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Lecture 01c PDF
Lecture 01c PDF
guide. The spiritual teacher must know every inch of the way, every danger and pitfall, and
not from books or maps or hearsay. He must have traveled it himself, from the foothills
to the highest peaks. And he must have managed to get back down again, to be able to
relate to students with humanity and compassion.” — Eknath Easwaran, The Upanishads
We learn...
— William Glasser
“True philosophy doesn’t involve
exotic rituals, mysterious liturgy,
or quaint beliefs. Nor is it just
abstract theorizing and analysis.
It is, of course, the love of
wisdom. It is the art of living a
good life.”
“Philosophy is intended for
everyone, and it is authentically
practiced only by those who
wed it with action in the world
toward a better life for all.
Philosophy’s purpose is to
illuminate the ways our soul has
been infected by unsound beliefs,
untrained tumultuous desires,
and dubious life choices and
preferences that are unworthy
of us.”
The Hedonic Treadmill
The hedonic treadmill, also known as hedonic
adaptation, is the observed tendency of humans to
quickly return to a relatively stable level of happiness
despite major positive or negative events or life changes.
According to this theory, as a person makes more
money, expectations and desires rise in tandem, which
results in no permanent gain in happiness.
Scene From Wall Street — Money Never Sleeps
https://www.youtube.com/watch?v=8VsZr5KGNGM
THIS SLIDE INTENTIONALLY DELETED
https://www.youtube.com/watch?v=qFOMLzPt_4E
https://www.linkedin.com/feed/update/urn:li:activity:
6305385426773385216/
Years ago, I cold-called a candidate about a new opportunity. It was a big step up from his current role, and he had all the right skills and qualifications.
I pressed him on it until he said something that really confused me. He told me that he "already made it to the top".
I was familiar with his current company and looked at his resume again.
He wasn't anywhere near the top. He would have needed a telescope to see the top. He wasn't even a manager yet.
He explained to me that "making it to the top" for him meant he loved the exact work he did each day, he loved his company, he was treated fairly and with respect, he made enough money to be comfortable, he had excellent benefits, he had flexibility, and most importantly to
him, he's never missed a single Little League game, dance recital, parent-teacher conference, anniversary, birthday, or any family event.
He knew what taking the next step in his career meant. More time, travel, and sacrifice. "Not worth it," he said.
Your definition of "making it to the top" doesn't have to be society's or anyone else's definition.
Frugality
“What maintains one vice, would bring up two children.You
may think perhaps that a little tea, or a little punch now
and then, diet a little more costly, clothes a little finer, and a
little entertainment now and then, can be no great Matter;
but remember what Poor Richard says, many a little makes
a mickle, and farther, beware of little expenses; a small leak
will sink a great ship.” — Benjamin Franklin, The Way To
Wealth
You may think, perhaps, that a little tea, or a little punch
now and then, diet a little more costly, clothes a little finer,
and a little more entertainment now and then can be no
great matter but remember what Poor Richard says “Many
a little makes a mickle; beware of little expense for a small
leak will sink a great ship.1” — Benjamin Franklin, Poor
Richard’s Almanac
But what madness must it be to run in debt for these
superfluities! We are offered, by the terms of this when
due, six months’ credit; and that perhaps has induced some
of us to attend it, because we cannot spare the ready
money, and hope now to be fine without it. But, ah, think
what you do when you run in debt; you give to another
power over your liberty. If you cannot pay at the time, you
will be ashamed to see your creditor; you will be in fear
when you speak to him, you will make poor pitiful sneaking
excuses, and by degrees come to lose you veracity, and sink
into base downright lying; for, as Poor Richard says, the
second vice is lying, the first is running in debt. And again to
the same purpose, lying rides upon debt’s back.” —
Benjamin Franklin, The Way To Wealth
“It is easier to suppress the first desire than to satisfy all
that follow it.” — Benjamin Franklin, Poor Richard’s
Almanac
“The Art of getting Riches consists very much in THRIFT.
All Men are not equally qualified for getting Money, but it is
in the Power of everyone alike to practise this Virtue.”
You are the CFO of a textile company which manufactures commodity yarn and operates in an extremely competitive market.
Both industry, and your company, earns sub par return on capital.
A textile machinery manufacturer approaches you with a proposal to sell you a new type of textile machine, which is more efficient than any machine invented till date.
What does DCF teach you?
Accept or reject?
Which
Tool
Did
You
Use?
DCF
Where discipline does DCF belong to?
Corporate Finance
What did he do?
He SHUT
DOWN the
Textile
Operation!
WTF?
How did he solve the problem? Let’s read his own words. And as I read the words, focus a bit on the highlighted text.
“The domestic textile industry operates
in a commodity business, competing in a
world market in which substantial excess
capacity exists.
“Much of the trouble we experienced was
attributable, both directly and indirectly,
to competition from foreign countries
whose workers are paid a small fraction
of the U.S. minimum wage...
But what about cost accountants and their idea of “shut down point?”
What’s the problem with people who only use DCF or
Cost Accounting concepts like “shut down point?
To a Man with a Hammer, Everything Looks Like a Nail
“[Buffett] knew that the huge
productivity increases that would
come from a better machine
introduced into the production of a
commodity product...
“would all go to the benefit of the
buyers of the textiles. Nothing was
going to [come to us] as owners...
“That’s such an obvious concept
– that there are all kinds of
wonderful new inventions that
give you nothing as owners...
“except the opportunity to
spend a lot more money in a
business that’s still going to be
lousy...
“The money still won’t come to
you. All of the advantages from
great improvements are going to
flow through to the customers…
“Conversely, if you own the only
newspaper in town and they were to
invent more efficient ways of composing
the newspaper...
“then when you got rid of the old
technology and got new, fancy
computers, then all of the savings would
come right through to the bottom line...
“In all cases, the people who sell the
machinery – and even the internal
bureaucrats urging you to buy the
equipment...
“show you
projections with
the amount you’ll
save at current
prices with the
new technology...
“However, they don’t do
the second step of the
analysis – which is to
determine how much is
going to stay home and
how much is just going to
flow through to the
customer…
“I’ve never seen a
single projection
incorporating that
second step in my
life. And I see them
all the time...
“Rather, they always
read: “This capital
outlay will save you
so much money
that it will pay for
itself in three
years…”
payback period
“So you keep buying things that will pay
for themselves in three years…
“And after twenty years of doing it,
somehow you’ve earned a return of only
about four percent per annum. That’s the
textile business...
“And it isn’t that the machines weren’t
better. It’s just that the savings didn’t go
to you...
“The cost reductions came through all
right. But the benefit of the cost
reductions didn’t go to the guy who
bought the equipment...
“It’s such a simple idea. It’s so basic. And
yet it’s so often forgotten.”
How
did he
decide?
Buffett doesn’t suffer from
He used several
“man with a hammer”
“tools”
syndrome
“All the wisdom in the
world is not to be found in
one little academic
department.
That would be a disastrous
way to think and operate.”
Competition [Microeconomics]
“Viewed collectively, the decisions neutralized each other
and were irrational (just as happens when each person
watching a parade decides he can see a little better if he
stands on tiptoes)...
http://en.wikipedia.org/wiki/Prisoner's_dilemma
“In a business selling a
commodity-type product, it's
impossible to be a lot smarter
than your dumbest
competitor.”
1 2 3 4 5 6
He compared his prospective investment for efficiency improvement in textile with those in newspaper and candy.
And the IRRs were LOWER in Candy and Newspaper. But he was going to RETAIN ALL OF THE BENEFIT of the investment in candy and newspaper and none of it in textiles.
1 2 3 4 5 6
Did not fall for the “throwing good money after bad” trap even though the money to be spent was small in comparison with money already spent.
1 2 3 4 5 6
Sunk costs are irrelevant. He did not think “Oh I have already invested so much. Now I can’t write it off.”
Buffett used a
framework of
mental models
from multiple
disciplines
Mental Models
Competition [Microeconomics]
Prisoner’s Dilemma [Game Theory]
Return on Capital [Accounting]
Opportunity Cost [Microeconomics]
Contrast Effect [Psychology]
Commitment & Consistency [Psychology]
A mental model is
a representation
inside your head of
an external reality
You observe something and then you try to relate to it a model inside your head.
Learn from history and other disciplines and make wise connections. When you
later see something, ask, “Have I seen this before or has this happened before and
what happened then?”
“What normally happens in such situations? Why should this be any different?”
http://www.thebrain.com
My latticework of mental models
“There are a relatively small number of disciplines and a relatively small number of truly big ideas. And it’s a lot of fun to figure it out. Plus, if you figure it out and do the outlining yourself, the
ideas will stick better than if you memorize ‘em using somebody else’s cram list.” - CM
About 20 models
from psychology
will become
behavioral finance
Why do you need a
checklist?
Because the human
mind is like the
human egg
As soon as a sperm enters the egg, there’s an automatic shut-off device that bars other sperms from getting in.
Mind jumps to
conclusions: First
conclusion bias
The Monkey Mind
https://www.youtube.com/watch?v=OX0OARBqBp0
“If you go around figuring out what doesn’t work and then avoid it and you also learn to handle sorrow that you cannot avoid
- well that’s pretty good encapsulated wisdom.”
THE DEADLY CONSEQUENCES OF RISK SEEKING BEHAVIOR
Sanjay Bakshi, 23 Jan 2015, Mumbai
On 27 October 2011, two stuntmen were shooting a scene for a movie called The Expendables 2 starring Sylvester Stallone, Arnold Schwarzenegger and Bruce Willis. One of the scenes involved throwing a live grenade in water to create an
explosion.
Stuntmen and documentary makers aren’t the only ones who display risk seeking or risk blind behavior. As a collector of human folly, let me share a few examples with you.
The fellow on the motorcycle forgot Newton’s third law.
And here are two examples that many of you will relate to.
What are the eventual consequences of risk seeking behavior? One of the principles of probability — something that all of us studied in school — is that the probability of occurrence of a rare event, if you increase the number of trials tends
to become 1. If you keep jumping out of planes with parachutes which fail to open just 1% of the time, you will eventually get killed.
Or if you do something unethical and get away with it most of the time, you will eventually get caught. And then you lose money, relationships, reputation. You will lose everything.
“If you want to get smart,
the question you’ve got to
ask is why? why? why? And
you relate the answers to a
structure of deep
theory.” [Mental Models]
To acquire general wisdom, you also need:
3.Full attribution ethos; and
4.Extreme reductionism (like in algebra)
to understand lollapalooza outcomes
e.g. 2x + 6y = 12 can be reduced to
x + 3y = 6.
If you don’t attribute the models you are using to the discipline you are grabbing them from, you get a sloppy filing system in your brain.
Lollapaloooza = 1+1 = 3 e.g like in a chain reaction - critical mass - a model from physics.
Is not an offer for sale in an overpriced IPO the “functional equivalent” of a zero-sum game?
A stock buyback at a bargain price
Is not a stock buyback at a bargain price the “functional equivalent” of a zero-sum game?
Day trading
Are not day traders, in aggregate, the “functional equivalent” of a group playing a zero-sum game?
EXAMPLE
Economic “law”: “If you want to sell more, you
have to reduce the price.” Provide two
exceptions.
Exception # 1: Luxury goods
Pavlovian Association: [Psychology]
Exception # 2: Raise price, use extra
money to bribe the intermediaries
Incentives: [Economics]
Incentive-caused bias (“whose bread I
eat, his song I sing”): [Psychology]
e.g. penny stocks, IPOs, cocaine, time
shares, overpriced-insurance, ANY
product or service with a FAT
commission behind it
The FUNCTIONAL EQUIVALENTS of Boiler Rooms
Application of CIALDINI
EXAMPLE
Feedback Loops
[Engineering]
Positive feedback:
Negative feedback: Nuclear Chain
Bathroom Gyeser reaction
Negative feedback loops: from physiology- Body temperature, blood clotting, digestive system- SELF CORRECTING
Functional Equivalents?
Positive - Spiral, runaway, vicious circle - business success - e.g. wall mart
Business Cycles- Negative Feedback
Business cycles - booms follow busts follow booms - Feedback loop, power of incentives (psychology), envy (psychology),
overoptimism (psychology), prisoners’ dilemma (game theory), Tobin’s Q (microeconomics).
Bank Runs (Positive Feedback)
Low prices and high
volumes feed on
each other
Dominant
newspaper
(Circulation and
advertising feed on
each other)
Positive Feedback
Business Cycles- Negative Feedback
Business cycles - booms follow busts follow booms - Feedback loop, power of incentives (psychology), envy (psychology),
overoptimism (psychology), prisoners’ dilemma (game theory), Tobin’s Q (microeconomics).
Bank Runs (Positive Feedbacks)
Bank runs
Email sent to my colleagues last night
Leverage in positive feedback loops
EXAMPLE
Regression to the Mean”
[Statistics]
Powerful model
applicable in a “bell
curve” world.
Coin flipping example
Mean as an attractor
Stock prices and Stock
returns
“Bull markets and Bear
markets can obscure
mathematical laws,
they cannot repeal
them.” – Buffett
Notice Buffett’s
extreme reductionism?
“In the short run
the market is a
voting machine, but
in the long run its a
weighing machine.”
- Ben Graham
“Many shall be restored that are
now fallen and many shall fall that
are now in honor” - Ben Graham
Quoting Horace
EXAMPLE
The Red Queen Effect
In Lewis Carroll’s “Through the Looking Glass,” the Red Queen seizes Alice by the hand and draggs her, faster and faster, on a frenzied run through the
countryside, but no matter how fast they run they always stay in the same place. Alice is understandably puzzled, and says, “Well in our country you'd
generally get to somewhere else - if you ran very fast for a long time as we've been doing.” “A slow sort of country!” Says the Queen. “Now, here, you see,
it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”
From Deep Simplicity:
“Kauffman is particularly fond of describing this in terms of an imaginary species of frog that feeds on an imaginary species of fly, and we will follow his example. There are lots of ways
in which the frogs, who want to eat flies, and the flies, who want to avoid being eaten, interact. Frogs might evolve longer tongues, for fly-catching purposes; flies might evolve faster
flight, to escape. Flies might evolve an unpleasant taste, or even excrete poisons that damage the frogs, and so on. We’ll pick one (hypothetical) possibility. If a frog has a particularly
sticky tongue, it will find it easier to catch flies. But if flies have particularly slippery bodies, they will find it easier to escape, even if the tongue touches them. Imagine a stable situation
in which a certain number of frogs live on a pond and eat a certain proportion of the flies around them each year…”
“...Because of a mutation (or even just through the natural variations between individuals) a frog developes an extra sticky tongue. It will do well, compared with other frogs, and genes
for extra sticky tongues will spread through the frog population. At first, a larger proportion of flies gets eaten. But the ones who don’t get eaten will be the more slippery ones, so
genes for extra slipperiness will spread through the fly population. After a while, there will be the same number of frogs on the pond as before, and the same proportion of flies will be
eaten each year. It looks as if nothing has changed – but the frogs have got stickier tongues, and the flies have got more slippery bodies.”
“In August 2000, Jerry Mayfield, a forty-one-year-old Louisiana policeman diagnosed with CML, began treatment with Gleevec. Mayfield’s cancer responded briskly at first. The fraction of leukemic cells in his bone
marrow dropped over six months. His blood count normalized and his symptoms improved; he felt rejuvenated—“like a new man [on] a wonderful drug.” But the response was short-lived. In the winter of 2003,
Mayfield’s CML stopped responding. Moshe Talpaz, the oncologist treating Mayfield in Houston, increased the dose of Gleevec, then increased it again, hoping to outpace the leukemia. But by October of that year, there
was no response. Leukemia cells had fully recolonized his bone marrow and blood and invaded his spleen. Mayfield’s cancer had become resistant to targeted therapy.”
… “Even targeted therapy, then, was a cat-and-mouse game. One could direct endless arrows at the Achilles’ heel of cancer, but the disease might simply shift its foot, switching one vulnerability for another. We were
locked in a perpetual battle with a volatile combatant. When CML cells kicked Gleevec away, only a different molecular variant would drive them down, and when they outgrew that drug, then we would need the next-
generation drug. If the vigilance was dropped, even for a moment, then the weight of the battle would shift. In Lewis Carroll’s Through the Looking-Glass, the Red Queen tells Alice that the world keeps shifting so quickly
under her feet that she has to keep running just to keep her position. This is our predicament with cancer: we are forced to keep running merely to keep still.”
Ben Graham’s Frozen Corporation
Frozen Corporation was a metaphorical company whose charter prohibited it from ever paying out anything to its owners or
ever being liquidated or sold.
“The worst business of all is the one that grows a lot, where you’re forced to grow just to stay in the game at all and where
you’re re-investing the capital at a very low rate of return.”
Munger
Identifies
Functional
Equivalents of
Frozen
Corporation
“I think there is a class of business where the eventual “cash back” part of the equation tends to be an illusion. There are
businesses like that – where you just constantly keep-pouring it in and pouring it in, but where no cash ever comes back.”
A Drop of 95%
http://www.youtube.com/watch?v=m6ZKVdKTWww
The PSA commercial on previous slide was persuasive, but was it right? Take a look at this:
YouTube - Sam Peltzman on the Peltzman Effect
http://www.youtube.com/watch?v=7IB2xRfRHOA
The Peltzman effect is a contributing factor in the explanation of Smeed's Law, an empirical observation that traffic fatality rates in many countries are correlated with the number of
vehicle registrations per capita, and differing safety standards do not appear to be significant.
Peletzman effect is a mental model which tells you to not ignore the second or third order effects like the designer of the incentive scheme which rewarded students a $1 for catching a
rat on campus after all other efforts to get rid of the rats failed. Well, pretty soon, the students were breeding rats…
People not only respond to incentives, sometimes one’s well-intentioned decisions result in perverse outcomes. We call that “perverse incentives.” Read more about this from:
http://en.wikipedia.org/wiki/Perverse_incentive
DEMONITIZATION
The key thing in
economics, whenever
someone makes an
assertion to you, is to
always ask, “And then
what?”
That’s what he asked when he was pitched capex in his textile operations…
“We can never
merely do one
thing.” — Garrett
Hardin
Functional Equivalents?
“You can either
control the
price, or the
supply, but not
BOTH!”
http://www.blonnet.com/2004/08/31/stories/2004083100111100.htm
Urea subsidy.