Category Archives: Behavioral Economics

Klein Vs. Kahneman

Transcript of my first lecture at BFBV course at MDI.

Playing Socratic Solitaire on a Gal Called NIMBY

I got a mail from a student. Nikhil wrote:

Your approach to multidisciplinary thinking is highly pragmatic but it is an approach never taken in the entirety of our education. Throughout we are taught subjects individually and each of the problems that we are given is confined to the context of that particular subject only, even in our MBA the cases that we have usually try to deal with a business case within the context of a few concepts from a particular field such as marketing, finance or operations. Hence my problem is that I find it very difficult to be able to come out of the confines of one particular subject and think of a problem in a more holistic manner which would be useful in real life as well. The key issue is making a connect between the problem at hand and the list of mental models that you have stored away in the back of your head. Your functional equivalence approach is very useful but again how do you learn to apply it in situations? Can you guide me as to how I can start training myself to think in such a fashion, looking at a problem and coming up with a set of concepts to apply as in like the check-list you mentioned?

Nice mail.

I promised Nikhil that I will write a teaching note. This is that note.

Socratic Solitaire

I am going to play a game based on ideas derived from Socrates and Charlie Munger. We will start with “Socratic Questioning” which is described as

disciplined questioning that can be used to pursue thought in many directions and for many purposes, including: to explore complex ideas, to get to the truth of things, to open up issues and problems, to uncover assumptions, to analyze concepts, to distinguish what we know from what we don’t know, to follow out logical implications of thought, or to control the discussion.

Socratic Questioning relates to “Socratic Method,” which is:

a form of inquiry and debate between individuals with opposing viewpoints based on asking and answering questions to stimulate critical thinking and to illuminate ideas.

Charlie Munger started using these two Socratic devices in a variation he called Socratic Solitaire, because, instead of a dialogue with someone else, his method involves solitary play.

Munger used to display Socratic Solitaire at shareholder meetings of Wesco Corporation. He would start by asking a series of questions. Then he would answer them himself. Back and forth. Question and Answer. He would do this for a while. And he would enthral the audience by displaying the breadth and the depth of his multidisciplinary mind.

I am going to play this game. Or at least, I am going to try. Watch me play.

Rules

What are the rules? Here are some tips from Charlie.

      1. If you want to get smart, the question you have to keep asking is “why, why, why, why?” [Being Curious]
      2. Relate the answers to a structure of deep theory. You’ve got to know the main theories. And it’s mildly laborious, but it’s also a lot of fun. If you get into the mental habit of relating what you’re reading to the basic structure of the underlying ideas being demonstrated, you’ll gradually accumulate wisdom. [Connecting experience with mental models using pattern recognition]
      3. To a man with a hammer, everything looks like a nail. Don’t try to answer the question which begins with “why” by using the first explanation that comes to mind. Use a checklist. [First Conclusion Bias]

So, that’s what I’ll do. I will pick up the newspaper and identify a story. I will then ask a question relating to the story which I will try to answer by relating what I read to multiple mental models in my head. As I do that, I will experience related thoughts. I will not control those thoughts. More questions will arise.  I will continue to relate my thoughts and questions to mental models from multiple disciplines. I will allow my mind to wander from one discipline to another finding more questions and looking for answers. In seeking answers, I will need some tools.

Tools

I will use five tools: (1) My brain; (2) My computer; (3) Wikipedia; (4) Google; (5) a couple of cards from Creative Whack Pack;  and (5) My Kindle.

Each of these has its own benefits and disadvantages. My brain cannot store everything, but is good at recognising patterns. I have a ton of stuff I have collected on my computer over the years and I am likely to find something interesting that is related to whatever I am investigating but my computer can’t possibly have everything that’s worth knowing on the subject. So, I’ll get leads and I will investigate by going to Wikipedia, which is a great free resource for research but I have to be careful about its accuracy. Google is a great search engine but it also produces results which can cause unnecessary distractions. On the other hand, my Kindle has a a better organised body of knowledge – my library of 396 books. Kindle has a search function which allows me to search for terms across all my e-books which solves the “I-know-I-have-seen-something-like-this-before-but-I-don’t-remember-where” problem in paper books. Moreover, I expect to serendipitously find things related to my search terms – things I did not know existed in my library but have popped up while I was searching. At the same time, I must be careful not to get too distracted.

So I have my tools near me. Now I need a topic.

Topic

Let these pictures give us the topic.

Oh Shit! Who died? Why are these women crying?

What’s going on here? What are these people doing? What’s that building in the background?

These people are protesting against the construction of a nuclear power plant on India’s East coast in a place called Kundankulam in Tamil Nadu. The building in the background is Kundankulam Atomic Power Station and the women in the earlier photograph are crying because they are petrified at the idea of living near a nuclear power plant. You can read more about the ongoing protests from here.

Cards on the Table

But wikipedia only tells us about this one project. Our task however, begins from here. Let me now put one of the cards from Creative Whack Pack on the table.

Creative Whack Pack: Ask Why?

Let’s get curious like Leonardo da Vinci and ask some questions.

Why are these people protesting? What are they scared of? How can we learn more about what’s happening in Kundankulam? Are there any precedents? What do they tell us? Is is only about nuclear power or are there other situations where similar protests happen?

Before I attempt to answer these questions, let me first put my second card from Creative Whack Pack on the table.

Creative Whack Pack: Let Your Mind Wander

Now, I am going to use my associative brain, together with my research tools to study this topic.

Letting My Mind Wander (but not too far from topic)

Here are some thoughts that immediately occur to me – in no particular order. I record them in a mind-mapping software. While playing socratic solitaire I am essentially brainstorming with myself, so organizing thoughts is not as important as capturing them in the first place.

While you read about these thoughts, also notice how my associative memory (connection with a mental model) works. Here are some thoughts.

  1. Clearly there is Recency effect here (Bias from Availability Heuristic). People over-react to recent event and a recent event that’s clearly effecting these people is the Fukushima disaster.
  2. Vividness (Bias from Availability Heuristic) is clearly there. The media coverage of the Fukushima situation was so vivid that it’s easy to see why these people are worried.
  3. Clearly there is loss aversion here. Precisely because of the recency and vividness effects, people over-react to extremely low probabilities. When fear is looming in their heads, they don’t think probabilities, they think possibilities. Events that are extremely bad but also extremely unlikely are likely to be over-weighed if they occupy people’s minds. Moreover because losses loom larger than gains, people who lose over-react to the loss of perceived security, while people who gain from cheap and abundant electricity don’t value gains equivalently.
  4. This will happen despite the fact that number of people who have died in nuclear accidents is a tiny fraction as compared to the number of people who die because of lung cancer caused by pollution due to proximity to coal fired power plants. This is insensitivity to base rates. People ignore prior statistical experience in favour of influential stories. Nuclear and radiation accidents have, from 1961 till date, resulted in only 69 deaths. Globally. Nuclear power plants are among the safest things engineers build in the world (Margin of Safety). But try telling that to a person who is contemplating living near a nuclear power plant.
  5. Hang on! This reminds of the situation of those people who already live near Dams. How do they treat the threat of dam bursting. It turns out that the closer they stay near the dam, the less worried they are. This is psychological denial and i wrote about it almost seven years ago. Notice, I don’t use the label of “psychological denial” in my head. For me people suffering from psychological denial, which is an extreme form of bias from commitment and consistency are the functional equivalents of Jared Diamond’s “Dam Fools.” (It’s good to use catchy labels like “Dam Fools” and “Boiling Frogs” instead of boring one like “psychological denial” and “slow contrast.”
  6. Is there a generalised model which explains why people don’t want power stations, railway stations, airports etc near where they live? Yes of course! It’s called NIMBY – Not In My Backyard.
  7. NIMBY is a subset of incentive-caused bias. People realise that they need electricity but they don’t like to have power stations (and especially Nuclear Power Stations) in their backyards. They conclude, incorrectly, that what’s bad for them is also bad for civilisation.
  8. Clearly there are other “interests” involved. For example people with a political agenda have an interest in provoking the protesters by bringing the fear factor to the forefront of their minds (Availability Heuristic).
  9. Pavlovian association which arises out of Representativeness heuristic clearly exists here – in the minds of people who live near nuclear power stations, all nuclear power accidents are comparable, even when they are not.
  10. Let me think a bit about how the problem from society’s viewpoint instead of the viewpoint of people protesting and other people with political motives. How should a right thinking leader think about this NIMBY problem? What are the possible solutions. Well, I know what the solution isn’t. (Invert, always invert). Ben Franklin’s advice then “if you were to persuade, appeal to interest, not reason” applied here in hordes. No amount of statistical evidence based reasoning as in “This installation is super safe and you have no cause to get worried blah blah blah” will ever work. (Insensitivity to base rates). An appeal to reason won’t work. So what will?
    1. Hmmmm. I have to appeal to interest. I have to find a way for people to want to live near a nuclear power station. Reminds me of the Tom Sawyer story in which Tom uses the “scarcity” principle to get his friends to paint a fence – a task that was boring to begin with but became desirable when it became scarce. What if there was an auction in which people bid money to get a right a to stay right in the vicinity of the nuclear power station? To invoke the scarcity principle, the govt may mandate that free electricity will be given to all homes within 10 km radius of the power station. That’s the incentives superpower. Wouldn’t that get many people interested in living there? Who knows? But I think it’s the right way to approach the problem. Appealing to reason won’t work, appealing to interests, just might.
    2. If people in Mumbai couldn’t care less about living right next to a nuclear plant, why should people living in Kundankulam care? Maybe people in Mumbai can influence scared-to-shit people in Kundankulam.  Maybe social proof will work. Incentives should work better. But these things are not mutually exclusive. Why not try both? What’s the downside?

NIMBY

Interesting ten thoughts, no? And they began after I saw a couple of vivid photos. Now I want to allow serendipity to help me even more. I will do this by employing the remaining two research tools: my computer and my kindle.

Searching My Computer

Over the years, I have accumulated so many documents on my computer that the space they take up adds up to about 300 gigabytes!

Now I know serendipity works beautifully. So let me search for the term “NIMBY” on my computer. Who knows what I might find? Let’s see.

Searching, searching, displaying search results…

Whoa! What an astonishing gem I found. Granted, it may not be directly related to NIMBY, but its bloody interesting to me especially in context of what’s happening in Indian power sector. What did I find?

I found extracts from talks given by Warren Buffett and Charlie Munger. Let me reproduce them here. Their words:

Buffett: Politicians don’t like to face major brownouts. They can try and blame it on someone else – and they may well be accurate in blaming it on someone else. But the public is going to, at least partially, blame political leaders if this country runs out of electricity – because it hasn’t run out of the ability to build generators. We could create all the generators we need to have plenty of electricity – and we could create the transmission lines and all of that.

But you do need a flow of capital to the industry. And the law restricts that flow to quite a degree, I would say.

Munger: Well, the production of electricity, of course, is an enormous business – and it’s not going away. And the thought that there might be something additional that we might do in that field is not at all inconceivable. It’s a very fundamental business.

You’re certainly right in that we have an unholy mess in California in terms of electricity. It reflects, I’d say, a fundamental flaw in the education system of the country; that so many smart people of all kinds – utility executives, governors, legislators, journalistic leaders – seemingly had difficulty recognising that the most important thing with a power system is to have a surplus of capacity. Is that a very difficult concept?

Everybody understands that if you’re building a bridge, you don’t want abridge that will handle exactly the maximum likely load and no more. You want a bridge that will handle a lot more than the maximum likely load. And that margin of safety is just enormously important in bridge-building.

Well, a power system is a similar thing. Why do all of these intelligent people ignore the single most obvious and important factor – and just screw it up to a fair-thee-well?

Buffett: Charlie’s obviously right in that from a societal standpoint, you’ve got perhaps three goals in what you would like your electric utility business to be. One is that you would like it to be reasonably efficiently operated. Secondly, since it does tend to have in many situations monopoly characteristics, you would want something that produced a fair return, but not a great return, on capital – enough to attract new capital. And then third, you’d want this margin of safety – this ample supply.

When you’ve got a long lead time to creation of supply –which is the nature of putting on generation capacity – you need a system that rewards people for fulfilling that obligation to maintain extra capacity. A regulated system can do that. If you give people a return on capital employed so that if they keep a little too much capital employed they get paid for it, then they’ll stay ahead of the curve – they’ll always have 15-20% more generating capacity than needed.

One of the disadvantages of that regulation and the monopoly nature is that it doesn’t have the spur to efficiency. They try to build it in various ways, but it’s difficult to have a spur to great efficiency if somebody can get a return on any capital they spend. Therefore, utility regulators have always been worried about somebody just building any damn thing and getting whatever the state-allowed return is.

But I’d say that the problems that would arise from, say, a little bit of sloppy management are nothing compared to the problems that arise from inadequate generation.

So in California, in my view speaking as an outsider, utilities had the incentive at one time to maintain a little extra generating capacity because they were allowed to earn a decent return on it – a return sufficient to attract capital.

But they you had, I think, the forced sell-off of something like half of their generating capacity. And they sold it at multiples of book value to a bunch of people who became generators who are deregulated and don’t have an interest in having too much supply. They’ve got an interest in having too little supply. So they totally changed the equation – because the fellow with the deregulated asset for which he paid 3 times book now has to earn a return on that 3 times book what the fellow was formerly earning under the regulated environment at 1 times book.

So he’s not going to build extra generating capacity. All that does is bring down the price of electricity. He hopes things are tight. If you’ve got a utility plant that was put in place at X and then you go out and encourage entrepreneurs to buy it at 3X, you can’t expect electricity prices to fall. So you’ve created a situation, in my view, where the interests of the utility companies have diverged in a significant way from the interests of society. And that was a very, very basic mistake. It just doesn’t make any sense to me – but maybe I don’t understand it fully.

I really think that the old system made more societal sense: Let people earn a good return (not a great return, but a return that attracts capital) on investment that has built into it incentives to keep ahead of the game on capacity because you can’t fine-tune it that carefully. And you do have this long lead time.

Now, what you do with the scrambled eggs now – with all the political forces back and forth… I think that you better have a system that encourages building extra capacity because you don’t know how much rainfall there will be in the Pacific Northwest and therefore, how much hydro will be available. And you don’t know what natural gas prices will do and, therefore, whether it’s advantageous for a gas-fired turbine to be operating.

The old system really strikes me as somewhat better than this semi-deregulated environment that we have more or less stumbled into. Charlie, what do you think?

Munger: Of course, even the old system got in some troubles. Everybody had the NIMBY syndrome – “Not In My Back Yard.” Everybody wanted new power plants to be anyplace not near me. If everybody feels that way and if the political system means that the obstructionists are always going to rule – which is true in some places in terms of zoning and other matters – you’re in deep trouble. If you let the unreasonable, self-centered people make all of the decisions of that kind, you may well get so that you just run out of power. That was a mistake.

And we may make that mistake with the oil refineries. We haven’t had many new big oil refineries in the last period. So you may get to do this all over again.

Shareholder: You talked about your interest in investing in new electrical capacity. Would you expound a little bit in terms of what you think would be a rational business model and a fair social model for doing so?

Munger: Well, of course, the energy situation in California is a disgrace. It’s a disgrace to our educators who turned out people who could make such dumb decisions in spite of going to the best colleges and the best business and law schools. It’s a disgrace to both political parties who sat around. It’s a disgrace to the executives that participated in making the decisions. There‚s enough disgrace to go around. There was an easy idea to retain when you’re running hospitals in the middle of a desert where it’s 110 degrees outside. It was not a radical, hard-to-grasp idea that the one thing the civilization always wanted was a surplus of generating power. Is that really difficult to understand? Well, of course it isn’t difficult. But all these people had these other models: If we simply have free enterprise‚ meaning deregulation, as they called it‚ it will automatically cause a surplus. Well, of course, it didn’t automatically cause a surplus. To have a surplus of generating capacity, you’ve got to have a surplus of well-fueled plants capable of generating the electricity.

And of course, there’s the system of allowing NIMBYism (Not In My Back Yard)‚ everybody wants the school, but not near me. So no new school is created for 10 years in Los Angeles and the kids are in unspeakable conditions. Everybody wants a power plant, but not near me. And if you just allow that kind of paralysis in our governmental system‚ We richly deserved this miserable result. We earned it fair and square by extreme stupidity and indifference. And we’re doing the rest of the country an immense favor. We’re like the canary in the mine that dies, but saves the other miners. State after state is looking at California and saying, Boy, have those guys done us a favor. That is one kind of stupidity we don’t want to have.

So, obviously, we need excess generating capacity. And we’ve got to reduce the pollution as much as we can. But once we’ve got it down as low as it’s feasible to get it, we’ve got to have the capacity. We also need conservation. We also need utility rates which encourage the right habits. There are perverse incentives built into the rates. And there are all kinds of ways that could have been done better. It’s obvious what should be have been done: the right incentives in the rates, always a surplus of power. This does not take great brain power. But we just mushed around in the same crazy way we did with the public schools‚ and we allowed something very important to go to hell. It was really awful behavior‚ awful cognition.

And what’s really bad is that you can go to modern academia right now and nobody’s ashamed of these recent bad results. They think if you teach about Beowulf, you’ve done your duty. And the fact that the people leave you and can’t think their way out of a paper sack is not their fault. But that’s not true. We should be graduating people from our educational institutions that can think better and behave better. Sometimes you have to stand up and do things that are against your own interests, but in the interests of the larger civilization. And we have all failed to a fair-thee-well.

That said, we’re going to need a lot more power. And there’ll be all kinds of creative ways to handle the thing. There will be some opportunities in the future. It’s a great, big permanent business. And electrical power is not going to be obsolete. There aren’t many fundamental things in nature. And one of them is electrical power‚ electromagnetism. It’s not going away.

Wow! Cool isn’t it? And how did I find this? By storing it when I read it many years ago, then forgetting about it, then while working on this project letting my mind wander and searching for NIMBY on my computer and finding it all over again!

Never ever underestimate the power of serendipity.

So what should we learn from the above extracts from Buffett and Munger?

Indian power tariffs just have to go up. The state electricity boards are bankrupt. If India wants more electricity it has to produce the right incentives. And allowing a decent rate of return isn’t sufficient. You have to ensure that the return is actually realized. If state electricity boards can’t and won’t pay electricity bills of generators, then the promised return is not earned, so India can forget about attracting private capital. Those half finished power plants which depended on “cheap” south-east Asian coal that became expensive later on won’t be finished unless tariffs were increased. It doesn’t matter what power purchase agreements say. If coal price is not allowed as pass-through the regulator or government can’t say too bad! If they do that, the plants won’t get finished and India must live with electricity shortage. Incentives matter.

If you keep on giving free electricity to farmers, then you will eventually get shortages. People will have perverse incentives to divert power from agricultural usage to non-agri usage. It’s very hard to stop it. Gujarat has done it. Every state must follow what it did. But do the politicians have the will (balls?) I doubt it. So until the politicians can be “convinced” that to get surplus power, the generators must be more than adequately incentivised, India power sector will suffer and India will suffer along with it. Nuclear power is cheap, and much safer as compared to coal power especially when health costs are concerned. Kundankulam Project must be finished.

Cool, now that I have given my sermon, I can move on to the last tool I will use for this exercise.

Searching my Kindle

There are many reasons why my wife is jealous of my Kindle but one huge reason why I love it so much is it has an awesome feature. As I type this blog, I find that I have 440 books on my Kindle. That’s an enormous library isn’t it? When all my books were on paper, I had this problem which inevitably made me say these words:

Shit man, I have read about NIMBY in some of my books but I don’t remember which ones!

And then I would spend hours browsing through books looking for that elusive sexy girl called NIMBY but I could never find her. I had a faint recollection of spending some very enjoyable time her but I could not find her anymore.

Enter Kindle. End of problem. Kindle allows you to search across all your books on the device for NIMBY or SUZIE or any woman or idea or concept you want to search. It’s like a google search engine on your books.

So I will do that now. I will search for NIMBY on my Kindle.

Switch Kindle on. Go to Search. Type NIMBY. Hit enter. Searching searching searching. A list of book appears. I go though them one by one.

Whoa! Look what I found! This from an excellent book called The Little Book that Builds Wealth.

Moody’s, the slot machine industry, and the for-profit education industry are all examples of single licenses or approvals giving companies sustainable competitive advantages. But this kind of moat isn’t always based on one large license; sometimes a collection of smaller, hard-to- get approvals can dig an equally wide moat.

My favorite example of this is what I call the NIMBY (“not in my backyard”) companies, such as waste haulers and aggregate producers. After all, who wants a landfill or stone quarry located in their neighbourhood? Almost no one, which means that existing landfills and stone quarries are extremely valuable. As such, getting new ones approved is close to impossible.

Trash and gravel may not sound exciting, but the moat created by scores of mini-approvals is very durable. After all, companies like trash haulers and aggregate firms rely on hundreds of municipal-level approvals that are unlikely to disappear overnight en masse.

What really makes these locally approved landfills and quarries so valuable for companies like Waste Management and Vulcan Materials is that waste and gravel are inherently local businesses. You can’t profitably dump trash hundreds of miles from where it is collected, and you can’t truck aggregates much farther than 40 or 50 miles from a quarry without pricing yourself out of the market. (Trash is heavy, and gravel is even heavier.) So, local approvals for landfills and quarries create scores of mini-moats in these industries.

Contrast waste and gravel with another industry that has strong NIMBY characteristics—refining. Although there hasn’t been a new refinery built in the United States for decades, and local approvals for expansions of existing refineries are pretty tough to come by, the economic situation of a refinery isn’t nearly as good as that of a landfill or quarry. The reason is simple: Refined gasoline has a much higher value-to-weight ratio, and it can also be moved very cheaply via pipelines.

So, if a refinery tried to raise prices in a particular area, gasoline from more distant refineries would flow into the locality to take advantage of the higher prices. As a result, while there are regional variations in gasoline pricing, refiners generally can barely eke out high-single-digit to low-teens returns on capital over a cycle, while aggregate producers and waste haulers enjoy much steadier returns on invested capital in the mid to upper teens over many years.

A Journey Ends and Another One Begins

Absolutely incredible!!! Isn’t it?

We started this journey with a couple of photos of emotionally distressed people. As we dug deeper into the likely causes of their distress, we encountered several models from psychology, engineering, and economics. By allowing our minds to wander a bit like Leonardo da Vinci and by employing a technique invented by Socrates and polished by Munger, we discovered possible explanations to something that needed an explanation using a multidisciplinary toolbox. We also used serendipity and the associative nature of our minds to unravel various facets of a gal called NIMBY.

Her most interesting facet, to an investor, was hiding in a book on investing in moats. How one thing leads to another! Now NIMBY will take me for a holiday to a bunch of very exotic islands called MOATS. I will tell you that story on another day. Right now I am going to have some fun with her.

Don’t look.

END

How to Boil a Frog

Hello there. My name is Umbridge. I am a slimy, green frog.

No, not the one who you heard croaking in a movie you watched last month. Nor the one you saw hopping about in your balcony this monsoon. (You shouldn’t have screamed at poor Groffy! He jumped over and broke a leg.)

I am the frog who boiled. And this is my story.

It started in a classroom. You see, the advantage of being a frog on a business school campus is that you can just hop over to any prof’s classroom and attend lectures unnoticed. You don’t have to croak your presence when the attendance is called out. No one asks any questions from you. And of course there is no fee to pay.

Look at this way. I am the most literate frog you know. With this introduction, let me croak my story to you.

There is this professor on campus. He teaches a big class in the auditorium. 140 human students meaning that I have to avoid being squashed under 280 very heavy feet. That’s quite a feat by the way. And then I have to hop over those huge stairs unnoticed to get a good vantage point from where I can see the prof and the vivid slides he puts on the screen.

One September morning it was drizzling on campus. My friends and cousins were merrily mud wrestling in our favourite puddle. I was shoving my cousin Kermit’s neck under water while she was splashing her feet wildly unable to breathe. Suddenly, I heard two students rushing past us.

We gotta run dude. I don’t want to miss this class.

Why? What’s the hurry man? It’s only a class.

He’s going to tell the boiling frog story today! My senior told me not to miss it.

Ok man, let’s run!

And off they went.

Boiling frogs???? They boil frogs???

How could anyone do that? My anger rose so quickly that I barely noticed just how far my eyes had protruded. My eyeballs almost fell out of their wet and sticky sockets. If my nostrils had flared any more they would surely have burst apart. And my breathing. Why was I panting?

Stop this atrocity Umbridge! I let go of cousin Kermit who by now that desperately choking and croaking under the mud in my puddle. I had to get to the auditorium and quickly.

How far is it? About 1,500 hops. I better be on my way. Hop Hop Hop.

Ten minutes later, I am stationed at my favourite spot in the auditorium. The lecture is already in progress. The prof is speaking.

…And so, imagine that everyday I consume 100 calories more than I expend. Will I look fatter the next day? Of course not. Not even the day after or the week after. Will I?

But if you saw me after an year, you’d notice that I have gained some weight. And if you saw me after 3 years, you’ll notice that I am obese. But if you saw me every day, you won’t notice that I gone from being fit to being obese in 3 years.

Small incremental changes tend to go unnoticed. This is a very powerful idea, which Charlie Munger called the boiling frog syndrome. 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 would’t be able to tell the tiny incremental changes. He will boil and die as this video shows. Brace yourself when you watch it.

By the time, the video reaches 1:36, my heart is pumping so loudly that I almost feel it burst my chest walls and hit the prof smash in his face. This is disgusting! I need to puke.

But, wait a sec! The video continues and now there is no real frog being boiled! A hoax!

Whew! I am sighing with relief and students are gasping. The prof, who now has a wide grin on his face, is saying

I can assure you that there is no truth whatever in this story, but the human equivalent of the boiling frog is there in all of us. Indeed, 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.

A metaphor! I smiled to myself. This is a cute prof. He is only talking metaphorically! There is no boiling frog. The video is a hoax too! Yay!!! I croaked out in relief.

The Prof is saying let me give you an example.

Take a look at these exhibits. They reflects a prosperous company. Why?

Well, for starters, it’s a debt-free company. Also notice it’s cash and bank balances of Rs 2,058 cr. (all figures in the exhibits are in Rs millions). Now take a look at it’s income statement.

This is a profitable company having a market value of Rs 13,500 cr. Now take a look at these exhibits which display symptoms of a company in a precarious financial condition.

Unlike the earlier company, this company is highly leveraged with very low cash and bank balances. Now see it’s income statement.

Unlike the earlier company which was profitable, this company is into huge losses. It’s market cap at Rs 2,300 cr. is a small fraction of the market cap of the prosperous company you saw earlier.

Now let me tell you one thing: These two companies are the same at different times. This is what happened to MTNL over a span of about 6 years.

This is what Munger means when he likens businesses which die to a boiling frog. Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny. Now you could see what happened to MTNL because I showed data pertaining to FY06 and then I showed you data pertaining to FY12. I exposed you to a high contrast effect, which always gets noticed. But investors who are looking at daily, weekly and quarterly information are likely to miss the tiny incremental changes or as Munger puts it, “miss a trend that’s destiny.”

So, the prof is asking, what’s the important lesson here? One student raises her hand.

Sir, this means that investors would be better off if they were exposed to lesser information and not more. Right?

Excellent answer! the prof says. Indeed there is a plenty of research done on this topic. In fact, way back in 1964, two researchers wrote a very interesting paper titled “Interference in Visual Recognition,” in which they described a fascinating experiment.

Take a look at the picture below. Do you see anything?

I see students shaking their heads. But I can see that it’s a fire hydrant. The one in the main building just outside the Director’s office. I have played hop skip and jump so many times on this hydrant. Why can’t they see it? Oh I get it? They aren’t frogs! Ha!

The Prof is saying.

This is a picture of an object which is out of focus. Human eyes can’t identify it in this state. Now imagine I divide this class into two groups. Both the groups will start by looking at the faded picture for 10 seconds. For one group, I will then bring the object into focus upto a point and then stop. I will do this in 20 tiny increments. For the other group too, I will bring this object into focus and stop at the same point at which I stopped for the first group, but the number of increments would be only 5. Now tell me which group will have more information?

A student replies, the first group! They will get to see a lot more data than the second group.

Right! But it turns out that the second group, which had less information, correctly guesses earlier what the object is. See this image.

He quotes from the paper

Pictures of common objects, coming slowly into focus, were viewed by adult observers. Recognition was delayed when subjects first viewed the pictures out of focus. The greater or more prolonged the initial blur, the slower the eventual recognition. Interference may be accounted for partly by the difficulty of rejecting incorrect hypotheses based on substandard cues.

It’s the same boiling frog syndrome again. When people see tiny incremental changes they take longer to recognise what’s going on. People who see just a few changes guess faster. Cool! So all those hourly bulletins issued by cousin Kermit titled “Likely Insect Whereabouts” are useless!

I should have known!

The Prof is now telling another story. This time it’s the story of Kodak.

A few months before kodak filed for bankruptcy, Lex of FT described situation briefly and beautifully:

The big story here is, of course, a simple tale with three parts: photography goes digital; Kodak doesn’t change with the times; the end.

Why did Kodak fail to change with the times. Part of the reason is the same boiling frog syndrome. To see how, let’s do a thought experiment.

Imagine that it’s 1998, just before digital cameras became popular. You are the CFO of Kodak and are enjoying the dominance of your company in the global photographic film market. The world is getting increasingly prosperous and film camera sales are booming because people want to preserve memories. More cameras means more demand for film. Life is good because Kokak is the dominant brand in the world.

One day an engineer walks in with what looks like a toy. He puts it on your table and makes an announcement:

This thing is going to kill us. This is a digital camera. The world will stop buying film cameras. We are going to die.

Now, since this is a thought experiment, let’s ignore the benefit of hindsight. We all know what happened to photographic film business but let’s ignore it for now. Put yourself in the shoes of Kodak’s CFO and give me four very plausible reasons which will convince you that the engineer is over-reacting to the threat from digitisation.

Student # 1: The Cost is too high. Digital cameras cost so much more than film ones. No one will buy them.

Student # 2: The quality sucks. The best digital cameras offer a maximum resolution of only 1.5 megapixel.

Student # 3: People will never watch photos on computers. They love printed albums.

Student # 4: People would never agree to store their memories on computers and take the risk of hard drive crashes and other disasters.

Great points! Now let’s see what happened to each of these objections. The cost went down, the quality got better and now you get 8 megapixel cameras inside mobile phones. New platforms like Facebook emerged on which you can do things with photos (sharing, commenting, tagging) which you couldn’t even have imagined as possible back in 1998. And as for security, online backup facilities, external hard drives, pen drives were invented.

So, you see every single objection to the possibility of digitisation killing the photographic film business turned out to be wrong. But notice that these changes did not happen in a day, or a quarter or a year. It took years. And the CFO and his colleagues, were just too close to all the noise (just like the people who were seeing too many images of the fire hydrant), that missed miss a trend that turned out to be Kodak’s destiny. It’s the same boiling frog effect again.

The boiling frog metaphor is a terribly powerful metaphor and can be applied in many situations. Take the case of the Indian government’s desperation to increase the price of diesel, which is being subsidised heavily because price hikes were not allowed earlier. And now, the government finds it very difficult to do anything about it.

Now imagine that the government had increased the price by just 20 paise a litre in a week. This would have gone unnoticed. In four weeks, the increase would have been 80 paise, and in a year, Rs 9.60, which is way more than Rs 5 increase implemented recently.

If the government had been psychologically astute, it could have used the boiling frog syndrome to implement a change in a manner which was much more likely to be accepted than the manner it actually chose. Partly as a consequence of this mis-step, it lost an ally. Not that she was worth keeping. Just saying.

We frogs surely have come a long way it seems! Humans are using us as examples of how to make people experience change! This was so cool, I am thinking but the Prof continues.

The idea of noise vs. signal has been further refined by the philosopher Nassim Taleb. He says

“Noise is what you are supposed to ignore; signal what you need to heed.”

“The more frequently you look at data, the more noise you are disproportionally likely to get (rather than the valuable part called the signal); hence the higher the noise to signal ratio. And there is a confusion, that is not psychological at all, but inherent in the data itself. Say you look at information on a yearly basis, for stock prices or the fertilizer sales of your father-in-law’s factory, or inflation numbers in Vladivostock. Assume further that for what you are observing, at the yearly frequency the ratio of signal to noise is about one to one (say half noise, half signal) —it means that about half of changes are real improvements or degradations, the other half comes from randomness. This ratio is what you get from yearly observations. But if you look at the very same data on a daily basis, the composition would change to 95% noise, 5% signal. And if you observe data on an hourly basis, as people immersed in the news and markets price variations do, the split becomes 99.5% noise to .5% signal. That is two hundred times more noise than signal —which is why anyone who listens to news (except when very, very significant events take place) is one step below sucker.”

The Prof also quotes Daniel Kahneman:

Investors should reduce 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 may 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. The typical short-term reaction to bad news is increased loss aversion. Investors who get aggregated feedback receive such news much less often and are likely to be less risk averse and to end up richer. You are also less prone to useless churning of your portfolio if you don’t know how every stock in it is doing every day (or every week or even every month). A commitment not to change ones position for several periods (the equivalent of locking in an investment) improves financial performance.”

So you see, you don’t have to suffer undesirable consequences of being boiled as a frog and you can use the metaphor to achieve desirable consequences of boiling other frogs.

But that’s not the end of the boiling frog story. There’s more. One big objection I have is that the boiling frog metaphor is used either to describe the absence of something undesirable being noticed by the one being boiled or used a tool to manipulate others. We have left out one very important application of the boiling frog syndrome. In fact, the negative connotation associated with the syndrome needs to change. You see, you can use the boiling frog syndrome to manipulate yourself. You can, and should become a boiling frog. Let me explain that with a couple of examples.

Take a look at this book.

This is a great book. 15 months years ago I was obese and unable to walk even one flight of stairs without losing my breath. Then I discovered this book and started using its techniques to start running. The book uses many techniques, of which one the major ones is boiling frog syndrome. You start with running just a few meters. The next day you a run a bit more then a bit more. In a few weeks, I was running 5 kilometres. In a few more, 10 km and before long i was running half marathons.

During this period, I also made changes in what I ate. My dieting and my running, both involved my treating myself like a boiling frog – small incremental changes. They went unnoticed at first, until people started noticing.

You see, all learning in that sense involves deliberate practice which occurs in tiny increments. Every day you add a bit to your knowledge and after many years of doing it right, you become an expert.

There’s another book I love on this subject.

I used this book, along with the book on marathon running to change my health and my shape. This book also teaches you how to become a boiling frog to achieve behaviour change that’s slow, goes unnoticed, and becomes permanent. The author quotes Lao Tzu

“A journey of a thousand miles must begin with the first step.”

“When you improve a little each day, eventually big things occur. When you improve conditioning a little each day; eventually you have a big improvement in conditioning. Not tomorrow, not the next day; but eventually a big gain is made. Don’t look for the big, quick improvement. Seek the small improvement one day at a time. That’s the only way it happens-and when it happens, it lasts.” -John Wooden, one of the most successful coaches in the history of college basketball

All changes, even positive ones, are scary. Attempts to reach goals through radical or revolutionary means often fail because they heighten fear. But the small steps of kaizen disarm the brain’s fear response, stimulating rational thought and creative play.

The class is now coming to an end and I, Umbridge the frog am feeling quite kicked about the whole thing!  Can’t wait to hop back to my puddle and boast to cousin Kermit about just how far we frogs have come.  We are now role models for humans to become better and better over time.

And that’s not too bad now is it?

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Story@BFBV: Watch Your Language!

What do you really mean when you say you are 90% sure about something? Are you really sure about what it means to be 90% sure? Probably not, according to several studies which show people are consistently overconfident about their beliefs, pretty much like the cat in the picture below:


One trick that makes it easier to visualize what a confidence level of 90% really means requires converting that confidence into a bet involving money. Here’s how.

Let’s say you are 90% sure that the stock market will close higher in 2010 than it did in 2009. If that is really the case i.e. if you are really 90% sure about your prediction, then you should be willing to win $1 in a bet but accept a loss of $9 if you lose. Why?

We already know that either you are right or you are wrong about your prediction. In fact, you are going to be right 90% of the time according to you. Thats what being 90% sure means. If that turns out to be the case, then the expected value of your winning is 90% of $1. That comes to +$0.90

You are going to be wrong 10% of the time according to you. That’s what being 90% sure means – that you will have an error rate of only 10%. If that turns out to be the case, then the expected value of your loss is 10% of $9. That comes to -$0.90.

Therefore, if you are 90% confident that the market will close higher in 2010 than in 2009, then this is a fair bet because it involves an equal exchange.

Put in those words, you may balk at the prospect of losing $9 versus winning only $1. But that is exactly what 90% confidence level means.

When your beliefs are framed in the form of money bets instead of confidence levels, you have a better chance of understanding the odds implied by your beliefs. Keep that in mind when you express confidence in your predictive abilities.

Watch your language!

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Story@BFBV: The 12 Angry Men Story

The jury system has been designed to be a great system of decision making.

So what happens in a jury system? Watch 12 Angry Men. Its a great movie to observe psychological models at work.

12 not so angry men (or women) who are honorable and have no connection with the case are required to sit in a room and listen. They are not allowed to talk – the talking is done by the lawyers and the witnesses and the judge. The jury members are required to keep them minds open and their mouths shut and hear the proceedings of the case including the arguments brought forward by both sides. They are required to NOT DECIDE AT THIS POINT. No jumping to conclusions allowed. No first conclusion bias here. No confirmation bias either.

Then they are asked to go sit in a room and NOT COME OUT until they have a UNANIMOUS (or majority in some countries) decision. To arrive at the decision, they need to debate, discuss, look at different points of view, and only AFTER this has been done are they required to DECIDE.

This is a WONDERFUL system of decision making because it forces objectivity, removes first conclusion bias, and confirmation bias – IF IT WORKS. In reality, psychologically astute lawyers will use all the tricks in the trade to manipulate jury members – but at least in theory the jury system is a fabulous system – and strongly advice you to adopt it in your own decision making process.

Remember this: The decision to not decide now on a matter is also a decision. There is wisdom in the Chinese proverb: “My indecision is final.”

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Story@BFBV: The Scott Fitzgerald Story

Fitzgerald was right. Almost always there is a reason to not to do something that you have decided to do.

People hate contradictions. They make you uncomfortable. You own a stock which is ridiculously cheap. The market, however, is not cheap. What should you do? Do you ignore the market or do you focus on the market and ignore the opportunity? Is there a way out of this contradiction?

Ben Franklin created a way to deal with contradictions. He called it Prudential Algebra. He described it in a letter he wrote to a friend in 1772:

“My way is, to divide half a sheet of paper by a line into two columns, writing over the one pro, and over the other con. Then during three or four days of consideration I put down under the different heads short hints of the different motives that at different times occur to me for or against the measure. When I have thus got them all together in one view, I endeavour to estimate their respective weights; and where I find two, one on each side, that seem equal, I strike them both out: If I find a reason pro equal to some two reasons con, I strike out the three. If I judge some two reasons con equal to some three reasons pro, I strike out the five; and thus proceeding I find at length where the balance lies; and if after a day or two of farther consideration nothing new that is of importance occurs on either side, I come to a determination accordingly. And though the weight of reasons cannot be taken with the precision of algebraic quantities, yet when each is thus considered separately and comparatively, and the whole lies before me, I think I can judge better, and am less likely to make a rash step; and in fact I have found great advantage from
this kind of equation, in what may be called Moral or Prudential Algebra. Wishing sincerely that you may determine for the best, I am ever, my dear Friend, Yours most affectionately – Ben Franklin”

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Story@BFBV: The Swan Story

You can never really prove the proposition that “all swans are white” even if you spot a million of them and all of them turn out to be white. But you can certainly disprove the proposition that “all swans are white” by sighting a single black swan. Nassim Taleb’s explains Karl Popper’s powerful idea of falsification in his book, “The Black Swan.”

Evidence that confirms your exiting beliefs is not as powerful as evidence that disconfirms those beliefs.

Great scientists like Richard Feynman agree. He once said, “If you’re doing an experiment, you should report everything that you think might make it invalid — not only what you think is right about it. Details that could throw doubt on your interpretation must be given, if you know them. The exception tests the rule. Or, put another way, the exception proves that the rule is wrong. That is the principle of science. If there is an exception to any rule, and if it can be proved by observation, that rule is wrong.”

Learn to recognize and respect disconfirming evidence if you want to make good judgements. Most people do just the opposite. They seek out evidence that proves them right and ignore or discard evidence that proves them wrong.

Don’t fall in love with your ideas.

 

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Story@BFBV: “I Have Too Much Invested in This” Story

If you have spent a month researching an idea, it does not become more attractive than a no-brainer flash you get which you are in the shower. The attractiveness of a stock comes from the difference between its intrinsic value and its market price, and the probability of the two converging. It does not come from the effort you have put into researching it.

Remember the experience you acquire by spending a month researching an idea which turns out to be not so good an idea after all counts towards the 10,000 hours of of experience you need to have to qualify as an expert.

Great scientists know the importance of this principle. Thomas Edison once said, “I have not failed. I’ve just found 10,000 ways that won’t work.”

Likewise, past actions don’t become worth continuing simply because you have too much invested into them. Many a bad marriage is continued because of this fallacy.

You are going to make mistakes. Recognize them, correct them, and move on. Don’t perpetuate your errors by rationalizing that “I have too much invested into this, and I can’t just write it off and start again.

Sunk costs (financial and emotional) are irrelevant for future decisions.

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Story@BFBV: The Story of the Three-Legged Stool

I love this story of Cialdini’s Three Legged Stool. The stool is stable because it has three legs. Take one away and it will fall. However, this magical stool does not fall because when one leg is taken away, another one grows to replace it.

The human mind pretty much works like the three-legged-stool. You do something for a reason, and then more reasons are created in your mind to justify your decisions. And when the original reason for doing that thing is taken away, new reasons are invented to allow you to continue with the decision. You are never wrong this way because there are always enough reasons to maintain your prior beliefs.

Take an example. You buy a stock because you think its prospects are good. Then you learn that the company’s earning power will be hurting for the several years in the future. In the meantime, the stock has fallen 20% from your cost. You mind will now invent new reasons to hold on to the stock. You will start thinking that this is just a temporary adversity, or the drop in price has made it even a better bargain so you should buy more, or you have new cash coming in which you can invest in new opportunities so no point liquidating this position, or the company is developing a new product line and that will surely result in resumption of profit growth, or the company has become an attractive acquisition target and will surely be acquired at a large premium to the prevailing price, or blah blah blah – you get the point I think.

Is your mind the functional equivalent of the three-legged stool magically growing legs to allow you to be consistent with you past dumb calls?

 

 

 

 

 

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Story@BFBV: The Swallow and Other Birds Story

It happened that a Countryman was sowing some hemp seeds in a field where a Swallow and some other birds were hopping about picking up their food. “Beware of that man,” quoth the Swallow. “Why, what is he doing?” said the others. “That is hemp seed he is sowing; be careful to pick up every one of the seeds, or else you will repent it.” The birds paid no heed to the Swallow’s words, and by and by the hemp grew up and was made into cord, and of the cords nets were made, and many a bird that had despised the Swallow’s advice was caught in nets made out of that very hemp. “What did I tell you?” said the Swallow.

Destroy the seed of evil, or it will grow up to your ruin.

Aesop’s story, which you possibly read as a child, is wise. There is a very wise man by the name of Lee Kuan Yew – the founder of Singapore. Mr Charlie Munger is a big fan of Mr. Lee. He encourages you to read his story in “From Third World to First: The Singapore Story: 1965-2000” Mr Lee followed the wise advice of the Swallow in this story. According to Mr. Munger, “Lee didn’t want people dying of Malaria so he drained all the swamps and didn’t care if a little fish went extinct. He didn’t like the drug problem and he looked around the world to solve the drug problem. He found the solution in US by copying the US Military’s policy. Any time you can be tested and if you fail you go to jail. If something was going to grow like cancer he would check it hard with the wrath of God. He turned a country with no resources or agriculture into a prosperous country.”

It’s very important to think about virtue and vice effects. Once something evil begins it spreads due to a combination of several psychological tendencies we have been talking about in BFBV. And then it gets rationalized. Its easy to be evil when everyone around you is also doing evil things. Which is why once evil is spotted, it must be nipped in the bud. Great leaders like Lee know and follow the advice of Swallow. It does not matter if some people are inconvenienced or treated unfairly. Great leaders think of the problem from the viewpoint of not individuals, but from the viewpoint of their civilization.

Read this book:

http://www.amazon.com/Third-World-First-Singapore-1965-2000/dp/0060197765

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