Greater fool theory

Devil Take the Hindmost is a great book about the history of financial speculation. I enjoy reading financial history and comparing market crashes. Financial history reveals a lot about the similar patterns that emerge in the market.  For example, the real estate crises of 1920’s and 2007

Tulip mania is one of the first recorded financial crises in the book. A pattern that appeared a lot in tulip mania was the greater fool theory. In Tulip mania, everyone thought that tulip bulbs would sell at a higher price to some greater fool. The feeling of hope to sell to a greater fool wasn’t limited to just tulip mania. Every crash since the tulip mania has experienced some form of the greater fool theory. Therefore, it is important to avoid falling for the greater fool theory. To avoid the greater fool theory learn the difference between speculation and investing. Benjamin Graham shared an explanation of the difference in Security Analysis:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

History doesn’t repeat itself, but it does rhyme.

I was reading Security Analysis for the fourth time. And read about the disastrous development of the real estate mortgage-bond crises. It occurred between 1923 and 1929. Here is an excerpt:

Misleading Character of Appraisals. The foregoing discussion is important in its bearing on the correct attitude that the intending investor in real estate bonds should take towards the property values asserted to exist behind the issues submitted to him. During the great and disastrous development of the real estate mortgage-bond business between 1923 and 1929, the only datum customarily presented to support the usual bond offering—aside from an estimate of future earnings—was a statement of the appraised value of the property, which almost invariably amounted to some 66% in excess of the mortgage issue. If these appraisals had corresponded to the market values which experienced buyers of or lenders on real estate would place upon the properties, they would have been of real utility in the selection of sound real estate bonds. But unfortunately they were purely artificial valuations, to which the appraisers were willing to attach their names for a fee, and whose only function was to deceive the investor as to the protection which he was receiving.

The method followed by these appraisals was the capitalization on a liberal basis of the rental expected to be returned by the property. By this means, a typical building which cost $1,000,000, including liberal financing charges, would immediately be given an “appraised value” of $1,500,000. Hence a bond issue could be floated for almost the entire cost of the venture so that the builders or promoters retained the equity (i.e., the ownership) of the building, without a cent’s investment, and in many cases with a goodly cash profit to boot. This whole scheme of real estate financing was honeycombed with the most glaring weaknesses, and it is sad commentary on the lack of principle, penetration, and ordinary common sense on the part of all parties concerned that it was permitted to reach such gigantic proportions before the inevitable collapse.

Evil Effects of Competition and Contagion. The rise of the newer and more aggressive real estate bond organizations had a most unfortunate effect upon the policies of the older concerns. By force of competition they were led to relax their standards of making loans. New mortgages were granted on an increasingly liberal basis, and when old mortgages matured, they were frequently renewed in a larger sum. Furthermore, the face amount of the mortgages guaranteed rose to so high a multiple of the capital of the guarantor companies that it should have been obvious that the guaranty would afford only the flimsiest of protection in the event of a general decline in values. When the real estate market broke in 1931, the first consequence was the utter collapse of virtually every one of the newer real estate bond companies and their subsidiary guarantor concerns. As the depression continued, the older institutions gave way also. The holders of guaranteed mortgages or participations therein (aggregating about $3,000,000,000 guaranteed by New York title and mortgage companies alone) found that the guaranty was a mere name and that they were entirely dependent upon the value of the underlying properties. In most cases these had been mortgaged far more heavily than reasonable prudence would have permitted. Apparently only a very small fraction of the mortgages outstanding in 1932 were created under the conservative conditions and principles that had ruled up to, say, eight years previously.

The crises of the real estate mortgage-bond seem to rhyme with the Financial crises of 2007/2008.  Mark Twain said, “History doesn’t repeat itself, but it does rhyme.” It was easy to find appraisers in both eras willing to attach their name for a fee to an artificial valuation. Also, the lending rules kept going down the drain in both the crises. Incentives mattered more than the integrity of doing the right thing.

Kaizen

Today I will talk about a concept called kaizen which Japanese have used for a while. I stumbled upon this concept while researching about financial success. I stumbled upon the work of Warren Buffett. He said something along the line of, “knowledge compounds over time just like money”. At first, I was confused about how can knowledge compound? It seemed weird until I stumbled upon the concept of kaizen. 

Kaizen is captured in this familiar but powerful saying:

“A journey of a thousand miles must begin with the first step.” -Lao Tzu

Kaizen concept was first applied in America during the depression era to improve manufacturing productivity during the world war. The US government created management courses called Training within industries (TWI) for American corporations. One of these courses led to the idea of known as Kaizen. 

The training within industries (TWI) courses encouraged corporation managements to focus not on innovation, but focus on hundreds of small things they could improve on. Everyone from top to bottom of the corporation was encouraged to find little ways to increase the quality of their product and the efficiency of creating it. Suggestion boxes were positioned on factory floors so that line workers could suggest ways to improve productivity, and executives were obliged to treat each of these comments with great respect.At first, this philosophy must have seemed shockingly inadequate under the circumstances but, somehow, these little steps added up to a brilliant acceleration of America’s manufacturing capacity. The quality of American equipment and the speed of its production were two of the major factors in the Allied victory.

“When you improve a little each day, eventually big things occur. When you improve conditioning a little each day, eventually you have a big improvement in conditioning. Not tomorrow, not the next day, but eventually a big gain is made. Don’t look for the big, quick improvement. Seek the small improvement one day at a time. That’s the only way it happens-and when it happens, it lasts. ” -John Wooden, one of the most successful coaches in the history of college basketball

Here is an excerpt about kaizen transforming the Japanese businesses from the book: One Small Step Can Change Your Life

Post war the Japanese businesses were run poorly, with slack management practices and low employee morale.

General MacArthur saw the need to improve Japanese efficiency and raise business standards. A thriving Japanese economy was in MacArthur’s best interest because a strong society could provide a bulwark against a possible threat from North Korea and keep his troops in steady supplies. He brought in the U.S. government’s TWI specialists, including those who emphasized the importance of small, daily steps toward change. And, at the same time that MacArthur was holding forth on small steps, the U.S. Air Force developed a class in management and supervision for the Japanese businesses near one of its local bases. The class was called the Management Training Program (MTP), and its tenets were almost identical to those developed by Dr. Deming and his colleagues at the beginning of the war. Thousands of Japanese business managers were enrolled. The Japanese were unusually receptive to this idea. Their industrial base destroyed, they lacked the resources for sweeping reorganization. And it wasn’t lost on Japanese business leaders that their country had been defeated by America’s superior equipment and technology-so they listened closely to the Americans’ lessons on manufacturing. Viewing employees as a resource for creativity and improvement and learning to he receptive to subordinates’ ideas was an unfamiliar notion (as it had been for Americans), but the graduates of these programs gave it a try. These entrepreneurs and managers and executives went on to work in civilian industries, where they excitedly spread the gospel of small steps. In the U.S., Dr. Deming’s series of strategies for enhancing the manufacturing process were largely ignored once the troops were home and production was back to normal. In Japan, however, his concepts were already part of the emerging Japanese business culture. In the late 1950s, the Japanese Union of Scientists and Engineers (JUSE) invited Dr. Deming, the wartime proponent of quality control, to consult further on their country’s economic efficiency and output. As you probably know, Japanese businesses-which rebuilt themselves on the bedrock of small steps-soon rocketed to unheard-of levels of productivity. Small steps were so successful that the Japanese gave them a name of their own: kaizen.

We don’t try new things usually cause of fear and because we resist change. Taking small steps (kaizen) doesn’t trigger the fear or change sensors. Therefore, I love the idea of kaizen. You can use the process of Kaizen for anything ranging from weight loss to career goals. The reason kaizen is so effective is because it focusses on taking small steps to improve. Make sure to practice kaizen every day just like sweeping the floor. Just because we’ve done it once, doesn’t mean the floor is clean forever. Every day the dust comes back. Every day we must sweep.

Dangers of Artificial Intelligence

I have been reading a lot about artificial intelligence recently. Especially when people smarter than me like Bill Gates, Elon musk, Stephen Hawking and many others are being vocal about the dangers of artificial intelligence.

I was browsing Reddit and saw this gif:

3uxxldb-imgur

This gif is a user created a scenario of a classic game called Roller Coaster Tycoon. First I dismissed the gif as an evil creation of a bored gamer for fun but then I read this comment by TummyDrums:

The reason I love this, is because unlike the gifs you see where a roller coaster is crashing into a large group of people, these guys are in go carts that they have full control over. I just imagine them thinking, “What could go wrong? Lets get this race started!”

What struck me about TrummyDrums comment was the fact that, “How can someone with the thinking ability ride those go karts?”. Even a child old enough to reason would know the consequences and the devastation those go-karts would cause. Then it clicked in my head, “What if there was no thinking ability?”. Like the game, “What if it was an artificial intelligence machine just programmed to do a certain task without thinking about the consequences?” This gif is an example of what could happen if artificial intelligence machines get too much control or power. Lack of thinking about consequences in artificial intelligence machines could be devastating.

Focus on process not outcomes.

Jim Chanos was on Bloomberg for an interview. Around the seven minute mark he said:

I point out that when we first went public[short] on caterpillar. We talked about it here[bloomberg] and elsewhere. In 2012 caterpillar was supposed to earn $15 this year[2016] and $18 next year[2017]. It’s going to earn a little over $3 this year. The stock is up a little bit over this 5 year period. It is the cruelty of the market. You can get them really right and still obivously get the stocks wrong. 

In life and business, the outcome depends on a lot of random things. You can only control the process not the outcomes. Therefore, one should only focus on the process and things you can control in life and business.

Welcome!

I’m a life-long learner who loves to read. I specialize in being humbled by life every year. I will be blogging a lot from now on.

I would like to warn you that:

Life is really complicated and future is really hard to predict. Therefore, I change my mind a lot when presented with a different set of facts. Also, when I reanalyze existing situations or when presented with a new way to look at things.

I hope we will have fun learning together!