Xerox

Lessons from Nokia: Companies, unlike cockroaches, aren't great survivors

nokia-logoVivek Kaul

Cockroaches are great survivors. They can even survive a nuclear attack. As Dylan Grice, formerly with Soceite Generale and now the editor of the Edelweiss Journal wrote in a report titled Cockroaches for the long run! in November 2012 “Cockroaches may not be able to build nuclear bombs, but they can withstand the nuclear war. They survive.”
Grice also points out that the oldest cockroach fossil is nearly 350 million years old. “According to the record of the rocks, cockroaches first appeared just after the second of the earth’s five mass extinctions (defined as the loss of 75% of all species). In other words, that means they survived, the third, the fourth and fifth mass extinctions which followed,” writes Grice.
And there is no rocket science behind the ability of cockroaches to survive. They follow a very simple algorithm. As Grice writes “According to Richard Bookstaber, that algorithm is “singularly simple and seemingly suboptimal: it moves in the opposite direction of gusts of wind that must signal an approaching predator.” And that’s it.”
Such a simple straight forward strategy, along with their ability to go without air for 45 minutes, survive submerged underwater for half an hour, withstand 15 times more radiation than humans and eat almost anything, including the glue on the back of stamps, helps cockroaches survive.
Companies do not come with the same kind of flexibility. Neither are they good at avoiding trouble. And given that their turnover rate is pretty high. The average life span of a company listed on the S&P 500 index of leading American companies is around 15 years. This has come down dramatically from around 67 years in the 1920s.
Companies have a very high mortality rate. As an article in the Bloomberg Businessweek points out “The average life expectancy of a multinational corporation-Fortune 500 or its equivalent-is between 40 and 50 years. This figure is based on most surveys of corporate births and deaths.”
Companies are either acquired, merged, broken to pieces or simply shut down. Nokia, which till a few years back was the world’s leading mobile phone manufacturer, is now going through a phase of trying to stay relevant. It was announced yesterday that the mobile phone division of the Finnish company would be sold to Microsoft for $7.2 billion.
Nokia produced the first mobile phone in 1987, more than a quarter century back. It was the world’s largest vendor of mobile phones, until Samsung overtook it in 2012. Even now, Nokia makes nearly 15% of the world’s mobile phones. But it only has 3% share in the lucrative smart phone market, where the most of the mobile phone users seem to be moving towards.
So what went wrong with Nokia? It failed to see the rise of a new category of mobile phones i.e. the smart phone market. As marketing consultants Al and Laura Ries,write in War In the Boardroom, “The biggest mistake of logical management types is their failure to see the rise of a new category. They seem to believe that categories are firmly fixed and a new one seldom arises.”
Companies tend to remain obsessed in selling a product they are good at selling and thus fail to see the rise of a totally new category. Nokia fell victim to this as well.
The history of business is littered with many such examples. Sony invented the walkman but allowed Apple and others to walkway with the MP3 player market. RCA ,which was big radio manufacturer, had earlier allowed Sony to walkway with the pocket radio market. Southwest Airlines created an entirely new low cost airline market which gradually spread to all other parts of the world. Incumbents like Panam, Delta, Singapore Airlines and British Airways did not spot this opportunity. The 24 hour news market was spotted by CNN and not BBC as you would have expected to given the dominance they have had in the global news market.
So the question is why do incumbents which are doing particularly well fail to see the rise of a new category? The answer for this lies in what happened with Kodak, a company which was a global leader in film photography. As Mark Johnson writes in Seizing the White Space – Business Model Innovation for Growth and Renewal “In 1975, Kodak engineer, Steve Sasson invented the first camera, which captured low-resolution black-and-white images and transferred them to a TV. Perhaps fatally, he dubbed it “filmless photography” when he demonstrated the device for various leaders at the company.”
Sasson was told “that’s cute – but don’t tell anyone about it.” The reason for this reluctance was very simple. What Sasson had invented went against the existing business model of the company. Kodak at that point of time was the world’s largest producer of photo film. And any camera that did not use photo-film was obviously going to be detrimental to the interests of the company.
So Kodak ignored the segment. By the time it realised the importance of the segment other companies like Canon had already jumped in and become big players. Also by then brand Canon had come to be associated very strongly with the digital camera whereas Kodak continued to be associated with the old photo film.
The same thing happened to Sony as
well. The MP3 player was ultimately an extension of the Walkman and the Cdman market which the company had successfully captured. So what stopped them from capturing the MP3 player market as well? Over the years, other than being a full fledged electronics company, Sony had also morphed into a music company which had the rights to the songs of some of the biggest rock stars and pop stars. Hence, Sony supporting MP3 technology would mean that one of the biggest music companies in the world was supporting the free copying and distribution of music because that was what MP3 was all about.
And that of course wouldn’t work. This obsession with the current way of doing business stops companies from seeing the rise of a totally new category of doing business. Closer to home, Bharti Beetel is an excellent example. The company pioneered the sale of landline phones which had buttons. But it was so busy selling these phones that it failed to see the rise of the mobile phone market. And by the time the market took off brands like Nokia were firmly entrenched. This happened at the same time as Beetel’s sister concern, Bharti Airtel, became the largest mobile phone company in India.
Imagine the possibilities here. If Bharti Airtel during its heydays had sold a Bharti Beetel mobile phone along with every connection, a lot of money could have been made.
Another excellent example of this is Xerox. “Just think of Xerox’s Palo Alto Research Center, which famously owned the technologies that helped catapult Apple (the graphical user interface, the mouse), Adobe (post script graphical technology) and 3Com (Ethernet technology) to success,” writes Johnson. But the company had an excellent product in the photo copy machine which was selling like hot cakes, and there was no need for it to concentrate on other products which would be viable some day in the future.
Nokia became a victim of this phenomenon as well where it completely ignored the rise of a new category. The company was busy selling its mobile phones and failed to see the rise of the smart phone market. Even though smart phones have been around for a while now its only in the last couple of years that they have really taken off. Hence, as long as the basic phones of Nokia were selling well, it had no real interest in thinking about the smart phone market.
By the time it woke up to the smart phone game, the likes of Galaxy (from Samsung) and iPhone (from Apple) had already captured the smart phone market. The company has been trying to play catchup in the smart phone market through its Lumia brand but has very little market share. As a Reuters report points out “Although Nokia also said in July it had shipped 7.4 million Lumia smart phones in the quarter, up 32 percent from Q1, it was fewer than the 8.1 million units analysts had anticipated. Nokia now boasts only around 15 percent of the handset market share, with an even smaller 3 percent share in smart phones.”
Blackberry is another such company. It was busy selling phones which had an excellent email application. Meanwhile, it failed to see the rise of the smart phone market like Nokia. It is now trying catchup but other companies have already captured the market. In the days to come, the chances of Blackberry being acquired by another company, like Nokia has been, are very high.
What the Nokia story tells us is that companies unlike cockroaches are not great survivors. As the Bloomberg Businessweek article quoted earlier points out “Even the big, solid companies, the pillars of the society we live in, seem to hold out for not much longer than an aver-age of 40 years. And that 40-year figure, short though it seems, represents the life expectancy of companies of a considerable size…A recent study by Ellen de Rooij of the Stratix Group in Amsterdam indicates that the average life expectancy of all firms, regardless of size, measured in Japan and much of Europe, is only 12.5 years.”
Nokia started operating in 1871 and was named after the Nokianvirta river. It spent more than a 100 years manufacturing everything from boots to cables to tyres. In 1987, the company made the first mobile phone. In 2013, the mobile phone division was sold to Microsoft. That’s a period of 26 years. Almost double the life expectancy of 12.5 years which prevails for companies in Europe. As per that parameter, Nokia survived long enough.

The article originally appeared on www.firstpost.com on September 4, 2013 

 (Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why Samsung is the new Nokia

samsung
Vivek Kaul
I grew up reading The Indian Express. But a few years back my parents started subscribing to The Times of India after my mother complained once too often that “Express main masala nahi hai!”
The fall of The Indian Express along with The Statesman which used to be two very good newspapers (Express still is. And I haven’t read Statesman in a while, though at a point of time it was regarded the best English newspaper in Asia) are nowhere in the reckoning now, as far as the number of readers is concerned.
What happened? To some extent the papers remained stuck to their past glory and did not see the rise of the new Indian middle class, which along with hardcore news also wanted a dash of masala every morning. They wanted to know how the Congress party was screwing up the country but they also wanted to know whether Amitabh and Rekha smiled when their eyes met at a film industry party. 
The Times of India was the only newspaper which caught on to this trend (or should we say created it), raked in the moolah and got way ahead of almost all its competitors in the race.
So what is the point of I am trying to make? Incumbents who are firmly entrenched in their businesses more often than not fail to see the rise of a new category. The most recent example of the same is Nokia, which after being the top mobile phone brand in the world for a period of nearly 14 years has lost out to Samsung.
And the reason for this is very simple. Nokia did not see the smart phone. There are loads of other examples of existing companies that did not see the rise of a new category.
Sony invented the walkman but allowed Apple to walkway with the MP3 player market. RCA which was big radio manufacturer had earlier allowed Sony to walkaway with the pocket radio market. Southwest Airlines created an entirely new low cost airline market which gradually spread to all other parts of the world. Incumbents like Panam, Delta, Singapore Airlines and British Airways did not spot this opportunity.
In India Hindustan Lever Ltd did not spot the low cost detergent market, Nirma did that. Amabassador and Premier Padmini which were the only two car companies in India did not see the rise of the small car market which Maruti Suzuki captured. More recently Maruti did not spot the growing demand for diesel cars and continued to be primarily a company which manufactured petrol cars. It lost out in the process.
Bharti Beetel, revolutionised the landline phone market in India with the introduction of push button phones. But it got into the mobile phone market very late. And this was a huge business opportunity missed given that Bharti Airtel became the largest mobile phone company in India and could have easily bundled Beetel mobile phones along with Airtel mobile phone connections. An entire first generation of Indian mobile phone users could have ended up using Beetel mobile phones. Kodak a company which invented digital photography went bankrupt recently. And BBC, the most respected news organisation in the world did not see the rise of the concept of 24 hour news and left it to CNN to capture that market.
As marketing consultants Al and Laura Ries,write in War In the Boardroom, “The biggest mistake of logical management types is their failure to see the rise of a new category. They seem to believe that categories are firmly fixed and a new one seldom arises.”
And why is that? The answer lies in the fact that incumbent companies are too cued into what they are doing at that point of time. A brilliant example is Kodak. How could a company which invented digital photography go bankrupt because of it? Mark Johnson explains this phenomenon in Seizing the White Space – Business Model Innovation for Growth and Renewal. As he writes “In 1975, Kodak engineer, Steve Sasson invented the first camera, which captured low-resolution black-and-white images and transferred them to a TV. Perhaps fatally, he dubbed it “filmless photography” when he demonstrated the device for various leaders at the company.”
Sasson was asked to keep quiet about his invention. This was because Kodak was the biggest producer of photo films at that point of time. And any invention that did not use photo films would have hit the core business of the company. So Kodak ignored the segment. By the time it realised the importance of the segment other companies like Canon had already jumped in and become big players. Also by then brand Canon had come to be associated very strongly with the digital camera whereas Kodak continued to be associated with the old photo film.
The same would have stood true for Beetel in India. They would have been making good money on selling landline phones and wouldn’t have seen any sense in entering the nascent mobile phone market in India where calls were priced at Rs 16 per minute. And by the time the market took off brands like Nokia would have been firmly entrenched. Amabssador and Premier Padmini fell victim to the same thing.
Another excellent example of this is Xerox. “Just think of Xerox’s Palo Alto Research Center, which famously owned the technologies that helped catapult Apple (the graphical user interface, the mouse), Adobe (post script graphical technology) and 3Com (Ethernet technology) to success,” writes Johnson.
But Xerox executives were busy selling the photocopier. They did not have time for these small tinkerings that seemed to have been happening in their company labs. The photocopiers brought in all the money and their attention was firmly focussed on them.
Sony is a really interesting example in this trend. Sony had created the Walkman and the entire market of listening to music anywhere and everywhere. But they somehow failed to latch onto the MP3 player market which was captured by the likes of Apple iPod. An MP3 player was just an extension of the Walkman.
Other than being an electronics company Sony had also morphed into a music company owning the rights to the music of some of the biggest pop and rockstars. Hence Sony supporting MP3 technology would mean one of the biggest music companies in the world supporting the free copying and distribution of music because that was what MP3 was all about.
And with this logic which might have seemed perfectly fine at that point of time Sony lost out to Apple in the MP3 space. Also, over the years music became free anyway.
Getting back to where we started, Nokia made the same mistake. It did not see the rise of the smart phone category as other players like Samsung and Apple did. And the reason was simple. Even though smart phones have been around for a while only now have they really taken over the market because they are robust enough. Hence, as long as the basic phones of Nokia were selling well, as they were till a couple of years back, it had no real interest in thinking about the smart phone market.
By the time the company caught on with the launch of Lumia other international players like Samsung and Apple already had a major presence in the market. In India the smart phone space has loads of local players like Micromax battling for the market as well.
And so Nokia lost the race!
The interesting thing is that Samsung will also will lose the race when the next evolution in the mobile phone space happens. It will be too focused on the smart phone.
The article originally appeared on www.firstpost.com on December 20, 2012
(Vivek Kaul is a writer. He can be reached at [email protected]) 

"In future, VCs will help launch new brands. Tata, Reliance had better watch out"


Companies are in a perpetual race to expand sales. And the easiest way to do that is to expand their well known successful brands into other categories. As marketing consultant and author of many bestsellers Al Ries puts it “If a brand is well known and respected, why can’t it be line extended into another category. That’s common sense. That’s why Xerox, a brand that dominated the copier market, introduced Xerox mainframe computers. A decision that cost the company billions of dollars. That’s why IBM, a brand that dominated the mainframe computer market, introduced IBM personal computers. In 23 years of marketing IBM personal computers, the company lost $15 billion and finally threw in the towel and sold the operation to Lenovo, a Chinese company.” Ries is the author of such marketing classics (with Jack Trout) as The 22 Immutable Laws of Marketing and Positioning: The Battle for Your Mind. In this interview to Vivek Kaul he speaks on various aspects of branding and marketing.
You have often said in the past that there is a a big difference between common sense and marketing sense. Could you discuss that in some detail with examples?
Common sense is another way of saying “logical.” Almost every rule of marketing is not logical, it’s illogical, which I defined as “marketing sense.” It takes years of study and personal experience to develop good marketing sense. Yet too many management people dismiss the ideas of their marketing managers because “marketing is nothing but common sense and who has better common sense than the chief executive?” Line extension is a typical example. If a brand is well known and respected, why can’t it be line extended into another category. That’s common sense. That’s why Xerox, a brand that dominated the copier market, introduced Xerox mainframe computers. A decision that cost the company billions of dollars. That’s why IBM, a brand that dominated the mainframe computer market, introduced IBM personal computers. In 23 years of marketing IBM personal computers, the company lost $15 billion and finally threw in the towel and sold the operation to Lenovo, a Chinese company. That’s why Kodak, a brand that dominated the film-photography market, introduced Kodak digital cameras. In spite of the fact that Kodak had invented the digital camera, the company was never successful in marketing the cameras under the Kodak name. And recently Kodak went bankrupt.
With all the experience you have had consulting companies all these years which area of marketing do you feel that marketers have the most trouble with?
We have had the most trouble working with large companies marketing big brands. And the issue is always line extension. Companies want to expand their sales so they figure the easiest way to do that is by expanding their brands into new categories. In other words, line extension. We have worked with Burger King, Intel, Xerox, IBM, Motorola, Procter & Gamble and dozens of other companies that invariably wanted to expand their brands whereas we almost always recommend the opposite strategy. Narrow the focus so your brand can stand for something. The second issue is timing. We have always recommended that companies try to be the first brand in a new category. But that is a difficult sell to top management. Their first question is usually, What is the size of the market? Of course, a new category is a market with zero revenues. And many, many management people never want to launch a product into any category that doesn’t already have a sizable market. We worked for Digital Equipment Corporation, a leader in the minicomputer market. We tried to get them to be the first to launch a personal computer for the business market. (IBM eventually was the first to do so, but without a new brand name which led to their failure.) In spite of days of meetings and presentations, the CEO of Digital Equipment refused to launch such a product. “I don’t want to be first,” he said, “I want IBM to be first and then I’ll beat their specs.” After IBM launched its personal computer, Digital Equipment followed, but never achieved more than a few percent market share. Eventually the company more or less fell apart and was bought by Compaq at a discount price.
How can a No. 2 brand compete successfully with a leader?.
What a No.2 brand should do is easy to explain, but difficult to execute. A No. 2 brand should be the opposite of the market leader. Why is this difficult to do? Because it’s illogical. Everyone assumes the No.1 brand must be doing the right thing because it’s the market leader. Therefore, we should do exactly the same thing, but better. That seldom works. Take Red Bull, the first energy drink and the global market leader. One reason for Red Bull’s success was the fact that it came in a small, 8.3-oz. can that symbolizes “energy,” like a stick of dynamite. So almost every competitive brand was introduced in 8.3-oz. cans and marketed as “better” than Red Bull. Except Monster, a brand introduced in 16-oz. cans in the American market. Today, Monster is a strong No.2 brand with a 35 percent market share compared to Red Bull’s 43 percent share. Also in the American market, BlackBerry was the leading smartphone until Apple introduced the iPhone. BlackBerry had a keyboard. Apple eliminated the keyboard and used a “touchscreen” instead. Mercedes-Benz was the leading luxury-vehicle brand until BMW came into the market. Mercedes vehicles were big and comfortable, so BMW became smaller and more nimble, as dramatized in the brand’s long-running advertising theme, “The ultimate driving machine.” As a matter of fact, BMW introduced the campaign with a two-page advertisement headlined: “The ultimate sitting machine vs. the ultimate driving machine.”
Do long running marketing campaigns help? How many companies have the patience to run a marketing program for two or three or four decades?
Next to line extension, that’s the biggest problem in marketing today. Companies don’t run marketing programs nearly long enough. The best example of a long-term successful campaign is the one for BMW. “The ultimate driving machine” strategy was launched in 1975 and the company still uses the same slogan today. That’s 37 straight years. Most marketing programs don’t last longer than three or four years. That’s way too short a time to make a lasting impression in consumers’ minds. I can’t recall any major marketing program, except for BMW, that has lasted more than a decade or so.
In a recent column you wrote that logic is the enemy of a successful brand name. What did you mean by that?
By “logic” I mean what you would use as a brand name if you did not study marketing and had no experience as a marketing person. In other words, common knowledge versus specialized knowledge. It’s like the Sun and the Earth. Common knowledge would suggest that the Sun revolves around the Earth and not the reverse. Look out your window and it’s obvious that the Sun is moving and the Earth is standing still. But specialized knowledge knows that isn’t true.
What is the connection with brand names?
As far as brand names are concerned, logic or common knowledge suggests that a generic name like Books.com would be a better choice than Amazon.com. If the prospect wants to buy a book, then logically the prospect would go to a website like Book.com or Books.com.
But a marketing-trained person knows that isn’t true. It’s not how a mind words. When a person hears the word “Book,” he or she doesn’t think it’s a website at all. It’s the generic name for a category of things. On the other hand, thanks to its marketing program, “Amazon” has become a specific name for a website devoted to selling books. So when a person thinks, “I want to buy a book on the Internet, he or she doesn’t think “Books.com,” he or she thinks “Amazon.com.” In almost every category, a specific “brand” name performs better than a generic “category” name. Google.com is a better name than Search.com. YouTube.com is a better name than Video.com. There is a caveat, however. In the absence of a marketing program that establishes a brand name in consumers’ minds, a generic name could do well.
Why do you say that as a general rule, any name that specifically defines a category is bound to be a loser?
Consider how a mind works. If I say “coffee,” you literally hear that word in your mind spelled with a lower-case “c.” It’s a common noun, or a generic word that stands for an entire category of things. The same reasoning hold true for a more specific name like “High-end coffee shop.” If I say “Starbucks,” on the other hand, you literally hear that word in your mind spelled with a capital “S.” It’s a proper noun, or a brand name that stands for a specific chain of high-end coffee shops. Oddly enough, you can use common English nouns in another country as brand names? Why is this so? Because consumers don’t know the meaning of these common words. So these words become proper nouns instead and usable as brand names. For example, a stroll down a street in Copenhagen turned up these store names: Biggie Best, Exit, Expert, Face, Flash, Joy, Limbo, Nice Girl, Redgreen, Sand and Steps. Nice brand names in Copenhagen perhaps. But they wouldn’t work in America.
What do you mean when you say that “the internet is exceptionally good at promoting web, not physical, brands.” Could you explain through examples?
First of all, consider the fact that the Internet has created a host of new, very-valuable Internet brands including Amazon, Google, Facebook, YouTube, Groupon, Pinterest, LinkedIn and dozens of others. How many new physical brand names were created on the Internet? I can’t think of any. The Internet is the newest, latest medium. It attracts people who are interested in what’s new and different on the Internet. So there is intense interest in any new website that promises a revolutionary way to handle some of your affairs. But there’s not the same level of interest in new physical brands. Like a new toothpaste, or a new camera, or a new breakfast cereal. That doesn’t mean that new physical brands can’t take advantage of the PR potential represented by the Internet. They certainly can, but it’s going to be more difficult for a physical brand to get a lot of attention on the Internet than an Internet brand.
You recently wrote that “If you don’t have the right strategy, good tactics won’t help you very much. And social, like all media, is a tactic. What concerns me is that too many marketers have elevated tactics — especially those of social media — to the level of strategy.” Could you elaborate on this statement?
Our leading marketing publication is called “Advertising Age.” I have suggested facetiously that the publication should be called “Social Media Age,” because a high percentage of the stories the publication writes about involve social media and marketing on the Internet. Strategy is seldom mentioned. One reason for the intense interest in the Internet is because many aspects are easily measured. A video on YouTube, for example, will be measured by: (1) The number of “Views.” (2) The number of “Likes.” (3) The number of “Dislikes.” And (4) The number and content of “Comments.” That’s a range of responses no other medium can deliver. No wonder marketing people devote endless hours to evaluating the success of Internet programs. But suppose a marketing program is not successful. Do you blame the strategy or the tactics? Today, it’s too easy to blame the tactics. My feeling, however, is that most of the time strategy is at fault.
Are there any ideas on branding which you have espoused in the past which you have now junked?
Yes, we used to think that brand names ought to communicate something tangible about the brand. Duracell is a good example. It suggests that the appliance battery is a “long-lasting” brand. But today, there are too many competitors in any given market. A tangible name like Duracell is likely to be surrounded by many other brands with similar names, confusing the consumer. A meaningless name is often a better choice. It allows you to develop your own unique meaning for the brand. Google is a good example. Initially it meant nothing, but today it means “search.”
What is your opinion on big brand names. India has a lot of them like Tata and Reliance. And they attach these names to every business or product they launch? How do you view that?
That’s line extension and it might work today in India, but would never work in America. In America, there are too many competitors in every category with distinctive brand names. A line-extended name like Tata and Reliance would be at a serious disadvantage here. Why does it work in India? I’m not an expert, but I believe that India suffers from a shortage of venture capital as compared to the United States. It’s hard for an entrepreneur to launch competitive brands to Tata and Reliance because it’s difficult to raise enough money for their introduction. But I believe that will change in future so both Tata and Reliance should be concerned about the future of their brands.
(Interviewer Kaul is a writer and can be reached at [email protected])

People should listen to market experts for entertainment, not elucidation.


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])