Tag: Warren Buffett

Jeff Bezos on Why People that Are Often Right Change Their Minds Often

Jeff Bezos recently stopped by the office of 37 Signals. After talking product strategy he answered some questions.

In his answer to one question he shared some thoughts on people who were “right a lot.”

He said people who were right a lot of the time were people who often changed their minds. He doesn’t think consistency of thought is a particularly positive trait. It’s perfectly healthy — encouraged, even — to have an idea tomorrow that contradicted your idea today.

He’s observed that the smartest people are constantly revising their understanding, reconsidering a problem they thought they’d already solved. They’re open to new points of view, new information, new ideas, contradictions, and challenges to their own way of thinking.

This doesn’t mean you shouldn’t have a well formed point of view, but it means you should consider your point of view as temporary.

What trait signified someone who was wrong a lot of the time? Someone obsessed with details that only support one point of view. If someone can’t climb out of the details, and see the bigger picture from multiple angles, they’re often wrong most of the time.

Bezos isn’t alone. Warren Buffett’s long time business partner Charlie Munger captures this:

If Berkshire has made modest progress, a good deal of it is because Warren and I are very good at destroying our own best-loved ideas. Any year that you don’t destroy one of your best-loved ideas is probably a wasted year.

John Kenneth Galbraith put it this way:

Faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.

If you liked this, you’ll love:

How to Change How We Think — In the end changing how we think — that is our thought patterns — becomes about changing the language we use for internal and external communication.

Multitasking: Giving the World an Advantage it Shouldn’t Have — “I think when you multi-task so much, you don’t have time to think about anything deeply. You’re giving the world an advantage you shouldn’t do. Practically everybody is drifting into that mistake.”

Mental Model: Prisoners’ Dilemma

The prisoners’ dilemma is the best known strategy game in social science. The game shows why two entities might not cooperate even when it appears in their best (rational) interest to do so. What is rational for the individual in certain circumstances is not rational for the group — that is, pursuing a strategy that is rational for you leads to a worse outcome.

With applications to economics, politics, and business the game illustrates the conflict, which can sometimes arise, between individual and group rationality.

From Greg Mankiw’s Economics textbook:

The prisoners’ dilemma is a story about two criminals who have been captured by the police. Let’s call them Mr Black and Mr Pink. The police have enough evidence to convict Mr Black and Mr Pink of a relatively minor crime, illegal possession of a handgun, so that each would spend a year in jail. The police also suspect that the two criminals have committed a jewelery robbery together, but they lack hard evidence to convict them of this major crime. The police question Mr Black and Mr Pink in separate rooms, and they offer each of them the following deal:

Right now we can lock you up for 1 year. If you confess to the jewelery robbery and implicate your partner, however, we’ll give you immunity and you can go free. Your partner will get 20 years in jail. But if you both confess to the crime, we won’t need your testimony and we can avoid the cost of a trial, so you will each get an intermediate sentence of 8 years.

If Mr Black and Mr Pink, heartless criminals that they are, care only about their own sentences, what would you expect them to do? Would they confess or remain silent? Each prisoner has two strategies: confess or remain silent. The sentence each prisoner gets depends on the strategy chosen by his or her partner in crime.

Consider first Mr Black’s decision. He reasons as follows:

I don’t know what Mr Pink is going to do. If he remains silent, my best strategy is to confess, since then I’ll go free rather than spending a year in jail. If he confesses, my best strategy is still to confess, since then I’ll spend 8 years in jail rather than 20. So, regardless of what Mr Pink does, I am better off confessing.

In the language of game theory, a strategy is called a dominant strategy if it is the best strategy for a player to follow regardless of the strategies pursued by other players. In this case, confessing is a dominant strategy for Mr Black. He spends less time in jail if he confesses, regardless of whether Mr Pink confesses or remains silent.

Now consider Mr Pink’s decision. He faces exactly the same choices as Mr Black, and he reasons in much the same way. Regardless of what Mr Black does, Mr Pink can reduce his time in jail by confessing. In other words, confessing is a dominant strategy for Mr Pink.

In the end, both Mr Black and Mr Pink confess, and both spend 8 years in jail. Yet, from their standpoint, this is a terrible outcome. If they had both remained silent, both of them would have been better off, spending only 1 year in jail on the gun charge. By each pursuing his own interests, the two prisoners together reach an outcome that is worse for each of them.

To see how difficult it is to maintain cooperation, imagine that, before the police captured Mr Black and Mr Pink, the two criminals had made a pack not to confess. Clearly, this agreement would make them both better off if they both live up to it, because they would each spend only 1 year in jail. But would the two criminals in fact remain silent, simply because they had agreed to? Once they are being questioned separately, the logic of self-interest takes over and leads them to confess. Cooperation between the two prisoners is difficult to maintain because cooperation is individually irrational.

* * *

Michael J. Mauboussin writes:

The classic two-player example of game theory is the prisoners’ dilemma. We can recast the prisoners’ dilemma in a business context by considering a simple case of capacity addition. Say two competitors, A and B, are considering adding capacity. If competitor A adds capacity and B doesn’t, A gets an outsized payoff. Likewise, if B adds capacity and A doesn’t than B gets the large payoff. If neither expands, A and B aren’t as well-off as if one alone had added capacity. But if both add capacity, they’re worse off of than if they had done nothing.

* * *

Avinash Dixit offers:

Consider two firms, say Coca-Cola and Pepsi, selling similar products. Each must decide on a pricing strategy. They best exploit their joint market power when both charge a high price; each makes a profit of ten million dollars per month. If one sets a competitive low price, it wins a lot of customers away from the rival. Suppose its profit rises to twelve million dollars, and that of the rival falls to seven million. If both set low prices, the profit of each is nine million dollars. Here, the low-price strategy is akin to the prisoner’s confession, and the high-price akin to keeping silent. Call the former cheating, and the latter cooperation. Then cheating is each firm’s dominant strategy, but the result when both “cheat” is worse for each than that of both cooperating.

* * *

Warren Buffett provides some illumination as to how the Prisoners’ Dilemma plays out in business in the 1985 Berkshire Hathaway Annual report.

The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess capacity exists. Much of the trouble we experienced was attributable, both directly and indirectly, to competition from foreign countries whose workers are paid a small fraction of the U.S. minimum wage. But that in no way means that our labor force deserves any blame for our closing. In fact, in comparison with employees of American industry generally, our workers were poorly paid, as has been the case throughout the textile business. In contract negotiations, union leaders and members were sensitive to our disadvantageous cost position and did not push for unrealistic wage increases or unproductive work practices. To the contrary, they tried just as hard as we did to keep us competitive. Even during our liquidation period they performed superbly. (Ironically, we would have been better off financially if our union had behaved unreasonably some years ago; we then would have recognized the impossible future that we faced, promptly closed down, and avoided significant future losses.)

Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.

But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industry-wide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.

Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital. After the investment, moreover, the foreign competition would still have retained a major, continuing advantage in labor costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers. I always thought myself in the position described by Woody Allen in one of his movies: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray we have the wisdom to choose correctly.”

For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries, by far the largest U.S. textile company both 21 years ago and now. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours. Its stock sold at 60 at the end of 1964; ours was 13.

Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington’s basic commitment to stay in textiles, I would also surmise that the company’s capital decisions were quite rational.

Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at 34 — on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid but they, too, have shrunk significantly in purchasing power.

This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise. The situation is suggestive of Samuel Johnson’s horse: “A horse that can count to ten is a remarkable horse – not a remarkable mathematician.” Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company – but not a remarkable business.

My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Some years ago I wrote: “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Nothing has since changed my point of view on that matter. Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.

* * *

Mauboussin adds:

Our discussion so far has focused on competition. But thoughtful strategic analysis also recognizes the role of co-evolution, or cooperation, in business. Not all business relationships are conflictual. Sometimes companies outside the purview of a firm’s competitive set can heavily influence its value creation prospects.

Consider the example of DVD makers (software) and DVD player makers (hardware). These companies do not compete with one another. But the more DVD titles that are available, the more attractive it will be for a consumer to buy a DVD player and vice versa. Another example is the Wintel standard—added features on Microsoft’s operating system required more powerful Intel microprocessors, and more powerful microprocessors could support updated operating systems. Complementors make the added value pie bigger. Competitors fight over a fixed pie.

* * *

Mankiw offers another real world example:

Consider an oligopoly with two members, called Iran and Saudi Arabia. Both countries sell crude oil. After prolonged negotiation, the countries agree to keep oil production low in order to keep the world price of oil high. After they agree on production levels, each country must decide whether to cooperate and live up to this agreement or to ignore it and produce at a higher level. The following image shows how the profits of the two countries depend on the strategies they choose.

Suppose you are the leader of Saudi Arabia. You might reason as follows:
I could keep production low as we agreed, or I could raise my production and sell more oil on world markets. If Iran lives up to the agreement and keeps its production low, then my country ears profit of $60 billion with high production and $50 billion with low production. In this case, Saudi Arabia is better off with high production. If Iran fails to live up to the agreement and produces at a high level, then my country earns $40 billion with high production and $30 billion with low production. Once again, Saudia Arabia is better off with high production. So, regardless of what Iran chooses to do, my country is better off reneging on our agreement and producing at a high level.

Producing at a high level is a dominant strategy for Saudi Arabia. Of course, Iran reasons in exactly the same way, and so both countries produce at a high level. The result is the inferior outcome (from both Iran and Saudi Arabia’s standpoint) with low profits in each country.

This example illustrates why oligopolies have trouble maintaining monopoly profits. The monopoly outcome is jointly rational for the oligopoly, but each oligopolist has an incentive to cheat. Just as self-interest drives the prisoners in the prisoners’ dilemma to confess, self-interest makes it difficult for the oligopoly to maintain the cooperative outcome with low production, high prices and monopoly prices.

Other examples of prisoners’ dilemma’s include: arms races, advertising, and common resources (see the Tradegy of the Commons)

The Prisoners’ Dilemma is part of the Farnam Street latticework of Mental Models.

Warren Buffett on Temperament

“Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

Warren Buffett

This is a World of Incentives

I thought Warren Buffett said a lot of interesting things in his recent interview with Charlie Rose.

Here are some of the bits that stood out for me.

Fairness:

BUFFETT: …I also think fairness is important and I think getting rid of promises that you can’t keep is important. I don’t think we should cut spending dramatically now. I don’t think that what I’m talking about on taxes solves the — the deficit gap at all. But I think fairness is important. I think having a sensible long-term plan is important to explain and I think having it be believable is terribly important because people don’t believe these out year things generally with Congress. They see too much of what’s happened.

The deficit as stimulus

BUFFETT: The deficit is our stimulus. You can — you can say a bridge someplace is part of that act, you can say cutting taxes is part of it as was the case in our stimulus act. But the stimulus is the government pouring more money out than it’s taking in. And we have a — a stimulus going on that’s 10 percent of GDP which we haven’t seen since World War II. So we have a huge stimulus going on. Nobody wants to call it a stimulus because that’s gotten to be a dirty word. But we have a big stimulus. So we do — in my view, whether we have a 10 percent of GDP deficit —

ROSE: Right.

BUFFETT: — which is a huge stimulus or a 12 percent or eight percent it doesn’t make much difference. I — I think that we pushed monetary policy to a level, we’ve pushed fiscal policy to the limit but fortunately the most important thing in terms of this country ever coming out of recessions has been the natural workings of capitalism and I think you’ve seen that for the last couple of years.

Following through

BUFFETT: What our leaders were saying to us then, the key players are saying we’ll do whatever it takes. And I believed it. I knew they had the power to do whatever it took and I believed they would do it.

Now, the problem about government now is that if they come out and get on the Sunday talks shows and say “I’ll do whatever it takes”, you know, people don’t believe them. And I mean, they — they — they’ve got to see action and — and here they see something like the raising the deficit limit used as a hostage for something of vital importance to the United States. And if you — you can use it as a hostage in terms of spending, you can use it as a hostage on funding on education or anything else. I mean, it isn’t limited about it; if you’ve got something that comes up like it.

Incentives

BUFFETT: But I just use it to illustrate that this is a world of incentives and we work on incentives in every way. If we work on education, in business, every other place. And what I try to think of the incentives to get somebody who comes up for re-election in a year to do something where the policy cycle goes out five years or ten years, how do you do it when the policy cycle exceeds the electoral cycle? You’ve got to make sure the electoral cycle is in the equation.

An Introduction to the Mental Model of Redundancy (with examples)

“The reliability that matters is not the simple reliability of one component of a system,
but the final reliability of the total control system.”

Garrett Hardin

***

We learn from Engineering that critical systems often require back up systems to guarantee a certain level of performance and minimize downtime. These systems are resilient to adverse conditions and if one fails there is spare capacity or a backup system.

A simple example where you want to factor in a large margin of safety is a bridge. David Dodd, a longtime colleague of Benjamin Graham, observed “You build a bridge that 30,000-pound trucks can go across and then you drive 10,000-pound trucks across it. That is the way I like to go across bridges.”

Looking at failure, we can see many insights into redundancy.

There are many cases of failures where the presence of redundant systems would have averted catastrophe. On the other hand, there are cases of failure where the presence of redundancy caused failure.

How can redundancy cause failure?

First, in certain cases, the added benefits of redundancy are outweighed by the risks of added complexity. Since adding redundancy increases the complexity of a system, efforts to increase reliability and safety through redundant systems may backfire and inadvertently make systems more susceptible to failure. An example of how adding complexity to a system can increase the odds of failure can be found in the near-meltdown of the Femi reactor in 1996. This incident was caused by an emergency safety device which broke off and blocked a pipe stopping the flow of coolants into the reactor core. Luckily this was before the plant was active.

Second, redundancy with people can lead to social diffusion where people always assume it was someone else who had the responsibility.

Third, redundancy can lead to increasingly risky behavior.

* * *

In Reliability Engineering for Electronic Design, Norman Fuqua gives a great introduction to the concept of redundancy.

Websters defines redundancy as needless repetition. In reliability engineering, however, redundancy is defined as the existence of more than one means for accomplishing a given task. Thus all of these means must fail before there is a system failure.

Under certain circumstance during system design, it may become necessary to consider the use of redundancy to reduce the probability of system failure–to enhance systems reliability–by providing more than one functional path or operating element in areas that are critically important to system success. The use of redundancy is not a panacea to solve all reliability problems, nor is it a substitute for good initial design. By its very nature, redundancy implies increased complexity, increased weight and space, increased power consumption, and usually a more complicated system …

In Seeking Wisdom, Peter Bevelin mentioned some interesting quotes from Buffett and Munger that speak to the concept of redundancy/resilience from the perspective of business:

Charlie Munger
Of course you prefer a business that will prosper even if it is not managed well. We are not looking for mismanagement; we like the capacity to withstand it if we stumble into it….We try and operate so that it wouldn’t be too awful for us if something really extreme happened – like interest rates at 1% or interest rates at 20%… We try to arrange [our affairs] so that no matter what happens, we’ll never have to “go back to go.”

Warren Buffett uses the concept of margin of safety for investing and insurance:
We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.

David Dodd, on the same topic, writes:

You don’t try to buy something for $80 million that you think is worth $83,400,000.

Buffett on Insurance:

If we can’t tolerate a possible consequence, remote though it may be, we steer clear of planting its seeds.

The pitfalls of this business mandate an operating principle that too often is ignored: Though certain long-tail lines may prove profitable at combined ratios of 110 or 115, insurers will invariably find it unprofitable to price using those ratios as targets. Instead, prices must provide a healthy margin of safety against the societal trends that are forever springing expensive surprises on the insurance industry.

Confucius comments:

The superior man, when resting in safety, does not forget that danger may come. When in a state of security he does not forget the possibility of ruin. When all is orderly, he does not forget that disorder may come. Thus his person is not endangered, and his States and all their clans are preserved.

Warren Buffett talked about redundancy from a business perspective at the 2009 shareholder meeting:

Question: You’ve talked a lot about opportunity-costs. Can you discuss more important decisions over the past year?

Buffett: When both prices are moving and in certain cases intrinsic business value moving at a pace that’s far greater than we’ve seen – it’s tougher, more interesting and more challenging and can be more profitable. But, it’s a different task than when things were moving at more leisurely pace. We faced that problem in September and October. We want to always keep a lot of money around. We have so many extra levels of safety we follow at Berkshire.

We got a call on Goldman on a Wednesday – that couldn’t have been done the previous Wednesday or the next Wednesday. We were faced with opportunity-cost – and we sold something that under normal circumstances we wouldn’t.

Jonathan Bendor, writing in Parallel Systems: Redundancy in Government, provides an example of how redundancy can reduce the risk of failure on cars.

Suppose an automobile had dual breaking (sic) circuits: each circuit can stop the car, and the circuits operate independently so that if one malfunctions it does not impair the other. If the probability of either one failing is 1/10, the probability of both failing simultaneously is (1/10)^2, or 1/100. Add a third independent circuit and the probability of the catastrophic failure of no brakes at all drops to (1/10)^3, or 1/1,000.

Airplane Design provides an insightful example. From the code of federal regulations:

The airplane systems and associated components, considered separately and in relation to other systems, must be designed so that the occurrence of any failure condition which would prevent the continued safe flight and landing of the airplane is extremely improbable, and the occurrence of any other failure conditions which would reduce the capacity of the airplane or the ability of the crew to cope with adverse operating conditions is improbable.

* * *

Ways redundancy can fail

In The Problem of Redundancy Problem: Why More Nuclear Security Forces May Produce Less Nuclear Security, Scott Sagan writes:

The first problem with redundancy is that adding extra components can inadvertently create a catastrophic common-mode error (a fault that causes all the components to fail). In complex systems, independence in theory (or in design) is not necessarily independence in fact. As long as there is some possibility of unplanned interactions between the components leading to common-mode errors, however, there will be inherent limits to the effectiveness of redundancy as a solution to reliability problems. The counterproductive effects of redundancy when extra components present even a small chance of producing a catastrophic common-mode error can be dramatic.

This danger is perhaps most easily understood through a simple example from the commercial aircraft industry. Aircraft manufacturers have to determine how many engines to use on jumbo jets. Cost is clearly an important factor entering their calculations. Yet so is safety, since each additional engine on an aircraft both increases the likelihood that the redundant engine will keep the plane in the air if all others fail in flight and increases the probability that a single engine will cause an accident, by blowing up or starting a fire that destroys all the other engines and the aircraft itself.

In (the image below) I assume that 40% of the time that each engine fails, it does so in a way (such as starting a catastrophic fire) that causes all the other engines to fail as well.

Aircraft manufacturers make similar calculations in order to estimate how many engines would maximize safety. Boeing, for example, used such an analysis to determine that, given the reliability of modern jet engines, putting two engines on the Boeing 777, rather than three or more engines as exist on many other long-range aircraft, would result in lower risks of serious accidents.

In more complex systems or organizations, however, it is often difficult to know when to stop adding redundant safety devices because of the inherent problem of predicting the probabilities of exceedingly rare events.

The second way in which redundancy can backfire is when diffusion of responsibility leads to “social shirking.”

This common phenomenon—in which individuals or groups reduce their reliability in the belief that others will take up the slack—is rarely examined in the technical literature on safety and reliability because of a “translation problem” that exists when transferring redundancy theory from purely mechanical systems to complex organizations. In mechanical engineering, the redundant units are usually inanimate objects, unaware of each other’s existence. In organizations, however, we are usually analyzing redundant individuals, groups, or agencies, backup systems that are aware of one another.

The third basic way in which redundancy can be counterproductive is when the addition of extra components encourages individuals or organizations to increase production in dangerous ways. In most settings, individuals and organizations face both production pressures and pressure to be safe and secure. If improvements in safety and security, however, lead individuals to engage in inherently risky behavior—driving faster, flying higher, producing more nuclear energy, etc.—then expected increases in system reliability could be reduced or even eliminated. Research demonstrates, for example, that laws requiring “baby-proof” safety caps on aspirin bottles have led to an increase in child poisoning because parents leave the bottles outside the medicine cabinet.

* * *

Another example of people over-confident in redundant systems can be found in the Challenger Disaster:

A dramatic case in point is the January 1986 space shuttle Challenger explosion. A strong consensus about the basic technical cause of the accident emerged soon afterward with the publication of the Rogers Commission report: the unprecedented cold temperature at the Kennedy Space Center at the time of launch caused the failure of two critical O-rings on a joint in the shuttle’s solid rocket booster, producing a plume of hot propellant gases that penetrated the shuttle’s external fuel tank and ignited its mixture of liquid hydrogen and oxygen. In contrast to the technical consensus, a full understanding of why NASA officials and Morton Thiokol engineers decided to launch the shuttle that day, despite the dangerously cold weather, has been elusive.

The Challenger launch decision can be understood as a set of individuals overcompensating for improvements in space shuttle safety that had been produced through the use of redundant O-rings. This overcompensation interpretation differs significantly from both the traditional arguments that “production pressures” forced officials to break safety rules and consciously accept an increased risk of an accident to permit the launch to take place and Diane Vaughan’s more recent argument, which focuses instead on how complex rules and engineering culture in NASA created “the normalization of deviance” in which risky operations were accepted unless it could be proven that they were extremely unsafe. The production pressures explanation—that high-ranking officials deliberately stretched the shuttle flight safety rules because of political pressure to have a successful launch that month—was an underlying theme of the Rogers Commission report and is still a widely held view today.(35) The problem with the simple production pressure explanation is that Thiokol engineers and NASA officials were perfectly aware that the resilience of an O-ring could be reduced by cold temperature and that the potential effects of the cold weather on shuttle safety were raised and analyzed, following the existing NASA safety rules, on the night of the Challenger launch decision.

Vaughan’s argument focuses on a deeper organizational pathology: “the normalization of deviance.” Engineers and high-ranking officials had developed elaborate procedures for determining “acceptable risk” in all aspects of shuttle operations. These organizational procedures included detailed decision-making rules among launch officials and the development of specific criteria by which to judge what kinds of technical evidence could be used as an input to the decision. The Thiokol engineers who warned of the O-ring failure on the night before the launch lacked proper engineering data to support their views and, upon consideration of the existing evidence, key managers, therefore, unanimously voted to go ahead with the launch.

Production pressures were not the culprits, Vaughan insists.Well-meaning individuals were seeking to keep the risks of an accident to a minimum, and were just following the rules (p. 386). The problem with Vaughan’s argument, however, is that she does not adequately explain why the engineers and mangers followed the rules that night. Why did they not demand more time to gather data, or protest the vote in favor of a launch, or more vigorously call for a postponement until that afternoon when the weather was expected to improve?

The answer is that the Challenger accident appears to be a tragic example of overcompensation. There were two O-rings present in the critical rocket booster joint: the primary O-ring and the secondary O-ring were listed as redundant safety components because they were designed so that the secondary O-ring would seal even if the first leaked because of “burn through” by hot gasses during a shuttle launch. One of the Marshall space center officials summarized the resulting belief: “We had faith in the tests. The data said that the primary would always push into the joint and seal . . . . And if we didn’t have a primary seal in the worst case scenario, we had faith in the secondary” (p. 105).

This assumption was critical on the night of January 27, 1986 for all four senior Thiokol managers reversed their initial support for postponing the launch when a Marshall Space Center official reminded them of the backup secondary O-ring. “We were spending all of our time figuring out the probability of the primary seating,” one of the Thiokol managers later noted: “[t]he engineers, Boisjoly and Thompson, had expressed some question about how long it would take that [primary] O-ring to move, [had] accepted that as a possibility, not a probability, but it was possible. So, if their concern was a valid concern, what would happen? And the answer was, the secondary O-ring would seat”(p. 320).

In short, the Challenger decision makers failed to consider the possibility that the cold temperature would reduce the resilience of both O-rings in the booster joint since that low probability event had not been witnessed in the numerous tests that had been conducted. That is, however, exactly what happened on the night of unprecedented cold temperatures. Like many automobile drivers, these decision makers falsely believed that redundant safety devices allowed them to operate in more dangerous conditions without increasing the risk of a catastrophe.

Redundancy is part of the Farnam Street latticework of mental models.

The decline of Berkshire Hathaway’s stock from Triple-A status

From Alice Schroeder’s new chapter: THE CRISIS: The decline of Berkshire Hathaway’s stock from Triple-A status in the updated (and condensed) version of The Snowball.

As the financial crisis evolved, the lame-duck Bush administration and the new Obama administration followed a consistent course under Federal Reserve Chairman Benjamin Bernanke and Treasury Secretary Timothy Geithner, with the Fed injecting trillions of dollars into the U.S. banking system, trying to forestall deflation—chronic falling prices such as occurred in 1932. The still unfolding crisis revealed its complex brew of causes, including artificially low interest rates, foolish borrowing by businesses and individuals, foolish lending by banks and investors, overreliance by institutions on complex financial instruments, aggressive behavior by derivatives traders, conflicts of interest at the banks being paid as agents to package loans sold to them by originators and resell them to investors, a climate of deregulation, lax oversight and enforcement by regulators, abdication of responsibility by rating agencies, inadequate capitalization of bond insurers, investor indifference—in other words, effects of all the normal dysfunctions that precipitate a bubble.

Of the responsible parties, it was the banks and AIG that earned the public’s greatest ire, while Buffett became the public’s greatest symbol of financial responsibility.

Treasury yields soon reached zero, but the flood of money failed to open the channels of business lending; credit remained virtually nonexistent. Buffett, who was at the time acting as the economy’s greatest cheerleader, lent at interest rates that in some instances bordered on usurious—$150 million of twelve percent notes in Sealed Air; $300 million of Harley-Davidson debt for a fifteen percent interest rate; $300 million of ten-percent contingent convertible senior notes from USG; $250 million of Tiffany bonds at ten percent; and a $2.7 billion, twelve-percent perpetual convertible stake in Swiss Re that would give Berkshire a thirty-percent ownership in the insurance giant.

This latter move baffled insurance industry insiders, including Swiss Re employees. Swiss Re was General Re’s biggest competitor; observers concluded that, on any terms, the investment to prop up Swiss Re made no sense because of its negative long-term strategic consequences to Berkshire—unless Buffett ultimately meant to take over Swiss Re and merge it with General Re. In the past, however, Buffett had made opportunistic insurance investments that worked against Berkshire’s long-term interests. Challenged on this, he would respond, “If we don’t do it, somebody else will.” Thus it was equally likely that there was no strategy whatsoever behind the deal besides extracting some fast cash from the pockets of the Swiss.

Throughout, Buffett became an even more frequent presence on CNBC and other networks. He filled the role of America’s statesman and father figure during the financial crisis, but he had also fallen into the trap of competing for attention instead of trusting that his sterling record would bring it to him. “Dignity, Warren, dignity,” counseled one of his friends—but Buffett had never wanted to be dignified; he had never minded looking silly if it would get people to pay attention to him. He was a performer and a showman, and now he feared the show might end. He would keep on giving as many performances as possible while there was time. And indeed, his profile grew and grew in proportion to how often he appeared on the magic medium of television.

All this was not only personally effective—Buffett was his own best publicist—but also understandable for someone his age, until his marathon performances on CNBC resulted in some serious gaffes: criticizing newly elected President Obama’s performance, giving advice to the White House (the Shoe Button Complex, something that Buffett had heretofore spent a lifetime avoiding), and a claim that he, like everyone else, had thought housing prices could only go up—an absurdity that raised eyebrows.

When Berkshire finally reported its 2008 earnings, the consequences of some of Buffett’s earlier decisions became even clearer. The insurance businesses had suffered large losses from that year’s unusually active hurricane season. “Last year was a bad year for a float business,” Munger would later say at the shareholder meeting, citing GEICO and the energy and utility businesses as bright spots. Although Buffett referred to Berkshire’s “Gibraltar-like” balance sheet, the erosion in its financial strength was unmistakable. Because of Berkshire’s heavy insurance exposure and its concentration in financial stocks such as American Express, Wells Fargo, and U.S. Bancorp, its book value was down by 9.6 percent—only the second decrease in its history (and the largest). Berkshire had recorded $14.6 billion of accounting losses on its derivative contracts. While many of these losses would probably be reversed in the long run, they had a significant impact on the balance sheet. Nearly all of the decline was due to bets on financial assets that were market-dependent.

Even so, the decrease in Berkshire’s book value was insignificant compared to major banks and nonbank lenders, which were technically insolvent or close to it, and receiving hundreds of billions in government aid. Buffett had steered Berkshire to a stellar performance, by that measure. All the work of many years had culminated in this moment: Berkshire standing alone after other businesses crumbled around it.

You would not know this by reading some of the commentary on Buffett. One of his challenges at this late stage of his long career was that he tended to be measured by some observers and journalists against a standard of perfection, as if he had to be infallible to be any good at all.  Bloggers and financial writers went wild writing about Buffett’s derivatives exposure. Buffett went on the counterattack. That year’s shareholder letter contained a lengthy explanation of his reasoning for selling the equity-index puts. Yet by some calculations, under various scenarios Berkshire could indeed lose billions at the expiration dates of these contracts, which were not as well priced as Buffett had apparently thought when he entered into them. Ultimately, the concentration of financial assets and their effect on Berkshire’s value was significant enough that first Fitch Ratings, then Moody’s, downgraded the credit ratings of Berkshire and its subsidiaries (such as National Indemnity and MidAmerican) by one notch, from AAA or the equivalent.

The top rating had given Berkshire a lower cost of funding and significant advantages in its insurance business, which made it attractive to sellers of businesses. Buffett had displayed quiet satisfaction when Berkshire’s two largest insurance competitors lost their triple-A ratings, and had at times said privately that the one thing he would never do was jeopardize Berkshire’s triple-A, which he considered one of its most precious assets. In his shareholder letters, he liked to comment that Berkshire was one of only “seven,” or whatever the dwindling number was, of the remaining triple-A companies. He considered it unlikely that this rating, once lost, would be reinstated.

Now Berkshire had suffered that blow, which it probably could have avoided by raising (expensive) equity capital, something Buffett chose not to do. At the 2009 shareholder meeting, he downplayed the consequences. He said the derivatives did not impinge on capital and that a triple-A rating only conveyed “bragging rights.” “We’re still a triple-A in my mind,” he said. It was actually possible that Berkshire—in its uniqueness—could get the rating reinstated, but if so, it would be expensive even if Berkshire did not have to raise capital: It would have to reduce its exposures to insurance and equity market risk as a percentage of book value. Buffett probably would choose not to pay that price because its benefit was limited; no other financial institution remained with a triple-A rating.

Thus, the real meaning of the downgrade, in a larger context, was that the crisis had unveiled the true risk inherent in the global financial system—and the rating agencies had responded by increasing the capital threshold for a triple-A rating to a level that meant even the soundest institution found it financially unattractive to qualify.

Buffett also revealed at the 2009 shareholder meeting that to reduce Berkshire’s derivative risk, he had renegotiated two of the equity-index put contracts, shortening the terms by eight years in order to lower the price at which Berkshire would have to pay out losses. By then, the values of Wells Fargo, U.S. Bancorp, and American Express had begun to recover, but Wells and U.S. Bancorp had cut their dividends, which would also affect Berkshire’s future earnings. Buffett predicted that Wells Fargo would not have to issue stock, a prediction that was almost immediately contradicted when Wells Fargo did just that. He scored better a few weeks later when Berkshire’s SEC filings revealed that he had been buying American Express while the stock was on its back.

Thus, during the financial crisis, Buffett made a series of characteristic brilliant moves interspersed with some surprising errors. Above all, he stood pat on existing investments while adding cleverly structured new deals, deals that for the most part were not available to ordinary investors. These opportunities came to Berkshire because of its ready cash and underlying financial strength, and because of Buffett’s willingness to rent his well-earned reputation and provide quick, trustworthy handshake dealmaking.

The actions he had taken with deals struck in 2008 and 2009, in accordance with his saying “Cash combined with courage in a crisis is priceless,” would enrich Berkshire shareholders for many years to come. At the same time, the crisis—which admittedly had so many episodes of heart-stopping disintegration into near economic collapse that in some ways it eclipsed the events leading to the Great Depression—left Berkshire a weaker company financially. It undercut Buffett’s reputation as a nearly infallible manager, and cost the company its top financial rating.

The 2009 shareholder meeting would prove to be both a celebration of Berkshire’s success and a chance for Buffett to defend himself. He had changed the meeting format so that half the questions would concern Berkshire and would be submitted through a panel of journalists: Carol Loomis, Becky Quick of CNBC, and Andrew Ross Sorkin of the New York Times. A torrent of five thousand questions poured in, many of them tough-minded queries from people who wanted answers but who had not, in the past, been willing to wait hours for a position at the microphone while others asked Buffett about his personal relationship with Jesus Christ and what books he and Munger had read lately.

The new format and the unsteady economy attracted what was said to be a record thirty-five thousand people in attendance despite Berkshire’s stock price, which hovered at $90,000 per share. Buffett, who never said anything spontaneous, always seemed to have an answer prepared for every question that could be anticipated. The main difference in 2009 was that shareholders were asking truly challenging questions, rather than flattering him with their gratitude for being able to stand in his presence and receive his wisdom. At his most impressive he rattled off statistics and explained economics with a clarity that people were not hearing from anyone else. But his answers on other questions were more awkward. Buffett liked to deal with confrontation indirectly. Put on the spot, he behaved as he did in private, avoiding direct answers to some questions and meting out unpleasant information through hints and sometimes by omission.

Challenged on his decision not to sell financial stocks in the spring of 2008, he said he only sold when a company’s competitive advantage disappeared, he lost faith in management, or he needed cash. He was cutting a fine distinction in trying to separate his criteria for selling stocks when companies’ circumstances were changing materially all the time, versus selling whole businesses, which happened only when they became economically unviable or had persistent labor problems. With newspapers folding in cities all over the United States, he also went so far as to raise the possibility of eventually shuttering the Buffalo News, but said that as long as the News made a little money and had no labor problems, he and Munger would “keep it going.”

Buffett was questioned sharply about why he did not sell Moody’s when its business model was fundamentally compromised after the rating agencies were implicated in causing the financial crisis. He said he thought the odds were that Moody’s was still a good business, and that he did not think conflict of interest—rating agencies are paid by the entities they rate—was “the major cause” of the problem. (Another conflict of interest, not mentioned, was Berkshire’s twenty-percent ownership of Moody’s when Moody’s rated Berkshire.) Many in the audience had spent years listening to Charlie Munger’s often repeated saying, “whose bread I eat, his song I sing,” and understood that Buffett was rationalizing as he always did in pursuit of a profit or when he felt backed into a corner—or both.

When Buffett was asked how the four investment managers he had chosen as possible replacements performed during the 2008 market crash, and whether they were still on the list of candidates, he said they “didn’t cover themselves with glory,” then commented that neither did most investment managers during this period. Buffett did not respond to how these managers did relative to the market or to their relevant benchmarks. He left a vague impression that the list of candidates might change, over time.

What was certain, whichever candidates were chosen, was that the stock market would eventually recover. More important were Berkshire’s businesses. Most were among the best in their respective industries. Buffett had built a conglomerate of stable businesses that were likely to be profitable for a long time. Still, the events of 2008 had certainly convinced many shareholders that Berkshire was not a company that could be run by a ham sandwich after Buffett was gone.

At the meeting they grilled Buffett about the question of succession with new intensity. The next CEO’s challenges would be keeping Berkshire’s managers happy, managing the company’s franchise and risks, and investing the cash flow the businesses threw off. Buffett insisted that all the candidates were internal.

He said that running a major operating business was the best qualification for the CEO job. He next talked about what he actually did as CEO, which did not involve anything remotely resembling running an operating business (nor had Buffett ever run an operating business; nor could he have, had he been forced to do so). He stated that the operating managers had experience allocating capital—perhaps a necessary rationalization, although nobody truly allocated capital at Berkshire other than Buffett, particularly not in financial services, the heart of the company and the site of Berkshire’s recent woes.

The answer revealed that Buffett was publicly introducing a rationale to pave the way for someone like David Sokol, the presumed front-runner who ran MidAmerican Energy. Buffett was also using a selection process that in some ways mirrored his two disastrous experiences at Coca-Cola, one that could someday put the board in an awkward spot.

To be sure, Buffett had already divided executive authority in a way that many outside candidates would not find comfortable—with his son Howie succeeding him as chairman, and Bill Gates taking on the role of de facto lead board member as representative of Berkshire’s largest future shareholder, the Bill and Melinda Gates Foundation. This meant that, for better or worse, Berkshire probably would always be run in an unusual manner by unusual people.

The unusual company that Buffett—or Sokol, or possibly even a committee—would be running was stable and successful, and had, because of the financial crisis, gained relative advantage over its rivals in many of the businesses in which it operated, even though as of spring 2009 its results and financial condition also reflected the weakened economy.

As for the future, Buffett said retailing, especially of luxury products, might not recover for years. Companies like Borsheim’s and NetJets were going to struggle. He said little more about NetJets; the sparsely populated aisles at Borsheim’s on Sunday after the meeting spoke for themselves. On a brighter note, he said that new household formation was the key to recovery of housing related sales, with 1.3 million new households formed in the United States every year.

He spoke optimistically of the long-term future of the U.S. economy, which had survived two world wars, many panics and depressions, the resignation of a president in disgrace, and civil unrest. At various times, he had discussed what he expected to be inevitable inflation and the declining value of the dollar. Yet it was the “unleashed potential” of the human race that caused economies to grow over time, he said; in other words, productivity. The world’s system to increase productivity works naturally and has been working for a long time. Munger waxed enthusiastic over Berkshire’s investment in BYD, a Chinese maker of electric cars. We are about to harness the power of the sun, he said, and use more electric energy to preserve hydrocarbon energy for chemicals that are more important. The main technical problem of mankind is about to be fixed, he opined. Then he and Munger headed off to meet with the international shareholders, and Buffett and Astrid attended another round of parties on Saturday night.

Within days, Buffett would begin planning the 2010 meeting—when he would be almost eighty. He couldn’t believe he would be eighty. Every year he attacked the meeting planning as though this year would be his ultimate statement—his greatest show on earth. In 2009, he had shown off an electric car. He would have to find some way to top that in 2010.

Meanwhile, to his slight chagrin, Borsheim’s had missed out on one sale in 2009. (Every sale mattered to Buffett.) At 3:00 p.m. during the shareholder meeting, “Alex from Boston” asked Buffett what individuals could do to help the economy. Buffett said, first, to spend money, then repeated that new household formation would be helpful to the economy. With that, “Alex from Boston,” who was Buffett’s grandnephew Alex Buffett Rozek, asked his girlfriend Mimi Krueger to marry him. Mimi, stunned to be asked in front of thousands of people, said yes, and Alex gave her his grandmother Doris’s sapphire-and-diamond ring, which Warren had given his sister for her seventy-fifth birthday.

Buffett the showman had always wanted to have a wedding at the Berkshire shareholder meeting, but had never quite managed to pull that off. He would settle for an engagement instead.