Explaining Mr. Munger’s "Kantian Fairness Tendency"

Arpan Ranka, a student at MDI, recently asked me to explain Mr. Charlie Munger’s mental model titled “Kantian Fairness Tendency”. This model was mentioned by Mr. Munger in the revised version of his essay titled “The Psychology of Human Misjudgment”. This essay is one of several essays contained in “Poor Charlie’s Almanac“.

I believe Mr. Munger was referring to man’s overlove of fairness for all, often resulting in bad outcomes for humanity. Earlier, he had made a reference to this subject in his UCSB talk in which 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 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.”

I see a connection between the above quote and the “law of the higher good” which I discovered in Machiavelli’s “The Prince“. Last year, I had written a note on the law of the higher good to my students. Here’s a revised version of that note:

Machiavelli’s “The Prince” is a great book and should be made compulsory reading for all MBA students.

To many people, The Prince is an evil book. But Joseph L. Badaracco, who teaches a hugely popular course titled “The Moral Leader” at the Harvard Business School uses this book to teach ethics. And he teaches ethics by telling students to follow Machiavelli’s advice in The Prince. In an interview, Badaracco has said that four different takes on The Prince usually emerge in classroom discussions of The Prince at HBS:

Version 1 : “This book is a mess. It was written by a guy who hoped to get to the center of things, was there briefly, offended some of the wrong Medicis, was exiled, was tortured, and wanted to get back in.” It’s “a scholar’s dream because you can find anything you want in it and play intellectual games. But just put it aside.”

Version 2 : “Now wait a minute. There’s some good common sense in there. Machiavelli is basically saying that if you want to make an omelet you have to break some eggs… To do some right things, you may have to not do some other right things.”

Version 3 : Other students believe the book is still around because it’s so evil. Why is it evil? “If you look closely at The Prince,” he said, “it’s quite interesting what isn’t in the book. Nothing about religion. Nothing about the Church. Nothing about God. There’s nothing about spirituality. Almost nothing about the law. Almost nothing about traditions. You’re out there on your own doing what works for you in terms of naked ambition.”

Version 4 : “A fourth Prince that other students uncover is the most interesting one, in Badaracco’s mind. Students find that the book reveals a kind of worldview, he says, and it’s not an evil worldview. This version goes: “If you’re going to make progress in the world you’ve got to have a clear sense, a realistic sense, an unsentimental sense, of how things really work: the mixed motives that compel some people and the high motives that compel some others. And the low motives that unfortunately captivate other people.” Students who claim the fourth Prince, Badaracco said, believe that if they’re going to make a difference, it’s got to be in this world, “and not in some ideal world that you would really like to live in.”

One of my favourite mental models comes from The Prince. I call this model, the “law of the higher good”. Before I read The Prince, I read an excellent book called, “The Contrarian Guide to Leadership” by Steven Sample. In this book, which was recommended by Mr. Munger, Sample’s thoughts on the law of the higher good from The Prince resonated very well with what Mr. Munger has been advocating for years. I reproduce here an extract from Sample’s book which deals with the law of the higher good:

“Let me clarify the most fundamental misunderstanding. Machiavelli was not an immoral or even an amoral man; as mentioned earlier, he had a strong set of moral principles. But he was driven by the notion of a higher good: an orderly state in which citizens can move about at will, conduct business, safeguard their families and possessions, and be free of foreign intervention or domination. Anything which could harm this higher good, Machiavelli argued, must be opposed vigorously and ruthlessly. Failure to do so out of either weakness or kindness was condemned by Machiavelli as being contrary to the interests of the state, just as it would be contrary to the interests of a patient for his surgeon to refuse to perform a needed operation out of fear that doing so would inflict pain on the patient.”

The law of the higher good is a terribly useful model for leaders because it forces them to think about things from a totally different perspective. Here’s a hypothetical situation to ponder about:

You are in charge of running a retail store and one of your cashiers, an elderly woman, is caught committing a minor embezzlement. Fearing that she might be dismissed, she approaches you to plead forgiveness. She tells you that this is the first time she embezzled money from the company and promises that she’ll never do it again. She tells you about her sad situation, namely that her husband is very ill and that she was going to use the money to buy medicines for him. She becomes extremely emotional and your heart is melting. What do you do?

Something similar to the above situation was described by Mr. Munger in a talk given by him. He used two models to produce his answer. The first model was probability. Mr. Munger implores you to reduce the problem to the mathematics of Fermat/Pascal by asking the question: How likely is it that the old woman’s statement, “I’ve never done it before, I’ll never do it again” is true?

Note that this question has nothing whatsoever to do with the circumstances in this particular instance of embezzlement. Rather, Munger is relying on his knowledge of the theory of probability. He asks: “If you found 10 embezzlements in a year, how many of them are likely to be first offences?”

The possible actions are: (1) She is lying and you fire her (good outcome – because it cures the problem and sends the right signals); (2) She is telling the truth and you fire her (bad outcome for her but good outcome for system integrity); (3) She is lying and you pardon her (bad outcome for system integrity); and (4) She is telling the truth and you pardon her (bad outcome for system integrity because it will send the wrong signal that its ok to embezzle once).

Weighed with probabilities, and after considering signaling effects of your actions on other people’s incentives and its effect on system integrity, its clear that the woman should be fired.

Looked this way, this is not a legal problem or an ethical problem. Its an arithmetical problem with a simple solution. This extreme reductionism of practical problems to a fundamental discipline (in this case mathematics), is, of course, the hallmark of the Munger way of thinking and living.

So, from a leader’s perspective, it’s more important to have the right systems with the right incentives in place, rather than trying to be fair to one person – even if that person is the leader or someone close to the leader.

The logic is that leaders must look at such situations from their civilization’s point of view rather than the viewpoint of an individual. If we create systems which encourage embezzlements, or tolerate such systems, we’ll ruin our civilization. If we don’t punish the woman, the idea that its ok to do minor embezzlement once in a while, will spread because of incentive effects, and social proof (everyone’s doing it so its ok). And we cannot let that idea spread because that will ruin our civilization. Its that simple.

Carol Loomis, Risk, and the Law of Conservation of Energy

Carol Loomis is a legend. Her columns in Fortune are a collector’s item and I have been a collector since 1994 – the year in which I started out my career in investments.

In March 1994, Loomis wrote an article on derivatives in Fortune titled “The Risk that Won’t Go Away“. I was totally blown away after I read that article. At that time, derivatives were the talk of the town. There was an explosion in the usage of derivatives, particularly, non-traded ones, which ostensibly enabled companies to “manage risk” at a low cost.

Loomis however took the opposite view and predicted trouble ahead. And sure enough, trouble followed soon after, when several derivatives-related financial fiascos like those at Bankers Trust, Gibson Greetings, Orange County, and P&G emerged. These were covered by Loomis a year later in March 1995 in a column titled “Untangling the Derivatives Mess” which essentially said “I told you so”.

What is the connection between the law of conservation of energy and the concept of risk in financial markets?

In my view, there’s a big connection. I feel that they are essentially the same – an insight I got after reading the above Loomis’ columns although she herself did not talk about the connection.

The law of conservation of energy states that the total inflow of energy into a system must equal the total outflow of energy from the system, plus the change in the energy contained within the system. In other words, energy can be converted from one form to another, but it cannot be created or destroyed.

Simply change “energy” for “risk” and you’ll have the law of conservation of risk.

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) 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.

Risk can be sliced and diced. Risk can be transferred from one person to another. And one form of risk might replace another form, but at the end of the day, the total risk in the system is not going to change.

In other words, just like energy, risk can be converted from one form to another, but it cannot be created or destroyed.

And that’s one insight that has paid me well over the last eleven years…

Jared Diamond’s "Dam Fools"

Jared Diamond is one hell of a thinker. I really like the way he thinks. The ideas described by him in his talks and in his wonderful books are also portable i.e. their lessons can be applied in other fields like investments.

His book, “Guns, Germs, and Steel: The Fates of Human Societies” contains highly useful ideas about how to think correctly. It’s no wonder that Mr. Charlie Munger has been recommending Diamond’s book for years. Diamond’s way of thinking is highly multidisciplinary, which I think, is exactly what Mr. Munger likes about him.

I’ve yet to start reading Diamond’s other famous book, “Collapse: How Societies Choose to Fail or Succeed“. However, a couple of days ago, I started watching the recently released DVD on Guns, Germs, and Steel. If you do not have the time or the inclination to read the book, watch the DVD.

You will also enjoy reading the transcripts of two of Diamond’s talks from here and here.

The earlier of these two talks titled “How to Get Rich?” beautifully illustrates the role of competition in wealth creation rather than wealth destruction. This talk also wonderfully explains how innovation really works.

The second talk titled “Why Do Some Societies Make Disastrous Decisions?” could actually have easily been titled “Why Do Some Investors Make Disastrous Decisions?” In this talk, I loved Diamond’s discussion of “Psychological Denial” one of the several mental models from psychology used by Mr. Munger. Here’s a wonderful quote on psychological denial from that talk:

“Consider a narrow deep river valley below a high dam, such that if the dam burst, the resulting flood of water would drown people for a long distance downstream. When attitude pollsters ask people downstream of the dam how concerned they are about the dam’s bursting, it’s not surprising that fear of a dam burst is lowest far downstream, and increases among residents increasingly close to the dam.

Surprisingly, though, when one gets within a few miles of the dam, where fear of the dam’s breaking is highest, as you then get closer to the dam the concern falls off to zero! That is, the people living immediately under the dam who are certain to be drowned in a dam burst profess unconcern. That is because of psychological denial: the only way of preserving one’s sanity while living immediately under the high dam is to deny the finite possibility that it could burst.”

How can the idea of psychology denial as explained by Diamond be applied to another field like investments? Diamond’s example of what I call “dam fools” has a close parallel to what happens to most investors, the media, and the politicians at the peak of an asset price bubble. The most recent example was that of the dotcom bubble where most people were victims of sheer psychological denial. They were blissfully ignorant of the trouble ahead.

Another application of psychological denial which I have observed is when I meet with, or read the interviews of, the managements of some companies. For example, Steel executives were bullish when prices were at their peak. Why does this happen? I think part of the reason why it happens is that people are too close to the scene of the action, just like the “dam fools” in Diamond’s example.

I think one the traits one needs to learn is the ability to “zoom out” and look at the big picture which is not easy when you are too close to the scene of the action.

Yet another example of psychological denial is seen when management is over-confident of its own abilities and under-confident of the abilities of its competition. Recently, I met with the management of a profitable Indian company which manufactures a commodity product at a low cost. However, a much bigger competitor is creating new capacity in China. If this new capacity comes on stream, it can destroy the profitability of the most of the players in the industry. The management of the company I met, however, feels that the Chinese player will not be able to stabilise the plant. When I come across such responses from managements, the “Dam Fool” example of Diamond pops up in my mind!

Why would a fellow who is spending hundreds of millions of dollars to build capacity in a growing industry not be able to stabilise a plant? Sure, it would cost money to poach some of the smartest engineers and technicians, but for a person who has already made that large size commitment, the incremental cost required to get the right people to get the job done will be really small, isn’t it? [Commitment and Consistency - Psychology, Contrast Effect - Psychology]

It’s such a simple question, but the management of the Indian company would not like to ask it. Now that’s psychological denial. So, psychological denial operates at a subconsious level in the minds of investors as well as company managers.

A marvelous example of psychological denial at both levels was depicted in the movie “Other People’s Money“. In this fantastic film, which I recommend watching, “Larry the Liquidator”, played by the giant of American cinema, Danny DeVito, is trying to convince the shareholders of New England Wire & Cable Company to vote him into power so that he can liquidate the company because in his view it deserves to be liquidated. You can hear the speech of the incumbent manager, Andrew Jorgenson, played by Gregory Peck, from here and that of DeVito from here.

Here’s a quote from DeVito’s speech which beautifully illustrates psychological denial, both at the corporate as well as the investor level:

“This company is dead. I didn’t kill it. Don’t blame me. It was dead when I got here. It’s too late for prayers. For even if the prayers were answered, and a miracle occurred, and the yen did this, and the dollar did that, and the infrastructure did the other thing, we would still be dead. You know why? Fiber optics. New technologies. Obsolescence. We’re dead alright. We’re just not broke.

And you know the surest way to go broke? Keep getting an increasing share of a shrinking market. Down the tubes. Slow but sure. You know, at one time there must’ve been dozens of companies makin’ buggy whips. And I’ll bet the last company around was the one that made the best goddamn buggy whip you ever saw. Now how would you have liked to have been a stockholder in that company? You invested in a business and this business is dead. Let’s have the intelligence, let’s have the decency to sign the death certificate, collect the insurance, and invest in something with a future.”

Revisiting Oxford Book Club Talk Given in July 2002

In July 2002, I was invited to give a talk on value investing at the famous Oxford Bookstore in Mumbai. The talk was attended by about forty fund managers and analysts.

Today, I found that presentation on my computer and was reading it. I was fascinated to find how well some of the stocks that I had spoken about in 2002 have performed since then.

Gesco Corporation has gone from Rs 11 in June 2000 to Rs 204 now. Trent has gone from Rs 60 in August 2001 to Rs 875. Gujarat Mineral Development Corporation has gone from Rs 45 in January 2002 to Rs 436 now. Zodiac Clothing has gone from Rs 43 in October 2001 to Rs 535 now. Blue Star Infotech has gone from Rs 35 in August 2001 to Rs 150 now. SRF has gone from Rs 26 in July 2002 to Rs 314 now (excluding the value of shares of a company spun off from SRF). Hindustan Motors has gone from Rs 9 in July 2002 to Rs 46 now. And Himatsingka Seide has gone from Rs 97 in July 2002 to Rs 556 now. All of these stocks have outperformed the market handsomely.

The only disappointment has been Regency Ceramics which has not gone anywhere in the last four years.

All of the above stocks were identified using very simple hueristics derived from Graham’s philosophy of deep value investing.