Sherlock Holmes, The Grain of Wheat, and The Snowball

The great fictional detective Sherlock Holmes was a frequent user of cocaine, and his companion Dr. Watson disclosed that the great man preferred a 7% solution, to ease his mind and let him relax to ponder various complex cases. Perhaps slightly obliquely, the phrase “7% solution” immediately made me think of long term investment strategies. A compounded return of some 7% annually (well 7.2%) will see a sum double every ten years, and somewhat strikingly in a period of 100 years, the capital will have grown by over a thousand fold. Quite a “solution”!


This idea of the enormous power of compounding was nicely illustrated by the great Islamic scholar Ibn Kallikan in 1256 (though its origins are almost certainly far older), when he considered the simple task of putting grains of wheat on a chessboard. The puzzle asks you to put one grain of wheat on the first square and double the amount on each subsequent square thereafter…so two grains on square two, four grains on square four etc…until all sixty four squares of the board are covered. So how many grains of wheat will be on the board overall?

Perhaps somewhat astonishingly, on the entire chessboard there would be no less than 18,446,744,073,709,551,615 grains of wheat, weighing about 1,199,000,000,000 metric tons. This is about 1,538 times the global production of wheat (780.8 million tonnes in 2019).

So, doubling is a hugely powerful force, but away from wheat on chessboards, how realistic is this in long-term investment? Interestingly 7% average returns are not that impossible, over many different time horizons global equity markets have delivered those sort of total returns. Detailed information across various asset classes can be found in the Annual Credit Suisse Global Investment Returns Yearbook (see reference below) and for example US equities in real terms (i.e., after inflation) between 1900 and 2019 returned on average 6.5% p.a., and in the last ten years global equites generated 7.6% p.a. (Though it should be noted returns across a wider portfolio of all stock markets for the last 120 years produces a lesser return of 5.2% p.a.) So our desired 7.2% cannot be guaranteed but investment returns can still be a powerful creator of wealth.

Now on to the snowball – this is a simple way to think of the effect of re-investing any investment income – in time it starts to act like a snowball. This analogy was used in a well-known book on the celebrated investor Warren Buffet, The Snowball: Warren Buffett and the Business of Life by Alice Schroeder.

All of these examples point to two simple investment precepts, invest early (or at least regularly throughout your savings life) and always re-invest any income. In forty years at 6.5% p.a. a £1,000 racks up nicely to around £12,500.
Whilst we may not quite get to Holmes’s 7% solution, we will get wealthier and stay somewhat healthier than the great detective.

References

https://www.credit-suisse.com/about-us-news/en/articles/media-releases/credit-suisse-global-investment-returns-yearbook-2020-202002.html

On-Line Talk From Here to Uncertainty

Talking at the London Richmond Group on 13th March
My online talk is entitled “From Here to Uncertainty” with three “provocations” to stimulate ideas and debate
– The false god of certainty
– The dangers of an “over connected” world
– Efficiency is the enemy of innovation
More info and tickets for non members here

https://www.eventbrite.co.uk/e/from-here-to-uncertainty-tickets-138645234629

In Praise of Effectuation

This is an extract from Two Speed World – a book I co-wrote in 2010. The topic of effectuation seems little discussed but is a good way to think about how entrepreneurs think and act in new fields where there is little or no past data and so plenty of uncertainty.

Effectuation

As we have noted, Ed Roberts produced the Altair 8800 without having any idea who would buy it, or what they would use it for. In the event it pushed IBM into producing the PC which in turn created 10,000 millionaires from Microsoft employees by the year 2000. One was Rob Glaser who took his money in 1994 with the intention of becoming involved with charitable works and civic projects. He wanted to promote his progressive politics and decided that the Web, plus Mosaic, plus 14.4kbps modems made streaming audio a possible route. Because no-one had done such thing before, there was no pattern to follow and in the event Glaser never did promote his ideas through the Web. He had said that he was not interested in the purely economic end of this ‘anymore than Pavarotti is interested in getting paid to sing’, but he became rich just the same and found another way to promulgated his politics, donating over $2.2 million to pro-Democratic organisations the 2004 US election.

There was no way to make a business plan with a pre-determined goal, because at that time there was no real-time audio streaming on the Web. There was no way to gauge market acceptance in a non-existent market. There could be no measurable risk, no statistical uncertainty, just an unknowable future. On the face of it, it was the worst possible situation, but only from the standpoint where a plan is constructed to maximise expected returns only after comprehensive analysis. Glaser did not have to do that, he was going to invest his money into streaming audio anyway and see what goals emerged. This changed the picture completely.

While Knightian Uncertainty with its unknowable future does not allow us to predict a particular outcome as bystanders, if we control events then we do not need to predict the future, we can create it. This neat inversion is called ‘effectual reasoning’, causing things to happen, rather than ‘causal reasoning’, measuring the causes of external events. In the causal world ‘to the extent that we can predict the future, we can control it’. With effectuation ‘to the extent that we can control the future, we do not need to predict it’. In a position of Knightian Uncertainty, the person who bases his decisions on effectuation has a market advantage, because unlike the causal reasoner, he knows where he is going.

Professor Saras Sarasvathy, a leading scholar on the cognitive basis for high-performance entrepreneurship believes that effectuation is a powerful tool in expert entrepreneurial hands. She uses a simple cooking analogy to show the difference between the two styles of decision making.

 ‘You can start from a recipe and follow it (causal), or you can look in the fridge and rustle up something with what you find (effectual).’

Only by using the latter technique will anything new ever be produced. In the absence of similar products in established markets, it is the only way that such goods can be created.

Sarasvathy believes that Glaser was able to employ effectuation because his payoff from Microsoft enabled him to consider the affordable loss, rather than an expected return; his ten years in the software business provided many opportunities to establish strategic partnerships despite the untried nature of the venture; he could react quickly to unexpected events and benefit from them.

Rather than predicting the future and following it, the entrepreneur needs the logic of control to create the market and thereby define the future. This makes prediction unnecessary, Knightian Uncertainty is destroyed, and surprises can be turned into advantages.

How is control of the future achieved?

Firstly by influencing industry standards, which is made easier by being first.

Secondly by alliances and stakeholder commitments so that everyone is singing from your song sheet.

Finally by continual innovation, because a new industry is very unlikely to be right first time.

Sarasvathy and Kotha analysed Rob Glaser’s company RealNetworks, and its products RealAudio, RealVideo and RealPlayer against the effectuation criteria. They found that because Glaser was prepared to incur an affordable loss, products were brought quickly to market, RealPlayer achieved 80% market share and as a result RealNetworks products became the de facto standards. RealNetworks products sat between the content providers and the computer software suppliers and so it was vital to have alliance to maximise the linkages between the two sides. This RealNetworks did to great effect with150 strategic partnerships agreed in 29 months. Innovation was not neglected, with one third of the staff engaged in Research and Development. By 1997, three years after its creation, the company had revenues of $36.3M and went public. This shows the power of effectuation for the entrepreneur, especially in the presence of an external driver as powerful as the Internet. But as a company moves from start-up to established multi-national, the market becomes mature and causal processes come to the fore. In early 2010, Rob Glaser the entrepreneur stepped aside from day-to-day management, McKinsey and Co conducted a strategic review and management talked in the causal, and some might say contradictory,  terminology of an ‘exciting roadmap for the future’.

References

Two Speed World by Gerald Ashley & Terry Lloyd

Effectuation: Elements of Entrepreneurial Expertise by Saras D Sarasvathy

Human Risk Podcast – An interview with me and Rory Sutherland (Part 1)

To celebrate the Podcast “Human Risk” achieving one hundred interviews; advertising and marketing guru Rory Sutherland and I, did a special celebration podcast for the site.

In fact it is in two parts – here is Part One where we cover a whole host of topics including the tube map, eating eggs, and Rabbit phones.

https://www.podpage.com/the-human-risk-podcast/rory-sutherland-gerald-ashley-on-networks-part-i/

The How’s and Why’s of Decision Making

A few years back I was lucky enough to chair a series of talks at The Royal Institution in London. The audiences were made up of finance types usually with a science background and the idea was to a get a series of speakers in to range across a number of topics that would spark lively debate. A particularly memorable speaker was the distinguished American physicist Larry Krause. His theme was the importance of questioning and critical thinking in science, and indeed in life in general.

Professor Krause raised an important idea that really resonated with me; namely when confronted by a problem or examining an issue, we tend to rush towards asking Why? This seems particularly true in my own field of finance. Why is the Dow lower? Why are people buying gold? Why are “those idiots” buying at these levels?

Krause suggested that we should not forget to ask How?  Indeed, How, might often be the more appropriate question and may lead to a wider set of possible answers. By thinking about the How, it draws our mind to seek to understand the underlying mechanics and relationships that may help better explain things. We should acknowledge that this wider set of explanations can be a good thing – all too often we grab at the first answer to a problem, and fondly believe that it, must be the solution. Regrettably the human desire for slam dunk solutions knows no bounds and can lead to bad decision making.

By way of example he noted that in his own specialised field many outsiders, particularly non-scientists, spent a lot of time asking Why and Who created the universe, but rarely thought enough about How it came to be. As ever of course, there can be an uncomfortable twist – answering How may be devilishly difficult and potentially impossible. Hence the rush to concentrate on answering Why (or at least present a plausible scenario) and quickly move on, triumphantly announcing the issue was “solved”.

But why may answering How be impossible? Well some of the most difficult issues we face do not readily give up the answer to How. We have to understand that many interactions in life; science, markets, business, and our own behaviour do not always follow predictable linear paths. The past may be an extremely poor guide to the future, and so teasing out the structure or pattern of a current situation and how it may unfold may be impossible. We find this doubly a problem as humans are very attracted to pattern matching, finding patterns in random or noisy data that not really there. (The age-old example of the supposed image of Jesus on burnt toast comes to mind).

So tackling How can mean a very big challenge. In recent years interest in and the application of Complexity Science and understanding non-linear networks has attracted a lot of attention. This is still very much a developing field, but decision makers need to be aware of it might unlock the How puzzle and lead to a wider set of better decisions.

If you are interested in learning more about Complexity, and its applications I would suggest the following links:

Books

Positive Linking – By Paul Ormerod 

The Tangled World by myself and Terry Lloyd

Elsewhere

New England Complex Systems Institute

https://necsi.edu/an-introduction-to-complex-systems-science-and-its-applications

Santa Fe Institute 

https://www.santafe.edu/applied-complexity/office

Animal Spirits and Beauty Contests

This is a short extract from my book Financial Speculation. Its a quick look at two key components to successful investing as espoused by John Maynard Keynes. To me it is timeless advice that I try to adhere to.

Animal Spirits and Beauty Contests
Perhaps as a final observation on Keynes activities we should consider the fact that he never published any work on his secret investment techniques etc., though his views and attitudes are well documented. In particular Keynes wrote interestingly about speculation and what he called ‘Animal Spirits’. He noted that most market players are driven by optimism rather than mathematical expectation, and he was an early observer of one of the most corrosive of market practices – excessive activity or overtrading. He correctly realised that when under stress people often adopt active roles for the sake of it. Such is usually a substitute or a displacement activity, or as a way of trying to shake off the stress. Many people feel stress when involved in financial markets and they often alleviate this with quite manic trading activity. Bizarrely they trade even more ferociously when in fact they should calm down and draw back. Though in fact this only one side of the ‘behavioural’ coin in market psychology, the other big problem is curiously the exact opposite, freezing and being unable to act to stop losses from running out of control. Trading like so many things requires a happy medium of activity – few of us seem to be able to do this on a consistent basis.

Keynes also saw the problem of market speculation and prediction as akin to trying to guess who would win a beauty contest; he compared speculation to a newspaper beauty contest, where one is asked to pick out the prettiest faces among hundreds of photographs; and also most crucially to predict which is the most popular choice of all the entrants in the competition. So for example you may pick contestant number 54 – but sense that girl number 23 is the most popular. This is akin to looking at say the FTSE 100 list of stocks and you decide that you really like BP – but realise that the market really likes Vodafone.
Keynes held that to be successful in investment we have to choose not the ones we think are the “prettiest”, but the ones that we think everyone else will select. This piece of market thinking demolishes much of the supposed value of market analysts and commentators – what’s the point in knowing the best oil company in the market if all the price action is in say transport stocks? When Keynes first postulated this idea in the 1930’s it was considered somewhat radical and certainly didn’t conform to the standard views of rationality and assessing financial markets and assets in terms of fair value etc. Over time though, this idea has been developed further, now with a lot of interest being shown in market behaviour and psychology – though many market players and intermediaries seem to ignore it.
Finally, once again Keynes seems to prove the rule that successful market operators let their results speak for themselves. Only the also rans and hopefuls promote their ‘secret’ investment theories and systems, the successful just do it.