Category: Decision Making

Preserving Optionality: Preparing for the Unknown

Reading Time: 8 minutes

We’re often advised to excel at one thing. But as the future gets harder to predict, preserving optionality allows us to pivot when the road ahead crumbles.

***

How do we prepare for a world that often changes drastically and rapidly? We can preserve our optionality.

We don’t often get the advice to keep our options open. Instead, we’re told to specialize by investing huge hours in our passion so we can be successful in a niche.

The problem is, it’s bad advice. We live in a world that’s constantly changing, and if we can’t respond effectively to those changes, we become redundant, frustrated, and useless.

Instead of focusing on becoming great at one thing, there is another, counterintuitive strategy that will get us further: preserving optionality. The more options we have, the better suited we are to deal with unpredictability and uncertainty. We can stay calm when others panic because we have choices.

Optionality refers to the act of keeping as many options open as possible. Preserving optionality means avoiding limiting choices or dependencies. It means staying open to opportunities and always having a backup plan.

An option is usually defined as something we have the freedom to choose. That’s a fairly broad definition. In the context of a strategy, it must also have a limited downside and an open-ended upside. Betting in a casino is not an option, for example—the upside is known. Losses and gains are both constrained. What about betting on a new tech startup? That’s an option—the upside is theoretically unlimited; the losses are limited to the amount you invest.

Options present themselves all the time, but life-altering ones often come up during times of great change. These options are the ones we have the hardest time capitalizing on. If we’ve specialized too much, change is a threat, not an opportunity. Thus, if we aren’t certain where the opportunities are going to be (and we never are), then we need to make choices to keep our options open.

Baron Rothschild is often quoted as having said that “the time to buy is when there’s blood in the streets.” That’s a misquote, however. What he actually said was “buy when there’s blood in the streets, even if the blood is your own.” Rothschild recognized that those are the times when new options emerge. That’s when many investors make their fortunes and when entrepreneurs innovate. Rothschild saw opportunity in chaos. He made a fortune buying during the panic after the Battle of Waterloo.

When we occupy a small niche, we sacrifice optionality. That means less freedom and greater dependency. No one can predict the future—not even experts—so isn’t it a good idea to have as many avenues open as possible?

The coach’s dilemma: strength vs. optionality

In Simple Rules: How to Thrive in a Complex World, Kathleen Eisenhardt and Donald Sull describe the experience of strength coach Shannon Turley. For the uninitiated, the role of a strength coach is to help athletes stay healthy and perform better, rather than teach specific skills.

Turley began his career working at Virginia Polytechnic Institute and State University. When he started, the football players there followed a strength program based on weightlifting alone. Athletes wore t-shirts listing their personal records and competed to outdo each other. The mantra was: get stronger by lifting more weight.

But Turley soon realized that this program was not effective because it left the athletes with limited optionality. Turley found no correlation between weightlifting prowess and competitive performance. Being able to bench press a lot of weight didn’t serve them well on the football field. As he put it, “In football if you’re on your back, you’ve already lost.” Keeping a record of what he saw, he began looking for different options for the athletes.

After gaining experience coaching in several sports, Turley realized that strength was not the most important factor for athletic success. What mattered for any type of athlete was staying free of injuries and good nutrition. Why? Because that gave athletes greater optionality.

An uninjured, healthy player could stay in each game for longer and miss fewer training sessions. It also meant less chance of requiring surgery, which many of his students faced, or of being forced to retire from competitive sports at a young age.

Turley began coaching football players at Stanford University. He implemented a program focusing on proper nutrition and flexibility exercises such as yoga—not weightlifting. He also focused on healing existing injuries that restricted athletes’ performance. One football player he worked with had ongoing back problems, so Turley designed a regime to improve that issue. It worked: the athlete never missed a game and went on to play in the NFL. Turley’s approach served to preserve optionality for his players. Even the best athlete will lose many competitions. So the more an athlete is healthy enough to participate in games, the greater the chances of those crucial successes. Turley’s experience illustrates the trade-offs between particular physical abilities and optionality.

Over-specializing in one area is highly limiting, especially if it requires extensive upkeep. Like a football player, we can retain optionality by avoiding overtly damaging risks and ensuring we stay in the game for as long as possible—whatever that game is. That might mean lifting less metaphorical weight at any one time, while also working to keep ourselves flexible.

The tyranny of small decisions

Few people would deliberately lock themselves into an undesirable situation. Yet we often make small, rational decisions that end up removing options over time. This is the tyranny of small decisions. Economist Alfred Kahn identified the concept in 1966. Kahn begins the article with a provocative thought experiment:

Suppose, 75 years ago, some being from outer space had made us this proposition: “I know how to make a vehicle that could in effect put 200 horses at the disposal of each of you. It would permit you to travel about, alone or in small groups, at 60 to 80 miles an hour. But the costs of this gadget are 40,000 lives per year, global warming, the decay of the inner city, endless commuting, and suburban sprawl.” What would we have chosen collectively?

Put that way, the answer, of course, is no—we wouldn’t choose the advancement of transportation technology if we could immediately see the grievous cost. But we have said yes to that exact offer over time through a million small decisions, and now it is difficult to back out. Most of the modern world is built to accommodate cars. Driving is now the “rational” choice, no matter the destructive effect. Sometimes it feels as though we have no other option.

Kahn’s point is that small decisions can lead to bad outcomes. At some point, alternatives disappear. We lose our optionality. It is easy to see the downsides of big decisions. The costs of smaller ones can be more elusive. In a market economy, Kahn explains, change is the result of tiny steps. Combined, they have a tremendous cumulative effect on our collective freedom. Day to day, it is hard to see the path that is forming. At some point, we may look up and not like where we are going. By then it is too late. Kahn writes:

Only if consumers are given the full range of economically feasible and socially desirable alternatives in a big discrete bundle will misallocation of resources due to the tyranny of small market-determined decisions be broken.

The tragedy of the commons is another such instance of the power of small decisions. Garett Hardin’s parable illustrates why common resources are used more than is desirable from the standpoint of society as a whole. No one person makes a single decision to deplete the resources. Instead, each person makes a series of small choices that ultimately cause environmental ruin. In the original example where villagers are freely able to graze their animals on common land, having access to it gives everyone a lot of options for raising animals or farming. Once the pasture is exhausted from everyone putting too many animals out to graze, however, everyone loses their optionality.

Optionality can be a matter of perspective

As Seneca put it, “In one and the same meadow, the cow looks for grass, the dog for a hare, and the stork for a lizard.” Where some people only see blood in the streets, other people see a chance to succeed.

Preserving optionality can be as much about changing our attitudes as our circumstances. It can be about learning to spot opportunities—and to make them. Optionality is not a new concept. A portion of the Old Testament dating back to between 450 and 180 BCE declares:

Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land. If clouds are full of water, they pour rain on the earth. Whether a tree falls to the south or to the north, in the place where it falls, there it will lie. Whoever watches the wind will not plant; whoever looks at the clouds will not reap . . . Sow your seed in the morning, and at evening let your hands not be idle, for you do not know which will succeed, whether this or that, or whether both will do equally well.

In today’s world, optionality can be integrated into a number of different areas of our lives by looking for ways to prepare for a variety of possible events, instead of optimizing for the recent past.

Keeping our options open means developing generalist skills like creativity, rather than specializing in one area, like a particular technology. The more diverse the knowledge and skills you can draw on, the better positioned you are to take advantage of new opportunities.

It means not relying on a single distributor for your company’s product or having the supply chain for an entire industry dependent on one country. You can’t make your decisions solely on how the world was yesterday. Preserving optionality means you may take a short-term hit in sales by funding diversity, but the result is you will be much better positioned in the future to keep your business going when circumstances change.

It means not relying on a single energy source to power the vehicles that move us and the goods we need around. Building our society around oil—a finite resource—is limiting. Developing multiple forms of sustainable energy creates new options for when that finite resource is depleted.

Or consider the lean startup methodology. Building a minimum viable product means having the flexibility to pivot or change plans. No demand? No problem! Just try something else. Lean startups iterate until they find product/market fit. Many founders keep their teams as small as possible. They avoid fixed costs and commitments. They keep their options open.

The lean startup methodology recognizes that a new company cannot make a grand plan; it needs to adapt and evolve. As Steve Jobs understood, most customers don’t know they will want something until they have tried it. It’s hard to prepare for changing customer desires without optionality. If a company is flexible, they can adapt to the information they receive once a product hits the market.

“Wealth is not about having a lot of money; it’s about having a lot of options.”

— Chris Rock

Ultimately, preserving optionality means paying attention and looking at life from multiple perspectives. It means building a versatile base of foundational knowledge and allowing for serendipity and unexpected connections. We must seek to expand our comfort zone and circle of competence, and we should take minor risks that have potentially large upsides and limited downsides.

Paradoxically, preserving optionality can mean saying no to a lot of opportunities and avoiding anything that will prove to be restrictive. We need to look at choices through the lens of the optionality they will give us in the future and only say yes to those that create more options.

Preserving your optionality is important because it gives you the flexibility to capitalize on inevitable change. In order to keep your options open, you need diversity. Diversity of perspective, thought, knowledge, and skills. You don’t want to find yourself in a position of only being able to sell something that no one wants. Rapid, extraordinary change is the norm. In order to adapt in a way that is useful, keep your options open.

Tagged: , , , ,

Chesterton’s Fence: A Lesson in Second Order Thinking

Reading Time: 8 minutes

A core component of making great decisions is understanding the rationale behind previous decisions. If we don’t understand how we got “here,” we run the risk of making things much worse.

***

When we seek to intervene in any system created by someone, it’s not enough to view their decisions and choices simply as the consequences of first-order thinking because we can inadvertently create serious problems. Before changing anything, we should wonder whether they were using second-order thinking. Their reasons for making certain choices might be more complex than they seem at first. It’s best to assume they knew things we don’t or had experience we can’t fathom, so we don’t go for quick fixes and end up making things worse.

Second-order thinking is the practice of not just considering the consequences of our decisions but also the consequences of those consequences. Everyone can manage first-order thinking, which is just considering the immediate anticipated result of an action. It’s simple and quick, usually requiring little effort. By comparison, second-order thinking is more complex and time-consuming. The fact that it is difficult and unusual is what makes the ability to do it such a powerful advantage.

Second-order thinking will get you extraordinary results, and so will learning to recognize when other people are using second-order thinking. To understand exactly why this is the case, let’s consider Chesterton’s Fence, described by G. K. Chesterton himself as follows:

There exists in such a case a certain institution or law; let us say, for the sake of simplicity, a fence or gate erected across a road. The more modern type of reformer goes gaily up to it and says, “I don’t see the use of this; let us clear it away.” To which the more intelligent type of reformer will do well to answer: “If you don’t see the use of it, I certainly won’t let you clear it away. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it.”

***

Chesterton’s Fence is a heuristic inspired by a quote from the writer and polymath G. K. Chesterton’s 1929 book, The Thing. It’s best known as being one of John F. Kennedy’s favored sayings, as well as a principle Wikipedia encourages its editors to follow. In the book, Chesterton describes the classic case of the reformer who notices something, such as a fence, and fails to see the reason for its existence. However, before they decide to remove it, they must figure out why it exists in the first place. If they do not do this, they are likely to do more harm than good with its removal. In its most concise version, Chesterton’s Fence states the following:

Do not remove a fence until you know why it was put up in the first place.

Chesterton went on to explain why this principle holds true, writing that fences don’t grow out of the ground, nor do people build them in their sleep or during a fit of madness. He explained that fences are built by people who carefully planned them out and “had some reason for thinking [the fence] would be a good thing for somebody.” Until we establish that reason, we have no business taking an ax to it. The reason might not be a good or relevant one; we just need to be aware of what the reason is. Otherwise, we may end up with unintended consequences: second- and third-order effects we don’t want, spreading like ripples on a pond and causing damage for years.

Elsewhere, in his essay collection Heretics, Chesterton makes a similar point, detailed here:

Suppose that a great commotion arises in the street about something, let us say a lamp-post, which many influential persons desire to pull down. A grey-clad monk, who is the spirit of the Middle Ages, is approached upon the matter, and begins to say, in the arid manner of the Schoolmen, “Let us first of all consider, my brethren, the value of Light. If Light be in itself good—” At this point he is somewhat excusably knocked down. All the people make a rush for the lamp-post, the lamp-post is down in ten minutes, and they go about congratulating each other on their un-mediaeval practicality. But as things go on they do not work out so easily. Some people have pulled the lamp-post down because they wanted the electric light; some because they wanted old iron; some because they wanted darkness, because their deeds were evil. Some thought it not enough of a lamp-post, some too much; some acted because they wanted to smash municipal machinery; some because they wanted to smash something. And there is war in the night, no man knowing whom he strikes. So, gradually and inevitably, to-day, to-morrow, or the next day, there comes back the conviction that the monk was right after all, and that all depends on what is the philosophy of Light. Only what we might have discussed under the gas-lamp, we now must discuss in the dark.

As simple as Chesterton’s Fence is as a principle, it teaches us an important lesson. Many of the problems we face in life occur when we intervene with systems without an awareness of what the consequences could be. We can easily forget that this applies to subtraction as much as to addition. If a fence exists, there is likely a reason for it. It may be an illogical or inconsequential reason, but it is a reason nonetheless.


“Before I built a wall I’d ask to know
What I was walling in or walling out,
And to whom I was like to give offence.”

— Robert Frost, “Mending Wall”

Chesterton also alluded to the all-too-common belief that previous generations were bumbling fools, stumbling around, constructing fences wherever they fancied. Should we fail to respect their judgement and not try to understand it, we run the risk of creating new, unexpected problems. By and large, people do not do things for no reason. We’re all lazy at heart. We don’t like to waste time and resources on useless fences. Not understanding something does not mean it must be pointless.

Take the case of supposedly hierarchy-free companies. Someone came along and figured that having management and an overall hierarchy is an imperfect system. It places additional stress on those at the bottom and can even be damaging to their health. It leaves room for abuse of power and manipulative company politics. It makes it unlikely that good ideas from those at the bottom will get listened to.

However, despite the numerous problems inherent in hierarchical companies, doing away with this structure altogether belies a lack of awareness of the reasons why it is so ubiquitous. Someone needs to make decisions and be held responsible for their consequences. During times of stress or disorganization, people naturally tend to look to leaders for direction. Without a formal hierarchy, people often form an invisible one, which is far more complex to navigate and can lead to the most charismatic or domineering individual taking control, rather than the most qualified.

It is certainly admirable that hierarchy-free companies are taking the enormous risk inherent in breaking the mold and trying something new. However, their approach ignores Chesterton’s Fence and doesn’t address why hierarchies exist within companies in the first place. Removing them does not necessarily lead to a fairer, more productive system.

Yes, doing things the way they’ve always been done means getting what we’ve always got. There’s certainly nothing positive about being resistant to any change. Things become out of date and redundant with time. Sometimes an outside perspective is ideal for shaking things up and finding new ways. Even so, we can’t let ourselves be too overconfident about the redundancy of things we see as pointless.

Or, to paraphrase Rory Sutherland, the peacock’s tail is not about efficiency. In fact, its whole value lies in its inefficiency. It signals a bird is healthy enough to waste energy growing it and has the strength to carry it around. Peahens use the tails of peacocks as guidance for choosing which mates are likely to have the best genes to pass on to their offspring. If an outside observer were to somehow swoop in and give peacocks regular, functional tails, it would be more energy efficient and practical, but it would deprive them of the ability to advertise their genetic potential.

***

All of us, at one point or another, make some attempt to change a habit to improve our lives. If you’re engaging in a bad habit, it’s admirable to try to eliminate it—except part of why many attempts to do so fail is that bad habits do not appear out of nowhere. No one wakes up one day and decides they want to start smoking or drinking every night or watching television until the early hours of the morning. Bad habits generally evolve to serve an unfulfilled need: connection, comfort, distraction, take your pick.

Attempting to remove the habit and leave everything else untouched does not eliminate the need and can simply lead to a replacement habit that might be just as harmful or even worse. Because of this, more successful approaches often involve replacing a bad habit with a good, benign, or less harmful one—or dealing with the underlying need. In other words, that fence went up for a reason, and it can’t come down without something either taking its place or removing the need for it to be there in the first place.

To give a further example, in a classic post from 2009 on his website, serial entrepreneur Steve Blank gives an example of a decision he has repeatedly seen in startups. They grow to the point where it makes sense to hire a Chief Financial Officer. Eager to make an immediate difference, the new CFO starts looking for ways to cut costs so they can point to how they’re saving the company money. They take a look at the free snacks and sodas offered to employees and calculate how much they cost per year—perhaps a few thousand dollars. It seems like a waste of money, so they decide to do away with free sodas or start charging a few cents for them. After all, they’re paying people enough. They can buy their own sodas.

Blank writes that, in his experience, the outcome is always the same. The original employees who helped the company grow initially notice the change and realize things are not how they were before. Of course they can afford to buy their own sodas. But suddenly having to is just an unmissable sign that the company’s culture is changing, which can be enough to prompt the most talented people to jump ship. Attempting to save a relatively small amount of money ends up costing far more in employee turnover. The new CFO didn’t consider why that fence was up in the first place.

***

Chesterton’s Fence is not an admonishment of anyone who tries to make improvements; it is a call to be aware of second-order thinking before intervening. It reminds us that we don’t always know better than those who made decisions before us, and we can’t see all the nuances to a situation until we’re intimate with it. Unless we know why someone made a decision, we can’t safely change it or conclude that they were wrong.

The first step before modifying an aspect of a system is to understand it. Observe it in full. Note how it interconnects with other aspects, including ones that might not be linked to you personally. Learn how it works, and then propose your change.

Tagged: , , ,

Externalities: Why We Can Never Do “One Thing”

Reading Time: 8 minutes

No action exists in a vacuum. There are ripples that have consequences that we can and can’t see. Here are the three types of externalities that can help us guide our actions so they don’t come back to bite us.

***

An externality affects someone without them agreeing to it. As with unintended consequences, externalities can be positive or negative. Understanding the types of externalities and the impact they have in our lives can help us improve our decision making, and how we interact with the world.

Externalities provide useful mental models for understanding complex systems. They show us that systems don’t exist in isolation from other systems. Externalities may affect uninvolved third parties which make them a form of market failure —an inefficient allocation of resources.

We both create and are subject to externalities. Most are very minor but compound over time. They can inflict numerous second-order effects. Someone reclines their seat on an airplane. They get the benefit of comfort. The person behind bears the cost of discomfort by having less space. One family member leaves their dirty dishes in the sink. They get the benefit of using the plate. Someone else bears the cost of washing it later. We can’t expect to interact with any system without repercussions. Over time, even minor externalities can cause significant strain in our lives and relationships.

The First Law of Ecology

To understand externalities it is first useful to consider second-order consequences. In Filters Against Folly, Garrett Hardin describes what he considers to be the First Law of Ecology: We can never do one thing. Whenever we interact with a system, we need to ask, “And then what? What will the wider repercussions of our actions be?” There is bound to be at least one externality.

Hardin gives the example of the Prohibition Amendment in the U.S. In 1920, lawmakers banned the production and sale of alcoholic beverages throughout the entire country. This was in response to an extended campaign by those who believed alcohol was evil. It wasn’t enough to restrict its consumption—it needed to go.

The addition of 61 words to the American Constitution changed the social and legal landscape for over a decade. Policymakers presumably thought they could make the change and people would stop drinking. But Prohibition led to numerous externalities. Alcohol is an important part of many people’s lives. Few were willing to suddenly give it up without a fight. The demand was more than strong enough to ensure a black-market supply re-emerged.

Wealthy people stockpiled alcohol in their homes before the ban went into effect. Thousands of speakeasies and gin joints flourished. Walgreens grew from 20 stores to 500, in large part due to its sales of ‘medicinal’ whiskey. Former alcohol producers simply sold the ingredients for people to make their own. Gangsters like Al Capone made their fortune smuggling, and murdered his rivals in the process. Crime gangs undermined official institutions. Tax revenues plummeted. People lost their jobs. Prisons became overcrowded and bribery commonplace. Thousands died from crime and drinking unsafe homemade alcohol.

Policymakers did not fully ask, “And then what?” before legislating. Drinking did decrease during this time, on average by about half.  But this was far from the hope of a total ban. The second-order consequences outweighed any benefits.

As economist Gregory Mankiw explains in Principles of Microeconomics,

In the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers who participate in the market; it also includes the well-being of bystanders who are affected indirectly…. The market equilibrium is not efficient when there are externalities. That is, the equilibrium fails to maximize the total benefit to society as a whole.

Negative Externalities

Negative externalities can occur during the production or consumption of a service or good. Pollution is a useful example. If a factory pollutes nearby water supplies, it causes harm without incurring costs. The costs to society are high and are not reflected in the price of whatever the factory makes. Economists often view environmental damage as another factor in a production process. But even if pollution is taxed, the harmful effects don’t go away.

Transport and manufacturing release toxins into the environment, harming our health and altering our climate. The reality though, is these externalities are hard to see, and it is often difficult to trace them back to their root causes. There’s also the question of whether we are responsible for externalities or not.

Imagine you’re driving down the road. As you go by an apartment, the noise disturbs someone who didn’t agree to it. Your car emits air pollution, which affects everyone living nearby. Each of these small externalities will affect people you don’t see and who didn’t choose them. They won’t receive any compensation from you. Are you really responsible for the externalities you cause? If you’re not being outright careless or malicious, isn’t it just part of life? How much responsibility do we have as individuals, anyway?

Calling something a negative externality can be a convenient way of abdicating responsibility.

Positive Externalities

A positive externality imposes an unexpected benefit on a third party. The producer doesn’t agree to this, nor do they receive compensation for it.

Scientific research often leads to positive externalities. Research findings can have applications beyond their initial scope. The resulting information becomes part of our collective knowledge base. However, the researcher who makes a discovery cannot receive the full benefits. Nor do they necessarily feel entitled to them.

Blaise Pascal and Pierre de Fermat developed probability theory to solve a gambling dispute. Their work went on to inform numerous disciplines (like the field of calculus) and transform our understanding of the world. Probabilities are now a core part of how we think. Pascal and Fermat created a positive externality.

Someone who comes up with an equation cannot expect compensation each time it gets used. As a result, the incentives to invest the time and effort to discover new equations are reduced. Algorithms, patents, and copyright laws change this by allowing creators to protect and profit from their ideas for years before other people can freely use them. We all benefit, and researchers have an incentive to continue their work.

Network effects are an example of a positive externality. Silicon Valley understands this well. Each person who joins a network, like a marketplace app, increases the value to all other users. Those who own the network have an incentive improve it to encourage new users. Everyone benefits from being able to communicate with more people. While we might not join a new network intending to improve it for other people, that is what normally happens. (On the flipside, network effects can also produce negative externalities, as too many members can decrease the value of a network.)

Positive externalities often lead to the “free rider” problem. When we enjoy something that we aren’t paying for, we tend not to value it. Not paying can remove the incentive to look after a resource and leads to a Tragedy of the Commons situation. As Aristotle put it, “For that which is common to the greatest number has the least care bestowed upon it.” A good portion of online content succumbs to the free rider problem. We enjoy it and yet we don’t pay for it. We expect it to be free and yet, if users weren’t willing to support sites like Farnam Street, they would likely fold, start publishing lower quality articles, or sell readers to advertisers who collect their data. The end result, as we see too frequently, is low-quality content funded by page-view advertising. (This is why we have a membership program. Members of our learning community create a positive externality for non-members by helping support the free content.)

Positional Externalities

Positional externalities are a form of second-order effects. They occur when our decisions alter the context of future perception or value.

For example, consider what happens when a person decides to start staying at the office an hour late. Perhaps they want a promotion and think it will endear them to managers. Parkinson’s Law states that tasks expand to fit the time allocated to them. What this person would otherwise get done by 5pm, now takes until 6pm. Staying late becomes their norm. Their co-workers notice and start to also stay late. Before long, staying at the office until 6pm becomes the standard for everyone. Anyone who leaves at 5pm is perceived as lazy. Now that 6pm is the norm, everyone suffers. They are forced to work more without deriving any real benefits. It’s a lose-lose situation for everyone.

Someone we know once made an investment with a nearly unlimited return by gaming the system. He worked for an investment firm that valued employees according to a perception of how hard they worked and not necessarily by their results. Each Monday he brought in a series of sport coats and left them in the office. He paid the cleaning staff $20 a week to change the coat hanging on his chair and to turn on his computer. No matter what happened, it appeared he was always the first one into the office even though he often didn’t show up from a “client meeting” until 10. When it came to bonus time, he’d get an enormous return on that $20 investment.

Purchasing luxury goods can create positional externalities. Veblen goods are items we value because of their scarcity and high cost. Diamonds, Lamborghinis, tailor-made suits — owning them is a status symbol, and they lose their value if they become cheaper or if too many people have them. As Luca Lambertini puts it in The Economics of Vertically Differentiated Markets,

The utility derived from consumption is a function of the quantity purchased relative to the average of the society or the reference group to whom the consumer compares.” In other words, a shiny new car seems more valuable if all your friends are driving battered old wrecks. If they have equally (or more) fancy cars, the value of yours drops. At some point, it seems worthless and it’s time to find a new one. In this way, the purchase of a Veblen good confers a positional externality on other people who own it too.

That utility can also be a matter of comparison. A person earning $40,000 a year while their friends earn $30,000 will be happier than one earning $60,000 when their friends earn $70,000. When someone’s salary increases, it raises the bar, giving others a new point of reference.

We can confer positional externalities on ourselves by changing our attitudes. Let’s say someone enjoys wine but is not a connoisseur. A $10 bottle and a $100 bottle make them equally happy. When they decide to go on a course and learn the subtleties and technicalities of fine wines, they develop an appreciation for the $100 wine and a distaste for the $10. They may no longer be able to enjoy a cheap drink because they raised their standards.

Conclusion

Externalities are everywhere. It’s easy to ignore the impact of our decisions—to recline an airplane seat, to stay late at the office, or drop litter. Eventually though, someone always ends up paying. Like the villagers in Hardin’s Tragedy of the Commons, who end up with no grass for their animals, we run the risk of ruining a good thing if we don’t take care of it. Keeping the three types of externalities in mind is a useful way to make decisions that won’t come back to bite you. Whenever we interact with a system, we should remember to ask Hardin’s question: and then what?

Tagged: , , , , , , , , , , , ,

The Anatomy of a Great Decision

Reading Time: 6 minutes

Making better decisions is one of the best skills we can develop. Good decisions save time, money, and stress. Here, we break down what makes a good decision and what we can do to improve our decision-making processes.

***

Improving our decision-making abilities is a central goal at Farnam Street. Better decisions save time, money, and stress. While it’s an investment now, in the long run, learning principles and developing a multidisciplinary lens that we can apply throughout life is a worthy investment.

As we have said before, a decision should not be judged solely on its outcome. Sometimes good decisions produce bad results. A recruiting process that has resulted in mostly excellent candidates will still occasionally fail to weed out a bad fit. It is impossible to have perfect and complete information for all the variables involved. So we do the best with what we have.

Using a decision journal can move us to that place where we are consistently making better decisions. At its core, the technique of identifying and reflecting on process from beginning to end helps us achieve the two main qualities in better decisions:

  1. Using principles, not tactics
  2. Looking at a situation through a multidisciplinary lens

These qualities are what we need to improve over time. And in the same way compounding interest increases our bank balance, better decisions produce exponentially better results the more of them we make. Hard decisions today, made well, prepare us to make decisions more easily in the future.

When we look around, however, to see what we can learn from others who made great decisions, we often judge based solely on the outcomes. Whether a decision by a family member to buy Coca-Cola stock in the ’80s, or Caesar to cross the Rubicon, we evaluate a decision as good based on how things turned out.

Evaluating decisions on outcomes prevents us from learning. We need to dive into a decision, cut it open and examine its parts. Regardless of what happened, learning how a decision was made is the place to find knowledge. So what does the anatomy of a great decision look like?

The Marshall Plan

After WWII, Europe was in ruins. Much of the infrastructure had been destroyed. Many people were starving, and had lost everything they possessed. Those systems we take for granted, but on which we rely daily—transportation, manufacturing, agriculture—had been devastated. The economies were essentially broken, and the countries that saw a lot of fighting had much to rebuild. But with what money? Many countries were in serious debt. Continued, widespread economic hardships were on the horizon.

In 1947, Secretary of State General George Marshall put forward a plan that has since carried his name, a plan to give a massive amount of money to several European nations. Those countries accepted, the continent was rebuilt, and Marshall is credited with one of the most positive defining acts of economics, politics, and ethics in the last century. But when you look at the thinking that went into the Marshall Plan, the reasoning behind the details, you see that it would have been a great decision regardless of the outcome.

Asking the Right Questions

At the beginning, participants asked questions. What do we want to achieve? What problems are we addressing? What does a successful outcome look like?

From there came the principles, things like: strong economies minimize social unrest; countries that work toward mutual goals are less likely to fight each other; let’s not have another war in Europe anytime soon.

Starting from these principles, decision makers evaluated the situation through a multidisciplinary lens. Economics, politics, humanitarian responsibilities, historical and psychological factors—the plan sought to address issues on many fronts and took a wide perspective into account.

The plan was developed in the State Department of the United States. It was not the work of a single individual, and contributions from many people made it into the final version that Marshall fought for in Congress.

In the end, there were three key decisions made in terms of the structure of the plan:

  1. To give, versus lend, the majority of the aid
  2. To require the nations receiving the aid to work out how to allocate it
  3. To invite Russia to partake

Using Multiple Lenses

The decision to give rather than lend the majority of the aid was the result of looking at the situation through economic, political, and humanitarian lenses. It was also a win-win.

Immediately following the war, the European nations had put significant effort into restarting their economies. But they were doing it with borrowed dollars, needing to import far more than they were capable of exporting. Many economies needed modernization, which was impossible to fund while paying for imports at the same time. Without full economic recovery in Europe, there was great danger of a recession, or even a second depression. Basically, Europe needed money.

But economies are also about people. It is people who produce and consume and develop the economy. So it wasn’t just the countries that needed financial assistance, but the people in them. The designers of the plan knew that hungry, desperate people would only create more social unrest. They saw that if they didn’t give the money to Europe they might very well have to spend it on national security as Europe fell apart.

And we can’t discount the impact of the physical reality of the aftermath of the war that the liberating forces confronted—starving people, towns reduced to rubble. The case for humanitarian assistance was strong.

Letting the World Do the Work For You

The decision to have the participating nations allocate the aid among themselves was the answer to what the historical, political and psychological lenses revealed.

Many people felt that the approach to reparations after WWI was a significant impetus for WWII. The First World War had a similar effect on the economies and infrastructures of the nations involved. In 1918, angry at Germany, France and Britain had demanded huge sums of money. The problem was, it essentially crippled Germany economically, and caused a social and political situation that created enmity among the European nations. Many argue that it was this series of events that produced a situation in which Hitler could come to power.

The creators of the Marshall Plan were aware of this, and it was one of the elements that influenced the design of the terms. If Germany collapsed again, they might be fighting World War III in twenty years.

By asking enemies to work together and approve each other’s share, the plan created a buy-in that defused much of the anger and animosity between the nations. Just a couple of years earlier they had been at war with each other. After sacrificing so much in both lives and money, it was natural that the various peoples were angry over both who started the war, and the many violent and destructive events that were enacted over those six years.

But the US decided to not take sides and extend the alliances of the war. The plan creators realized this wouldn’t help fulfill the principles they had chosen to abide by. Europe working meant Europe working together.

Outcomes Over Optics

Inviting Russia to share in the aid was another important result of applying those political, historical, psychological, and humanitarian lenses.

The end of WWII marked the beginning of the Cold War. More nebulous by nature, starting a couple of years after the liberation of Europe and the dropping of the atomic bomb, this political climate would shape international relations for the next 40 years. The Marshall Plan took into account how best to navigate this complicated territory. Russia had been a valuable ally during the war, holding the eastern front and inflicting considerable damage on Hitler’s efforts. But immediately post-war their actions demonstrated a desire to at least influence, if not control, the political structure of the world. Their version of communism was at direct odds with US democracy, and was thus considered a legitimate threat.

Even though there was very little expectation that Russia would participate, and possibly even less desire to give them money, Russia and its allied countries were invited by both the US and the European nations to participate in the talks involving the implementation of the plan. They chose not to, and followed up with accusing the plan of being a front to American imperialist goals. This was important because it forced Russia’s hand. They could not later claim that the Iron Curtain was something that was thrust on them. It was, instead, something they deliberately chose to build.

The Marshall Plan is remembered as a great decision, not strictly because of its outcomes—though it did contribute to the debatably successful reconstruction of Europe, it did not succeed in preventing the deterioration of relations with Russia—but because it was firmly grounded in principles that were identified and executed through a multidisciplinary lens.

Tagged:
Footnotes
  • 1

    Sutcliffe, Anthony. An Economic and Social History of Western Europe since 1945. London: Longman, 1996.

  • 2

    Unger, Debi and Irwin. George Marshall: A Biography. New York: HarperCollins, 2014.

How Not to Be Stupid

Reading Time: 7 minutes

After a four-hour conversation on The Knowledge Project (Part 1, Part 2), Adam Robinson (@IAmAdamRobinson) and I shared another 10-minutes that shouldn’t be missed on how not to be stupid.

Shane Parrish: Adam, you did a presentation once on how not to be stupid. Can you tell me about that? What is stupidity?

Adam Robinson: Right. It’s so funny you should ask that, because people think stupidity is the opposite of intelligence. In fact, stupidity is the cost of intelligence operating in a complex environment. It’s almost inevitable. And so I was asked by an organizer of an investment conference in the Bahamas of some elite global investors to do a talk on anything I wanted to do, except not about investing. It’s just, pick an interesting topic. So I thought for a second and I blurt out, “Okay. How about how not to be stupid?” He laughed and he said, “Okay. Great.” It took me a month of hard thinking, mind you, just to define stupidity. By the way, if you’re in any field and you want to find ways to innovate, focus on words that are commonly used and try to define them simply.

It took me about a month, and I defined stupidity as overlooking or dismissing conspicuously crucial information. Right? It’s crucial information, like you better pay attention to it. It’s conspicuous, like it’s right in front of your nose and yet you either overlook it or you dismiss it. How not to be stupid, what are the causes of human error—and it took me a couple of months of research just to come up with data points, because most stupidity is ignored or swept under the rug. I studied instances of scientific stupidity and literary stupidity and military stupidity and every other kind of stupidity, as well as two domains that engineer stupidity.

One is benign: magic. The magician misdirects your attention. The whole goal of the magician is to make you stupid, to not notice something you should have. The other is frauds and cons and hoaxes. That’s also—but that’s a malicious, malevolent kind of engineering of stupidity. The magician does so with our full consent, for entertainment purposes. The conman engineers stupidity for their own gain. I do historical research, everything, and I identify seven factors that lead to stupidity.

These seven factors are fascinating. In no particular order: one, being outside your normal environment or changing your routines. Two, being in the presence of a group. Three, being in the presence of an expert or if you, yourself, are an expert. Four, doing any task that requires intense focus. Five, information overload. Six, physical or emotional stress, fatigue. Seven—I’ll come back to seven. I forget it right now. It’s a few years. It’ll come back to me in a second.

All seven factors are present in U.S. hospitals. All seven factors. This will astonish you. This was recently written about, but I don’t think it’s really dawned on people. In the United States every year, there are roughly 30,000 fatalities from automobile accidents. That is a benchmark. How many deaths accidentally occur, accidentally, in hospitals every year? In other words, you go in with a broken arm and you don’t come out. Not, you died as a result of what you went in for. You died because of error, human error. I would tell you the current best estimate—this is deaths, mind you, not injuries—is 210 to 440 thousand people die every year in the United States from hospital error.

Stupidity is overlooking or dismissing conspicuously crucial information

(Editors note, that was not part of the conversation but will add context: When it comes to overloading our cognitive brains, the seven factors are: being outside of your circle of competence, stress, rushing or urgency, fixation on an outcome, information overload, being in a group where social cohesion comes into play, and being in the presence of an “authority.” Acting alone any of these are powerful enough, but together they dramatically increase the odds you are unaware that you’ve been cognitively compromised.)

We know what to do, we just don’t do it correctly. (Atul Gawande and I talk about this in our interview). 

It’s the third leading cause of death in the United States, right behind cancer and heart disease. If those seven factors—by the way, you don’t need all seven factors to be present. They’re additive. Oh, I remember what the final one was, and it’s so funny I should forget it because it’s the one that usually triggers stupidity. Rushing or a sense of urgency. So funny I would forget that one. It’s usually the first one I say. By the way, if you’re outside your normal environment and you are rushing, you are in big trouble, which is why often people are rushing on the way to the airport and they forget their passport or they do something. It has to do with information overload. All seven factors were present at the U.S. Challenger disaster. Remember back in 1986?

Didn’t have to happen. All seven factors were present. There was the musician Yo-Yo Ma, in 1998 I believe, was rushing to an appointment in New York City. He lives in Boston. He was outside his normal environment, rushing, and he was preoccupied because he was late for an appointment. Three of the seven factors. You don’t need all seven to create stupidity. In the back of the cab in which he’s being driven is his million-dollar cello in a big blue Plexiglas thing. It’s in the trunk. He gets out of the cab, he leaves it in the back of the trunk. All of a sudden, because Yo-Yo Ma is such a celebrity, the mayor is called, the police chief and all cars bulletin goes out, find this cello.

Cello?

They do. In the press conference, get this, he says, “I just did something stupid.” I’m using air quotes. That’s an exact phrase. “I just did something stupid. I was in a rush.” Sure enough, in my research, I found three other situations where world class musicians were in a different city, rushing, and they left their instruments. Each one of them. One a $3 million violin. He was on a national tour, left a $3 million violin in an Amtrak train. Imagine $3 million violin in the luggage compartment of an Amtrak train. Fortunately, they called ahead and they found it at the next station. He was lucky. Each of the musicians, in exactly the same—

Circumstance.

—circumstances led to stupidity. Now, Atul Gawande wrote a book called The Checklist Manifesto. Atul Gawande is brilliant. Brilliant, brilliant, brilliant. However, the problem with checklists is that the stupidity factors override them. The worst aviation disaster in history, Shane, occurred in 1977. Nearly 600 lives were lost when two planes collided during the day on the ground. Imagine, two planes collided in an airport on the ground. Six hundred lives were lost. You might say, how does that even happen? All seven factors were present. Something else. Do you know what the pilot that caused the crash was doing right before he took off and slammed into the plane? He was racing through a checklist.

Checklists don’t help you if you’re stupid about the checklist. You’re just not going to use it. A really important takeaway from that, and I’m so glad we got that final question in, is beware of rushing—and if these factors are present, don’t make any important decisions. It doesn’t take much. By the way, I mentioned fatigue and illness. If you’re tired or emotionally overwrought, if you have pulled an all-nighter, you have the motor control and the reflex speed of someone who is legally drunk. An all-nighter you think, I mean we’ve all pulled all-nighters, right? We all sometimes pull multiple all-nighters.

You gotta be aware. You may think that cognitively you’re okay, but your motor control skills and your reflexes are those of someone who’s legally drunk. You’ve really got to be careful. By the way, multitasking is information overload. That comes under the information overload thing, and if you’re talking on Bluetooth while you’re driving a car, you have exponentially increased the odds that you’re going to get into an accident.

This is why when you’re lost, the first thing you do is turn down the radio.

Oh, fascinating. You’re right.

When you’re in a car, when you get lost, you always…one of the first things you do is eliminate an input, which is the radio.

That’s so funny. You’re right.

Or if you’re talking with somebody you say, “Hold on a second,” because you intuitively know that that’s just—subconsciously, you know that’s distracting you.

By the way, that’s so funny you should mention that, because that’s why when I tell people that statistic about…talking on Bluetooth on the phone when you’re driving is incredibly dangerous. People say, “Yeah, but what about if someone’s in the front of the seat talking to you?” That in fact doubles your odds. If someone’s in the front seat with you, talking while you’re driving, you’ve doubled the chances of your getting into an accident. Just doubled. Just that, but the difference is that that person, when you are dealing with unusual traffic conditions, he or she will shut up.

Right, they can see it.

They can see it. The person on the phone who’s talking on Bluetooth doesn’t shut up. You’re still getting the input. That’s why it’s so dangerous.

That’s really interesting. I never thought of that.

Yeah. Well, I didn’t think about it until I researched it.

Still curious? Check out our full conversation on The Knowledge Project (Part 1, Part 2) and Hemingway, a Lost Suitcase, and the Recipe for Stupidity.

Members of the FS Learning Community can discuss this article on the learning community forum.

Tagged: , ,

Defensive Decision Making: What IS Best vs. What LOOKS Best

Reading Time: 3 minutes

“It wasn’t the best decision we could make,” said one of my old bosses, “but it was the most defensible.”

What she meant was that she wanted to choose option A but ended up choosing option B because it was the defensible default. She realized that if she chose option A and something went wrong, it would be hard to explain because it was outside of normal. On the other hand, if she chose option A and everything went right, she’d get virtually no upside. A good outcome was merely expected, but a bad outcome would have significant consequences for her. The decision she landed on wasn’t the one she would have made if she owned the entire company. Since she didn’t, she wanted to protect her downside. In asymmetrical organizations, defensive decisions like this one protect the person making the decision.

My friend and advertising legend Rory Sutherland calls defensive decisions the Heathrow Option. Americans might think of it as the IBM Option. There’s a story behind this:

A while ago, British Airways noticed a reluctance for personal assistants to book their bosses on flights from London City Airport to JFK. They almost always picked Heathrow, which was further away, and harder to get to. Rory believed this was because “flying from London City might be better on average,” but “because it was a non-standard option, if anything were to go wrong, you were much more likely to get it in the neck.”

Of course, if you book your boss to fly out of Heathrow—the default—and the flight is delayed, they’ll blame the airline and not you. But if you opted for the London City airport, they’d blame you.

At first glance, it might seem like defensive decision making is irrational. It’s actually perfectly rational when you consider the asymmetry involved. This asymmetry also offers insight into why cultures rarely change.

Some decisions place the decisionmakers in situations where outcomes offer little upside and massive downside. In these cases, it can seem like great outcomes carry a 1% upside, good outcomes are neutral, and poor outcomes carry at least 20% downside—if they don’t get you fired.

It’s easy to see why people opt for the default choice in these cases. If you do something that’s different—and thus hard to defend—and it works out, you’ve risked a lot for very little gain. If you do something that’s different and it doesn’t work out, and you might find yourself unemployed.

This asymmetry explains why your boss, who has nice rhetoric about challenging norms and thinking outside the box, is likely to continue with the status quo rather than change things. After all, why would they risk looking like a fool by doing something different? It’s much easier to protect themselves. Defaults give people a possible out, a way to avoid being held accountable for their decisions if things go wrong. You can distance yourself from your decision and perhaps be safe from the consequences of a poor outcome.

Doing the safe thing is not the same as doing the right thing. Often, the problem with the safe thing is that there is no growth, no innovation. It’s churning out more of the same. So in the short term, while you may think that the default is a better choice for your job security, in the long game there’s a negative. When you are unwilling to take risks, you stop recognizing opportunities. If you aren’t willing to put yourself out there for 1% gain, how do you grow? After all, the 1% upsides are more common than the 50% upsides. But in either case, if you become afraid of downside, then what level of risk would be acceptable? It’s not that choosing the default makes you a bad person. But a lifetime of opting for the default limits your opportunities and your potential.

And for anyone who owns a company, a staff full of default decision makers is a death knell. You get amazing results when people have the space to take risks and not be penalized for every downside.

Tagged: ,
Footnotes
  • 1

    Image source: https://www.flickr.com/photos/hyku/3474143529

Explore

Browse

123›»