Tag: Over-weight short term

James March: On Leadership

After reading The Ambiguities of Experience, I set out to read another book by James March: On Leadership.

The genius of March takes a while to appreciate. I assure you, however, this thought-provoking book is packed full of wisdom you won’t find in the business best seller section.


On Leadership offers a stunning demonstration of stubborn nonconformity, through the lens of some great works of literature. The questions March poses are simple; the answers are not.

The book, based on March’s lectures in a leadership course he taught at Stanford University from 1980 to 1994 is one of the best resources on the subject I’ve come across. The lectures were based on three primary convictions.

The first was that the major issues of leadership were indistinguishable from issues of life. A proper discussion involved reflecting on grand dilemmas of human existence as they presented themselves in a leadership context. The second conviction was that great literature was a primordial source of learning about such issues for educated people. An inquiring, skeptical, and tolerant gaze was cast on leadership, primarily through a lens provided by four great works of literature – Othello by William Shakespeare, Saint Joan by George Bernard Shaw, War and Peace by Leo Tolstoy, and Don Quixote by Miguel Cervantes. The third conviction was that education, including education in business schools, should not attempt to furnish students with recipes or prescriptions for success.

Here are some of my notes from the book:

If we are to believe the current thinking, the issue of leadership has been resolved.

What is certain is that the industry recycles, sometimes with blatant opportunism, materials and techniques whose link to leadership is not readily apparent: 360 degrees, group dynamics, etc.

The fundamental issues of leadership — the complications involved in becoming, being, and confronting, and evaluating leaders—are not unique to leadership. They are echoes of critical issues of life more generally. As a result, they are characteristically illuminated more by great literature than by modern essays or research on leadership.

Future leaders are taught to remove inconsistencies, ambiguities, and complexities through precise objectives and well-conceived plans. … However, inconsistency and ambiguity have a role in change and adaptation, and the compulsion toward coherence could be an incomplete basis for understanding or improving leadership and life.

In general, effective leadership implies an ability to live in two worlds: the incoherent world of imagination, fantasy, and dreams and the orderly world of plans, rules, and pragmatic action.

There is often ambiguity about outcomes and their attractiveness. There is ambiguity about who is responsible for the outcomes. As a result, reputations are social constructs negotiated among observers, accountants, journalists, academics, leaders, competitors, friends, and enemies. Reputations diffuse through a population of observers and often change over time.

History is pictured as being the result of intention and actions of leaders. Biographies of leaders are a steady element of lists of best selling books. These writings develop notions of the role of leaders in society, on the attributes of leaders, and on the relation between being a leader and being a proper person. they create a language of leadership, a language filled with ideas, vision, power, and virtue.

To an overwhelming extent, contemporary ideologies of action within theories of choice see action as instrumental, coherent, and justified subjectively. Action is instrumental in the sense that it is taken intentionally and is based on expectations of future consequences for the objectives of the actor. Actors are intendedly rational. Action is coherent in the sense that goals and alternatives are well-defined and the decision rule is clear. Actors choose from among alternatives by calculating and comparing their expected returns. And the justification for action is subjective. It is assumed that the value an individual associates with a particular outcome cannot be compared meaningfully with the value another individual associates with a particular outcome. There is no interpersonal comparison of utilities. Values, thus, are assumed to be irrefutable.

Human behavior has often been described as stemming less from calculations of consequences than from the fulfilment of an identity, a logic of appropriateness than a logic of consequence. Moreover, such a bias for action has been praised as resulting in more deeply human, even more effective, actions.

Nothing significant about leadership is likely to be said by people who have been leaders. People who have been leaders are no more capable of an intelligent appreciation of leadership than Americans are of appreciating the American experience, men are of appreciating masculinity, artists are of appreciating art, or the elderly are of appreciating old age. Comment.

In the contemporary western world relationships based on contracts (economic relations) have increased in importance relative to relationships based on senses of belonging (family, group, nation).

Our understanding of the actions of individuals is often influenced by various myths and interpretations of the world that determine what we think of as true, beautiful, and just.

Do we expect a good leader to be clever or innocent? Being clever involves a worldview in which every player pursues individual interest, a virtuous action is one that is effective, and the end justifies the means, with God rewarding the toughest by allowing them to survive—unless he simply bestows the gift of cleverness on those he loves. In this scheme, we admire the wily politician who achieves personal end at the expense of gullible fools, the crafty negotiator, and manipulator.

Being innocent involves a worldview in which people are naturally good, virtue is based on a clear knowledge of good and evil or, at the very least, on simple actions, God rewards virtue, history is marked by human progress.

We only tolerate cleverness when it is crowned with success, while the failure of innocence is attributed to the perversity of the world.

We condemn the military commander whose troops have committed atrocities, because he is morally culpable if he know about them and unworthy of his command if he did not know (because he should have).

What happens in a world populated by a mixture of clever and innocent people? In one standard morality/evolutionary tale, at first, the clever ones dominate and exclude the innocents from all positions of power. the distinctions between the powerful very quickly become tenuous, however, as only the clever have survived and cleverness no longer represents a decisive advantage in a competitive situation. The deviants who remain worthy of confidence now become rare and much sought-after allies and find themselves associated with victorious coalitions. This does not lead to a stable equilibrium, however, as when a society of trust is established once again, opportunistic behavior can become worthwhile.

The person responsible for a decision will tend to interpret its consequences in a favorable light, whereas a changeover of power can lead to accusations that past strategies were failures.

It is therefore very difficult to maintain a balance between efficiency and the capacity to adapt, as there is a tendency, in the case of success, to specialize and refine the procedures that have been successful; and, in the case of failure, to be impatient for positive results and novel innovations.

The stories of successful change recounted after the event by leaders, consultants, or researchers are deceptively simple, as they depict the leader as a hero guided by a vision that goes against the prevailing ideas and is brought to fruition through heroic efforts.

Most original ideas are bad ones. Those that are good, moreover, are only seen as such after a long learning period; they rarely are impressive when first tried out. As a result, an organization is likely to discourage both experimentation with deviant ideas and the people who come up with them, thereby depriving itself, in the name of efficient operation, of its main source of innovation.

The choices of an organization therefore depend on the respective importance that it attaches to its mean performance and the achievement of a few dazzling successes.

As a general rule, politically weak, peripheral, or subordinated groups will advocate diversity and decentralization, while dominant groups will sing the praises of unity and centralization.

The genius therefore makes it possible to explore unknown and sometimes profitable paths in a situation in which the exploitation of the run-of-the-mill skills mastered by the institution does not serve in a crisis. When exploration becomes too costly or creates too much uncertainty and threatens established positions, the institution abandons the genius.

Organizational leadership is a contradiction in terms. The essence of organization is routine, conventional behavior, bound by the standards of knowledge, morality, and legality of the time. The essence of leadership, on the other hand, is escaping the routine, the standard, and the contemporary to implement a new morality, knowledge and legality quite different from that seen by others. Leadership is pre-eminently anti-organizational. Leaders confront organizations rather than build or serve them. Comment.

Modern leaders are, in a similar way, deluded into heroic commitments by the St. Catherines of modern life — journalists, pundits, and professors. The promises are the same—that heroic action will be rewarded by honor and respect—and those promises are as false today as the ones made to Joan by her voices.

War and Peace develops Tolstoy’s theory that history does not follow any defined structure, but arises from the complex interaction of countless insignificant events.

Power gives rise to desire, envy, and celebration, but also to revulsion, fear, and jealousy.

The taste for power can be considered an individual characteristic that varies from one person to the next, from one culture to another, from one sex to the other. Like the thirst for vengeance, ambition, or love, it is potentially insatiable.

If there is to be change, we need to reconsider our ideas about order founded on the domination of leaders and an endless tug-of-war among contending interests.

War and Peace proclaims that most people cannot escape from the corruptions of society, but that it is possible to attain some degree of wisdom, based on a lack of faith both in accepted truths and in great expectations along with a capacity to lead a simple life and perform everyday tasks effectively.

Widely diffused competence and initiative, allied with coordination via mutual adjustments, allows for efficient reactions and avoids the need for costly specialists or hierarchical controls. Heroic leadership is neither required nor helpful.

It is unfortunate that studies of visionary leadership focus too much on the lone leader and not enough on the way that he or she can maintain a climate propitious to the blossoming of original visions.

The logic of reality entails two aspects of relevance to a leader. On one hand, reality is complex and our knowledge of it is limited, so we are not sure whether a particular action will achieve our desired goal. This awareness can lead to paralysis (what is the point of doing anything if the results depend on chance?) or cynicism (what is the the point of fighting for a better world if we are not certain of the effect of our actions?). On the other hand, reality can be created by action. It need not necessarily be taken as given.

Heroic leadership demands great action and great commitment. Such commitment is usually justified by expectations of great consequences.

For Quixote, intention is primary in judging virtue; consequences are secondary.

It is often, therefore, easier to understand certain aspects of leaders’ behavior by focusing on the pleasures that they can gain from their actions rather than on the consequences they achieve.

“Do you not see, senor, that what is gained by restoring Don Quixote’s sanity can never equal the enjoyment his delusions give?”

There are two essential dimensions of leadership: “plumbing,” i.e., the capacity to apply known techniques effectively, and “poetry,” which draws on a leader’s great actions and identity and pushes him or her to explore unexpected avenues, discover interesting meanings, and approach life with enthusiasm.

The plumbing of leadership involves keeping watch over an organization’s efficiency in everyday tasks, such as making sure the toilets work and there is someone to answer the telephone. This requires competence, not only at the top but also throughout all parts of the organization; a capacity to master the context (which supposes that the individuals demonstrating their competence are thoroughly familiar with the ins and outs of the organization); a capacity to take initiatives based on delegation and follow-up; a sense of community shared by all the members of the organization, who feel they are “all in the same boat” and trust and help each other; and, finally, an unobtrusive method for coordination, with each person understanding his or her role sufficiently well to be able to integrate into overall process and make constant adjustments to it. These aspects are essential for the smooth operation of organizations, but they do not appear in most treatises on leadership, no doubt because they are too mundane or too closely linked to a precise context and specific techniques.

Leadership also requires, however, the gifts of a poet, in order to find meaning in action and render life attractive.

A leader must know how to appreciate life and be aware of reality, without falling into the cynicism and bitterness that can arise from the knowledge that our efforts are probably in vain.

If variations are almost always less efficient than tried and tested methods, particularly in the beginning, how can we encourage exploration?

There is a sizable industry devoted to producing books about leadership and optimal leadership styles. For the most part, such books, portray relatively heroic attributes of leadership as producing relatively heroic consequences.

In our contemporary sophistication about the limits of elementary efficiency, we sometimes forget the simple fact that organizations cannot work well unless ordinary tasks are performed routinely and well.

Organizing so that problems are handled quickly and more or less automatically by whoever is there requires certain general attributes within the culture, certain kinds of individual feelings within the organization, a distribution of individual competences, and some organizational arrangements.

If you are going to encourage initiative, you need to be tolerant of small deviations from what you would do yourself in the same situation. Delegation implies the right to be wrong.

These four things—competence, initiative, identification, and unobtrusive coordination—are very conventional. They are found in any standard book on administration. Because they are so conventional and so standard, many of us who think we are sophisticated sometimes act as through they are unimportant.

As managers rise through an organization, managerial power is celebrated; the trappings of managerial importance are increased; but it becomes less clear that a leader’s actions have major effects on organizational performance.

The procedures and drama of decision are organized to emphasize the importance of management and managers, to reassure us of the significance of leaders.

As a result of these rituals and ceremonies, it seems very likely that most organizational leaders exaggerate their control over their success.

The managers we see in an organization are typically people who have risen to their present positions by being evaluated as success in previous positions. Such success encourages them to see their own histories as the consequences of their own actions and competences.

Organizations work because they have mutual trust without personal favoritism.


Still curious? Read the book and check out my notes from The Ambiguities of Experience.

Suppressing Volatility Makes the World Less Predictable and More Dangerous

I recommend reading Nassim Taleb’s recent article (PDF) in Foreign Affairs. It’s the ultimate example of iatrogenics by the fragilista.

If you don’t have time here are my notes:

  • Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting not visible risks.
  • Seeking to restrict variability seems to be good policy (who does not prefer stability to chaos?), so it is with very good intentions that policymakers unwittingly increase the risk of major blowups.
  • Because policymakers believed it was better to do something than to do nothing, they felt obligated to heal the economy rather than wait and see if it healed on its own.
  • Those who seek to prevent volatility on the grounds that any and all bumps in the road must be avoided paradoxically increase the probability that a tail risk will cause a major explosion. Consider as a thought experiment a man placed in artificially sterilized environment for a decade and then invited to take a ride on a crowded subway; he would be expected to die quickly.
  • But although these controls might work in some rare situations, in the long-term effect of any such system is an eventual and extremely costly blowup whose cleanup costs can far exceed the benefits accrued.
  • … Government interventions are laden with unintended—and unforeseen—consequences, particularly in complex systems, so humans must work with nature by tolerating systems that absorb human imperfections rather than seek to change them.
  • Although it is morally satisfying, the film (inside job) naively overlooks the fact that humans have always been dishonest and regulators have always been behind the curve.
  • Humans must try to resist the illusion of control: just as foreign policy should be intelligence-proof (it should minimize its reliance on the competence of information-gathering organizations and the predictions of “experts” in what are inherently unpredictable domains), the economy should be regulator-proof, given that some regulations simply make the system itself more fragile.
  • The “turkey problem” occurs when a naive analysis of stability is derived from the absence of past variations.
  • Imagine someone who keep adding sand to a sand pile without any visible consequence, until suddenly the entire pile crumbles. It would be foolish to blame the collapse on the last grain of sand rather than the structure of the pile, but that is what people do consistently, and that is the policy error.
  • As with a crumbling sand pile, it would be foolish to attribute the collapse of a fragile bridge to the last truck that crossed it, and even more foolish to try to predict in advance which truck might bring it down.
  • Obama’s mistake illustrates the illusion of local causal chains—that is, confusing catalysts for causes and assuming that one can known which catalyst will produce which effect.
  • Governments are wasting billions of dollars on attempting to predict events that are produced by interdependent systems and are therefore not statistically understandable at the individual level.
  • Most explanations being offered for the current turmoil in the Middle East follow the “catalysts as causes” confusion. The riots in Tunisia and Egypt were initially attributed to rising commodity prices, not to stifling and unpopular dictatorships.
  • Again, the focus is wrong even if the logic is comforting. It is the system and its fragility, not events, that must be studied—what physicists call “percolation theory,” in which the properties of the terrain are studied rather than those of a single element of the terrain.
  • Humans fear randomness—a healthy ancestral trait inherited from a different environment. Whereas in the past, which was a more linear world, this trait enhanced, fitness and increased changes of survival, it can have the reverse effect in today’s complex world, making volatility take the shape of nasty Black Swans hiding behind deceptive periods of “great moderation.”
  • But alongside the “catalysts as causes” confusion sit tow mental biases: the illusion of control and the action bias (the illusion that doing something is always better than doing nothing.) This leads to the desire to impose man-made solutions. Greenspan’s actions were harmful, but it would have been hard to justify inaction in a democracy where the incentive is to always promise a better outcome than the other guy, regardless of the actual delayed cost.
  • As Seneca wrote in De clementia, “repeated punishment, while it crushes the hatred of a few, stirs the hatred of all … just as trees that have been trimmed throw out again countless branches.”
  • The Romans were wise enough to know that only a free man under Roman law could be trusted to engage in a contract; by extension, only a free people can be trusted to abide by a treaty.
  • As Jean-Jacques Rousseau put it, “A little bit of agitation gives motivation to the soul, and what really makes the species prosper is not peace so much as freedom.” With freedom comes some unpredictable fluctuation. This is one of life’s packages: there is no freedom without noise—and no stability without volatility.


Still curious? Nassim Taleb newest book is Antifragile: Things That Gain from Disorder. He is also the author of The Black SwanFooled By Randomness, and The Bed of Procrustes.

The Art and Science of High-Stakes Decisions

How can anyone make rational decisions in a world where knowledge is limited, time is pressing, and deep thought is often unattainable?

Some decisions are more difficult than others and yet we often make these decisions in the same way easy decisions are made, on autopilot.

We have difficulty contemplating and taking protective actions towards low probability, high stakes threats. It almost seems perverse when you consider we are least prepared to make the decisions that matter most.

Sure we can pick between the store brand of peanut butter and the Kraft label and we can no doubt surf the internet with relative ease, yet life seems to offer few opportunities to prepare for decisions where the consequences of a poor decision are catastrophic. If we pick the wrong type of peanut butter, we are generally not penalized too harshly. If we fail to purchase flood insurance, on the other hand, we can be financially and emotionally wiped out.

Shortly after the planes crashed into the towers in Manhattan some well-known academics got together to discuss1 how skilled people were at making choices involving low and ambiguous probability of a high-stakes loss

High-stakes decisions involve two distinctive properties: 1) existence of a possible large loss (financial or emotional) and 2) the costs to reverse decisions once made are high. More importantly, these professors wanted to determine if prescriptive guidelines for improving decision-making process could be created in an effort to help make better decisions.

Whether we’re buying something at the grocery store or making a decision to purchase earthquake insurance, we operate in the same way. The presence of potentially catastrophic costs of errors does little to reduce our reliance on heuristics (or rules of thumb). Such heuristics serve us well on a daily basis. For simple decisions, not only are heuristics generally right but the costs of errors are small, such as being caught without an umbrella or regretting not picking up the Kraft peanut butter after discovering the store band doesn’t taste as you remember. However, in high-stakes decisions, heuristics can often be a poor method of forecasting.

In order to make better high-stakes decisions, we need a better understanding of why we generally make poor decisions.

Here are several causes.

Poor understanding of probability.
Several studies show that people either utilize probability information insufficiently when it is made available to them or ignore it all together. In one study, 78% of subjects failed to seek out probability information when evaluating between several risky managerial decisions.

In the context of high-stakes decisions, the probability of an event causing loss may seem sufficiently low that organizations and individuals consider them not worth worry about. In doing so, they effectively treat the probability of something as zero or close to it.

An excessive focus on short time horizons.
Many high-stakes decisions are not obvious to the decision-maker. In part, this is because people tend to focus on the immediate consequences and not the long-term consequences.

A CEO near retirement has incentives to skimp on insurance to report slightly higher profits before leaving (shareholders are unaware of the increased risk and appreciate the increased profits). Governments tend to under-invest in less visible things like infrastructure because they have short election cycles. The long-term consequences of short-term thinking can be disastrous.

The focus on short-term decision making is one of the most widely-documented failings of human decision making. People have difficulty considering the future consequences of current actions over long periods of time. Garrett Hardin, the author of Filters against Folly, suggests we look at things through three filters (literacy, numeracy, and ecolacy). In ecolacy, the key question is “and then what?” And then what helps us avoid a focus solely on the short-term.

Excessive attention to what’s available
Decisions requiring difficult trade-offs between attributes or entailing ambiguity as to what a right answer looks like often leads people to resolve choices by focusing on the information most easily brought to mind. Sometimes things can be difficult to bring to mind.

Constant exposure to low-risk events without realization leads to us being less concerned than we probably would warrant (it makes these events less available) and “proves” our past decisions to ignore low-risk events were right.

People refuse to buy flood insurance even when it is heavily subsidized and priced far below an actuarially fair value. Kunreuther et. al. (1993) suggests underreaction to threats of flooding may arise from “the inability of individuals to conceptualize floods that have never occurred… Men on flood plains appear to be very much prisoners of their experience… Recently experienced floods appear to set an upward bound to the size of loss with which managers believe they ought to be concerned.”Paradoxically, we feel more secure even as the “risk” may have increased.

Distortions under stress
Most high-stakes decisions will be made under perceived (or real) stress. A large number of empirical studies find that stress focuses decision-makers on a selective set of cues when evaluating options and leads to greater reliance on simplifying heuristics. When we’re stressed, we’re less likely to think things through.

Over-reliance on social norms
Most individuals have little experience with high-stakes decisions and are highly uncertain about how to resolve them (procedural uncertainty). In such cases—and combined with stress—the natural course of action is to mimic the behavior of others or follow established social norms. This is based on the psychological desire to fail conventionally.

The tendency to prefer the status-quo
What happens when people are presented with difficult choices and no obvious right answer? We tend to prefer making no decision at all, we choose the norm.

In high-stakes decisions many options are better than the status-quo and we must make trade-offs. Yet, when faced with decisions that involve life-and-death trade-offs, people frequently remark “I’d rather not think about it.”

Failures to learn
Although individuals and organizations are eager to derive intelligence from experience, the inferences stemming from that eagerness are often misguided. The problems lie partly in errors in how people think, but even more so in properties of experience that confound learning from it. Experience may possibly be the best teacher, but it is not a particularly good teacher.

As an illustration, one study finds that participants in an earthquake simulation tended to over-invest in mitigation that was normatively ineffective but under-invest when it is normatively effective. The reason was a misinterpretation of feedback; when mitigation was ineffective, respondents attributed the persistence of damage to the fact that they had not invested enough. by contract, when it was effective, they attributed the absence of damage to a belief that earthquakes posted limited damage risk.

Gresham’s Law of Decision making
Over time, bad decisions will tend to drive out good decisions in an organization.

What can you do to improve your decision-making?

A few things: 1) learn more about judgment and decision making; 2) encourage decision makers to see events through alternative frames, such as gains versus losses and changes in the status-quo; 3) adjust the time frame of decisions—while the probability of an earthquake at your plant may be 1/100 in any given year, the probability over the 25 year life of the plant will be 1/5; and 4) read Farnam Street!

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Seth Klarman: The Forgotten Lessons of 2008

Seth Klarman: The Forgotten Lessons of 2008

In this excerpt from his annual letter, investing great Seth Klarman describes 20 lessons from the financial crisis which, he says, “were either never learned or else were immediately forgotten by most market participants.”

* * *

The Forgotten Lessons of 2008

One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. We all know about the “depression mentality” of our parents and grandparents who lived through the Great Depression. Memories of tough times colored their behavior for more than a generation, leading to limited risk taking and a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior. One state investment board recently adopted a plan to leverage its portfolio – specifically its government and high-grade bond holdings – in an amount that could grow to 20% of its assets over the next three years. No one who was paying attention in 2008 would possibly think this is a good idea.

Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt- down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

Twenty Investment Lessons of 2008

  1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
  2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
  3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
  4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
  5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
  6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.
  7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
  8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
  9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
  10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.
  11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
  12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
  13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
  14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
  15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.
  16. Financial stocks are particularly risky. Banking, in particular, is a highly lever- aged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
  17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
  18. When a government official says a problem has been “contained,” pay no attention.
  19. The government – the ultimate short- term-oriented player – cannot with- stand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
  20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

False Lessons

  1. There are no long-term lessons – ever.
  2. Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.
  3. There is no amount of bad news that the markets cannot see past.
  4. If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.
  5. Excess capacity in people, machines, or property will be quickly absorbed.
  6. Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.
  7. In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.
  8. The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.
  9. The government can indefinitely control both short-term and long-term interest rates.
  10. The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost. (Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)


Still curious? Check out Basically, It’s Over: A Parable About How One Nation Came To Financial Ruin by Charlie Munger.

Lessons of the Past

The tendency to relate contemporary events to earlier events as a guide to understanding is a powerful one. The difficulty, of course, is in being certain that two situations are truly comparable. Because they are similar in some respects does not assure us that they are similar in all respects.


We all know the way in which we set policy is flawed. Ernest May, someone you’ve likely never heard of, argues that in attempting to avoid the mistakes of the previous generations we pursue policies that would have been the most appropriate from a historical context. May argues that lawmakers mentally resort to analogies and tend to seize upon the first analogy that comes to mind without seeking evidence that would disprove their assumptions (like, say, highlighting differences between this event and the previous one before drawing conclusions?). After publicizing policy ambitions our politicians, like anyone, are likely to reject evidence that does not confirm their conclusions

Ernest May, in his book Lessons of the past, traced the impact of historical analogy on US foreign policy.


He found that because of reasoning by analogy, US policymakers tend to be one generation behind, determined to avoid the mistakes of the previous generation. They pursue the policies that would have been most appropriate in the historical situation but are not necessarily well adapted to the current one. 

Policymakers in the 1930s, for instance, viewed the international situation as analogous to that before World War I. Consequently, they followed a policy of isolation that would have been appropriate for preventing American involvement in the first World War but failed to prevent the second. Communist aggression after World War II was seen as analogous to Nazi aggression, leading to a policy of containment that could have prevented World War II. 

The Vietnam analogy had been used repeatedly over many years to argue against an activist US foreign policy. For example, some used the Vietnam analogy to argue against US participation in the Gulf War–a flawed analogy because the operating terrain over which battles were fought was completely different in Kuwait/Iraq and much more in our favor there as compared with Vietnam. 

May argues that policymakers often perceive problems in terms of analogies with the past, but that they ordinarily use history badly: When resorting to an analogy, they tend to seize upon the first that comes to mind. They do not research more widely. Nor do they pause to analyze the case, test its fitness, or even ask in what ways it might be misleading.