Over the four-day long weekend between March 24 and March 27, two exciting cricket matches were played. The Indian cricket team won both the matches.
I saw both these cricket matches end to end, but I had my TV on mute. I do this because I strongly feel that on most occasions TV commentary does not add any value to the visuals on the screen. And honestly, if there was an option which allowed me to just listen to the noise coming from the stadium, without the commentary, I would choose it.
Most cricket commentary and analysis is full of hindsight bias. And what is hindsight bias? As Jason Zweig writes in The Devil’s Financial Dictionary: “Only perhaps a half dozen market pundits saw the financial crisis coming before 2008, but you can’t swing a Hermès necktie on Wall Street without hitting someone who claims to have predicted it. That is typical of hindsight bias, the mechanism in the human mind that makes surprises vanish. Once you learn what did happen, your mind tricks you into believing that you knew it would happen.”
Take the match between India and Bangladesh. Bangladesh had almost won the match and needed to score two runs of three balls. They lost three wickets of the last three balls and India won the match by one run. Of these three wickets, two batsman got out trying to finish the game by hitting a six.
I think the Indian captain Mahindra Singh Dhoni summarised the situation best in what he said after the match: “At times, you look to finish it with a big shot. When you are batting well, you go for it. It is a learning for him [Mahmudullah] and others who finish games. That is what cricket is all about. If it had gone for six, everybody would have said what a shot.”
The trouble is that the Bangladeshi batsman Mahmudullah got out trying to hit a six and win the game for his team. And the commentators immediately pounced on him and declared that he should not have gone for the glory shot. The Bangladeshi cricketers were also called chokers. Nevertheless, if Mahmudullah had been able to hit a six, the same set of commentators would have had good things to say about him.
As Dhoni further said: “In-form batsmen often try to play big shots to finish the game. If that shot by Mahmudullah had crossed the ropes, he would have been hailed as a courageous gutsy batsman. Now he will face criticism for playing such a shot.”
An almost similar thing was at view when Virat Kohli single-handedly helped India beat Australia. After India won, the commentators kept talking about his aggression and how it helped him play the innings that he did. The point is that if he had gotten out, the same aggression would have been blamed for his and the Indian team’s downfall.
The outcome of the game determines the analysis that follows. And the confidence with which the commentators speak makes you believe that they had really seen it coming. Of course, the fact that they have played the game in the past, adds to the confidence that they are able to project. But do they really see it coming? I don’t think so.
They day batsmen get out trying to hit shots, the analysis blames them for hitting rash shots. On days these shots come off, the commentators feel that taking a certain amount of risk is a very important part of modern day cricket.
In fact, hindsight bias impact even the commentary that accompanies every ball that is bowled and not just the analysis accompanying the overall result of the match. In the India versus Australia game, I was listening to the Hindi commentary and I think Shoaib Akhtar was speaking (though I am not sure about this) at that point of time. Virat Kohli hit a ball in the air and from the initial looks of it, it seemed that the ball would not cross the boundary and an Aussie fielder would take the catch.
So the first thing Akhtar said was “Kharab shot (A bad shot)”. Just a second later the ball had sailed across the boundary, Kohli had hit a six, and Akhtar said: “behtareen shot (what a good shot)”. Akhtar’s commentary immediately took into account the end result (i.e. Kohli hitting a six) and what was a bad shot suddenly became a terrific one.
The question is why does this happen? The Nobel Prize winning psychologist Daniel Kahneman has an answer for this in his book Thinking, Fast and Slow. As he writes: “The mind that makes up narratives about the past is a sense-making organ. When an unpredicted event occurs we immediately adjust our view of the world to accommodate the surprise. Imagine yourself before a football game between two teams…Now the game is over, and one team trashed the other. In your revised model of the world, the winning team is much stronger than the loser, and your view of the past as well as the future has been altered by that new perception.”
Then there is this other point that Dan Gardener writes about in Future Babble: “After a football team wins a game, for example, all fans are likely to remember themselves giving the teams better odds to win than they actually did. But researchers found that they could amplify this bias simply by asking fans to construct explanations for why the team won.”
This is precisely what happens to cricket commentators and the analysis that they have to offer after any game of cricket is over. Given that they have offer explanations of why the team wining, actually won, they end up amplifying the hindsight bias.
Depending on the result, the commentators offer an analysis. Some of it can be as banal as the winning side fielded better, batted better and bowled better (Something that Mohammed Azharuddin used to say all the time in his post-match comments when he was the India captain).
This is not to say that this analysis is incorrect, but why do we need a commentator to tell us this. It is very obvious. On most occasions a team that bats better, bowls better and fields better, is likely to win.
The hindsight bias also impacts stock market experts and analysts who try and make sense of the stock market on a regular basis. After a crash you will hear all kinds of pundits trying to claim they had seen it coming all along. And believe me they will make a very compelling case for it.
Nevertheless, it is important to keep in mind what Jason Zweig says. As he writes: “Contrary to popular cliché, hindsight is not 20/20; it is barely better than legally blind. If you don’t record and track your forecasts, you shouldn’t say that you knew all along what would happen in the end. And if you can’t review all predictions of pundits, you should never believe that they foresaw the future.”
Vivek Kaul A lot has been written on India’s fabulous win over Australia on October 16, 2013. The underlying message in almost all of these articles has been very positive. As one columnist put it in the Daily News and Analysis “Make no mistake, Jai Ho! Pur is no flash in the pan. It is a sign of the things to come.” If what happened on October 16, 2013, is a sign of things to come, then I am really worried. And so should be you, if you are an average Indian cricket fan, like I have been. I have followed the travails of the Indian cricket team, largely on television and radio, for more than 25 years now. I have watched games, where I knew from the very beginning that it’s a lost cause. I have religiously gone through scoreboards in the next day’s newspaper after having watched the full match on television, a day earlier. I have laughed my heart out while reading Hindi newspapers, which referred to leg before wicket as pagbadha. I have prayed to God to ensure that there is an uninterrupted supply of electricity on days India was playing. I have spent hours trying to tune in to short wave radio to listen to commentary in the late 1980s and early 1990s, before the advent of cable television, when most international tours of the Indian cricket team were not broadcast live on television. And it was on radio I heard that a certain Sachin Ramesh Tendulkar, had scored his first century and helped India save a test match against England, in 1990. I have spent time watching an ODI series between England and India, before my tenth standard exams, and am still paying the the price for it. I have prayed to God that the other God bats well and helps India win, a countless number of times. I was depressed for almost one week when Sri Lanka beat India in the World Cup semi final at Calcutta (now Kolkata) in 1996, on an underprepared pitch which broke down and started turning like a top, in the second innings. I still hate Jagmohan Dalmiya for it. Sachin Tendulkar’s straight drive and Venkatesh Prasad’s slow leg cutter are two things that I can watch over and over again. I almost jumped out of my seat in office, when Joginder Sharma dismissed Misbah-ul-Haq, and helped India win the first T20 world-cup in September 2007. And I wished that I was a part of the impromptu celebration that broke out at Firayal Chowk in Ranchi, after the city’s most famous son, hit a six at the Wankhede Stadium, to help India win the 2011 fifty over world cup. Watching cricket has been a non-stop roller-coaster ride with emotions from fear to exhilaration to hope to defeat, built into it. But on October 16, 2013, I wondered whether all these years of watching cricket has really been worth the trouble? I saw more or less the entire match on mute(to be honest I just can’t hear Ravi Shastri saying and that went like a tracer bullet one more time). And by the end of the match I wasn’t really sure if I was watching an international cricket match or a video game. My Samsung phone has a cricket video game built into it. In this game, the batsman knows exactly where the bowler is going to pitch the ball. He also knows the likely speed at which the ball is going to come at him. Hence, he can decide in advance which shot to play. Typically, most balls can be hit for a four or a six. In short, the game is loaded totally in favour of the batsmen. The bowler is just an insignificant part of the game. What I saw on October 16, 2013, was very similar. The wicket was dead. It did not have anything in it either for spinners or for fast bowlers. The worst of ODI cricket where the rules and the playing conditions are totally against the bowlers, was at work. The power of heavy bats was at display, with even mis-hits crossing the boundary line. Cricket bats have become heavier over the years. Anyone who watches slow motion replays carefully, can easily figure out that even rank mis-hits go for a six these days. Only, four players are now allowed outside the 15 yard circle at any point of time, making it even more difficult for bowlers specially spinners. Spinners rely a lot on mis-hits to take wickets. These mis-hits can be caught in and around the boundary line. But with only four fielders allowed outside circle, the chances of that happening are significantly lower. This has made it even more difficult for captains to bowl spinners in the final overs. Also, two white balls are now used in a 50 over game. This has led to a situation where reverse swing that a fast bowler can get from an old ball, has been more or less taken out of the equation. It is rare to see toe crushing yorkers these days, which the likes of Waqar Younis, Wasim Akram and Brett Lee, had turned into an art form. This has also made it important for spinners to be able to bowl with the new ball. While it is important to adapt, it was very interesting to see the kind of turn that spinners used to get with the old ball earlier and fox the batsmen. Over the years, boundary lines in cricket stadiums have been brought in. The cricket administrators seem to like the idea of batsmen hitting more sixes. Apparently that is what the crowds want I am told. ODI cricket was never really meant for bowlers. The basic fact that a batsman can keep batting till he gets out, whereas a bowler cannot bowl more than 10 overs in a match, proves that. Over the years, limits were also placed on the number of bouncers that a bowler could bowl in one over. Thankfully this has been corrected, and bowlers are now allowed to bowl two bouncers in an over. This has ensured that batsmen can’t simply jump out of their creases after the one bouncer for the over has been bowled. But even with this, ODI cricket is now loaded totally in favour of the batsmen. And what happened in Jaipur is a brilliant example of that. The era when a team could defend a low score is more or less over (that only happens when the pitch is really bad). The days when the Indian cricket team could score 125 at Sharjah and win the match by bowling out Pakistan for 87, are gone. One of my favourite ODIs was at Perth in 1992, when India made 126 against the West Indies, and managed to tie the match, with Sachin Tendulkar taking the last wicket in the 41 st over, after the captain Mohammed Azharuddin had used up his four major bowlers. Sachin on that occasion had bowled medium pace and got the last wicket with a beautiful outswinger. It’s been a while since I saw such a match in which the bowlers dominated from the very beginning. These days the only way to win a match is to out bat the other team. Bowlers rarely win matches any more. The ICC has been trying to save 50 over cricket over the last few years. It has put an artificial cap on the number of international T20 matches that a team can play during the course of a year. It has also made changes favouring the batsmen, in order to liven up proceedings in 50 over cricket. But anyone who watched the Jaipur match carefully enough on television, would have realised that large parts of the ground were empty (the BCCI commentators of course did not talk about it). This wasn’t the case with the T20 match that happened in Rajkot a few days earlier. Why can’t ICC make a few changes in favour of the bowlers as well? Why limit the number of overs that a bowler can bowl in a match to ten? Why not allow, lets say, two bowlers per team, to bowl even 15 overs in a match? Why not even allow bowlers to tamper the ball in certain ways? The ICC doesn’t stop batsmen from using heavier bats, where the wood is concentrated right at the bottom. As mentioned earlier a lot of mis-hits now cross the boundary line. Given this, I don’t see any harm even allowing bowlers to tamper with the ball. Let the batsmen figure out how to play them. Also, ICC needs to seriously look at the size of the boundaries. Cricket administrators need to stop bringing in boundary lines. As a true cricket fan, I want to see a somewhat equal contest between bat and ball, which has gone out of the window, over the last few years. Maybe, I am getting a little too nostalgic here. Maybe, I am getting old. But for me, on October 16, 2013, 50 over ODI cricket, just died. The article originally appeared on www.firstpost.com on October 19, 2013 (Vivek Kaul is a writer. He tweets @kaul_vivek)
Roger Martin is the Dean of the Rotman School of Management at the University of Toronto, in Canada. In 2011, Roger Martin was named by Thinkers 50 as the sixth top management thinker in the world. He is the author of several best-selling books like The Design of Business: Why Design Thinking is the Next Competitive Advantage (2009), The Opposable Mind: How Successful Leaders Win Through Integrative Thinking (2007) etc. His latest book is Fixing the Game, Bubbles, Crashes, and What Capitalism Can Learn From the NFL(2011) in which Martin argues that there is a lot capitalism can learn from the world of sport. In this interview he speaks to Vivek Kaul. Your book “Fixing the Game” is essentially a criticism of western capitalism. What’s the central idea behind the book? The central idea is that capitalism made a conceptual error when it asserted that the interests of executives would be aligned with those of shareholders if executives were given stock-based compensation. It was a simple and elegant theory – that if shareholders did well, so would executives and if shareholders did poorly, so would executives – but it turns out to produce the exact opposite. Overall, shareholders have done less well and CEOs have done spectacularly better. There has been dis-alignment, not alignment. The current theory threatens the future of capitalism. It produces inauthenticity in management, volatility in the capital markets and contributes to the strength of forces detrimental to broad prosperity – in particular the hedge funds. What is the game that needs to be fixed? And why? The title is double entendre. It means that there are people manipulating, or in the betting parlance, ‘fixing’, the current game of democratic capitalism and we need to fix it in the sense of repairing it. It needs to be fixed now because the current game of democratic capitalism is being undermined. Capitalism can only take so much undermining until it is irreparably damaged. One of the things that you talk about in your book is a real game and an expectations game. Can you take us through that? The real game is the one in which real companies build real factories (or service operations), to make real products (or services), to sell to real customers, to earn real revenues and a real profit (or loss). The expectations game is the one in which investors look at the real market and, on the basis of that observation, form expectations as to the likely performance of the real companies and, on the basis of those expectations, buy or sell shares which collectively sets the prices of those companies in the stock market. Since stocks tend to sell for a large multiple of present earnings – 15 times earnings for the SENSEX over the long term – most of the value of a given stock is in the expectations of future earnings rather than the reality of the current earnings. What can capitalism learn from sport? Capitalism can learn a lesson from all of modern sport – whether American football or Indian cricket for that matter. Each major spectator sport actually involves a real game and an expectations game. In the real game of cricket, batsmen, bowlers and fielders take a real pitch and play real wickets, make real outs and score real runs. Eventually there is a real winner and real loser. There is an associated expectations game: betting on cricket matches. In this game, betters imagine what will happen when the teams take the field and on the basis of those expectations place their bets. On the basis of those bets, bookmakers adjust the odds against the favorites and for the underdogs to balance the amount of money bet on either side. So what are you trying to suggest? The betting odds in a cricket match are identical to the stock price in capitalism – both are products of the expectations market. But that is where the similarity ends. The world of sports is clear about the relationship between the expectations market and the real market: they must be kept separate. If they are not kept separate – i.e. if players in the real game are allowed to participate in the expectations game, they will wreck the real game. Cricket fans know that from the 2010-1 betting scandals in cricket in Pakistan. There key players were accused and tried for influencing the results of real games to aid bettors in making illegal profits in the expectations game. In great contrast to the world of sport, capitalism not only allows, it insists on the key players in the real market also playing in the expectations market. CEOs and other key executives are forced to take a significant portion of their compensation by way of stock-based compensation. In doing so, capitalism threatens the health of the real game. On this front, capitalism is not as smartly managed as cricket. How does this entire idea of “real game and expectations game” contribute to the kind of volatility we have seen in the last ten years? When executives have substantial stock-based compensation incentives, they focus on managing expectations rather than managing the real operations of their company. If an executive is given a stock option with an exercise price at the existing trading price of the stock (the way the vast majority of stock options are priced and given), the only way that option will have any value for the executive is if he or she raises expectations of the future earnings of the company to a higher level than what they are at the time of the stock option award. That means if expectations are already high, then the executive needs to take actions to prod those expectations even higher still – even it is takes extreme actions. And because expectations cannot rise forever because they get ahead of reality, executives know that the most profitable thing that they can do for themselves is jerk expectations up and then leave before they come plummeting back down. This creates wild swings in the capital markets of the sort we have seen in the past decade. Could you give us an example on how this real and expectations game would play out in a company like Google and Microsoft for that matter? At Microsoft, its stock dropped dramatically after the dot.com meltdown like many other technology stocks. But thereafter, Microsoft spent the next decade doubling its sales and tripling its profits for an entire decade. Despite that spectacular performance, Microsoft stock price stayed flat over the entire decade. That is because expectations were already high at the start of the decade and even with impressive growth and profit increase, Microsoft couldn’t increase expectations. Similarly, Google recently reported a large increase in sales and profits yet experienced a drop in its stock price because it didn’t meet its expectations. Both demonstrate how the real and expectations markets often diverge. What about a company like Procter and Gamble? Like all companies, P&G faces similar schisms between expectations and reality. At times, expectations get too high and then fall too low. However, this is less pronounced at P&G because it has a culture of focusing more on the real market than the expectations market which has served it well over time. So how do we separate expectations and reality in business? It is impossible to completely separate expectations from reality. Humans cannot help but form expectations; even animals do. If you feed a pet dog at the same time of morning for a week, it will be pawing at your bedroom door at that exact time the next time you sleep in past the usual time. However, one form of expectations is dramatically more damaging and those are the expectations of hordes of investors, especially hedge fund managers and high frequency traders. Only publicly-traded companies are exposed to the detrimental effects of that form of expectations. The best way to avoid exposing your company to the expectations market is to be a private company – like Cargill or Koch Industries. Facebook prospered for a number of years as a private company, then went public and felt the wrath of the expectations market. It is unclear whether Facebook will be able to pursue its strategy as a public company in the way it did as a private company as it faces investor wrath for having its stock price plummet after its IPO. One of the things that comes out in your book is that despite all the regulations that have been put in place after the crisis of 2008, you still feel that it’s only a matter of time before another crisis hits us. Why do you say that? I do not believe that the regulations that have been put in place or are being put in place the cause of the last two crashes. The theory of Sarbanes-Oxley was that lax boards and audit committees and conflicted auditors caused the dot.com crash and the Enron/WorldCom/Aldephia, etc. scandals. And theory of Dodd-Frank is that excess bank leverage and mixing of commercial banking and investment banking caused the subprime meltdown. I do not believe that those theories are even remotely accurate. In my view, inappropriate mixing of the real market and the expectations market contributed centrally to both crashes and neither Sarbanes-Oxley or Dodd-Frank address that problem. For that reason, I think that the risk of another crash continues to build. All I am confident of is that the next crash won’t be because of an Internet-bubble or sub-prime residential mortgages. Any other cause is as likely to precipitate a bubble/crash as it was before the various regulatory changes. This entire about paying CEOs well in terms of the stock of the company was put forward by Michael Jensen in the 1970s. And it was lapped up left right and centre. What was the reason behind its popularity? I believe that it was lapped up because it was incredibly simple and compellingly logical. The alignment theory sounds so lovely – shareholders and executives win together and lose together. It was so easy to understand that people gobbled it up rather than first asked themselves to work through the consequences of it in a more sophisticated way. Essentially they ignored a logical fallacy. The theory held that executives were gaming the system to their own advantage but implicitly assumed that they would stop gaming the system to their own advantage after the proposed change. There is nothing to suggest that such a behavioral change would occur – and indeed they have kept on gaming! How was it responsible for the current state of things? The central thrust of the Jensen argument was that the real market needed to be wedded directly to the expectations market through stock-based compensation. The minute those two markets were tied together, democratic capitalism was changed from an enterprise that was primarily focused on building value in the real market to one primarily focused on trading value in the expectations market. What went wrong with that idea? The tool was wrong. Attempting to increase shareholder value over the long term is not a bad idea. Utilizing the short term stock price as a perfect measure of long term shareholder value was the error. This enabled craven executives and hedge fund managers to exploit the schism between the short term measure of shareholder value and the long term creation of shareholder value. So is banning stock options a way out? Has any company done it? Many companies have moved from utilized stock options as their form of stock-based compensation to deferred share units or restricted share units, which are in essence synthetic versions of the underlying stock which go both up and down with the movement of the underlying stock. They are an improvement over stock options because they result in the executive feeling both the downside and upside of stock movements rather than only the upside. However, it still focuses the executive on the expectations market. There is a trend toward deferring them for longer periods which also makes it harder for the CEO to exploit short-term movements. But no public company of which I am aware has banned stock-based compensation entirely. So what is way out? You talk about boards rewarding their employees based on real outcomes and not expectation oriented outcomes. Could you elaborate through an example? Real outcomes are things like market share, return on invested capital, customer satisfaction, etc. The most important real outcomes vary by company and depend on the company’s context. Most companies use these measures as part of their compensation structures. What needs to happen is for companies to raise these measures from part of their incentive compensation packages to 100% of them.
The interview was originally published in the Daily News and Analysis on October 8,2012. (Interviewer Kaul is a writer. He can be reached at [email protected])
Michael J. Mauboussin is Chief Investment Strategist at Legg Mason Capital Management in the United States. He is also the author of bestselling books on investing like Think Twice: Harnessing the Power of Counterintuition and More Than You Know: Finding Financial Wisdom in Unconventional Places. His latest book The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing is due later this year. In this interview he speaks to Vivek Kaul on the various aspects of luck, skill and randomness and the impact they have on business, life and investing. Excerpts:
How do you define luck? The way I think about it, luck has three features. It happens to a person or organization; can be good or bad; and it is reasonable to believe that another outcome was possible. By this definition, if you win the lottery you are lucky, but if you are born to a wealthy family you are not lucky—because it is not reasonable to believe that any other outcome was possible—but rather fortunate. How is randomness different from luck? I like to distinguish, too, between randomness and luck. I like to think of randomness as something that works at a system level and luck on a lower level. So, for example, if you gather a large group of people and ask them to guess the results of five coin tosses, randomness tells you that some in the group will get them all correct. But if you get them all correct, you are lucky. And what is skill? For skill, the dictionary says the “ability to use one’s knowledge effectively and readily in execution or performance.” I think that’s a good definition. The key is that when there is little luck involved, skill can be honed through deliberate practice. When there’s an element of luck, skill is best considered as a process. You have often spoken about the paradox of skill. What is that? The paradox of skill says that as competitors in a field become more skillful, luck becomes more important in determining results. The key to this idea is what happens when skill improves in a field. There are two effects. First, the absolute level of ability rises. And second, the variance of ability declines. Could you give us an example? One famous example of this is batting average in the sport of baseball. Batting average is the ratio of hits to at-bats. It’s somewhat related to the same term in cricket. In 1941, a player named Ted Williams hit .406 for a season, a feat that no other player has been able to match in 70 years. The reason, it turns out, is not that no players today are as good as Williams was in his day—they are undoubtedly much better. The reason is that the variance in skill has gone down. Because the league draws from a deeper pool of talent, including great players from around the world, and because training techniques are vastly improved and more uniform, the difference between the best players and the average players within the pro ranks has narrowed. Even if you assume that luck hasn’t changed, the variance in batting averages should have come down. And that’s exactly what we see. The paradox of skill makes a very specific prediction. In realms where there is no luck, you should see absolute performance improve and relative performance shrink. That’s exactly what we see. Any other example? Take Olympic marathon times as an example. Men today run the race about 26 minutes faster than they did 80 years ago. But in 1932, the time difference between the man who won and the man who came in 20th was close to 40 minutes. Today that difference is well under 10 minutes. What is the application to investing? The application to investing is straightforward. As the market is filled with participants who are smart and have access to information and computing power, the variance of skill will decline. That means that stock price changes will be random—a random walk down Wall Street, as Burton Malkiel wrote—and those investors who beat the market can chalk up their success to luck. And the evidence shows that the variance in mutual fund returns has shrunk over the past 60 years, just as the paradox of skill would suggest. I want to be clear that I believe that differential skill in investing remains, and that I don’t believe that all results are from randomness. But there’s little doubt that markets are highly competitive and that the basic sketch of the paradox of skill applies. How do you determine in the success of something be it a song, book or a business for that matter, how much of it is luck, how much of it is skill? This is a fascinating question. In some fields, including sports and facets of business, we can answer that question reasonably well when the results are independent of one another. When the results depend on what happened before, the answer is much more complex because it’s very difficult to predict how events will unfold. Could you explain through an example? Let me try to give a concrete example with the popularity of music. A number of years ago, there was a wonderful experiment called MusicLab. The subjects thought the experiment was about musical taste, but it was really about understanding how hits happen. The subjects who came into the site saw 48 songs by unknown bands. They could listen to any song, rate it, and download it if they wanted to. Unbeknownst to the subjects, they were funneled into one of two conditions. Twenty percent went to the control condition, where they could listen, rate, and download but had no access to what anyone else did. This provided an objective measure of the quality of songs as social interaction was absent. What about the other 80%? The other 80 percent went into one of 8 social worlds. Initially, the conditions were the same as the control group, but in these cases the subjects could see what others before them had done. So social interaction was present, and by having eight social worlds the experiment effectively set up alternate universes. The results showed that social interaction had a huge influence on the outcomes. One song, for instance, was in the middle of the pack in the control condition, the #1 hit on one of the social worlds, and #40 in another social world. The researchers found that poorly rated songs in the control group rarely did well in the social worlds—failure was not hard to predict—but songs that were average or good had a wide range of outcomes. There was an inherent lack of predictability. I think I can make the statement ever more general: whenever you can assess a product or service across multiple dimensions, there is no objective way to say which is “best.” What is the takeaway for investors? The leap to investing is a small one. Investing, too, is an inherently social exercise. From time to time, investors get uniformly optimistic or pessimistic, pushing prices to extremes. Was a book like Harry Potter inevitable as has often been suggested after the success of the book? This is very related to our discussion before about hit songs. When what happens next depends on what happened before, which is often the case when social interaction is involved, predicting outcomes is inherently difficult. The MusicLab experiment, and even simpler simulations, indicate that Harry Potter’s success was not inevitable. This is very difficult to accept because now that we know that Harry Potter is wildly popular, we can conjure up many explanations for that success. But if you re-played the tape of the world, we would see a very different list of best sellers. The success of Harry Potter, or Star Wars, or the Mona Lisa, can best be explained as the result of a social process similar to any fad or fashion. In fact, one way to think about it is the process of disease spreading. Most diseases don’t spread widely because of a lack of interaction or virulence. But if the network is right and the interaction and virulence are sufficient, disease will propagate. The same is true for a product that is deemed successful through a social process. And this applies to investing as well? This applies to investing, too. Instead of considering how the popularity of Harry Potter, or an illness, spreads across a network you can think of investment ideas. Tops in markets are put in place when most investors are infected with bullishness, and bottoms are created by uniform bearishness. The common theme is the role of social process. What about someone like Warren Buffett or for that matter Bill Miller were they just lucky, or was there a lot of skill as well? Extreme success is, almost by definition, the combination of good skill and good luck. I think that applies to Buffett and Miller, and I think each man would concede as much. The important point is that neither skill nor luck, alone, is sufficient to launch anyone to the very top if it’s a field where luck helps shape outcomes. The problem is that our minds equate success with skill so we underestimate the role of randomness. This was one of Nassim Taleb’s points in Fooled by Randomness. All of that said, it is important to recognize that results in the short-term reflect a lot of randomness. Even skillful managers will slump, and unskillful managers will shine. But over the long haul, good process wins. How do you explain the success of Facebook in lieu of the other social media sites like Orkut, Myspace, which did not survive? Brian Arthur, an economist long affiliated with the Santa Fe Institute, likes to say, “of networks there shall be few.” His point is that there are battles for networks and standards, and predicting the winners from those battles is notoriously difficult. We saw a heated battle for search engines, including AltaVista, Yahoo, and Google. But the market tends to settle on one network, and the others drop to a very distant second. I’d say Facebook’s success is a combination of good skill, good timing, and good luck. I’d say the same for almost every successful company. The question is if we played the world over and over, would Facebook always be the obvious winner. I doubt that. Would you say that when a CEO’s face is all over the newspapers and magazines like is the case with the CEO of Facebook , he has enjoyed good luck? One of the most important business books ever written is The Halo Effect by Phil Rosenzweig. The idea is that when things are going well, we attribute that success to skill—there’s a halo effect. Conversely, when things are going poorly we attribute it to poor skill. This is often true for the same management of the same company over time. Rosenzweig offers Cisco as a specific example. So the answer is that great success, the kind that lands you on the covers of business magazines, almost always includes a very large dose of luck. And we’re not very good at parsing the sources of success. You have also suggested that trying to understand the stock market by tuning into so called market experts is not the best way of understanding it. Why do you say that? The best way to answer this is to argue that the stock market is a great example of a complex adaptive system. These systems have three features. First, they are made up of heterogeneous agents. In the stock market, these are investors with different information, analytical approaches, time horizons, etc. And these agents learn, which is why we call them adaptive. Second, the agents interact with one another, leading to a process called emergence. The interaction in the stock market is typically through an exchange. And, finally, we get a global system—the market itself. So what’s the point you are trying to make? Here’s a key point: There is no additivity in these systems. You can’t understand the whole simply by looking at the behaviors of the parts. Now this is in sharp contrast to other systems, where reductionism works. For example, an artisan could take apart my mechanical wristwatch and understand how each part contributes to the working of the watch. The same approach doesn’t work in complex adaptive systems. Could you explain through an example? Let me give you one of my favorite examples, that of an ant colony. If you study ants on the colony level, you’ll see that it’s robust, adaptive, follows a life cycle, etc. It’s arguably an organism on the colony level. But if you ask any individual ant what’s going on with the colony, they will have no clue. They operate solely with local information and local interaction. The behavior of the colony emerges from the interaction between the ants. Now it’s not hard to see that the stock market is similar. No individual has much of a clue of what’s going on at the market level. But this lack of understanding smacks right against our desire to have experts tell us what’s going on. The record of market forecasters has been studied, and the jury is in: they are very bad at it. So I recommend people listen to market experts for entertainment, not for elucidation. How does the media influence investment decisions? The media has a natural, and understandable, desire to find people who have views that are toward the extremes. Having someone on television explaining that this could happen, but then again it may be that, does not make for exciting viewing. Better is a market boomster, who says the market will skyrocket, or a market doomster, who sees the market plummeting. Any example? Phil Tetlock, a professor of psychology at the University of Pennsylvania, has done the best work I know of on expert prediction. He has found that experts are poor predictors in the realms of economic and political outcomes. But he makes two additional points worth mentioning. The first is that he found that hedgehogs, those people who tend to know one big thing, are worse predictors than foxes, those who know a little about a lot of things. So, strongly held views that are unyielding tend not to make for quality predictions in complex realms. Second, he found that the more media mentions a pundit had, the worse his or her predictions. This makes sense in the context of what the media are trying to achieve—interesting viewing. So the people you hear and see the most in the media are among the worst predictors. Why do most people make poor investment decisions? I say that because most investors aren’t able to earn even the market rate of return? People make poor investment decisions because they are human. We all come with mental software that tends to encourage us to buy after results have been good and to sell after results have been poor. So we are wired to buy high and sell low instead of buy low and sell high. We see this starkly in the analysis of time-weighted versus dollar-weighted returns for funds. The time-weighted return, which is what is typically reported, is simply the return for the fund over time. The dollar-weighted return calculates the return on each of the dollars invested. These two calculations can yield very different results for the same fund. Could you explain that in some detail? Say, for example, a fund starts with $100 and goes up 20% in year 1. The next year, it loses 10%. So the $100 invested at the beginning is worth $108 after two years and the time-weighted return is 3.9%. Now let’s say we start with the same $100 and first year results of 20%. Investors see this very good result, and pour an additional $200 into the fund. Now it is running $320—the original $120 plus the $200 invested. The fund then goes down 10%, causing $32 of losses. So the fund will still have the same time-weighted return, 3.9%. But now the fund will be worth $288, which means that in the aggregate investors put in $300—the original $100 plus $200 after year one—and lost $12. So the fund has positive time-weighted returns but negative dollar-weighted returns. The proclivity to buy high and sell low means that investors earn, on average, a dollar-weighted return that is only about 60% of the market’s return. Bad timing is very costly. What is reversion to the mean? Reversion to the mean occurs when an extreme outcome is followed by an outcome that has an expected value closer to the average. Let’s say you are a student whose true skill suggests you should score 80% on a test. If you are particularly lucky one day, you might score 90%. How are you expected to do for your next test? Closer to 80%. You are expected to revert to your mean, which means that your good luck is not expected to persist. This is a huge topic in investing, for precisely the reason we just discussed. Investors, rather than constantly considering reversion to the mean, tend to extrapolate. Good results are expected to lead to more good results. This is at the core of the dichotomy between time-weighted and dollar-weighted returns. I should add quickly that this phenomenon is not unique to individual investors. Institutional investors, people who are trained to think of such things, fall into the same trap. In one of your papers you talk about a guy who manages his and his wife’s money. With his wife’s money he is very cautious and listens to what the experts have to say. With his own money his puts it in some investments and forgets about it. As you put it, threw it in the coffee can. And forgot about it. It so turned out that the coffee can approach did better. Can you take us through that example? This was a case, told by Robert Kirby at Capital Guardian, from the 1950s. The husband managed his wife’s fund and followed closely the advice from the investment firm. The firm had a research department and did their best to preserve, and build, capital. It turns out that unbeknownst to anyone, the man used $5,000 of his own money to invest in the firm’s buy recommendations. He never sold anything and never traded, he just plopped the securities into a proverbial coffee can(those were the days of paper). The husband died suddenly and the wife then came back to the investment firm to combine their accounts. Everyone was surprised to see that the husband’s account was a good deal larger than his wife’s. The neglected portfolio fared much better than the tended one. It turns out that a large part of the portfolio’s success was attributable to an investment in Xerox. So what was the lesson drawn? Kirby drew a more basic lesson from the experience. Sometimes doing nothing is better than doing something. In most businesses, there is some relationship between activity and results. The more active you are, the better your results. Investing is one field where this isn’t true. Sometimes, doing nothing is the best thing. As Warren Buffett has said, “Inactivity strikes us as intelligent behavior.” As I mentioned before, there is lots of evidence that the decisions to buy and sell by individuals and institutions does as much, if not more, harm than good. I’m not saying you should buy and hold forever, but I am saying that buying cheap and holding for a long time tends to do better than guessing what asset class or manager is hot. (The interview was originally published in the Daily News and Analysis(DNA) on June 4,2012. http://www.dnaindia.com/money/interview_people-should-listen-to-market-experts-for-entertainment-not-elucidation_1697709) (Interviewer Kaul is a writer and can be reached at [email protected])