidents enjoyed, together, and had for generations. Consumers felt that something had been taken away from them and replaced with something they didn’t ask for and didn’t like. The ‘New Coke’ was a colossal failure. Coca Cola had to recall the new product and immediately bring back the original Coke.


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Chapter 5 - Deprival Super Reaction Tendency | Mental Models, Investing, And You Don’t underestimate the power of DSRT!

DSRT and Lollapalooza One of the places where DSRT has ghastly effects is open-outcry auctions. Social psychology experiments show that bidders in auctions often get carried away and end up bidding far more than underlying value of the objects being auctioned. Such outcomes are almost always caused by a combination of multiple forces working in the same direction. In auctions, these include greed, envy, bias from commitment (every bid is a public endorsement of the bidder’s belief that value exceeds his bid), social proof (last price from another bidder was reasonable), low contrast (every successive bid is only a tiny increment over the previous one), and DSRT. So the best antidote to saving yourself from auctions is Warren Buffett’s advice – “Don’t go.” And Charlie Munger says in his Psychology of Human Misjudgment lecture – …the open-outcry auction is just made to turn the brain into mush: you’ve got social proof, the other guy is bidding, you get reciprocation tendency, you get deprival superreaction syndrome, the thing is going away… I mean it just absolutely is designed to manipulate people into idiotic behavior. Another area where DSRT, along with other behavioural biases, creates lollapalooza is the field of negotiations. In labour negotiations, the last thing negotiators want is the proposal to reduce wages. That’s because such decisions receive a disproportionately intense reaction from the unions due to DSRT triggered by the threat to take away something (wages, benefits etc.).


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Chapter 5 - Deprival Super Reaction Tendency | Mental Models, Investing, And You Many corporate salary structures include sign-on bonus (or retention bonus) which is given upfront with the condition that it will be recovered in case the employee leaves the organisation early. That’s a neat trick to exploit DSRT to keep the employees from quitting early. In fact, persuasion experts (salespeople and marketing professionals) know it very well that the easiest way to convince people is to take their focus on what they will lose rather than what they might gain if they don’t use the promoted product/service.

In Investing Peter Bevelin writes in his book Seeking Wisdom – We hate to admit we’ve lost money…we hate to sell losing stocks. It is the same as admitting to others and ourselves that we’ve made a mistake. We therefore hold on to our losers too long and sell our winners too soon. A realized loss feels worse than suffering the same loss on paper. In fact, the paper loss sometime drives people to such levels of irrationality that without questioning the quality of the business they buy more and try to average down their cost. Loss-aversion combined with ego, writes Peter Bernstein in his book Against The Gods, “leads investors to gamble by clinging to their mistakes in the fond hope that someday the market will vindicate their judgment and make them whole.” Sadly, the market doesn’t know that you’re holding on to a loser and neither does the losing stock.


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Antidote to DSRT We’ve already seen the most effective antidote against DSRT, under specific situation of auctions, is to avoid going to such places. How do you save yourselves from the vicious design of slot machines? I suggest – “Don’t go to the casino!” But if you must, set aside a small amount of money marked as “sin money” and use that. What to do when it comes to saving ourselves from DSRT arising out of conventional thinking? How do you deal with it at personal level and at organizational level in general? Answer is – invite a “Devil’s Advocate”. Deliberately bring in able and articulate disbelievers of your ideas, people who hold contrary views. Make them your “adversarial collaborators”, a term introduced by Daniel Kahneman in his book Thinking, Fast and Slow. To avoid falling for DSRT while investing in stocks, don’t focus on your purchase price. Ask: Suppose I hadn’t made the investment; would I make this investment today at current price? Don’t throw good money after the bad money. Charlie Munger advises – People go broke that way – because they can’t stop, rethink and say, “I can afford to write this one off and live to fight again. I don’t have to pursue this thing as an obsession – in a way that will break me.” Part of what you must learn is how to handle mistakes and new facts that change the odds. Life, in part, is like a poker game, wherein you have to learn to quit sometimes when holding a much-loved hand.


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Chapter 5 - Deprival Super Reaction Tendency | Mental Models, Investing, And You Now you know what to do when you hear the relationship manager from your bank tells you, “You will miss a 3X return if you don’t invest in our new scheme.” Don’t panic. Remind yourself that it’s the DSRT play. Knowing that our loss aversion makes us more sensitive to information that has negative implications for us, can we make use of DSRT to create positive results for us? Here is an idea – Extending the persuasion argument about DSRT, we can motivate ourselves to adopt good habits by focusing on the information emphasizing the possible negative consequences (loss of good health, longevity) of not performing certain activities.

Conclusion From coke to dogs, from stock market to open auctions, DSRT rules our lives. It should be pretty obvious by now that DSRT plays an important role in understanding the human behaviour.


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Chapter 6 Do Something Bias Let me introduce you to another of my imaginary friend, Dr. Placebo. He runs a thriving medical practice. In his clinic you’ll find a very interesting quote, uttered by famous scientist Blaise Pascal, displayed in the patient waiting area – All of humanity’s problems stem from man’s inability to sit quietly in a room alone. He hopes that his waiting patients learn something from this deep thought. Little does he realize that, more than his patients, he is the one who needs to meditate over Pascal’s quote. Before you lose your patience allow me to hold your attention for few more seconds. All that I have said above is quite related to our mental model – Do Something Bias. In case it sounds too simple a name for a mental model, there is another term which I learnt from Nassim Taleb and it’s called ‘Naive Intervention’. If that sounds too jargon-ish then how about ADHD?

ADHD I am sure many of you know few friends who are so restless that they find it impossible to sit at one place quietly. They have very short attention span and can’t stay with one activity for long. In medical science this abnormality is known as ADHD (Attention Deficit Hyperactivity Disorder). What medical science doesn’t tell you explicitly that evolution (yeah, the same process which transformed monkeys into humans) has installed the seeds of ADHD in every human brain.


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Chapter 6 - Do Something Bias | Mental Models, Investing, And You

A survey in US revealed that the average holding period of a stock is 22 seconds. Pretty close to the attention span of a 5-year-old. Now in some cases this tendency is more pronounced and for few, with very severe symptoms of ADHD, may actually need medical treatment but for the rest of us this disorder manifests very subtly in our day to day decision making. In an attempt to be efficient and productive we force ourselves to always stay busy with some task or other. Not being occupied gives the impression that we are incompetent and wasteful. But sometimes, quite often actually, too much activity becomes counterproductive. In psychology this flavour of ADHD is known as Do Something Bias (DSB). 19th Century American writer Henry David Thoreau said – It is not enough to be busy; so are the ants. The question is: What are we busy about?’ Don’t confuse activity with results. There is no reason to do a good job with something you shouldn’t do in the first place. DSB is not only wasteful but can harm you in the long term. Ironically, even medical profession isn’t immune to the ill effects of DSB. In medical terms this is called Iatrogenic, which means causing unintentional harm while trying


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Chapter 6 - Do Something Bias | Mental Models, Investing, And You to help. Nassim Taleb has extensively discussed this topic in his book Antifragile. Here is an excerpt from the book – Consider this need to do-something through an illustrative example. In the 1930s, 389 children were presented to New York City doctors; 174 of them were recommended tonsillectomies [surgically removing the tonsil, a small bell shaped piece of organ hanging inside your throat]. The remaining 215 children were again presented to doctors, and 99 were said to need the surgery. When the remaining 116 children were shown to yet a third set of doctors, 52 were recommended the surgery…note that a death occurs in about every 15000 such operations … every child who undergoes an unnecessary operation has a shortening of her life expectancy… When you medicate a child for an imagined or invented psychiatric disease, say, ADHD or depression, instead of letting him out of the cage, the long-term harm is largely unaccounted for. You can routinely find Dr. Placebo prescribing heavy doses of antibiotics for a minor seasonal cold. Most of these strong antibiotic drugs are hepatotoxic i.e. causing damage to liver. In short they expedite the recovery from flu but the liver damage isn’t visible immediately. Why doesn’t he just send his patients back home with only an instruction to take rest and allow the body’s natural healing system to cure the minor cold? Taleb explains – …the doctor who refrains from operating on a back (a very expensive surgery), instead giving it a chance to heal itself, will not be rewarded and judged as favourably as the doctor who makes the surgery look indispensable, then brings


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Chapter 6 - Do Something Bias | Mental Models, Investing, And You relief to the patient while exposing him to operating risks, while accruing great financial rewards to himself. Obviously it’s not just the medical profession which is plagued with DSB. James Montier, in his book The Little Book Of Behavioral Investing, explains the prevalence of this psychological bias in the field of soccer. During penalty kicks, 94% or the times the goal keepers either dive towards their left or towards their right. However, if they stay at the center their success rate is far higher. Explanation offered by these goalkeepers was that at least they feel they are making an effort when they dive left or right, whereas standing in the center and watching a goal scored to the left or the right of you would feel much worse. The idea of DSB originates from the human urge to say “Look what I did for you” than “Look what I avoided for you”. This is closely related to the concept of silent evidence that we discussed in the first issue of Value Investing Almanack (the first issue is freely downloadable). My fears came true when I prodded Dr. Placebo little more about this – Anshul: Doctor, don’t you know that most of these flu cases don’t need medical intervention? And these strong doses of antibiotics that you prescribe have long term harmful effects. Dr. Placebo: Yes, Anshul. You’re right. But if I don’t prescribe any medicine to my patients they feel I haven’t done anything to help them. Why would they pay a hefty fee for doing nothing? Moreover, prescribing these medicines have psychological effect also. Just because they are popping a pill makes them believe that they are getting better. Placebo effect you know! (smiling sheepishly)


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Anshul: In that case you could actually prescribe them placebos. You don’t need to stuff them with toxic drugs. Dr. Placebo: People are smart these days. Even before buying the drug they pull out their smart phones and google about the drug. If they find that I am prescribing them simple placebos they might stop coming to me or worse they might even file a malpractice lawsuit against me. Can you see my predicament? Even though this is an imagined conversation, Dr. Placebo has a point here. Just like the Soccer situation, this is a classic lollapalooza created by incentive caused bias and DSB. In case you haven’t heard of the term lollapalooza, you must read Poor Charlie’s Almanack. One of the culprits for triggering DSB in human mind is the overload of information. Has it ever happened that you opened the front page of the leading financial newspaper and it said “Nothing significant happened today”. For that matter majority of news (financial or non-financial) is toxic. You don’t believe me? Check out Rolf Dobelli’s article on why you shouldn’t read news.

In Business and Investing Let’s turn to the field of finance and see how this behavioural model explains certain peculiarities present in the markets. The market ups and downs are natural economic cycles (very similar to a living organism whose pulse is not a straight line) and it’s the natural way of maintaining a dynamic equilibrium (supply and demand). Any human intervention (faulty government policies to bail out failing banks or printing excess money) to iron out


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Chapter 6 - Do Something Bias | Mental Models, Investing, And You these natural cycles only seems to help in the short run. In the long run these actions actually build up a bigger bubble and results in severe devastating markets crashes. Any small fluctuation in the markets/economies creates an urge in policy maker’s mind to do something about it. This itch to DSB (instead of giving market some time to self-correct) creates unintended consequences by blowing up the severity of original boom and bust cycles. Short term fluctuations in the stock prices is a noise that you are supposed to ignore. If you start reacting to every small portfolio fluctuations and churn your portfolio frequently, in the long run your performance will be poor. Another interesting property of DSB is that the urge to act tends to intensify after a loss (a period of poor portfolio performance). So if your portfolio hasn’t performed well for some time (short term), it’s very difficult to sit and do nothing about it. This is when you need to be alert and be aware of your vulnerability. Similarly, if you have cash but no opportunity available (a common problem for value investors during bull market), you need to practice patience and remind yourself of ill effects of DSB. Warren Buffett says – Holding cash is uncomfortable, but not as uncomfortable as doing something stupid. This video aptly captures the idea. Making too many decisions also introduces something called decision fatigue. The more decisions you have to make lower the quality of each decision. Too many decisions and over activity increase the odds of failure especially in stock market investing.


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How to Overcome DSB So how do you deal with this bias? The cure for this irrational behaviour is patience. Let’s look at a role model in the field of professional sports (after all we are aiming to become multidisciplinary thinkers) who has successfully overcome this behavioural bias. Even if you aren’t a big cricket fan you must be familiar with Rahul Dravid and his batting style. He is known to be the most patient batsman. Instead of swinging his bat at every ball he would patiently wait for the right one, a ball which is well inside his circle of competence (remember those perfectly executed cover drives). That’s what made him one of the most consistent batsman in cricket history. Scoring 5 double centuries in test cricket isn’t a joke. So what does it mean for you when it comes to stock market investing? Does it mean that you should close your eyes and stop looking for ideas? Not really. It definitely doesn’t mean that you should stop reading annual reports. It means that instead of trying to score a six on every ball, if you can patiently wait for the right stock to appear at the right price, you too can become “the wall” in stock market investing. I know sitting on the sidetracks and waiting is boring but I hope you understand that investing is a serious game and its purpose is not entertainment. As legendary investor Seth Klarman puts it: In a world in which most investors appear interested in figuring out how to make money every second and chase the idea du jour, there’s also something validating about the message that it’s okay to do nothing and wait for opportunities to present themselves or to pay off. That’s


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Chapter 6 - Do Something Bias | Mental Models, Investing, And You lonely and contrary a lot of the time, but reminding yourself that that’s what it takes is quite helpful. What it means is that while making any decision or taking any action, you should question yourself whether your decision is backed by sound reasons and analysis or it is just an excuse to satisfy the itch to do something. S. Pulavarti, who manages the $ 1.5 billion UCLA endowment fund says – It’s like you are in jungle with a gun which has only 5 bullets. If you are told that there is tiger in the jungle, you will be very careful about when to pull the trigger. It’s the same with investments.

Conclusion I will close this discussion with a quote from Warren Buffett – I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches – representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.


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Chapter 7 Pavlovian Conditioning Last month I decided to pay a visit to my friend Dr. Placebo in his clinic. It was a Friday and for some strange reason people are too happy to fall sick on a Friday. So it was a relatively less busy day for my doctor friend. I wasn’t sick as such but I like to catch up with Dr. Placebo once in a while. He has helped me in thinking about important mental models including Do Something Bias (Chapter 6) and Mean Reversion (Chapter 19). So I was hoping that a chit chat with him will again nudge me to some fresh insights. I wasn’t wrong. “So doc! Tell me something ironical about your profession?”, I asked him thinking that a question like that could take the conversation to an interesting direction. “The biggest irony of being a physician is that many people don’t really need doctor’s help. Many a times, my prescription is effective because people believe in them. Their belief in my treatment is what cures them.” He continued, “Sometimes just the fact that a doctor or nurse is paying attention to us and reassuring us not only makes us feel better but also triggers our internal healing processes. In many cases they would benefit just by popping a sugar pill. And it’s a proven fact also known as Placebo Effect.” “I see. That kind of explains your strange name.”, I winked thinking that he wouldn’t mind a friendly tease. “Don’t get me started on the origins of my name. But you should read about Pavlovian Conditioning. Now if you please excuse me, I have to leave now. It’s Friday and I have plans.”, saying this he got up from his chair and started leaving.


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Chapter 7 - Pavlovian Conditioning | Mental Models, Investing, And You I think I had offended him by joking about his name. Moreover, he had already given me more time than what he usually gives to his fee paying patients. But the visit had good payoff for me because it led to me to discover an important mental model – Pavlovian Conditioning - which is sometimes referred to as classical conditioning. Based on my readings about Charlie Munger, I can say that one of his favorite mental model from psychology is Pavlovian Conditioning. It’s one of those topics which has appeared multiple times in many of Charlie’s speeches. So what is Pavlovian Conditioning? It’s a behavioural trait which was first discovered by a Russian scientist named Ian Pavlov. In Seeking Wisdom, Peter Bevelin describes Pavlov’s experiment – The Russian scientist Ivan Pavlov studied the digestive system of dogs when he observed that a stimulus unrelated to food made the dogs salivate. In one experiment he rang a bell just before giving food to the dog. He repeated this several times until the dog salivated at the sound of the bell alone. No sight or smell of food was present. The sound of the bell produced the same response as the food. The dog learned to associate the bell with food. I realize that I’m not much different from Pavlov’s dog. Every time I order a pizza, I start drooling when the doorbell rings. I wonder if it’s Pavlov standing on the other side of the door holding a notebook instead of a hot pizza. The conditioning also works to trigger negative emotions like fear. Bevelin adds – Experiments have shown that we can learn to fear a harmless stimulus if it is paired with an unpleasant one. If


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Chapter 7 - Pavlovian Conditioning | Mental Models, Investing, And You for example rats consistently receive mild electrical shock after hearing a tone, the rats learn to develop a fear of the tone alone.

A Manipulation Tool In his seminal work, Influence – Psychology of Persuasion, Robert Cialdini talks about his friend who was having trouble selling a certain kind of turquoise jewelry. In spite of trying all sales tricks and marketing gimmicks she couldn’t move the sales. One fine day her staff, by mistake, changed the price tags for those turquoise pieces to double the original price. To their surprise, because of this increased price, the stock was sold out in a day. How do you explain this strange behaviour from her customers? Well, Pavlov just told us. The customers, with little knowledge of turquoise, were conditioned to associate high price with high value. These were the people who had been brought up on the rule “You get what you pay for”. Their conditioning led them to mistake the high price (bell) for quality (food) and they swooped down(salivated). There is one place in the world where Pavlov is secretly revered like a god. Can you guess? It’s Las Vegas and for that matter any casino in the world. Casino operators probably use almost every kind of behavioural trick to keep the gamblers longer inside the casino because they know that the longer the game continues, the larger the bets. Large rooms, noisy and flashy machines, sounds of spilling coins, hubbubs of crowds, and entertaining music, along with the smells of free food, drinks and perfume, provide the essential Pavlovian vibes to encourage gamblers to stay with their games for as long as possible.


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Chapter 7 - Pavlovian Conditioning | Mental Models, Investing, And You The slot machines in the casinos exploit yet another behavioural bias called Variable Reinforcement (Chapter 2), which is another form of conditioning, also known as Operant Conditioning(OC). In Pavlovian conditioning the response(salivation) is involuntary whereas in OC it’s a conscious decision on the part of subject. Like a rat falsely associating a lever press with supply of food and keeps pressing the lever endlessly.

In Business In 1996 Charlie Munger delivered a talk titled Practical Thought on Practical Thought. In this talk he used the example of Coca-Cola’s business model and explained how Pavlovian association lies at the heart of coke’s strategy. Charlie explains – 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. …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 other things consumers like or admire. For decades, Coke’s strategy has been to create a strong association between its drink and ‘happiness’ in the consumer’s mind. And it’s not just Coke but a large part of modern advertising industry has relied on Pavlovian Conditioning. There is another interesting manifestation of this bias in the world of business, also known as “Persian Messenger Syndrome”. Here is an excerpt from Charlie’s talk on The Psychology Of Human Misjudgment –


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Chapter 7 - Pavlovian Conditioning | Mental Models, Investing, And You Some of the most important miscalculations come from what is accidentally associated with one’s past success, or one’s liking and loving, or one’s disliking and hating, which includes a natural hatred for bad news…Ancient Persians actually killed some messengers whose sole fault was that the brought home truthful bad news, say, of a battle lost… [this tendency] is alive and well in modern life, albeit in less lethal versions. It is actually dangerous in many careers to be a carrier of unwelcome news. Charlie uses the example of CBS (as warning) and explains how this problem is tackled in Berkshire – Chairman Paley (at CBS) was hostile to people who brought him bad news. The result was that Paley lived in a cocoon of unreality, from which he made one bad deal after another, even exchanging a large share of CBS for a company that had to be liquidated shortly thereafter…. At Berkshire, there is a common injunction: Always tell the bad news promptly. It is only the good news that can wait. It also helps to be so wise and informed that people fear not telling you bad news because you are so likely to get it elsewhere. Charlie Munger has his own nomenclature for most of these biases including Pavlovian Conditioning which he calls Influence by Mere Association.

In Investing One of the ways Pavlovian Conditioning shows its effect in investing is when investors start associating indexes to be the true and accurate representation of the whole


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Chapter 7 - Pavlovian Conditioning | Mental Models, Investing, And You economy. Remember the indexes don’t necessarily reflect the whole world of stocks. It’s just a collection of few companies based on their market capitalization. When the Sensex falls (akin to Pavlov ringing the bell), it triggers a conditioned response (panic or fear akin to salivation) in investors and without even investigating the business fundamentals of the stocks in their portfolio they start selling. Another interesting implication of classical conditioning is a tendency to classify businesses as stereotypes. In his lecture in Google campus, Professor Sanjay Bakshi explained how hostile stereotyping by Mr. Market can have wonderful consequences for the value investor.

Exploiting Pavlovian Conditioning So far our discussion has hovered around unintended and mostly undesired outcomes of pavlovian conditioning. In the spirit of inversion let’s see if we can exploit this behavioural quirk for our benefit. Awareness about classical conditioning can be very useful for creating good habits or breaking bad habits. Once you can identify the cue which triggers the associated conditioned response you can easily break the routine and replace the bad habit with a good one. Charles Duhigg, author of Power of Habits, explains this idea brilliantly in this video.

Conclusion I suspect that towards the end of his research, Mr. Pavlov was probably getting manipulated by his dogs. My suspicion was later confirmed by this image which I found on the internet.


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Chapter 7 - Pavlovian Conditioning | Mental Models, Investing, And You

Image Source: Google. Just kidding!


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Chapter 8 Framing Effect “Is it okay to smoke a cigarette while praying to God?” a young man asked his father. “Of course it’s bad. It’s a great sin and very disrespectful act,” the father replied. Being a religious man, he seemed deeply disturbed with his son’s atrocious question. “But last time you told me that to get rid of my addiction I should start praying while smoking. Didn’t you say that?” It seemed to him that his father was contradicting himself. “No my son! Don’t confuse smoking-while-praying with praying-while-smoking,” the father explained. “But what’s the difference?” the son was perplexed. “There is a difference. A huge difference. I don’t know what but my brain tells me that there is.” Now before we get started on a debate about the validity of father’s argument, let me clarify that the reason I brought up this anecdote was to highlight an important mental bias which plays out in our affairs very subtly. In fact someone made a TV commercial on the same line of thought and I found it very amusing. The way you frame the options is very important. How a message is communicated affects the way it is received. Framing has strong implications on our behaviour. Even


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Chapter 8 - Framing Effect | Mental Models, Investing, And You small and seemingly inconsequential changes in the wordings of a problem can result in large changes of preferences. In his book, The Art of Thinking Clearly, Rolf Dobelli writes – Glossing is a popular type of framing. Under its rules, a tumbling share price becomes ‘correction’. An overpaid acquisition

price

is

branded

‘goodwill’.

In

every

management course, a problem magically transforms into an ‘opportunity’ or a ‘challenge’. A person who is fired is ‘reassessing his career’. A fallen soldier – regardless of how much bad luck or stupidity led to his death – turns into a ‘war hero’. Genocide translates to ‘ethnic cleansing’. Now, it may just seem an intelligent play of words. And one might be tempted to explain this human behaviour by a simple logic – different words arouse different level of emotional response. But if you stop there, you’re going to miss a very critical idea here. There is more juice than meets the eye. It turns out that Framing is a cognitive bias and hence a very important mental model from psychology. It says people react differently to a particular choice depending on whether, and especially when, it is presented as a loss or as a gain. We find “99% fat free” food products enticing but if the same message says “contains 1% fat”, it would trigger a different response from us. Just by rearranging the available set of options, people can be nudged to opt for a specific choice. It’s not only a clever marketing trick to sell products but it can effectively be used by policy makers to increase compliance and even for improving our relationships. In case you want to dig deeper on this, Richard Thaler has written a book called Nudge, which primarily deals with the subject of choice architectures.


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Chapter 8 - Framing Effect | Mental Models, Investing, And You What scientists and psychologists have found is that people tend to avoid risk when a positive frame is presented but seek risks when a negative frame is presented. Gain and loss are defined in the scenario as descriptions of outcomes (e.g. lives lost or saved, disease patients treated and not treated, lives saved and lost during accidents, etc.).

Framing and Loss Aversion Framing is an outcome of our aversion to losses. Evolution has programmed our brain to seek loss minimization instead of gain maximizing. As a result, our brains, subconsciously, are always choosing the path of least pain. Let’s assume that there is a way to quantify or measure the human emotions of pain or pleasure and let’s say the units for that measure is ‘Aha’. So, ideally, loss of say Rs 100 should give you a pain of 10 Ahas and gain of Rs 100 will fetch you a pleasure of 10 Ahas. Right? Not really! The fact of the matter is that the pain of losing Rs 100 is little more, something like 15 Ahas. Daniel Kahneman, in his book Thinking, Fast and Slow, describes an experiment – We introduced our discussion of framing by an example that has become known as the “Asian disease problem”: Imagine that the United States is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows:


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Chapter 8 - Framing Effect | Mental Models, Investing, And You 1. If program A is adopted, 200 people will be saved. 2. If program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved. A substantial majority of respondents choose program A: they prefer the certain option over the gamble. The outcomes of the programs are framed differently in a second version: 1. If program X is adopted, 400 people will die. 2. If program Y is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 people will die Look

closely

and

compare

the

two

versions:

the

consequences of programs A and X are identical; so are the consequences of programs B and Y. In the second frame, however, a large majority of people choose the gamble. So we see that the way in which an uncertain possibility is presented may have a substantial effect on how people respond to it. And many a times this has serious implications. For example, when asked whether they would choose surgery in a hypothetical medical emergency, many more people said that they would when the chance of survival was given as 80 percent than when the chance of death was given as 20 percent. As you can see, it’s not the trivial matter about to-eat-or-not-to-eat that 99% fat free ice cream. It’s the matter of life and death and still people, under the spell of Framing, falter in thinking rationally.


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In Investing The problem of Framing surfaces in investor behaviour in numerous ways. Let’s look at some of them. One of the common mistakes made by early investors in stock market is to sell their winning stocks and hold on to their losers. It’s called Disposition Effect which is an instance of narrow framing. So narrow framing, a flavour of framing effect, is our inability to zoom out on the situation. This creates a faulty perspective. Instead of looking at the overall portfolio performance we look to gain from every stock. To explain this with the help of an example. Let’s say we toss a coin and offer you the following bet – 1.

On heads, you win Rs 60.

2.

On tails, you lose Rs 40.

Should you accept or reject the bet? Most people would reject it. What if you had an option to accept a series of such bets, say 100 coins tosses each with the same offer? Now it becomes an attractive proposal, because over a series of multiples tosses, the probability of head and tail is 50-50. So even if you lose money on some of the bets, your net gains are going to be much closer to the expected value of this bet i.e., Rs 10 per bet. That’s roughly the idea behind broad framing. Kahneman writes –


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Chapter 8 - Framing Effect | Mental Models, Investing, And You The combination of loss aversion and narrow framing is a costly curse. Individual investors can avoid that curse, achieving the emotional benefits of broad framing while also saving time and agony, by reducing the frequency with which they check how well their investments are doing. Closely following daily fluctuations is a losing proposition, because the pain of the frequent small losses exceeds the pleasure of the equally frequent small gains. Once a quarter is enough, and many be more than enough for individual

investors.

In

addition

to

improving

the

emotional quality of life, the deliberate avoidance of exposure to short-term outcomes improves the quality of both decisions and outcomes. So now you have another reason to get rid of your portfolio tracker.

Breaking the Frame So how do you overcome Framing? Peter Bevelin, author of the must read book, Seeking Wisdom, suggests – The answers we get depend on the questions we ask. The British philosopher Herbert Spencer said: “How often misused words generate misleading thoughts.” Consider how a statement, problem, consequence, or question is presented. How is it worded? What is its context? Are we considering certain features and ignoring others? Emotional, selective and appealing frames influence us. The second strategy is to invert the problem statement. That’s called principle of inversion (Chapter 44). By doing so, some of the things which usually remain hidden from your view, because of your intuitive brain, resurface and you get a fresh view.


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Chapter 8 - Framing Effect | Mental Models, Investing, And You Scientists have also discovered that using a foreign language reduces decision-making biases. Some experiments show that framing effect disappears when choices are presented in a foreign tongue. That probably happens because when you’re using your native language, your thinking is more intuitive. The moment you’re asked to reframe the problem in a different language, your brain comes out of the auto-pilot mode and it has to employ a deliberate mode of thinking. Kahneman calls it your system 2 – the rational, deliberate and slower mode of thinking. Other remedies include looking at the problem from different vantage points and also making provision for probabilistic thinking.

Conclusion It’s important to realize the power of framing. Even school kids are learning this trick to manipulate their unsuspecting elders. The kid knows – “It’s not what you say, it’s how you say it.”

One clear advantage of learning about framing is that you can save yourself from getting manipulated from your kids.


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Chapter 9 Status Quo Bias Do you own a smartphone? Chances are that you’re reading this on a smartphone or a tablet. One of the most interesting thing about these smartphones is that they allow you to customize everything – data usage, app synchronization, phone encryption, even how loud you want the camera shutter to sound. How many of these customization settings have you used? In my case – almost none! What has phone customization got to do with mental models? Let me explain. In Chapter 6 we discussed about Do Something Bias. It’s a cognitive bias where people get an urge to take action or make unnecessary decisions when ‘not doing anything’ is required. Now let’s turn the table, and talk about a bias which is exactly opposite of Do Something Bias. It’s called Status Quo Bias. The tendency of people where they don’t do anything and continue to maintain the current state of affairs including their smart phone’s default settings. If we could boil down this cognitive bias to a more fundamental body of knowledge, it would be Physics. I am sure you must have heard of Newton’s laws of motion. The third law of motion states – An object either remains at rest or continues to move at a constant velocity, unless acted upon by an external force.


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Chapter 9 - Status Quo Bias | Mental Models, Investing, And You This characteristic, called inertia, is exhibited by all physical bodies. And when it comes to human behaviour, this tendency manifests in the form of Status Quo Bias. Here is a very intriguing case study which Dan Ariely, author of wildly popular book Predictably Irrational, mentions in his first – This graph shows the percentage of people, across different European countries, who are willing to donate their organs after they pass away. When people see this plot and try to speculate about the cause for the differences between the countries that donate a lot (in blue) and the countries that donate little (in orange) they usually come up with “big” reasons such as religion, culture, etc.

But you will notice that pairs of similar countries have very different levels of organ donations. For example, take the following pairs of countries: Denmark and Sweden; the Netherlands and Belgium; Austria and Germany (and depending on your individual perspective France and the UK). These are countries that we usually think of as rather similar in terms of culture, religion, etc., yet their levels of organ donations are very different.


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Chapter 9 - Status Quo Bias | Mental Models, Investing, And You

So, what could explain these differences? It turns out that it is the design of the form at the DMV. In countries where the form is set as “opt-in” (check this box if you want to participate in the organ donation program) people do not check the box and as a consequence they do not become a part of the program. In countries where the form is set as “opt-out” (check this box if you don’t want to participate in the organ donation program) people also do not check the box and are automatically enrolled in the program. In both cases large proportions of people simply adopt the default option. This default effect caused by Status Quo Bias on human behaviour is so strong that a whole discipline of ‘choice architectures’ has evolved around this idea of creating intelligent default options in different policy frameworks and various human interfacing systems. If you really want to learn more about choice architecture, Nudge by Richard Thaler is an excellent book to read. Thaler writes … People have a more general tendency to stick with their current

situation…

[It]

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. But status quo bias can occur even when the stakes are much larger, and it can get us into a lot of trouble. …Those who are in charge of circulation [magazine subscriptions business] know that when renewal is automatic, and when people have to make a phone call to cancel, the likelihood of renewal is much higher than it is


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Chapter 9 - Status Quo Bias | Mental Models, Investing, And You when people have to indicate that they actually want to continue to receive the magazine. So next time when you apply for a new credit card and later figure out that you have been enrolled for couple of unnecessary “premium services” (which you of course don’t remember opting for), then don’t be surprised because the credit card application form probably had those options selected by default and you were actually required to specifically opt out of them. That’s an intelligent albeit a manipulative practice. These very dubious tactics makes me feel that the credit card industry is largely evil. In his awesome book Seeking Wisdom, Peter Bevelin writes… We prefer to keep things the way they are. We resist change and prefer effort minimization. We favour routine behaviour over innovative behaviour. The more emotional a decision is or the more choices we have, the more we prefer the status quo. This is why we stick with our old jobs, brand of car, etc. Even in cases where the costs of switching are very low. …We are more bothered by harm that comes from action than harm that comes from inaction. We feel worse when we fail as a result of taking action than when we fail from doing nothing. We prefer the default option, i.e., the alternative that is selected automatically unless we change it.


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Chapter 9 - Status Quo Bias | Mental Models, Investing, And You Of course people don’t blindly go with the current status. It’s only when they are either confused about the options or there is an uncertainty with a decision, that they choose to stick with the current state of affairs. Shane Parrish, in his wonderful blog Farnam Street, writes What happens when people are presented with difficult choices and no obvious right answer? We tend to prefer making not decision at all-that is, we choose the norm. In high-stakes decisions many options are better than the status-quo and we must make trade-offs. Yet, when faced with decisions that involve life-and-death trade-offs, people frequently remark “I’d rather not think about it.” In other words, when faced with a complex decision, people tend to accept the status quo, as reflected in the old adage, “When in doubt, do nothing.”

Image Source: www.dilbert.com What’s the reason behind this cognitive bias? Behavioural scientists believe that Loss Aversion Bias could be the culprit here. Any kind of change in the status quo brings the possibility of disruption in your comfort zone.


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Chapter 9 - Status Quo Bias | Mental Models, Investing, And You “The present may stink, but I still don’t want to lose it,” This is how we comfort ourselves when we face a need to change.

In Investing Several investors fall in love with their stocks in the garb of “buy and hold”. So they tend to protect the status quo by inventing new reasons to hold onto a dud investment. They will remain stuck in a status quo mode because they hate to admit they’ve lost money. Talking about status quo bias in the context of making the most efficient use of capital, Warren Buffett write We are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining status quo. That’s important: If horses had controlled investment decisions, there would be no auto industry.

Benefits of Status Quo I might have created a very negative picture about Status Quo Bias. It isn’t that bad either. It’s something which mother nature and evolution has ingrained in our psyche so it must have some purpose after all. There are some upsides to this bias too. Daniel Kahneman, in his book Thinking Fast and Slow, writes Loss aversion is a powerful conservative force that favours minimal changes from the status quo in the lives of both institutions and individuals. This conservatism helps keep


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Chapter 9 - Status Quo Bias | Mental Models, Investing, And You us stable in our neighborhood, our marriage, and our job; it is the gravitational force that holds our life together near the reference point. Nassim Taleb, in his book Antifragile, argues that Status Quo bias has been made to look unnecessarily bad and it can coexist with Do Something Bias. He writes Few understand that procrastination [possibly caused by Status

Quo

Bias]

is

our

natural

defense…I

use

procrastination as a message from my inner self and my deep evolutionary past to resist interventionism [do something bias] in my writing. Yet some psychologists and behavioural economists seem to think that procrastination is a disease to be remedied and cured. Psychologists document the opposite of interventionism, calling it the status quo bias. But it seems that the two can co-exist, interventionism and procrastination, in one’s profession (where one is supposed to do something) and in one’s personal life (the opposite). It depends on domain. It is a sociological and economic problem, one linked to norms and incentives rather than mental property. One of the ways in which Status Quo can be exploited for your benefit is to start an investment SIP. The reason SIP works is because once it’s setup people aren’t willing to take the pain of changing or stopping the SIP.

Don’t Let Status Quo Kill Your dreams Status quo bias holds a lot of relevance in how we live our lives. Most of us born in a middle-class family, and with protective parents, must have heard and experienced


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Chapter 9 - Status Quo Bias | Mental Models, Investing, And You endless stories of the dangers of being curious, standing up, standing out or breaking the tradition. Believe it or not, this bias manifests in minor things like taking the same driving route, shopping from the same old store, using the same old brands coffee, soap, toothpastes and washing powder. Deliberately building habits and consciously creating routines is a nice hack to simplify life and focus on important things but please understand that following a set pattern unconsciously could ruin the possibility of a promising future. Settling for the status quo is living for something less than God desires for us. It’s not the way you make your dreams come true. The defender of the status quo appeals to the known against the unknown, to the bird in the hand against the bird in the bush, to present possessions against future dreams, to established precedent and well-tried methods against all kinds of dangerous innovations. Dreamers have no respect for the status quo, says Steve Jobs in the famous Apple ad. May be it’s the time to question your assumptions about career, work, money and relationships. I hope you’re not running your life on autopilot mode. “Only one thing would be worse than the status quo. And that would be for the status quo to become the norm.” – Elizabeth Dole, 1999 campaign speech

Conclusion Remember that deciding to do nothing is also a decision. And the cost of doing nothing could be greater than the cost of taking an action. So how do you overcome Status Quo Bias?


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Chapter 9 - Status Quo Bias | Mental Models, Investing, And You One trick is to periodically revisit your processes and ask whether they are serving their purpose. I’ll close this with a quote from Thomas Henry Huxley, a 19th Century British biologist. He said Perhaps the most valuable result of all education is the ability to make yourself do the thing you have to do when it ought to be done whether you like it or not. It is the first lesson that ought to be learned and however early a person’s training begins, it is probably the last lesson a person learns thoroughly.


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Chapter 10 Twaddle Tendency Open any financial news channel and often you can find a so called expert being interviewed on his opinion about the direction of the stock market and health of the economy. On being asked such macro questions, the answer usually goes something like this –

Maybe the gentleman above has a point. But I just don’t see it. Do you? All I see is that his verbal diarrhea was completely useless. In most cases, the right (and honest) answer is – I don’t know.


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Chapter 10 - Twaddle Tendency | Mental Models, Investing, And You But how can experts not know? They are interviewed because they’re supposed to know about everything. And even if they don’t know, what is Google for? All the facts and figures are few key strokes away, so it’s a sin to not have an opinion about everything, especially if you’re considered an expert and probably being compensated by pay per word. So does it mean you are entitled to have an opinion on a subject just because you know a lot of facts and figures about it? Absolutely not! The more books I read, bigger is the realization that “I don’t know” is usually the most honest answer and also the toughest one, more so if the questions are about complex world around us. Then why is it that we find it so hard to acknowledge our ignorance? I don’t know the answer to that but my guess is that saying “I don’t know” puts the human ego at risk, and to avoid looking like fools, people end up talking something which usually is crap. That reminds me of this quote from Plato – Wise men speak because they have something to say; Fools because they have to say something. This ‘need to say something’ when one doesn’t have anything useful to say is what Charlie Munger dubs as Twaddle Tendency. The word ‘twaddle’ means a speech or writing that is silly, trivial, pretentious and not true. In other words – nonsense.


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Chapter 10 - Twaddle Tendency | Mental Models, Investing, And You Twaddle tendency is the smoke screen created by shallow thinkers to hide their ignorance. The unnecessary jargons and pompous language is used to disguise the intellectual laziness and half-baked ideas. Sometimes this trick works, but only for a short while. And many a times this twaddle tendency is so obvious that it’s embarrassing. Checkout this video to see how this girl made a big fool of herself. It wasn’t her ignorance about the subject but her unwillingness to say, “I don’t know” that put her into real trouble. She felt she had to say something smart so she just twaddled. Like other behavioural biases, this tendency is also tattooed deep into human behaviour and probably evolution is the culprit behind this. Often, if the person is not prepared to answer he or she will simply make something up instead of saying nothing at all. Recently I met an accomplished value investor and asked his feedback about how to make Safal Niveshak more valuable for its readers. Instead of falling for the Twaddle Tendency and make up something, he did the most honest thing. He said, “I can’t give you an answer off the cuff. Let me think about it.” It’s rare to find people like that. According to Munger, people waste a lot of time talking about meaningless stuff which then leads to equally meaningless activities. In Poor Charlie’s Almanack, Charlie Munger describes an interesting experiment … A trouble from the honeybee version of twaddle was once demonstrated in an interesting experiment. A honeybee


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Chapter 10 - Twaddle Tendency | Mental Models, Investing, And You normally goes out and finds nectar and then comes back and does a dance that communicates to the other bees where the nectar is. The other bees then go out and get it. Well some scientist, clever like B. F. Skinner [perhaps Charlie’s favorite scientist], decided to see how well a honeybee would do with a handicap. He put the nectar straight up. Way up. Well, in a natural setting, there is no nectar a long way straight up, and the poor honeybee doesn’t have a generic program that is adequate to handle what she now has to communicate. You might guess that this honeybee would come back to the hive and slink into a corner, but she doesn’t. She comes into the hive and does an incoherent dance. Well, all my life I’ve been dealing with the human equivalent of that honeybee. And it’s a very important part of wise administration to keep prattling people, pouring our twaddle, far away from the serious work. In 1998 Wesco meeting, Charlie added … I try to get rid of people who always confidently answer questions about which they don’t have any real knowledge. To me they are like the bee dancing its incoherent dance. They are just screwing up the hive. Twaddle is perhaps harmless for the twaddler (if there is such word) except that he loses respect in the eyes of wise people. But if you’re at the receiving end and your bullshit filter isn’t strong enough to separate the twaddle from real talk, then you run a risk of not only wasting your time hearing the trash talk but may also end up losing your money and resources. In fact, most of the talking heads on financial TV (even the non-financial ones) are dishing out twaddle.


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Chapter 10 - Twaddle Tendency | Mental Models, Investing, And You

Charlie Munger is quite fond of the word and has used it at multiple occasions. It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books, so there’s a lot of twaddle and fuzzy concepts that have been introduced that don’t add much. (WESCO annual meeting, 2000) I think the notion that liquidity of tradable common stock is a great contributor to capitalism is mostly twaddle. The liquidity gives us these crazy booms, so it has as many problems as virtues. (BRK Annual Meeting, 2004) At Farnam Street, Shane Parrish writes… While we all hold an opinion on almost everything, how many of us do the work required to have an opinion? The work is the hard part. You have to do the reading. You have to talk to anyone you can find and listen to their arguments. You have to think about the key variables that govern the interests. You have to think about your biases and incentives. You have to think not emotionally but rationally. And you need to become your most intelligent critic. Part of doing that means you need to have the intellectual honesty to kill some of your best loved ideas.


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Only then, when you can argue better against yourself than others can you hold an opinion. After you’ve done that, after you’ve done the work, that is the time you can say “Hey, I can hold this view, because I can’t find anyone else who can argue better against my view.” Simply regurgitating facts and anecdotes doesn’t add any value to an argument. Unless somebody has struggled with an idea and spent some mental energy thinking about it, his or her knowledge is pretty superficial, second hand and precursor to a twaddle. Munger says, “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.” Unless one qualifies Munger’s test to have an opinion, whatever he or she speaks on a subject, especially with overconfidence, is possibly just twaddle. In his book The Art of Thinking Clearly, Rolf Dobelli summarizes the idea very well … Verbal expression is the mirror of the mind. Clear thoughts become clear statements, whereas ambiguous ideas transform into vacant ramblings. The trouble is that, in many cases, we lack very lucid thoughts. The world is complicated, and it takes a great deal of mental effort to understand even one facet of the whole. Until you experience such epiphany, it’s better to heed Mark Twain: ‘If you have nothing to say, say nothing.’ Simplicity is the zenith of a long, arduous journey, not the starting point. So how do you identify a twaddle?


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Whenever you hear a talk or read a statement with signs of overconfidence, coloured with hindsight bias, suggesting anecdotal evidences, predictions about unknowable, and high sounding complicated jargons, you can be pretty sure that the person is either lying or mad and possibly both.

Conclusion I don’t know who said this but there is some degree of truth to this statement – Unsolicited advices are like armpits. Everyone has one and they stink. Based on my personal experience I know something needs to be ignored when someone pulls me aside and gives a free and especially an unsolicited advice. Here’s how Elon Musk cuts through the twaddle when he is recruiting people … When you struggle with a problem that’s when you understand it…when I interview people, I ask them to tell me about the problems that they worked on and how they solved them. And if someone is really the person who has solved it then he would be able to answer it at multiple levels…if they aren’t then you can say ...oh! this isn’t the person who really solved the problem. Because anyone who struggles hard with a problem, never forgets it. It’s amazing how quickly you can find somebody’s edge of knowledge. Just ask why a couple of times and you can see how deeply that person has thought through the problem or issue. That’s what Musk means by ‘multiple levels’.


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Chapter 10 - Twaddle Tendency | Mental Models, Investing, And You And do you know the most dangerous form of twaddle? It’s the one which you tell yourself. Because the easiest person to fool is always yourself, says Richard Feynman.


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Chapter 11 Reciprocation Tendency Few months back I was watching a Bollywood action crime drama movie ‘Badlapur’. The movie portrays the human emotion of ‘revenge’ and how far someone can go to seek it. The protagonist in the movie patiently waits 15 years to avenge his wife’s and son’s murder. The urge to take revenge can manifest in smallest of things. Someone cuts you off in the traffic and the first thought that comes to mind is to get back at him and settle the account. In fact, people getting shot dead in road rage incidents isn’t uncommon these days. So what could be the reason for this strong force, a need to reciprocate the wrongdoing, in human behaviour? Is it just the anger? Or is it the resentment for receiving an unfair treatment? Let’s use the inversion mental model (Chapter 44) and turn the question around. If humans can have such a strong need to reciprocate to an injustice, can they also have a similar need to reciprocate a favour? To answer that question in a truly multidisciplinary way, let’s explore the field of Psychology. Robert Cialdini, a professor of Psychology and author of wildly popular book Influence: The Psychology of Persuasion, has done extensive research on human behaviour. One of the human biases that he talks about in his book is Reciprocity Bias. According to Cialdini – the rule for reciprocation is one of the most potent weapons of influence around us.


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Chapter 11 - Reciprocation Tendency | Mental Models, Investing, And You The rule says that we should try to repay, in kind, what another person has provided us. We are obligated (not by some external force but an internal urge) to the future repayment of favors, gifts, invitations, and the like. This rule is deeply implanted in us by the process of socialization that homo sapiens has undergone over thousands of years. Each one of us has been taught to live up to the rule, says Cialdini “and each of us knows about the social sanctions and derision applied to anyone who violates it.” So there is a strong social stigma attached to the act of not returning a favour. Not just that, the force of reciprocity is not only extremely strong but very subtle too. Cialdini compares the psychological force of reciprocity to a martial arts form called jujitsu. In jujitsu the key is to use the force and energy of the opponent against him. It exploits and manipulates the naturally present principles of gravity, leverage, momentum, and inertia. A skilled jujitsu artist can defeat an opponent without exerting much personal force. Surprisingly, to the onlookers (including the opponent), the manipulation is almost invisible. Cialdini writes … One of the reasons reciprocation can be used so effectively as a device for gaining another’s compliance is its power. The rule possesses awesome strength, often producing a “yes” response to a request that, except for an existing feeling of indebtedness, would have surely been refused. By the way, here is another reason why you shouldn’t miss this book – Charlie Munger was so impressed with Cialdini’s work that he gifted a Class A share of BRK (which was worth more than USD 100,000 at the time) to him.


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Chapter 11 - Reciprocation Tendency | Mental Models, Investing, And You It wouldn’t be an overstatement if I say that your Latticework of Mental Models is incomplete without this book. So do yourself a favour (no pun intended) and buy the book. The rule of reciprocation is so strong that it simply overwhelms the influence of other normal factors that affect the decision making. This makes it a powerful weapon of influence. People who we usually dislike, including pushy salesmen, can make us acquiesce to their requests if they provide us a small (even unwanted) favour beforehand. Remember those free samples in the supermarket cookie shop? Or those welcome beverages offered to you and your wife in a jewelry store? Well I am not debating your prowess for judging the quality of precious jewels but your jeweler knows something more. He knows how to play a mental jujitsu and subconsciously trigger the rule of reciprocation. It’s fascinating how the rule of reciprocation can be deployed by some clever salespeople in an indirect way without actually doing any favour. I remember meeting a financial expert, a salesman in disguise, who first offered me a premium credit card with loads of features including elite club memberships and access to 5 star lounges at the international airports (ironically to a guy who had never been on an airplane till then). I had to refuse but not without feeling guilty for having wasted his time on me. Then he took out another colourful brochure and showed me the benefits of lifetime free credit cards. Did I take that? Of course! It didn’t matter that I had no need for credit card. He had done me a favour by offering concession on his product. I had to comply under the excruciatingly heavy weight of reciprocation.


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Chapter 11 - Reciprocation Tendency | Mental Models, Investing, And You Cialdini dubs this flavour of reciprocity as rejection-then-retreat (RTR) technique. The idea is to first make a larger request, one that will most likely be rejected followed by retreating to a smaller request which you were really interested in all along.

Image Source: Influence – Psychology of Persuasion

In Business and Investing Because of the subconscious effect of reciprocity, the corporate code of conduct laid out by big organizations often prohibit its employees from taking any favours from their vendors/suppliers or customers. They understand that under the subconscious influence of reciprocity, people can unknowingly end up giving unfair advantage to people who they are dealing with. Here’s an excerpt from Poor Charlie’s Almanack – Wise employers, therefore, try to oppose reciprocate-favor tendencies of employees engaged in purchasing. The simplest antidote works best: Don’t let them accept any


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Chapter 11 - Reciprocation Tendency | Mental Models, Investing, And You favors from vendors. Sam Walton [founder of Wal-Mart] agreed with this idea of absolute prohibition. He wouldn’t let purchasing agents accept so much as a hot dog from a vendor. Given the subconscious level at which much Reciprocation Tendency operates, this policy of Walton’s was profoundly correct. Reciprocity, especially RTR, is an important negotiation tool. Labor negotiations often begin with extreme demands (to a reasonable limit) that they don’t actually expect to win but from which they can retreat in a series of seeming concessions designed to draw real concessions from the opposing side. Perhaps that gives an edge to the first mover in negotiations.

Image Source: Dilbert.com So next time when you see a positive analyst report for a seemingly dud business, it’s likely that the analyst was treated well with good food and expensive drinks in the company’s investor presentation meeting.


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Chapter 11 - Reciprocation Tendency | Mental Models, Investing, And You And when you attend the next AGM, think twice before accepting any freebies or free lunch from the management. Whoever said – there are no free lunches – was probably thinking about rule of reciprocation.

How to Fight Reciprocity The first problem in countering the reciprocity bias is that you can’t know beforehand whether the offer is an honest or whether it is the initial step in an exploitation attempt. You might end up rejecting the legitimate favours coming from individuals who had no ulterior motives. Cialdini suggests – As long as we perceive and define his [person offering a favor] action as a compliance device instead of a favor, he no longer has the reciprocation rule as an ally. If you find yourself in a possible reciprocity-situation with the realization that the primary motive is to sell you something, all you need is a mental act of redefinition. Look at the favour not as gift but as a sales device. So the trick is to be alert and cultivate a habit of catching yourself in such situation. Being aware of it can diminish the force exerted by the rule of reciprocation. Here’s Charlie Munger’s suggestion to save yourself from this bias – The standard antidote to one’s overactive hostility is to train oneself to defer reaction. As my smart friend Tom


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Chapter 11 - Reciprocation Tendency | Mental Models, Investing, And You Murphy so frequently says, “You can always tell the man off tomorrow if it is such a good idea.”

The Positive Side of Reciprocity In his book, The Education of A Value Investor, Guy Spier writes … I decided that I would write three letters per working day, or 15 per week. I began to thank people for giving a great speech, for sending me their investor letter, for providing a great meal in their restaurant, for inviting me to their conference…At first, my letter-writing experiment was quite calculated, since I did it with an explicit desire to improve my business…But it started to feel really good… This small action of writing hundreds of letters a year was transformational for me…this habit of writing letters is an incredibly effective way of compounding goodwill and relationships instead of merely compounding money… My letter-writing crusade had begun as a way of marketing my fund, but it ended up giving me a richness of life that I could hardly have imagined. Rather than becoming a good salesperson, I found myself starting to care about the people I was writing to and to think about how I could help them. The paradox is that, as I became more authentic and discarded my agenda, people became more interested in investing in the fund. As a corollary to the rule of reciprocation, let me dispense a free but not-be-taken-asa-favour advice here.


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In life and in business, focus on seeking those who you can help instead of who can help you. And then let reciprocity weave its magic.

Conclusion We started this chapter with an intention to explore the psychology of revenge. Revenge, as it turns out, is the ugly side of reciprocity. Revenge breeds counterrevenge and you soon find yourself in a full-scale war. Confucius said, “Before you embark on a journey of revenge, dig two graves.” Mahatma Gandhi seemed to agree with him when he said, “An eye for eye only ends up making the whole world blind.” So if you do want to get even with people, do so with those who have helped you. At the same time be careful while accepting any favours, for the subconscious force of positive reciprocity can make you take decisions which aren’t always in your best interest. Perhaps Bollywood star Salman Khan says it best. (Rough translation: Do me a favour, that don’t do me any favours!) To that, I have nothing to add.


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Chapter 12 Gambler’s Fallacy Let’s start with a small riddle. A man, who is a statistician by profession, believes that his next child will be a girl since his wife has already borne him three sons. Do you find his argument convincing? The argument intuitively doesn’t feel right. But why? We’ll circle back to this puzzle but before that let me indulge you in another interesting thought experiment. Imagine yourself as a spectator in a coin flipping tournament. You notice that in one of the plays, the coin has landed on heads for 5 consecutive flips. If you were given an opportunity to bet on the next flip, would you bet on heads or tails? I know you’re a value investor and don’t believe in speculating or gambling away your hard earned money on frivolous coin flipping tournaments, but this being a thought experiment I would request you to play along. So what’s your answer? The basic concepts of probability tell us that for random events like outcomes of coin flipping, both the head or tail are equal likely. In other words, the probability of a head and a tail are both 1/2 (0.5).


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Chapter 12 - Gambler’s Fallacy | Mental Models, Investing, And You So using my elementary knowledge of probability, I would reason that the universe will try to balance out the too many heads. When I use this argument to put my bet on tails, I am falling for a bias called Gambler’s Fallacy. The Gambler’s Fallacy is the mistaken belief that, if something happens more frequently than normal during some period, it will happen less frequently in the future, or that, if something happens less frequently than normal during some period, it will happen more frequently in the future (presumably as a means of balancing nature). (source: Wikipedia) That explains why our statistician friend’s argument is flawed. The gender of the fourth child is causally unrelated to any preceding chance events or series of such events. His chances of having a daughter are no better than 1 in 2 i.e., 50-50. With independent events (the gender of kids, result of toss using a fair coin, etc.) there is no harmonising force at work. The coin doesn’t know that it had landed heads in the last 5 tosses. The most famous example of the gambler’s fallacy occurred in a game of roulette at the Monte Carlo Casino in 1913 when the ball fell in black 26 times in a row. This was an extremely uncommon occurrence, although no more or less common than any of the other 67,108,863 sequences of 26 red or black. Gamblers lost millions of francs betting against black, reasoning incorrectly that the streak was causing an “imbalance” in the randomness of the wheel, and that it had to be followed by a long streak of red. (source: Wikipedia) So why is it called a gambler’s fallacy? Because it’s rampant among gamblers and speculators.


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Chapter 12 - Gambler’s Fallacy | Mental Models, Investing, And You There was a guy who claimed that he had a scientific way of playing the lottery. He diligently maintained a spreadsheet of winning numbers and would bet on those numbers which had appeared the least. Alas! another victim of Gambler’s fallacy. Now if a coin (a fair one) has equal probability (50:50) of turning heads or tails then why is it fallacious to expect a tail after 5 consecutive heads? That’s a fair question to ask. To answer that, let me take help from Daniel Kahneman. In his book, Thinking Fast and Slow, Danny writes … People expect that a sequence of events generated by a random process [coin toss] will represent the essential characteristics [equal probability of head and tail] of that process even when the sequence is short [few tosses]. In considering tosses of a coin for heads or tails, for example, people regard the sequence H-T-H- T-T-H to be more likely than the sequence H-H-H-T-T-T, which does not appear random, and also more likely than the sequence H-H-H-HT-H, which does not represent the fairness of the coin. Thus, people expect that the essential characteristics of the process will be represented, not only globally in the entire sequence, but also locally in each of its parts. A locally representative sequence [the sequence of 5 heads which you observed], however, deviates systematically from chance expectation: it contains too many alternations and too few runs. Another

consequence

of

the

belief

in

local

representativeness is the well-known gambler’s fallacy. After observing a long run of red on the roulette wheel, for example, most people erroneously believe that black is now


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Chapter 12 - Gambler’s Fallacy | Mental Models, Investing, And You due, presumably because the occurrence of black will result in a more representative sequence than the occurrence of an additional red. Chance is commonly viewed as a self-correcting process in which a deviation in one direction induces a deviation in the opposite direction to restore the equilibrium. In fact, deviations are not “corrected” as a chance process unfolds, they are merely diluted. Kahneman’s insights are remarkable. So if you didn’t understand the above two paragraphs, please read them slowly and then re-read them. Now if you were given an opportunity to bet on many such tosses, say 100 tosses, what would be your strategy for betting? Again the assumption being that it’s a fair coin (with no specific bias for either head or tail) and with the knowledge that probabilities are still 50:50. Kahneman explains this using an anecdote about famous economist Paul Samuelson. He writesThe great Paul Samuelson—a giant among the economists of the twentieth century—famously asked a friend whether he would accept a gamble on the toss of a coin in which he could lose $100 or win $200. His friend responded, “I won’t bet because I would feel the $100 loss more than the $200 gain. But I’ll take you on if you promise to let me make 100 such bets.” Unless you are a decision theorist, you probably share the intuition of Samuelson’s friend, that playing a very favorable but risky gamble multiple times reduces the subjective risk. Samuelson’s friend was pretty smart. He understood that Gambler’s fallacy arises out of a belief in a law of small numbers, or the erroneous belief that small samples must


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Chapter 12 - Gambler’s Fallacy | Mental Models, Investing, And You be representative of the larger population. Hence he was willing to bet on the aggregate outcome of bigger sample size than a single outcome. You probably noticed that I have been mentioning the use of a fair coin for our tosses. A fair coin ensures the pre-condition for a gambler’s fallacy to hold true, i.e. independent events.

Gambler’s Fallacy – Reversed! If I told you that in the same coin tossing tournament, there is play where the coin has turned heads for 50 consecutive tosses. What would you bet on for the 51st coin toss? The probability of that happening, using a fair coin, is 1 in a 1100 trillion but there’s also a chance that the coin is biased. A biased coin or an imperfect roulette wheel can also lead to outcomes like 5 consecutive heads but for totally different reasons. In these cases, the gambler’s fallacy might superficially seem to apply, when it actually does not. If you suspect that you’re dealing with a biased coin or a loaded dice, it’s reasonable to expect that long streak of skewed outcomes are not due to randomness. But sometimes human brain takes it too far in the other direction when a belief in the idea of hot hand takes root. This is the reverse of gambler’s fallacy, also known as hot hand fallacy. It originates from basketball where players who scored several times in a row are believed to have a hot hand, i.e. are more likely to score at their next attempt. In cricket, players are often declared to be “in-form” and are expected to consistently perform above average until the form lasts. Perhaps a hot-bat fallacy!


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Chapter 12 - Gambler’s Fallacy | Mental Models, Investing, And You At first the idea of gambler’s fallacy might look paradoxical to the mental model of mean reversion (Chapter 19) but it’s not. In his book, The Art of Thinking Clearly, Rolf Dobelli explains the subtle difference between the two. …if you are experiencing record cold where you live, it is likely that the temperature will return to normal values over the next few days, If the weather functioned like a casino, there would be 50% chance that the temperature would rise and a 50% chance that it would drop. But the weather is not like a casino. Complex feedback (Chapter 32) mechanisms in the atmosphere ensures that extremes balance themselves out. So,

take

a

closer

look

at

the

independent

and

interdependent events around you. Purely independent events really only exist at the casino, in the lottery and in theory. In real life, in the financial markets and in business, with the weather and your health, events are often interrelated. Which means a domain prone to truly random and independent events, like a casino, is more prone to gambler’s fallacy. However, in systems which behave like complex adaptive systems (Chapter 24) i.e. prone to self-correction, both mean reversion (negative feedback loops) and extreme outcomes (positive feedback loops) are a possibility.

In Investing In stock markets how many times have we heard, ‘whatever goes up must come down’ or ‘how much more can it drop?’.


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Chapter 12 - Gambler’s Fallacy | Mental Models, Investing, And You These beliefs are a manifestation of gambler’s fallacy in investor’s behaviour. Vishal is fond of quoting the example – A stock that falls 95%, first fell 90% and from that level fell another 50%. When Warren Buffett said, “turnarounds seldom turn” he probably had gambler’s fallacy in mind. Expecting that the future events will smoothen out the stock prices, just because it has been falling for ‘n’ continuous trading days, is an irrational way of thinking. Sometimes investors abruptly change their belief from gambler’s fallacy to hot-hand fallacy. When their patience runs out, having lost money by betting on outcomes which are supposedly “long overdue”, they tend to go overboard in assuming that a stock has come to its “form” and will continue its trend. They bet heavily on the new “trend” and right then the tide turns and the roaring market makes a mincemeat out of those unsuspecting hot-hand believers.

Conclusion Typically, humans intuitively find it hard to deal with randomness as a result we tend to put a tremendous amount of weight on previous events, believing that they’ll somehow influence future outcomes. Gambler’s fallacy dictates that the idea of “balancing force of the universe” is a baloney. Gambler’s fallacy requires you to understand the basics of probability. If you aren’t acquainted with the basic probability concepts, you need to learn it else you might end up like the proverbial (as described by Charlie Munger) single legged man in an asskicking contest.


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Chapter 13 Mental Accounting Imagine yourself with your friend in the Sin City, i.e. The Las Vegas. While walking on the Las Vegas Boulevard you find a $10 bill sticking out from the side of the pavement, as if it’s telling you “Please Pick me!”. You pick it up and feel ecstatic about your moderately good fortune. “Wait a minute! Is that a sign from the universe?”, a strange but perfectly reasonable thought appears in your mental screen. Perhaps Lady Fortuna is nudging you to try out your luck using this $10 totem. After all it’s the Las Vegas. The Gambler’s Paradise. Your friend however is tired and heads back to the hotel. But you just can’t ignore the sign from above. Taking this as an omen, you enter the first Casino and head straight to the roulette table. You want to bet on your lucky number 7. Sure enough, the roulette ball hits 7 and 35-1 bet wins you $350. You let your winnings ride and the ball lands on 7 again, paying you $12,250. And so it goes. Within an hour you are a multimillionaire with $50 million in your kitty. Feeling like Daniel Ocean from Ocean’s Eleven, you intend to bring the house down with your raging streak of luck. Being just one step away from becoming a billionaire you bet all your money on number 7 one last time – only to lose it all this time. Broke, dejected and little flabbergasted you walk down several miles to join your friend in the hotel room. “Where were you man?” asks your friend as you enter the room. “Playing roulette.” You’re still feeling a little shaken. “How did you do?”


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You cut the story short and tell him, “Not bad. I lost ten dollars.” My question to you is – “Did you really just lose $10?” If your answer is yes, then perhaps you are unaware of the behavioural bias called Mental Accounting. This concept, first proposed by University of Chicago’s Richard Thaler, states that human beings have the tendency to categorize and handle money differently depending on where it came from, where it is kept, or how it is spent. Are you confused a bit? Here is another thought experiment to get a better handle on curious effects of mental accounting. Try to answer the questions honestly.

The Case of Lost IPL Ticket Imagine you have bought a ticket to an IPL cricket match where your favourite team is playing. When you reach the venue you realize you’ve lost the ticket, which cost you 2000 rupees. Are you going to spend another 2000 bucks and buy a new ticket at the venue (assuming it’s available at the ticket counter) to see the match? Your answer would probably be no. That was my answer too when I heard this for the first time. Now let’s re-construct the same scenario little differently. Instead of buying the ticket beforehand you’re standing in the line to buy the ticket in the stadium. At the ticket counter you realize that you’ve lost 2000 rupees cash somewhere on your way to the stadium. Still, you have more than enough in your wallet to buy the ticket. What would you do in this case? Buy a ticket?


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Chapter 13 - Mental Accounting | Mental Models, Investing, And You Intuitively, like most people, you’d probably answer yes. Like I did when I was asked the same question. Irrespective of the fact, whether you buy the ticket again or not, aren’t both the cases setting you back by 2000 rupees? Then why is your behaviour different in above two cases? You might say that the loss of the ticket and the loss of 2000 rupees aren’t the same. It’s possible that I might find either the ticket or the 2000 rupees later (that it’s misplaced instead of lost). However, the ticket will have become useless to me whereas the 2000 rupees will not have. But not everybody is so rational (and so hopeful about lost money) while standing at the ticket counter. This inclination of human mind to mentally separate the two losses in different categories is a classic case of mental accounting. We shift perspectives on money as the surrounding circumstances change. We tend to mentally put money into different ‘accounts’ and that determines how we think about using it. The economic theory says that money is fungible, and there should be no difference in the way we spend the bonus money and the salary income. Think about it for a moment, won’t it sound ridiculous if your local grocery store guy tells you, “Sir! Since you’re paying using the money from your salary, I am going to give you 20% discount. However, if you want to pay using the money from your Diwali bonus, then I’ll charge you 20% extra.”? But a similar logic seemed perfectly reasonable at the IPL ticket counter.

Earned Money Vs Found Money Have you ever been guilty of spending your stock dividends (or the interest on fixed deposits) as if it was free money? Before you answer that let me admit that I have been


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Chapter 13 - Mental Accounting | Mental Models, Investing, And You guilty of this mistake multiple times in the past. I used to mentally compartmentalize the dividend money as excess money. The outcome is that my salary (earned money) gets spent on my needs first however the year-end bonus (found money) gets spent on discretionary items, like vacations, first. Do you know somebody who pays 18% interest on revolving loans on credit card in spite of having money invested in bond funds earning 7% returns? It’s pretty obvious that his mental wall separating the two accounts is not going to come down for a long time. For that matter plastic money (credit cards) is the scariest exhibit of mental accounting for messing up your personal finances.

Lollapalooza of Mental Accounting The funny thing about mental biases is that they usually don’t come alone. In most cases there are multiple biases acting together creating a lollapalooza effect. So even in this case there is a subtle interplay of mental accounting and contrast effect. Let me share my personal experience. Every time I go for my monthly grocery shopping, I am always surprised at number of unplanned small items I end up picking. A 10 rupees cookie pack, a 15 rupees coffee sachet (even though I am a tea drinker) and a glittery ball pen displayed near the billing counter. We justify these small items purchases in contrast to a usually larger grocery bill. This is what contrast bias does to you. I would never have bought those items if my final bill amount was going to be small. A brilliant insight found in the book Why Smart People Make Big Money Mistakes –


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Chapter 13 - Mental Accounting | Mental Models, Investing, And You Mental accounting helps explain the one of the greatest puzzles of personal finance – why people who don’t see themselves as reckless spenders can’t seem to save enough…Although people are cost conscious when making large financial decisions – such as buying a house, car, or appliances – mental accounting makes them relax their discipline when making small purchases. The cost of such purchases gets lost among larger expenses, such as the week’s grocery bill…The problem, of course, is that while you might purchase a car or refrigerator every few years, you buy groceries every week or every day. Being costconscious when making little purchases is where you can often rack up big savings. By the way, a side note – Psychologists suggest that you should never go for grocery shopping when you are feeling hungry. You would end up buying stuff that you don’t need unnecessarily bloating up your bill. Sales people understand these quirks in human behaviour. They don’t shy away from exploiting these biases for their benefit. Now you can guess why consumer electronic stores promote the extended warranties so much at the time of purchase. Or why insurance agents push those exotic policy riders.

Side Effects of Mental Accounting In some cases, mental accounting can actually come back and bite you harder. Let me use my favourite thinking tool -hypothetical situations - to explain the point – Let’s say you plan to spend 20,000 rupees for buying a smartphone. On the day of the purchase, you suddenly find a 10% discount deal and end up saving 2000 rupees on your phone. Research has shown that most people in this scenario start accounting


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Chapter 13 - Mental Accounting | Mental Models, Investing, And You those 2000 rupees as ‘found money’ and end up spending not just those 2000 bucks but some more to use up the free money. So you see how the ‘bonus money’ can sometimes do more harm than good. It’s another mental accounting mind bender.

Overcoming Mental Accounting If your grandmother gifted you 1000 rupees on your birthday, are you going to use that money for paying your electricity bill? Sounds insensitive right? You aren’t going to splurge the same money on gambling either. That’s the basic idea for countering the harmful effects of mental accounting. Convert every inflow mentally into “earned income” and then evaluate what do you want to do with it. So imagine that all kinds of income are earned income including dividends from stocks, interest on fixed deposits, money found on the road, the Diwali bonus from your employer, income tax refunds and for that matter even the money gifted from your grandmother. Second trick is to delay spending any ‘bonus’ money. Just keep it in a fixed deposit for a month. Sleep over it before splurging it on anything. You would be surprised how quickly your brain re-categorizes your ‘bonus’ money to ‘earned’ money. Another common sense approach is to limit the use (rather abuse) of plastic money. I have gotten into the habit of using my credit card only for online purchases (that too I prefer net banking or even cash on delivery option). Of course that increases my trips to the ATM but that’s the whole point. Spending money shouldn’t become so convenient that you end up spending all.


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Exploiting Mental Accounting I am a big fan of Nassim Taleb’s books. I like experimenting with his mental models wherever I can find some useful application. Antifragility is one such concept, which says that you arrange your affairs in such a manner that harmful effects generated by uncertainties (mental accounting) of life make you stronger and better. So let’s see how we can actually not just shield ourselves from ill effects of mental accounting but use it for our benefit. This starts with the understanding that all human biases have a reason behind them. Let’s assume that you are a perfectly rational human being. Before spending any money, you would always check the opportunity cost i.e. before buying nice t-shirt for yourself, you would ask what other things you are foregoing in order to have the new shirt. Obviously this process is too rigorous and nobody has the time and mental capacity to go through this exercise every time we spend money. So we fall back to the behavioural short cut of mental accounting by pre-assigning money for each cause. Explained that way mental accounting doesn’t look all that evil. It gives us an easy and simple way to carry out our day to day financial transactions without too much of cognitive overload. When you associate your money to a specific emotional goal, you channelize the will power to save money for that goal. Saving money for years to buy that dream house of yours or to buy that long cherished dream vacation in Europe. In fact, the first advice given by any reasonably good personal financial advisor is to create a do-not-touch emergency fund for yourself. The idea is to stash away some part of your saving in an ultra-safe asset and not to touch it unless there is an emergency. Here is an example of how famous Hollywood actor Dustin Hoffman used mental accounting when he was struggling to make a career in Hollywood.


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Conclusion So the central idea here is that money is not truly fungible in a human mind, and this oddity produces an irrational behaviour while dealing with certain situations involving money. Although mental accounting can distort your thinking process and lead you to make erroneous decisions, with proper awareness it can also be used for our benefit. If I were to summarize mental accounting in one sentence, it would be – Reimbursements send people on trips to the bank, and bonuses send people on trips to Goa.


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Chapter 14 Social Proof Imagine it’s Friday evening, the beginning of a long weekend, and you decide to watch the latest action flick in your nearest multiplex. Since you don’t want to miss the beginning of the movie, you decide to take the elevator as soon as you reach the mall. Although the health freak inside you is mad because you promised him to always take the stairs in a mall. The moment you enter the elevator you notice that there are half a dozen other people inside but strangely everybody is facing towards the back of the elevator. Isn’t that odd? So what would you do in this situation? Can you guess what most people do in such situation? Watch this video of a social experiment which tried to capture people’s reaction in the similar situation. Most people fall for this and blindly copy the actions of others without resisting or questioning. They assume that if everybody is doing it, there must be some reason for it. They fear looking like an odd man out. This tendency is called Social Proof. As per Wikipedia, social proof is: A psychological phenomenon where people assume the actions of others in an attempt to reflect correct behavior for a given situation. This effect is prominent in ambiguous social situations where people are unable to determine the appropriate mode of behavior, and is driven by the assumption

that

surrounding

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possess

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Chapter 14 - Social Proof | Mental Models, Investing, And You In short, monkey see, monkey do. That’s how you can explain the social proof tendency to your kids. Can you guess what’s shown in the picture below?

Image Source: bashny.net If you can’t make out, that’s a top view of a flock of sheep leaving the stall. All the sheep are stampeding to pass through the narrow gate. And there is no fence, only the gate! Social proof, also known as herding, is a terribly useful mental model from psychology. So let’s dig deeper.


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Chapter 14 - Social Proof | Mental Models, Investing, And You Humans are social animals. We want what others want and we tend to avoid what others avoid. When we’re uncertain, in an unfamiliar environment, we try to resolve the ambiguity by following others. But why is it so? Why do we follow the herd? To answer that you’ll have to cross the boundaries of psychology and step into the discipline of biology. Darwin’s Theory of Evolution give us some clues. In the hunter gatherer environment if you saw a group of panic struck homo sapiens running past you, the obvious conclusion was that they were being chased by a ferocious, and perhaps hungry, beast. It gave you a tremendous evolutionary advantage if you started following the herd behaviour under such circumstances. So that’s how the social proof tendency has been wired in human behaviour. Although we don’t live in the hunter gatherer environment anymore it still makes our lives seemingly easier if we just stay in the herd. Being part of the majority acts as a protection from criticism. If we’re wrong and everybody else is wrong too, we get blamed less.

Benefits of Social Proof It would be unfair to say that every social proof situation is bad. As we have seen that social proof tendency, like many other behavioural biases, came into human behaviour because of evolutionary reasons so it must have utility in carrying out routine activities. We see this helping us in our daily lives. From our selection of books at Amazon to relying on other people’s experience with a particular seller on eBay, we rely on other people’s decisions to make our own.


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Chapter 14 - Social Proof | Mental Models, Investing, And You Most of the times, these decisions are good and extremely helpful. In his wonderful work, The Wisdom of Crowds, James Surowiecki argues convincingly that the quality of decisions taken by a group is usually better than the one that a single member of group will make. In fact, e-commerce and social networking websites spend a lot of efforts in developing strong recommendation engines which are primarily based on the idea of “social proof” i.e. figuring out the most popular products (or online content). These social proof based recommendations help us discover the right products. Herding becomes particularly useful in ambiguous situations because it simplifies the decision making process. So there is nothing wrong in making small decisions based on social proof. It actually makes our lives easier and saves a lot of time and energy. Social proof can be a wonderful tool for nudging people to adopt good behaviour and follow best practices. In the book, Yes! 50 Scientifically Proven Ways to Be Persuasive, authors describe an interesting experiment which was conducted in a hotel to promote recycling of used towels by the hotel guests. The researchers placed a message card indicating that the majority of guests already chose to reuse their towels. Guests whose cards subtly employed the principle of social proof were 26% more likely to recycle their towels than those who saw only the basic environmental protection message. That’s a big improvement at no additional cost to the hotel. When it comes to making crucial decisions, you have to take a step back and think for yourself. And when you fail to do that you not only miss tremendous opportunities but can often get into serious troubles. This is the dark side of social proof.


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The Dark Side of Social Proof Routinely it’s pretty much safe, even efficient, to follow others. However, it can have dangerous consequences when the stakes are high. It won’t be an overstatement if I say that social proof has the potential to cost you your life. The story of lemmings jumping off the cliff in large groups may be apocryphal but it’s scary when the herd behaviour drives even humans to commit dangerously foolish acts. In 1978, under a strong spell of social proof bias, more than nine hundred followers of the cult leader Jim Jones and his organization committed mass suicide. As far as human behaviour is concerned, German-Swiss philosopher Friedrich Nietzsche was accurate in his observation when he said: Madness is rare thing in individuals – but in groups, parties, peoples, and ages it is the rule. Skilled marketing people are experts in persuasion techniques and adept at exploiting such behavioural biases to shove their products down the customer’s throat. Social proof is what is at work in canned laughter – what you hear in comedy shows. The reason such laughter exists is because it causes the audience to laugh longer and more often when humorous material is presented and to rate the material as funnier. In fact, you will hear the laughter even when there’s nothing to laugh about. I propose they add such laughter to business channels as well.

In Investing It’s sad but most of the financial industry is plagued by ill effects of social proof. Warren Buffett’s writes -


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Chapter 14 - Social Proof | Mental Models, Investing, And You Most managers have very little incentive to make the “intelligent but with some chance of looking like an idiot” decision. Their personal gain/loss ratio is too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.) If you start analysing the portfolios of majority of the mutual fund managers, you will discover that they’re very similar or differ only minutely and very rarely we observe any manager taking a very big and ‘against the consensus’ call. It’s no surprise that their returns are also not much different. John Maynard Keynes, one of the most influential economist of 20th century, captured this tendency with a sarcastic comment: Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. A lot of investors also exhibit social proof in their investment decisions. They hold a particular stock because most of the people in their ‘investing groups’ are positive on a stock. This act of mindless copying also leads to mindless selling in tough times because it’s difficult to buy with ‘conviction’ in tough times (and low prices) when there is no knowledge base to get that ‘conviction’ at the very first place.

Overcoming Social Proof One of the best ways to brace yourself from being a victim of social proof is to choose your role models carefully. Your heroes can serve as reference points for making a decision about our own behaviour.


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Chapter 14 - Social Proof | Mental Models, Investing, And You Guy Spier, author of the book The Education of a Value Investor, shares a wonderful strategy in his book: “here is a wisdom here that goes far beyond the narrow world of investing. What I’m about to tell you may be the single most important secret I have discovered in all my decades of studying and stumbling…What I stumbled upon was this. Desperate to figure out how to lead a life that was more like his [Warren Buffett], I began constantly to ask myself one simple question: “What would Warren Buffett do if he were in my shoes?” …The minute I started mirroring Buffett, my life changed. It was as if I had tuned in to a different frequency.” So find out your heroes and populate your thoughts with them. For the second strategy to counter the force of social proof, let’s take Mark Twain’s help who said: Whenever you find yourself on the side of the majority, it is time to pause and reflect. Taking a contrarian position isn’t an iron rule. Don’t take pride in being contrarian just for the sake of it. Mr. Twain is essentially asking us to become an independent and rational thinker. Warren Buffett simplifies it furtherWe derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t.


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Chapter 14 - Social Proof | Mental Models, Investing, And You Would you sell your brand new car if some of your neighbours came to you and started offering 30 percent less than your purchase price? Of course not. You know the real worth of your car and selling it at a price quoted by Mr. Neighbour (a close cousin of Mr. Market) isn’t a wise decision. So why would you do that with your stocks? Benjamin Graham, the highest authority on security analysis, reminds usYou’re neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. Checklist is another great tool to save yourself from social proof tendency. The catch is that you have to create the checklist beforehand. When the whole world (crowd) is stampeding in one direction, checklist can bring some sanity in your decision making process. And last but not the least, tune out the unnecessary noise i.e. the newspapers and news channels. More than any real information they just resound the “market sentiments” which is nothing but herding. Just because somebody is on the TV, who is articulate and wears a business suit, doesn’t mean he is a superior thinker and has valuable insights.

Conclusion Conformity often results from uncertainty. In situations where we aren’t sure what to do, we conform to popular choice. But when the stakes are high, you don’t want to be in a situation where you’re unsure because that would trigger the force of herding. Becoming an independent thinker may not earn you any popularity but it surely will make you wealthy over long term.


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Chapter 15 Reason Respecting Tendency Next time when you approach an ATM machine and find a queue in front of it, try this hack – tell the person in front of the queue “Excuse Me. May I go before you because I have to withdraw money?” I am sure you haven’t tried this before, neither have I. Sounds like a poor idea. Doesn’t it? Why would anyone let you go ahead unless you have a genuine reason. Isn’t withdrawing money a redundant excuse? Isn’t it obvious that everybody in the queue is there to withdraw money? But there might be some merit to above idea because in 1970s Harvard psychologist Ellen Langer conducted a similar experiment. She went into a library, where there was a long waiting queue in front of the photocopier, and approached the first person in the queue and asked, “Excuse me. I have five pages. May I use the Xerox machine?” That would probably infuriate a lot of people because everybody was there to make copies. Naturally most people refused to oblige to Langer’s request. In the second part of the experiment she gave a reason while making a request. “Excuse me. I have five pages. May I use the Xerox machine, because I’m in a rush?” This time most people gave in to her request and allowed her to go ahead. This is reasonable because if people are in a hurry, you would often let them cut into the front of the queue. But then came the interesting twist in the experiment. In the final part of the experiment she tried another approach, this time saying, “Excuse me. I have five pages. May I go before you, because I have to make some copies?” Now that’s a lame excuse. Everybody in the queue has to make copies, but


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Chapter 15 - Reason Respecting Tendency | Mental Models, Investing, And You surprisingly the result in this approach was amazing. She was allowed to pass to the front of the queue in almost all cases. It turns out when people justify their behaviour they face less resistance. Our need for making sense makes us even believe in nonsense. So for most people it seems to matter very little if the excuse is good or not. They aren’t really looking for a reason but just an answer, no matter how unreasonable the answer is.

Image Source: eBay Lewis Carroll (British mathematician and writer, 1832-1898, from Through the Looking Glass) In Art of Thinking Clearly, Rolf Dobelli writes – It seems people are addicted to the word ‘because’ – so much so that we use it even when it’s not necessary. If


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Chapter 15 - Reason Respecting Tendency | Mental Models, Investing, And You you’re a leader, undoubtedly you have witnessed this. If you

provide

no

rallying

call,

employee

motivation

dwindles. It simply doesn’t make the grade to say that the purpose of your shoe company is to manufacture footwear. No: today, higher purposes and the story behind the story is all-important; for example: ‘We want our shoes to revolutionalize the market’ (whatever that means) Charlie Munger has termed this bias as Reason Respecting Tendency (RRT). In his famous lecture ‘Psychology of Human Misjudgment’, Charlie explains the origin of this bias – There is in man, particularly one in an advanced culture, a natural love of accurate cognition and a joy in its exercise. This accounts for the widespread popularity of crossword puzzles, other puzzles, and bridge and chess columns, as well as all games requiring mental skill. This tendency has an obvious implication. It makes man especially prone to learn well when a would-be teacher gives correct reasons for what is taught, instead of simply laying out the desired belief ex cathedra with no reasons given. Few practices, therefore, are wiser than not only thinking through reasons before giving orders but also communicating these reasons to the recipient of the order. In general, learning is most easily assimilated and used when, lifelong, people consistently hang their experience, actual and vicarious, on a latticework of theory answering the question: Why?


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Chapter 15 - Reason Respecting Tendency | Mental Models, Investing, And You Unfortunately, Reason Respecting Tendency is so strong that even a person’s giving of meaningless or incorrect reasons will increase compliance with his orders and requests…This sort of unfortunate byproduct of ReasonRespecting Tendency is a conditioned reflex, based on a widespread appreciation of the importance of reasons. And, naturally, the practice of laying out various claptrap reasons is much used by commercial and cult “compliance practitioners” to help them get what they don’t deserve.

Reason for RRT There is a reason for reason respecting tendency. Peter Bevelin, in his book Seeking Wisdom, writes – When people ask us for a favor we are more likely to comply if they give us a reason even if we don’t understand the reason or it is wrong. Often it isn’t the reason itself that is important, but the way the reason is phrased. Sometimes the word “because,” without a sensible reason, is all that matters. We want explanations and the word “because” imply an explanation. Charlie Munger tells the story of Carl Braun, the creator of CF Braun Engineering Company – His rule for all the Braun Company’s communications was called the five W’s – you had to tell who was going to do what, where, when and why. And if you wrote a letter or directive in the Braun Company telling somebody to do something, and you didn’t tell him why, you could get fired. In fact, you would get fired if you did it twice.


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You might ask why that is so important? Well, again that’s a rule of psychology. Just as you think better if you array knowledge on a bunch of models that are basically answers to the question, why, why, why, if you always tell people why, they’ll understand it better, they’ll consider it more important, and they’ll be more likely to comply. Even if they don’t understand your reason, they’ll be more likely to comply. So there’s an iron rule that just as you want to start getting worldly

wisdom

by

asking

why,

why,

why

in

communicating with other people about everything, you want to include why, why, why.

Stock Market Fell Because ... Whenever there is a significant movement in stock prices, you’ll never find the talking heads on the financial news channels saying, “We don’t know what caused this rise/fall in the markets.” If they did, who would listen to them? They know the human need for attaching a reason to every wiggle in the stock market. And there is never a dearth of twaddle (Chapter 10) when it comes to explaining the market movements. Dobelli writes – If the stock market rises or falls by half a percent, you will never

hear

the

true

cause

from

stock

market

commentators – that it is white noise, the culmination of an infinite number of market movements. No: people want a palpable reason and the commentator is happy to select one. Whatever explanation he utters will be meaningless –


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Chapter 15 - Reason Respecting Tendency | Mental Models, Investing, And You with frequent blame applied to the pronouncements of Federal Reserve bank presidents. When I started investing in stock market, I first turned to the paid research reports. These reports had colorful fonts, impressive pie charts and graphs, detailed financials and numerous intelligent sounding reasons for buying the recommended stocks. I was convinced and started buying stocks based on their monthly recommendations. But soon a pattern emerged in their stock reports. It seemed that they had a standard template for their stock reports which they filled with their opinions (not reasons) and copied the data from annual reports. Needless to say that I lost money in almost all those stock recommendations. It took me few years to realize the importance of independent thinking in investing. Every research report is just an opinion unless you agree with it based on your own sound reasoning and rational thinking. The only way you can save yourself from RRT is by questioning the reasons provided by others. And not just others, develop the habit of questioning the reasons generated by your own mind because, as Richard Feynman says, the easiest person to fool is yourself.

Image Source: Dilbert.com


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Conclusion Reason Respecting Tendency is where people want the answers to something but don’t care to know the background information or reasoning to gain a better understanding. So next time when you find yourself standing at the end of a long queue, you know what to do to save time. And if somebody tries this trick with you, you can counter it by giving another random excuse. Or you can tell him, “Do you think you’re the only one who reads Safal Niveshak?”


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Chapter 16 The Bystander Effect Just after 3 a.m., March 13, 1964 in New York City, Catherine Genovese, a 28-year old woman, was stabbed to death in a parking lot in front of her apartment complex. Catherine’s murder story could have drowned in the middle pages of most newspapers like many other crime stories, except that it didn’t. Catherine’s murder wasn’t a quick, muffled death. It had been a long, loud, tortured, public event. The killer had chased and attacked her in the street three times over a period of thirty-five minutes before his knife finally silenced her cries for help. Shockingly, thirty-eight people, all in the surrounding apartments, witnessed at least one of her killer’s three attacks from the safety of their apartment windows for 25 minutes without calling the police. The story has since been thoroughly debunked, a case of sensational reporting, but at the time it was written it led to intense interest in the phenomenon from psychologists. Even if there is a ten percent truth to above story, it’s a baffling account of a crime, not because it was a murder, but because “good people” failed to call the police. Why didn’t the neighbours help? Were they indifferent? Frightened? Why should they be afraid of calling the police from the safety of their own homes? Has the violence on TV and movies made people so insensitive? Was it the beginning of a new epidemic known as large scale social apathy? Interview with the witnesses revealed none of these explanations was the real reason behind people’s inaction.


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Chapter 16 - The Bystander Effect | Mental Models, Investing, And You I found Genovese’s story in Robert Cialdini’s masterpiece, Influence – The Psychology of Persuasion. Cialdini writes – A simple anonymous call to the police could have saved Catherine without threatening the witness’s future safety or free time. No, it wasn’t the observers’ fear or reluctance to complicate their lives that explained their lack of action; something

else

was

going

on

there…They[social

psychologists] examined the reports of the Genovese incident and, on the basis of their knowledge of social psychology, hit on what had seemed the most unlikely explanation of all – it was that thirty-eight witnesses were present…no one had helped precisely because there were so many observers. This is called The Bystander Effect, which basically states that as humans, we don’t only imitate good actions, but we also have a tendency to follow wrong actions and inactions of fellow humans. Friedrich Nietzsche was on to something when he proclaimed Madness is a rare thing in individuals – but in groups, parties, peoples, and ages it is the rule.

Diffusion of Responsibility When several people, potential helpers, around you are witnessing the same event, the personal responsibility of each individual reduces. It’s called diffusion of responsibility. Have you ever seen someone broken down on the side of the road and thought, “I could help them, but I’m sure someone will be come along.” Everyone thinks that. And no


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Chapter 16 - The Bystander Effect | Mental Models, Investing, And You one stops. Watch the following video of a social experiment which demonstrates the bystander effect. In a crowd, your inclination to rush to someone’s aid fades, as if diluted by the potential of the group. Everyone thinks someone is going to eventually do something, but with everyone waiting together, no one does. To be able to extend any help we must interpret an event as an emergency. When we are uncertain, we have a tendency to look at people around us to see how they react. If others don’t react, we interpret that as evidence that it is not an emergency, and we therefore don’t react. We don’t want to be the ones that stand out in a crowd and risk embarrassment for acting in a non-emergency situation. Fear of embarrassment plays a big role into group dynamics. Talking about fear of embarrassment, it should be obvious to see that bystander effect is founded on the principle of Social Proof. But here comes the problem. If each person reasons the same way, everyone draws the same conclusion. “Since nobody is concerned, nothing is wrong. It can’t be an emergency.” Sometimes it’s also termed as Pluralistic Ignorance – a psychological state characterized by the belief that one’s private thoughts are different from those of others. Simply put, it’s a situation where everyone is thinking the same thing but believes he or she is the only person who thinks it. When it comes to explaining behavioural biases humorously, there is no one who can do it better than Dan Ariely, author of wildly popular book Predictably Irrational. Dan, in this short video, not only explains but demonstrates (watch it till the end) the idea of pluralistic ignorance.


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Chapter 16 - The Bystander Effect | Mental Models, Investing, And You Social psychologists determined that when the potential helper doesn’t see anyone around, except the victim, he’s more likely to come forward for help. So the more people present when a person needs emergency help, the less likely it is any one of them will lend a hand. What aggravates pluralistic ignorance? Cialdini writes – It seems that the pluralistic ignorance effect is strongest among strangers: Because we like to look poised and sophisticated in public. I suspect if people were to witness the Genovese murder case in present time, instead of watching silently they would, probably and unfortunately, tweet about it.

Image Source: Eric Allie Cartoons.


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Chapter 16 - The Bystander Effect | Mental Models, Investing, And You

Breaking The Spell of Pluralistic Ignorance So the two primary factors that create bystander effect is uncertainty about the emergency and diffusion of responsibility. If we can address these two things, we can break the spell of pluralistic ignorance. Many studies have shown it takes only one person to help for others to join in. Whether it is to donate blood, assist someone in changing a tire, drop money into a performer’s coffers, or stop a fight—people rush to help once they see another person leading by example. In fact, it’s usually not the first person but the second one who tips the attention of the crowd. See this video where the first follower converts a lone nut’s dance into a movement. God forbid, if you ever find yourself in a situation where you’re the one who needs the help and people around you seemed to be under a strong spell of Bystander effect, what should you do? The key is to first realize that bystanders fail to help, not because they are unkind, but because they are unsure. They are still guessing whether an emergency actually exists and whether they are responsible for taking action. Should you cry for help? No, that doesn’t work as we have seen in the case of Catherine Genovese. Cialdini suggests – Based on the research findings we have seen, my advice would be to isolate one individual from the crowd: Stare, speak and point directly at that person and on one else: “You, sir, in the blue jacket, I need help. Call an ambulance.” With that one utterance you should dispel all the uncertainties that might prevent or delay help…In


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Chapter 16 - The Bystander Effect | Mental Models, Investing, And You general, then, you best strategy when in need of emergency help is to reduce the uncertainties of those around you concerning your condition…Be as precise as possible about your need for aid. Do not allow bystanders to come to their own conclusions because, especially in a crowd, the principle of social proof and the consequent pluralistic ignorance effect might well cause them to view your situation as nonemergency. When a person realizes that he’s the one responsible for taking an action, bystander effect disappears. There is no diffusion of responsibility. So the takeaway here is to remember you are not so smart when it comes to helping people. In a crowded room, or a public street, you can expect people to freeze up and look around at one another. I hope you remember the fairy tale about The Emperor’s New Clothes where everyone pretends the king is wearing clothes, until a child points out the emperor isn’t wearing any clothes. Whether it’s the naked emperor or a rag picker dying on street, the Bystander Effect gives both of them an equal treatment – a stare of ignorance.

In Investing Warren Buffett says – We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t. A stock price may or may not reflect the true value of the underlying business, however what it does reflect, at all times, is either the pluralistic ignorance or the wisdom of the crowd. How would you know?


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Chapter 16 - The Bystander Effect | Mental Models, Investing, And You Is the falling stock price really an emergency situation i.e. is the underlying business is deteriorating? Does it require your intervention, in terms of selling your holding or buying more? Why is nobody buying a particular stock which is languishing in spite of a great underlying business? May be it’s a victim of bystander effect. But how do you know? The only way you can know that is by becoming an independent thinker. By not letting the uncertainty and the diffusion of responsibility let you affect. Decide for yourself, do your own evaluation, think independently and then take action. As we have seen in the case of the lone dancer in the video, you could be the first follower, the first mover and then you will reap the benefits when the crowd follows you.

In Business Most of the so called “independent directors” on the boards of publicly listed companies are mere bystanders. Even if some of them feel that the CEO of the company is taking wrong decisions, they rarely raise a voice against it. And the reason is again the same – uncertainty and diffusion of responsibility. Most independent directors sit on the board to help the CEO comply to regulation for a minimum number of independent directors. And of course the easy money (director’s compensation) doesn’t hurt. When an independent director doesn’t understand the business of the company and/or doesn’t have the required experience to contribute to the decision making process for the company, it’s obvious that he/she will be uncertain about the quality of decisions that CEO takes. Moreover, these people don’t have their skin in the game, i.e. their interests aren’t aligned with the minority shareholder, so their attitude is mostly – It’s not my responsibility.


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Chapter 16 - The Bystander Effect | Mental Models, Investing, And You Charlie Munger, while talking about social proof, said – …the outside directors on a corporate board usually display the near ultimate form of inaction. They fail to object to anything much short of an axe murder until some public embarrassment of the board finally causes their intervention. A typical board-of-directors’ culture was once well described by my friend, Joe Rosenfield, as he said, “They asked me if I wanted to become a director of Northwest Bell, and it was the last thing they ever asked me. In life and in business, the importance of independent thinking can never be over emphasized. It’s this one skill that will separate you from the crowd. George Patton wisely summarized the idea in few words, “If everyone is thinking alike, then somebody isn’t thinking.”

Conclusion Learning about mental models will not only make you smarter but can also save your life. Having seen the potentially dire consequences of bystander effect, you now know how to rescue yourself, if you ever find yourself a victim of emergency situation in a public place.


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Chapter 17 Liking Bias It was March 2007 and I was desperately looking for a tax saving investment product. Until that year I had been sticking to the old fashioned conservative options like tax saving FDs and LIC policies. But the stock market frenzy of 2007 was rubbing off on me. So when I received a call from a stranger who called himself a “financial advisor” and showed a great concern for my financial wellbeing, I couldn’t say no to his request for a meeting. Although the young chap seemed to have just a few years of experience in the industry but his demeanor was nothing less than that of a CEO of a large company. He was well dressed, tidy, confident and articulate. When we met he took interest in my hobbies and complimented me about my reading habits. Needless to say I took an instant liking to him. He told me about a new financial product called ULIP (unit linked insurance plan). I had never heard of ULIP, so before committing any money to it I borrowed some time from him and did a quick research on google. The reviews on the internet weren’t very encouraging. Some even claimed of unethical selling by private banks and insurance companies as far as ULIP was concerned. But my financial advisor seemed to know what he was talking and I liked him. He even told me that one of his elder cousin was from my college. So I went ahead and invested my money.


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Chapter 17 - Liking Bias | Mental Models, Investing, And You It turned out that I wasn’t the only one who lost money in toxic financial products which were indiscriminately peddled by many suit-tie wearing sales people. So why did I succumb in spite of knowing that ULIP wasn’t the best option for me? I would like to put the blame on the so called “financial advisor”. But he was just doing his job i.e. selling stuff. Even today I can’t imagine him as a crook or unethical person. It was much later, after reading Robert Cialdini’s book Influence, when the realization set in that I had been a victim of something called Liking Bias or Liking Tendency. Because of liking tendency, we tend to like who are physically attractive, popular, cooperative, or people we have positive associations with. Also, those who are similar to us in background, opinion, lifestyle, interest, attitude, looks, values, and belief. We also like and trust anything familiar. Most people prefer to say yes to the requests of someone they know and like. It’s a natural tendency to ignore the faults of those we find likeable while doing just the opposite to the people we don’t like. According to Charlie Munger, Liking tendency acts as a conditioning device that makes the liker or lover tend: 1. To ignore the faults of, and comply with the wishes of, the object of his affection; 2. To favor people, products, and actions merely associated with the object of his affection (Influence from Mere Association Tendency); and 3. To distort other facts to facilitate love.


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Chapter 17 - Liking Bias | Mental Models, Investing, And You Just as liking and loving make humans agree with each other despite their vices, the tendency to hate or dislike does the absolute reverse and leads to ignoring or refuting the person we dislike or hate despite the virtues. Here is what Munger has to say on that: Disliking/hating tendency also acts as a conditioning device that makes the disliker/hater tend to: 1. Ignore virtues in the objects of dislike, 2. Dislike people, products and actions merely associated with the objects of his dislike, and 3. Distort other facts to facilitate hatred Liking bias, due to its persuasion power, is widely used by negotiation experts and salespeople to tip the scale in their favour. Since it is extremely profitable, there is a huge demand of people who can persuade other people to take desired actions and some people have a natural flair for it. There are numerous examples of war Marshalls, CEOs, sports managers etc. In fact, the first thing any salesman is taught is to Be Likeable. Which means their sales training programs not only teach them all the nuances of communications skills but also teach them to dress well and create an impeccable first impression. Their aim is to be likeable even before they open their mouth. People who exploit this bias know that first impression is not only the last impression but the lasting impression too. Joe Girard is considered the most successful car salesman in the world. His tip for success:


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Chapter 17 - Liking Bias | Mental Models, Investing, And You There is nothing more effective in selling than getting the customer to believe, really believe, that you like him and care about him.

What Creates Liking Bias According to Cialdini following factors cause one person to like another person – 1. Physical Attractiveness – Research has shown that we automatically assign to good-looking individuals such favorable traits as talent, kindness, honesty, and intelligence. Good looking people are likely to receive highly favorable treatment in many setups including elections, employment interviews and even in judicial process. Experiments show that attractive criminals are seen as less aggressive and get a milder punishment than ugly criminals. In another study the better looking men and women received aid more often, even from members of their own sex. In short, good-looking people enjoy an enormous social advantage in our culture. 2. Similarity – We like people who are similar to us. This similarity could be in the area of opinions, personality traits, background, or lifestyle. Salespeople can manipulate similarity to increase liking by claiming that they have backgrounds and interests similar to ours. They are trained to look for evidence of such things while interacting with the potential customer. There are techniques like mirroring and matching the customer’s body posture, mood and verbal style to subconsciously trigger the feeling of similarity. As a corollary we don’t like the ones we perceive as dissimilar to us. 3. Being Liked – We like people who like us. If we feel that a person likes us, we tend to like them back. Remember Joe Girard? Do you know his trick to get his customers to like him? Each month he sent every one of his thousands of former customers a holiday greeting card containing just one line – ‘I like you’. Being liked and accepted is basic emotional need for all human beings. British Prime


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Chapter 17 - Liking Bias | Mental Models, Investing, And You Minister and novelist Benjamin Disraeli said, “Talk to a man about himself and he will listen for hours.” We are phenomenal suckers for flattery. And we reciprocate the way others see us. If we perceive others dislike us, we tend to dislike them. 4. Cooperation – We like people who cooperate with us. How do we get people to cooperate? Create an external common threat or an opportunity for mutual gain. A typical example could be a salesman pretends to be on our side and “negotiates with his boss” to secure a good deal for us. Another example is the good cop/bad cop trick routinely employed by police to get a confession from a suspect. One police officer acts hostile and other, acting as a good cop, tries to calm down his angry partner and pretending a soft corner for the suspect. The suspect develops a subconscious liking for the good cop and cooperates. Here’s another interesting trick. Asking a favor of someone is likely to increase that person’s liking for us. Counterintuitive right? But it works because people want to be seen as consistent with their behavior. Benjamin Franklin tells us about an old maxim: “He that has once done you a kindness will be more ready to do you another, than he whom you yourself have obliged.”

In Business In his book, The Art of Thinking Clearly, Rolf Dobelli writes – Aid agencies employ the liking bias to a great effect. Their campaigns use beaming children or women almost exclusively. Never will you see a stone faced, wounded guerrilla fighter staring at you from billboards – even though

he

also

needs

your

support.

Conservation

organizations also carefully select who gets the starring


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Chapter 17 - Liking Bias | Mental Models, Investing, And You role in their advertisements. Have you ever seen a World Wildlife Fund brochure filled with spiders, worms, algae or bacteria? They are perhaps just as endangered as pandas, gorillas, koalas and seals – and even more important for the ecosystem. But we feel nothing for them. The more human a creature acts, the more similar it is to us, the more we like it. Companies already understand this. Employees at Disney theme parks and Hilton Hotels wear name tags emblazoned with their hometowns. So the visitors feel comfortable when they see people from their own place.

In Investing Almost all the financial news commentators on TV have great personalities and outstanding communication skills. You’ll never find them untidy or with unkempt hair. They’re articulate, confident, humourous and witty. There’s no way you can’t like these talking heads on TV unless you have lost significant money following their advices and forecasts. Some of them are so likeable that people don’t mind losing money and still continue to like them. That’s the power of psychological biases. You can’t counter its force even if you know about it. So the only way to save yourself from this is to stop watching financial news channels. Many successful investors don’t talk to the management because they understand the power of liking bias. A direct talk with a management, especially a charismatic CEO with likeable personality, can trigger liking bias and create a prejudice in our minds. The legendary investor Peter Lynch reminds us not to fall in love/get emotional with a stock. The stock doesn’t know that we own it, so falling in love with it only makes us susceptible to bad judgment.


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Chapter 17 - Liking Bias | Mental Models, Investing, And You Remaining detached enough from our investments to look at them objectively is a crucial skill to becoming a successful investor.

Overcoming Liking Bias The biggest problem with behavioural biases is that their force is so strong that it’s extremely difficult to counter them. And the best strategy is to avoid being in such situations. So this is what Guy Spier writes in his book, The Education of a Value Investor, about how he deals with such situations – …I soon began to see that I made lousy decisions when I bought things that salespeople were hawking to me. The problem is that my brain (and most likely your brain too) is awful at making rational decisions when confronted with

a

well-argued,

detailed

pitch

from

a

gifted

salesperson. So I adopted a simple rule that has proved extraordinarily beneficial. When people call to pitch me anything at all, I reply in as pleasant a manner as possible, “I’m sorry. But I have a rule that I don’t allow myself to buy anything that’s being sold to me.” I may miss out in the short term. But over a lifetime I have no doubt that I’ll benefit much more by detaching myself from people with a self-interest in getting me to buy stuff. So now whenever I get a call from these financial advisors, asking for a meeting, I just refuse to meet them.


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Chapter 17 - Liking Bias | Mental Models, Investing, And You Still you may find yourself in such situations where it’s unlikely that you could muster a timely protection against the unconscious effect of liking bias. First thing that needs to happen in that situation is to bring the awareness. Ask yourself, “Have I come to like this person more than I would have expected in such a short time?” If the answer is yes then it’s time for a quick counter maneuver, which doesn’t mean that you should look for reasons to dislike the person. That would be like fighting with natural force of behavioural bias which isn’t going to help much. What you need to do is to put a conscious effort to separate the person from the deal. Concentrate exclusively on the merits of the deal. Try to look at the facts and situation objectively. This may save you.

Conclusion We do things for people we like, because it’s a natural reciprocation to being liked. William James said, “The deepest principle in human nature is the craving to be appreciated.” So don’t forget that I like you!


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Chapter 18 Winner’s Curse Consider this thought experiment – A friend of yours is the Chairman of the Acme Oil Company. He occasionally calls with a problem and asks your advice. This time the problem is about bidding in an auction. It seems another oil company has gone into bankruptcy and is forced to sell off some of the land it has acquired for future oil exploration. There is one plot Acme is interested. Until recently, it was expected that only three firms would bid for the plot, and Acme intended to bid $10 million. Now they have learned that seven more firms are bidding, bringing the total to ten. The question is, should Acme increase or decrease its bid? What advice would you give? Do you advise bidding more or less? If you’re like me and seeing this case study for the first time you’d probably go with a higher bid. After all, there are additional bidders, and if you don’t bid more you won’t get this land. Isn’t it? Unfortunately, if you decide to increase the bid, you’d be falling in a trap called Winner’s Curse. The above example of oil auction comes from Richard Thaler’s book The Winner’s Curse. Thaler writes – Most people’s intuition in this problem is to bid more…However, there is another important consideration that is often ignored. Suppose that each participant in the auction is willing to bid just a little bit less than the amount he or she thinks the land is worth (leaving some room for the profits). Of course, no one knows exactly how much oil


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Chapter 18 - Winner’s Curse | Mental Models, Investing, And You is in the ground: some bidders will guess too high, other too low. Suppose, for the sake of argument, that the bidders have accurate estimate on average. Then, who will be the person who wins the auction? The winner will be the person who was the most optimistic about the amount of oil in the ground, and the person may well have bid more than the land is worth. This is the dreaded winner’s curse. In other words, the winner’s curse says that in a competitive auction, the highest bidder will typically overpay for the asset. Hence the bidder “wins” the auction but is “cursed” by the overpayment. “Winning is an informative event, telling us whose estimate was most optimistic,” writes Peter Bevelin, in his book Seeking Wisdom “When we place a bid on a house, company, project, or negotiate to buy something, we don’t realize what is implied by an acceptance of our offer. That we may have overestimated its value and therefore paid too much.” Following are the key characteristics of a winner’s curse situation – 1.

There are many bidders. That’s because auctions, by definition, are competitive. If there is only one bidder it is not an auction, it is a sale.

2.

No one is certain about the true value of the asset being auctioned.

3.

The winner is typically the one who is most optimistic about the value of the asset.

Winner’s curse becomes very important mental model in corporate mergers and acquisitions, because when companies bid against one another to buy a target corporation, the highest bidder frequently pays too much.


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Chapter 18 - Winner’s Curse | Mental Models, Investing, And You In his book, The Art of Thinking Clearly, Rolf Dobelli writes – The Winner’s curse suggests that the winner of an auction often turns out to be the loser. Industry analysts have noted that companies that regularly emerged as winning bidders from these oilfields auctions systematically paid too much, and years later went under. This is understandable…The highest bid at an auction is often much too high –unless these bidders have critical information other aren’t privy to. Today this phenomenon affects us all. From eBay to Groupon to Google AdWords, prices are consistently set by auction. Bidding wars for cell phone frequencies drive telecom companies to the brink of bankruptcy. Initial public offerings (IPO) are also examples of auctions. And, when companies buy other companies – the infamous mergers and acquisitions – the winner’s curse is present more often than not. Astoundingly, more than half of all acquisitions destroy value, according to a McKinsey study. So why do we fall victim to the winner’s curse? First, the real value of many things is uncertain. Additionally, the more interested parties, the greater the likelihood of an overly enthusiastic bid. Second, we want to outdo competitors. The buyer in an auction is no longer just purchasing a product, he or she is engaged in a test of will, trying to outdo other participants. Remember Warren Buffett’s words – It’s not greed that drives the world, but envy.


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Chapter 18 - Winner’s Curse | Mental Models, Investing, And You According to Charlie Munger, open-outcry auctions are a perfect setup for driving people to highly irrational behaviour. Auction is a place where multiple psychological biases act together, creating a lollapalooza effect, and results in a series of bad decisions. The list of cognitive biases that are at play in an auction is just mind boggling. Here’s a sample that I pulled out from Prof. Bakshi’s recent blog post– … an open-outcry auction situation is a very interesting social setting where multiple models from psychology like authority (where the auctioneer is a symbol of authority who not only certifies the authenticity of the object being auctioned, he also announces an initial big price which serves as an “anchor”, social proof (caused by observing other bidders bid up the price), the incentives of the auctioneer (the higher the price at which the object sold, the

more

the

money

reciprocation/retaliation

made

by

the

auctioneer),

(resulting

in

competitive

bidding), envy , low contrast effect (every new bid is a small increment over a previous bid), commitment bias (every bid and escalation of the bid is a public commitment), overconfidence, and deprival super reaction (caused by the countdown to end of auction) combine to turn this social setting into something like a death trap.

In Business Many business acquisitions are justified using fancy jargons such as ‘synergistic benefits’ and ‘strategic advantage’. But what really happens in most acquisitions? The winning bid is largely a result of overestimation of future benefits and succumbing to the competitive pressures (with investment bankers adding fuel to the fire). One just


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Chapter 18 - Winner’s Curse | Mental Models, Investing, And You has to look at the projected ‘synergistic benefits’ at the time of benefits and the actual results a couple of years down the line. If you want see the proof, you don’t need to go very far. In his post, Prof. Bakshi quotes the example of Tata Steel’s disastrous acquisition of Corus in 2006 in a competitive open-outcry auction. Just before Tata Steel’s first bid on 20 October, 2006, the market cap of the company was about Rs 26,000 cr. On 31 January, 2007 Tata Steel won its bid for Corus after offering 608 pence per share for the target company, valuing it for about $11 billion. Eight years later, Tata Steel’s market cap stands at Rs 23,000 cr. What an amazing case of value destruction! And Hindalco’s acquisition of Novelis was not different. Knowing what happens to people who get into open-outcry, auction-like situations, psychologically astute people like Buffett and Munger have a no-fault rule when they get invited to auction situations. The rule is: Don’t Go. When you win an auction, what you win is the right to pay more (for the asset being auctioned) than everyone else thought it was worth. Explained in this way, it’s quite easy to see why Warren Buffett had this simple “Don’t Go!” advice for auctions. Winner’s curse presents itself not just in auctions and large M&A activities but even in smaller business decisions. Let’s say you are the business head who has limited resources to execute only one project among many. All your 10 reporting managers have presented their plans to you. Which one would you pick? Of course, the one that looks most attractive. Isn’t it?


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Chapter 18 - Winner’s Curse | Mental Models, Investing, And You But all managers have an incentive to make their own project the most attractive one. The risk is therefore that you end up choosing the project with the most optimistic forecast. Which means you selected the one which has higher chances of turning out to be more expensive and time consuming than it was initially projected to be.

In Investing The winner’s curse does not need a fancy auction. The same curse may be visited on an investor in a hurry to buy a stock on which someone has provided a hot tip. During bull markets, the rising prices and increasing demand for the stocks creates an auction like environment. As the price of equities climb, more and more people get enticed into making higher bids and driving the prices even higher. In effect, people who agree to buy stocks at inflated prices are being overly optimistic, just like an auction winner, about the future prospects of the businesses which those stocks represent. If you want to participate in the stock market auctions, you must ascertain the true value of what’s being offered. Peter Bevelin, in his book Seeking Wisdom, writes (emphasis mine)Research shows that the more bidders there are competing for a limited object, each having the same information, and the more uncertain its value is, the more likely we are to overpay. Instead, if our objective is to create value, the more bidders there are, the more conservative our bidding should be. This also implies that the less information we have compared to other bidders or the more uncertain we are about the underlying value, the lower we should bid. It’s the winner’s curse that Warren Buffett warns us against when he says, “Be fearful when others are greedy.”


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Chapter 18 - Winner’s Curse | Mental Models, Investing, And You So how do you save yourself from Winner’s curse? First, acquire as much information as you can. If you can determine what an item (or a stock) is worth, you will avoid overspending. And second, know your limits. If you do not have enough information, wait and get some more, and if you think long and hard to establish a top price, stick to it. Additionally, thinking about following questions can help you in making a rational decision. 1.

How would I reason if I think it through from the viewpoint of the other person?

2.

Why are they selling? Don’t forget that the seller might have an informational advantage. So why would I make a better decision than someone who has all the information?

3.

The other person is most likely to accept our offer when it’s least favourable to us, especially when he or she is anonymous (typical in stock market transactions). What are the chances that the other person’s decision is being made under pressure and is irrational?

In fact, a practitioner of value investing tries to find a situation which is reverse of an auction. Chetan Parikh, an accomplished value investor, writes in his blog In value investing you are buying a stock where in many cases sellers are bidding to sell you a company at lower levels (how else do you explain the fact that even 70 years after Benjamin Graham’s Security Analysis, one gets to buy companies at less than cash on the balance sheet). Also


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Chapter 18 - Winner’s Curse | Mental Models, Investing, And You most of the estimates are working in your favour if like all good value investors, you insist on a good margin of safety.

Conclusion To summarize, in an auction with many bidders, the winning bidder is often a loser. A key factor in avoiding the winner’s curse is bidding more conservatively when there are more bidders. While this may seem counterintuitive, it is the rational thing to do. Remember, when the applause of the auction is over, you want to make sure you are still happy with the deal.


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SECTION 2: STATISTICS


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Chapter 19 Mean Reversion There are certain days in everybody’s life which in spite of being ordinary remain etched in the memory for a long time. It was 15th of December. I distinctly remember it because I bought my car that day. The ownership of new car brought with it an excitement to take care of it. The first task in front of me was to be diligent about tracking the mileage. At an average of 13 km/liter it was a satisfactory performance. However, after few weeks I started noticing that the mileage numbers would go down occasionally and then come back again to the normal. There wasn’t any change in my driving style or driving routes. Except the source of fuel there was no other variable that could cause the variation in performance. So my hypothesis was that the quality of fuel was affecting my vehicle’s performance. To empirically validate my hypothesis, I decided to keep track of different fuel stations where I got the petrol from. The next time when I saw a dip in the mileage numbers I went to a different fuel station and the improvement in the numbers followed. This made me conclude that my earlier fuel station was the culprit. Having discovered this, yours truly (i.e. me) proudly announced his statistical prowess to everybody and asked them to avoid that particular fuel station. Not long after discovering the “dishonest fuel pump,” I started seeing those mileage fluctuations again. Obviously my earlier deduction was flawed. So what happened then?


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Chapter 19 - Mean Reversion | Mental Models, Investing, And You Daniel Kahneman recounts a similar experience in his book Thinking Fast and Slow. While teaching flight instructors he was told how the act of praising the pilots on a recent good performance usually resulted in a poorer performance subsequently and vice versa. This logic goes against the conventional motivation theory that encouragement leads to improved performance. According to Kahneman, the flaw in their reasoning was that they had attached a causal interpretation to the inevitable fluctuations of a random process. Let’s try to understand the concept in light of my mileage counting experiment. The reality was that my mileage numbers were experiencing fluctuations due to randomness and there didn’t exist any specific pattern. Even if I hadn’t changed my fuel station, I would have seen the mileage numbers improving anyway because the numbers were simply fluctuating around a mean. This phenomenon is called Mean Reversion. Mean reversion is a mental model from the field of statistics. It says that an event that is not average will be followed by an event that is closer to the average. I was suffering from the tendency to attribute meaning to a phenomenon governed only by chance. Here is an interesting insight from the book Innumeracy: Mathematical Illiteracy and Its Consequences – ...very intelligent people can be expected to have intelligent offspring, but in general the offspring will not be as intelligent as the parents. A similar tendency toward the average or mean holds for the children of very short parents, who are likely to be short, but not as short as their parents. If I throw twenty darts at a target and manage to hit the bull’s-eye eighteen times, the next time I throw twenty

darts,

I

probably

won’t

do

as

well.

This

phenomenon leads to nonsense when people attribute the


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Chapter 19 - Mean Reversion | Mental Models, Investing, And You regression to the mean to some particular scientific law, rather than to the natural behavior of any random quantity. Nassim Taleb in his book Fooled by Randomness observes – The ‘hot hand in basketball’ is another example of misperception of random sequences: It is very likely in a large sample of players for one of them to have an inordinately lengthy lucky streak. As a matter of fact it is very unlikely that an unspecified player somewhere doesn’t have an inordinately lengthy lucky streak. This is a manifestation of the mechanism called regression to the mean....in real life, the larger the deviation from the norm, the larger the probability of it coming from luck rather than skills...This can be easily verified in stories of very prominent people in trading rapidly reverting to obscurity, like the heroes I used to watch in trading rooms. Let’s see some of the areas where mean reversion raises some serious concerns about our decisions.

Your Doctor’s Secret Weapon Remember Mr. Irrational? It so happened that Mr. Irrational wasn’t keeping well due to common cold virus. Now for most people the immune system is strong enough to fight the virus and allow the body to heal on its own. Although this healing process usually takes few days. So after two days of discomfort, right when his body is on the verge of bouncing back to normal healthy state, Mr. Irrational decides to visit his doctor, Dr. Placebo. Remember Dr. Placebo? We discussed in Chapter 6 how Dr. Placebo himself suffers


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Chapter 19 - Mean Reversion | Mental Models, Investing, And You from a behavioural anomaly called “Do something Bias”. So Dr. Placebo prescribes a mild antibiotic drug, which is quite unnecessary in this case. Unsurprisingly, the very next day Mr. Irrational is back to normal, healthy as a horse. He concludes, irrationally of course, that Dr. Placebo has the ability to cure any disease in a single day. The inherent randomness present in the natural process of falling sick and healing back makes it an obvious candidate for mean reversion. Alas! Mr. Irrational hasn’t heard about mean reversion.

Scope of Mean Reversion It’s very important to understand that reversion to the mean is meaningful only in those activities or situations where there is some element of randomness involved. The intensity with which mean reversion affects an activity is directly proportional to the element of luck controlling the outcome in that activity. So if you are looking at something like professional swimming and recording the lap time for Michael Phelps, it won’t be a revelation that the outcome (lap timings) stays pretty much consistent with very little scope for reversion to the mean. Sports like swimming or chess are activities where luck plays relatively small role. They are dominated by skill resulting in very consistent and predictable outcomes. However, not all sports enjoy the same level of predictability. Games like Cricket, Basketball and especially many other team sports have quite a bit of luck dictating the end result. When it come to my car mileage there were myriad of factors like traffic conditions, road condition, the minor fluctuations in my driving style, the weather, wind speed etc. which affected the mileage. The randomness introduced by these environmental factors makes this activity prone to mean reversion.


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Chapter 19 - Mean Reversion | Mental Models, Investing, And You

In Investing You would agree with me that stock market investing is also one such activity where luck plays a significant role in investor’s performance. Consider this typical process that many investors follow. They look at the last few years performance of a fund manager and put their money in his fund. Soon they observe that the fund underperforms the benchmark for next few years. Frustrated and flabbergasted, they pull out the money and find another fund manager based on the same criteria i.e., last few years’ performance. The naive investor is clueless why the fund performance deteriorates immediately after he puts his money into it. Mean reversion buddy! In stock market periods of above average performance are usually followed by below average returns and periods of below average performance are typically followed by above average returns. When Warren Buffet said Be greedy when others are fearful and be fearful when others are greedy. He was perhaps hinting us to exploit the mean reversion. And that’s why it’s essential that you shouldn’t go just by the outcome (fund performance) of such activity. The trick is to look at the process that leads to the outcome. Choose the process which is sound and rational. The second trick for dampening the effect of mean reversion is to take a bigger sample size. Which means you shouldn’t rely on short term performance records. If you are looking at ten-year performance figures of a fund, then odds are high that the


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Chapter 19 - Mean Reversion | Mental Models, Investing, And You fluctuations introduced by randomness and luck have evened out over long term and what you see is a reasonable proxy for fund manager’s skill.

Illusion Created by Mean Reversion So we see that mean reversion creates two kinds of illusions. The first is the illusion of cause and effect. Out inherent tendency to look for what is causing a measurement to regress toward the mean, an exercise that is frequently fruitless. The second is the illusion of feedback, which makes it seem like favourable feedback leads to worse results and unfavourable feedback leads to better results. Michael Mauboussin, author of The Success Equation, writes in his book – Understanding and using the phenomenon of reversion to the mean is essential in making sound predictions [decisions]... Reversion to the mean is most pronounced at the extremes, so the first lesson is to recognize that when you see extremely good or bad results, they are unlikely to continue that way. This doesn’t mean that good results will necessarily be followed by bad results, or vice versa, but rather that the next thing that happens will probably be closer to the average of all things that happen. When I first understood the concept of mean reversion, it was one the eureka moments of life. Suddenly I had an answer for a lot of unexplained observations around me. Remember, the only reason mean reversion happens is because of randomness. Anytime you hear that mean reversion is happening because of competitive forces, declining moat, etc. wear your lens of mental models and then investigate further.


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Conclusion In the current world of digital revolution and information explosion, it has become increasingly important for you to build a strong bullshit filter to separate the noise from real knowledge. Mean reversion is one such bullshit filter.


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Chapter 20 Law of Small Numbers Other than the closed glass chambers in the corporate world, there is one very unusual place where grand scheming about workplace strategies (office politics) happens regularly. Don’t worry, there is nothing hush-hush about this place and it’s not at all surrounded by thick soundproof walls. Wondering what I am talking about? Let me give you another hint. It’s the designated open area in every large company, where people go out in fresh air to fill their lungs with freshly brewed smoke. You guessed it right. I am talking about the smoking areas. Mind you, it’s not just a place trafficked by the smoke billowing nicotine guzzlers, but you’ll often find those hapless passive smokers too who don’t realize that their lungs are going to collapse sooner than their active smoker buddies. Before you dismiss my lame attempt at sarcasm, let me confess that I used to be one such ignorant passive smoker who would stand next to a friendly smoke machine and take pride in my ability to resist the temptation of those white sticks. Smokers! Please forgive me if I have offended you. But trust me, it was intentional! Anyways, my sole consolation on those suffocating trips were some of the delusional (and absolutely hilarious) arguments that I would get to hear by my nicotine addicted pals. You know what my favourite argument was? This one –


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Chapter 20 - Law of Small Numbers | Mental Models, Investing, And You My grandfather was a lifelong chain smoker and still lived up to a ripe age of 90 years. So don’t tell me that smoking kills.

Image Source: Fine Tobacco NYC There is just one problem with this logic – it is dead wrong! I can’t help but imagine how Charlie Munger would react to this line of thought. He would probably snort with laughter, as if he wanted to say – “Boy, you’re suffering from I-know-a-man syndrome.” A classic mistake of taking a specific instance and blindly generalizing it. Cognitive dissonance is one mental model that we had discussed in the April 2015 issue of Value Investing Almanack, which explains the self-deceptive behaviour of tobacco addicts. But an irrational behaviour is rarely the result of a single behavioural bias. We have something else at play here.


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Chapter 20 - Law of Small Numbers | Mental Models, Investing, And You What we’re going to explore today is a bias which was first identified by Amos Tversky and Daniel Kahneman. It’s called the Law of Small Numbers, also known as ‘insensitivity to sample size’. In fact, this ‘I-know-a-man-syndrome’ is an extreme case where people tend to generalize from small amounts of data. Most people, including many experts (involved in serious empirical research), don’t appreciate how research based upon small numbers or small populations can often generate extreme observations. As a result, people have a tendency to believe that a relatively small number of observations will closely reflect the general population. Consider my argument – “I know a man who jumped from 5th floor and survived the fall. Which implies that it’s safe for anyone to repeat the act.” “No it’s not!” Intuitively dismissing the argument, you might say, “It’s an aberration, an exception that can’t be relied on.” The point I am trying to make here is that sample size matters while trying to establish any patterns.

Fooled by Sample Size Next time when you watch a commercial on TV, pay attention and see if you find any of the following claims – “Seven out of ten housewives prefer this washing powder.” Or for that matter, “Four out of five dentists recommend this toothpaste.” Rings a bell? And there is no end to such compelling claims. It’s a common trick used by marketing people to win your trust. Truth be told, these claims don’t tell us anything unless we know how many dentists or housewives were surveyed. Maybe they surveyed just 10 housewives and dentists; an observation that can’t be extrapolated to include all dentists or housewives.


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Chapter 20 - Law of Small Numbers | Mental Models, Investing, And You Anytime you see such statistics thrown at you, please don’t forget to question the sample size. With small sample size, odds are pretty high that conclusions can’t be trusted. Peter Bevelin in his must-read book Seeking Wisdom, explains – A small sample size has no predictive value. The smaller the sample is, the more statistical fluctuations and the more likely it is that we find chance events. We need a representative comparison group, large enough sample size, and long enough periods of time. Small samples can cause us to believe a risk is lower or higher than reality. Why? A small sample increases the chance that we won’t find a particular relationship where it exists or find one where it doesn’t exist. Charlie Munger gives an example of the importance of getting representative data – even if it’s approximate – 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. Many a times people fall for the confirmation bias and try to back-fit the data to their theory or model. If something doesn’t fit their hypothesis, they discard it and cherry pick the smaller set of observations which conform to their assumptions. Munger adds –


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Chapter 20 - Law of Small Numbers | Mental Models, Investing, And You 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. All I can tell you is that around Wesco and Berkshire, we try not to be like that. We have Lord Keynes’ attitude, which Warren quotes all the time: “We’d rather be roughly right than precisely wrong.” In other words, if something is terribly important, we’ll guess at it rather than just make our judgment based on what happens to be easily countable. In Thinking Fast and Slow, Daniel Kahneman writes – Extreme outcomes (both high and low) are more likely to be found in small than in large samples. So why do we fall for this bias? One reason is our love for stories. Instead of questioning the accuracy and uncertainty associated with the sample, we focus on the story those numbers are telling us. Kahneman further explains – The exaggerated faith in small samples is only one example of a more general illusion – we pay more attention to the content of messages than to information about their reliability, and as a result end up with a view of the world around us that is simpler and more coherent than the data


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Chapter 20 - Law of Small Numbers | Mental Models, Investing, And You justify. Jumping to conclusions is a safer sport in the world of our imagination than it is in reality.

Luck and Small Numbers It’s important to understand the context or circumstance where this fallacy becomes more pronounced. Let me use an example to explain my point. If you were observing Michael Phelps, the swimming legend, compete against few amateur swimmers, even few observations would be enough to make a generalization about future outcomes of such competitive events i.e., Michael Phelps will trounce each one of them every single time. Here you don’t need to worry about the law of small numbers. Why? The answer lies in understanding the role of skill and luck in any activity. The magnitude of the fallacy grows larger as the luck-to-skill ratio rises. Be it sports or investing, a lot in our life is governed by luck. Certain games (cricket or poker) have higher element of luck and some are completely devoid of luck (chess or swimming). So an amateur player can win a game of poker a few times just because of luck, but over a longer period of time i.e., over a large number of hands played, the luck evens out and skill prevails. A corollary to our law of small numbers would be – over short periods of time, luck is more important than skill. The more luck contributes to the outcome, the larger the sample you’ll need to distinguish between someone’s skill and pure chance. For that matter, how do you determine if an activity is ruled by luck or pure skill? There’s a simple and elegant test proposed by Michael Mauboussin in his book, The Success Equation, which is to ask whether you can lose on purpose. If you can’t lose


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Chapter 20 - Law of Small Numbers | Mental Models, Investing, And You on purpose, or if it’s really hard, luck likely dominates that activity. If it’s easy to lose on purpose, skill is more important. This has huge implications not only in sports but in investing too. David Einhorn, billionaire hedge fund manager and author of Fooling Some of the People All of the Time, explains – People ask me “Is poker luck?” and “Is investing luck?” The answer is, not at all. But sample sizes matter. On any given day a good investor or a good poker player can lose money. Any stock investment can turn out to be a loser no matter how large the edge appears. Same for a poker hand. One poker tournament isn’t very different from a coinflipping contest and neither is six months of investment results. On that basis luck plays a role. But over time – over thousands of hands against a variety of players and over hundreds

of

investments

in

a

variety

of

market

environments – skill wins out.

In Business and Investing Business and investing are fields where this fallacy is rampant and that’s because luck plays a significant role, especially in the short term. As a result, unscrupulous finance professionals (salesmen) mis-sell their useless financial products by decorating them with flawed performance statistics. Similarly, shrewd managements use the same tricks to hide their poor performance.


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Chapter 20 - Law of Small Numbers | Mental Models, Investing, And You If a mutual fund manager has had three above-average years in a row, many people will conclude that the fund manager is better than average, even though this conclusion does not follow from such a small amount of data. A prudent way to assess the real performance of a fund manager is to observe his returns and actions over a longer period of time. Recently, my relationship manager-cum-stockbroker offered me a new fund scheme. He claimed, “Our fund has generated a 60% CAGR in last one year.” It sounded not only misleading but outright hilarious. CAGR stands for compounded annual growth rate and the idea of compounding isn’t much useful if you’re talking about a period as short as one year. I am sure he would be peddling a different “one-year-60-percent-cagr” product to another gullible investor next year. Following the same line of inquiry, it’s obvious that while evaluating businesses, you should look at long-term performance numbers. Preferably past ten years. Doing this not only gives you an idea about resilience of the business during downturns, but also shrinks the possibility of extreme numbers (very poor performance in one quarter or extraordinary performance in another quarter) skewing your decision making process. I am guessing that this law is equally applicable in human relationships too. You can’t judge somebody’s character based on your interaction with him or her a couple of times. Character is revealed by observing a person’s behaviour under diverse set of situations and over extended periods of time.

Conclusion To summarize, relying on small set of observations, especially in activities where luck plays some role, can lead you to faulty conclusions. Many decision makers do not understand this fallacy and are often fooled by the high degree of randomness inherent in the small numbers.


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Chapter 20 - Law of Small Numbers | Mental Models, Investing, And You The solution is to develop a knack for placing an activity in the skill-luck continuum and maintain a healthy skepticism for the patterns observed in the small samples. I wish I could go back in time and tell my smoke buddy that his grandfather represented an extremely small sample size and perhaps the luck was heavily on his side. Who knows he could have survived past the age of 100 had he stopped smoking.


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Chapter 21 The Power Law Do you know how much property damage and loss of lives is caused by earthquakes every year? No idea? Consider this – An earthquake in Japan in 2011 caused an estimated property loss of US$ 235 billion. The deadliest earthquake in recorded history (in terms of loss of lives) occurred in Shaanxi (China) killing more than 800,000 people. According to one study, annual average losses from earthquakes range from US$ 1.3 to 5.7 billion. That’s loss per year because of all the earthquakes. This is quite huge, considering that it’s caused by an event which we have no control over. These statistics show that when mother nature’s fury is unleashed, even the modern society with all its technology and resources, finds itself helpless. Now another question. What do you think is the average loss caused by an earthquake, in terms of dollars per earthquake? Let’s do a quick back of the envelope calculation. So yearly loss of US$ 5.7 billion divided by number of earthquakes per year. How much would that be? Take a guess. Probably that number would be couple of million dollars per earthquake. Right? It’s actually little over US$ 10,000. That’s it! How come? That’s because the total number of earthquakes (excluding the ones that can’t be detected by instruments) occurring every year are more than 500,000. Yes you read it right.


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Chapter 21 - The Power Law | Mental Models, Investing, And You But the catch is that majority (more than 80 percent) of these tremors are so minor that they can’t even be felt by humans. Animals, they say, are more sensitive to such minute shocks. So next time when you see a dog with raised ears or a kitten with tilted head, they’re probably experiencing an earthquake. Of these 20 percent (100,000) earthquakes which are felt by humans. And about 1 percent actually cause any damage. So we see that more than 99 percent of the damage is caused by less than 1 percent of the earthquakes. That, my friend, is the Power Law, a very important mental model from Algebra. It’s not just earthquakes but other natural calamities, like floods, also adhere to Power Law. 40 percent of a decade’s damage due to flood usually comes from just one such event. You might argue that a severe earthquake or a monstrous flood, or any other natural calamity won’t cause any damage if it were to occur at a place where there aren’t any property or human presence. True, but it’s not about loss in terms of money. Damage is a proxy for the intensity of the earthquake. And intensity of an earthquake is a function of energy released during the earthquake. Mark Buchanan, in his book Ubiquity – Why Catastrophes Happen, describes how some systems, including earthquakes, can be represented by the Power Law. He writes … 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 type B, then type A quakes happen four times less frequently. Double the energy, that is, and an earthquake becomes four times as rare. [For wildfires] Once again we find the same geometric pattern: double the area covered by a fire, and it becomes about 2.48 times as rare…In other words, despite the


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Chapter 21 - The Power Law | Mental Models, Investing, And You 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 GutenbergRichter law for ecological conflagration. In algebra, a Power Law is any curve in which the height changes in proportion to the horizontal distance raised to some power. Power law is an extension of the Pareto principle, named for Italian economist Vilfredo Pareto. Pareto principle describes the relationship between how common a factor is and how much influence it exerts. It says that the most unusual events will have the greatest impact. In his book, The Black Swan, Nassim Taleb writes … It [Pareto principle] is the common signature of a power law – actually it is how it all started, when Vilfredo Pareto made the observation that 80 percent of the land in Italy was owned by 20 percent of the people. Some use the rule to imply that 80 percent of the work is done by 20 percent of the people. Or that 80 percent worth of effort contributes to only to only 20 percent of results, and vice versa. …The 80/20 rule is only metaphorical; it is not a rule, even less a rigid law. In the U.S. book business, the proportions are more like 97/20 (i.e., 97 percent of book sales are made by 20 percent of the authors) Power law is an acute form of Pareto principle where the proportion of 80:20 becomes as much skewed as 99:1. This law can be seen all around us. For example, in most businesses, 80% of the revenue is brought in by top 20% of the activities.


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Chapter 21 - The Power Law | Mental Models, Investing, And You This relationship between low frequency and high impact is found again and again, in various fields of science, business, and elsewhere including Twitter (20 percent of the Twitter users are responsible for 80% of all the tweets, roughly). In movie business, for instance, 90 percent of the profits come from 10 percent of the movies. Which means many films lose money, and a few are huge hits. But if you compute the average box office receipts, you may be fooled into thinking that all films earn money — which is far from the case. And for directors, 40 percent of their lifetime revenues come from a single film. It’s also known as ‘winner takes all’ effect. Charlie Munger, while talking about advantages of scale, explains There’s another kind of advantage to scale. In some businesses, the very nature of things is to sort of cascade toward the overwhelming dominance of one firm. The most obvious one is daily newspapers. There’s practically no city left in the United States, aside from a few very big ones, where there’s more than one daily newspaper. And, again, that’s a scale thing. Once I got most of the circulation, I got most of the advertising. And once I got most of the advertising and circulation, why would anyone want the thinner paper with less information in it? So it tends to cascade to a winner-take-all situation. Here is a fascinating example of how Power Law can be used in the context of health and fitness. Arthur De Vany in his book, The New Evolution Diet, writes There is a power law of exercise, too: Your least frequent most extreme exertions will have the greatest influence on your fitness. The peak moments of a workout count far more than the amount of time you spend working out. This


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Chapter 21 - The Power Law | Mental Models, Investing, And You is why a series of 40-yard sprints at full speed benefits you more than a half an hour of jogging. It’s also the reason why lifting a weight heavy enough to make your heart pound your muscles burn counts more than spending hours at the gym always in your comfort zone, never truly challenging your body. When a workout becomes an unvarying, monotonous routine, it loses its effectiveness. In modern world, the increased complexity around us makes our world more prone to Power Law. There are few other mental models which are relevant here – Complex Adaptive Systems (Chapter 25), Feedback Loop (Chapter 32) and Network Effect (Chapter 37). These, to some extent, explain the occurrence of Power Law. As systems become more complex, with individual parts interacting and evolving (like stock market), the behaviour of the systems become highly unpredictable. And because of the mutual interaction and network effect (e.g. more people join Facebook because they find more people there instead of any other social network) the outcome becomes highly skewed. Nassim Taleb has named these complex systems as ‘Extremistan’. And Black Swan is the term he has coined to represent those rare and unexpected outliers which have high impact (like those rare but severe earthquakes).

In Investing When it comes to investing, power of compounding is one of the most important fundamental principle to learn. Rs 100,000 compounded at the rate of 15 percent for 40 years becomes Rs 26,800,000 or Rs 2.6 crore. What’s the most important part of this compounding process is that more than 50 percent of this Rs 2.6 crore comes in the last 5 years!


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Chapter 21 - The Power Law | Mental Models, Investing, And You For that matter, the world’s greatest investor, Warren Buffett, made 80 percent of his current total wealth after his 60th birthday. Call it compounding, call it Power law – it’s very counter intuitive to human brain. And that’s why most people just can’t comprehend the huge element of nonlinearity present in the process of long term value investing. Patience has non-linear payoff. Peter Theil writes in his book Zero To One In venture capital, where investors try to profit from exponential growth in early-stage companies, a few companies attain exponentially greater value than all others. This is because venture returns don’t follow a normal distribution overall. Rather, they follow a power law: a small handful of companies radically outperform all others. If you focus on diversification instead of singleminded pursuit of the very few companies that can become overwhelmingly valuable, you’ll miss those rare companies in the first place.

Conclusion Let me close this chapter with an insight from Rolf Dobelli’s book The Art of Thinking Clearly Back in the Stone Age, we hardly ever encountered anything truly extraordinary. The deer we chased was sometimes a bit faster or slower, sometimes a little bit fatter or thinner. Everything revolved around a stable mean.


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Chapter 21 - The Power Law | Mental Models, Investing, And You Today is different. With one breakthrough, you can increase your income by a factor of 10,000. Just ask Larry Page [founder of Google], George Soros, J.K. Rowling [author of Harry Potter series] or Bono. Such fortunes didn’t exist previously… So what can be done? Put yourself in situations where you can catch a ride on a positive Black Swan…become an artist, inventor or entrepreneur with a scalable product. If you sell you time (e.g. as an employee, dentist or journalist), you’re waiting in vain for such a break. But even if you feel compelled to continue as such, avoid surroundings where negative Black Swans thrive. This means:

stay

out

of

debt,

invest

your

savings

as

conservatively as possible and get used to modest standard of living – no matter whether your big breakthrough comes or not.


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SECTION 3: SOCIAL SCIENCES


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Chapter 22 Tragedy of Commons I have never been bitten by a dog. By an unfriendly dog to be precise. However, there were few friendly ones who would chase me for fun. Well it was fun for them but as a kid I didn’t particularly enjoy that kind of sport much. So when I moved into my current apartment community, housing nearly two thousand flats, it felt nostalgic because the campus had multiple patches of large open areas which meant it was a boon for dog owners (and heaven for their dogs). Few years back, it wasn’t uncommon to see few fitness conscious dogs taking regular morning and evening walks (along with their disinterested owners) inside the apartment campus. But as the resident population grew, the population of pets followed suit. Pretty soon, it became a common practice for dogs to relieve themselves anywhere in the campus. The pet owners perhaps assumed that cleaning was a responsibility of maintenance staff. This resulted in a campus littered with dog poop. It was ironical that the mess was equally disturbing for all residents (including those offending dog owners) but it was quite logical, in absence of any specific laws about pet poop management, for people to keep their houses clean and compromise with the common area. I couldn’t help but marvel at Aristotle’s insight about this issue. He said – What is common to many is taken least care of, for all men have greater regard for what is their own than for what they possess in common with others.


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Chapter 22 - Tragedy of Commons | Mental Models, Investing, And You Perhaps Aristotle’s neighbourhood had many pets too. Although, during his times people were probably more fascinated with horses than dogs. That reminds me of an interesting trivia – In late 1800s the primary mode of transport was horse carriage and in New York city alone there were close to 150,000 horses. This resulted in more than three million pounds of horse manure per day that somehow needed to be disposed of. Holy crap! Pardon me for all the crappy (and stinky) discussion so far. I think I digressed from the subject. My mind, like an unchained monkey, hops from one branch of thought to other. That’s what I call “google-ification” of human mind. A phenomenon where even before you are finished thinking about a word, the google(ish) mind starts regurgitating interesting trivia about it. The mental model that we are going to look at is called Tragedy of Commons, TOC in short. It’s an important idea from the field of economics and ecology.

Tragedy of Commons TOC is a phenomenon, as we have seen in the case of dog owners above, that results from actions that benefit the individual (meaning single persons, households, villages, companies or nations) in the short term but often end up hurting the collective. Mind you, it’s not a cognitive bias neither a result of irrational human behaviour. On the contrary, it’s the perfect rational behaviour that leads to the long-term ruin of the common resources. This shows how individually good decisions lead to collectively bad outcomes. Gregory Mankiw, in his book Principles of Economics, explains the idea using this simple parable –


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Chapter 22 - Tragedy of Commons | Mental Models, Investing, And You 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. Many of the town’s families own flocks of sheep and support themselves by selling the sheep’s wool, which is used to make clothing. …the sheep spend much of their time grazing on the land surrounding the town…No family owns the land. Instead, the town residents own the land collectively, and all the residents are allowed to graze their sheep on it. Collective ownership works well because land is plentiful. [Very soon] 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, raising sheep is impossible, and the town’s once prosperous wool industry disappears. Many families lose their source of livelihood. What causes the tragedy? Why do the shepherds allow the sheep population to grow so large that it destroys the Town Common? 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. In essence, the Tragedy of the Commons arises because of an externality. When one family’s flock grazes on the


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Chapter 22 - Tragedy of Commons | Mental Models, Investing, And You common land, it reduces the quality of the land available for other families. Because people neglect this negative externality when deciding how many sheep to own, the result is an excessive number of sheep. The Tragedy of the Commons is a story with a general lesson: When one person uses a common resource, he or she diminishes other people’s enjoyment of it. Because of this negative externality, common resources tend to be used excessively. This mental model was further made popular by an American Ecologist Garret Hardin. Charlie Munger spoke about this in his 2003 talk at University of California. He said Well, I thought that the Hardin model made economics more complete, and I knew when Hardin introduced me to his model, the tragedy of the commons, that it would be in the economics textbooks eventually. And, lo and behold, it finally made it about twenty years later. And it’s right for Mankiw to reach out into other disciplines and grab Hardin’s model and anything else that works well.

TOC Is Everywhere TOC isn’t limited to just dogs and sheep. It applies to ecosystems, rivers, oceans, organisms or mineral resources. Even meetings in office! Claims this post – In a culture where anyone can call a meeting for any reason at any time, they will.


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Chapter 22 - Tragedy of Commons | Mental Models, Investing, And You After getting familiar with this mental model, I started noticing it in many others places. In fact, in my apartment complex (for that matter for any community living) I found few more TOC issues – 1. The campus has designated car parking slots for each flat and if someone has multiple cars then they can rent a parking slot. However, the visitor parking area is free. A visitor parking area is supposed to be used as common resource. But TOC kicks in and what do you see? People start using the visitor parking for their extra cars. Not only that, people would even invite their friends’ and relatives’ to leave their cars in the visitor parking for many days. 2. In apartment complexes you can still enforce rules but what about houses which don’t really belong to a closed community? In Bangalore, and perhaps in all big cities, it’s common for people to build their houses without making provision for garage. Why? The road is a common resource and free of cost. So you see most of the roads being used as permanent parking areas by most of the car owners. TOC again!

Image Source: XKCD.com I found this interesting piece of observation on Farnam Street blog about TOC –


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Chapter 22 - Tragedy of Commons | Mental Models, Investing, And You While walking my dog around Philadelphia during the blizzard aftermath, I couldn’t help but notice an interesting trend. Virtually all of the houses with a single occupant or family (as indicated by a single doorbell or knocker) were shoveled

clean.

Nearly

every

house

with

multiple

occupants — and most businesses — were unshoveled. This seems like a TOC in reverse: A common good that requires work to maintain is ignored if there is a diffusion of responsibility. If you really think about it, a lot of social vices are aggravated as a result of TOC. Everyone wants to get rid of corruption but when it comes to getting our work done at public office we don’t mind paying a small bribe, knowing very well that it’s a harmful practice for the society over long term. Peter Bevelin, in his book Seeking Wisdom, writes – Why do people abuse the health care and welfare system? Isn’t it natural that people use the system if they don’t have to pay anything? And if people don’t have to pay for a benefit, they often overuse it. The more people that benefit from misusing the system, the less likely it is that anyone will draw attention to what really happens. Individually they get a large benefit and it’s a small loss for society. Until everyone starts thinking the same.

Limitations of TOC Are there any limitations to this mental model? With all the rules, policies, taxes, and regulations at place a lot of common resources around us have become less prone to fall for TOC.


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Chapter 22 - Tragedy of Commons | Mental Models, Investing, And You Even Garret Hardin revised his theory of TOC a bit to account for this factor. He wrote – To judge from the critical literature, the weightiest mistake in my synthesizing paper was the omission of the modifying adjective “unmanaged.” In correcting this omission, one can generalize the practical conclusion in this way: “A ‘managed commons’ describes either socialism or the privatism of free enterprise. Either one may work; either one may fail: ‘The devil is in the details.’ But with an unmanaged commons, you can forget about the devil: As overuse of resources reduces carrying capacity, ruin is inevitable.” With this modification firmly in place, “The Tragedy of the Commons” is well tailored for further interdisciplinary syntheses. (source: extensions of tragedy of commons) The word “managed” is an important key in addressing the issue of TOC. Let’s see how.

How to Solve TOC Before jumping on the answers let me state that there is no silver bullet solution for this problem, however there are few ways in which you can manage and minimize the impact. Singapore is a great example of how to solve TOC issues especially in dealing with traffic problems. Broadly there are two ways to contain the problem of TOC. First, an enforcement body (like government) can use regulations or taxes to reduce consumption of the common resource. Mankiw suggests in his text –


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Chapter 22 - Tragedy of Commons | Mental Models, Investing, And You If the tragedy had been foreseen, the town could have solved the problem in various ways. It could have regulated the number of sheep in each family’s flock, internalized the externality by taxing sheep, or auctioned off a limited number of sheep-grazing permits. That is, the medieval town could have dealt with the problem of overgrazing in the way that modern society deals with the problem of pollution. This is how the management committee at my apartment complex addressed the issues. They came up with strict rules for pet owners to take the responsibility of cleaning the mess themselves. Of course they had to facilitate poop disposal waste bins which made the task easier. Similarly, management had to come up stringent policies and parking violation fines to control the TOC tendency in car parking problem. The idea of carbon credits and its trading is to contain the carbon emission (pollution). There are some interesting insights in this article about how social entrepreneurs are working with TOC. Second way is to turn the common resource into a private good. Mankiv writes – The town can divide the land among town families. Each family can enclose its parcel of land with a fence and then protect it from excessive grazing. In this way, the land becomes a private good rather than a common resource. This outcome in fact occurred during the enclosure movement in England in the 17th century. Here is an interesting thought – the attached toilet in your bedroom? Isn’t it a private good? May be one day pet lovers might consider installing dog-loo inside their houses. I think that would be sign of a developed country.


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Chapter 22 - Tragedy of Commons | Mental Models, Investing, And You By the way here is an interesting piece of thought, unrelated to the current topic of discussion (just can’t control the unchained monkey in my head) about characteristics of a developed country (or community) – A developed country is not a place where the poor have cars. Its where the rich use public transportation. Interestingly, Garret Hardin seems to be talking on the same lines in this video.

Conclusion Before writing this chapter I was vaguely aware about the idea of TOC. But in the process of researching I learned a lot of new stuff. Please forgive me if I have sounded insensitive towards dogs. I don’t hate dogs. I love them especially when they are chasing other people.


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Chapter 23 Externalities About five years back when I moved into my current apartment community, the area around was pretty much empty. The open land and the surrounding greenery attracted me so much that making the decision was a no-brainer. But I forgot one thing. I should have asked for a guarantee that the greenery will stay that way. It didn’t take much time for small houses to start mushrooming around the campus. Honestly, I shouldn’t be complaining. It’s a free country and people are allowed to construct houses. But it’s always the second order effects which create unexpected problems. With inadequate supply of water from the government, came the need for bore wells for every house. I guess you can imagine where this story is going. With bore wells getting installed in some or the other house every few weeks, started the unwanted and unbearably irritating noise emanating from heavy mechanical devices, drilling holes in mother nature’s heart. I felt I was living in the middle of a 19th century steel manufacturing factory. I had never signed up for this. In today’s capitalist society, when I want to listen to a song on iTunes, I have to shell out money for it. But if I am forcefully exposed to a deafening, non-musical, and unhealthy sound, why am I not being compensated for it? Who should pay for my misery? The driller, the landowner, or the government? I demand that all of them should, but nobody seems interested.


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Chapter 23 - Externalities | Mental Models, Investing, And You Once someone has bought a piece of land and paid the required taxes and duties, he or she is legally allowed to drill a hole in their land, because they have paid the price. But have they really paid the full price? Does the tax include the ‘cost of inconvenience’ caused by such activities to others? For many years I have been at the receiving end of quite a few unpleasant noise polluting activities and sadly I don’t remember getting a tax rebate for the same. I am sure I am not alone. It’s a social problem affecting almost everybody in some way or other. Now before I give a picture of myself as an innocent and helpless victim of such atrocious and violent acts of noise pollution, let me admit that I have been an offender myself. There is at least one instance that my selective memory allows me to divulge. While getting a pigeon net installed in my balcony, which required drilling at least 4050 holes on the shared concrete wall, I ended up creating severe nuisance for my neighbours for couple of hours. And all I had to do was fetch a permission letter from the apartment owner’s association without paying a dime for it. There’s nothing that my neighbours could do except to wait for their opportunity to put holes in their walls and feel avenged. So how do we explain this socio-economic aberration? Sometimes our actions do not have direct costs. These actions can affect others and yet we do not suffer any consequences. The instance of drilling that I just quoted above is a great example of something called negative externality. Imagine the plight of those living close to airports. They neither get a sound sleep nor a discount coupon from airlines. Or for that matter those living close and downwind to industrial areas emitting toxic gases and air pollutants.


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Chapter 23 - Externalities | Mental Models, Investing, And You So that’s the mental model we’re going to discuss – Externalities. An externality is cost incurred or benefit received by a third party who has no control over the factors that created the cost or benefit. In other words, externalities are the spillover effects we experience from an economic decision made by someone else. We experience the externalities without paying a price for the benefit or receiving compensation for the cost. Which means externality can be both negative and positive.

Negative Externality Imagine yourself reaching home on a Friday after a very tiring and hectic work week and all you want to do is crash on your bed and sleep. But your neighbours are in the party mood. I smell a perfect setup for negative externality. Let’s go back to the example of the factory that emits too much smoke. Its owners do not suffer the costs experienced by those downwind, so there is a mismatch between private and public costs. It is not that it’s an unsolvable problem. Policies – like imposing taxes on emissions – can correct the mismatch. Still there is no channel for the emission taxes to directly flow to the victims. An attempt to solve this problem has given rise to a whole new industry called carbon emission trading. Every pollution causing industry is assigned its quota of carbon credits that it’s allowed to do. If it emits more carbon dioxide (a proxy for pollution) than it’s allowed, it can buy carbon credits from another company which hasn’t used its quota of carbon credits. Passive smoking is another hazard in form of negative externality.


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Chapter 23 - Externalities | Mental Models, Investing, And You

Positive Externality If the exterior of a house is particularly beautiful, both passersby and neighbours alike will receive a benefit from its appearance. When a private gardener grows an assortment of beautiful plants in her front garden, it enhances the environment for her neighbours and passers-by. Public goods like parks, national security, and public education are costly to provide. Economic theory tells us people will try to free ride i.e., to let others do the work and pay the costs. But, of course, many public goods are provided voluntarily. People vote to pay taxes to educate other people’s children and to maintain parks they will never visit. Another interesting example that I came across is about the polio vaccination program that government of India has been doing for years. It requires vaccination of every child up to the age of 5 years irrespective of the fact that the child has already been vaccinated before. When a child is vaccinated, the concentration of polio antibodies increases in the environment and the threat to unprotected children gets diluted. That’s a positive externality created by a protected child for the unprotected ones. When someone is courageous enough to pursue their life’s calling, they not only end up creating a meaningful life for themselves but create a positive externality for others who get inspired. If you think about it, people like Warren Buffett and Charlie Munger generate tremendous amount of positive externalities by continuing to do their own work.

Measuring Externalities Without a price tag on externalities, it is difficult to consider their value and, therefore, their effect on society’s total welfare. Indeed, this is how they are defined.


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Chapter 23 - Externalities | Mental Models, Investing, And You The inability to charge for externalities may be a problem and is therefore an opportunity for better resource allocation. Markets have trouble measuring externalities. Ensuring maximum social welfare may require specialized institutions to monitor the positive and negative spillovers created in private markets. We already have some institutions that do this: government agencies that limit air and water pollution, tax credits that reward energy conservation, a legal system that imposes liability on firms that supply unsafe products, and professional codes that proscribe unethical conduct.

In Business Value creation is an important goal for all companies, but value creation for a company’s shareholders isn’t always necessarily aligned with value creation for society as a whole. A company involved in manufacturing tobacco products or alcohol (even sugared beverages) may be operating very ethically in all money matters. But when it comes to adding value to the society by such businesses, it becomes a highly debatable topic. If one used the mental model of externalities, it may help think through this problem.

In Investing Investing in a well-run business where the management changes subsequently and misallocates capital, creates negative externalities for its investors. Another example of negative externalities in the stock market is when a leading company from an industry lists on the exchanges, which reduces the valuation premium that other listed companies from that industry enjoyed in the past. This is what happened, for example, when TCS listed on the exchanges in 2004, which


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Chapter 23 - Externalities | Mental Models, Investing, And You reduced the valuation premium that investors in Infosys and Wipro had enjoyed in the past. Speculators selling good quality stocks in a market crash is a positive externality for a sensible, long term investor. Of course you have to be prepared to take the full advantage of these opportunities. After all, bargains in market aren’t as easy as finding a neighbour with a beautiful garden.


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Chapter 24 Complex Adaptive Systems Let me share with you two very interesting case studies. The first one is set in the time of British India. The British government was concerned about the number of venomous cobra snakes in Delhi. The government therefore offered a bounty for every dead cobra. Initially this was a successful strategy as large numbers of snakes were killed for the reward. Eventually, however, enterprising people began to breed cobras for the income. When the government became aware of this, the reward program was scrapped, causing the cobra breeders to set the now-worthless snakes free. As a result, the wild cobra population further increased. The apparent solution for the problem made the situation even worse. (Source – Wikipedia) Now there is no way to validate the authenticity of above story but the second one is very recent and a true incident set again in the city of Delhi. It’s equally amusing. Among many bridges built over the river Yamuna in Delhi, one is DND Flyway which is a toll bridge. During rush hour (evening and morning) there is a huge pile up right at the start of the toll where vehicles stop to pay toll charges. To ease this traffic jam, officials came up with a simple strategy. They made the rush hours toll free. So vehicles didn’t have to pay the toll if they crossed the bridge between 8 to 10 am and 5 to 7 pm. As a result, drivers who were about to cross the bridge even 30 minutes before the free timings started waiting right before the toll until 5 pm evening (or 8 am in the morning). This made the problem worse and increased the traffic.


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Chapter 24 - Complex Adaptive Systems | Mental Models, Investing, And You I couldn’t help but admire the ingenuity of the cobra breeders and the intelligent cost conscious drivers. But think about it for a moment. In spite of good intentions, did the government and the toll-road officials eliminate bad consequences? No.

Outcomes and Intentions Samuel Johnson said, “The road to hell is paved with good intentions.” By solving one problem, we generate another one and sometimes create an even worse one. The common pattern here is that somebody tried to modify the behaviour of a system by tinkering with it in a small way. But that small action produced significant unintended consequences. In fact, every action has consequences, intended and unintended. No matter how carefully we plan, we can’t anticipate everything. This brings forth a very important learning about how the world around us works and responds to our actions.

Complex Adaptive Systems Look around and you’d realize how you are surrounded by complex systems. Your car, TV, smart phone, and the elevator (that you use to avoid stairs) are all complex systems. They involve multiple independent moving parts that interact with each other to produce desired behaviour. Any system composed of independent components working with each other can be termed as complex system. Is your body a complex system? Actually it’s more than that. When you exercise, your body builds new muscles and stronger bones. It adapts. That makes our bodies complex adaptive systems. For that matter, every living organism is a complex adaptive system.


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Chapter 24 - Complex Adaptive Systems | Mental Models, Investing, And You Traffic is also a complex adaptive system. When you see traffic in your lane, you change lane or probably take an alternate route to your destination. It is a complex system in which its inhabitants adapt to each other’s actions. The key element of a complex adaptive system is the social element. The belts and pulleys inside a car do not communicate with one another and adapt their behaviour to the behaviour of the other parts in an infinite loop. Drivers, on the other hand, do exactly that. Consider the human society. When you buy a new iPad that is manufactured in China, with materials derived from African soils, and with software developed by programmers from India, you need to realize that those actions are made by autonomous organizations, firms and individuals. These many individual actions are guided by rules and agreements we have developed, but there is no ruler who can control these interactions. These are thus complex adaptive systems.

Systems Thinking When you are dealing with complex adaptive systems, you have to look at it as a whole system in which actions and reactions are taking place. The system is more than just the sum of its parts. Charlie Munger understood the risks of unintended consequences while dealing with social systems. When asked about corporate responsibility for social problems, he answered – I’m all for fixing social problems. I’m all for being generous to the less fortunate. And I’m all for doing things where, based on slight preponderance of the evidence, you guess that it’s likely to do more good than harm...


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Chapter 24 - Complex Adaptive Systems | Mental Models, Investing, And You What I’m against is being very confident and feeling that you know, for sure, that your particular intervention will do more good than harm given that you’re dealing with highly complex systems wherein everything is interacting with everything else. I assume that if you are looking for ideas that can make you a better investor, then you might be on the verge of losing interest in this post. Please allow me hold your attention for few more seconds by telling you this – you acquire tremendous edge in understanding the behaviour of stock market if you have the mental model of complex adaptive systems in your toolbox.

In Investing Complex adaptive systems mental model is a useful way to think about the stock market, since the market can be characterised as a weighing machine built on many investors’ individual views and transactions (and their behavioural biases). This weighing machine is continually adapting to new information under conditions of uncertainty and complexity. Investors are component parts of the system capable of responding to positive and negative feedback from the system. From these interactions (or transactions in stock market terms), patterns emerge which inform the behaviour of agents in the system and, ultimately, the behaviour of the system itself. However, just like studying one worker bee in a hive, analysis of individual investors yields limited insight, since market direction emerges at a higher, aggregate level. In fact, the efficient market theory (EMT) has its roots in this idea. It assumes that the ability of stock market to instantaneously adapt to any new information or fact is flawless. However, EMT fails to take into account that complex adaptive systems don’t always go in the direction of correction. From time to time, they can (and do) become highly unstable by virtue of their ability to respond to any stimuli.


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Chapter 24 - Complex Adaptive Systems | Mental Models, Investing, And You Forecasting, because of these unpredictable dynamics of markets, especially in short term is next to impossible. Fidelity’s former manager Peter Lynch said in One Up on Wall Street: There are 60,000 economists in the U.S., many of them employed full-time trying to forecast recessions and interest rates, and if they could do it successfully twice in a row, they’d be millionaires by now...As far as I know, most of them are still gainfully employed, which ought to tell us something. Charlie Munger says – Economics involves too complex a system...economics should emulate physics’s basic ethos, but its search for precision in physics-like formulas is almost always wrong. You can’t look at a single investor’s action or one industry performance or an isolated econometric parameter to predict the behaviour of stock market. Howard Marks explains in his must-read book The Most Important Thing – ...investing can’t be reduced to an algorithm and turned over to a computer. Even the best investors don’t get it right every time...no rule always works. The environment isn’t controllable, and circumstances rarely repeat exactly. There are always people who claim to know the cause-effect relationship in market cycles but those theories are mostly built with the advantage of hindsight. Don’t believe the financial experts and stock market gurus who say they can forecast unforeseeable variables. Nobody can forecast the stock market, interest rates or


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Chapter 24 - Complex Adaptive Systems | Mental Models, Investing, And You currency rates, GDP, market cycles, etc. The more widely publicised forecast, the less reliable it is. Michael Mauboussin has written a detailed paper on the similarity of stock markets and complex adaptive systems. Mr. Mauboussin champions a view that the stock market is a complex adaptive system, which, like an ant colony or flock of birds, is a highly organized system with no leader.

In Business Consider this common mistake that many naive business managers are guilty of making. They see sales volumes dropping and in an attempt to correct that, they reduce prices. They reason that what they lose on price will be made up by increased volume and the market share will increase. However, they fail to anticipate all the consequences of cutting prices. What if the increased volume is not supported by current capacity? What if the competitors also cut prices? What if the price cut reduces the brand value perception for customers? You can’t keep thinking linearly in one routine way and hope to beat the index returns. You need to learn to think about second order effects. A brilliant insight from Howard Marks’ on this – First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy! First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.”


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Chapter 24 - Complex Adaptive Systems | Mental Models, Investing, And You First-level thinking is simplistic and superficial...Secondlevel thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account. Second-level thinking is a very effective skill to deal with the uncertainties of complex adaptive systems like stock market. When you are about to buy a stock, ask yourself following questions – 1.

Why is the seller selling it?

2.

How would I reason if I think it through from the viewpoint of the other person?

3.

Why would I make a better decision than someone who has all the information?

4.

What is the probability that I am right?

It’s easy to forget this in the excitement of a new opportunity. These questions can save you from the unintended consequences of your decision. Porter’s five force analysis model is another great tool to apply systems thinking into business analysis. It zooms out your vision to look at the industry and takes your focus away from overused and incomplete parameters like P/E ratios.

Conclusion I hope now you can appreciate the role of complex adaptive systems in providing a useful perspective to demystify the stock market behaviour. And not just the stock market but it gives us an edge in business analysis too.


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Chapter 25 Moral Hazard Millions of years ago, before the agriculture revolution, when homo sapiens was still living life as a hunter-gatherer, there was this one naturally occurring phenomenon which aroused a sense of wonder, fear and longing at the same time in his mind. The phenomenon occurred on its own in nature and humans found it very useful but it espoused extreme dread too because of its destructive capabilities. I think you can guess what I am talking about. That natural phenomenon was wild fire! About 100,000 years ago, humans finally learned how to create fire and it accelerated the development of human race. Fast forward to this day. Even after having developed technologies to create, douse and control all sorts of fires, wildfire is one thing where humans have found themselves helpless in front of mother nature. Wildfire kills 339,000 people every year, even today! So why we haven’t been able to do much about wildfire carnages? Agreed, we can’t prevent a tsunami or an earthquake but we can surely prevent and contain a fire. Right? The surprising truth is that with the help of modern technology the number of wildfires have come down drastically over the last hundred years but the total destruction caused by these fires hasn’t gone down proportionately. It even seems to have increased. That’s perplexing, isn’t it? Is there something wrong with these wildfire prevention efforts? Of course we aren’t doubting the intentions of these fire prevention squads. Here is a hint from famous philosopher Karl Marx who said –


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Chapter 25 - Moral Hazard | Mental Models, Investing, And You

The road to hell is paved with good intentions. This takes me back to the year 1991. “Why can’t government print lots of money and distribute it to the poor?”, as a 10-year-old I remember asking this from my social science teacher. It was puzzling to me that why wasn’t the solution obvious to government. “Printing money is a bad idea because it will solve the problem in short term but it will increase the inflation.” My teacher explained to me. Of course I had no clue what inflation meant and I wasn’t the curious type so I left it at that. It took me another decade and a half to finally understand the relationship between inflation and currency supply. I know I haven’t uttered a single word about our mental model, but please bear with me. Your patience will be rewarded well. Let’s return to our wildfire conundrum. Frequent wildfires are mother nature’s mechanism to get rid of the inflammable biomass that accumulates in forests. Every time someone intervenes, with all good intentions, to suppress these relatively smaller wildfires, it sets the stage for bigger, meaner and deadlier conflagration. Because of artificial suppression of the smaller fires, people living in those areas assume that the risk has gone away. This may attract more people to inhabit those areas and eventually when the bigger fire erupts (with more than enough fuel in form of unused biomass), not only its size and intensity is much higher but it engulfs a much larger area. The effect is non-linearly amplified. Suppressing five small fires doesn’t result in a five times bigger fire, it could mean a 10 times bigger fire or even a 100 times. Howard Marks, author of The Most Important Thing, writes –


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Chapter 25 - Moral Hazard | Mental Models, Investing, And You The government’s long campaign to tame wildfires has, perversely, made the problem worse...By stamping out most wildland blazes as quickly as possible, the Forest Service has stymied nature’s housekeeping – the frequent, well-behaved fires that once cleaned up the pine forests of the Sierra Nevada and the Southwest. Now, woodlands are tangled with thick growth and dead branches. When fires break out, they often explode…. the policy of fighting fires early also created moral hazard by encouraging people to build homes further into the forest. Please note the word ‘Moral Hazard’, because that’s the mental model we are going to discuss in this chapter. Moral hazard describes a situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly. As a result, a party, which does not bear the true costs associated with its action, is likely to behave in a reckless fashion. A simplest example would be the business of insurance. Someone who has a fire insurance for his house is going to be less vigilant about fire hazards like not installing the fire alarms. This creates a moral hazard for the insurance companies. Essentially the risk is not just transferred to the other party but it may even increase. A similar case with medical insurance too. Medical professionals tend to prescribe more expensive treatment (even if it’s not required) for patients covered under medical insurance. I hope you remember our discussion on Complex Adaptive Systems (Chapter 24). Recall the story of cobra snakes and how government’s policy, incentivizing the snakekilling, backfired. It was an apt example of law of unintended consequences, which states that good intentions don’t always result in good outcomes especially when


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Chapter 25 - Moral Hazard | Mental Models, Investing, And You you’re dealing with complex adaptive systems. So it’s not uncommon when the cure turns out to be worse than the disease. Economy or for that matter stock market is a complex adaptive system, very much prone to the law of unintended consequences. Because of that Moral Hazard is something which needs to be thought about before making any decision. Every time government prints more money for bailing out a failing bank or a troubled PSU, they are sending a wrong signal which says – it’s okay to take absurd risks because we will protect you. And that sets the stage for an eventual meltdown. There is a clear analogy between financial crises and forest wild fires. Politicians and economists have a tendency to quickly douse any and every small fire (a bank or institution facing crunch) which leads people to take foolish risks. Just like forest department felt a need to keep those unwisely built forest houses safe, government feels it has to rescue the imprudent borrowers and financial institutions. Robert Rubin, former secretary of US treasury, in his book, In An Uncertain World, describes moral hazards problems at the macroeconomic level – …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 market-based 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.


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Chapter 25 - Moral Hazard | Mental Models, Investing, And You Ironically, Mr. Rubin earned $120 million from Citibank in bonuses over about a decade. The risks taken by the institution were hidden. Citibank collapsed, but he kept his money while taxpayers had to compensate him retrospectively since the government took over the banks’ losses. In the moral hazard equation Rubin chose to be on the profitable side, writes Nassim Taleb in his book Antifragile.

Image Source: Dilbert.com Howard Marks went on to add How can a free-market economy allocate capital effectively if capital creation is abetted and capital destruction is prevented? The fact is, excesses have to be corrected – painfully – and if they aren’t, they’ll just grow bigger and bigger as the cycles wear on. “Moral hazard” will arise, convincing people that risk takers will always be bailed out, something that’s bound to encourage greater risk taking. If you give it a thought you would realize that a similar thing is currently happening in Indian tech-startup industry where mindless growth supported by venture capital is creating a moral hazard for investors since many of the tech entrepreneurs, having diluted most of their stake, aren’t exposed to much risk. Most of these reckless founders have already cashed on multimillion dollar pay cheque as CEOs and won’t bear the direct risk if the company goes under.


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Chapter 25 - Moral Hazard | Mental Models, Investing, And You The idea is simple, explains Jeffrey Tucker, in an article published by the Mises Institute in December 1998 If you are continually willing to protect people from the consequences of their own errors, your benevolence will be factored into the future decisions of the persons rescued. In the long run, they will make even more errors. The principle exists at all levels. The teacher who changes grades when students plead hardship isn’t helping in the long

run.

The

teacher

is

rewarding

and

thereby

encouraging poor study habits. He is creating moral hazard. Taleb dubs this as transfer of fragility. He writes – The worst problem of modernity lies in the malignant transfer of fragility and antifragility from one party to the other, with one getting the benefits, the other one (unwittingly) getting the harm, with such transfer facilitated by the growing wedge between the ethical and the legal. This state of affairs has existed before, but is acute today – modernity hides it especially well. When a suit-tie wearing middlemen (investment banker) bundles a bad loan as securities to other investors, he doesn’t worry whether the borrower will repay in five years’ time. He gets paid just for making the deal so all he will care about is more quantity than quality. The 2008 financial crisis was largely a moral hazard created by these kind of credit derivatives. Consider an example of a CEO who is not the owner of the company and has recently been appointed. His pay depends on company’s performance in subsequent year, which means he has all the reasons to take (risky) decisions which will benefit


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Chapter 25 - Moral Hazard | Mental Models, Investing, And You company in short term including the ones which may be detrimental over long term. The way things unfold after that isn’t that hard to guess. At the end of the first year he goes home with a fat paycheque and few years down the line when business suffers the long term effects of his decision, he is sacked but not without a healthy severance package. Shareholders become the victims of this moral hazard situation. Seth Klarman, in his 1998 letter to shareholders, wrote – Investors are strangely willing to ignore the moral hazard of their own behavior, rewarding managements which successfully manipulate quarterly earnings into a steady and predictable uptrend. And don’t forget that the sacked CEO, having learned that he doesn’t face the risk, will soon be repeating his tactics at some other company, conveniently spreading the moral hazard. In designing social policies, there is fine line between discouraging entrepreneurship and making them dependent on a safety net. In the long run bailing out people is less harmful to the system than bailing out firms.

Skin in The Game The solution of course is that nobody should be in a position to have the upside without sharing the downside, particularly when others may be harmed. But how? Warren Buffett offers a solution – If I were running things and if a bank had to go to the government for help, the CEO and his wife would forfeit all


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Chapter 25 - Moral Hazard | Mental Models, Investing, And You their net worth. … And that would apply to any CEO that had been there in the previous two years. …I think you have to change the incentives. The incentives a few years ago were try and report higher quarterly earnings. It’s nice to have carrots, but you need sticks. Moral hazard being a problem caused by human behaviour is obviously not a new one and so the solution also exists in the ancient code of Hammurabi, which was formulated 4000 years ago. It says – If a builder builds a house for a man and does not make its construction firm, and the house which he has built collapses and causes the death of the owner of the house, that builder shall be put to death. Therefore, you have to redesign the incentives because at the end of the day it’s nothing but an agency problem (incentive caused bias). We need people to have their skin in the game.

Conclusion Moral hazard is very tightly coupled to other mental models like complex adaptive systems and incentive caused bias. No wonder it manifests as lollapalooza, a confluence of multiple mental models working in the same direction. Look around you and you’ll find that moral hazard isn’t just limited to wildfires, insurance and financial transactions.


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SECTION 4: ECONOMICS


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Chapter 26 Matthew Effect In April 2013, Little Brown, an American publishing company, released The Cuckoo’s Calling, a début novel by an obscure author called Robert Galbraith, who the publisher described as “a former plainclothes Royal Military Police investigator who had left in 2003 to work in the civilian security industry”. The novel, a crime detective story, sold 1500 copies in hardback. Some even say that this number is the number of copies that were printed for the first run, while the sales total was closer to a meagre 500. Nothing surprising, as more than 90% percent of the books that are published worldwide, hardly sell more than couple of hundred copies. But unlike others, something remarkable happened with Galbraith’s novel. Four months after it was first published, the sale skyrocketed by 4000 percent. This happened when it was revealed that Robert Galbraith was a pseudonym used by J.K. Rowling, author of Harry Potter series and United Kingdom’s best-selling living author. (source: Wikipedia) Calling her a successful author would be a huge understatement. Her books have sold more than 400 million copies. J. K. Rowling isn’t the only one who has experimented with pseudonyms. Another famous novelist, Stephen King, published a handful of short novels under the pseudonym Richard Bachman. He wanted to test whether he could replicate his success again. Unfortunately, the experiment confirmed his fears that his popularity wasn’t entirely a result of his talent. My point is that the rich and famous have an advantage in attracting more fame and money. In other words, those who have more have an advantage in acquiring more. So


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Chapter 26 - Matthew Effect | Mental Models, Investing, And You it’s easier for the rich to get richer, for the famous to become more famous. It’s called Matthew Effect. Now before you jump to the black-and-white world of deterministic reasoning, let me clarify a bit. I don’t mean to say that the rich and famous always get richer and more famous. They just have odds in their favour. The term Matthew Effect was first coined by sociologist Robert Merton in 1968 and takes its name from a verse in the biblical Gospel of Matthew, pertaining to Jesus’ parable of the talents: For unto every one that hath shall be given, and he shall have abundance: but from him that hath not shall be taken even that which he hath. I am sure you have grown up hearing a similar version of it – “The rich get richer, and the poor get poorer.” Matthew was probably referring specifically to wealth but Merton argues that the same rule applies to success more generally. Simply put, an individual’s early success confers on him certain structural advantages that make subsequent successes much more likely, regardless of their intrinsic aptitude. I distinctly remember one of the debates that I had with my college roommate. It was a time when I had overdosed on the self-help literature and strongly believed in the storyline – The hero (billionaire, entrepreneur, rock star, celebrity etc.) is born in modest circumstances and by virtue of his own grit and talent fights his way to greatness. My roommate had a better worldview and argued that luck had a significant role to play in most runaway success stories. An initial advantage, however small, has the potential to turn the direction of future events, sometimes wildly.


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Chapter 26 - Matthew Effect | Mental Models, Investing, And You It took me another decade, after that fateful discussion, to appreciate his point. Malcolm Gladwell, in his wildly popular book Outliers, describes the case study on Canadian Ice Hockey in 1980s where the rules for admission into hockey leagues favoured people who were born in first quarter of the calendar year. Ice Hockey in Canada is what Cricket is in India, so you can imagine that luck (date of birth) had a huge role to play in a player’s career, success and fame. So players born in the months of January, February or March got head start in their career. Gladwell writes – It is those who are successful who are most likely to be given the kinds of special opportunities that lead to further success. It’s the rich who get the biggest tax breaks. It’s the best students who get the best teaching and most attention…Success is the result of what sociologists like to call “accumulated advantage.” Nassim Taleb, in his book Black Swan, argues – This theory can easily apply to companies, businessmen, actors, writers, and anyone else who benefits from past success. If you get published in The New Yorker because the color of your letterhead attracted the attention of the editor, who was daydreaming of daisies, the resultant reward can follow you for life. More significantly, it will follow others for life. Failure is also cumulative; losers are likely to also lose in the future, even if we don’t take into account the mechanism of demoralization that might exacerbate it and cause additional failure.


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Chapter 26 - Matthew Effect | Mental Models, Investing, And You Again, every initial advantage doesn’t turn into success story. But whenever you see a successful person, don’t ignore the possibility that an initial advantage got him or her into series of events supported by positive feedback loop (Chapter 32) and over a period of time the accumulated advantage resulted in final outcome. In a wonderful book Everything Is Obvious, the author, Duncan Watts, writes on the Matthew effect – …when we try to explain why some individual is rich or successful common sense insists that the outcome arises from some intrinsic quality of the object or person in question. A best-selling book must be good some-how or else people wouldn’t have bought it. A wealthy man must be smart in some manner or else he wouldn’t be rich. But what the Halo Effect and the Matthew Effect should teach us is that

these

common

sense

explanations

are

deeply

misleading. It may be true that abjectly incompetent people rarely do well, or that amazingly talented individuals rarely end up as total failures, but few of us fall into those extremes. For most of us, the combination of randomness and cumulative advantage means that relatively ordinary individuals can do very well, or very poorly, or anywhere in between. None of this is to say, of course, that people, products, ideas, and companies don’t have different qualities or abilities. Nor does it suggest that we should stop believing that quality should lead to success. What it does suggest, however, is that talent ought to be evaluated on its own terms.


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Chapter 26 - Matthew Effect | Mental Models, Investing, And You The cynic’s question, if you’re so smart, why aren’t you rich? is misguided not only for the obvious reason that at least some smart people care about rewards other than material wealth, but also because talent is talent, and success is success, and the latter does not always reflect the former.

Matthew Effect in Knowledge acquisition Imagine you’re sitting in front of Charlie Munger and both of you are silently reading the same issue of Economist. Can you guess who would end up with more insights at the end of this reading session?

Image Source: All About Learning Press


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Chapter 26 - Matthew Effect | Mental Models, Investing, And You That’s a no brainer, isn’t it? The obvious answer is Charlie Munger. With all due respect to your intelligence, unless you are Warren Buffett, there is nobody on this planet who can match Munger’s brilliance. And I am not saying that because I am Munger fanatic. There is a strong reason behind my claim. Charlie is 92 and continues to read boatload of books every year. Not only he got an early start but he has been accumulating knowledge for more than half a century. A person with more expertise has a larger knowledge base, and the large knowledge base allows that person to acquire even greater expertise at a faster rate. So the amount of useful insights that Charlie can draw from Economist would be quite high as compared to any other human being, and Munger would again end up becoming smarter at a faster rate. As you learn to read more, your capacity to read even more and absorb more increases rapidly. When I started reading books, most books didn’t make a whole lot of sense. But slowly I started finding connection between ideas spread across different books. These connections deepen understanding of those ideas and makes the brain more efficient and smarter to make sense of the new information. So start early to take advantage of Matthew Effect in your quest for acquisition of worldly wisdom.

In Investing What makes value investing versatile is that all the knowledge that you gain while studying businesses is cumulative. When you study a business, even if you end up rejecting it, you gain important knowledge about the industry in which that business operates and at the very least learn more about characteristics of poor businesses.


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Chapter 26 - Matthew Effect | Mental Models, Investing, And You Once you have accumulated a certain amount of knowledge base, any incremental addition to that foundation increases the value of that knowledge base exponentially. Noted value investor Mohnish Pabrai, in his book The Dhandho Investor, describes how his knowledge about oil shipping industry (which he gained while researching a stock that he eventually didn’t invest in) helped him find another bargain later. He writes – I knew nothing about the oil shipping business, but was curious to find out more about the industry and why these businesses had such high dividend yields. I spent a few days studying

Knightsbridge

and

the

oil

shipping

business…Knightsbridge was making astronomical profits at the time, and the dividend yield went through the roof. But, of course, it was not durable or sustainable. At the time I studied Knightsbridge, I also took a look at half a dozen other publicly traded pure plays in oil shipping. Since the dividend could go to zero, Knightsbridge was an easy pass. In investing, all knowledge is cumulative. I didn’t invest in Knightsbridge, but I did get a decent handle on the crude oil shipping business. In 2001, we had an interesting situation take place with one of these oil shipping companies called Frontline. Pabrai Funds had a 55 percent return on the Frontline investment and an annualized rate of return of 273 percent. Not bad for a near risk-free bet based on boning up on the nuances of oil shipping by reading a few documents. So don’t worry if you haven’t found any businesses worth investing after spending months together analysing and rejecting couple of dozen stocks. If you keep at it, the


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Chapter 26 - Matthew Effect | Mental Models, Investing, And You day is not far when you’ll be connecting the dots faster than you imagined. When that happens, don’t forget to thank Matthew.

Conclusion People who belong to the meritocratic school of thought believe that successful people must be more talented or must have worked harder than their less successful counterparts or at the very least they must have taken better advantage of their opportunities. It is the best and the brightest who always rise to the top is much too simplistic a worldview.


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Chapter 27 Game Theory Every time I get into my car, the thought of crossing the “dead-circle” sends a shiver down my spine. “Dead-circle” is the name that I have given to the intersection near my house. It’s a small intersection with no traffic lights and rarely managed by any traffic police. What scares me most about this intersection is that it doesn’t need a lot of traffic to invite a gridlock situation. A traffic gridlock is so frequent in that junction that I have started calling it the deadcircle. Throw in four five cars, couple of two wheelers and you have the perfect recipe for a jam. In the first few minutes of traffic jam the whole area drowns in the echo of incessant honking. In another few minutes you find few restless drivers rolling down their windows and shouting at each other. I feel very bad for the people living near that intersection. Poor victims of a serious case of negative externality (Chapter 23) What’s interesting is that just like stock market, greed and fear rules the behaviour in traffic jams. Everybody is either scared of staying stuck in traffic (even if it’s only for 5 more minutes) or greedy about saving another 5 seconds by not giving way to another fellow. Given an option between offering the way to another car and zooming past shamelessly, most people go for the latter. It’s as if they are trying to cross a collapsing bridge.


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Chapter 27 - Game Theory | Mental Models, Investing, And You If they just let one car pass turn by turn, the traffic would flow smoothly. By being selfish some cars do manage to save few seconds but it’s not uncommon to find the offending driver getting caught right in the middle of the gridlock. Overall the gridlock ends up wasting time for many other commuters. The example shows what’s best for you, the individual (or a small group), may not be best for society (or a larger group). This brings us to an important idea from the discipline of Economics. It’s called Game Theory. Game theory deals with what happens when individuals or groups of people interact with one another to achieve their goals. Unless you really understand game theory, you can’t begin to actually understand human behaviour. The best way to understand the concept of game theory is to look at the problem of prisoner’s dilemma. Let me take Peter Bevelin’s help in describing this problem. Peter, in his masterpiece book Seeking Wisdom, writes Suppose you and a partner commit burglary. Both of you are picked up by the police who then question you one by one. There is not enough evidence to convict you unless one of you confesses. The interrogator gives you a choice to cooperate or not. 1. If you both deny the crime, there is still enough evidence to put you both in jail for 1 year. 2. If you both confess, you both go to jail for 3 years. 3. If you confess but your partner denies, you will be free and your partner will go to jail for 10 years. 4. If you deny but your partner confesses, you will go to jail for 10 years.


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Chapter 27 - Game Theory | Mental Models, Investing, And You What should you do? The consequences for you depend on what your partner does. From an outsider’s perspective, it seems that both of you would be better off denying the crime (1 year). But from your point of view, it seems best to confess (freedom). The problem is that you don’t know what your partner will do. If your partner betrays you, it is better that you also betray him and get 3 years in prison, instead of the 10 years you get if you deny, but your partner ends up confessing. If on the other hand your partner denies, it is still better that you confess because this way you will be free, instead of the 1 year you get if you deny. Since both you and your partner follow this “logic” and confess, you will both go to jail for 3 years. Doing what you believe is in your best interest leads to a worse outcome than if you cooperate and deny. But here is the dilemma. You don’t know if you can trust your partner. Cooperation only works if you and your partner can trust each other. Same logic holds in the traffic gridlock situation. If you let the other guy go first (akin to denying), you can’t trust that the next guy will let you pass (confess). So a rational response is to confess i.e. be greedy and selfish in crossing the intersection.



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Chapter 27 - Game Theory | Mental Models, Investing, And You As an aside, some of you might remember the movie A Beautiful Mind, which was based on John Nash’s life. John Nash won the Nobel prize in economics for making important contributions to game theory. Let’s explore how game theory gives us insight into the world of business, investing and other areas.

In Business In a competitive market, each firm is so small compared to the market that strategic interactions with other firms are not important. In a monopolized market, strategic interactions are absent because the market has only one firm. So when it comes to understanding the monopolistic or competitive markets, game theory isn’t much useful. But game theory becomes particularly interesting in oligopolistic market, where there are two or three equally strong players. Because each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce. In making its production decision, each firm in an oligopoly should consider how its decision might affect the production decisions of all other firms. In their paper, Avinash Dixit and Barry Nalebuff, use the example of Pepsi and Cocacola to explain how game theory works in business. The prisoner’s dilemma has applications to economics and business. Consider two firms, say Coca-Cola and Pepsi, selling similar products. Each must decide on a pricing strategy. They best exploit their joint market power when both charge a high price; each makes a profit of ten million dollars per month. If one sets a competitive low price, it wins a lot of customers away from the rival. Suppose its profit rises to twelve million dollars, and that of the rival


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Chapter 27 - Game Theory | Mental Models, Investing, And You falls to seven million. If both set low prices, the profit of each is nine million dollars. Here, the low-price strategy is akin to the prisoner’s confession, and the high-price akin to keeping silent. Call the former cheating, and the latter cooperation. Then cheating is each firm’s dominant strategy, but the result when both “cheat” is worse for each than that of both cooperating.

Game Theory and Arms Race It’s estimated that US alone has a stock of weapons and ammunition which can destroy the planet earth many hundred times over. Same with other countries like Russia. Why do these countries keep manufacturing weapons? Game theory, Dixit and Nalebuff say, has answers – Arms races between superpowers or local rival nations offer another important example of the dilemma. Both countries are better off when they cooperate and avoid an arms race. Yet the dominant strategy for each is to arm itself heavily. Yuval Harari, in his brilliant book Sapiens, connects biology and game theory in an interesting way. He writes – Game theory explains how in multi-player systems, views and behaviour patterns that harm all players nevertheless manage to take root and spread. Arms races are a famous example. Many arms races bankrupt all those who take part in them, without really changing the military balance of power. When Pakistan buys advanced aeroplanes, India responds in kind. When India develops nuclear bombs, Pakistan follows suit. When Pakistan enlarges its navy,


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Chapter 27 - Game Theory | Mental Models, Investing, And You India counters. At the end of the process, the balance of power may remain much as it was, but meanwhile billions of dollars that could have been invested in education or health are spent on weapons, yet the arms race dynamic is hard to resist. ‘Arms racing’ is a pattern of behaviour that spreads itself like a virus from one country to another, harming everyone, but benefiting itself, under the evolutionary criteria of survival and reproduction. (Keep in mind that an arms race, like a gene, has no awareness – it does not consciously seek to survive and reproduce. Its spread is the unintended result of a powerful dynamic.)

In Investing In the context of investing, no one can explain game theory better than Buffett. He wrote in his 1986 letter to shareholders – Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures

in

our

highly-profitable

candy

and

newspaper businesses. But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industry-wide.


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Chapter 27 - Game Theory | Mental Models, Investing, And You Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.

Conclusion The Game Theory mental model is useful in understanding not just the traffic gridlock but a host of other problems in Economics, Biology, Political Science, Computers, Poker and even why people arrive late. Further reading: 1.

Split or steal?

2.

The art of acting rational.

3.

Prisoner’s Dilemma


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Chapter 28 Gresham’s Law Between the years 1324 to 1351, Delhi was ruled by an emperor named Mohammadbin-Tughluq from the Tughluq dynasty. He had a scholastic background and spoke multiple languages. In spite of good intentions, some of the policies that he enforced during his rule backfired which made him infamous as an eccentric ruler. One such failed idea was about an experiment that he did with the local currency. Tughluq noticed that India had very few silver coins and a comparatively larger number of bronze and copper coins. He decided to promote bronze or copper coins by passing a royal order that bronze and copper coins are to be accorded the same value (i.e., same purchasing power) as silver coins. In other words, he wanted the markets to mentally consider bronze and copper as silver itself so that 1 gm coin of bronze can buy the same goods as 1 gram of silver. It looked like a neat idea however the emperor failed to consider the law of unintended consequences (Chapter 24) The loophole in this strategy was that copper and bronze coins were very easy to forge. As a result, the silver coins completely disappeared from markets and this led to a tremendous increase in the circulation of bronze and copper in the market because people started minting their own coins. Consequently, this led to a rise in the prices of essential commodities and a hyper-inflation like scenario. Eventually, Tughlaq had to withdraw this order and bronze and copper returned to their nominal value i.e., their value fixed by the free market. (Source: Wikipedia) This phenomenon is known as Gresham’s Law, named after Sir Thomas Gresham, an English financier who formalized this observation as a law of economics. Before moving ahead, let’s look at the formal definition of Gresham’s Law.


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Chapter 28 - Gresham’s Law | Mental Models, Investing, And You Gresham’s Law is a monetary principle stating that “bad money drives out good.” In currency valuation, Gresham’s Law states that if a new coin (bad money) is assigned the same face value as an older coin containing a higher amount of precious metal (good money), then the new coin will be used in circulation while the old coin will be hoarded and will disappear from circulation. (Source: Wikipedia)

Image Source: Wikipedia I think discussion of Gresham’s Law would be incomplete without mentioning the apocryphal account of India’s most celebrated capitalist Mr. Dhirubhai Ambani’s businesses acumen. During his days in Yemen when Dhirubhai used to work as a manager in a filling station, he observed that the Yemini Rial was made of silver coins and was very much in demand in London Bullion exchange. He would collect the silver


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Chapter 28 - Gresham’s Law | Mental Models, Investing, And You coins and melt them into pure silver to sell them into the market. Hearing Dhirubhai’s story Mr. Gresham would surely have felt vindicated. In the world we live today, Gresham’s Law in its original form may not find much utility. In his speech given at Harvard-Westlake school in California in January 2010, Charlie Munger said – In economics textbooks they teach you Gresham’s Law: Bad money drives out good. But we don’t have any bad money that amounts to anything. We don’t have any coins that are worth a lot, that have precious metals that you can melt down. Nobody cares what the melt-down value of the quarter is in relationship to the dime, so Gresham’s Law is a non-starter in the modern world. Bad money drives out good. But the new form of Gresham’s Law is ungodly important. The new form of Gresham’s Law is brought into play – in economic thought, anyway – in the savings and loans crisis, when it was perfectly obvious that bad lending drives out good. Think of how powerful that model is. Think of the disaster that it creates for everybody. What do you do when the world’s greatest multidisciplinary thinker tells that Gresham’s Law holds tremendous insights? Well you want to explore this mental model in other fields of human endeavors. Don’t you? Let’s find out.

In Learning In yesteryears, the sources of information were acutely limited for most people. But the story is remarkably different in the modern world where the quantum of information that an average person consumes in a week is more than what an earlier


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Chapter 28 - Gresham’s Law | Mental Models, Investing, And You generation was exposed to in a lifetime. Although accessibility to wide array of information brings with it the advantage of better efficiency in our affairs, but can you guess what kind of risk this introduces? It is said that an intelligent way to answer a question is to pose another question. And Gresham’s Law asks us the fundamental question: Is bad information driving out good information? Unlike a currency whose value is easy to measure, the quality of information is not. In spite of having a strong bullshit filter, which mental models help you construct, it’s still a complex issue to separate a bad information from real knowledge. Why is it so? Majority of the content we consume these days doesn’t cost us anything. With no money at stake, the primary criteria for choosing something to read is the attractiveness of the content. This brings us to the next question. What makes a content attractive? Evolution has programmed us to be attentive to psychologically arousing content i.e., content that is gross, violent, or gossip which is humiliating, embarrassing, or offensive. Sadly, this isn’t really knowledge. It’s an illusion and mostly a waste of time. Incentives of the modern media is aligned to supply us the stories we want to read — not the ones we should read. Please note that there is nothing bad about the notion of reading for entertainment, but the thin line between knowledge and entertainment is getting blurred. Most of us consume information under the illusion that our knowledge is increasing, not realizing that our precious time is getting spent in reading for entertainment. And this is how the high quality information is driven out by cheap low cost content. You have to brace yourself from becoming a victim of Gresham’s Law. This means that information you should ingest doesn’t always have to be interesting initially. It also


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Chapter 28 - Gresham’s Law | Mental Models, Investing, And You means that an effort is required on your side to resist the seductive content and focus on something which may be difficult to digest. Some of the most valuable sources of information (including books) may not consistently give you interesting information but if you keep at it, over a long term, you will end up becoming more knowledgeable and better decision maker. Mr. Gresham would be never have imagined that his ideas will find application in information age.

In Business and Investing In a raging bull market, where a lot of poor quality businesses become center of attraction for majority of investors, nobody talks about business fundamentals. So, in a way, the sound practices of identifying a business are ousted by greed and envy driven shortcuts. One of the common practices among investors is selling the winners and holding on to the losers (because of sunk cost fallacy). A natural outcome is that they are left with a portfolio consisting of losers only. Gresham’s Law of investing – bad stocks driving out the good stocks from the portfolio. Talking about culture of bad accounting practices, Warren Buffett wrote in his 1999 letter to investors – ...managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree). To pump the price, they strive, admirably, for operational excellence. But when operations don’t produce the result hoped for, these CEOs resort to unadmirable


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Chapter 28 - Gresham’s Law | Mental Models, Investing, And You accounting stratagems. These either manufacture the desired ‘earnings’ or set the stage for them in the future. Rationalizing this behaviour, these managers often say that their shareholders will be hurt if their currency for doing deals – that is, their stock – is not fully priced, and they also argue that in using accounting shenanigans to get the figures they want, they are only doing what everybody else does. Once such an everybody’s-doing-it attitude takes hold, ethical misgivings vanish. Call this behaviour Son of Gresham: Bad account drives out good. Charlie Munger, in his 1984 Letter to Wesco Shareholders, expressed his concerns about Gresham’s Law affecting the loan practices. He pointed out how bold (bad) loan practices were driving out the conservative (good) loan practices which could lead to widespread insolvencies in the banking industry. The concept also applies to morals. William Ophuls writes – As with Gresham’s Law in economics, bad values drive out good, so moral currency is continuously debased. Unethical behaviour is contagious. If you find that it’s easy to cheat and steal in an organization, it’s just a matter of time before majority of the people in that system start exhibiting dishonest and unethical behaviour. Even if everybody was absolutely honest to begin with, social proof makes it increasingly hard for any individual to behave in a good way. Watching those around you succeed for wrong reasons isn’t easy to handle. Envy is hard to counter. Such is the human behaviour. If you closely observe, you would realize that ‘Incentive Bias’ and ‘Social Proof’ together create the lollapalooza of Gresham’s Law. This proves how interplay of multiple behavioural biases result in extreme irrational outcomes.


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Chapter 28 - Gresham’s Law | Mental Models, Investing, And You In politics also, bad behaviour tends to drive out higher moral values and principles. It’s not very uncommon to see young people with good intentions get into politics only to get sucked in by dark forces of so called “dirty politics”.

Conclusion Gresham’s Law explains a lot of happenings in the world around us. But keep in mind that no mental model explains everything completely. So Gresham’s Law too needs few pre-conditions to take shape i.e., a positive feedback loop reinforcing the bad behaviour/practice/value etc.


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Chapter 29 Law of Diminishing Marginal Utility “Chocolates!” replied Soham, my nephew, with a glint in his eyes. That was his response to my question “What is happiness?” “So you think the secret of happiness lies in chocolates?” I quizzed him further. “Yeah! It’s bliss,” he blurted while going around in circles in his tricycle. “Bliss?” I thought to myself, “That’s quite a mouthful of adjective coming from a fiveyear-old.” “Okay! Here is a chocolate. Tell me if it makes you happy?” “Thanks Mamaji (that’s what he calls me),” he screamed as he literally snatched it from my hand and in no time the chocolate was gone. He was ecstatic. May be he was right. Chocolate is bliss. “So if one chocolate makes your happy, more chocolates should make you happier. Isn’t it?” I was attempting to play Socratic Solitaire (the tradition of asking question that helps somebody discover the wisdom) with an unsuspecting kid. “Yes…more bliss!” he quipped, while making bigger circles with his tricycle and relishing the after taste of the first éclair. Where in the world did he learn this word ‘bliss’, I wondered. “All right. So here is another chocolate and let me know if this one makes you happier than the first one?”


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Chapter 29 - Law of Diminishing Marginal Utility | Mental Models, Investing, And You With this move, I thought I was just a few steps away to make the kid realize the futility of materialism. However, what the smart aleck inside me didn’t know that in next few minutes, that little boy was going to stump me with his raw intellect. “Very happy!” he screamed again and gulped the second éclair too. After two more chocolates, as I expected, Soham’s excitement for the chocolates dwindled and he didn’t look interested in the fifth chocolate. I started telling him, “So you see, you don’t want the fifth one as much as you wanted the first chocolate. It means happiness is not in chocolates.” I expected a blank stare from him followed by the expression where the truth dawns upon him. Instead what he said left me dumbfounded. “No. It’s not in all chocolates. Happiness is in the first four chocolates,” and he took off in his super bike leaving me with my chocolates and the seed for a remarkable insight. The insight, of course, was about an important mental model from the field of economics. It’s called the Law of Diminishing Marginal Utility. For the rest of this post, we will use the acronym DMU. Let me define DMU now. As a person increases consumption of a product – while keeping consumption of other products constant – there is a decline in the marginal utility that the person derives from consuming each additional unit of that product. In other words, for each additional unit of a good (in my nephew’s case, a piece of chocolate) the added satisfaction you receive from consuming the good decreases. Let’s deconstruct it and look at each term in isolation first. What does the term “utility” mean?


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Chapter 29 - Law of Diminishing Marginal Utility | Mental Models, Investing, And You In economics, scientists are concerned with examining issues of the supply and demand of goods and services. This theory assumes that people are perfectly rational and make choices about purchasing goods or services depending on what is in their best self-interest. And how do you measure what is in someone’s best self-interest? This is where the concept of utility comes in. Think of utility as the benefit a person gets from consuming a good or service. For Soham, utility was the satisfaction he gained from eating chocolates. Now imagine how utility changes (increases or decreases) as a person consumes more of the same good. In Soham’s case, the utility was the highest for the first piece of chocolate. Even the second and third chocolates delivered the same utility as the first one. However, the satisfaction he got from the fourth piece was definitely not as high as the first three. As a result, he refused the offer for the fifth chocolate.

It is important to understand that the concept of utility is a relative one. As a kid, I probably had a higher threshold than Soham and would have accepted half a dozen more éclairs. Different people gain different levels of satisfaction from eating chocolate depending on their preferences. Let’s explore some areas where DMU surfaces in the world around us.


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Chapter 29 - Law of Diminishing Marginal Utility | Mental Models, Investing, And You

DMU and Buffet (not Warren!) I am sure you must have been to one of those “all you can eat” food buffet restaurants offering wide array of food items. Have you wondered how do they manage to provide you so much quantity and variety for such reasonable prices? Buffet restaurant owners would not make the promise of unlimited food if they weren’t going to make a profit. The simple truth is; they know a secret. And the secret is that we can’t eat all. Why? DMU, buddy! Restaurant owners know all too well that each additional plate of food provides less utility than the plate before. By the time we get to our second or third serving, we’re so full that eating anything extra will actually harm us (dis-utility). So, in reality, there is no such thing as all you can eat because we simply cannot eat it all. By the way, did you know that Coca Cola’s (yes, that caffeinated, celebrity promoted, black coloured sugar syrup) flavour is designed in such a way that it leaves very little aftertaste in your mouth, which means your marginal utility of coke consumption doesn’t diminish as rapidly as it should with any other sugared drink. That is, unfortunately though, the beauty of Coca Cola’s product. Let’s talk about something other than food.

DMU and Taxes Benjamin Franklin once said – In this world nothing can be said to be certain, except death and taxes.


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Chapter 29 - Law of Diminishing Marginal Utility | Mental Models, Investing, And You I don’t know about death (haven’t experienced it yet) but there is an interesting rationale behind progressive tax rates. Progressive taxation results when the rate of taxation increases with an increase in income. The logic is based on the assumption that the rich have lower marginal utility of money as compared to the poor people. Hence the rich should be taxed higher.

Loss Aversion and DMU Once you get a hang of DMU, it’s easy to understand Daniel Kahneman’s loss aversion theory which states that losses hurt more than gains feel good. Simply put, the pain generated by a loss of Rs 100 would be more than the pleasure of gaining Rs. 100. This explains why people’s fear of loss is much greater than desire to gain.

Look at the graph above. It shows how the utility goes down with every incremental step. To summarize the graph, if Rs 100 is added to your wallet which already contains


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Chapter 29 - Law of Diminishing Marginal Utility | Mental Models, Investing, And You two hundred rupees, it gives you a pleasure worth of 15 units. Another hundred, and your pleasure increases by a relatively smaller amount, i.e., 10 units. And so on. When somebody moves from point B to point A, the utility derived by getting Rs. 100 is 15 units. Whereas when one moves from point A to point C, 10 units of utility is derived by gaining Rs 100. In the same graph, imagine that point A is now the origin, i.e. left of A corresponds to negative X-axis (losing money). Now if we start from point A and move towards point B, loss of Rs. 100 sets us back by 15 units of utility. On the contrary, if we move from point A to point C, a gain of Rs. 100 fetches us a utility of 10 units. So the loss of Rs 100 is heavier, in terms of utility, than a gain of Rs 100. That’s what loss aversion theory says.

In Business and Investing The concept of marginal utility is also useful in thinking about the idea of marginal cost in businesses. Marginal cost is the cost of producing one more unit of a good. In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. For a business which sells software products, the marginal cost of an extra piece of end product is close to zero. However, for a typical brick and mortar business, selling tangible products like FMCG, the marginal cost of additional product is significant. Consider social networks like Facebook, Twitter or LinkedIn. The marginal cost of signing up one additional member is close to zero. But each new member brings nonzero, sometimes pretty substantial, value to the entire network. In general, marginal cost favors businesses that have differentiated products and brand names. So, extending the above logic, if a manufacturer wants to make a decision about producing more, it should keep producing unless the per unit revenue is less than the


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Chapter 29 - Law of Diminishing Marginal Utility | Mental Models, Investing, And You marginal cost of production (assuming that all products can be sold). However, this strategy can be fatal for commodity type of business, where every competitor cuts prices so that the price hovers just above the marginal cost. Airlines is a great example of being victim of marginal cost. So much so that, Charlie Munger calls them ‘marginal cost with wings’. Many researches have proven that DMU is applicable in case of portfolio construction also. Having multiple stocks in your portfolio decreases the risk of permanent capital loss. However, every additional stock in your portfolio brings down the risk in diminishing order. So much so that, after certain point (many experts suggest that number to be 20), the risk doesn’t decrease at all by adding more stocks.

Increasing Marginal Utility Your knowledge about an idea, or mental model, isn’t complete until you know where it fails to work. What’s more important, than an idea itself, is the knowledge about its limitations. Charlie Munger said – I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do. So let’s see where DMU doesn’t work. Many a times the marginal utility or the marginal cost remains constant with additional unit of consumption. Can you think of an example? If you buy 1 kg of gold bar for x rupees, how much would you have to spend for 2 kg of gold? 2x. And the equation is linear. No DMU here!


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Chapter 29 - Law of Diminishing Marginal Utility | Mental Models, Investing, And You Can you think of an example where the marginal utility not just stays constant but increases with each additional unit of consumption? Some of you might be tempted to say “alcohol”. Well, I like the way you think but I am calling it a dry day today. Diamond! The price of a 10 carat diamond is not twice the price of a 5 carat diamond. In fact, the price for every additional carat increases pretty rapidly and non-linearly. “Anshul, can we please talk about something other than jewelry and Jack Daniels?” I hear your concerns. Okay, how about stock market? In stock market, when somebody wants to buy a meaningful stake in a company, perhaps with an intention of acquiring control, the marginal utility of every additional share and its cost increases. That’s why most of the acquisitions happen at a large premium to the current market price. We can call this phenomenon as the law of increasing marginal utility. I am not sure if this term is recognized by economists so let’s just keep it between you and me. Oh, I almost forgot to mention. The pleasure I derive out of sharing mental model ideas with you, follows the law of increasing marginal utility for me. How about you? I hope it’s not DMU for you.


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Chapter 30 Pari-mutuel System You don’t win by predicting the future; you win by getting the odds right. You can be right about the future and still not make any money. ~ Will Bonner The way to win in stock market, according to Charlie Munger, is to work, work, work, work and hope to have a few insights. Now, the question is – how many insights do you need in your investing lifetime? Not many, as Munger says… …you don’t need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that’s with a very brilliant man—Warren’s a lot more able than I am and very disciplined—devoting his lifetime to it. I don’t mean to say that he’s only had ten insights. I’m just saying, that most of the money came from ten insights. So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced something or other. And you’re probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It’s just that simple.


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Chapter 30 - Pari-mutuel System | Mental Models, Investing, And You Munger uses horse racing’s Pari-mutuel betting system as one of his mental models to make sense of stock market investing. He is asking us to think like a Pari-mutuel player and look for the mispriced bets. So what’s a Pari-mutuel system and how does one find a mispriced bet in such a system?

Pari-mutuel System Pari-mutuel is a system of betting in which the winners divide the total amount bet, after deducting management expenses, in proportion to the sums they have wagered individually. Unlike many forms of casino gambling, in Pari-mutuel betting the gambler bets against other gamblers, not the house. The simplest and most common example of a Pari-mutuel system is horse race betting.

Image Source: Poor Charlie’s Almanack


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Chapter 30 - Pari-mutuel System | Mental Models, Investing, And You Let’s assume a hypothetical horse race with 5 horses where people can bet their money on their choice of horse. Once the race starts, no more wagers are accepted. So here’s the distribution of money bet on each horse just before the race starts. Horse

1:

Rs. 20,000

Horse

2:

Rs. 3,000

Horse

3:

Rs. 2,000

Horse

4:

Rs. 500

Horse

5:

Rs. 4,500

Thus, the total pool of money on the event is Rs. 30,000. Let’s say that horse-1 wins the race. The payout is now calculated. First the commission or the take for the house (company organising the race) is deducted from the pool. For example, with a commission rate of 15% the house keeps 30,000 x 15% = Rs. 4,500. This leaves a remaining amount of Rs. 25,500. This remaining amount in the pool is now distributed to those who bet their money on the winning horse i.e. horse-1. So people who bet their money on winning horse get 25,500 / 20,000 = 1.2 for each rupee wagered. So the payout ratio for them was 1.2. With the same logic the payout ratio for each horse is as follows – Horse

1:

25,500 / 20,000

= 1.2

Horse

2:

25,500 / 3,000

= 8.5

Horse

3:

25,500 / 2,000

= 12.7

Horse

4:

25,500 / 500

= 51

Horse

5:

25,500 / 4,500

= 5.6

This is a simplified example. In real-life horse racing the pool size often extends into millions of dollars with many different types of outcomes (winning horses) and complex commission calculations. From this example you can see that if one puts money on a horse which is a favorite of most people, the payout isn’t much. However, the payoff ratio for horse-4 is 51-to-1.


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Chapter 30 - Pari-mutuel System | Mental Models, Investing, And You Now the payoff ratio isn’t necessarily same as the odds of winning. However, in a world where everyone has the same information the payoff ratio acts as proxy for the odds.

Handicapping When the odds aren’t commensurate with the payoff ratios, the opportunity for making disproportionate returns arises for the handicappers. The science of predicting the outcome of a race is called handicapping. It is the practice of predicting and quantifying the results of a horse race. Handicappers attempt to determine the odds and see if the payoffs are skewed compared to those odds. Put simply, it’s a way to find the mispriced bets. Steven Crist, CEO and editor of the Daily Racing Form argues that even a horse with a very high likelihood of winning can be either a very good or a very bad bet, and that the difference between the two is determined by only one thing: the odds. So a horse with a 50 percent probability of winning can be either a good or bad bet based on the payoff. In other words, it is not the frequency of winning that matters, but the frequency times the magnitude of the payoff. That’s the idea behind expected value analysis for the events ruled by probabilistic outcomes including gambling, horse race handicapping and investing. In the example used above, if a handicapper, based on his knowledge and analysis (about horses, tracks and past races) figures out that the odds of winning for the horse4 is 10 percent then his expected value for the bet would be 0.1×51 – 0.9×1 = 4.2. Based on this he can take a call if he wants to make a bet or not. The upfront commission of 15-17 percent makes Pari-mutuel system hard to beat for most people. Charlie Munger writes – Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position, etc., etc., is way more likely to win than a horse with a terrible


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Chapter 30 - Pari-mutuel System | Mental Models, Investing, And You record and extra weight and so on and so on. But if you look at the damn odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then, it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it’s very hard to beat the system. And then the track is taking seventeen percent off the top. So not only do you have to outwit all the other bettors, but you’ve got to outwit them by such a big margin that on average, you can afford to take seventeen percent of your gross bets off the top and give it to the house before the rest of your money can be put to work. Given those mathematics, is it possible to beat the horses using only one’s intelligence? Intelligence should give some edge because lots of people who don’t know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical could have a very considerable edge, in the absence of the frictional cost caused by the house take. Unfortunately, what a shrewd horseplayer’s edge does in most cases is to reduce his average loss over a season of betting from the seventeen percent that he would lose if he got the average result to maybe ten percent. However, there are actually a few people who can beat the game after paying the full seventeen percent. At 16 years of age Warren Buffett had mastered the art of handicapping. He was introduced to the world of Pari-mutuel betting very early in his life. He learned that


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Chapter 30 - Pari-mutuel System | Mental Models, Investing, And You the key was having more information than the other guy—then analysing it right and using it rationally. Buffett implemented his handicapping strategies in Ak-Sar-Ben race track. He recalls – …what I would do is read all these books. I sent away to a place in Chicago on North Clark Street where you could get old racing forms, months of them, for very little. They were old, so who wanted them? I would go through them, using my handicapping techniques to handicap one day and see the next day how it worked out. I ran tests of my handicapping ability day after day, all these different systems I had in my mind. Buffett was back testing his handicapping strategies in 1940s when there were no computers. No wonder his obsessions with handicapping lead him to read every book on the subject available at the Library of Congress. One of the greatest insight that Buffett and Munger had early in their investing career was about market inefficiencies. And the insight came from their knowledge about Pari-mutuel system. Charlie Munger, in his lecture at UCSB in 2003, said – It was always clear to me that the stock market couldn’t be perfectly efficient, because, as a teenager, I’d been to the racetrack in Omaha where they had the pari-mutuel system. And it was quite obvious to me that if the ‘house take’, the croupier’s take, was seventeen percent, some people consistently lost a lot less than seventeen percent of all their bets, and other people consistently lost more than seventeen percent of all their bets. So the pari-mutuel system in Omaha had no perfect efficiency. And so I didn’t accept the argument that the stock market was always perfectly efficient in creating rational prices.


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Chapter 30 - Pari-mutuel System | Mental Models, Investing, And You Stock market has lower frictional costs than horse race betting. In the absence of high transactional costs, it’s easier to be profitable in stock market than horse races. Munger writes – The stock market is the same way – except that the house handle is so much lower. If you take transaction costs – the spread between the bid and the ask plus the commissions – and if you don’t trade too actively, you’re talking about fairly low transaction costs. So that, with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things. It is not a bit easy…But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking. Drawing analogy between investing and Pari-Mutuel system, Munger says – To us, investing is the equivalent of going out and betting against the pari-mutuel system. We look for a horse with one chance in two of winning and which pays you three to one. You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing. Pari-mutuel system is wonderful mental model to think about the stock market. Like a horse race track, people go to stock market offering to buy/sell stocks and based on the price paid the odds of winning keep changing. One of the most important learning from the Pari-mutuel system is: making infrequent bets. In his lecture, A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business, Charlie Munger said –


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Chapter 30 - Pari-mutuel System | Mental Models, Investing, And You I used to play poker, when I was young, with a guy who made a substantial living doing nothing but bet harness races. Now, harness racing is a relatively inefficient market. You don’t have the depth of intelligence betting on harness races that you do on regular races. What my poker pal would do was to think about harness races as his main profession. And he would bet only occasionally when he saw some mispriced bet available. And by doing that, after paying the full handle to the house – which I presume was around seventeen percent – he made a substantial living. It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one. And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.

Conclusion Understanding how a Pari-mutuel system works gives you important clues about stock market. We learnt that market, like a Pari-mutuel, are efficient but not always. However, it’s not easy and with all the frictional costs and house’s commission, on average people end up losing money in Pari-mutuel set up. But you can make money by learning to handicap and betting infrequently. I would leave you with this piece of wisdom straight from horse’s mouth (no pun intended). Buffett wrote this in his 1993 letter to shareholders -


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Chapter 30 - Pari-mutuel System | Mental Models, Investing, And You Charlie and I decided long ago that in an investment lifetime it’s just too hard to make hundreds of smart decisions. That judgment became ever more compelling as Berkshire’s capital mushroomed and the universe of investments that could significantly affect our results shrank dramatically. Therefore, we adopted a strategy that required our being smart – and not too smart at that – only a very few times. Indeed, we’ll now settle for one good idea a year.


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SECTION 5: PHYSICS


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Chapter 31 Thermodynamics The big idea that we are going to look at today from the field of Physics is Thermodynamics. Before you get too scared of the big word let me assure you that we’re not going to be discussing any mind bending formulae here. In fact, here a confession is in order. The subject of Thermodynamics has fascinated me since my college days. And the fascination was mostly because it provoked more dread than excitement. Perhaps my bad karma from past life, call it Karma-dynamics, made sure that I barely got passing marks in any paper related to Thermodynamics. So trust me, I won’t even make an attempt to go anywhere near complex equations. The plan is to learn some basics and use that knowledge to gain useful insights that will help us make an educated guess about few interesting problems. What kind of problems? Here is one for starter – Why is there disproportionate difference in size between the largest mammal on land (elephant) and the largest mammal in water (the blue whale)? In case you aren’t aware of the difference, here is a visual to give you some perspective. Click here for bigger image.


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Eye popping, isn’t it? Blue whale is an ultimate display of mother nature’s marvels. So let’s start probing by thinking about a simpler question. If you had an ice cube weighing 8 kgs, and if you had 8 smaller ice cubes each weighing 1 kgs, will there be any difference in melting time? This is a question that Peter Bevelin asks in his book Seeking Wisdom. I suggest you take a few moments and think about the problem before reading further. To be able to solve this, you need to have some basic idea about surface areas and volumes of 3 dimensional bodies. This video will help you get some handle on the fundamentals. In short, as the volume grows for any object, its surface area grows at a much slower rate and the ratio (volume) / (surface area) becomes increasingly bigger. You still with me on this? Okay, once this concept is clear, let’s look at the first law of thermodynamics.

The Law of Conservation of Energy First law encompasses several principles, one of which is the law of conservation of energy, which states that energy can be neither created nor destroyed. However, energy can change forms, and energy can flow from one place to another. The total energy of an isolated system does not change. Which means that the total energy produced by metabolism (which results from the breakdown of food consumed) inside an animal’s body has to be expended in form of physical activity or heat produced or a combination of both.


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Chapter 31 - Thermodynamics | Mental Models, Investing, And You Now let’s take Bevelin’s help in connecting above two concepts. He describes an interesting thought experiment in his book – Assume we make a human 10 times larger than normal. This means he is now 10 times longer, 10 times wider, and 10 times higher…The giant has 1,000 times more meat on the body but only 100 times the skin to hold it …[which] means that his skin surface area is too small to remove the heat emitted from his huge body. He would suffer from overheating since the amount of heat his body produces is proportional to the cube of his length (1,000), while the amount of heat he dissipates through the skin is proportional to the square of his length (100). If the difference between heat produced and heat released is large, it will raise the core temperature of the animal body which might lead to death if the temperature goes beyond a normal body temperature range. So we know that heat loss becomes a hurdle for size of a land mammal. But what about animals in the water? I remember when my grandmother wanted to cool down the hot milk, she would partially immerse the milk vessel in a bigger vessel containing cold water. When I studied Thermodynamics in college it formally explained how the rate of heat loss in water is higher than rate of heat loss in air. My grandmother didn’t know anything about principles of Thermodynamics but she intuitively understood that immersing in water expedites the loss of heat. So, extending the logic, we conclude that water mammals can afford less surface area per unit of volume because of their ability to lose heat faster inside water.


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Chapter 31 - Thermodynamics | Mental Models, Investing, And You Hence we can make a reasonable speculation as to why Blue Whale is so big. Now this may not be the only reason but it shows how multidisciplinary learning can help us construct approximately right answers and that’s what Charlie Munger suggests – It’s better to be approximately right than precisely wrong. So far so good, but what’s the use of learning all this Thermo-Shermo if you can’t use it for gaining insights about stocks market investing?

In Investing Instead of trying to find an analogy myself, I would redirect you to a blog post written by Prof. Bakshi (in 2005) which takes the first law of thermodynamics and applies it to the idea of risk. He writes The law of conservation of risk states that the total inflow of risk in a system must equal the total outflow of risk from the system, plus the change in the risk contained within the system. In other words, risk can be converted from one form to another, but it cannot be created or destroyed. Take the simple example of a hedging operation involving shorting index futures. The hedger who shorts the index futures is trying to protect herself from a market decline. Should the market decline, the value of her stock portfolio will also decline, but this decline is expected to be offset by the profit she will make on the short futures position. So far, so good. But, is it? Is it really that simple? Has the risk to the hedger been reduced? Of course not. The risk of the decline in the price has merely been transferred to the buyer (counter-party)


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Chapter 31 - Thermodynamics | Mental Models, Investing, And You of the index futures. But that’s not the whole story. There is more to it. By selling the index futures, the hedger has transferred the price risk to the buyer of the index futures but has assumed another risk. That risk is credit risk i.e. the risk that the counter-party may default. While it’s true that with the presence of organized futures markets with margin requirements and other risk mitigation measures in place, credit risk is much lower at the individual level, this does not mean that the risk in the entire system has been reduced. At the individual level, risk may be reduced but not at the system level. Apart from this, there are few interesting parallels between the capital markets and the laws of thermodynamics, as described in this post which I found in Capital Ideas Online blog. Here is an excerpt – In considering energy in nature or markets, it is helpful to think of potential energy, on the one hand, and “working” transformations of energy, on the other. Active forms of energy include kinetic, chemical, electric, electromagnetic, elastic (as in a bouncing ball), nuclear, heat, and sound. Money available to buy stocks may be thought of as a form of potential energy. When cash piles up in money-market accounts and investment in stocks dwindles, as it did in 2001 and 2002, the situation is similar to a pendulum pausing at the top of its arc. At that moment, the energy seems to have disappeared. In reality, it is there in


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Chapter 31 - Thermodynamics | Mental Models, Investing, And You potential form and quite likely to be converted into movement. When movement beings, one possible route is into equity funds. At the beginning of 2002, the ratio of assets in equity funds relative to money market funds was 1.5, close to a four-year low of 1.4. A high of 2.6 occurred in the spring of 2000 just as the market was embarking on its terrible 18 months descent. What about the other laws of Thermodynamics? Well, the second law of thermodynamics, in simple terms, states that anytime work is done, some energy is used nonproductively (not to do work) to simply increase the entropy (disorder, chaos) of the universe. So the entropy of the universe is constantly increasing. For example, when you burn fuel to heat water, some part (a substantial) of the heat energy will be lost to the surroundings. When you ride a bicycle some part of your energy is lost in dealing with friction. This entropy is somewhat similar to the transactional cost (brokerage, taxes etc.) that we incur in the stock market. The entropy of stock markets could be the brokers and no-skin-in-the-game money managers. Look at Berkshire Hathaway, it may look huge like a one big monolithic cube but in reality it’s more of a collection of loosely coupled smaller cubes. So the heat loss is very efficient for this big organism.


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Chapter 31 - Thermodynamics | Mental Models, Investing, And You As I have said earlier, it’s good to learn about an idea but it’s absolutely critical to know its limitations too. Let’s see where Thermodynamics doesn’t really explain things but continue to be used and abused.

Thermodynamics and Weight Loss One of the areas where the law of conservation of energy (calorie) has been overused and misused is weight loss diets and fads. Shane Parrish has compiled few interesting ideas from the book Why We Get Fat which questions the conventional wisdom about the calorie-in-calorie-out model – The very notion that we get fat because we consume more calories than we expend would not exist without the misapplied belief that the laws of thermodynamics make it true. When experts write that obesity is a disorder of energy balance—a declaration that can be found in one form or another in much of the technical writing on the subject—it is shorthand for saying that the laws of thermodynamics dictate this to be true. And yet they don’t. Nassim Taleb, in his masterpiece Antifragile, voices similar concerns about misplacing the idea of conservation of absolute calories and its limitations in weight loss – …there is no clear evidence that sugar-free sweetened drinks make you lose weight in accordance with the calorie saved…Somehow those recommending these drinks [1 calorie diet coke] are under the impression, driven by the laws of physics (naive translation from thermodynamics), that the concept we gain weight from calories is sufficient for further analysis. This would be certainly true in


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Chapter 31 - Thermodynamics | Mental Models, Investing, And You thermodynamics, as in a simple machine responding to energy without feedback, say, a car that burns fuel. But the reasoning doesn’t hold in an informational dimension in which food is not just a source of energy; it conveys information about environment. The ingestion of food combined with one’s activity brings about hormonal cascades (or something similar that conveys information), causing cravings (hence consumption of other foods) or changes in the way your body burns the energy, whether it needs to conserve fat and burn muscle, or vice versa. Complex systems have feedback loops, so what you ‘burn’ depends on what you consume, and how you consume it.

Conclusion So we see that there are quite a few ideas from the subject of thermodynamics that can used for gaining interesting insights about the world we see around us. Some of the ideas in this chapter are a result of my tendency to think aloud. It’s especially true about the analogies between stock market and entropy. The problem is that it’s easy to win an argument in my own head. So I invite you to chip with your own interpretations and insights. Be the devil’s advocate and challenge my views.


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Chapter 32 Feedback Loops Sometime back Vishal was conducting the Art of Investing workshop in Bangalore and he asked me to speak on the subject of human behaviour. Now, unlike him, I am not used to speaking in front of a large audience. Although it was a room full of around 50 people, but for me anything more than two is a crowd. So to say that I had butterflies in my stomach would be an understatement. It felt like flying horses in my belly. Finally, when Vishal handed over the mic to me, one part of my brain was trying hard to control my shaking legs, the other part was busy adjusting (with trembling hands) the microphone attached to my shirt. Just when the first word came out from my mouth, a loud screeching noise echoed in the room. For a moment I thought that my heart, which by that time was pounding hard against my chest, had come out. Then I realized that the loud noise was coming from the speakers. I immediately cut it by covering the mic with my hand. It’s a pretty common problem (sound from the speakers feeding back into the microphone, and then going in an unending loop between speaker and mic, often causing a loud squeal) and most of you must be familiar with this kind of audio feedback noise. This acoustic problem can be easily corrected by tuning the instruments and using few filters. But what’s fascinating about this feedback loop phenomenon is that it pervades almost every other natural as well as man-made systems. So let’s explore this mental model i.e., Feedback Loop, and see how it can help us understand the world around us.


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Chapter 32 - Feedback Loops | Mental Models, Investing, And You Here is a working definition from Wikipedia – Feedback occurs when outputs of a system are routed back as inputs as part of a chain of cause-and-effect that forms a circuit or loop. The system can then be said to feed back into itself. In other words, in many systems, the output re-enters the system as another input. So a feedback loop is like an input, but its origin is from within the system itself, not from outside the system.

Positive and Negative Feedback Loops As we saw that systems adjust in response to feedback. Feedback Loops can be positive or negative. A positive feedback amplifies an effect, while a negative feedback dampens the effect. A thermostat is an example of negative feedback. In fact, the human body has an inbuilt thermostat. The tendency of human body, and for that matter all living beings, to maintain orderly conditions, including body temperature, is called homeostasis. Victor Niederhoffer, in his book The Education of A Speculator, elaborates on this: In system theory, it is called negative feedback … A common homeostatic behavior in humans is temperature regulation. If the temperature rises above the 98.6 F optimum for normal human activity, sensors on the skin detect it and signal the brain that a rise has occurred. The brain relays the information to the effectors that increase blood flow to the skin. This induces perspiration….[which on] evaporation lowers the body temperature. When the body cools below a certain point, a comparable mechanism


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Chapter 32 - Feedback Loops | Mental Models, Investing, And You is set off, this time reducing blood flow and causing shivering. This activity generates heat through physical activity thus raising the body temperature.

A negative feedback loop usually keeps the system in equilibrium whereas an uncontrolled positive feedback loop can cause a system to reach a critical state, a tipping point, and then fundamentally change it. If you want to see positive feedback in action, stock market is great place. We will come back to stock market shortly.

Learning and Feedback Loops Human behaviour can be improved to a great extent with the power of feedback loops. Experiential learning is one area where feedback loops play a terribly important role.


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Chapter 32 - Feedback Loops | Mental Models, Investing, And You In fact, the whole philosophy of deliberate practice is strongly based on the process of getting frequent quality feedback. Elon Musk says – I think it’s very important to have a feedback loop, where you’re constantly thinking about what you’ve done and how you could be doing it better. In investing and in life, what makes all the difference is the ability to make right decision. Right decision may not guarantee the desired outcome every time but they increase your odds of success. Perfect decision-making is next to impossible, and what matters more is forward momentum and a tight, fact-based feedback loop to quickly recognize and reverse bad decisions. We have to constantly incorporate feedback generated by our decisions and keep improving the process. Let me take a moment of yours and share my personal experience. My primary purpose for writing about mental models is to enhance my own learning. Now if you think about it, the feedback loop model is very much applicable in my learning process also. How? In order to write, I need to read a lot. The more I read about a chosen topic, the more insights and ideas I stumble upon which results in an ever increasing list of topics to learn (and write) about. So more reading results in more writing. A virtuous cycle of learning, a nice feedback loop.

Complexity of Feedback Loops So far, we have seen examples where the feedback produces somewhat predictable outcome (positive or negative). But in many cases, especially in complex adaptive


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Chapter 32 - Feedback Loops | Mental Models, Investing, And You systems (Chapter 25), feedback loops can result wild unpredictable swings in system behaviour. The legendary trader George Soros writes I

envision

reflexivity

as

a

feedback

loop

between

participants’ understanding and the situation in which they participate, and I contend that the concept of reflexivity is crucial to understanding the situation that have

thinking

participants.

Reflexivity

renders

the

participants’ imperfect and ensures that their actions will have unintended consequences. What it means is that changing one variable in a system will affect other variables in that system and other systems. In systems such as economies, stock markets etc., behaviour often changes as a result of the behaviour of others and experiential learning (feedback loop). These systems therefore become difficult to predict as unexpected properties may emerge. It is unlikely therefore that history will exactly repeat itself as participants keep modifying (learning with feedback loops) their behaviour. So it’s important to make the distinction as to what kind of systems are we dealing with. Is it a system prone to cascading effects of positive feedback loops? Or is it a system which tends to remain at equilibrium by virtue of negative feedback loops? Or is it a complex adaptive system prone to unintended consequences Here is a nice video illustration about different types of feedback loop systems. While trying to predict the behaviour we must not only consider particular elements of a design, but also their relation to the design as a whole and to the greater environment.


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Chapter 32 - Feedback Loops | Mental Models, Investing, And You Another important factor, while thinking about feedback loops, that needs to be considered is time lag between a feedback and its effect on the system. Feedback is a circle and it takes time to travel round a circle. This means that effects may not appear immediately. In their book The Art of Systems Thinking, the authors, Joseph O’Connor & Ian Mc Dermott, write – Think of appetite as part of a feedback loop…there is a time delay between the stomach being full and the sensation of satisfaction…the feeling of fullness is not directly related to how much food is in your stomach at that time, but to how much food was in your stomach several minutes ago. This delay between being full and the sensation of being full means you may continue to eat past the satisfied stage to the uncomfortable stage. If you are still eating when you feel full, you have gone too far. The way to avoid this is to eat more slowly, chewing well to speed the digestion of the sugars. Give yourself time for the feedback to appear. Not being aware of this time delay can lead to faulty understanding of cause and effect in a system. When we do not take time delays into account we evaluate the success of our strategies too soon, long before the full consequences are observed.

In Business and Investing The heart of value investing and long term wealth creation is the idea of compounding. What makes compounding interesting is that every small incremental change (interest on principal amount) goes back in the system (the principal amount) and becomes the part of it which in turn generates a slightly bigger feedback (bigger interest). Allow this


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Chapter 32 - Feedback Loops | Mental Models, Investing, And You to happen for a long time and what you have effectively is a positive feedback loop in action, a snowballing effect. On the contrary, dancing in and out of the market in response to every wiggle in the stock prices is akin to creating a negative feedback loop for your wealth. The frictional costs (taxes and brokerage) coupled with interrupted compounding brings back your system (wealth) into a stable (non-increasing) equilibrium position. So what do I do when my broker pushes me to trade? I look at it as a trigger for negative feedback loop and I simply ignore him. While trying to understand a business, this mental model can be of tremendous use. If you can figure out the kind of feedback loops operating for a business or an industry, it can give you invaluable insights about the company. Look at the Berkshire Hathaway’s (BRK) model. The humongous cash generated by BRK’s businesses is in the hands of world’s best capital allocator, Warren Buffett. He uses this cash to purchase other companies which in turn produces earnings which are then used for buying other companies. This feedback loop has been happening at Berkshire for a very long time. Prof. Sanjay Bakshi, in his interview with Safal Niveshak, mentioned – Vicious circles can turn into virtuous ones and if you can get in before they do, on very favourable terms, then good things should happen, if you keep on doing it repeatedly. A vicious circle is positive feedback loop in a negative direction and a virtuous cycle is a one in positive direction causing snowballing effect.


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Chapter 32 - Feedback Loops | Mental Models, Investing, And You You can easily visualize a positive feedback loop in action during bull (or bear) markets. Fall in stock market causes a sell-off. This creates a ripple effect of further sell-off and price declines. The opposite occurs in a stock market bubble. I found an interesting insight about nested positive and negative feedback loops in this email exchange – …you’re on the right track when you visualize a positive feedback loop as a mechanism which is nested inside a negative feedback loop. To illustrate, why do bear markets follow bull markets? Because over the long run, markets operate inside a negative feedback loop with built-in corrective mechanisms. When prices run too far away from underlying values, there are forces that pull them back. So over a long term the stock market shows characteristics of negative feedback loop i.e. the markets gradually go upwards with periodic corrections but in short term, especially during bubbles and crashes, it seems to be operating under the influence of positive feedback loops. Legendary value investor Seth Klarman, in his book Margin Of Safety, used this mental model to explain the fallacy of indexing. He says – I believe that indexing will turn out to be just another Wall Street fad. When it passes, the prices of securities included in popular indexes will almost certainly decline relative to those that have been excluded. More significantly, as Barron’s has pointed out, “A selfreinforcing feedback loop has been created, where the success of indexing has bolstered the performance of the index itself, which, in turn promotes more indexing.”


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Chapter 32 - Feedback Loops | Mental Models, Investing, And You When the market trend reverses, matching the market will not seem so attractive, the selling will then adversely affect the performance of the indexers and further exacerbate the rush for the exits.

Conclusion So we see that feedback loops are everywhere. In nature, in human behaviour and in stock markets. If you can identify the nature of feedback loop, you can safely guess the direction in which the system or sequence of events will proceed. This insight gives you a tremendous edge over someone who doesn’t understand this basic idea from physics.


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SECTION 6: DECISION MAKING


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Chapter 33 Occam’s Razor Have you ever wondered why Mark Zuckerberg (founder of Facebook) always wears the same grey t-shirt? Do you remember Steve Jobs’ black turtleneck that he wore for all his stage appearances? These billionaires could afford anything in the world. Then what’s going on here? The credit for this idiosyncratic behaviour goes to a principle called Occam’s Razor, named after 14th-century English logician, theologian and Franciscan friar, William of Ockham. Wikipedia explains – Occam’s razor is a principle of parsimony, economy, or succinctness used in logic and problem- solving. It states that among competing hypotheses, the hypothesis with the fewest assumptions should be selected. Other, more complicated solutions may ultimately prove to provide better predictions, but—in the absence of differences in predictive ability—the fewer assumptions that are made, the better. Simply stated it means – all things being equal, the simplest solution tends to be the best. In investing, simplicity is the way to long term success. Warren Buffett supposedly has a ‘too-hard’ bucket on his desk and majority of the ideas that he comes across end up in that bucket. He says –


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Chapter 33 - Occam’s Razor | Mental Models, Investing, And You The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective...We haven’t succeeded because we have some great, complicated systems or magic formulas we apply or anything of the sort. What we have is just simplicity itself.


In his 1990 letter to shareholders, Buffett wrote – After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers. The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult. Buffett has been emphasising on the idea of simplification for a long time. This is what he wrote in his 1993 letter –


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Chapter 33 - Occam’s Razor | Mental Models, Investing, And You ...we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows. Incidentally, that shortcoming doesn’t bother us. Charlie Munger agrees – People calculate too much and think too little…We have a passion for keeping things simple. If something is too hard, we move on to something else. What could be more simple than that? As simple as possible, but no simpler. Search for simpler business that requires fewer assumptions and fewer hypothetical scenarios to work out. After all the research, due diligence and sufficient margin of safety, the investment decision should look almost like a no-brainer. You don’t get paid anything extra for cracking difficult cases or figuring out a hidden moat in a convoluted business model. And the funny thing is that even if you solve a complex problem with multiple variables, you can never be sure that it was completely your skill and not dumb luck. In engineering it’s the “KISS principle” (keep it simple, stupid) – avoiding complexity and overspecification.

Avoid Unknowable and Unimportant The first step to simplification is to understand the futility of running after things that are unknowable and unimportant. Buffett explains –


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Chapter 33 - Occam’s Razor | Mental Models, Investing, And You 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. Where the interest rates are going, what the stock market is going to do next, etc. are all important but unknowable. Avoiding the activities heavily influenced by unknowable is an act of simplification. Similarly, before attacking a problem ask if it is worth solving?

Focus, Focus, Focus Second step to simplification is focus. When one tries to accomplish too many things simultaneously, he/she ends up doing all of them poorly. Decision making is simpler when we focus on one thing at a time. Multiple researches have shown again and again that human brain is not optimized for multitasking especially when you are working on complicated and unfamiliar tasks. This is what Buffett says about focus in his 1997 letter – …serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse...Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding. Don’t forget the Pareto Principle – “80% of your profits come from 20% of your activities.” Focus on those top 20% activities and de-prioritize the bottom 80%. And


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Chapter 33 - Occam’s Razor | Mental Models, Investing, And You this is why Buffett’s philosophy of sticking to your circle of competence makes so much sense.

Invert, Always Invert Third trick for simplification is to start backwards. Instead of trying to arrive directly at the solution, start eliminating the options which aren’t correct. You get enormous advantage by narrowing down your problem space and then you can bring your attention to more productive regions. Keep asking ‘why not’ until you reduce the problem to more fundamental body of knowledge. Ask: Why am I doing this? What really matters? Will more information affect my decision? Here is a simple but brilliant insight from Sherlock Holmes – How often have I said to you that when you have eliminated the impossible, whatever remains, however improbable, must be the truth? In fact, in Peter Bevelin’s A Few Lessons from Sherlock Holmes, the detective is quoted as saying – There never was a sounder logical maxim of scientific procedure than Ockham’s Razor...before you try a complicated hypothesis, you should make quite sure that no simplification of it will explain the facts equally well. Sometimes people confuse intelligent simplicity with being dull. It’s not. The art of being wise is the art of knowing what to overlook. And it’s not just true for problems and situations but people also. Stop giving attention to the wrong people. I don’t know who said this but it made a ton of a sense when I read it –


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Chapter 33 - Occam’s Razor | Mental Models, Investing, And You You can never do enough right things with wrong people. And that’s precisely what Buffett has done in his business and personal life. He always chose to work with people whom he liked and trusted. As a result he rarely had to deal with nasty problems created by bad people. When it comes to investing, the world’s best behavioural economist, Professor Daniel Kahneman, suggests that we should simplify our financial plan – Keep it simple and aim to beat inflation. Don’t try to beat the market. When it comes to investing, less is more. And if you try to do more, you’ll often end up with less. Do you have 100 different stocks in your portfolio spread across 5 different demat accounts? I urge you to simplify. Make fewer decision, make better decisions. This give us enough room to think about each decision deeply and reduces the chances of making a mistake. And now you can guess the reason behind Mark Zuckerberg’s and Steve Jobs’ preference for wearing the same attire. It is a great example of simplifying life. Making decisions is exhausting. The more decisions you make the less will power you have. It’s called decision fatigue. Zuckerberg and Jobs understood this. They used Occam’s Razor to slice out the need for wasting mental energy everyday on unnecessary elements, what to wear being one of them. In fact, building a latticework of mental model is nothing but a way to simplify your decision making process. What could be simpler than to just run through your checklist of mental models while solving a problem?


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Conclusion The mental model of Occam’s Razor has been accepted widely among many disciplines. I was surprised to find out that there is even a programming language named after Occam. It was created as a means to keep the programming process simple. Bear in mind that Occam’s Razor doesn’t prove anything. Also, while it is a very useful mental model, it should not be seen as a substitute for good empirical testing. It relies on subjective assessment of simplicity, rather than an objective tests in evaluating arguments. It’s not a rule. It’s more of a guide or a suggestion. You may get tempted to make it ‘the hammer’ for nailing every problem you see. Don’t assume simplicity where there is none. While Sherlock Homes was looking first for the simplest, most natural explanation for a case, he also believed in not over-simplifying complex matters, especially when dealing with systems with complicated interactions. Even Albert Einstein, who believed in the power of simplicity, understood its limitations. He said – Everything should be kept as simple as possible, but no simpler.


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Chapter 34 Checklists Few months back, I was visiting a friend in the hospital. He was getting discharged after a minor surgery. While helping him pack his stuff I casually flipped through his discharge summary papers. Most of the medical jargon in the file didn’t make much sense to me but one particular thing caught my attention. Under details of surgery, the last line read – “Mops/instrument counts were correct”. The first thought that came to mind was – are these guys so concerned about their instruments (and even cotton mops) that they count it after the operation? Many of those instruments are anyway disposable and can’t be used again. So what’s the big deal about counting them? Later I came to know that counting all the instruments and mops is part of their protocol. It’s to make sure that they haven’t left any items inside the body of the person being operated. It was an important step in their written ‘list of things to check’. Made sense. Hundreds of people die every day because of unavoidable blunders (like leaving an instrument inside the patient’s body) by surgeons. In US alone the number of deaths following surgery is 75,000 per year which is more than the number of road accident fatalities. And these are the cases which are avoidable because they emanate from human errors. The failure rate is disproportionately high and can’t be ignored. But medicine has become a field of extreme complexity. And not just medicine but many other fields have grown so far beyond the usual kind that avoiding daily mistakes is proving impossible even for our most super-specialized.


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Chapter 34 - Checklists | Mental Models, Investing, And You So how do you approach this problem? This is the question that intrigued Dr. Atul Gawande, professor of medical surgery in Harvard Medical School, and his quest to find the solution ended at a totally unrelated place. The aviation industry. In 1930’s the airline industry was manufacturing more powerful and better planes but flying these sophisticated machines became too complicated. Relying on any one person (however expert) to deal with all the complexities invited disaster. So to address this a ridiculously simple tool was proposed which even seemed crazy to those who had spent years carefully developing ever more advanced skills and technologies. And the strategy was – A Pilot’s Checklist. It was simple, brief and to the point – short enough to fit on an index card. And it worked wonders. How could something as simple as a checklist be of substantial help? Dr. Gawande, in his book The Checklist Manifesto, explains – In a complex environment, experts are up against two main difficulties. The first is the fallibility of human memory and attention, especially when it comes to mundane, routine matters that are easily overlooked under the strain of more pressing events…A further difficulty is that people can lull themselves into skipping steps even when they remember them…Checklists remind us of the minimum necessary steps and make them explicit. They not only offer the possibility of verification but also instill a kind of discipline of higher performance. The researchers have found that simply having the doctors and nurses in the ICU create their own checklists for what they thought should be done each day improved the consistency of care to the point that the average length of patient stay in intensive care dropped by half.


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Chapter 34 - Checklists | Mental Models, Investing, And You This was a remarkable discovery and a brilliant example of cross pollination of ideas across unrelated disciplines. The apparent simplicity of checklist belies its power. It’s difficult to accept that such a humble tool can be so effective at improving the results. But when people ignore this simple idea, disaster ensues. Such as this – In 1987, Northwest Airlines flight 255 crashed shortly after takeoff. All 155 persons aboard except one were killed. A federal report concluded that the probable cause of the accident was the flight crew’s failure to use the taxi checklist to ensure that the flaps and slats were extended for takeoff. Contributing to the accident was the absence of electrical power to the airplane’s takeoff warning system, which consequently could not warn the flight crew that the airplane was not configured properly for takeoff. Today, no wise pilot, no matter how great his talent and experience, takes off without going through his checklist. Checklists have proved to be extremely effective decisionmaking tools in fields as diverse as aviation, medicine, and construction. Herbert Simon, a Nobel laureate and author of Models of My Life, wrote – If one could open the lid, so to speak, and see what was in the head of the experienced decision maker, one would find that he had at his disposal repertoires of possible actions; that he had checklists of things to think about before he acted. That’s how Charlie Munger, vice-chairman at Berkshire Hathaway and Warren Buffett’s partner, thinks. Munger is a strong proponent of a checklist approach. In Wesco annual meeting (2007) he said – I’m a great believer in solving hard problems by using a checklist. You need to get all the likely and unlikely


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Chapter 34 - Checklists | Mental Models, Investing, And You answers before you; otherwise it’s easy to miss something important.

In Investing When you find a promising new investment idea with a prospect of making a lot of money, it triggers the emotion of human greed which is the enemy of a rational mind. Guy Spier, a noted value investor and author of The Education of a Value Investor, calls it The Cocaine Brain. According to him – You go into the greed mode …Neuroscientists have found that the prospect of making money stimulates the same primitive reward circuits in the brain that cocaine does. Checklists are a systematic way to engage the rational brain, and for investors, they can be highly effective vaccines, inoculating against conventional wisdom and cocaine brain. In fact, Spier, in his book, has devoted a whole chapter discussing the importance of checklist. He writes – …the mind has a way of skipping over certain pieces of information—including rudimentary stuff like where I’ve left my keys. This also happens during the investment process. The checklist is invaluable because it redirects and challenges the

investor’s wandering

attention in a

systematic manner. I sometimes use my checklist in the middle

of

the

investing

process

to

deepen

my

understanding of a company, but it’s most useful right at the end as a way of backstopping myself.


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Chapter 34 - Checklists | Mental Models, Investing, And You When it comes to investing Munger suggests using models in a checklist fashion. He says – Generally speaking, I think you need mental models – and what I call checklist procedures – where you take a worthwhile list of models and run right down them: “Is this here? Is that here?” and so on and so on…Now if there are two or three items that are very important that aren’t on your checklist – well, if you’re an airplane pilot, you can crash. Likewise, if you’re trying to analyze a company without using an adequate checklist, you may make a very bad investment. The idea of checklist is very subjective. A borrowed or outsourced checklist isn’t going to be of much help. Every investor has to build his own checklist based on his unique experience, knowledge, and previous mistakes. A checklist created in this manner would be most useful. “You need a different checklist and different mental models for different companies.”, says Munger, “I can never make it easy by saying, “Here are three things.” You have to derive it yourself to ingrain it in your head for the rest of your life.” In Poor Charlie’s Almanack, Peter Kaufman has condensed Munger’s teachings into a checklist. He calls this “Investing Principles Checklist”, as it contains the core principles that has made Munger the brilliant investor he is today. Needless to say, you must read it.

Building Checklists So how do you go about creating checklists? Here’s what Prof. Sanjay Bakshi suggested in his interview with Safal Niveshak –


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Chapter 34 - Checklists | Mental Models, Investing, And You The checklist for a small investor who focuses on buying good companies with durable moats would revolve around three factors – business, people, price. For evaluating business, I highly recommend reading Pat Dorsey’s book – The Little Book that Builds Wealth. It’s such a simple, common-sensical book that investors can learn from. It will help them in spotting moats. It will also help them in keeping away from thousands of companies that have no moats. So, for “business” factor checklist, read that book. For “people factor”, you need a checklist for evaluating management. Perhaps, we can work on this together for the benefit of your readers. It would be a simple checklist covering skills (operating as well as capital allocation) and ethical conduct. There are lot of red flags one should look for: 1. You don’t want to see management paying itself exorbitant salaries and perks. 2. You don’t want to see promoters merging their private companies into the company whose stock you are evaluating. 3. You don’t want them to appoint their relatives who don’t have adequate qualifications.


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Chapter 34 - Checklists | Mental Models, Investing, And You 4. You don’t want them to have a lot of related-party transactions

with

their

own

privately

held

companies. 5. You don’t want to be involved with companies where the promoters trade in and out of the stock. 6. You don’t want to be get involved with promotional managements. Essentially, you want to keep away from shady promoters. For “price factor,” a simple rule can be used. You don’t have to make it complicated. A rule like never paying a more than a P/E multiple of 13 (where “E” is expected minimum future earnings) can be used. Since the stock has already passed the tests on “business factors” and “people factors,” having a simple rule on the “price factor” makes a lot of sense. Peter Bevelin, author of the wonderful book Seeking Wisdom, warns that excessive reliance on checklists isn’t good either. He writes – They [checklists] may sometimes give us a false sense of security. Checklists work well as long as what may happen can be foreseen. But the unexpected sometimes happens. An unmentioned item may be the core cause of a problem. To be able to use checklist effectively, we need to understand which situations they work and in which they don’t.


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Chapter 34 - Checklists | Mental Models, Investing, And You Doing something according to pre-established rules, filters and checklists often makes more sense than doing something out of pure emotion, writes Bevelin, “But we can’t have too many rules, filters or items without thinking. We must always understand what we’re trying to accomplish.” Building construction is one such profession where people seem to understand the importance as well as the limitations of checklists. To deal with uncertainties associated with the construction, the builders trust on the power of communication. So they maintain two types of checklists. First they have a set of checklists to ensure that stupid but critical stuff is not missed and second they have another set of checklists to ensure people talk and coordinate and accept responsibility. You would be surprised to discover the rampant use of communication checklist in some unusual places – like award winning restaurants. At Safal Niveshak, in all our investor interviews, especially the Investor Insight column in Value Investing Almanack, we have a standard question for the investors. Do you use checklists and what does it look like? And every time we have found remarkable insights about checklists.

Conclusion So we learnt that the purpose of creating a checklist is to avoid obvious and predictable errors. Checklists promote analysis and rationality and eliminate the distractions that often cloud complex decisions. Put simply, checklist acts as the final circuit breaker in a decision-making process. A checklist is a way of managing your own mind and guarding against your own specific follies. In the end, checklist is not a mere formula but a means of selfawareness.


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Chapter 34 - Checklists | Mental Models, Investing, And You I would posit that today we learnt a meta-model because the purpose of learning the mental models is to create a checklist of mental models which you can run through mentally while thinking about a problem. And one of those models is checklist itself. In fact, all the mental models are supposed to be used in a checklist-style. I’ll close this discussion with a following quote from Munger – You’ve got all the tools. And you’ve got to have one more trick. You’ve got to use those tools checklist-style because you’ll miss a lot if you just hope that the right tool is going to pop up unaided whenever you need it. But if you’ve got a full list of tools and go through them in your mind, checklist-style, you will find a lot of answers that you won’t find any other way.


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Chapter 35 Loser’s Game In the hope of executing an impressive smash, I again sent the ball flying away from the table. Losing yet another game of table tennis to Navin, a good friend and a colleague in my previous job. It was probably 50th consecutive loss since I started playing TT with Navin. “It isn’t that I am an extraordinary player,” explained Navin, “I just focus on returning the ball back on your side. Your unforced errors are just too many so you continue to lose.” The idea of unforced error didn’t make much sense to me at that time. And the streak of losses continued for another few months until our employer decided to remove the TT facility from the office. They reasoned that some employees were spending more time on TT table than their workstation. I wonder who those employees were. It took another few years for the idea of ‘unforced errors’ to sink in properly. It happened when I learned about a concept called – Loser’s Game. Charlie Ellis popularized this concept through a paper he wrote in 1975 which was later adopted into a book called Winning The Loser’s Game. The paper talked about how the approach taken by good and bad tennis players is also seen in investing. Ellis article was based on Dr. Ramo’s research.

The Two Games Dr. Simon Ramo, in his book Extraordinary Tennis for the Ordinary Tennis Player, argues that in expert tennis the ultimate outcome is determined by the actions of the winner. Professional tennis players stroke the ball hard with laser like precision


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Chapter 35 - Loser’s Game | Mental Models, Investing, And You through long and often exciting rallies until one player is able to drive the ball just out of reach or force the other player to make an error. These splendid players seldom make mistakes. This game, played by professionals and experts, is called a winner’s game. But when it comes to amateur players they play a totally different kind of game. The ball is all too often hit into the net or out of bounds, and double faults at service are not uncommon. Amateurs seldom beat their opponents but instead beat themselves. The victor in this game of tennis gets a higher score because the opponent is losing even more points. Ramo calls this kind of game as loser’s game. Put simply, in a winner’s game, the outcome is determined by the correct actions of the winner whereas in a loser’s game, the outcome is determined by mistakes made by the loser. Both Navin and I being amateurs in TT were always playing the loser’s game. Navin intuitively understood the idea. That’s what he was trying to tell me – instead of adding power to a serve or hitting closer to the line to win, I should concentrate on consistently getting the ball back. In other words – minimize the unforced errors. When an expert is playing against an amateur, both are playing by the same rules in the same court and possibly using similar equipment. But even then, fundamentally, they are playing different games. It’s a winner’s game for the professional player because when he hits a smash, which he has practiced thousands of times, the odds of getting it right are close to 100 percent. He isn’t taking a chance on execution of his shot because he knows the conditions under which that particular shot is played best. But when an amateur, having seen professionals play those mesmerizing shots, attempts a similar forehand, he is inviting an unforced error. His is a loser’s game because pulling off that move repeatedly is extremely hard.


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Chapter 35 - Loser’s Game | Mental Models, Investing, And You Charlie Munger was hinting at the idea of curtailing the avoidable mistakes, the unforced errors, when he said – “All I want to know is where I’m going to die so I’ll never go there.” In his letter to Wesco shareholders Charlie once wrote – It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.

In Investing Few decades back the stock market wasn’t dominated by the institutional investors. A retail investor who transacted in the stock market was most likely pitted against another smallinvestor. And among the two, the one who did superior analysis and had access to better information about the business usually made the better decision and more money. But in the current markets when a small investor like us buys or sells a stock, the odds are high that the party on the other side is an institutional investor. The kind of resources, information and analysis that these institutional investors have makes it unlikely that a small investor can beat them in their game. What’s their game? Institutional investors are in a race to bigger and bigger AUM which is dependent on their quarter to quarter performance. They are into the short term performance game. And if that’s where you, as a small investor, tries to outperform them, you’re playing a loser’s game. No wonder why the small investor beats himself all the time! Most wealth destruction happens owing to unforced errors – hitting into the net or out of bounds, and repeating double faults at service (while making buying decisions). I would argue that investing in IPOs is a loser’s game too. The promoters and investment bankers who set the IPO price are better informed about the value of the


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Chapter 35 - Loser’s Game | Mental Models, Investing, And You business than a small investor. To draw an analogy from Tennis, you an amateur player is playing against Roger Federer or Serena Williams. It’s their game and they have massive edge. They have designed a winner’s game and enticing you to join in. Looking for 20, 50, 100 bagger stocks in a few short years is also a form of loser’s game. Day trading is another example. It’s even worse than loser’s game. Charles Ellis has another name for day trading – The Sucker’s Game. John Bogle, who is considered the father of Mutual Fund industry, reasoned – Short-term market timing is a loser’s game. None of us know what tomorrow holds, not Bogle nor anybody else. And that’s why I have never done anything other than a 10year reasonable-expectations perspective. Any day, any week, any month, any year can do what it wishes, but 10 years it comes down to how corporations do, and that’s more important than how the stock market does. How do you win against Tiger Woods? The answer is simple – just don’t play him in Golf! So how do you win a loser’s game? Just by extending your focus from short term to long term, you transform your playground and take it into the winner’s game arena. Ellis in his book concludes – Winning the loser’s game of beating the market is easy: Don’t play it. Concentrate on the winner’s game of defining and adhering faithfully to sound investment policies that are right for the market realities and right for your longterm goals and objectives.


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Chapter 35 - Loser’s Game | Mental Models, Investing, And You Concentrate on playing the winner’s game. For a small investor, playing the winner’s game in stock market means ignoring the mood swings of Mr. Market, concentrating where the earnings and cash flows of the underlying businesses you own, or want to own, are going to go over long term and most crucially, knowing your limitations as an investor. This doesn’t sound very complicated right? But don’t forget Warren Buffett’s words – Investing is simple—but it’s not easy. Ironically, when these institutional investors are transacting with each other, their winner’s game turns into a loser’s game for themselves. Since they don’t have any special edge against each other and are driven by same rules, conventions and incentives. The basic assumption that most institutional investors can outperform the market is false. When institutions are the market they cannot, as a group, outperform themselves. In fact, given the cost of active management—fees, commissions, market impact of big transactions, etc.— a large majority of investment managers have and will continue over the long term to underperform the overall market. And the statistics prove that. So investing is a loser’s game, not only at the amateur level, but also at the professional level.

Conclusion “We all like winning with investments,” writes Ellis, “and we all can win—at lower cost, less risk, and less time and effort by knowing our real objectives, developing a sensible strategy, and sticking with it for the long term so that the markets are working for us. For most investors, the hardest part is not figuring out the optimal investment policy; it is staying committed to sound investment policy through bull and bear markets.”


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Chapter 35 - Loser’s Game | Mental Models, Investing, And You In investing, you are your own worst enemy…not bankers, not brokers, not business channel experts. You. Investing can become a winner’s game for you only if you work towards reducing those unforced errors – errors in picking up stocks, and misbehaving. Of course that will come only after you start playing the game, learn to play the right shots, and keep playing them for some time. When Michelangelo, the famous 16th century sculpture, was asked about the secret of his genius and how he created his masterpiece, the statue of David, his answer was, “It’s simple. I removed everything from the stone that is not David.” One of the ways to think more clearly and rationally is to adopt Michelangelo’s method. Don’t focus on David, instead concentrate on everything that’s not David and chisel it away. In other words, eliminate all the cognitive errors and better thinking will follow. Warren Buffett says – Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. So to be successful all you need to know is what blocks the success. Eliminate the downside, the thinking errors, and the upside will take care of itself. The biggest lesson from Ellis’ Loser Game mental model is this – It’s better to avoid stupidity rather than seeking brilliance. If you understand only this single concept, that investing is a loser’s game, you will do well as an investor throughout your life.


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SECTION 7: BUSINESS


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Chapter 36 Switching Costs How many times in last 6 months have you bought something from any of these websites – 1.

Flip kart

2.

Amazon

3.

Snap deal

In my case I have used all three, at least once, in last 6 months. With two infants at home, my wife’s favourite online shopping destination is firstcry.com these days. But when it comes to buying diapers, I order sometime from Amazon and sometimes from First cry. Why? Whichever website has discount deals going on, I go for it. I am not loyal to any particular online store. Now let me ask you another similar question. How many times have you switched your bank in last 6 months? In last 1 year? Or in last 5 years? Well even if another bank comes with an offer of higher savings interest rates, how many people actually take the pains of shifting all their cash and bank deposits to another bank? Very few I guess. My father hasn’t changed his bank in last 30 years. But why is it that we change our online shopping stores in the blink of an eye but never really change our banks. Even credit cards or demat brokers don’t see too much churning in their customer base. If you talk to bankers, you’ll find that the average


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Chapter 36 - Switching Costs | Mental Models, Investing, And You turnover rate for deposits is around 15 percent, implying that the average customer keeps his or her account at a bank for six to seven years. When you think about it, that’s a curiously long time. After all, money is the ultimate commodity, and bank accounts don’t vary a whole lot in terms of their features. Why don’t people switch banks frequently in search of higher interest rates and lower fees? Because it’s a pain to do that. Switching your bank isn’t as simple as opening another browser window and few clicks to order something online. Changing banks involve lot of efforts and lot of paperwork. I remember my experience in closing a bank account. The process was so cumbersome that I eventually had to get it done through direct help from a friend who was an employee in the bank. Banks know this, so they take advantage of their customer’s reluctance to leave by giving them a bit less interest and charging them somewhat higher fees than they would if moving a bank account were as easy as buying diapers online. This pain of changing or switching is called Switching Cost. It’s those one-time inconveniences or expenses a customer incurs in order to switch over from one product to another. Take a look at the following list – 1.

Operating system in your computer

2.

DTH set top box.

3.

Internet service provider

4.

Newspaper

These are all examples of businesses where the cost of switching is high for the customer. You find switching costs when the benefit of changing from Company A’s product to Company B’s product is smaller than the cost of doing so.


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Chapter 36 - Switching Costs | Mental Models, Investing, And You You may not think twice before stopping your vehicle on the next fuel pump but you will think 10 times before changing your mobile number or cellphone service provider. The cost of switching could also be psychological. For example, if you were asked to change the layout of your keyboard, i.e. instead of standard QWERTY keyboard, I asked you to switch to a keyboard where keys are laid out in alphabetical order. You’ll go crazy. There is a huge psychological costs associated with this change. The standard QWERTY keyboard isn’t going anywhere for a long time. Switching costs make a product or service sticky. Now, switching costs can be tough to identify because you often need to have a thorough understanding of a customer’s experience – which can be hard if you’re not the customer.

In Business and Investing As we have seen some businesses have high switching costs, may be due to hassle of switching (banks, DTH), or complexity (PC operating system) or habit (newspapers or QWERTY keyboards). These switching costs generate a very valuable competitive advantages for the business because a company can extract more money out of its customers if those customers are unlikely to move to a competitor. Microsoft Windows is a great example which has high switching costs for the customers. Since majority of the world uses Windows operating system, most of the software applications are first built for Windows. Because of which most people are forced to work with Windows since many tools and software are available only for Windows platform. This type of switching cost is because of network effect which we will discuss in the next chapter.


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Chapter 36 - Switching Costs | Mental Models, Investing, And You

Image Source: Glasbergen.com

Here’s another example. Smartphone marketplaces like the App Store or the Google Play Store host content and apps that can’t be transferred elsewhere. Android or Apple users will have to give up their purchased music tracks, apps or movies if they want to switch to a competitor. Consider the case of Indian IT companies. Repeat business for them forms anywhere around 80-95% of their total revenues, suggesting that they benefit from the switching cost advantage, which is ultimately seen in their high margins. So switching cost is an important source of Moat for a business. Moat is a metaphor used by Warren Buffett to explain the economic characteristics of those businesses which have sustainable competitive advantage. This type of economic moat, by virtue of higher switching costs, can be very powerful and long-lasting.


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Chapter 36 - Switching Costs | Mental Models, Investing, And You So what kind of businesses have low switching costs? Many consumer oriented firms, such as retailers, restaurants, packaged-goods companies, and the like. You can walk from one clothing store to another, or choose a different brand of toothpaste at the grocery store, with almost no effort whatsoever. That makes it very hard for retailers and restaurants to create switching costs in their businesses.

Creating Switching Costs There are several ways in which switching costs are created by companies. Here are few examples – 1.

Base Product and Consumable trick – Companies lure customers into

their ecosystem with a base product and then milk profits from ‘consumables’ that customers are forced to buy. A good example is home printers by companies like HP, Canon and Epson. The printer itself isn’t very expensive but the cartridge is where the company earns real profit. Printer specific cartridge also makes it hard for the customer to switch to other product since the original base product (printer) works only with the consumable (cartridge). 2.

Data trick – In this arrangement customers are encouraged to create or

purchase content that are exclusively hosted on a platform. ERP software companies like SAP and Oracle enjoy this advantage. If an enterprise has been using Oracle’s database software, a competing database would have to be phenomenally better (or cheaper) than an Oracle database for a company to choose to pay the massive cost of ripping out its Oracle database and installing another one. 3.

Learning curve trick – Customers can be discouraged when they have to

start over and learn how to use a new product. The ‘learning curve’ trick is centered around offering a great value proposition that’s only accessible to those


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Chapter 36 - Switching Costs | Mental Models, Investing, And You willing to train to know how to use it. Adobe uses this trick to get customers hooked to their products. Adobe’s Photoshop and Illustrator programs are taught to budding designers in school, and they’re complex enough that switching to another program would mean significant retraining. 4.

Servitization trick – In this approach, a company can bundle their

products with complementary services provided only to their customers. Rolls Royce creates such switching costs in their ‘power by the hour’ offer. In essence, ‘power by the hour’ consists of leasing jet engines, maintenance and repair services for a flat fee. The real game-changer is that Rolls Royce only charges airlines for the time they use the engine. This experience is outstanding for airlines because it relieves them from the huge pain of losing money when defective engines block planes from flying. By bundling its highly profitable services with its first-class engines into one integrated offer, Rolls Royce makes it harder for airlines to switch to a competitor. 5.

Industry standards trick – Sometimes, you are forced to do things

because everyone else does it a certain way. That’s another way companies lock customers in. They position themselves as leaders by public acceptance. Their product, or one of their product features, has become the standard in an industry, which makes it very difficult to use something else. Microsoft Office’s Word software is one of them. The .doc format, distinctive to Word documents, has been the industry standard since Microsoft’s early entrance on the word processing software market. Switching costs are high because it is nearly impossible to work with a word processing software that doesn’t create or accept .doc files today. The .pdf format is another widely accepted file format around the world and has enabled Adobe to create switching costs the same way. 6.

Exit penalty trick – This arrangement forces customers to use a product

for a certain period of time specified in a contract. If the customer wants to exit the contract, he/she has to pay early termination fees. This strategy is commonly used to dissuade customers from switching to a competitor before their contract


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Chapter 36 - Switching Costs | Mental Models, Investing, And You ends. For example, banks discourage its depositors for breaking fixed deposits prematurely by levying a penalty. This is how businesses lock in customers. The more customers are locked in, the more likely a company can pass along added costs to them without risking customer loss to a competitor. So we see that switching costs come in many flavour—tight integration with a customer’s business, monetary costs, and retraining costs, to name just a few. Companies that make it tough for customers to use a competitor’s product or service create switching costs. If customers are less likely to switch, a company can charge more, which helps maintain high returns on capital.

Human Brain on Switching It’s not just businesses which have switching costs. Even human brain has characteristics of high switching costs. Daniel Levitin, in his book The Organized Mind, writes – Switching attention comes with a high cost…Our brains evolved to focus on one thing at a time. This enabled our ancestors to hunt animals, to create and fashion tools, to protect their clan from predators and invading neighbors. The attentional filter evolved to help us to stay on task, letting through only information that was important enough to deserve disrupting our train of thought. But a funny thing happened on the way to the twenty-first century: The plethora of information and the technologies that

serve

it

changed

the

way

we

use

our

brains. Multitasking is the enemy of a focused attentional system. Increasingly, we demand that our attentional


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Chapter 36 - Switching Costs | Mental Models, Investing, And You system try to focus on several things at once, something that it was not evolved to do. We talk on the phone while we’re driving, listening to the radio, looking for a parking place, planning our mom’s birthday party, trying to avoid the road construction signs, and thinking about what’s for lunch. We can’t truly think about or attend to all these things at once, so our brains flit from one to the other, each time with a neurobiological switching cost. The system does not function well that way. Once on a task, our brains function best if we stick to that task. Higher switching costs may be good for a business but it’s bad for human brain. Apart from all the factors that create switching costs, the most important one, especially relevant in today’s world, is network effect. So turn over to the next chapter to see the power of networks.


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Chapter 37 Network Effect I clearly remember the day, it was in July 1999, when I was first introduced to the internet. I was so excited to get a brand new email address. I could now send and receive emails. However, the excitement didn’t last very long. I quickly realized that the email address wasn’t of much use to me because none of my family or friends had any email addresses at that time. Who would I mail? But slowly as more and more people started using internet, my email address became increasingly valuable. Similarly, I remember the time when the social networking bug bit me and I signed up for Orkut. But within few years when all my friends had moved to Facebook, I was forced to abandon Orkut and climb on the Facebook bandwagon. So you’d notice that the utility of certain products and services is directly proportional to its number of users. Another recent example that comes to mind is the social messaging app WhatsApp. There are quite a few other messaging services which offer better features than WhatsApp but majority of people continue to use WhatsApp because all their friends are on WhatsApp. This is called Network Effect. Now the idea may sound very simple, but it’s fairly unusual. When you board an airplane, do you get excited when you see that the flight is completely full? Or when you visit your favourite restaurant, do you prefer it to be


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Chapter 37 - Network Effect | Mental Models, Investing, And You crowded? In these cases, as a consumer you don’t get any benefit if the product or service is also being used by others. But when it comes to social networks like Facebook, LinkedIn and Twitter, members join these networks because other members are in this network. These are the businesses that benefit from the network effect. The value of their product or service increases with the number of users. When network effect kicks in people feel compelled to use it, or are forced to use it because of its popularity. For instance, Microsoft Word is more commonly used because it’s packaged with Windows and comes free with windows PC. Since so many businesses and individuals utilize Word, their customers and suppliers are compelled to have it as well. The network effect leads to positive feedback in which the product’s presence in the market increases. It’s not that Microsoft Office doesn’t have a competitor. “Open Office” offers almost all the features of MS Word and it’s free. In spite of that it hasn’t been able to make any dent to MS Word’s market share. Because of minor issues related to compatibilities between Open Office and MS Word, people just don’t bother using Open Office. Bob Metcalf, the inventor of Ethernet, 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 users, then the total value of the network (to all users) is proportional to N*(N-1). If the value of a network to single user is Rs.1 for each other user on the network, then a network of size 10 has a total value of roughly Rs. 100. In contrast, a network of size 100 has a total value of roughly Rs 10,000. A tenfold increase in the size of the network leads to a hundredfold increase in its value.


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Chapter 37 - Network Effect | Mental Models, Investing, And You Which means, as the network grows, the rate of growth of the network value (represented by number of connections between different nodes) is faster than the rate of growth of network (represented by number of nodes in the network). The image below illustrates the ideas very well.

Image source: Little Book That Builds Wealth by Pat Dorsey


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Chapter 37 - Network Effect | Mental Models, Investing, And You Not all connections in a network are equally meaningful and valuable but it’s fair to say that the value of a network to its users is more closely tied to the number of connections than it is to the number of nodes. A market can sustain only few network for a given kind of product or service. You don’t find many social networking sites out there. Facebook, Twitter and LinkedIn pretty much dominate the industry. In fact, Orkut, in spite of having the first mover advantage, had to shut down when it was squeezed out by Facebook. So we can say that network based businesses tend to create natural monopolies and oligopolies. Look at the world of credit card networks. It’s dominated by VISA, MasterCard and Amex. That’s a huge amount of market concentration. The barrier to entry in this industry is a result of network effect. Even if a competitor showed up on the scene next week, it has to first convince millions of merchants to accept the new card which require the competitor to first have millions of customer using the new card. In simple words it’s classic catch-22 problem for any new player to enter this market. “A competing firm would need to replicate the network —or at least come close”, says Pat Dorsey, author of wonderful book The Little Book That Builds Wealth, “- before users would see more value in the new network and switch away from the existing one.” Talking about common characteristics shared by businesses having network effect, Dorsey writes – …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.


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Chapter 37 - Network Effect | Mental Models, Investing, And You That means you’re more likely to find the network effect in businesses which are heavy on technology. So businesses like eBay come out like text-book examples of network effect. Dorsey writes in his book – As of this writing, eBay had at least an 85 percent share of Internet auction traffic in the United States…The buyers are on eBay because the sellers are there, and vice versa. Even if a competing site were to launch tomorrow with fees that were a fraction of eBay’s, it would be unlikely to get much traffic—no buyers, no sellers, and so forth. And the intrepid first users wouldn’t have the benefit of eBay’s feedback ratings, telling them which other users they can trust to fulfill a transaction, nor could they be assured of getting the best price, given the paucity of other users. (I once asked a candidate applying for an analyst job at Morningstar what he would do if I played venture capitalist, gave him huge amounts of financial backing, and told him to go beat eBay at its own game in the United States. He thought for a minute and then replied, “I’d return the money.” Good answer.) Similarly, in e-commerce space it’s almost impossible to displace Amazon from its position. It’s not just the network of buyers and sellers but imagine the immense value that the accumulated information about product ratings and reviews creates for the buyers. The product reviews on Amazon are tremendously useful for the buyers to make purchase decisions. And bigger the network of buyers and sellers grows, bigger is the value of the whole Amazon platform. Once a certain critical mass is achieved the network effect starts riding on positive feedback loop (Chapter 32)and this self reinforcing virtuous cycle creates a winnertakes-all scenario.


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Chapter 37 - Network Effect | Mental Models, Investing, And You Network effect can be seen in newspaper business also. More readers for newspaper attracts more advertisers and hence more valuable it becomes for the readers as a source of information about new products and services. Warren Buffett wrote in his 2006 letter – Advertisers preferred the paper with the most circulation, and readers tended to want the paper with the most ads and news pages. This circularity led to a law of the newspaper jungle: Survival of the Fattest. Thus, when two or more papers existed in a major city (which was almost universally the case a century ago), the one that pulled ahead usually emerged as the stand-alone winner. After competition disappeared, the paper’s pricing power in both advertising and circulation was unleashed. Typically, rates for both advertisers and readers would be raised annually – and the profits rolled in. For owners this was economic heaven. MCX, the multi-commodity exchange in India, which accounts for more than 85% of total value traded in the Indian commodity futures markets (2013), is another business which benefits from network effect. As more buyers and sellers utilize the MCX, the alternative exchanges become less attractive in terms of pricing and liquidity. Another example is Info Edge, where the key business of Naukri benefits from a virtuous cycle –


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Network effect is an important attribute to look for while evaluating the presence of economic moat, a metaphor for durable competitive advantage, in a business. Network effect, according to Pat Dorsey, is an important sources of structural competitive advantage. The other being switching costs (Chapter 36), cost advantage and intangible assets. So if you can find a company with solid returns on capital and a presence of network effect in its business, you’ve likely found a company with a moat. In fact, network effect and switching costs are related because network effect creates a switching costs for the consumer. Here’s an interesting insight about Tesla Motors.


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Chapter 37 - Network Effect | Mental Models, Investing, And You I am guessing that Tesla Motors are also on their way to creating a very strong moat using network effect. Like Google’s driverless cars, Tesla is also working on self-driving cars (it’s available as part of the latest software upgrade for Tesla cars). As thousands of Tesla electric cars are being driven around, each car is charting the roads. So each Tesla automobile effectively becomes a data gathering agent. The data is sent to Tesla (every car is connected to central Tesla server for downloading upgrades to its software) which helps in mapping the roads around the world. As more and more people use Tesla and longer they use it, the data about geography (the road quality, unexpected curves on the road, real time traffic conditions, even proximity with rash drivers etc.) will benefit the Tesla owners to rely more and more on the autopilot. This looks like a moat in creation. The more robust the Tesla’s geographical data becomes, more the value of Tesla vehicle for the users. The more users drive Tesla cars the bigger and better Tesla’s data. Isn’t this a network effect? I am not sure if this is an intentional move by Elon Musk but if it is, then any other electric car company will find it very tough to replicate this competitive advantage.

Conclusion Network effect can create an extremely strong competitive advantage. It’s a very powerful type of economic moat that can lock out competitors for a long time.


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Chapter 38 Float About 12 years back, I first came to Bangalore to join my first job in IT industry. Known as city of lakes and the Silicon Valley of India, Bangalore was the place to be in. However, the initial euphoria soon evaporated when I was told by the real estate agent that renting a house required me to deposit an advance. What added insult to the injury was the size of security deposit amount. It was supposed to be 10 months of rent. Holy cow! That was several times more than my monthly salary at that time. But it turned out that the practice was pretty common in Bangalore, and still is, which I suppose is not the case in other metros. It infuriated me that the house owner would conveniently put that advance money in his bank and pocket the interest income too. So in effect he wasn’t just making money from rent, but from free deposit also. Now here is an interesting question to puzzle over. The security deposit which in effect was a borrowing for the house owner – can we call that money as debt for him? Yes and No. ‘Yes’ because it’s not his money and he would have to return that money sometime in future and ‘No’ because he doesn’t have to pay any interest on this borrowing. So it’s a debt but quite different from a traditional debt. Let’s see how.


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When I moved out from his house, the money which he returned to me was replenished by the new tenant. So it was a revolving fund. Effectively he would never have to return that money to his tenant, provided he doesn’t run out of tenants, which is unlikely because his house was in busy locality in Bangalore. The deposit was an income generating asset which costed the landlord nothing. He could very well be using that money for making other investments too, like buying stocks or making down payment for another house. This is a very interesting type of debt. It’s called Float. Here are the three characteristics of Float which separates it from the plain vanilla debt. 1. There is no collateral in float. If the house owner refuses to return my security deposit, there is no easy way for me to recover my money. 2. There is no, as we saw, interest either. The house owner doesn’t pay any interest on the money that he borrowed from me. 3. It’s long enduring i.e. you don’t have to return the money. The security deposit was a revolving fund and hence always available. So we see that conventional debt is onerous. But this float thing sounds like a Ponzi scheme, doesn’t it? Well, it’s not just the case of security deposits, there are numerous other businesses which use this idea of float to generate better returns on their capital. In fact, there is a whole industry which is founded on the idea of float. Can you guess?

Insurance Float Those who are familiar with Warren Buffett and his company Berkshire Hathaway, know that Buffett built his business empire by using the float from his insurance subsidiaries.


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According to him, Float, is in effect, the money that we are holding that eventually will go to other people, but of which we have temporary possession. So how does float work in insurance business? Buffett’s wrote in his 2002 letter to investors…float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an “underwriting loss,” which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money. Moreover, the downward trend of interest rates in recent years has transformed underwriting losses that formerly were tolerable into burdens that move insurance businesses deeply into the lemon category. For a typical insurer, the premiums it takes in do not cover the losses and expenses it must pay. That leaves it running an “underwriting loss” – the cost of float – which is the functional equivalent of interest on conventional debt. So the float is useful in insurance only if the cost of float is less than the prevailing interest rates. A low cost float is great but what’s even better is a free float i.e. one where the cost of float is zero. Now, this calls for an insurance business to run its operations efficiently and ensure that the insurance premiums are commensurate with the risks.


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That’s precisely what my landlord was enjoying. A free float. And with increase in rent every year, which resulted in bigger security deposits, his float was increasing too. There is no dearth of businesses which generate float. Even a loss making insurance business generates float but what makes float attractive is its low cost. There is no other form of financing better than free float. Or is there one? Wait! There is one, at least for Warren Buffett because he’s always one step ahead. Most of Buffett’s insurance business have a negative cost of float (better than free) which means his businesses are run super efficiently. Buffett writes – If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it. That’s like your taking out a loan and having the bank pay you interest. To see how important the idea of float is for a business, let’s invert the problem. Assume that a business can’t generate float. What are the other source of funds to replace the float? Debt? But conventional debt isn’t free, rather it’s quite expensive. The interest on debt will reduce the earnings. What about equity? Well, raising money through equity will lead to dilution. Not a desirable option for existing shareholders. The more of an asset that you can fund with a free float, the less the need to fund it with expensive debt or equity becomes.

Berkshire’s Float Buffett’s tryst with float started in 1960s when the salad oil scandal attracted his attention to American Express. The scandal created a one-time liability of $150 million


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for Amex which tanked the stock price. However, Buffett discovered something interesting in Amex’s balance sheet. Amex was carrying a liability of half a billion dollars which was money paid to Amex by its customers in lieu of a piece of paper, i.e. Traveler’s Cheque. There was neither any collateral nor any interest associated with liability. The paper was redeemable at demand, but there was always a lag between issue and encashment and sometimes people even forgot to encash them. More importantly, when people encashed them, there were others who bought new TCs, so the balance in the liability account had become a “revolving fund.” It was a no-brainer for Buffett to pull the trigger on a heavily loaded gun. He accumulated 5% of Amex, amounting to a total of 40% of Buffett’s total portfolio at that time. Within two years that investment multiplied by more than 2.5 times. Float baby float! Today, Berkshire’s insurance operations generate a float of $88 billion with an underwriting profit of $1.8 billion. Isn’t it incredible that Buffett is getting paid in billions for holding on to other people’s money? That’s the magic of float.

Few More Floats The simplest example of a float is the gift card issued by retailers. Yes, that Amazon gift card! The issuer gets paid for it upfront, and there is quite a bit of lag until the giftee uses it. And there are people who only make a partial use of the gift card leaving free money on the table for the issuer. Some even forget to encash the gift card and some gift cards expire before they can be used. More free money! No wonder many consider gift card industry the biggest billion dollar scam.


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Can you think of some more examples of float around you? Here are few that comes to my mind – 1. The tickets that you book (airlines and train) in advance. When a waitlist train ticket is booked 2 months in advance only to be cancelled (most of them) at the last moment, the money keeps lying with railways for 2 months. Isn’t that a free float? How profitably this float is used/misused is another question altogether. 2. When you get a refund from an online-store, they usually credit your virtual wallet. That money is an interest free loan for them. However, the current regulation in India doesn’t allow these online stores to use that money for other purpose, so not exactly a real float here. 3. If you use your credit card, you get a free credit for a month from the credit card company. By the time you settle your last month’s credit card bill, you would have accumulated another month’s expenses on credit card. Effectively you’re revolving the funds (equal to your monthly expenses) on your credit card. It’s a free float for you. Of course, just like underwriting discipline is required for profitable insurance operations, credit card float is useful only if you’re using it prudently and not incurring a high cost of float (late fee and astronomical credit card interests).

Source of Float We have seen how insurance business generates float. Now if you own a non-insurance business and intend to generate float, what are your options? Here’s what Prof. Bakshi has to say – Businesses employ assets. These assets can be financed by (1) Equity; (2) Debt; and (3) Float. Float is preferable if it’s free or cheap and if it’s long-enduring. Recall float is Other


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People’s Money. Who are the other people? They aren’t equity, and they aren’t debt. So who can they be? Well there are only four main categories: suppliers (trade credit, deposits from distributors), customers (advance from customers), employees and government (deferred taxes). Let’s focus on suppliers and customers. What kinds of businesses are those where suppliers and/or customers provide float? Those with moats. [These are the] businesses which dominate their markets [and] can dictate their terms. Suppliers will provide lenient credit and not charge higher prices (no implicit interest). Customers will pay in advance and not ask for cash discount (no implicit interest). Distributors will give interest free deposits. Negative working capital without implicit interest. Amazon is one such businesses which funds all its assets (including fixed assets, receivables and inventories) by other people’s money (account payables and accrued interests). As per 2015 annual report, their negative working capital is more than $13 billion. And it’s growing every year. When you buy something from Amazon, they get the money almost immediately but most of the distributors/publishers don’t get their payment until 90 days. The bigger Amazon grows, the more cash it gets to hold. The faster it turns the inventory, the bigger its cash grows.


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Most people just look at a company’s margins and judge the quality of the business model based on that, but the cash flow characteristics of the business can make one company a far more valuable company than another with the exact same operating margin. Amazon could have had a margin of zero and still made money. (source) And Amazon is not unique when it comes to creating floats using negative working capital. Lot of FMCG companies, like HUL, have strong moats because of this kind of float in their balance sheets. Mahindra holiday’s (MHRIL) is another business with an interesting business model which generates large amount of float. As of 2015, the company had advances from customers totaling to Rs. 1500cr, which is more than 50% of the balance sheet.


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However, the receivables are also pretty high (Rs. 870 cr) which offsets the float quite a bit but you need to dig further and find out what’s going on here. Consider it as your homework for today.


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NESCO, the company behind Bombay Exhibition Center, also carries float on its balance sheet. It gets the exhibition fee in advance. Not just that, the commercial space that NESCO has leased out generates float in form of advance security deposits.

Conclusion The standard accounting calculations consider the float as normal liability, like conventional debt, which introduces inaccuracy in evaluating a business’s true value. Presence of large float in a balance sheet can skew the real picture. Buffett, in his latest (2015) letter to shareholders, writes – So how does our float affect intrinsic value? When Berkshire’s book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and could not replenish it. But to think of float as strictly a liability is incorrect. It should instead be viewed as a revolving fund. Daily, we pay old claims and related expenses – a huge $24.5 billion to more than six million claimants in 2015 – and that reduces float. Just as surely, we each day write new business that will soon generate its own claims, adding to float. If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this liability is dramatically less than the accounting liability. Owing $1 that in effect will never leave the premises – because new business is almost certain to deliver a substitute – is worlds different from owing $1 that will go out the door tomorrow and not be replaced. The two types of liabilities, however, are treated as equals under GAAP.


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So the lesson here is that float is an important mental model to think about businesses especially if you’re looking for hidden moats. Note: Many examples of the examples above come directly from Prof. Bakshi’s MDI lecture –Floats and Moats. It’s a must read.


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Chapter 39 Arbitrage In 1954, a temporary shortage of cocoa in US caused its price to increase from 5 cents to 60 cents per pound, a whopping 12 times. As a result, Rockwood & Co., a Brooklyn based chocolate products company, found itself in a sweet spot. They were sitting on 13 million pounds of excess inventory of cocoa which instantaneously became a huge asset because of cocoa price increase. It was a no brainer to sell the inventory and make a handsome profit except there was just one catch to it. Rockwood & Co. followed LIFO (last in first out) inventory valuation which would have created a 50% tax liability on profits from sale of inventory. So to avoid this tax, they came up with an ingenious way to exploit the temporary opportunity. They extended a share buyback offer which allowed the shareholder to tender a share in exchange for 80 pounds of cocoa. This maneuver, according to 1954 tax code, was perfectly legal and didn’t invite heavy tax liability. This caught the attention of a 24-year-old investment analyst who was working in New York for Graham Newman Corp. It was obvious to him that one could buy Rockwood shares for $34, sell them back to the company for 80 pounds of cocoa beans (worth $36), and then sell the cocoa beans making an instant profit of $2. Considering the transaction could be done in less than a week, it worked out to a sky-high annualized return. “For several weeks I busily bought share, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts.”, recounts Warren Buffett, the protagonist in the story above, “The profits were good and my only expense was subway tickets.”


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What Buffett did is called an Arbitrage. It’s a process of identifying market inefficiencies. The classic idea is that of buying an item in one place and selling it in another. In the very early days the word applied only to the simultaneous purchase and sale of securities or foreign exchange in two different markets. Mohnish Pabrai, in his wonderful book The Dhandho Investor, explains – Arbitrage is classically defined as an attempt to profit by exploiting price differences in identical or similar financial instruments. For example, if gold is trading in London at $550 per ounce and in New York at $560 per ounce, assuming low frictional costs, an arbitrageur can buy gold in London and immediately sell it in New York, pocketing the difference. Just like any other profitable opportunities, arbitrage plays don’t remain open for long. As people execute these arbitrage trades, the price spread collapses and the arbitrage


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Chapter 39 - Arbitrage | Mental Models, Investing, And You opportunity eventually vanishes. While these arbitrage spreads seem virtually risk free and it is free money while it lasts, most of them are only available for fleeting moments. For people who don’t know, Warren Buffett indulged in quite a few arbitrage kind of investments early in his career. He used to call them workouts. Explaining arbitrage, Buffett writes – …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, selftender, etc. In most cases the arbitrageur expects to profit regardless of the behaviour of the stock market. The major risk he usually faces instead is that the announced event won’t happen. Arbitrage is a powerful construct and a fundamental tool in the arsenal of any value investor. Although many different types of arbitrage exist, here are few that Pabrai mentions in his book.

Traditional Commodity Arbitrage This is the one we saw above where the price difference for a commodity like gold can create a short window of arbitrage opportunity.

Correlated Stock Arbitrage A typical example is Berkshire’s class A and class B stocks. BRK.B is economically worth 1/30 of BRK.A. So these two stocks should trade in lockstep with each other – or perhaps BRK.B should trade at a small discount due to its inferior voting rights and one-way conversion feature. However, in reality, on many days the two stocks differ


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Chapter 39 - Arbitrage | Mental Models, Investing, And You by up to 1 percent. Assuming minimal frictional costs, an arbitrageur can potentially benefit from this spread. Another example is holding companies. Sometimes holding company stocks trade at a discount to a sum of the parts even if the parts are individually publicly traded.

Merger Arbitrage Let’s say a public company A announces it is to buy public company B for Rs. 100 a share. Prior to the announcement, B was trading at Rs. 75 a share; immediately after the announcement, B goes to Rs. 95 a share. If an investor buys B at Rs. 95 and holds the stock until the deal closes, then the Rs. 5 spread can be captured for a tidy profit in a few months. However, there is always some risk that the deal doesn’t close. In that case, B’s stock price might head back down to Rs. 75 (or lower). So you see that this is not completely risk free, however the downside is limited. There are well-documented statistics on percentages of announced mergers that never close, don’t get government approval, don’t get shareholder approval, or the like. If you don’t understand the business and these dynamics, it’s better to stay away from such transactions. These kind of corporate events – mergers, spin-offs, open offers, buybacks, restructuring etc. – are also known as special situation investing. Buffett has practiced arbitrage for decades and according to his own estimates he has averaged annual pre-tax returns of at least 25% from arbitrage. In his 1986 letter to shareholders, Buffett wrote – You will notice that we had significant holding in Beatrice companies at year end. This is a short-term arbitrage holding – in effect, a parking place for our money (though not a totally safe one, since deals sometimes fall through and create substantial losses). We sometimes enter the


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Chapter 39 - Arbitrage | Mental Models, Investing, And You arbitrage field when we have more money than ideas, but only to participate in announced mergers and sales. So how do you evaluate arbitrage opportunities? Here’s the blueprint from Warren Buffett – To evaluate arbitrage situations, you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire – a competing takeover bid, for example? and (4) What will happen if the event doesn’t take place because of anti-trust action, financing glitches, etc.? If that’s not enough for you, Joel Greenblatt has written a wonderful book – You Can Be A Stock Market Genius – on this subject. Now before you get too excited about arbitrage style of investing, you should note that in today’s world where information flows too quickly, you have to stay on top of your arbitrage bets all the time. It’s quite different from the long term value investing which requires you to buy good businesses and holding them for long time. Mind you, even Buffett got into arbitrage deals only to utilize the un-invested cash. It wasn’t his first choice either. Explaining Berkshire’s take on arbitrage investing, Buffett writes – Arbitrage positions are substitute for short-term cash equivalents, and during part of the year [1989] we held relatively low levels of cash. In the rest of the year, we had a fairly good-sized cash position and even so chose not to engage in arbitrage. The main reason was corporate


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Chapter 39 - Arbitrage | Mental Models, Investing, And You transactions made no economic sense to us; arbitraging such deals comes too close to playing greater-fool game. Another aspect of special situation investing you have to keep in mind is that usually the arbitrage opportunity arises out of corporate events and the quality of underlying business becomes irrelevant in this operation. Which means an adequate diversification is required to bring in the margin of safety. Because betting a significant part of your capital on a single arbitrage deal, even if it’s a short term bet, can be dangerous. Buffett says – Berkshire’s arbitrage activities differ from those of many arbitrageurs. First, we participate in only a few, and usually

very

large,

transactions

each

year.

Most

practitioners buy into a great many deals perhaps 50 or more per year. With that many irons in the fire, they must spend most of their time monitoring both the progress of deals and the market movements of the related stocks. This is not how Charlie nor I wish to spend our lives. (What’s the sense in getting rich just to stare at a ticker tape all day?) Here’s what Prof. Sanjay Bakshi mentioned in his interview with Safal Niveshak – You can make a lot of money doing risk arbitrage where you have to monitor — perhaps 20 deals at any given point of time and be ready to react quickly when odds change. But it’s stressful. The concept of arbitrage isn’t limited to investing only. The arbitrage mental model is based on the mispricing mindset and can be applied just as well in business. Outsourcing, for example, is the buying of labour in one location for sale in another.


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Chapter 39 - Arbitrage | Mental Models, Investing, And You The biggest Indian IT companies like TCS, Infosys, and Wipro derive most of their revenues by exploiting the low-cost offshore arbitrage model. These businesses incur most of their expenses in rupees (as salaries and other costs for offshore employees are borne in India) and revenues are billed in dollars.

Time Arbitrage Here’s another interesting take on the idea of arbitrage. When you buy a good quality business for a cheap price and hold it for long time, what you are essentially doing is an arbitrage – buying cheaper from one place (present) and selling at higher price another place (future), thus pocketing the spread. This is time arbitrage and it’s a huge advantage for a small investor who is willing to stay invested for long term. If Mr. Market and its other participants are discounting things 12-15 months down the line, and if you can look out 5-10 years, you will have a time arbitrage advantage, which is a structural advantage to have. Time arbitrage is not easy. A few months of a falling market or seeing your stocks going nowhere can feel like years. The impulse to “do something” can be overwhelming. Unfortunately, that impulse, more often than not, would hurt your long-term returns. Time arbitrage yields tremendous financial and psychological benefits for those with the discipline to hold fast against the noise. This is an edge worth cultivating. It costs nothing but time and can be applied by anyone, including you.

Conclusion Speaking at Columbia Business School, Warren Buffett once said – Because my mother isn’t here tonight, I’ll even confess to you that I’ve been an arbitrageur.


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Chapter 39 - Arbitrage | Mental Models, Investing, And You That should give you a clue that it’s not something even Buffett feels very proud of. The game of arbitrage is exciting but has the potential to derail your focus from long term investing. Take this advice from Buffett, which he dispensed in his 1989 letter, seriously – Arbitrage has looked easy recently. But this is not a form of investing that guarantees profits of 20% a year or, for that matter, profits of any kind. As noted, the market is reasonably efficient much of the time. An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline. Investing in arbitrage situations, per se, is no better a strategy than selecting a portfolio by throwing darts. Learning arbitrage gives you insights about its presence in different business models, but applying it in your own investing is something which needs a close evaluation of your own temperament. If you want to learn more about arbitrage, go to Prof. Sanjay Bakshi’s blog and search for the word ‘arbitrage’. The results will keep you busy for weeks.


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Chapter 40 Surfing A Wave In spite of having a coastline of more than 7,500 km with warm oceans and favourable conditions, surfing is not a familiar sport to Indians. It seems we are more fascinated with the swing of a cricket ball than the twists and turns of water waves. In many western countries including the US and Australia, surfing is a popular sport as well as a recreational activity. Surfing is a surface water sport in which the wave rider, referred to as a surfer, rides on the forward or deep face of a moving wave, which is usually carrying the surfer towards the shore. A surfer not only is carried by the wave, but it gives an exceptional forward speed to its rider, provided the surfer can get on to the wave at the right time and not get thrown off in between. The second most important thing required to ride a wave is to recognize that a wave is approaching. Which means 90 percent of the times you would find a surfer lying on his surfing board and paddling slowly, waiting for the right wave. So why are we talking about waves and surfers in a place reserved for discussing mental models? That’s because “surfing” isn’t just a sport. There are brilliant insights that can be used to analyse a business opportunity through the lens of a mental model with the same name i.e., Surfing A Wave. Charlie Munger used the surfing metaphor in his lecture on Elementary Worldly Wisdom to represent the idea of some large business force that developed, which a company was able to ride to grow itself much bigger.


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Chapter 40 - Surfing | Mental Models, Investing, And You As the saying goes – A rising tide lifts all the boats. But it’s important that one keeps his or her boat ready and identifies the tide on time. Many a times the same rising tide finds some people off guard and instead of lifting, it drowns them. That’s competitive destruction. Charlie Munger says – When technology moves as fast as it does in a civilization like ours, you get a phenomenon which I call competitive destruction. You know, you have the finest buggy whip factory and all of a sudden in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you’re dead—you’re destroyed. It happens again and again and again. And when these new businesses come in, there are huge advantages for the early birds. And when you’re an early bird, there’s a model that I call “surfing” – when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallows…. But people get long runs when they’re right on the edge of the wave – whether it’s Microsoft or Intel or all kinds of people. Microsoft was a result of a 16-year-old catching a wave right on the edge. Bill Gates and his friend Paul Allen were just 16 years and 18 years old respectively when the PC wave hit. Gates recounts his experience –


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Chapter 40 - Surfing | Mental Models, Investing, And You As early as 1971, Paul and I had talked about the microprocessor. And it was really his insight that because of semi-conductor improvements, things would just keep getting better. I said to him, “Oh, an exponential phenomenon is pretty rare, pretty dramatic. Are you serious about this? Because this means, in effect, we can think of computing as free.” It is a gross exaggeration, but it is probably the easiest way to understand what it means to cut cost like that. And Paul was quite convinced of that. So I would sort of say to Paul, “Well, you know what that means?” And he’d say, “Yeah, that is what it means.” It is kind of fun to know this, and think, gosh, how are companies going to react, how are they going to respond to something that phenomenal? The early days were very slow moving, though. By the time I went to Harvard, all there was the 8008 chip. And the 8080 was just coming out, which was the first good general purpose microprocessor chip that Intel was coming out with. Do these waves hit only selected people? Obviously no. But only few people see them coming. Why? Two people can see the same thing, but have a very different understanding of the implications. When Internet was in its early phase, a lot of people said, “What’s the big deal about the Web?” But when Jeff Bezos, who was working in a Wall Street firm until then, saw the Internet, he had different thoughts. He started looking for things that could be done with this strange technology called world wide web. He said this in one of his interviews –


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Chapter 40 - Surfing | Mental Models, Investing, And You I started working at the intersection of computers and finance, and stayed on Wall Street for a long time, ultimately worked for a company that did this thing called quantitative hedge fund trading. What we did was we programmed the computers and then the computers made stock trades, and that was very interesting too. The wakeup call was finding this startling statistics that web usage in the spring of 1994 was growing at 2,300 percent a year. You know, things just don’t grow that fast. It’s highly unusual, and that started me about thinking, “What kind of business plan might make sense in the context of that growth?” For him the moment of recognition happened when he saw the unusual growth numbers associated with internet. Jeff Bezos recognized the potential of the wave called Internet. And then he didn’t sit there paddling, he climbed onto his surfing board called Amazon, and got on the wave. Needless to say, the wave lifted this surfer to such heights that he changed the way things are bought and sold. After 20 years, Bezos is still riding the wave. As an aside, do you know who is the greatest surfer of all time? And I am not talking about riding a business wave. I mean the real wave in the ocean. His name is Laird Hamilton. He infamously surfed the most dangerous wave in the world. It was as tall as a seven-story building. Talking about catching the next wave in technology, Steve Jobs, in an exclusive interview with Fortune, said – These waves of technology, you can see them way before they happen, and you just have to choose wisely which ones


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Chapter 40 - Surfing | Mental Models, Investing, And You 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 [year 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. This reminds me of Malcolm Gladwell’s book Outliers where he explains how these Silicon Valley tech entrepreneurs, who were born within a couple of years of each other, like Bill Gates, Steve Jobs and Bill Joy, recognized and caught the same wave. And then you have Indian tech czars like Narayan Murthy, Azim Premji, and Shiv Nadar who were also born within a space of few years and ended up riding the same software services wave in India. Sunil Mittal was another guy who rode the GSM wave and became one of India’s richest men. All the examples above tend to suggest that surfing a wave phenomenon is only relevant in technology related businesses. But that’s not entirely true. Charlie tells the story of John Patterson and his company National Cash Registers – The cash register was one of the great contributions to civilization. It’s a wonderful story. Patterson was a small retail merchant who didn’t make any money. One day, somebody sold him a crude cash register which he put into his retail operation. And it instantly changed from losing money to earning a profit because it made it so much harder for the employees to steal….


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But Patterson, having the kind of mind that he did, didn’t think, “Oh, good for my retail business.” He thought, “I’m going into the cash register business.” And, of course, he created National Cash Register. And he “surfed”. He got the best distribution system, the biggest collection of patents and the best of everything. He was a fanatic about everything important as the technology developed. I have in my files an early National Cash Register Company report in which Patterson described his methods and objectives. And a well-educated orangutan could see that buying into partnership with Patterson in those early days, given his notions about the cash register business, was a total 100% cinch.


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In Investing Another great example that Munger talks about is of Les Schwab who rode the Japanese tire invasion wave, because of which he grew his tire store chain into multimillion dollar sales. When it comes to investing, Surfing is an important mental model that every investor should be thinking about for picking stocks. That’s exactly what an investor should be looking for, says Charlie, “In a long life, you can expect to profit heavily from at least a few of those opportunities if you develop the wisdom and will to seize them. At any rate, surfing is a very powerful model.” Now an important question is – how easy or difficult it is to catch a wave? Or for that matter, do you really need to surf every wave coming? When the PC wave and the Internet wave hit, Warren Buffett was not just a spectator. Especially in the case of Intel and Microsoft, Buffett was right there, rubbing shoulders with the people who are considered pioneers in getting onto those waves. As part of the finance committee of Grinnell College, he signed off the decision to make an initial investment in a company called Integrated Electronics. However, Buffett never put his own money into the company which later became Intel. Similarly, Buffett met Bill Gates in 1991 and they became good friends. But in spite of Gates’ suggestions to invest in Microsoft, Buffett passed the opportunity. So why did Buffett choose to be a mere bystander to both PC wave and the Internet wave? Charlie Munger explains – Berkshire Hathaway, by and large, does not invest in these people that are “surfing” on complicated technology. After all, we’re cranky and idiosyncratic—as you may have


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Chapter 40 - Surfing | Mental Models, Investing, And You noticed. And Warren and I don’t feel like we have any great advantage in the high-tech sector. In fact, we feel like we’re at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies. Again, that is a very, very powerful idea. Every person is going to have a circle of competence. And it’s going to be very hard to advance that circle…So you have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence. Some of you may find opportunities “surfing” along in the new high-tech fields—the Intels, the Microsofts and so on. The fact that we don’t think we’re very good at it and have pretty well stayed out of it doesn’t mean that it’s irrational for you to do it. The fact that Buffett and Munger don’t invest in technology (though Buffett has invested in IBM of late) doesn’t mean that it’s irrational for you to do it. What’s irrational is to try to catch on a wave which is outside of your circle of competence. You have to figure out where you’ve got an edge and then wait for a wave in that area.


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Conclusion A lot of business fortunes are made because someone happened to be in the right place at the right time – i.e., luck. Luck does play a large role for someone who surfs a wave. Luck, fortunately or unfortunately, is not sufficient. Charles Darwin wrote – It’s not the strongest of the species who survive, nor the most intelligent, but the ones most responsive to change. I think that sums up the idea of surfing a wave perfectly well. Remember, waves favour the prepared mind.


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SECTION 8: ENGINEERING


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Chapter 41 Redundancy What’s your favourite day or time of the week? For someone like me with a busy workweek, the favourite part of the week usually is Saturday morning. Now, what could be the best way to ruin a Saturday morning? Let me tell you how I (almost) achieved the feat. On a cool and breezy weekend morning when most people prefer to sit in the balcony and sip on a hot beverage, I was standing just outside my front door with a milk packet in my hands and toothbrush in my mouth, wondering why do they build these autolock doors. Yes, you guessed it right. I managed to lock myself out of my house. Everything including my keys, glasses, cell phone, wallet, and slippers were behind the door which was slammed shut by the very same Saturday morning breeze. However, the story had a happy ending when I was rescued by my saviour. Saviour? Yes, and it was none other than Mr. Red (short for Redundancy). Fortunately, I had kept a spare key with my trustworthy friend living few blocks away. I quickly ran to his house, got my spare key and thanked Mr. Red. Although it did raise few eyebrows among the neighbours when they saw a guy with disheveled hair, scurrying across the street barefoot with a milk packet in hand and toothbrush sticking out from mouth. Forgive me for being little too dramatic here but please stay with me for a little longer to know more about the insightful personality of Mr. Red.


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Chapter 41 - Redundancy | Mental Models, Investing, And You Sharing a spare key isn’t a novel idea. People do it all the time but it highlights the significance of building redundancy in our day to day affairs. If redundancy is so important in such small matters, imagine its utility in other critical matters. That’s what we are going to explore today. So let’s start with a working definition. Redundancy is defined as the existence of more than one means for accomplishing a given task. To be more specific, redundancy refers to the process of adding ‘extra’ instances of critical components to a system so that one can take over for another if something breaks. Thus all of these ‘instances’ must fail before there is a system failure. Look around you. Spare tyre in your vehicle, power backup generator in your apartment, fire exits in your office building, etc., are all typical examples of redundancy designs. To an untrained eye, redundancy may seem ambiguous because it looks like a waste of resources if nothing unusual happens. Except that the complexity of modern world ensures that the unusual would happen quite frequently and unexpectedly. Have you ever keenly observed the nature? It’s the best place to learn about redundancy.

In Nature If you look at the mother nature, it’s easy to see that redundancy is everywhere. Nassim Taleb writes in Fooled by Randomness – Mother

Nature

likes

redundancies…the

simplest

to

understand, is defensive redundancy, the insurance type of redundancy that allows you to survive under adversity, thanks to the availability of spare parts. Look at the human body. We have two eyes, two lungs, two kidneys, even two


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Chapter 41 - Redundancy | Mental Models, Investing, And You brains – and each has more capacity than needed in ordinary circumstances. So redundancy equals insurance, and the apparent inefficiencies are associated with the costs of maintaining these spare parts and the energy needed to keep them around in spite of their idleness…Layers of redundancy are the central risk management property of natural systems. A lot of species in animal kingdom give birth to multiple offspring (it’s common for some insects and fishes to lay millions of eggs in a single season) to ensure that at least some of them survive and carry forward the gene. Isn’t that redundancy? Nature likes to over-insure itself. As an aside to the central argument of redundancy, it’s worth mentioning an interesting insight which comes from Bill Gates. One of the focus areas for his philanthropic initiatives is to improve the child survival rates in poor African countries. For many naive armchair philosophers, it seems counter intuitive because logic says that instead of focusing on saving newborns, we should educate the poor women to have fewer kids since it’s common in these countries for families to have 34 children. Moreover, saving children will eventually lead to a bigger population in future which in turn will worsen the living conditions further. Right? Wrong! Look at this situation from the lens of redundancy mental model. One of the reasons people (and this could be a subconscious drive instilled by nature) have multiple children is – they assume some of those children aren’t going to survive to adulthood because of poor health care facilities. However, Mr. Gates’ argument is that the moment you improve the survival rate for children, people won’t feel the need to have multiple children. So, over the long term, you end up eliminating the root cause of population growth. It’s a brilliant insight.


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Chapter 41 - Redundancy | Mental Models, Investing, And You Let’s now shift gears a bit and turn to the field of engineering.

In Engineering We saw redundancy in nature is quite common but this mental model can be formally categorised as a big idea from the field of Engineering. In fact, when it comes to software engineering, building backup and additional redundant capacity is at the heart of architecting software systems. Large software enterprises (including Facebook, Google, Twitter, and all the banks) go as far as having multiple data centers spread across continents to ensure that even large scale catastrophic events don’t cause irrecoverable damage. Most of the commercial airliners have multiple engines. So in case of failure of an engine, the flight can continue with spare engines. And not just the engine, most of the critical parts in an airplane have redundancy of some form or other. In fact, while designing critical systems, it doesn’t suffice to build redundancy based on the historical worst case scenario. You actually have to overcompensate. Because the so-called worst-case event, when it happened, exceeded the worst case at that time. Nassim Taleb has named this inconsistency as “The Lucretius Problem”.

In Investing The great Chinese philosopher Confucius said – The superior man, when resting in safety, does not forget that danger may come. When in a state of security, he does not forget the possibility of ruin. When all is orderly, he does not forget that disorder may come. Thus his person is


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Chapter 41 - Redundancy | Mental Models, Investing, And You not endangered, and his States and all their clans are preserved. One of first things advised for personal finance is to create an emergency fund for yourself. This fund should cover 6 to 8 months of your expenses and it should be kept ultra-safe i.e., either in FDs or liquid funds. That’s creating redundancy for securing the future of your family. Getting adequate medical and life cover adds additional redundancy. The father of value investing, Benjamin Graham, pioneered the concept of margin of safety which is nothing but building redundancy in your investment portfolio. Warren Buffett, in his 1993 letter to investors, says – We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe

this

margin-of-safety

principle,

so

strongly

emphasized by Ben Graham, to be the cornerstone of investment success. In fact, having redundant cash in your investment kitty isn’t merely a defensive strategy. Come a market crash and your defensive strategy opportunistically turns into an aggressive strategy. It’s more like an investment rather than insurance. For that matter, debt is the inverse of redundancy. It not only takes away the safety, it actually makes your finances extremely fragile in the face of unexpected adversity.

Where It Fails Before we become too obsessed with the idea of redundancy, it’s important to understand its limitations, lest we become the proverbial man with the hammer to whom every problem looked like a nail.


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Chapter 41 - Redundancy | Mental Models, Investing, And You Can redundancy backfire? Shane Parrish, in his blog Farnam Street, explains it wonderfully – First, in certain cases, the added benefits of redundancy are outweighed by the risks of added complexity. Since adding redundancy increases the complexity of a system, efforts to increase reliability and safety through redundant systems may backfire and inadvertently make systems more susceptible to failure. An example of how adding complexity to a system can increase the odds of failure can be found in the near-meltdown of the Femi reactor in 1996. This incident was caused by an emergency safety device which broke off and blocked a pipe stopping the flow of coolants into the reactor core. Luckily this was before the plant was active. Second, redundancy with people can lead to social diffusion where people always assume it was someone else who had the responsibility. Another way in which redundancy can cause damage is when it makes people overconfident. How? You must have heard this joke floating around on the Internet – You don’t need a parachute for skydiving. You need it for trying skydiving more than once. Every skydiver jumps with a reserve parachute. What if even the second doesn’t open up? Well…so much for skydiving! Irony is that presence of a backup promotes the skydivers to attempt even riskier maneuvers which defeats the purpose of having additional safety.


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Chapter 41 - Redundancy | Mental Models, Investing, And You Similarly, as the automobiles become safer, drivers go faster and take on more risks (known as Peltzman Effect). Same in case of sports too. The tragic demise of Australian cricketer Phil Hughes can probably be attributed to the same reason. Facing express bowlers of the past, whether Harold Larwood, Andy Roberts or Malcolm Marshall, helmet-less batsmen were less inclined to play the hook—a shot that involves swatting a short-pitched ball from in front of your nose—because of the danger of getting it wrong. They were also more likely to keep their eye on a threatening ball and sway out of the way at the last moment, as the coaching manual demands. Today, with greater protection, there seems to be more of a propensity for batsmen to flinch and turn their backs on anything nasty… those with exposed heads were more likely to play back-foot shots, which give batsmen extra time to follow the flight of the ball. (source: Economist) So do you see the paradox of redundancy? Nonetheless it’s an important mental model and extremely useful one in designing systems around us.

Conclusion If you thought that after that fateful Saturday morning, I would have learnt my lesson, then you are underestimating me. I repeated the same blunder but this time with my car and as usual Mr. Red saved me again. With redundancy, one doesn’t have to worry about predicting the worst case scenario. Building redundancy means assuming that the worst case will happen time to time and then making arrangements to minimize the harm.


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Chapter 42 Critical Mass It’s said that you can find extraordinary intelligence in nature. To unearth this brilliance, all you need is curious eyes and close observation. In that spirit, let me start today with the story of a Chinese bamboo tree. Imagine that you were given few Chinese bamboo seeds and asked to grow them. You take the little seed, plant it, and start watering it. You add fertilizer and wait patiently for the seed to turn into a plant. You wait for a whole year, and nothing happens. The second year you continue to water it and fertilize it, but still nothing happens. Looks like somebody is testing your patience. The third year you water it and fertilize it, and the same story repeats i.e., no visible results. Many people would have given up on the tree by this time. But not you. At least not in my story. The twist in the tale comes sometime during the fifth year. One fine day a tiny bamboo sprout breaks through the ground. Yay! Your happiness knows no bounds, after all you didn’t give up and your perseverance finally paid off. While the neighbouring trees are bullying the innocent baby bamboo, you wish that the tiny sapling at least lives for few more weeks. But the bamboo tree has some other plans. What transpires in the next few weeks is phenomenal. In a matter of six weeks that puny sapling shoots up in the sky, not stopping until it achieves a dizzying height of ninety feet. This unreal growth leaves you flabbergasted and the fellow trees in shambles.


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Image Source: Google.

What the heck happened? To many readers, this story might sound familiar. But chances are that you were told this story in a different context. The anecdote is quite popular among motivational coaches and self-help gurus who use this metaphor to extol the virtues of tenacity and never-give-up attitude. Their pep talks sound something like – “Don’t give up! Keep putting in efforts and the results will one day come like the Chinese bamboo tree!” I don’t disagree with them, however, my intention here is not to pump you up. I want to dig deeper and try to unravel an interesting mental model depicted by this phenomenon. So let me start by putting out some obvious questions on the table. •

What do you think was going on in the case of the Chinese bamboo tree?

•

Was there really nothing happening at all in the first five years?

•

Why did the visible growth happen so fast in such a short period of time?


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Chapter 42 - Critical Mass | Mental Models, Investing, And You •

Is it just the Chinese bamboo tree, or are there other areas where a similar pattern can be observed?

The Big idea from Physics Before we can make an attempt to answer those questions, we need to understand the notion of Critical Mass which made its debut in nuclear physics. Well, I know nuclear physics excites very few. So before you run away, let me just reassure you that I’ll be done with my physics lecture even before you open your eyes. In nuclear physics, Critical Mass is the minimum amount of a given fissile material (raw material for nuclear reaction) necessary to achieve a self-sustaining fission chain reaction. The term, however, is now used as a much broader construct. In astrophysics, for example, Critical Mass is a concept used to designate any mass that when exceeded causes something to happen. You can open your eyes now. Jokes aside, Critical Mass can be understood by observing something as simple as a metal spring. A spring goes back to its original size and shape when you release it after stretching it a bit. However, if stretched beyond a certain limit, it merely deforms rather than returning to its original position. That limit is akin to the critical mass for the spring. To make it more clear, I want to take Peter Bevelin’s help. So let me draw your attention to this excerpt from his book, Seeking Wisdom – At a certain scale, a system reaches a critical mass or a limit where the behavior of the system may change dramatically. It may work better, worse, cease to work or change properties.


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Chapter 42 - Critical Mass | Mental Models, Investing, And You 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 small change may have no effect on a system until a critical threshold is reached. For example, a drug may be ineffective up until a certain threshold and then become effective, or it may become more and more effective, but then become harmful. Another example is from chemistry. When a system of chemicals reaches a certain level of interaction, the system undergoes a dramatic change. A small change in a factor may have an unnoticeable effect but a further change may cause a system to reach a critical threshold making the system work better or worse. A system may also reach a threshold when its properties suddenly change from one type of order to another. For example, when a ferromagnet is heated to a critical temperature it loses its magnetization. As it is cooled back below that temperature, magnetism returns. This mental model finds its relevance not only in physics but in scores of other areas. Let’s explore some of them.

Critical Mass as Tipping Point Malcolm Gladwell has done a brilliant job of refining this concept further to explain the phenomenon of epidemics, like social trends or contagion of ideas, in his book The Tipping Point.


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Chapter 42 - Critical Mass | Mental Models, Investing, And You The advent and popularity of fax machines is an interesting case study he explained in his book – Sharp introduced the first low-priced fax machine in 1984, and sold about 80,000 of those machines in the United States in that first year. For the next three years, business slowly and steadily bought more and more faxes, until, in 1987, enough people had faxes that it made sense for everyone to get a fax. Nineteen eighty-seven was the fax machine Tipping Point. A million machines were sold that year, and by 1989 two million new machines had gone into operation. It’s very interesting to note that, using the concept of Critical Mass, a lot of social behaviour can be decoded like how rumors spread, voting, mob behaviour (leading to strikes or riots), adoption of new technology, consumer behaviour, education, and host of other things. Farnam Street has put together some great insights and relevant examples describing the above situations in the light of Critical Mass mental model. Coming back to the Chinese bamboo tree puzzle, now we have some clues to explain the explosive growth. Although, outwardly nothing significant seemed to have occurred for the first five years but the bamboo roots, underneath the ground, were slowly taking shape and growing steadily. In effect, the foundation was getting built to support the upcoming rapid growth. The moment a critical mass, in terms of amount of roots required for external growth, was achieved the bamboo sampling broke free and grew with a nonlinear speed. You could say that the day, when bamboo sapling saw the sunlight for the first time, was the tipping point.


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Checkout the non-linearity as shown in the graph above. In any system prone to critical mass effect, the tipping point is where the non-linearity kicks in. For that matter, the boiling point and the freezing point for water are kind of tipping points where the state transition happens for the water. Another great example around us is the city traffic. On any given day the traffic affects our commute time. If you increase the traffic by twice, our commute time may also increase by a factor of two. However, at a certain point, addition of few more cars chokes the road completely and the vehicles movement comes to a grinding halt. The number of cars on the road at that inflection point can be dubbed as the Critical Mass for the commute system.

In Business and Investing Warren Buffett suggests that for finding great businesses, one should look for strong moats. And one of the underlying forces for a moat is economies of scale.


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Chapter 42 - Critical Mass | Mental Models, Investing, And You A company may reach a certain critical size, writes Peter Bevelin …and get advantages of scale in experience purchasing, marketing,

manufacturing,

administration,

research,

logistics, distribution, etc. For example, expenses can be spread out over larger amounts of volume, lowering average costs. These advantages often permit greater specialization, making people better at what they do. That’s the positive side of Critical Mass. How about its role in understanding the financial disasters? Think about the 2008 economic crisis. One of the factors contributing to the fiasco was poor quality debt issued by financial institutions. Now, in a healthy economy, few bad practices and bad loans can be absorbed without much news. However, when certain factors related to environment and regulations promote the misaligned incentives, they end up triggering positive feedback loops feeding the bad. Remember Gresham’s Law (Chapter 28)? Unfortunately, before a Critical Mass (of bad debt) could be achieved, no dramatic changes were visible for a long time. And one fine day in 2008, people were caught off guard when the whole financial system tipped. Reminds me of the saying – “It is the last straw that breaks the camel’s back.” Perhaps, the first bad loan (packaged as mortgage backed security) which defaulted and the first buyer in the stock market who couldn’t find another buyer became the last pieces of the Critical Mass puzzle.


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Conclusion When it comes to multidisciplinary learning, one leg of the latticework of mental models is hinged on the idea of Critical Mass. Take a look at the definition of Lollapalooza as defined in Poor Charlie’s Almanack – Lollapalooza is, as personified by Charles Munger, the critical mass obtained via a combination of concentration, curiosity,

perseverance,

and

self-criticism,

applied

through a prism of multidisciplinary mental models. If you could look at the world from Charlie’s eyes, who according to Warren Buffett has the world’s best 30-second brain, majority of the worldly problems would be nobrainers. In simple words, when you learn the most important mental models and start applying them for problem solving, you will realize that multiple models seem to converge in one direction and together they form the dynamic critical mass for a cascading of positive effects – a lollapalooza. It simplifies your decision making tremendously.


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Chapter 43 Theory of Constraints Few years back, while I was employed in a IT MNC, my office commute route involved a stretch of road which had quite a few traffic signals. One of these traffic signal was very nasty. It would sometimes take up to 20-30 minutes just to cross this one. A real bottleneck. Soon the government decided that there should be a flyover built over this traffic signal. When I heard the news about flyover, I felt that it would solve the bottleneck problem. Three years and few crore rupees later the flyover was finally ready. But did it solve the problem? Partially. The bottleneck dissolved at that one particular traffic signal but all that flyover did was shift the bottleneck to the next traffic signal. Overall there was no improvement in my commute time. This is what happens when you fail to look at a problem in a holistic way. Building the flyover wasn’t the complete solution. When they thought of building the flyover, authorities were not really addressing the bottleneck, they were focused on the location of the bottleneck. And in this case the bottleneck was a moving target. This holistic way of looking at problems is called systems thinking. And Theory of Constraints is an important mental model to assist you in developing systems thinking. It’s the science of looking at the properties of bottlenecks in a system and how they behave.


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Theory of constraints says that a system’s performance is constrained by its weakest link. Peter Bevelin, in his book Seeking Wisdom, writes – Optimization of one variable may cause the whole system to work less efficiently. Why? The performance of most systems is constrained by the performance of its weakest link. A variable that limits the system from achieving its goal or optimum performance. An increase in production may for example be physically constrained by the production capacity on one of the machines. If one machine in a production line of two machines can produce 100 items and the second 90, the output is physically constrained by the second machine. When trying to improve the performance of a system, first find out the system’s key constraint(s)- which may be physical (capacity, material, the market) or non- physical (policies, rules, measurements) – and its cause and effect relationship with the system. Maybe the constraint is based on faulty assumptions that can be corrected. Then try to


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Chapter 43 - Theory of Constraints | Mental Models, Investing, And You “strengthen” or change the weakest link. Watch out for other effects – wanted or unwanted – that pop up as a consequence. Always consider the effects on the whole system. Theory of Constraints was made popular by Eliyahu Goldratt. His book The Goal features in the list of few books that Amazon’s CEO Jeff Bezos shares with his top executive. This book was a bible for the team that fixed and optimized Amazon’s fulfilment network. Sometimes the whole assumption – a bottleneck needs to be removed – may be a wrong one. Instead of removing the bottleneck, you could make the bottleneck itself more efficient and increase the flow through it by introducing clever hacks. Watch this simple experiment which illustrates the idea.

Click here to watch the video In simple words, TOC provides answers to this one fundamental question – What to change?


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Chapter 43 - Theory of Constraints | Mental Models, Investing, And You Why is it such an important question? It’s important because most of us naively think that we know the answer. Just ask anybody in your organization – what to change – and you will find out that everyone is a real expert in complaining and moaning. And each of these gripes is a suggestion about what to change. Now Pareto Principle says that 80 percent of results are produced by 20 percent of the problems. As a corollary, 80 percent of the failures are caused by top 20 percent of the problems. Which means if you focus on the top 20 percent of problems you get maximum impact. Simply put, before jumping on the solution, you first need to identify the right problems and then focus on addressing only those problems. These are the problems which can be called as the constraints which affect the throughput of the system under investigation. There are times when you discover multiple bottlenecks constraining the system. Then you need to measure the impact of each bottleneck and prioritise. That’s how you find the right problem to solve. That’s the way to get the maximum bang for the buck.

In Business Goldratt proposes the following framework to identify and address the bottlenecks in a system – 1.

Articulate the goal of the system i.e. how do we measure the system’s success?

2.

Identify the constraint. What resource is limiting the system from attaining its goal?


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Chapter 43 - Theory of Constraints | Mental Models, Investing, And You 3.

Exploit the constraint to its fullest. How can we keep the constraining resource as busy as possible, exclusively on what it does best?

4.

How can we align all processes so they give the constraining resource everything it needs?

5.

Elevate the constraint. If managing the constraining resource more efficiently does not give us all the improvement we need, then how can we acquire more of the resource?

6.

Avoid inertia. Has the constraint moved to some other resource as a result of the previous steps? (Like it happened with traffic and flyover problem)

Before one can start working on this framework, it’s important to arrive at right definition of success. You need to know what are the measurable things which can help us determine if the goal has been achieved. Here are few things which one can measureThroughput: It’s the rate at which the system generates money through sales. In our example it would be the number of people that pass through the system or from our pre-defined location A to location B. Inventory: It’s all the money that the system has invested in purchasing things which it intends to sell. This is akin to the investment that government makes for building the infrastructure for facilitating commute e.g. flyovers, broadening the roads, public transport etc. Operational Expense: It’s all the money the system spends in order to turn inventory into throughput. To understand it better, let’s ask this question from ourselves. What’s the goal of an organization or a business?


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Chapter 43 - Theory of Constraints | Mental Models, Investing, And You Is it to have motivated employees? Satisfied customers? Or better profit? You can’t look at it as single problem. The components are connected. So the goal of an organization is actually to keep the customers satisfied, while the employees remain motivated and better profits are achieved at the same time. Any one factor kept ignored will constraint the throughput of the whole system i.e. the organization. Here’s an example. Statistics say that 80 percent of the businesses started this year will be out of business within 3 years and many of these businesses will be forced to close down in spite of being profitable. Why? Because they would forget that the real problem to focus on isn’t the accounting profit but the cash flow. Cash becomes an important constraint which, if ignored, causes many profitable businesses to choke and die.

In Investing Here’s an interesting insight from Prof. Sanjay Bakshi. He mentioned this of cash-rich businesses in his interview with Safal Niveshak – Let’s say you own a business which has lot of cash on its balance sheet. What are the factors that you should think about while evaluating this situation? Charlie Munger says that having so much cash is a “high quality problem” and that “excess cash in an advantage, not a disadvantage”. But that’s just one way to look at it and it has certain hidden assumptions.


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Chapter 43 - Theory of Constraints | Mental Models, Investing, And You The metaphor I like here is that of a Tijori (Hindi term for a safety locker for storing valuables). Some of your money is in a Tijori, and it is open, and you don’t have access to it but the fellow who has access to it is a crook. What’s your money really worth? How much would you expect to fetch for your interest in that Tijori when you sell it to another person in an arms-length transaction? Well, the owner of a “cash bargain” in a company run by crooks is the functional equivalent of the part-owner of such a Tijori. Tijori describes the weak link in this system. Your cash’s worth depends on the integrity of the management. So the integrity of the management could become a severe bottleneck and unlocking of business value may not happen at all. A clear value trap. Similarly, an adequate diversification is a way to protect your portfolio from getting dragged down by one stock which forms a disproportionate part of your portfolio, a bottleneck. For example, if you have a portfolio of 10 stocks and each stock weights 10%, every time a stock increases to a size of 20% or 25% of your portfolio, you may want to sell a portion of that and rebalance it so that the initial structure, 10% for each stock, gets reinstated.

Conclusion So based on what we discussed so far, can you think of a solution for the traffic problem?


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Chapter 43 - Theory of Constraints | Mental Models, Investing, And You Before you start thinking about the answer, let me draw your attention again to Bevelin’s words - System’s key constraint(s)- which may be physical (capacity, material, the market) or non- physical (policies, rules, measurements). Can traffic jam problem be solved by addressing the capacity or it needs an intervention in the way policies are framed and implemented. I would love to hear from you if stumble upon any insights.


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SECTION 9: MATHEMATICS


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Chapter 44 Inversion Watch this one-minute video and when you’re done smiling, think about the problem in a rational way.

Click here to watch the video At first, the problem seemed that the kid had his head stuck between the iron bars. Although nobody saw how the kid’s head really got trapped in the first place – they just assumed that he somehow managed to slide his head through the narrow bars. Naturally, the intuitive solution was to pull the head in the same way it got stuck – which obviously didn’t seem to work. But the right solution appeared when people stood the problem on its head (no pun intended) i.e., instead of trying to pull the head they pushed in the body through the trap. They inverted the problem and voila! Problem solved.


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Chapter 44 - Inversion | Mental Models, Investing, And You That’s called principle of inversion. It’s a common trick used by mathematicians but rarely practiced outside the discipline of mathematics. Carl Jacobi, a German mathematician, said, “Invert, always invert”, expressing his belief that the solution of many hard problems can be clarified by re-expressing them in inverse form. Charlie Munger, the business partner of Warren Buffett and Vice Chairman at Berkshire Hathaway, came up with his own version of Jacobi’s maxim – All I want to know is where I am going to die so that I’ll never go there. Munger is 92 years now so I guess his strategy has worked out pretty darn well so far. It is not enough to think about difficult problems one way. You need to think about them forwards and backwards. “Indeed,” says Munger, “many problems can’t be solved forward.” You should read how inversion was used by one of Munger’s family members to guess the correct answer to a trivia question. Roger von Oech’s Creative Whack Pack is a great tool to instil Munger’s way of thinking – combining various ideas from different spheres of life and joining them to create a process of thinking creatively. Here is what the Inversion card says –

Image Source: Creative Whack Pack


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Chapter 44 - Inversion | Mental Models, Investing, And You Reversing how you look at a situation can open up new possibilities and dislodge assumptions. Example: When everyone else is gazing at a glorious sunset, why not turn around to see the blues and violets behind you? What do you notice when you look at a coffee cup? Its design or color? Reverse your focus and look at the space inside – that’s what gives it its functional value.

Inversion and Proofreading In this short video, a chess grandmaster walks us through retrograde analysis, which is a method to solve game positions in chess by working backwards from known outcomes. Even if you don’t play chess, you should watch it because it has interesting insights about problem solving. As mentioned in the video, reading a text backwards reveals glaring errors which aren’t normally caught while you’re reading forward. The reason this trick works is because when you are proofreading, especially your own work, your brain has a tendency to start skimming through the material and jumping from one sentence to the next. When it does this, it is very difficult to catch mistakes because you can very easily look past them as you are reading. When you go through your essay or article backwards you will catch more mistakes because each sentence is taken out of context so that you can focus on it by itself. Also, it’s easier to spot errors when you view words in a different order. This cool inversion hack tricks your brain into looking at everything in a different way.

Subtractive Knowledge Another useful way to think about forward vs backward thinking is to model them as additive vs subtractive measures. Additive measures manifest in form of an urge to do


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Chapter 44 - Inversion | Mental Models, Investing, And You something (Chapter 6) about a problem which may not need any intervention. Subtractive measures adhere to the philosophy of “don’t try to fix something which isn’t broken.” Nassim Taleb calls this ‘subtractive epistemology’. He argues that the greatest and most robust contribution to knowledge consists in removing what we think is wrong. According to him we know a lot more about what is wrong than what is right. What does not work, that is negative knowledge, is more robust than positive knowledge. This is because it’s a lot easier for something we know to fail than it is for something we know that isn’t so to succeed. He dubs this philosophy as Via Negativa. Taleb has written a whole book, The Black Swan, based on this idea that the absence of evidence doesn’t qualify as the evidence of absence. In other words, just because all the swans, that have been observed so far, are white doesn’t prove that all swans are white. Since one small observation (spotting a black swan) can conclusively disprove a statement – all swans are white – while millions can hardly confirm it, disconfirmation is more rigorous than confirmation.

Avoiding Stupidity Inverting the problem not just helps you in solving the problem, but it will also help you in avoiding trouble. So how does this idea translate into practice? It’s a choice between avoiding stupidity and seeking brilliance. A lot of success in life and success in business, says Munger, “comes from knowing what you really want to avoid-like early death and a bad marriage.” He writes – What will really fail in life? What do we want to avoid? Some

answers

are

easy.

For

example,

sloth

and

unreliability will fail. If you’re unreliable it doesn’t matter what your virtues are, you’re going to crater immediately.


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Chapter 44 - Inversion | Mental Models, Investing, And You So, faithfully doing what you’ve engaged to do should be an automatic part of your conduct. Of course you want to avoid sloth and unreliability. It’s a common knowledge that to succeed you should find role models and follow them. But it would be equally effective, and perhaps even more, to find anti-models – people you don’t want to resemble when you grow up. And then avoid the path they took.

In Business and Decision Making John Paul Getty, an American business tycoon, said – In every business deal or transaction, identify the worst thing that can possibly go wrong, and then make sure it doesn’t happen. Donald Keough in his book The Ten Commandments for Business Failure (a book recommended by Warren Buffett), used the inversion principle by showing the direct paths to failure. He talks about things like – not taking risks, being inflexible, playing the game too close to the foul line, etc. These are precisely the things that one can do to ensure a failure in business. Hence avoid them like a plague. Jeff Bezos, founder and CEO of Amazon, used the inversion principle to break his dilemma about leaving a high paying job and starting Amazon. He recounts – When you are in the thick of things, you can get confused by small stuff. I knew when I was eighty that I would never, for example, think about why I walked away from my 1994 Wall Street bonus right in the middle of the year at the worst possible time. That kind of thing just isn’t something you worry about when you’re eighty years old. At the same time, I knew that I might sincerely regret not having


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Chapter 44 - Inversion | Mental Models, Investing, And You participated in this thing called the Internet that I thought was going to be a revolutionizing event. When I thought about it that way … it was incredibly easy to make the decision. Have you heard of post-mortem technique? When a project fails, typically the stakeholders get together and do the root cause analysis trying to figure out the reason for failure and possible learnings from the mistake. It’s a good practice but it’s not sufficient. You need to again apply the inversion principle here. How? Instead of doing post-mortem at the end, why not do a pre-mortem at the beginning. Sounds confusing? Here is how it’s done. Before getting started, assume that the project has failed (or in case of a personal decision, assume that it has backfired) one year down the line. That done, run your imagination wild and come with possible reasons for failure. So in a pre-mortem, you think of ways in which the project in its current form is destined for failure before the launch. It’s not easy but if you want to exploit the inversion mental model, it’s something which you should definitely give a try.

In Investing In his Art of Investing workshops, Vishal talks about the concept of reverse DCF. The idea is that instead of asking what’s the present value of future cash flows, ask what growth rate market is assuming to justify the present value of future cash flows. Valuation, being an imprecise art, is a good candidate for inversion. By thinking forward (i.e. by estimating present value of future cash flows), we are prone to making mistakes. By thinking backward, we create a sanity check on thinking forward.


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Chapter 44 - Inversion | Mental Models, Investing, And You From perspectives on floats to risk arbitrage – everything can be investigated using the lens of inversion. And there is only one place where you can find truckloads of such insights about how to use inversion for stock analysis. That’s Prof. Sanjay Bakshi’s blog. Just go and search for the word “inversion” on his blog – the results would keep you busy for weeks. Remember Warren Buffett’s rules of investing? Rule 1: Don’t lose money. Rule 2: Don’t forget rule 1. Notice the core message here. It’s not focusing on how to make money, instead it asks you to invert the problem and ensure that you don’t lose money. Put simply, to implement the inversion principle in stock picking, you need to focus less on – 1.

How to earn great returns, and more on how to avoid permanent capital loss;

2.

How to pick the great stocks, and more on how to avoid the dangerous ones;

3.

Things to do for investing success, and more on things to avoid for investing failure.

Conclusion The inversion trick is a very powerful idea because it de-biases us. Backward thinking makes us more objective. And in business and life, just as in algebra, inversion will help you solve problems that you can’t otherwise handle.


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Chapter 44 - Inversion | Mental Models, Investing, And You Every time you learn a new mental model your scaffolding, to retain information in useful way, becomes stronger. A wise man once said – A man’s mind stretched to a new idea never goes back to its original dimensions. I hope that practicing inversion will stretch your mind and build stronger thinking muscles which will make you a better decision maker.


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Chapter 45 Permutation and Combination Here’s an interesting trivia. If you wear different tie on the same shirt, most people will think that you’re wearing a different shirt. That’s an interesting way to multiply your options without really buying new cloths (except few new ties). “That’s not a trivia, that’s a Jugaad.”, you might want to say. Anyways, that brings me to an equally interesting mind bender. If you have 2 shirts (white, blue), 3 pants (black, gray and brown) and 3 different ties (pink, orange, red), in how many different ways can you get dressed? Assumption here is that getting dressed requires you to wear all three i.e. a shirt, a pant and a tie. Using the multiplication principle, we can say that there are total 2 x 3 x 3 = 18 ways to get dressed. Of course some of the dress combinations will look outright funny but our concern here is to find out all possible ways to get dressed. Moreover, today we are getting into mathematics discipline and most mathematicians don’t really have whole lot of fashion sense anyways. So that’s the simplest example of using the idea of combinations in real life. Now let’s say, for some strange reason, we were also considering the order in which you put on the cloths, i.e. it matters to us if one puts on the shirt first instead of tie. Imagine wearing a tie first and then squeezing the shirt inside the tie, funny right? I told you mathematicians don’t care much about the dressing etiquettes


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Chapter 45 - Permutation and Combination | Mental Models, Investing, And You Okay, back to the same question again. In how many ways can you get dressed if the order of dressing matters? For each of those 18 combinations, there are six ways to dress. So for a given combination of pant, shirt and tie you could go pant first, followed by the shirt and then tie. Or you could wear the shirt first, followed by the tie and finally the pant. Or you could do shirt, pant and tie. And so on. Here the order (or the arrangement) of the objects matter. So permutation is just a fancy pants (no pun intended) definition of all possible ways of doing something. Simply put, permutations or rearrangements mean the different ways we can order or arrange a number of objects. Combinations means the different ways we can choose a number of different objects from a group of objects where no order is involved, just the number of ways of choosing them. For that matter a combination lock should really be called a permutation lock. The order you put the numbers in matters. A true combination lock would accept both 1017-23 and 23-17-10 as correct. In most simple terms, permutations and combinations (P&C) is all about counting the possible outcomes. I am not sure about the current curriculums in schools but I learnt about P&C after 10th standard. Perhaps they are teaching these mathematical principles to kids in junior classes now. Mathematicians get a kick out of converting simple numbers into complicated equations containing English and Greek letters. So this is how a typical mathematics text book would describe the idea of permutations –


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Chapter 45 - Permutation and Combination | Mental Models, Investing, And You If one event can happen in ‘n’ different ways, and a second event can happen independent of the first in ‘m’ different ways, the two events can happen in n x m (n multiplied by m) different ways. To add little more clarity to the above definitions, it would help to think it this way – Permutations are for lists (order matters) and combinations are for groups (order doesn’t matter).

The Factorial (!) Let me take help from Peter Bevelin, author of Seeking Wisdom, for explaining the idea of factorial. Bevelin writes – We have 3 hats to choose from – one black, one white and one brown. In how many ways can we arrange them if the order white, black and brown is different from the order black, white and brown? This is the same as asking how many permutations there are with three hats, taken three at a time. We can arrange the hats in 6 ways: 1.

Black-White-Brown

2.

Black-Brown-White

3.

White- Black-Brown

4.

White-Brown-Black

5.

Brown-White-Black

6.

Brown-Black-White.

Another way to think about this: We have three boxes in a row where we put a different hat in each box. We can fill the first box in three ways, since we can choose between all three hats. We can then fill the second box in two ways,


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Chapter 45 - Permutation and Combination | Mental Models, Investing, And You since we now can choose between only two hats. We can fill the third box in only one way, since we have only one hat left. This means we can fill the box in 3 x 2 x1= 6 ways. Another way to write this is 3! [another fancy pant word] If we have n (6) boxes and can choose from all of them, there are n (6) choices. Then we are left with n-1 (5) choices for box number two, n-2 (4) choices for box number three and so on. The number of permutations of n boxes is n! What n! [pronounced as n-Factorial] means is the product of all numbers from 1 to n. Suppose we have a dinner in our home with 12 people sitting around a table. How many seating arrangements are possible? The first person that enters the room can choose between twelve chairs, the second between eleven chairs and so on, meaning there are12! or 479,001,600 different seating arrangements. The number of ways we can arrange ‘r’ objects from a group of ‘n‘ objects is called a permutation of ‘n’ objects taken ‘r’ at a time and is defined as p(n,r) = n! / (n-r)! A safe has 100 digits. To open the safe a burglar needs to pick the correct 3 different numbers. Is it likely? The number of permutations or ways of arranging 3 digits from 100 digits is 970,200 (100! / (100-3)!). If every permutation takes the burglar 5 seconds, all permutations are tried in 5 6 days assuming a 24-hour working day.


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Chapter 45 - Permutation and Combination | Mental Models, Investing, And You In how many ways can we combine 2 flavors of ice cream if we can choose from strawberry (S), vanilla (V), and chocolate (C) without repeated flavors? We can combine them in 3 ways: SV, SC, VC. VS and SV are a combination of the same ice creams. The order doesn’t matter. Vanilla on the top is the same as vanilla on the bottom. The number of ways we can select ‘r‘objects from a group of ‘n’ objects is called a combination of n objects taken r at a time and is defined as C(n,r) = n! / r! (n-r)! The number of ways we can select 3 people taken from a group of 10 people is 120 i.e. (10! / (3!) (100-3)!)

In Investing The study of permutations applies to investing in a broad sense because a good understanding of probability is sometimes necessary to make rational financial choices. In fact, if you don’t understand P&C properly, you would have a tough time understanding probability. So P&C forms the foundation for understanding the concept of probability. Charlie Munger, in his famous talk at USC Business School in 1994 entitled A Lesson on Elementary Worldly Wisdom, said – Obviously, you’ve got to be able to handle numbers and quantities—basic arithmetic. And the great useful model,


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Chapter 45 - Permutation and Combination | Mental Models, Investing, And You after compound interest, is the elementary math of permutations and combinations. And that was taught in my day in the sophomore year in high school…It’s very simple algebra. It was all worked out in the course of about one year between Pascal and Fermat. They worked it out casually in a series of letters. It’s not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it’s a fundamental truth. So you simply have to have the technique. If you don’t get this elementary, but mildly unnatural, mathematics

of

elementary

probability

into

your

repertoire, then you go through a long life like a one legged man in an ass-kicking contest. You’re giving a huge advantage to everybody else.



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Chapter 45 - Permutation and Combination | Mental Models, Investing, And You One of the advantages of a fellow like Buffett, whom I’ve worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations.

Conclusion For me, preparing tea is a combination problem. All I know is that I need to throw in the ingredients (tea, water, milk, sugar) in a pan and heat it for 5-10 minutes. But for my wife it’s a permutation problem. She insists that milk be added at the last. No wonder, nobody wants to drink my tea. Okay now that you’re equipped with the knowledge of P&C, riddle me this. If my wife, my two kids and I go to a movie theatre, in how many different ways can four of us be seated on our four allotted seats, assuming that all four seats are on the same row and adjacent to each other? Did you say 24? That could be correct except that the real world hardly presents itself like a welldefined mathematics problem. In real world, there’s always a catch. The catch in my case is that my kids are identical twins. So for all practical purposes, assuming the kids are wearing the same attire, half of the seating arrangements will look identical. And the correct answer would be 12. Talking about probability, the odds of having an identical twin is approximately 1 in 300 i.e. 0.33 percent. My wife and I consider ourselves very lucky.


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Chapter 46 Bayes Theorem A statistics professor who travels a lot was concerned about the possibility of a bomb onboard his plane. He determined the probability of this and found it to be low but not low enough for him. So now he always travels with a bomb in his suitcase. He reasons that the probability of two bombs being onboard would be infinitesimal. Do you think he has really reduced the risk? Even those who aren’t well versed with the basic concepts of probability can say that the professor’s logic seems absurd. Well, the bomb riddle is a famous joke among mathematicians. Nevertheless, it’s a thought provoking one. So to help you think about the riddle, let’s explore another related thought experiment. A man wakes up in the middle of the night with a splitting headache. He remembers that there are few aspirin bottles in the bathroom. He dizzily stumbles into his bathroom to grab one of the four bottles in the dark and pops a pill from that bottle. An hour later, instead of getting relief from headache, he starts feeling a terrible nausea. Suddenly he realizes that only three of the four bottles in the bathroom contained aspirin and the fourth bottle contained poison. The tragedy of the situation was that, like poison, aspirin also causes nausea sometimes. The label on the poison bottle said that 75 percent people who take the poison will show the nausea symptoms. Whereas the sticker on the aspirin bottle read that only 10 percent would feel the same symptoms after taking aspirin.


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Chapter 46 - Bayes Theorem | Mental Models, Investing, And You What are the chances that the man took poison pill instead of aspirin? This question is different from – what’s the probability that man took poison before he started getting nausea? – because here we have an additional piece of information i.e., the man is experiencing nausea. I guess before you start thinking about the solution, your first comment would be – “A man stupid enough to keep a poison bottle next to aspirin deserves to die like this.” I agree. But this is just an imaginary case study to illustrate an academic idea in a simplified form. The idea we’re going to explore comes from the field of probability. It’s known as Bayes Theorem. Bayes theorem is named after the 18th century English minister Thomas Bayes whose essays concerned how we should adjust probabilities when we encounter new data.

Image Source: Datuopinion.com


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Chapter 46 - Bayes Theorem | Mental Models, Investing, And You

Conditional Probability Bayes rule helps us calculate the conditional probability which measures the probability of an event, given that another event has occurred. Most of us remember learning this definition and its formula in school and have conveniently forgotten about it. That’s because it’s a text book definition. It doesn’t really add much to our understanding about its utility in real world. The big idea behind Bayes theorem is that we must continuously update our probability estimates on an as-needed basis. Instead of looking at the Bayes formula, let’s first try to solve the ‘man with poison pill’ problem using basic concepts of probability. To make it simpler let’s talk in terms of numbers instead of percentages. So let’s extend the problem and assume that there were 400 men going through the same ordeal at the same time on the same fateful night. Step 1: Since there were 4 bottles in each case, 1 in 4 men is likely to pick up the poison bottle and 3 in 4 men are likely to pick up the aspirin bottle. Number of men who took the poison pill = 100 Number of men who took the aspirin = 300 Step 2: Based on the information provided by medical text on the bottle labels, we can say – Number of men who took the poison pill and showed the symptoms = 0.75 X 100 = 75 (75% according to the medical text)


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Chapter 46 - Bayes Theorem | Mental Models, Investing, And You Number of men who took the aspirin and showed the symptoms = 0.10 X 300 = 30 (10% according to the medical text) Step 3: Total number of men who showed the symptoms = 75 + 30 = 105 Number of men with symptom who actually took the poison pill = 75 Step 4: So the probability of a man taking the poison pill, given that he showed symptoms = 75/105 = 0.71 (71 percent) Thus, 71 of those nauseate men are likely to die of poisoning. And the answer to the problem is – the man should call the doctor immediately. To save yourself from doing all these elaborate calculations Pierre-Simon Laplace, a French mathematician and astronomer, translated Bayes idea into following formula– P (A/B) = P(B/A) x P(A) / P(B) •

P(A) = probability of taking the poison pill (This is 0.25 as there are four bottles)

•

P(B) = probability of person showing symptoms = Total number of men who showed nausea symptom / Total number of men. = 75/100

•

P(B/A) = probability of symptoms, given that person had taken the poison (This is what we calculated in step 3)

•

P(A/B) = probability of taking the poison, given that the person had symptoms (This is the answer to the main question i.e. step 4)


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Using Bayes Formula Let’s take a look at a realistic case where Bayes rule will help us make a rational decision. The following example is from Daniel Kahneman’s book Thinking Fast and Slow. A taxi was involved in a hit-and-run accident at night. Two taxi companies, the Green and the Blue, operate in the city. You are given the following data 85% of the taxis in the city are Green and 15% are Blue. A witness identified the taxi as Blue. The court tested the reliability of the witness under the circumstances that existed on the night of the accident and concluded that the witness correctly identified each one of the two colors 80% of the time and failed 20% of the time. What is the probability that the taxi involved in the accident was Blue? If this was a courtroom scene in a Bollywood movie the drama would probably revolve around the argument about witness’s honesty. But for a Bayesian thinker, the answer will be based on a probabilistic outcome. Let’s use Bayes rule here. P(A) = The probability that the involved taxi was Blue = 0.15 P(B/A) = The probability of witness identifying a taxi as blue, given that the taxi involved indeed was blue. = 0.8 P(B) = The probability of witness identifying the involved taxi as blue. =

Probability of witness identifying a blue taxi correctly + Probability of witness identifying a green taxi incorrectly.


384


= 0.15 X 0.8 + 0.85 X 0.2 = 0.29 P(A/B) = The probability of involved taxi being Blue given that witness has identified it as Blue. Plugging the values in the Bayes formula we get P(A/B)

= 0.15 X 0.8 / 0.29 = 0.41

Therefore, the confidence level of jury (for blue taxi being the culprit) should be only 41 percent! No matter how many examples I quote, you can always argue that we don’t really have the luxury of knowing the precise values for probabilities in many cases in real life. How do you put a number on the reliability of the witness’s testimony? The idea for learning Bayes theorem is not to master the formula but to develop the Bayesian thinking. And how do you do that? We’ll explore that but before we dig deeper let’s first understand the two important ideas on which Bayes theorem rests. First is the base rate (or prior odds) and the second is likelihood ratio (strength of the new evidence). In our taxi example, the base rate is the relative population of taxis. In other words, in the absence of witness, the probability of the guilty taxi being Blue (15 percent) is the base rate of that outcome. Similarly, in the ‘man with a poison pill’ example, the base rate was 25 percent (because there were four bottles out of which one was poison). The base rates typically come from historical statistical information.


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Chapter 46 - Bayes Theorem | Mental Models, Investing, And You The eye witness’s reliability to identify the taxi correctly (80 percent) is the likelihood ratio. The likelihood ratio represents new information about a specific case which changes the base rate for that particular case. Using these two ideas, base rates and likelihood ratio, Daniel Kahneman simplifies the Bayes rule which becomes – Posterior odds (Conditional Probability) = Prior odds (Base Rate) × Likelihood ratio Watch this video from Julia Galef which visually explains this idea. Imagine that a new eyewitness comes out in the taxi case and holds the same opinion as the first witness. In his case he’s able to correctly identify each one of the two colours 70% of the time and failed 30% of the time. With this new evidence (the new likelihood ratio is 0.7), the probability of involved taxi being blue will change again. By how much? Use Bayes rule but this time the base rate will not be 15 percent. Now you need to use the new base rate which is 41 percent, calculated as the posterior odds previously. So the new probability (the new posterior odds) will now become (using the same Bayes formula) 61 percent.

Bayesian Thinking People who aren’t familiar with Bayesian thinking make two kinds of mistakes. In both cases, the final estimate of the probability will lead to erroneous judgment. The first is when they completely ignore the base rates and tend to get influenced by the story of single evidence. Base rate neglect is a serious thinking error where people forget about the historical statistical evidence and tend to believe the anecdotal


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Chapter 46 - Bayes Theorem | Mental Models, Investing, And You evidence. A simple example is when someone argues – “My grandfather was a lifelong chain smoker and still lived up to a ripe age of 90 years. So don’t tell me that smoking kills.” He’s ignoring the fact that statistically a chain smoker isn’t likely to live a long life. This bias is sometimes referred as ‘I know a man syndrome’ (Chapter 20) The reason for this bias is our love for stories (Chapter 50) How does an investor avoid this mistake of base rate neglect in picking stocks? You should know the historical success rates in different industries and businesses. IPOs have been known to lose money for investors historically. Companies where the integrity of the management is questionable or where the balance sheet is highly leveraged, you have to find out the base rate of success in such situations. The second mistake is when we underestimate the strength of the new evidence (or a compelling story) and fail to update the base rates. Some of the world’s best thinkers change their mind in the light of new evidence. John Maynard Keynes reminds us – When facts change I change my mind. What do you do sir? Prof. Bakshi explains this beautifully in his talk Worldly Wisdom in an Equation – For investors investigating a specific opportunity, a genuinely good story improves the likelihood ratio which then translates into higher posterior odds…When it comes to narratives, it’s important to recognize that underneath every great compounding machine, there is a compelling story which makes it different from the rest of the crowd. Usually, that story is about an extraordinary individual or a group of such individuals who have demonstrated capabilities of creating value even in those businesses where it’s hard to create a lot of value. Charlie Munger likes to call such individuals intelligent fanatics.


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Chapter 46 - Bayes Theorem | Mental Models, Investing, And You Sometimes, information specific to the situation is so powerful that it should force you to change your mind. But how do you know that the facts are strong enough and relevant enough to invite a change in your mind? In fact, that’s one of the key problems faced by investors – how to respond to new information? You need to learn to differentiate between noise and signal. Essentially you should avoid news because most news doesn’t just distract but it can be toxic. Prof. Bakshi writes – How does one go about teasing subtle signals noisy news flows? To observe, one has to first quieten the mind. And then one has to look for slow gradual changes that are taking place. The way to do that is focus on long-term changes and not quarterly changes. These could be changes in the quality of the balance sheet, the earnings statement and the cash flow statement. And those changes should be related to a qualitative analysis of the reasons. Often such analysis creates unique insights.

Where Bayes Fails Besides seeing the world as an ever shifting array of probabilities, we must also remember the limitations of inductive reasoning. There are certain situations where progressive small evidences don’t reveal the underlying risk. Nassim Taleb, in his book The Black Swan, writes about the Turkey problem – Consider a turkey that is fed everyday. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed everyday by friendly members of the human race “looking out for its best interests,” as a politician would say.

On

the


afternoon

of

the

Wednesday

before

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Chapter 46 - Bayes Theorem | Mental Models, Investing, And You Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief. This is what happened during 2008 financial crisis. Such extreme events, which are not only high impact but are hard to predict, have been termed as Black Swan events by Taleb. Just because it fails to predict the black swan events doesn’t mean that one should abandon the Bayesian thinking. The way to handle black swan is to limit your exposure to it i.e. building a margin of safety.

Conclusion Developing the habit of Bayesian thinking is an admirable quality. In fact, thinking like a Bayesian is a way of life. If you learn it and practice it, it will change you in many ways. Prof. Bakshi summarizes it brilliantly – Basically, what Bayes Rule tells you is to be a bit less prejudiced. You may have a prejudice against family owned businesses, or Hyderabad companies, or Delhi based companies or turnaround situations or highly leveraged businesses or holding companies etc. That prejudice is reflected in your prior odds. At the same time, however, you should recognize the possibility that this particular business which you are evaluating could be different from the statistical class to which it belongs. Charlie Munger says –


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Chapter 46 - Bayes Theorem | Mental Models, Investing, And You If you don’t get this elementary, but mildly unnatural, mathematics

of

elementary

probability

into

your

repertoire, then you go through a long life like a one-legged man in an ass-kicking contest. You’re giving a huge advantage to everybody else. I think that statement from Munger should be more than enough to motivate you to learn more about probability and Bayesian thinking.


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Chapter 47 Alternate Histories Let me make an offer to you which has a potential to make you richer by couple of million dollars and that requires an effort not more than wiggling a finger. Would you be interested? “What’s the catch?” That would be your first question, right? Well, I’ll leave it to you to figure out the catch. So here is the deal, in fact I’ll let Nassim Taleb, author of Fooled By Randomness, do the explaining – Imagine you are offered $10 million to play Russian roulette, i.e., to put a revolver containing one bullet in the six available chambers to your head and pull the trigger [no effort, I told you!].

Image Source: Koulin


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Chapter 47 - Alternate Histories | Mental Models, Investing, And You Each realisation would count as one history, for a total of six possible histories of equal probabilities. Five out of these six histories would lead to enrichment; one would lead to a statistic, that is, an obituary with an embarrassing (but certainly original) cause of death. Although, Russian roulette is a hypothetical situation, a thought experiment, but it highlights a big flaw that exists in how we perceive the reality. Taleb adds – The problem is that only one of the histories is observed in reality; and the winner of $10 million would elicit the admiration and praise…the public observes the external signs of wealth without even having a glimpse at the source. So can you see how we are blind to alternative histories? The silent events i.e., the events which could have happened but didn’t. In the language of behavioural finance this irrationality is known as Survivorship Bias. The outcome which is visible, ‘survived’ and the ones which didn’t survive are hidden. In effect, the general belief is that if the outcome is good, the process and decisions made to arrive at that outcome must have been sound. Alas, life doesn’t follow such straight patterns. The randomness and ‘external factors’ play a defining role in life and, as we will see later in this post, in investing too. Taleb notes – Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands, of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under numbing false sense of security…one is thus capable of unwittingly playing


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Chapter 47 - Alternate Histories | Mental Models, Investing, And You Russian roulette and calling it by some alternative “low risk” name. We see the wealth being generated…people lose sight of their risks. The game seems terribly easy and we play along carelessly.

Image Source: Funnytime

What are these Russian roulette(ish) games in real life, you may ask. Using debt to buy things (especially the things that you don’t need) is one such game. Buying stocks on debt or on margin is another. And then comes along somebody who warns investors not to play this simple looking (but risky) game, but his advice is ignored. Say you engage in a business of protecting investors from rare events and say nothing happens during the period. Some of them will complain, “You wasted my money on


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Chapter 47 - Alternate Histories | Mental Models, Investing, And You insurance last year, the factory didn’t burn, it was a stupid expense. You should only insure for events that happen.” Another unintended outcome of alternative history blindness is that we grow confident about our understanding of the game. We rationalize the causal link between the event and the associated outcome (also known as Narrative Fallacy or Hindsight Bias). Our thinking becomes outcome-centric. In a wonderful book Everything is Obvious, the author, Duncan J. Watts writes – In a variety of lab experiments, psychologists have asked participants to make predictions about future events and then re-interviewed them after the events in question had taken place. When recalling their previous predictions, subjects consistently report being more certain of their correct predictions, and less certain of their incorrect predictions, than they had reported at the time they made them. An interesting experiment (you must read this) was designed to simulate parallel worlds and the results of this experiment proved that the role of randomness in success is bigger than we usually imagine. Does it mean that we should ignore the past and stop making plans for the future? Of course not! It just means that we should have a healthy skepticism towards predictions and explanations that are served to us by others (including the ones served by our own lizard-brain). You should first focus on the path/process that was followed to achieve the outcome. A good process ensures a good outcome over long term. The following matrix is helpful in understanding the importance of ‘good process’ in decision making.


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In Investing As Taleb writes in his book – …in time, if the roulette-betting fool keeps playing the game, the bad histories will tend to catch up with him. Thus, if a twenty-five-year-old played Russian roulette, say, once a year, there would be a very slim possibility of him surviving until his fiftieth birthday – but, if there are enough players, say thousands of twenty-five-year-old players, we can expect to see a handful of (extremely rich) survivors (and a very large cemetery). If you draw a parallel to this in the stock market, in a field populated by thousands of traders, speculators, and people buying stocks on leverage, at the end of a say 10-15 years, you may still find a very few lucky survivors, but there will also be a very large cemetery (of those who destroyed wealth using the same routes).


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Chapter 47 - Alternate Histories | Mental Models, Investing, And You Sometimes, people are indeed aware of the risks inherent in Russian roulette kind of investing, and they still do it. However, the quality of money earned this way (a stressful process) is not the same as the one earned by non-fatal means like sensible, patient, long-term investing without borrowing other people’s money (stress-free process). Of course, in the end, you may earn a similar amount of money either ways – through day trading, speculation, and leverage OR patient, long-term investing – but the former’s dependence on randomness is greater than the latter’s. To the accountant, they would be identical; to your next door neighbour too. Yet, deep down, you know that they are qualitatively different. As an investor, you may want to minimize the heart-wrenching rides that you may experience during the course of investing period. This is how Prof. Sanjay Bakshi concluded in his article on “Return per unit of stress” – My advice to those who ignore the stress part of the equation but focus only on returns per unit of risk: You cannot take it away with you, so what’s the point of all that stress, just for the money? The legendary Howard Marks wrote this in one of his memos to shareholders in 2006… In the investing world, one can live for years off one great coup or one extreme but eventually accurate forecast. But what’s proved by one success? When markets are booming, the best results often go to those who take the most risk. Were they smart to anticipate good times and bulk up on beta, or just congenitally aggressive types who were bailed out by events? Most simply put, how often in our business are people right for the wrong reason?


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The people Marks is referring to are the ones Taleb calls “lucky idiots,” and in the short run it’s certainly hard to differential between them and skilled investors. Here is what Marks wrote in a 2002 memo… I find that I agree with essentially all of Taleb’s important points. Investors are right (and wrong) all the time for the “wrong reason.” Someone buys a stock because he or she expects a certain development; it doesn’t occur; the market takes the stock up anyway; the investor looks good (and invariably accepts credit). The correctness of a decision can’t be judged from the outcome. Nevertheless, that’s how people assess it. A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown. Thus, correct decisions are often unsuccessful, and vice versa. Randomness alone can produce just about any outcome in the short run. In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof). But certainly market movements cannot be credited to the manager (unless he or she is the rare market timer who’s capable of getting it right repeatedly). For these reasons, investors often receive credit they don’t deserve. One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness


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Chapter 47 - Alternate Histories | Mental Models, Investing, And You alone. Few of these “geniuses” are right more than once or twice in a row. Thus, it’s essential to have a large number of observations – lots of years of data – before judging a given manager’s ability.

Invert, Always Invert! Although Survivorship Bias is a serious cognitive bias and leads to erroneous decision making, I believe it can be used for our benefit also. Using the idea of inversion, let me make an attempt to find a useful way to exploit this bias. It’s actually a nice little hack related to the concept of alternative history. I frequently use this imagination trick to increase the quality of my day to day life. Right now I am sitting on a comfortable chair, writing on my laptop while sipping an organic tea. But there is another possible path that history could have taken. In that alternative path, I imagine being born in a poor African country where (forget internet or even electricity) one has to walk 5 miles every day to fetch drinking water. Thinking about this alternative history forces my mind to be grateful for all the blessings that are present in my life right now. After all alternative histories aren’t just about Russian roulettes and investing.

Conclusion Warren Buffett’s appendix to the fourth revised edition of The Intelligent Investor describes a contest in which each of the 225 million Americans starts with $1 and flips a coin once a day. The people who get it right on day one collect a dollar from


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Chapter 47 - Alternate Histories | Mental Models, Investing, And You those who were wrong and go on to flip again on day two, and so forth. Ten days later, 220,000 people have called it right ten times in a row and won $1,000. Buffett writes – They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping. After another ten days, we’re down to 215 survivors who’ve been right 20 times in a row and have each won $1 million. They write books titled How I Turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning and sell tickets to seminars. “Worse yet,” Buffett writes, “they’ll probably start jetting around the country attending seminars on efficient coin-flipping and tackling skeptical professors with, “If it can’t be done, why are there 215 of us?” If you don’t know how to separate a good process from a bad one, you’ll surely fall for these ‘efficient coin-flipping’ wizards. Learn to focus on the process more than the outcome. Use common sense and your own thinking to filter out the outcome-centric hindsight-heavy theories.


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SECTION 10: LITERATURE


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Chapter 48 Journaling When historian Charles Weiner looked over a pile of Richard Feynman’s notebooks, he called them a wonderful ‘record of his day-to-day work’. “No, no!”, Feynman objected strongly. “They aren’t a record of my thinking process. They are my thinking process. I actually did the work on the paper.” “Well,” Weiner said, “The work was done in your head, but the record of it is still here.” “No, it’s not a record, not really. It’s working. You have to work on paper and this is the paper. Okay?”, Feynman explained. Richard Feynman, who won the Nobel prize for Physics, understood that writing his equations and ideas on paper was crucial to his thought. The above example comes from Clive Thompson’s book Smarter Than You Think. Let me ask you this – how many times it has happened that, after reading a book, you thought you understood the idea but found it difficult to explain it to others? The idea seemed pretty clear in your head but the moment you had to verbalise it you discovered that either you didn’t have a proper grasp on the idea at the first place or you were unable to explain it in a logical coherent way to a third person. As far as I am concerned, this is the kind of reaction people gave me, “You’re telling me that you just finished reading a compelling book but can’t explain the central idea in few sentences?”


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Chapter 48 - Journaling | Mental Models, Investing, And You Reading something passively creates an illusion of knowledge. It creates a confusion between ’mere familiarity with the concepts’ in the book and an actual understanding of them. Only by testing ourselves can we actually determine whether or not we really understand. This is when the Feynman Technique came to my rescue. It says that the mere action of writing something down allows for a more effective integration of the learning. Feynman’s discovery led me to a tremendously useful tool which I call Journaling. It was a Eureka moment. If the word Journaling sounds like a jargon, let me simplify it by providing you a definition. Journaling is simply an activity of writing in plain language about what’s going on around you and what are your thoughts about them. It can include things like your future goals, plans, dreams, reminders to yourself, comments on ideas/people or any unrelated thing that crosses your mind. It’s a conversation that you have with yourself. Today Journaling features in my personal list of top 10 big ideas for life.


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Our Brain On Journaling One fine day, while experimenting with journaling, it dawned on me that it’s almost impossible to write one thing and think something else at the same time. Just like it’s not possible to inhale through your nose and exhale through your mouth at the same time. It’s the way nature has built us. The practical implication of this insight was that when I forced my hand to write something, it channeled my thoughts also in the same direction. I discovered that my unchained-thought-monkey could finally be put on a leash. I did, after all, have some control over my thoughts. Journaling turns out to be not just a tool for thinking but a powerful weapon for focusing thoughts. The more your write, the more precision of thought you build. It allows you to take fuzzy thinking and distill it into precise line of thought. If you want to think better, you have to start writing your thoughts. Writing is a thinking exercise and it acts as a shield against the mental rust. I wonder when majority of the old people in their 80s and 90s can barely remember their family member’s names, how come Warren Buffett who is 85 and Charlie Munger who is 91 are still mentally so sharp? Perhaps a lifetime devotion to reading, writing and learning has something to do with it. It’s not a common knowledge that writing, apart from being a communication tool, is a thinking tool too. Famous author, Dan Pink, in a commencement speech, further validated my belief in this powerful tool. He recommends – “write things to figure out your thoughts”. For that matter, writing is terribly useful tool for retaining what you read. You have to intersperse your reading with independent thinking to really understand the concepts. Writing introduces that element of thinking hence deepens the understanding.


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Problem Solving Many creative people use writing as problem solving tool. On getting stuck they write down their question and listen for the answer to come. Sounds creepy right? Neale Donald Walsch, author of bestselling book series called Conversations With God, claims that his books were not written by him, but they happened through him. Can it happen to you? You won’t know until you give it a try. Maria Konnikova, in her book Mastermind, writes – The act of writing and speaking out loud your thesis forces you to slow down and catch those error that are invisible to your eyes... Your ear notes them when your eye doesn’t. Julia Cameron, in her book The Artist’s Way, talks about a similar idea called ‘morning pages’. She says that every artist should journal for least twenty minutes every morning to unleash their creativity. I believe everybody is an artist. It’s just that some have already discovered their art and the rest are on their way.

Decision Making and Investing The most serious disease that plagues decision making is Narrative Fallacy (also known as Hindsight Bias), the tendency to find a cause and effect relationship in historical events even if there is none. And the best cure for this disease is maintaining a decision journal.


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Chapter 48 - Journaling | Mental Models, Investing, And You When Michael Mauboussin posed the question to Daniel Kahneman, what is a single thing an investor can do to improve his or her performance, he said – …go down to a local drugstore and buy a very cheap notebook and start keeping track of your decisions. And the specific idea is whenever you’re making a consequential decision, something going in or out of the portfolio, just take a moment to think, write down what you expect to happen, why you expect it to happen and then actually, and this is optional, but probably a great idea, is write down how you feel about the situation, both physically and even emotionally. Just, how do you feel? I feel tired. I feel good, or this stock is really draining me. Whatever you think…When you’ve got a decision-making journal, it gives you accurate and honest feedback of what you were thinking at that time. Once the outcome of your decision is known revisit your decision journal. Odds are you’re going to discover some surprises. It won’t be uncommon to find that in spite of the favorable outcomes, the reasoning wasn’t always right. Outcomes

distort

your

thinking

a

lot.

It’s

very

counterintuitive to honestly recall how exactly the events unfolded after the result has come. Carol Loomis, who has been editing Warren Buffett’s letters since last 40 years, writes – Writing itself makes you realize where there are holes in things. I’m never sure what I think until I see what I write. And so I believe that, even though you’re an optimist, the analysis part of you kicks in when you sit down to construct


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Chapter 48 - Journaling | Mental Models, Investing, And You a story or a paragraph or a sentence. You think, ‘Oh, that can’t be right.’ And you have to go back, and you have to rethink it all. Even Warren Buffett observed – “Good writing clarifies your own thinking and that of your fellow shareholders.” A profound thought from the Oracle. Sir Richard Branson, founder of Virgin group, once said “my most essential possession is a standard-sized school notebook,” which he uses for regular writing. If he says so I am sure there must be some merit to the idea of journaling.

It’s A Therapy While I don’t claim to be a psychic, I reckon that almost everybody has some thoughts which they are scared to share with others, even with people who are very close to them. These thoughts create unfelt emotions which remain suppressed in your subconscious. They need a vent. Writing about your thoughts in a private journal can have great cathartic effects. Journaling gives an avenue for your unfelt emotions to process themselves. This release allows you to find freedom from the latent emotional baggage. When you jot down a thought, two things can happen. If it’s a negative thought, its toxicity will get diluted and it will die out. If it’s a positive thought, it will grow stronger and more refined. It’s interesting that some thoughts have their own personality and the threat of getting exposed may produce a subconscious resistance. This resistance can make you feel that this activity (writing) is boring and pointless. So it’s very crucial that you journal regularly to be able to discover the therapeutic value of Journaling.


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Chapter 48 - Journaling | Mental Models, Investing, And You Another psychological benefit created by journaling is that it deepens commitment. The very act of writing things down deepens your resolve to make good things happen in your life. It’s like a declaration to yourself. Journaling is no less than a therapy.

What and How Now that I have convinced you about the importance of Journaling, let me share some ideas about ‘what to write’ and ‘how to write’. First thing that you need to keep in mind is that you aren’t doing this to become a professional writer. The purpose here is to discover yourself. However, let me warn you that as an unintentional side effect you will anyway slowly become an effective writer. So what do you write about? Pour your heart out. Don’t bother too much about forming coherent sentences, incorrect grammar or bad handwriting. Write without fearing that somebody might see it. You can always destroy the paper later. What do I write about? I express my gratitude for all the blessing in my life. I wonder about the beauty and mystery of life. Sometimes, you will sit there holding your pen, staring at the blank paper and nothing would seem to appear in your thought screen. Then how about pondering over a question similar to what Steve Jobs regularly asked himself – “If I had only 30 days to live, what would I do?” In this digital era of smartphones and tablets it’s not an overstatement that coming generation will hardly be using a pen to write. Why should they? Pen is going to pretty much look like a stone age tool to them.


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Chapter 48 - Journaling | Mental Models, Investing, And You Now as far as journaling is concerned you could always use a digital device (using a keyboard) to write. It’s definitely better than not writing at all. But in my experience there is some magic in grabbing a pen and scribbling in your own handwriting. It generates a unique vibration and a different part of your brain is activated when you write the good old way. Clive Thompson has some useful insights about pen vs keyboard. He writes – Writing with a pencil is very effective for structuring your thoughts. The flow of ideas and clarity of thought comes better when you use a pencil…However when you want to get your thoughts out on paper for an audience, it needs to flow as fast as possible, i.e., your writing speed should match with your thoughts else you will lose the train of thought. This is where typing is a better medium…Keep a pencil and a notebook to take notes and capture the flash of insights whereas use a keyboard to communicate your ideas. According to Thompson, blogging is a great way to refine your ideas and thinking. In his book, Smarter Than You Think, writes – Blogging forces you to write down your arguments and assumptions. This is the single biggest reason to do it, and I think it alone makes it worth it. You have a lot of opinions. I’m sure some of them you hold strongly. Pick one and write it up in a post—I’m sure your opinion will change somewhat, or at least become more nuanced. When you move from your head to “paper,” a lot of the handwaveyness goes away and you are left to really defend your position to yourself.


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Conclusion One of the disciples of Gautam Buddha once asked him, “Master! what’s the highest form of knowledge?” Buddha replied, “Self-knowledge is the greatest knowledge. Know thyself.” I am speculating that self-knowledge starts with self-awareness. And in this journey of self-awareness pen is definitely mightier than sword. The point really is this – “Do you think your life is worth journaling about?” If not, then make it worth and then write about it. Or even better, start writing about it and you’ll discover that your experiences are indeed worth journaling about. If you carve out few hours every week for journaling, you will start discovering its value very soon. So I say, pen is your friend, my friend! Pick up the pen and journal on. And what could be a better way to start the practice of journaling than to start a blog and share your thoughts with the world.


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Chapter 49 Active Reading One of the things that always brings an instant smile on my face is when I think about how I spent my summer holidays when I was a kid. This thought sends me down the memory lanes of all those good old days when I played with friends all day, watched favourite cartoon programs on TV, and forgot all about school and homework. My summer holidays were jam packed with activities like playing carrom, card games, checkers, chess, monopoly, cricket, and most of all – reading comics. I loved reading comic books. By the time I reached 8th standard, I had amassed a collection of more than 300 comic books. I even ran a small library which unfortunately had to be closed down after 10 days of operation. The lesson learnt – kids like borrowing comics but don’t like returning them. Anyways, when I look back at my childhood days, I realize that reading comics was one of the most pleasurable activity. I am sure many of you can relate to me. When I entered college, those 30-page comic books were replaced by 500-page novels. But one thing remained unchanged about my reading habit. Most of my reading was for pleasure. Except of course college text books which I passionately disliked. For that matter, whenever I read anything which had a potential to challenge my cognitive resources, I forgot most of it by next evening. That explains my belief about studying for exams just a day before.


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Chapter 49 - Active Reading | Mental Models, Investing, And You However, as I started working, my interest increased in the area of personal development, investing and personal finance, I found myself picking business and investing related books every now and then. But my years of poor reading habits – reading only for pleasure – had become a serious roadblock to derive any meaningful benefit out of these new kind of books. Let me ask you this – how many times it has happened that, after reading a book, you thought you understood the idea but found it difficult to explain it to others? The idea seemed pretty clear in your head but the moment you had to verbalise it you discovered that you didn’t have a proper grasp on the idea at the first place. As far as I am concerned, this is the kind of reaction people gave me, “You’re telling me that you just finished reading a compelling book but can’t explain the central idea in few sentences?”

I soon learnt that reading for pleasure is one thing, but reading for thought is what separates men from the boys. Reading for pleasure is mostly a passive activity. You let the words roll down like a warm water bath. It’s fun but it shouldn’t be confused with reading for learning. By pleasure reading, I don’t necessarily mean fiction. I am not looking down upon fiction. Many works of fiction, I am told, are of extraordinary value. By pleasure reading I am referring to any easy to read content which is meant for light entertainment.


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Chapter 49 - Active Reading | Mental Models, Investing, And You And even with non-fiction, much of what we read regularly is about adding facts, rather than increasing understanding.

Active Reading Vs Passive Reading So how should one read? To answer this, let’s cross over the disciplinary boundary and look at the subject of Literature and see if we can find a mental model to answer this. The big idea to learn from Literature is called Active Reading or Reading for Thought. It’s the most effective way in which reading can increase our comprehension and understanding of what we read. The idea is to read for triggering stimulating thoughts and not just for accumulating knowledge. So active reading is a way to read thoughtfully and it’s a skill that needs to be developed deliberately. The benefits of active reading can never be understated. It adds substantially to our working knowledge of various fields and sharpens our skill at critical reading. You need to learn to analyze a book or any other reading material and critically evaluate its contents. This is important because you have limited time available and you can’t waste it on stuff that’s unworthy or superficial. Critical reading allows you to separate wheat from the chaff, signal from the noise, real information from the confusing (and sometimes toxic) noise. We need to develop the skill of discrimination, writes Robert Hagstrom, in his book Latticework, “learning to select, from the sea of information that threatens to drown us, that which will truly add to our knowledge.” Imagine how much time you’ll save over a lifetime if you could figure out (in 20-30 minutes) whether a book has value and it is worth your time to study it in depth.


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Chapter 49 - Active Reading | Mental Models, Investing, And You

Collecting Vs Understanding While seeking out new information and ideas from a wide variety of sources is admirable, it doesn’t necessarily give us an advantage. New information does not always equate to new insights. In fact, one key distinction that we need to make is – am I reading for collecting information or for understanding. Here is a simple way, coming from Hagstrom, to differentiate between collecting information and gaining understanding – Any time you read something and find you can easily ‘get it’, chances are you are just cataloging information. But when you come across a work that makes you stop, think, and reread for clarification, chances are this process is increasing your understanding. Using this as a litmus test, think about how much of the reading you have done over the past year was for information and how much was for increased understanding. Few years back, I was failing the litmus test consistently. For many years I had been guilty of being merely a collector of new information. It created an illusion of knowledge. I thought I was a good reader. But my shallow reading habit had turned me into a superficial learner. We need to go one step further than just being informed.

Reading, Thinking, Discovering The way to increasing understanding of what you read is to take a pause between reading and think about what you have read. Deliberately reflect on what the author is trying to say and how does it connect with your existing knowledge.


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The read-think loop leads you to make new connections and discover insights on your own. This way, you aren’t just learning from author but you’re also learning from your own discovery of new ideas. When you re-discover something on your own, it stays with you longer and in a more usable form. Gaining real understanding is not an easy task, it requires you to work, to think. In Chapter 48 we discussed the Journaling mental model which captures the idea of writing to deepen your understanding about a subject. When you finish a chapter, close the book and write in simple language what you understood in that chapter. By doing that you not only read the book, but make the book your own. Ownership of the book doesn’t come merely by paying money for it. You own the book when the book takes a new form by your interpretations and marginalia.

How to Read a Book Call it ironic but to learn to read a book effectively, you need to read another book – How To Read A Book by Mortimer J. Adler. It’s an old classic, first published in 1940 but still in print. In his book Adler teaches us how to become what he calls active reader, to move our minds and not just our eyes. Adler argues that there are four fundamental questions an active reader needs to ask while reading – 1.

What is the book about as a whole?

2.

What is being said in detail?

3.

Is the book true, in whole or part?

4.

What of it?

I am not going to cover Adler’s ideas in detail here as Vishal has already written a wonderful post about this book. You should read that if you haven’t already.


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Chapter 49 - Active Reading | Mental Models, Investing, And You Even though the original concept of Adler’s book is seventy-five years old, the lessons it holds for us as investors are timeless.

In Investing Critical reading is supremely important in investing because the sheer volume of reading material we come across while researching stocks is overwhelming and most of this information is of marginal value. Thoughtfully choosing investments requires the same mental skills as thoughtfully reading a book. Hagstrom argues – The mental skill of critical analysis is fundamental to success in investing. Perfecting that skill – developing the mind-set of thoughtful, careful analysis – is intimately connected to the skill of thoughtful, careful reading. To become a better investor, one has to first become a better receptor of ideas i.e. a better thinker. Because thinking is a skill which invariably makes you better at whatever work you do, including investing in stock market. In fact, there’s a positive feedback loop (Chapter 32) here. “Good readers are good thinkers;”, reasons Hagstrom, “good thinkers tend to be great readers and in the process learn to be even better thinkers.” A better investor, by virtue of being a critical thinker, can easily separate facts from opinions. This ability can save an investor from making expensive mistakes in stock market. If you don’t know how to think independently, the odds are stacked against you and in all probability you’ll end up losing money in stock market over longer term.


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Conclusion Earning a degree from a prestigious university is no guarantee that we have acquired what Charlie Munger calls worldly wisdom. So how does one cultivate the kind of depth and breadth of knowledge that leads to worldly wisdom? The answer is simple: we must educate ourselves. The key principles, the truly big ideas, are already written down, waiting for us to discover them and make them our own. And the way to do that is to read – books, journals, magazines, super-texts, annual reports etc. Of course you can’t read everything ever written. So you need to become a selective reader, a discriminating reader, a reader who knows what to reject and what to incorporate into his or her own latticework of mental models. This is why the art of reading is so important and we have learnt some important ideas on how to become an effective reader by jumping over to the jurisdiction of Literature. Here’s a powerful thought from the book Diaminds – The ordinary way of thinking about thinking is to ask: What do you think? The answer is usually some belief about the world. But the un-ordinary way of thinking rests with asking, rather, how do you think? The answer is not going to be a belief any more, but rather a description of some way of forming beliefs…So what one should aim to learn is – How do successful thinkers think? What these superthinkers know is far less relevant than is commonly assumed. But how they know what they know, and how they interact with the world through their senses is much more important. And ‘how one thinks’ is intimately connected with how one reads. I think I have said that twice before.


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Chapter 50 Storytelling What if I told you that the DCF (discounted cash flow) analysis and the principle of time value of money was first discovered in 600 B.C.? And the person who discovered it was neither an economist nor a mathematician. He was a storyteller called Aesop. “You must be kidding,” you might say. Well, let’s find out. In my personal experience, one of the most effective ways to make a conversation (written or verbal) interesting is to tell a story capturing your idea. In fact, I can safely claim that whenever I hear or read something that starts with “let me tell you a story,” it gets me hooked for at least few minutes. I am sure your experience won’t differ too much from mine. Even most of the holy texts in different religions contain lot of stories. Questions is, what’s so special about stories? Let’s try our multidisciplinary approach and look for possible explanations in the field of Biology. One of the big ideas from biology is the theory of evolution also known as ‘principle of natural selection’. It gives some clues to the question we are puzzling over. Our brains have been wired by evolution in such a manner that remembering a story is far easier than remembering isolated bits of information. Stringing together events and facts into a believable and satisfying narrative is brain’s way to conserve energy. It may seem an oddity but this characteristic of brain is used by prodigious memory champions also. When presented with random pieces of information, they take a story template and inject those random pieces in the story. It’s surprising that you can very easily recall that information (in the same order) even after weeks. Isn’t that awesome?


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Chapter 50 - Storytelling | Mental Models, Investing, And You For the second vantage point, let’s turn to the field of literature. Remember, we’re trying to find answers in multiple disciplines. Literature tells us that humans love stories. Stories are one of the most powerful and emotive ways that we communicate with one another. We heard stories from our parents and grandparents and we tell them to our children. In fact, the oral tradition of storytelling goes back to thousands of years, much before humans could write.

Image Source: Blackfeet Storyteller by Howard Terpning

Storytelling – A Powerful Tool Storytelling is a tremendously useful tool to increase the longevity of your message in audience’s mind. So it’s no surprise that being a master story teller is one of essential traits required for effective communication.


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Chapter 50 - Storytelling | Mental Models, Investing, And You So no prizes for guessing as to why Charlie Munger often quotes from Aesop’s fables. If you haven’t heard about Aesop’s fables, it’s very similar to Panchatantra fables which most of us in India have grown up hearing. These fables deliver wisdom of ages wrapped up in short and funny stories. They feature talking animals, and children especially love these short tales. The elements of surprise and/or suspense make these fables very interesting. Now coming back to our earlier question about Aesop being inventor of DCF analysis, while there is no way to prove my hypothesis but following saying from Aesop is particularly interesting – A bird in hand is worth two in the bush. And DCF in simple words is – a rupee (bird) received today (in hand) is worth more than a rupee received tomorrow (in bush). Can you come up with a better way to explain the concept of time value of money? Please pardon my poor attempt at humour but, as adults, we usually question the relevance of these old fables in modern world. However, if you look at them again with the lens of mental models, you can find that they are as relevant today as they were in ancient times. Stories are like those silver bullets. They are small, they hit hard and the effect stays for a long time. Let’s revisit some of those stories and see if we can discover some mental models in them.

Story 1: The Lion, the Panther and the Fox Who Went Hunting One day the lion, the panther and the fox went hunting together, and it was agreed that whatever they caught would be shared between them. After lulling a large stag,


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Chapter 50 - Storytelling | Mental Models, Investing, And You they decided to have a hearty meal. The lion asked the panther to divide the spoils, and after the panther made 3 equal parts, he told his friends to take their pick, whereupon the lion, in great indignation seized the panther and tore him to pieces. He then told the fox to divide the spoils, and the fox gathered everything into one great pile except for a tiny portion that he reserved for himself. “Ah, friend,” asked the lion, “Who taught you to divide things so equally?” “I needed no other lesson,” replied the fox, “than the panther’s fate.” Lesson – Better to learn from the mistakes of others than commit your own Mental Model – Vicarious Learning According to Charlie Munger, reading is one of the most reliable way for vicarious learning – Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day. In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero. When it comes to investing in stock market, it’s as important to learn about bad businesses as it is to know about good businesses. Good businesses give you a clue about what succeeds and bad businesses warn you about what fails.

Story 2: The Fox and the Grapes A famished fox crept into a vineyard where ripe, luscious grapes were draped high upon arbors in a most tempting display. In his effort to win a juicy prize, the fox jumped and sprang many times but failed to reach the bunch of grapes in spite of all


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Chapter 50 - Storytelling | Mental Models, Investing, And You his attempts. When he finally had to admit defeat, he retreated reluctantly and to console himself, muttered – “Well, what does it matter anyway? The grapes are sour!” •

Lesson – It is easy to despise what you cannot get

•

Mental Model – Cognitive Dissonance

Human beings are good at rationalizing the things that they can’t understand or accept. This behavioural bias is called Cognitive Dissonance. Consider what Nobel Laureate and popular physicist Richard Feynman has to say about this – Above all, never fool yourself, and remember that you are the easiest person to fool. Charlie Munger warns – Recognize reality even when you don’t like it – especially when you don’t like it. So next time when you fail to get something, ask yourself if you are holding any false beliefs or assumptions. May be your overconfidence about your false ideas may be hurting your performance in investing.

Story 3: The Man and the Lion Once, while a man and a lion were traveling together, they began arguing about who was the braver and the stronger of the two. Just as their tempers started to flare they happened to pass a statue carved in stone depicting a lion being strangled by a man. “Look at that!” exclaimed the man. “What more undeniable proof of our superiority can you have than this?”


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Chapter 50 - Storytelling | Mental Models, Investing, And You “That’s your version of the story,” responded the lion. “If we were the sculptors, there would be twenty men under the paw of a single lion.” •

Lesson – History is written by the victors

•

Mental Models – Survivorship Bias, Alternate Histories

We are blind to the outcomes which are hidden from us. When we look at the events we don’t realize that the event could have turned out in hundred other possible ways. For a human mind, the arrow of causality mostly seems to go in one direction. One trick that I recently read about which is employed by fund houses to lure the gullible investors, runs like this – every now and then they float a new fund with different name with different mix of stocks. With so many funds running in parallel, some are bound to do very well and these are the ones which are shown in the prospectus by the fund marketing team. But nobody talks about the other funds which faded away in obscurity of sub-optimal returns, or even ended up with permanent loss of capital!

Story 4: The Donkey, the Cock, and the Lion A donkey and a cock lived together in a farmyard. One day a hungry lion passed by and saw the donkey in such good condition that he decided to make a meal out of him. Now, they say that nothing irritates a lion so much as the crowing of a cock, and at that moment the cock happened to crow. So, the lion ran away as fast as he could. Greatly amused to think that a lion would be frightened by a mere bird, the donkey plucked up courage, galloped after him, and felt proud that he was driving the king of beasts out of the farmyard. He had not gone very far, however, when the lion turned around sharply and made mincemeat out of him within seconds. •

Lesson – Presumption begins in ignorance and ends in ruin

•

Mental Models – Overconfidence Bias, Skill Vs Luck


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Chapter 50 - Storytelling | Mental Models, Investing, And You

Many amateur investors, influenced by profits generated in a rising market, start living under the illusion that they have extraordinary stock picking skills. So, greatly amused to think that it’s easy to make money in the markets, they pluck up courage and start galloping with bigger money at stake. And before they go any far, the Lionish-market turns sharply and makes a mincemeat out of the overconfident investor. As Warren Buffett says – Only when the tide goes down, it’s revealed who were swimming naked. Are you swimming naked and hoping that the tide will never go down?

Conclusion The purpose here is not to amuse ourselves by finding mental models in some obscure fictional stories. My attempt is to highlight the importance of having storytelling in your mental model toolbox. It’s to illustrate how fables can prove to be a crucial vehicle for effective communication. I would like to leave you with this quote from Rudyard Kipling If history were taught in the form of stories, it would never be forgotten.


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Epilogue For eons, people have been searching for the magic recipe for wealth and happiness. In this search, they often look up to the uber-successful or ultra-wealthy individuals in contemporary society, hoping that they would divulge the secret. Fortunately, we live in an era where people like Charlie Munger have literally been shouting the secret from the rooftops since decades. Superior performance in life and in investing, according to Mr. Munger, doesn’t come from a magic formula. It comes from what he calls “constant search for better methods of thought,” a willingness to prepay through rigorous preparation, and from the extraordinary outcomes of multidisciplinary research model.

Self-Education When we come out, after spending 15-20 years, from our traditional education systems we have pretty narrow slices of knowledge. Most occupations encourage a degree of specialization. Which is why many people view diverse thinking as something that’s nice to have, not something that’s essential to success. But finding a connection between different disciplines plays a crucial role in advancing our investment skills. In fact, cognitive diversity is a pre-requisite for solving complex problems in every sphere of life, investing being one of them. We don’t feel that there is something evil with traditional education systems but it looks like a series of hurdles that one needs to jump to achieve something in life. The problem with traditional education system is that they are too good in doing what they were originally designed to do i.e., to mass produce skilled workers who would become very efficient cogs in the industrial wheel. But once you realize the limitation of such education, you will naturally gravitate towards the idea of self-education.


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Epilogue | Mental Models, Investing, And You A wise man once said, “The school education will help you earn a living, but selfeducation will make you a fortune.” Self-education is the only way to gradually become wiser in worldly affairs. Selfeducation starts the day when you start designing your own study curriculum. A curriculum which doesn’t get over in few semesters; where there are no grades (except the one you award yourself) and no project submission deadlines (excluding the ones you set for yourself). We actually don’t like the word deadline. Live-line sounds much more exciting. Because it’s the time you give yourself to inject life to the learning process. Moreover, the quest for multidisciplinary learning is serious but not deadserious. Remember, becoming a better thinker won’t just help you in investing and business. You will soon realize that its positive effects have started overflowing into other areas of your life as well. The odds are high that you will end up leading a very satisfying life.

Public Thinking We were recently exposed to an idea called “public thinking”. Simply put, it’s a tribe of like-minded people coming together and participating in an enriching discussion. Safal Niveshak is one such platform which can be used for “public thinking” and can incubate refreshing insights on a subject. Being selfish, we are more eager to listen to those comments which attack the loophole in our understanding of these ideas. We are guessing some of the readers may already be well-versed with the ideas presented here and might have developed deeper insights on the topic. We would love to know about your personal experience as to where have you found these ideas useful and how it has helped you in thinking through a real world problem. Moreover, do let us know what other mental models you would like us to write about in future.


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Epilogue | Mental Models, Investing, And You Even if you don’t have any new insights, even if you don’t find any flaw in our understanding, still write to us because just the act of writing will unleash interesting insights in your own head. So what are you waiting for? Lose the mouse, grab the keyboard and start typing.

Acquisition of Wisdom is a Responsibility We believe that luck plays a significant role in defining the direction of our lives and for us it was a wonderful stroke of luck that we stumbled upon the teachings of Charlie Munger. We must confess that, after discovering him, we lost our right to blame luck for our failures. This is as far as luck could have taken us – to the doorsteps of school of worldly wisdom. Now it’s up to us. We hope you agree with us. And we hope you take the responsibility of acquiring worldly wisdom seriously. The search for wisdom is a long journey and no matter how much we learn the destination may still seem elusive. That’s because we are still going to make misjudgments. The key is to know our limitations and keep improving. Sherlock Holmes said – “I confess that I have been as blind as a mole, but it is better to learn wisdom late than never to learn it at all.”

Final word As a closing thought, let us rehash what many wise men have said before – acquisition of knowledge at first may seem like a daunting task, but it’s amazing what you can achieve with a slow and steady progress – one idea at a time. And before you realize the snowball of knowledge will start paving the path to an immensely satisfying life.


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Epilogue | Mental Models, Investing, And You So keep the curious child inside you alive and learn as if you are going to live forever. It’s said that the best gift you could ever give someone is your time, because you’re giving them something that you will never get back. So, thanks for investing your precious time with us. We will always cherish this gift.


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Acknowledgement We would like to quote Publius Terentius who wrote – Nothing has yet been said that’s not been said before. But as they say, since very few were listening when it was said first, it needs to be said again. The ideas in this book are largely from the works and thoughts of others. At Safal Niveshak we are just collector of ideas. We like sharing but always keep reminding ourselves – The advice we offer others is the advice we ourselves need.

The biggest inspiration behind this quest for multidisciplinary education is Charlie Munger. We owe a lot to him. Anshul Khare Vishal Khandelwal


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Bibliography

1.

Thinking Fast and Slow By Daniel Kahneman

2.

Hooked: How to Build Habit Forming Products By Nir Eyal

3.

Predictably Irrational : The Hidden Forces that Shape Our Decisions By Dan Ariely

4.

Art of Thinking Clearly By Rolf Dobelli

5.

Influence: The Psychology of Persuasion By Robert Cialdini

6.

Poor Charlie’s Almanack By Peter Kaufman

7.

Seeking Wisdom : From Darwin To Munger By Peter Bevelin

8.

Against The Gods : The Remarkable Story of Risk By Peter Bernstein

9.

Antifragile : Things That Gain From Disorder By Nassim Nicolas Taleb

10. The Little Book Of Behavioral Investing By James Montier 11. Power of Habits : Why We Do What We Do, and How to Change By Charles Duhigg 12. Nudge : Improving Decisions About Health, Wealth and Happiness By Richard Thaler 13. The Education of A Value Investor By Guy Spier 14. Why Smart People Make Big Money Mistakes By Gary Belsky and Thomas Gilovich 15. The Wisdom of Crowds : Why the Many are Smarter than the Few By James Surowiecki


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Bibliography | Mental Models, Investing, And You 16. Yes!: 50 Scientifically Proven Ways to Be Persuasive By Noah Goldstein, Robert B. Cialdini, and Steve Martin 17. The Winner’s Curse : Paradoxes and Anomalies of Economic Life By Richard Thaler 18. Innumeracy: Mathematical Illiteracy and Its Consequences By John Allen Paulos 19. Fooled by Randomness : The Hidden Role of Chance in Life and in the Markets By Nassim Nicolas Taleb 20. The Success Equation By Michael Mauboussin 21. Fooling Some of the People All of the Time : A Long Short Story By David Einhorn 22. Ubiquity – Why Catastrophes Happen By Mark Buchanan 23. The Black Swan : The Impact of the Highly Improbable By Nassim Nicolas Taleb 24. The New Evolution Diet :The Smart Way to Lose Weight, Feel Great and Live Longer By Arthur De Vany 25. Zero To One : Note on Start Ups, or How to Build the Future By Peter Theil 26. Principles of Economics By Gregory Mankiw 27. One Up on Wall Street : How To Use What You Already Know To Make Money In the Market By Peter Lynch 28. The Most Important Thing : Uncommon Sense for the Thoughtful Investor By Howard Marks 29. In An Uncertain World : Tough Choices from Wall Street to Washington By Robert Rubin


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Bibliography | Mental Models, Investing, And You 30. Outliers : The Story of Success By Malcolm Gladwell 31. Everything Is Obvious : How Common Sense Fails By Duncan Watts 32. The Dhandho Investor : The Low-Risk Value Method to High Returns By Mohnish Pabrai 33. Sapiens : A Brief History of Humankind By Yuval Noah Harari 34. Why We Get Fat : And What to Do About It By Gary Taubes 35. The Education of A Speculator By Victor Niederhoffer 36. The Art of Systems Thinking By Joseph O’Connor and Ian Mc Dermott 37. Margin Of Safety : Risk-Averse Value Investing Strategies for the Thoughtful Investor By Seth Klarman 38. A Few Lessons from Sherlock Holmes By Peter Bevelin 39. The Checklist Manifesto : How to Get Things Right By Dr. Atul Gawande 40. Models of My Life By Herbert Simon 41. The Little Book that Builds Wealth : The Knockout Formula for Finding Great Investments By Pat Dorsey 42. Winning The Loser’s Game : Timeless Strategies for Successful Investing By Charlie Ellis 43. Extraordinary Tennis for the Ordinary Tennis Player By Dr. Simon Ramo 44. The Organized Mind : Thinking Straight in the Age of Information Overload By Daniel Levitin 45. You Can Be A Stock Market Genius : Uncover the Secret Hiding Places of Stock Market Profits By Joel Greenblatt 46. The Tipping Point : How Little Things Can Make a Big Difference By Malcolm Gladwell


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Bibliography | Mental Models, Investing, And You 47. The Goal By Eliyahu Goldratt 48. Creative Whack Pack By Roger von Oech 49. The Ten Commandments for Business Failure By Donald Keough 50. The Intelligent Investor By Benjamin Graham 51. Smarter Than You Think : How Technology is Changing Our Minds for the Better By Clive Thompson 52. Mastermind : How To Think Like Sherlock Holmes By Maria Konnikova 53. The Artist’s Way : A Course in Discovering and Recovering Your Creative Self By Julia Cameron 54. Latticework : The New Investing By Robert Hagstrom 55. How To Read A Book By Mortimer J. Adler 56. Diaminds : Decoding the Mental Habits of Successful Thinkers By Mihnea C. Moldoveanu and Roger L. Martin


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About The Authors Anshul Khare used to work as a Software Architect in IT

industry

in

Bangalore.

He

studied

chemical

engineering at IIT Bombay. In the next life, he wants to take birth as Calvin (Calvin & Hobbes fame). You can connect with Anshul on Twitter @anshul81.

Vishal Khandelwal has 15+ years’ experience as a stock market analyst and investor, and 5+ years as an investing coach. You can connect with Vishal on Twitter @safalniveshak.

Safal Niveshak (Hindi phrase for ‘successful investor’) is a movement to help small investors become intelligent, independent, and successful in their stock market investing decisions. Safal Niveshak was founded by Vishal in 2011 and it is now a community of 23,000+ dedicated readers. Safal Niveshak was recently ranked among the best value investing blogs worldwide. Vishal is ably supported by Anshul Khare, who is an avid learner in various disciplines like psychology, philosophy, and spirituality with special interests in human behaviour and value investing. You can visit safalniveshak.com or write to us at [email protected] or [email protected] to know more about this initiative and how you can benefit from it and/or support it.


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General Publication Information and Terms of Use This ebook is published at www.safalniveshak.com (the “Site”) by Skylab Media & Research. Use of this ebook and its content is governed by the Site Terms of Use. For your convenience, a summary of certain key policies, disclosures and disclaimers is reproduced below. This summary is meant in no way to limit or otherwise circumscribe the full scope and effect of the complete Terms of Use. No Investment Advice This ebook is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. This ebook is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. It does not constitute a general or personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors. The price and value of securities referred to in this ebook will fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of all of the original capital invested in a security discussed in this ebook may occur. Disclaimers There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth in this ebook. Skylab Media & Research will not be liable to you or anyone else for any loss or injury resulting directly or indirectly from the use of the information contained in this ebook, caused in whole or in part by its negligence in compiling, interpreting, reporting or delivering the content in this ebook.


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