Daniel Kahneman

Overconfidence of the ‘Bengaluru’ entrepreneur

flipkartThe last time I was in Bengaluru in late January and early February, almost everybody I met either wanted to be an entrepreneur or had already become one. I know I am stretching the truth here, nevertheless, the enthusiasm for entrepreneurship that I saw in Bengaluru is clearly missing in Mumbai, where I live, and Delhi, the city where my extended clan does.

A major factor that is needed for an individual to become an entrepreneur is “overconfidence”. As Gary Belsky and Thomas Gilovich write in Why Smart People Make Money Mistakes and How to Correct Them: “If people were not overconfident…significantly fewer people would ever start a new business…That their optimism is misplaced—that they are overconfident—is evidenced by the fact that more than two-thirds of the small businesses fail within four years of inception.”

It is worth clarifying here that overconfidence here does not mean arrogance. So what does it mean? As Belsky and Gilovich write: “What research psychologists have discovered about overconfidence is that most people—those with healthy egos and those in the basement of self-esteem—consistently overrate their abilities, knowledge, and skill, at whatever level they might place them.”

The entrepreneurs work along similar lines. In fact, research shows that even when entrepreneurs are told that their chances of survival are small, they don’t believe in it. As Nobel Prize winning psychologist Daniel Kahneman writes in Thinking, Fast and Slow: “The chances that a small business will survive for five years in the United States is about 35%. But the individuals who open such businesses do not believe that statistics apply to them. A survey found that

American entrepreneurs tend to believe that they are in a promising line of business…Fully 81% of the entrepreneurs put their personal odds of success at 7 out of 10 or higher, and 33% said their chance of failing was zero.”

Given that a whole host of Bengaluru denizens have worked in the United States or know someone who has, it is hardly surprising that the American way of doing things, has caught on, in the city as well. Nevertheless, this overconfidence works in several sways. It encourages people to become an entrepreneur in the first place. Further, it helps them to keep running the business in the face of all odds.

As Kahneman writes: “One of the benefits of an optimistic temperament is that it encourages persistence in the face of obstacles…[The] confidence [of the entrepreneurs] in their future success sustains a positive mood that helps them obtain resources from others, raise the morale of their employees, and enhance their prospects of prevailing. When action is needed, optimism, even of the mildly delusional variety, may be a good thing.”

On the flip side overconfidence also leads many entrepreneurs to launch businesses without any business model in place. Take the case of the Indian ecommerce companies, many of which are headquartered in Bengaluru. A significant number of these companies are operating without any business model, backed by an unending amount of private equity and venture capital money that has been pouring in.

The money that keeps pouring into these companies shows the ability of the entrepreneurs to keep raising money from investors in the hope of their companies making money someday. And this couldn’t have happened without them being overconfident.

As Kahneman explains: “Inadequate appreciation of the uncertainty of the environment leads economic agents to take risks they should avoid. However, optimism is highly valued, socially and in the market; people and firms reward the providers of dangerously misleading information more than they reward truth tellers.”

Given this, at this point of time, ecommerce is the flavour of the season, and anyone raising points about the viability of the entire sector, is usually shouted down upon. Nevertheless, as Warren Buffett said during the course of the dotcom bubble which burst in 2000, “but a pin lies in wait for every bubble.” And that is something worth remembering here as well.

The column originally appeared in the Bangalore Mirror on Sep 30, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Big fish in a small pond

fish
One of my bigger regrets in life is having spent two years getting an MBA degree, though I made some good friends along the way. Ironically over the last decade I have lost touch with these friends.

I have often asked myself why things turned out the way they did, given that they were a good bunch of people. And the answer I have come up with is that these friends over the years started cribbing a lot. They were unhappy people in their daily lives.

They were unhappy with their bosses. They were unhappy with their sales targets. They were unhappy with their bonuses. They were unhappy with their colleagues. Different things on different days. The only thing that gave them happiness was planning their weekends and their holidays. As one of them told me with great pride a few years back: “This year we did New Zealand. Next year we will do Turkey.” This was hardly surprising given our fascination for anything phoren.

What I found surprising was these friends spent more time figuring out what to do over a couple of weeks of holidays than trying to figure out what to do over the 50 weeks that they were slogging at their ‘unhappy’ jobs. Why would you want to be unhappy 50 weeks in a year, so that you can be happy for two weeks? Beats me.

The Nobel Prize winning psychologist Daniel Kahneman talks about the focussing illusion in Thinking, Fast and Slow. As he writes: “Any aspect of life to which attention is directed will look large in global evaluation. This is the essence of the focusing illusion, which can be described in a single sentence: Nothing in life is as important as you think it is when you are thinking about it.”

And this possibly explains why my MBA friends had turned themselves into non-stop cribs. Whatever bothered them at a given point of time took precedence in their thoughts and they chose to crib about it.

But cribbing was essentially a symptom to the problem. These friends were constantly comparing themselves with others while working for large companies. In other words they were small fish in a big pond. As Barry Schwartz writes in The Paradox of Choice: “If there were only one pond—if everyone compared his position to positions of everybody else—virtually all of us would be losers. After all, in the pond containing whales, even sharks are small.”

What this tells us clearly is that a major part of satisfaction from what we do comes from how well we look at ourselves in comparison to those around us. Hence, things are relative. As Schwartz writes: “As others start to catch up, the desires of those who are ahead in the “race” escalate so that they can maintain their privileged position.” And if they can’t stay ahead all the time, they crib.

In fact, a few years back an interesting piece of research was carried out. In this research participants where were asked to choose whether they would be like to be in a situation where they were earning $50,000 per year, while others were earning $25,000 or they would like to be in a situation where they were earning $100,000 per year, while others were earning $200,000. And the results were rather surprising.

As Schwartz writes: “In most cases, more than half of the respondents chose the options that gave them better relative position. Better to be a big fish, earning $50,000, in a small pond than a small fish, earning $100,000, in a big one.”

Hence, the trick to be happy is not keep comparing ourselves with those around us. As Schwartz writes: “Instead of comparing ourselves to everyone, we try to mark off the world in such a way that in our pond, in comparison with our reference group, we are successful. Better to be the third-highest-paid lawyer in a small firm…than to be in the middle of the pack in a large firm.”

The column originally appeared in the Bangalore Mirror on Sep 9, 2015

Benevolent autocracy: India is drawing the wrong lesson from Lee Kuan Yew

Lee_Kuan_Yew


One of the favourite arguments offered by middle class Indian men (especially when all other arguments fail) is that “India needs a benevolent autocrat,” if the economy has to grow at a fast pace. The word “autocrat” is often used interchangeably with the world “dictator”.
This argument is often made by the corporate types who have made their money in life and are now looking for some intellectual stimulation through what they consider as philosophical musings.
The argument has gained a new life with the death of Lee Kuan Yew (or LKY as he was commonly known as) who was the prime minister of the city-state of Singapore from 1959 to 1990. Between 1990 and 2011, he was the senior minister as well as minister mentor of Singapore. LKY died on March 23, 2015.
Data from the World Bank shows that the per capita income of Singapore in 2013 was $55,182.5. When LKY took over as the prime minister in 1959, the per capita income was $400. What this clearly tells us is that LKY turned around Singapore from a poor country to a developed country in about one generation. When he became the prime minister, Singapore was basically swamp with almost no natural resources. He turned it around into a global financial centre first and now an entertainment destination as well.
His achievements not withstanding, LKY was an autocrat who was honest enough to admit it. As he said in an interview to The Straits Times in April 1987: “I am often accused of interfering in the private lives of citizens. Yes, if I did not, had I not done that, we wouldn’t be here today. And I say without the slightest remorse, that we wouldn’t be here, we would not have made economic progress, if we had not intervened on very personal matters – who your neighbor is, how you live, the noise you make, how you spit, or what language you use. We decide what is right. Never mind what the people think.”
But as I have said above LKY’s autocratic style of working paid huge dividends for Singapore. It was transformed from a swamp to a developed country in around 50 years. And that was a huge achievement.
This high growth that Singapore achieved has led people to suggest that India also needs a benevolent autocrat to grow at a fast pace. LKY and Singapore are not the only example that is given to buttress this point. There are other examples as well—Chile under Augusto Pinochet. Or countries like Hong Kong, Singapore, South Korea and Taiwan, which grew at a very fast rate under autocratic regimes. They moved to a democratic form of government only after having grown fast for a significant period of time.
Then there is the example of China. The country is ruled by one party, the Chinese Communist Party (CCP).  It has had a generation of fast economic growth without any democracy. All this has led many people to believe that if a country has to grow fast it needs to be under an autocratic regime. Hence, India needs a “benevolent autocrat,” is the argument offered. QED.
But are things as simple as that? Or are people becoming victims of what behavioural economists term as the “availability heuristic”? As John Allen Paulos writes in A Mathematician Reads the Newspaper: “First described by psychologists Amos Tversky and Daniel Kahneman, it is nothing more than strong disposition to make judgements or evaluations in light of the first thing that comes to mind (or is “available” to the mind).”
So, Lee Kuan Yew was an autocrat. Under him Singapore grew at a very rapid rate. Hence, India needs a benevolent autocrat as well, if it has to grow at a very fast rate. That’s how it works for those who feel that India needs a “benevolent autocrat”.
Economist William Easterly has done some interesting research in this area, which he summarises in a research paper titled Benevolent Autocrats. As he writes: “The probability that you are an autocrat IF you are a growth success is 90 percent. This probability seems to influence the discussion in favour of autocrats.”
But that is the wrong question to ask. The question that needs to be asked should be exactly opposite—if a country is governed by an autocrat what are the chances that it will be a growth success? “The relevant probability is whether you are a growth success IF you are an autocrat, which is only 10 percent,” writes Easterly. To put it simply—most fast growing nations are ruled by autocrats. Nevertheless, most autocracies do not grow fast.
The thing is that one never knows whether an autocrat will turn out to be benevolent or will he turn out to be an out an out dictator, once he starts to rule. That depends on the luck of the draw. Most autocrats usually end up screwing up the economies they rule. This is a simple point that middle class Indian men who want a “benevolent autocrat” to rule this country, need to understand.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on Mar 30, 2015

Investing lessons from Aam Aadmi Party’s Delhi win

Arvind-Kejriwal3
Last week saw David(read the Aam Aadmi Party(AAP)) beat Goliath(read the Bhartiya Janata Party (BJP)) in the Delhi elections. AAP won 67 out of the seventy seats in the Delhi assembly, leaving only three seats for the BJP. This led to one WhatsApp forward which suggested that Delhi should now allow tripling(three people travelling on a bike) so that BJP legislators could ride to the Delhi assembly on a bike. Another forward suggested that the BJP legislators could drive to the assembly in a Tata Nano.
Jokes apart, in the aftermath of this electoral debacle many reasons have been offered on why and how the BJP lost Delhi. Reasons have also been offered on why and how the AAP won Delhi. Let’s sample a few here. The ghar wapasi campaign launched by the Sangh Parivar backfired in Delhi. The BJP ran a very negative and a highly vitriolic campaign against AAP and that didn’t quite work.
The AAP supporters on the other hand have been pointing out to the fact that the party ran a positive campaign and that went down well with Delhi residents. Further, the 49 days that Arvind Kejriwal was chief minister of Delhi, the levels of petty corruption in Delhi had come down dramatically. And this, we are told, is something that the people of Delhi haven’t forgotten.
Long story short—the number of reasons offered on AAP’s spectacular performance and BJP’s wipe out, is directly proportional to the number of political pundits analysing the issue. Nevertheless, most of these reasons have been offered with the benefit of hindsight. Most political pundits had no clue about BJP ending with up three seats and the Narendra Modi juggernaut losing steam. But now that it has happened, they need to find reasons and explanations for the same.
As Gary Smith writes in Standard Deviations—Flawed Assumptions, Tortured Data and Other Ways to Lie With Statistics: “Through countless generations of natural selection, we have become hardwired to look for patterns and to think of explanations for the patterns we find…We yearn to make an uncertain world more certain, to gain control over things we do not control, to predict the unpredictable.”
Also, some political pundits have now even said that they saw the whole thing coming and offered explanations of the same. As Nassim Nicholas Taleb writes in Fooled by Randomness: “Things are always obvious after the fact…It has to do with the way our mind handles historical information…Our mind will interpret most events not with the preceding ones in mind, but the following ones.” This tendency is referred to as hindsight bias in psychology.
Daniel Kahneman defines this in his book Thinking, Fast and Slow: “When an unpredicted event occurs, we immediately adjust our view of the world to accommodate that surprise…Once you adopt a new view of the world(or of any part of it), you immediately lose much of your ability to recall what you used to believe in before your mind changed.”
This leads to a situation where one feels that one has understood as well as predicted the past and given that one further feels that one can predict as well as control the future. As Jason Zweig writes in Your Money & Your Brain—How the New Science of Neuroeconomics Can Help Make You Rich: “Hindsight bias is another cruel trick that your inner con man plays on you. By making you believe that the past was more predictable than it really was, hindsight bias fools you into thinking that the future is more predictable than it ever can be.”
This is exploited in particular by financial pundits. As Kahneman writes: “Our tendency to construct and believe coherent narratives of the past makes it difficult for us to accept the limits of our forecasting ability. Everything makes sense in hindsight, a fact that financial pundits exploit every evening as they offer convincing accounts of the day’s events. And we cannot suppress the powerful intuition that what makes sense in hindsight today was predictable yesterday.” That of course is not the case.
Hindsight bias also is also at work when we invest. An excellent example, is of investors saying after a bubble has burst, that they knew all along it was a bubble. But the thing is that if a bubble is obvious to enough investors at the time it is in its initial stage, there would be no bubble in the first place.
Zweig has an excellent example in his book of the link between hindsight bias and investing. As he writes: “In the fall of 2001, after the terrorist attacks of September 11, you tell yourself, “Nothing will ever be the same again. The U.S. isn’t safe any more. Who knows what they’ll do next? Even if stocks are cheap, nobody will have the guts to invest.” Then the market goes on to gain 15% by the end of 2003, and what do you say? “I knew
stocks were cheap after September 11th!””
The moral of the story here is that you may have been able to explain the entire situation to yourself, but you have missed out on the rally.
Then there is the case of missing out on a bumper initial public offering. Zweig offers the case of Google which first sold its shares in August 2004. At that point of time, an investor wanting to invest in the stock, would have thought back about the bursting of the dotcom bubble and the money that he had lost back then.
Using this logic he would have decided not to invest in the stock. He would have then seen the price of the stock jump from the initial price of $85 to $460 by end 2006 and told himself: “I knew I should have bought Google!”
And this would lead to a change in the worldview of the investor and may well make him “more eager to take the plunge” the next time he has “a chance to get in on the ground floor of a risky high-tech start-up.” But as Zweig puts it: “Of course, “the next Google” may turn out to be the next Enron instead.”
Given these reasons it is very important for investors not to become victims of the hindsight bias while investing.

(The article originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Feb 16, 2015)

Of Yuvraj Singh, stock markets and the Vietnam War

 yuvraj

Vivek Kaul

 It is in the last week of March 2014 that I am writing this piece. The stock market in India is flirting with all time high levels. At the same time in the T20 cricket World Cup that is on, Yuvraj Singh’s bad form with the bat continues (as I write India has played two matches, and in both, Yuvraj has failed with the bat).
Despite the fact that the stock market is flirting with all time high levels, there are still a lot of investors who are holding onto stocks they had bought at the peak levels reached in 2008. Real estate and infrastructure stocks were a favourite among investors back then.
Once the stock market started to crash in 2008, these stocks crashed big time. They still are nowhere near the high levels they had achieved way back in 2008. And more than that, the prospects for these sectors(particularly real estate) in India, are not looking good either. Nevertheless, there are still some investors who have held onto these stocks bought in 2008, in the hope that these stocks will make money for them one day. So what is happening here? Barry Schwartz explains this in his book The Paradox of Choice. As he writes “People hold on to stocks that have decreased in value because selling them would turn the investment into a loss. What should matter in decisions about holding or selling stocks is only your assessment of future performance and not (tax considerations aside) the price at which the stocks were purchased.”
But the price at which the stock is bought does turn out to matter. This fallacy is referred to as the sunk-cost fallacy by behavioural economists.
And what about Yuvraj Singh? What is he doing here? Vijay Mallya owned IPL Royal Challengers Bangalore bought him for a mind-boggling Rs 14 crore in a recent auction in the Indian Premier League(IPL). The tournament starts in mid April, right after the T20 World Cup ends. From the way things currently are, Yuvraj doesn’t look in great form. But despite that he is likely to be played by Royal Challengers Bangalore in all the matches that they play.
And why is that? Simply because the sunk-cost fallacy will be at work. The Royal Challengers Bangalore have paid so much money to buy Yuvraj that they are likely to keep playing him in the hope that he will eventually start scoring runs. Schwartz discusses this in the context of professional basket ball players in the United States. “According to the same logic of sunk costs, professional basketball coaches give more playing time to players earning higher salaries independent of their current level of performance,” he writes.
The sunk-cost fallacy is a part of our everyday lives as well. Many of us make instinctive expensive purchases and then don’t use the product, due to various reasons. At the same time, we don’t get rid of the product either, in the hope of using it in some way in the future.
Richard Thaler, a pioneer in the field of Behavioural Economics, explains this beautifully through a thought experiment, in a research paper titled Mental Accounting Matters. “Suppose you buy a pair of shoes. They feel perfectly comfortable in the store, but the first day you wear them they hurt. A few days later you try them again, but they hurt even more than the first time. What happens now? My predictions are: (1) The more you paid for the shoes, the more times you will try to wear them. (This choice may be rational, especially if they have to be replaced with another expensive pair.) (2) Eventually you stop wearing the shoes, but you do not throw them away. The more you paid for the shoes, the longer they sit in the back of your closet before you throw them away. (This behaviour cannot be rational unless expensive shoes take up less space.) (3) At some point, you throw the shoes away, regardless of what they cost, the payment having been fully `depreciated’.”
Along similar lines people hold on to CDs they never listen to, clothes they never wear and books they never read. Keeping these things just holds up space, it doesn’t create any problems in life. But there are other times when the escalation of commitment that the sunk-cost fallacy causes, can lead to serious problems. As Daniel Kahneman, writes in Thinking, Fast and Slow “The sunk cost fallacy keeps people for too long in poor jobs, unhappy marriages, and unpromising research projects. I have often observed young scientists struggling to salvage a doomed project when they would be better advised to drop it and start new one.”
As far trying to salvage doomed projects go, CEOs and businesses seem to do it all the time. As Kahneman points out “Imagine a company that has already spent $50 million on a project. The project is now behind schedule and the forecasts of its ultimate returns are less favourable than at the initial planning stage. An additional investment of $60 million is required to give the project a chance. An alternative proposal is to invest the same amount in a new project that looks likely to bring higher returns. What will the company do? All too often a company afflicted by sunk costs drives into the blizzard, throwing good money after bad rather than accepting the humiliation of closing the account of a costly failure.”
A similar problem afflicts a lot of government infrastructure projects as well, where good money keeps getting thrown after bad. It also explains why the United States kept waging a war in Vietnam and then in Iraq, even though it was clear very early in the process that Vietnam was a lost cause and that there were no weapons of mass destruction in Iraq.
To conclude, it is important to understand why human beings become victims of the sunk-cost fallacy? “Sunk-cost effects are motivated by the desire to avoid regret rather than just the desire to avoid a loss,” writes Schwartz. And if you, dear reader, do not want to become a victim of the sunk-cost fallacy, this is an important point to remember.

 The article originally appeared in the April2014 issue of the Wealth Insight magazine.

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])