If you’ve seen one financial crisis, you’ve seen one financial crisis

The title of this post is a quote from former Fed governor Kevin Warsh. It’s reminiscent of the line from Tolstoy’s Anna Karenina that says happy families are all alike but every unhappy family is unhappy in its own way.

At the same time, our behavior is highly mimetic. Not only do we base most of our learning on imitation, but we are constantly searching for clues by comparing the current to the historic. I do this myself, literally all the time. 

When I’m looking at potential investments or trying to value stuff, I find myself searching for historical comparisons. When looking at XL Media, I immediately connected it with American Express and the famous Salad Oil Scandal. When I looked at CentralNic, I started drawing comparisons between the domain industry and cable industry in its early days.

Performing these mental model checks and looking for similar histories, is the default setting, in my experience. It seems to happen almost automatically. I need to force myself to not do it. It is in our nature. It’s a survival thing (see, I just looked for a comparable mental model and found evolutionary theory…).  

What’s obvious is obviously priced in…

The title of this post is a quote from a famous bond investor Jeffrey Gundlach. Gundlach is the manager of DoubleLine Capital, a huge bond fund, which has earned him the nickname the Bond King. 

It is clear to me that information that is obvious, should be priced into the market price of a public asset. This is logical. But if you abide by this logic, you should also agree with the statement that everything that is not obvious, is not priced in. 

By this logic, you would also have to assume that, unless every possible event is inherently obvious to market participants, the price of a public security is inevitably always wrong, since it does not account for the obvious. 

In the same vein, being a contrarian is a valuable stance, but only if there is an non-obvious truth that the market isn’t accounting for. Successful contrarians, try to approach the world from a different perspective. But they only act on it when they feel they have discovered an under appreciated possibility. 

The key is that thinking contrarian is a process, being contrarian is an action. You don’t always think contrarian, but only sometimes be contrarian.

The Efficient Market Paradox

Two economists are walking down a street, discussing the Efficient Market Hypothesis, when one of them suddenly stops in his tracks. He points to the street and says “look, there’s a $10 bill!”

The other economist looks at him with a mixture of amazement and disgust as he replies in a reprimanding tone: “Obviously, if there was a $10 bill there, someone would have already picked it up.”

What this joke illustrates is the inherent paradox of the Efficient Market Hypothesis. For markets to be efficient, they are active participants. For participants to be active in a market, there needs to be an arbitrage. In a perfectly efficient market, the arbitrage is competent away by the activity of the participants. 

The Markets are Mostly Efficient

No market is perfectly efficient. New information is constantly entering the collective perception of the market. Once information becomes obvious, it will obviously be priced in, when markets are efficient. 

WIth the internet and other technological advancement in data gathering, analytics and distribution, markets have undoubtedly become more efficient. In the early value investing days of Warren Buffett, he would read through Standard and Poor’s manuals, making mental calculations of stock’s intrinsic valuation. Nowadays, this information is readily available and calculated, practically in real time. 

In a podcast interview on the Invest with the Best Podcast, Michael Mauboussin, presented a fascinating statistic:  

I think that one of my other favorite statistics in the paper is that in 1976, there were less than 1 CFA charter holder, for every public company in the United States, and today there are 27 CFA charter holders for every public company in the United States. So a lot more eyeballs on the companies that are out there. And maybe there is clearly more dispersion in smaller midcap companies. But look, the world is just a super dynamic place. You see these value changes are quite dramatic. You think about 2020 and hardly anybody had any idea what was going to go on. It was really hard.

Degrees of Market Efficiency

It goes without saying that there are different degrees of efficiency. When you invest in big S&P 500 stocks such as Apple, Amazon or Netflix, you should be aware that there are hundreds of analysts that cover those stocks. You have to ask yourself what kind of an edge you have over those market participants. 

At the same time, there are plenty of markets and asset classes that are less efficient. There are many publicly traded stocks that don’t have a single analyst covering them. Outside of the stock markets there are all sorts of asset classes and markets where an individual can develop expertise and investment edge. Internet domains, for example, is an asset class that has a very vibrant secondary market and dedicated investors. 

There are plenty of $10 bills out there, waiting to be picked up.

The Net Benefits of Gaming

Is the video game industry a net benefit or a cost to society? Does it do more harm than good? If you were to perform a cost-benefit analysis of the video game industry you would go about trying to quantify the economic benefits (job creation, research and development, etc) against the societal costs (addition, power consumption, etc).

From a qualitative perspective, I would image that the effect of the video game industry on societies would be somewhat similar to wars. Wars have a huge cost to society. They take up huge resources both in terms of labor and capital but more importantly is the destruction of human lives and the irreparable damage it can leave on its participants.

Wolfenstein 3D" Graphics Compared to "Wolfenstein: The New Order ...
Castle Wolfenstein (1981) vs Wolfenstein: New Order (2019)

At the same time, wars have been known to accelerate the advancement of certain technologies and scientific discovery. Often, these advancements will have applications far beyond than just some wartime utility.

In the same vain, there are undoubtedly victims of the video gaming industry. Games are hyper-optimized to reward the user of playing and video game addiction is well recorded academically. Countless hours are spent daily on video games, that could otherwise have been deployed to more productive uses.

Yet, the video game industry is also a hotbed for technological advancement. There are countless examples of technologies that were originally developed for the gaming industry, which subsequently found application elsewhere. Slack – a public company with a $16 billion market capitalization as I write this – was originally developed as an internal chap application for a gaming company.


Cost-Benefit Analysis of the South Korean Digital Game Industry

In this cost-benefit analysis of the South Korean Gaming Industry, the researchers attempted to estimate the economic costs and benefits of the digital game industry. Addiction to digital games induces economic costs such as increase in crime, facilities investments for curbing addiction, increase in counselling costs and other welfare losses. The digital game industry in South Korea which is known to have one of the highest rates of game addiction.

The annual cost of game addiction is estimated to be approximately $3.5B while the annual benefit is approximately $24.3B ($3.7B for addicted user market). The proportion of the total costs to total benefits from the game industry is an alarming 14% (95% for addicted user market).


What is Inflation Anyway?

I feel like we have made inflation deceptively simple. We have this exact number for it. The Bureau of Statistics will declare something like “last month, the inflation was 2.46%, annually adjusted.” It will do so with an number that is so precise that at will have at least two decimals, implying the surgical accuracy employed to get to that particular number.

We don’t seem to ask ourselves how we come up with these number, do we?

Do We Even Know What Inflation Is?

The great Milton Friedman did not have even a shadow of a doubt: “Inflation is always and everywhere a monetary phenomenon.” Well, here is what the equally great Robert Solow said about Milton Friedman: “Another difference between Milton [Friedman] and myself is that everything reminds Milton of the money supply. Well, everything reminds me of sex, but I keep it out of my papers.”

In Japan they have been expanding the money supply for decades. They can’t seem to produce inflation, no matter how hard they try. If we ask the European Central Bank what inflation is, they say something like “inflation occurs when there is a general rise in prices.” (They will also ask if you have seen the inflation monster and offer you to watch a cartoon about price stability).

If inflation is just general rise in prices, then why do prices rise or fall? Most would say, because changes in supply and demand. Don’t prices of products and services tend to drop over time? How do we even measure this?

How to Measure Inflation?

This seams to me an exceptionally tricky undertaking. If inflation is supposed to measure changes in the price of the stuff we buy over a period of time, what happens when we start buying different stuff over time? Our behaviors and preferences are constantly changing? Imagine a lab scientist that has to test his experiment on rats one day and then repeat the experiments with hamsters.

Do you see the problem here? The stuff we buy is not constant. Take mobile phones for example. How can you realistically measure the inflation in mobile phones from one year to another? Or even, how do you compare the price inflation of mobile phones to a period 20 years ago, when there were no mobile phones?

What about all the stuff we don’t pay for yet derive some benefit from? How do you factor in the change in cost of consuming Google searches into any inflation measurement? Should you measure the increase and decrease in paid ads displayed with organic searches? 

And there there are substitute products. If pork rises in value, relative to beef, you might be inclined to consume more beef and less pork. But the baskets of goods and services will take that into account.

So next time, when you see an inflation number with a couple of decimal points. Ask yourself how it was measured and how accurate that measurement could be.

How to Value Your Job

The worst career advice that you get from people is when they say stuff like “you need to take control of your career, you need make sure you get what is coming to you, no one is going to care about you the way you do, so you need to make sure you fight for all of this stuff”, etc, etc. Those are all terrible advises. 

Your job, whatever your job is, is to add value to your employer. It is not your job to try to extract value from your employer and try to get as much of it into your pocket. Rather, your job is to add as much value as you can for the employer and then you can capture some of that value. 

Contrary to what most people think, being underpaid is a very powerful position to be in. Because, if you are adding more value than you are costing then it means also means that you are a very valuable employee. And if your employer is rational, you are going to be treated well.

Nobody has ever gotten fired for creating too much value for their employer. And nobody keeps a job very long if they are getting paid more than they are worth. 

This text was adapted from a podcast interview with legendary investor Bill Miller on Master in Business. The whole podcast is well worth the listen

Universal Basic Income and Inflation

Imagine if the government would decide that everybody would receive a monthly check of $4,000 as a Universal Basic Income. Now imagine that you are in need of a good plumber. How much do you think the plumber will charge:

  • Less than before UBI.
  • Same as before UBI.
  • More than before UBI.

If you think that the plumber will charge less than he did before UBI, you are probably overestimating the compassionate nature of plumbers. If you think a plumber would charge the same as before, you are assuming that plumber will disregard the effect of extra monthly $4,000 to their life.

My assumption would be that most plumbers are not plumbers of passion. Rather, they entered into plumbing because it paid well. The reason it pays well is because nobody aspires to be a plumber. But there is a price where the occupation of plumbing attracts enough of people to satisfy the need for plumbing.

My guess would be that many people would of alternative uses of their times when presented with Universal Basic Income. But the jobs aspire to leave behind would still need be done…just at another price.

The Joys of Compounding

On January 18, in 1963, a 32 year old Warren Buffett sent his annual letter to the limited partners of the Buffett Partnerships. The compound annul return for the limited partners that had been there from the start, five years ago, the return was 21.1%. The cumulative return for limited partners over the five years was 215.1%.

Gross of the management fees that he took as the general partner, Warren Buffett had compounded capital at 26% per year. In the letter, Buffett wanted to better educate his partners of the powers of compounding. In a section that he called “The Joy of Compounding”, he writes the following:

I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter’s rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that’s $2 trillion for those of you who are not government statisticians) by 1962. Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living a long time, or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point.

The following table indicates the compounded value of $100,000 at 5%, 10% and 15% for 10, 20 and 30 years. It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.

– Warren Buffett, 1963 Letter to Partners

Here’s the accompanying table:

Compounded Value of $100,000 at different rates and durations
Compounded Value of $100,000 at different rates and durations

All of Warren Buffett’s annual letters to partners are a treasure trove for any aspiring investor. You can find a compendium of the Buffett Partnership Letters over at CSInvesting.org.

Repugnant Markets | Alvin Roth on Trading Kidneys

A repugnant transaction is an economic term that describes an exchange between people that is generally perceived as morally or ethically wrong. These transactions fall outside of regular market mechanisms, hence the term repugnant markets. The repugnant nature of these transactions, cause these markets to be structurally inefficient. 

Examples of Repugnant Markets

  • Organ transplants
  • Child surrogacy 
  • Prostitution 
  • Recreational drugs

Whether a market is considered socially repugnant in not a binary definition. At the same time, what people consider to be a repugnant transaction can change over time and across cultures. Some transactions that are considered repugnant, are also illegal. Some are not.

Matching Markets

When you think about markets, the first examples that come to mind will be something like stock exchanges, farmers markets or auctions. In all these examples, the transaction is impersonal. If you want to buy a stock on the New Youk Stock Exchange, you simply need to place an order through a stockbroker. In fact, anybody can place a bid. 

Many markets are, however, personal. These markets are called matching markets. In order for a transaction to take place, a buyer and a seller need to be matched. A good example of this is the labour market. If you are in the labour market, you can’t simply choose a job. You need to match with an employer who is looking for someone who matches your skillset. 

Repugnant Transactions

In a matching market, price is not the only mechanism. For a matching market to be repugnant, it means that other people feel that it should not be allowed to engage in the desired transaction. 

Alvin Ross, the economist who coined the phrase, formulated the concept of repugnant transactions when studying kidney transplants. It is against the law almost anywhere in the world, to buy and sell kidneys for transplantation. Yet there is a black market for kidneys, which means that there are instances where individuals are willing to transact in kidneys, while people, in general, feel that it is immoral to do so. 

Alvin Roth on Repugnant Markets and Forbidden Transactions

In the following lecture, Nobel laureate Alvin E. Roth will investigate the nature of and reasons for repugnance with its implications for the design of markets. Why is it forbidden to sell and buy organs? Why is the exchange of kidneys that leads to many successful transplants allowed in some countries such as the US, but not in others like Germany? Which markets or transactions we allow, affects the choices that people have?

Watch the lecture and learn more:

Also on How to Value Stuff

10 Ways to Profit by being Less Logical than Anybody Else

Here at How to Value Stuff, we are all great admirers of Rory Sutherland. Rory is the head Ogilvy Advertising – founded by David Ogilvy, another man we greatly admire. David wrote a legendary book on marketing and sales, called Ogilvy on Advertising – and one of the most influential advertising professionals in the world today.

Rory has a fascinating view of how we perceive the value of the products and services we enjoy. In 2019, Rory published a book called Alchemy: The Surprising Power of Ideas That Don’t Make Sense, which was a follow up on a book he published the year before, Alchemy: The Dark Art and Curious Science of Creating Magic in Brands, Business, and Life.

Here are 10 rules you can adopt which will help you profit by being less logical than everybody else:

1. The Opposite of a Good Idea can be another Good Idea

Nobody can blame you for getting at a single right answer regardless of the materials you used to get there. Conventional logic uses the idea of a single right answer. This is mostly needed where your job is in the line and you need to make everything right.

When it comes to driving at a single right answer, no subjectivity is involved in decision making and what you decide is what you deem right.

2. Don’t Design for Average

Solving a problem with an average person in mind is very difficult. Some models in conventional logic require you to solve a problem for people in aggregate. This can make problems very difficult to solve.

Do not limit yourself to the average person and focus on the fringes. That way, it is easy to find things that will be adopted by extreme consumers.  They can then be ploughed back in the mainstream.

3. It Doesn’t Pay to be Logical if Everybody Else is being Logical

Being logical in business will get you to the same place just like everybody else. In business strategy, it does not pay to be logical because being logical will get you to the same place where your competitors are going. In business, you need to be differentiating yourself away from your competitors.

Find out what your competitors are logically wrong about. If you find out what is wrong with their model, you are in a position to exploit it. Adopt contrarian thinking.

4. Our Attention affects Our Experience

The nature of our attention affects the nature of our experience. Quality is relative. The perception of quality is determined by the difference between expectations and experience. It is more difficult to change how a person experiences something than the expectation of that experience.

Rory gives an example of one of the best hotels he has stayed in. The hotel had previously been a prison or a police station. Everything from the bed and bathroom to the TV and wall hangings was very spartan nature.

Under most circumstances, you normally would have experienced this as a lack of quality. But the hotel was in East Berlin and the experience came across as authentic East Berlin. It fit the circumstances. It met what you would have expected from an authentic East Berlin hotel.

5. If there were a Logical Answer We would have found it Already

If a problem becomes persistent even after discussing it with every person who can relate to it, it means you are giving it a logical explanation. There is a solution somewhere to be found through conventional linear rationality approach.

Exposing everything to logic and the problem persists, it indicates that logic is not the answer to that problem. Gather some courage and test less rational solutions. Context is a marketing superweapon.

6. The problem with Logic is it Kills off Magic

Logic and magic cannot coexist. There is no magic where logic is involved. The rules of logic demand that there can be no magic.

Logic requires that you change your product instead of improving the perception of the product in order to enhance the customer experience. This confines you into doing exclusively objective things because you think that people perceive the world objectively.

7. A Good Guess which stands up to Empirical Observation is still Science

You should not let methodological purity restrict your capability of coming up with multiple solutions. It is good to allow solutions that come in randomly rather than being restricted to explainable solutions. The latter will hold you captive and will monopolize your progress.

8. Test Counterintuitive Things because Nobody Else will

Since you do not want to put your source of livelihood on the line, create a space in your business where you can test things that do not make sense. This will be an advantage to win over your competitor because your experiment will land you in a lucrative business idea that will make you outdo your competitors.

9. Don’t Solve Problems using only Rationality

Solving problems using only rationality is like playing golf using only one club. Using rationality as the only way of solving a problem will get your solution based on a very narrow path.

Solving problems by using only rationality will generate solutions that restrict themselves to a very narrow definition of human motivation and how they think, act and decide.

10. Dare to be Trivial

Sometimes big problems do not require huge intervention. On the contrary, a small thing can have an enormous effect. You do not have to do things in the correct order simply because it is the way they should be done. Small changes, such as alternating the order of options or changing relative scales, can yield an order of magnitude in results.