The Illusion of the Irrelevance of the Long Term

In the early 80′s a riddle did the rounds which had everyone stumped for a few days until the solution followed shortly afterwards. Considering this was before you could forward something to a group in Outlook, ideas used to propagate themselves very quickly in those days. The riddle went like this:

3 MEN GO INTO A MOTEL. THE MAN BEHIND THE DESK SAID THE ROOM IS $30,
SO EACH MAN PAID $10 AND WENT TO THE ROOM. A WHILE LATER THE MAN BEHIND THE DESK REALIZED THE ROOM WAS ONLY $25, SO HE SENT THE BELLBOY TO THE 3 GUYS’ ROOM WITH $5. ON THE WAY, THE BELLBOY COULDN’T FIGURE OUT HOW TO SPLIT $5 EVENLY BETWEEN 3 MEN, SO HE GAVE EACH MAN A $1 AND KEPT THE OTHER $2 FOR HIMSELF. THIS MEANT THAT THE 3 MEN EACH PAID $9 FOR THE ROOM, WHICH IS A TOTAL OF $ 27. ADD THE $2 THAT THE BELLBOY KEPT = $29. WHERE IS THE OTHER DOLLAR?

The answer – which I must confess eluded me for ages – is that there is no $30. Each man pays $9 for the room which equals $27, plus the $2 equals $29. Simple. But the illusion is a powerful one.

In the same way, the powerful illusion is that every decision we make is important and that we never get the chance – like a share trader who makes dozens of trades a day, or the poker player who plays dozens of hands an evening – to get to the medium term. But we do.

No poker player gets to play any exact hand more than once. But you still make the decision that is right according to the Long Term every time, and that way you make a profit. No trader gets to invest in the exact same share with the exact same future prospects for the exact same price twice. But by investing with the best long term expectation in a series of inherently independent situations you give yourself the best chance of making the best Long Term return.

I understand that some decisions feel so big that we’ll never ever reach any kind of long term and so the best policy seems to be to play it safe. Putting your children through school; setting up your own business; buying your own home; getting married; going back into training; getting divorced; being completely honest with your team… the list is endless. And that’s the point.

While we look at the present and the future from one position at the point of making a decision… it all looks very different in the rear view mirror. Eventually the numinous truth of the illusion catches up with us and we realise that each monumental mountain was really only a molehill – only one of many problems that we had to overcome; just part of a continuum which eventually became a Long Run.

And those of us who explored the opportunities and took the risks in a calculated way will, eventually, have received what we expected (or Expected) and deserved. And those of us who eschewed them and feigned satisfaction with the safer option experience a pain much greater than the pain of setback or Short Term failure… in the Long Run they experience the agony of regret.

And the most amazing thing about it all? The most amazing thing is that we know this. That’s why when we have to make a difficult decision we feel torn… we feel torn between the person we are now and the person we know deep down that we’ll become in time. And that is the struggle that takes place inside us all whenever we make a decision. Long Term vs Short Term: the us we are tonight and the us we’ll be tomorrow.

Fundholders, Salespeople and Timeframe of Judgement

“Don’t worry Mr Berry, I can assure you that these fund managers are put through their paces rigorously. Not only do we meet them and psychologically profile them every 3 months or so but we are inspecting their results practically every day.” It was with these words that my investment advisor for a well known financial services company lost my custom in his attempt to sell me the virtues of their “fund of funds” investment practice.

I know from my work with investors in other similar well-known organizations that there are several fundamental problems with entrusting your money to people who work for institutions. Some people will tell you that the problem is that the money isn’t theirs and therefore they don’t care enough about it. This is not the problem. Or certainly not the only problem. Just as problematic is the fact that because they are accountable to others they care too much! About the Short Term, at least!

This isn’t entirely fair. There are some great companies out there with whom to entrust your savings and obviously there are equally big problems with investing it yourself such as plain old ignorance and your own personal fear of failure.

But ask any analyst what are the essential problems with his traders decisions and he will tell you: despite a billion dollars of IT telling them exactly what to do, professional investors still go and make emotional decisions. Most notably, they sell appreciating stocks too soon and depreciating ones too late. Why?

Because anyone who buys or acquires an asset (like a stock or share but hopefully the regular reader of this blog will think more broadly than this) that goes up in price will experience a pretty small increase in their overall utility or happiness as the price of that asset increases.

Let’s imagine for a moment that you are operating in an environment where your short term results are scrutinized. Lets imagine that someone (could be your manager, could be your fund-of-funds manager, could be your shareholders, it doesn’t really matter) sees the increase that you have just enjoyed as a green number on your screen or balance sheet. Looks good. Everyone’s happy. The problem is that you know that all the information you have is telling you to hold on to that asset because it’s Long Term value of Expectation is good and positive. It could go down – possibly even to below the buy price. But it could go up. Perhaps significantly so…. But it could go down.

And then that green number is would turn red. And all your congratulations would be rescinded. And the good first impression which you initially created would be called into question. So, despite the fact that everything is telling you to hold onto that asset the law of diminishing marginal utility means that as it does so you have more and more to lose and proportionately much much less emotionally to gain. So what would you do in a rational-emotional sense while it’s still green?

Conversely, let’s imagine for a moment that the price of the asset falls soon after you purchase it. You experience an initially quite severe loss of utility as you now have an ugly red number on your screen or in the wrong column on your balance sheet. What do you want to do deep down right now? Get rid of it sure. But that’s just going to bank the loss and preserve it for posterity and everyone to see. What do you really want to do in this situation? That’s right. Exactly what Nick Leeson wanted to do. You want to get even on the deal. You want hold on to it. Because even though all the information is telling you that this thing has a negative future Expectation… it could… it could go up. Maybe even back above the buy price. It could become a green number!

If it goes down it will just become a bigger red number, “well” you think, “you’ll deal with that when the time comes”. Your results for the day/week/month are going to be reviewed this afternoon, you decide to hold onto it just in case it goes up before then and turns green. Although it doesn’t.

What was the problem here? You work for an investment bank. And yet you’re making the emotional decisions which are not profit maximizing and therefore not serving your clients effectively. Why is that?

The problem is one of outlook, corporate culture or individual mentality. In the example cited, I am stressing the essentially Short Term nature of your assessment in a world where it is Long Term results that ultimately matter. Again, the Long Term is no particular time frame but just whatever your overall goal is. If someone could guarantee you that you’d make a 23% return this year you wouldn’t care what the results were in week two! By evaluating you on irrelevant results, the culture is forcing you to make rational-emotional decisions, of the kind that brought down Barings Bank.

These are the same rational-emotional decisions which persuade a poker player to quit for the evening because he’s made a sum of money with which he’s happy even though his opponents are drunk and effectively giving it to him in the Long Term. Of course, there is nothing to say that the next hand won’t give those same drunkards a four of a kind against your aces full, but that doesn’t matter. Your Long Term Expectation is positive. Quitting is effectively losing you money even though it may look like you’re saving it. And I’ll say it again, this isn’t just happening at the poker tables of Las Vegas, it’s happening every day with billions of dollars at stake. Short term accountability is costing you and me money! Oh the irony!

Success and Failure – All the Clichés in One Place

In my work I am more concerned with the principles of maximizing return on investment and the behavioural impediments to doing so than I am in more motivational ideas of success and failure. The bottom line, however, is that the reason most people don’t maximize their returns in all areas of their lives is good old loss aversion or what we generally call fear of failure.

So I end up talking about the need for short term failure in order to maximize long term returns – something that can often get bogged down in motivational speaker clichés. Here then are all the well-known stories in one place, enjoy:

Zen and the Art of Motorcyle Maintenance took four years to write, much of which while Pirsig was holding down another job. After such enormous investment it was rejected by 121 publishers – more than any other bestselling book according to the Guinness Book of Records – and went on to sell 4 million copies.

Vincent Van Gough did not sell a painting in his lifetime – a Long Run which sadly came too late for him to enjoy the benefits of having paintings such as Vase with Twelve Sunflowers, Irises and his Portrait of Doctor Gachet selling for as much as $82.5m and breaking world record auction values several times.

Michael Jordan – one of the few sportsmen who can genuinely lay a relatively undisputed claim to having been the greatest of all time – did not make his high school basketball team. When asked by a journalist how he went from not being the best of 300 to becoming the greatest of all time he replied: “I have missed 9000 baskets and lost 300 games of basketball. Critically, I have called for the ball in the dying seconds of a game and charged myself with scoring the winning basket… and I have failed. I fail and fail and fail and fail and THAT is why I succeed.” This pattern of Short Term failure Long Term success is evident throughout sport: at the point at which he held the record for the most number of home runs, Babe Ruth simultaneously held the record for the most number of strikeouts.

In science and creativity, failure is also critical with many of its major breakthroughs -  like X-Rays and Penicillin, being the by-products of essentially unsuccessful experiments, and almost every major innovation being the result of hundreds or thousands of failures. Greg Dyson’s “overnight” success story that ultimately made him a billionaire, the Dual Cyclone bagless vacuum cleaner, took five years and 5,127 prototypes. While part of the research and development team at Apple, David Levy was reprimanded by his boss for not making enough mistakes. He said he wanted to see at least 80% failure or he wasn’t exploring new ideas enough.

Coca Cola’s chief Roberto Goizuetta – himself no stranger to failure having been the person behind the most expensive product flop of all time (in New Coke) said he only trusted managers whom he had seen make a serious strategic error at some point. “The fastest way to succeed” said IBM head Thomas Watson Sr in his junior years “is to double your failure rate.” Perhaps the greatest CEO of modern times, Jack Welch, said that from time to time you had to reward failure or “nobody ever tried.”

Henry Ford called failure “the opportunity to begin again more intelligently” a reference, among other things, to the Ford motor company’s two previous incarnations before succeeding in the form that made history. Soichiro Honda, founder of the Honda corporation, in the wake of personal bankruptcy said that “Many people dream of success but success can only be achieved through repeated failure and introspection. Indeed success represents one percent of my work which results from the ninety nine percent that we call failure.” You can insert the words Short Term and Long Term into this sentence by now, I’m sure.

“A crank is a man with a new idea – until it catches on” said Mark Twain, referring to the way that many of the inventions that we now take for granted were usually rejected and ridiculed at the time of creation: “Louis Pasteur’s theory of germs is ridiculous fiction” so thought Pierre Pachet, Professor of Physiology at Toulouse in 1872. Lord Kelvin, President of The Royal Society in 1895, stated that “Heavier than air flying machines are impossible”.

“The device is inherently of no value to us” was Western Union’s opinion of Alexander Graham Bell’s Telephone in 1876 while Sir William Preece, Chief Engineer of Britain’s General Post Office, said in the same year that “The Americans have need of a telephone but we do not. We have plenty of messenger boys.” Dyson himself was told that his idea for the Dual Cyclone was “dead from the neck up” by Hotpoint while Electrolux said he would “never sell a cleaner without a bag” and AEG claimed point blank that it didn’t work.

There are now 18 types of bagless cleaner on the market plus one attempt by Hoover, whom Dyson managed to sue for patent infringement. “If you see a bandwagon it’s too late” James Goldsmith.

The point is that the people who have shaped history, created the present and are busy designing the future are people who embrace Short Term failure everyday. “If you want to have a good idea” advised Linus Pauling – one of only two people to win Nobel Prizes in two completely different fields “Have a lot of them.” Statistically, if you only have a 0.1% chance of success at doing something but you do it 800 times, you have a 97% chance of Long Term success.

One man who embraced this philosophy more than any other is, not surprisingly, the man with 1,093 patents to his name, Thomas Edison – the most prolific inventor in history. Having invented the electric lightbulb and the phonograph not to mention various revolutions in telegraphy, Edison can lay claim to having been the man who created much of the twentieth century. And he did it by failing repeatedly.

One legend has him accounting for his repeated failures to perfect the electric lightbulb as being simply the discovery of hundreds of ways of not achieving the desired result as he pressed on (to Long Term success). “Many of life’s failures are men who did not realise how close they were to greatness when they gave up” he said giving an insight into his philosophy that you only needed to succeed the last time.

There’s nothing wrong with a little bit of indulgence though as long as you remember why we’re thinking about these people: they maximized their returns be taking more risk than everyone else. They got the edge by being brave…

If you Want to Succeed you Must be Prepared to Fail

“Choose a dojo.”

With these words, at the beginning of Chapter 1 of Step 4 of his bestselling book, The Game, Neil Strauss lets us into a little secret of the world of the Pick-Up Artist (or PUA) which none of the other writers on the subject will tell you.

If you’re not familiar by now with the principles outlined in this particular book then it is unlikely that you are a man between the ages of 14 and 34. If you are a woman between those ages then you have more than enough reason to familiarize yourself with them because if you don’t then you leave yourself exposed to having them used on you to get you into bed.

The principles or “methods” themselves are currently being sold for literally thousands of dollars at weekend boot camps around the world to horny young men who are attracted to the promise of getting to sleep with a girl with whom they would otherwise stand no chance. But there is a secret that they will not learn there…

The secret is not that the methods he is paying top dollar for do not work. They do. Just as there is an effective way of selling cheese (which convinces the prospect that there is a high probability that they will accrue the pleasure they desire for an appropriate investment of money) there is an effective way of selling oneself as a potential mate. And it works.

But just as the best way to win as much money in a poker game as possible is to play every single hand, so the best way to get a girl to go home with you is to ask as many as possible.

Actually, we must remember the principles of the calculated risk and Expectation theory. A professional poker player plays about 10-20% of hands and it is really after the decision to play that the real work begins. Playing every hand is a surefire way to win the most money – by giving yourself the chance to win the most pots. But it is also a surefire way to lose the most overall. The aim of poker, it should be remembered is not to win money but to make money.

In much the same way, the art of seduction as presented, clinically and rather misogynistically, in The Game is to pick your target (much like a poker hand) which gives you a positive Long Term Expectation and play it effectively. As with poker there are definitely ways of playing the game which are better than others, but by conceding that you can choose a dojo, Strauss is effectively saying that the method you adopt is not the most significant thing about your choice to become a PUA. What is significant is that – like a poker player – you have made a decision that in order to achieve your Long Term goal (in poker making rent at the end of the month, in seduction getting laid) you are prepared to fail in the short term.

It’s very difficult to get a figure as to the kind of percentage of Short Term failure you need to embrace from any of The Game’s many acolytes around the world. Most of them now have a large financial interest in convincing you that their method will incur you the least. In poker there are definitely different strategies: some people win 65% of hands they play but the pots are small, other people win 20% of hands played but the pots are large. Both strategies can make a profit. Both can make a Long Term loss. There are no magic bullets. Although, in general, it is perhaps unsurprising given what we know now that the players who play “fast” lose more than their fair share but make the biggest Long Term gains.

In the same way, the guys who are prepared to be shot down in flames at various points in any given evening in the bars and clubs of Los Angeles are the guys more likely to be walking home with the Victoria’s Secret model at the end of the evening – the perfect 10s as they’re called.

Actually, Timothy Ferriss makes a staggeringly elegant, but strikingly insightful, point in his book The 4 Hour Workweek which is that it is actually often easier to “close” a 10 than a 7 in situations such as these (I realise how horribly sexist all this is) precisely because everyone is chasing 7s while no one has the courage to even approach a 10.

In this way, while there will undoubtedly be setbacks and rejections, the people with the courage to bear these actually end up exploring an area which no one else is, and reap the attendant benefits and Long Term returns of doing so.

The Origins of Fear of Failure

The Law of Diminishing Marginal Utility basically says that the more that we have of something (as denoted by increases in the Quantity measured on the horizontal axis) the less and less additional satisfaction we get from each additional unit of it.

At its simplest level this just means that if you eat a big bowl of ice cream, while each spoonful is making your tastebuds tingle as your dopamine is released when you start… about halfway through you’re probably a lot less keen on the taste of ice cream and each spoonful is giving you less and less satisfaction.

Clearly this is the case for ice cream because eventually you will feel sick, but it is also the case for many things: it would be nice to have a Ferrari but if you had 10 Ferraris most people who read this would probably not get the same happiness from the 11th Ferrari as you got from owning the first one. It would be nice to go on holiday but you probably wouldn’t be getting the same utility from the 66th day as you got from the first one. And even where money is concerned, while it would be nice to make a million pounds, but Warren Buffet almost certainly doesn’t get the same thrill of making a million pounds after having made thirty six thousand of them already that we would. Indeed as Arnold Schwarzenegger once said “Money doesn’t make you happy. I’ve got fifty million dollars. I’m no happier than when I had $48.”

The effect of this apparently irrelevant aspect of our psychology however could not be more profound when it comes to the decisions that we make. In other posts I’ve referred to the way in which otherwise rational people like Stuey Ungar and Nick Leeson made apparently insane decisions because of the allure of the upside and the limited downside associated with them. They gambled as a result of their emotional situation at the time. Well this is the opposite. Diminishing marginal utility means that most of the time we actually get LESS pleasure from our gains than we get pain or potential pain from our losses.

This muted upside and exaggerated downside in our Emotional Expectation calculation is what stops a lot of us from achieving the Long Term results that we want: we are scared of losing what we have in order to gain what we desire. Often, that is because we don’t even know what it is that we desire. Sometimes we do but we’re not prepared to lose what we have in order to achieve it in the Short Term.

Sometimes this fear is good. It’s what stabilizes our society. America’s delinquent youth don’t fear the downside as much as weedy academics – which is why they label them irrational and uncontrollable. It’s fashionable now to blame the parents, of course, but what it they’re not scared of what they’re parents have to say or do.

If Nick Leeson had been a little more frightened of his Mum or Dad then maybe Barings bank would not have gone the way it did. Likewise, if Kenneth Lay or Jeffrey Skilling had feared the eternal flames of hell a bit more then maybe they would not have tried to swindle their shareholders out of millions and embrace their own personal and corporate downsides to quite the same extent.

But there is a downside to this fear too. And it is a downside which costs similar shareholders a great deal more in the Long Run than a couple of corporate frauds no matter how massive and illegal they have been in recent years. The fact is that much more pervasive fraud is occurring every single day in boardrooms and offices every single day in companies across the world as leaders make decisions in direct contravention of the legal requirement to operate at all times in the shareholders best interests. They don’t. They don’t even come close to doing so. They operate largely out of a sense of self-preservation and fear of short term failure. I certainly would if I were in their situation and had the weight of quarterly shareholder reports bearing down on me on a daily basis. These are not the conditions necessary to motivate people to take the necessary risks to be the best at what they are doing.

On the last bend of the women’s BMX event in the 2008 Olympics British cyclist Shanaze Reade gave up a certain silver medal place in order to overtake the leader and push for gold. She failed, came off her bike and went home without a medal or – she says – any regrets. She was prepared to lose what she had in order to gain what she desired.  Would she have done the same had she had to report her results to a group of shareholders at the end of every race? Shanaze Reid went into that race as the world champion and the out and out favourite. And she got to that place by consistently being prepared to lose what she had in order to gain what she desired.

The ability to lose what you have in order to gain what you desire ultimately this is what will define your ability to achieve what you want – whatever that may be. The question is how do we embrace that mindset in poker, business and life?

All Decisions as Investments

All decisions are investment decisions, when you think about it. We tend to think of investment as being about the allocation of that scarce resource that is money and usually for a period of time but money is just one of many scarce resources that we have at any given moment. Others include time, energy, attention, liberty, health, reputation, credibility and life itself.

Consider first the obvious investment decisions: whether to buy a house, a car, a suit, a meal… The decision in each case is whether to part with a sum on money, in exchange for a large variety of tangible things and emotional feelings in return: some bricks, steel, cloth, steak, a feeling of security, a feeling of status, a faster way of getting from A to B (thus more time), and in all cases a sense of comfort and/or satisfaction. In only one of these cases do we really seek a financial return in exchange for our financial investment and there – as with all of these returns – we know that there are no guarantees.

Less obviously investment decisions are the choices we make about whether to stay in bed or do revision, which route to take to work, or how long to spend training new employees. Once again, though in each case we need to make an investment of a scarce resource, in this case, time and the choice is which of the available opportunities is going to yield us the best return. Bed or revision; leisure or career. This route or that route: the known or the unknown. Training or meeting; long term investment or short term productivity.

At the far end of the scale are the investments that we make without, apparently, “spending” anything at all. How is jumping out of an airplane an “investment”? Or opportunistically stealing a car? Or crossing  the room to chat up a girl? Many people would consider all of these high risk decisions and yet the amount of investment necessary beyond the obvious relatively minimal time involved seems small. How come?

John Smith (I’ve obviously changed his name here) is a successful man. Now retired from the organisation that made him millions, he mentors entrepreneurs of a variety of different ages and stages. His qualification for such a task is as the former CEO of the UK division of an international organisation. Himself a victim of an uncertain future: the advent of Google and Wikipedia left his business virtually worthless at no fault of his own. Fortunately, John saw change coming and made a series of investments one of which was to become a Lloyds name.

“I was attracted to the idea of making money without actually investing anything although I knew my assets were ultimately at risk. I took out some mitigating insurance to protect some but basically it was on the line.” Fortunately, the insurance crises of the 1990s didn’t affect John too much and while he made some losses on the deal the net effect (overall, in The Long Term) was positive.

This form of investment, i.e. putting something at risk without actually handing it over is the kind of investment decision in which we are engaging much of the time. When we jump out of a plane, we accept the possibility of loss of health or life, without ever actually investing it. When we commit a crime we accept the possibility of loss of liberty. When we cross a room to chat up a girl we accept the possibility of loss of status or reputation as we walk back again covered in Martini and shame.

All these possible outcomes are being factored in to our expectation calculations every time we make a decision to do anything. Hundreds, arguably thousands, possibly millions of times a day our minds are executing tiny Expectation calculations: investing time, energy, status, passion, reputation, money, health and wellbeing into opportunities that may or may not yield returns such a happiness, love, more time, more status, spiritual satisfaction, money, safety…. Even when eating food or walking down the street we accept tiny chances of possible downsides but we know we have to embrace them in order to survive. The consequences of staying bed and never consuming anything are much greater.

The concept that people think about potential consequences when they take actions is not universally accepted, by any means. But it is the prevailing view. And the man who first proposed it is a Nobel Laureate. In Tim Harford’s The Logic of Life he relates the story of Gary Becker and his theory of rational crime which first came to him while late for a doctoral examination and started weighing up the pros and cons of parking illegally. Just because an economics professor considered his decisions in such a way, however did not mean that juvenile delinquents did likewise. Becker’s young colleague at Chicago, Steven Levitt, co-author of Freakonomics, did the research comparing different US states with different ages of majority – that is ages to be tried in the court and sentencing levels -  in order to test the hypothesis that juvenile delinquents similarly considered consequences of crime when making their decision to offend.

It showed conclusively that length of sentence – or level of potential investment – had a pronounced effect on a potential offender’s likelihood or propensity to offend. But some are not convinced. In a paper entitled Body Count – Moral Poverty and How to Win America’s War Against Crime and Drugs, authors William J Bennett, John J Dilulio and John P Walters said that 1990s America was in a state of crisis. America was home to an increasing number of violent teenagers who “do not fear the stigma of arrest, the pains of imprisonment or the pangs of conscience. They perceive hardly any hardship between doing right (or wrong) now and being rewarded (or punished) for it later”. Indeed Levitt himself argued that while tougher sentencing worked up to a point, past that point America was just building jails with no discernible effect on the crime rate.

The question posed is twofold: firstly, are criminals rational or irrational when it comes to making their decisions about offending, or indeed anything they do, and secondly (in either event) if tougher sentences have ceased to have any effect, how do you effectively motivate someone to commit less crime? You change their intuitive probability calculation, that is the likelihood that they ascribe to getting caught.

Lying next to my computer as I write this is a disc which was posted to me with an accompanying letter addressed to Mr Caspa (sic). Apparently, if I insert it into my disc drive I will receive £1,500 to spend in the Golden Lion Casino!!! Isn’t that incredible??? What’s more incredible is the fact that I have no intention of ever taking it out of its case!!! Why? Because as lucrative as that potential upside is, my onboard probability machine tells me that is highly unlikely that I am ever actually going to receive it. The fact that there is a potential downside which involves the potential investment of my time and sanity is almost incidental. I just don’t believe that I will accrue the upside and therefore I simply decide not to it.

These “too good to be true” offers are everywhere in our lives from posters on lamp-posts enticing us to “earn £200 an hour in our spare time” to self help books which people dismiss on the grounds that “if it was that easy to have the life of my dreams then everyone’d be doing it…”

The fact is that we may well be wrong. It doesn’t matter. The probabilities that we ascribe to possible outcomes are critical in determining whether we choose to invest actual (or potential) time, money or status into an opportunity that promises their delivery or not. We’re always doing little calculations… but some of their impacts are huge.

The Impact of that Low Frequency High Impact Risk

I’m often fascinated by the fact that people perceive poker players as gamblers but people making business decisions outside a casino as sane, calculated risk-takers. If only that were true! Negative expectation bets are placed around the boardroom table just as often as the poker table. It’s just that every time a company goes pop, it’s considered to be an exceptional event that cannot possibly repeat itself in that form.

Consider for a moment a hypothetical game of roulette in which every number across the table appears to be offering a 20% return. Put your money on black and red comes up… you get 20% back. Put your money on 12 and 33 comes up… you get 20% return. Feels good, but there’s a catch.

In this apparently profitable game, if the 00 hits two spins in a row, you will be liable for 1000 times whatever you have on the table on that spin! Be clear about this… if you have $50, you will owe $50,000! OK, you reason but the chances of 00 hitting twice in a row are incredibly slim. 2.7% x 2.7% to be precise or 0.072%, roughly 7 in 10,000 spins. At 30 spins an hour, you could happily play all month without reasonably expecting it to happen! But what is your Long Term Expectation now?

Well for every dollar you invest in this situation now:

99.93% of the time you’re going to win $0.20 – that’s an upside Expectation of $0.199

0.07% of the time you’re going to lose $1000 – that’s a downside Expectation of – $0.70

Thus, giving you an overall expectation of $0.199 – $0.70 which equals – $0.5001. We’re losing nearly half a dollar for every dollar we invest.

Traditional risk management is about the need to prepare for this highly unexpected event. When United 93 went down in Pennsylvania, the impact extended well beyond the grief of the families of the brave deceased. It hit United Airlines too in ways that it could never have imagined. In 1992 one of the most profitable companies in the world posted the biggest corporate loss in history. The world had changed and IBM had failed to change around it. In 2008 Lehman brothers, RBS, Merril Lynch and some of the biggest financial institutions hit the wall and others, even Citigroup, came to their knees.

When Black Swans happen, their impacts can be devastating. They come from left field – from off the charts – and wipe out years of growth and achievement. The most important question, when they happen, is not could someone have prevented the risks. Naturally someone could have. Everyone can prevent something but no one can prevent everything. The real question is whether or not the risk that the organisation was taking on was priced correctly. In other words, was the company playing poker with a positive Long Term Expectation despite Short Term Losses? Or roulette, with some profitable Short Term wins but a negative Long Term prognosis?

In 1998 when the US banking sector started extending mortgages to the sub-prime sector part of the reason was definitely an imperative for profit. The oft untold side of this story, however, is that the other reason was a mandate from the Clinton administration to start making loans available to the underclass of American society. This socially well-meaning policy came with political strings attached, however. It just simply would not have looked good to charge one rate of interest to the predominantly white middle class and another – significantly higher one – to the predominantly black working class. And anyway, the economy, and house prices, were strong… So a compromise was reached. The rate of interest was perhaps not as high as it should have been, but for a long time, no one seemed to mind.

Whether or not the rate charged was correct given everything we knew at the time, the fact remains: In the same way that the world’s best skydiver could die tomorrow due to uncertainty, so can the world’s best run companies go under. In Why Most Things Fail Paul Ormerod observes that of the 100 biggest companies in the US in 1905 only 36 of them still exist today! How many of our 100 biggest companies will be with us in the next century, or the next decade… or next year?

Posted 02:14pm by Caspar and filed in Decision Making, Risk

The Buffet of Life

Warren Buffet, the world’s richest man has two rules of investment. 1) Don’t lose money. 2) Don’t forget rule 1). It’s a neat aphorism but it doesn’t exactly describe the practice. While not losing money is important because – as he says – a 50% loss requires the correction of a 100% profit, he has another, much more important maxim which is the secret to his success as an investor: “I buy a stock which I would be happy to earn even if the stock market were to close for 10 years”. What he means by that is that, within reason, whatever the value of the stock in the short term (and of course they go down as well as up) he’s happy to trust the phenomenal amount of work he’s done before buying the stock and place his faith in its Long Term prospects. Short term losses are a possibility in the quest for long term gain.

Argos prints 2 million brochures ever year. Of these it estimates that 88% are either thrown away or not directly responsible for a single sale. Naturally it wants this number to be as low as possible. But since the remaining 12% generate revenues in excess of £3bn a year – paying for the additional catalogues with much to spare – the short term losses are soon forgotten.

The life of a door-to-door salesman is not a happy one. Whatever the weather they are outside in the neighbourhood trying to sell whatever they have to whomever will be good enough to chat to them. A good door to door salesman works on a hit rate of about 5-8% success for every door he knocks on. Short term failure, long term success.

One organization, The Amway Corporation sought to increase that figure and came up with the idea for a “BUG” – a pack of free samples which it leaves with the customer for 24, 48 or 72 hours. During this time, the customer uses some of the products, with no obligation, and at the end of the period has a 15% chance of becoming a closed sale, a threefold increase on their natural propensity to buy. In just a few years, the Amway corporation has gone from a basement operation to a $1.5bn company. By increasing it’s short term losses, it increased its long term results.

Warren Buffet understands – like Argos and Amway – does everything he can to make sure he is as successful as possible, that’s why the first rule is Don’t lose money. But just like Argos and Amway,  Buffet knows that the ONLY way he’ll annualize 23% a year is by accepting short term setbacks and devaluations in his stock prices along the way. He doesn’t panic. He knows he’s in it for the long term, in his case 10 years. Not all of us have that luxury.

Luck & Return on Investment

If someone were to give us an even money return on the toss of a coin we might take it, we might not. We’d have an idea somewhere that in the Long Run we’d just be breaking even and the maths of the opportunity show that we’d be right.

There is actually quite an interesting conclusion we can draw from this theoretical proposition, however,. which is worth touching on because of course we also know, by now, that even after 100, 1000, 10,000 spins its very unlikely that we ever will absolutely even. More likely is the one of us will be up, the other down. And in this event we wouldn’t dream of calling the winner the more skillful player. We’d call them the luckiest. Which allows us to say something quite interesting about luck which flies in the face of a lot that has been written about it over the centuries:

Luck is not preparation meets opportunity, though preparation is important. And fortune will not, alas, favour the prepared mind, though it may sometimes give that impression. Contrary to popular opinion, Gary Player was not serious when he said “The more I practice the luckier I get”! He was being sarcastic, annoyed by those within the media who were putting his success down to good fortune rather than persistence and hard work.

The fact is that you do not make your own luck because luck – by its very definition – is that which we cannot control. In Covey’s terms, it is that which is outside of our circle of influence. It is that which happens after all the influence we can exert through preparation, practice and persistence is at an end. It is the source of our uncertainty; the root cause of our short term results.

We cannot change our luck. But we can usually decide which opportunity we invest in. So let’s now consider another opportunity.

Imagine now that the same person offers us a very similar but distinctly different opportunity. This time: same coin toss, same 50% chance of success but now instead of an even money return we are being offered a 10-1 reward when we win. What is our expectation now?

Posted 12:51pm by Caspar and filed in Decision Making, Uncategorized, Uncertainty