How Has Kahneman’s Work Influenced Your Own?

It was Daniel Kahnemans 80th birthday last week and it was celebrated in style by Edge.org. Richard Thaler suggested that the question “How has Kahneman’s Work Influenced Your Own?” be asked to friends working in the fields of behavioural economics, psychology, cognitive psychology, law and medicine, a consistent stream of response has flown in.

“It is not just a celebration of Danny. It is a celebration of behavioural science”  – Richard Nisbett

(Kahneman is the author of Thinking Fast and Slow — if you have not read it, purchase a copy tomorrow and make some time to, you won’t regret it.) 

There were over 25 entries posted to Edge.org and I will be honest, I did not read them all in detail. I am not familiar with most of the people commenting leading me to subjectively and prejudicially choose who was included and discluded. Provided below are comments from WSJ Journalist and author of Your Money and Your Brain, Jason Zweig, The author of Antifragile, Black Swan and Fooled By Randomness, Nassim Taleb and Harvard University’s Psychology Professor Steven Pinker. (Richard Thaler did not provided a comment under his section as of March 31st)

 

kahneman[Photo Credit: The Speculator] 

 

Jason Zweig: 

While I worked with Danny on a projectmany things amazed me about this man whom I had believed I already knew well: his inexhaustible mental energy, his complete comfort in saying “I don’t know,” his ability to wield a softly spoken “Why?” like the swipe of a giant halberd that could cleave overconfidence with a single blow.

But nothing amazed me more about Danny than his ability to detonate what we had just done.

Anyone who has ever collaborated with him tells a version of this story: You go to sleep feeling that Danny and you had done important and incontestably good work that day. You wake up at a normal human hour, grab breakfast, and open your email. To your consternation, you see a string of emails from Danny, beginning around 2:30 a.m. The subject lines commence in worry, turn darker, and end around 5 a.m. expressing complete doubt about the previous day’s work.

You send an email asking when he can talk; you assume Danny must be asleep after staying up all night trashing the chapter. Your cellphone rings a few seconds later. “I think I figured out the problem,” says Danny, sounding remarkably chipper. “What do you think of this approach instead?”

The next thing you know, he sends a version so utterly transformed that it is unrecognizable: It begins differently, it ends differently, it incorporates anecdotes and evidence you never would have thought of, it draws on research that you’ve never heard of. If the earlier version was close to gold, this one is hewn out of something like diamond: The raw materials have all changed, but the same ideas are somehow illuminated with a sharper shift of brilliance.

The first time this happened, I was thunderstruck. How did he do that? How could anybody do that? When I asked Danny how he could start again as if we had never written an earlier draft, he said the words I’ve never forgotten: “I have no sunk costs.”

To most people, rewriting is an act of cosmetology: You nip, you tuck, you slather on lipstick. To Danny, rewriting is an act of war: If something needs to be rewritten then it needs to be destroyed. The enemy in that war is yourself.

After decades of trying, I still hadn’t learned how to be a writer until I worked with Danny.

I no longer try to fix what I’ve just written if it doesn’t work. I try to destroy it instead— and start all over as if I had never written a word.

Danny taught me that you can never create something worth reading unless you are committed to the total destruction of everything that isn’t. He taught me to have no sunk costs.

Nassim Taleb:

The Problem of Multiple Counterfactuals

Here is an insight Danny K. triggered and changed the course of my work. I figured out a nontrivial problem in randomness and its underestimation a decade ago while reading the following sentence in a paper by Kahneman and Miller of 1986:

A spectator at a weight lifting event, for example, will find it easier to imagine the same athlete lifting a different weight than to keep the achievement constant and vary the athlete’s physique.

This idea of varying one side, not the other also applies to mental simulations of future (random) events, when people engage in projections of different counterfactuals (we treat alternative past and future histories in exactly the same analytical manner).

It hit me that the mathematical consequence is vastly more severe than it appears. Kahneman and colleagues focused on the bias that variable of choice is not random. But the paper set off in my mind the following realization: now what if we were to go one step beyond and perturbate both?

The response would be nonlinear. I had never considered the effect of such nonlinearity earlier nor seen it explicitly made in the literature on risk and counterfactuals. And you never encounter one single random variable in real life; there are many things moving together.

Increasing the number of random variables compounds the number of counterfactuals and causes more extremes—particularly in fat-tailed environments (i.e., Extremistan): imagine perturbating by producing a lot of scenarios and, in one of the scenarios, increasing the weights of the barbell and decreasing the bodyweight of the weightlifter.

This compounding would produce an extreme event of sorts. Extreme, or tail events (Black Swans) are therefore more likely to be produced when both variables are random, that is real life. Simple.

Now, in the real world we never face one variable without something else with it. In academic experiments, we do. This sets the serious difference between laboratory (or the casino’s “ludic” setup), and the difference between academia and real life. And such difference is, sort of, tractable.

I rushed to change a section for the 2003 printing of one of my books. Say you are the manager of a fertilizer plant. You try to issue various projections of the sales of your product—like the weights in the weightlifter’s story.

But you also need to keep in mind that there is a second variable to perturbate: what happens to the competition—you do not want them to be lucky, invent better products, or cheaper technologies. So not only you need to predict your fate (with errors) but also that of the competition (also with errors). And the variance from these errors add arithmetically when one focuses on differences. There was a serious error made by financial analysts.

When comparing strategy A and strategy B, people in finance compare the Sharpe ratio (that is, the mean divided by the standard deviation of a stream of returns) of A to the Sharpe ratio of B and look at the difference between the two. It is very different than the correct method of looking at the Sharpe ratio of the difference, A-B, which requires a full distribution.

Now, the bad news: the misunderstanding of the problem is general. Because scientists (not just financial analysts) use statistical methods blindly and mechanistically, like cooking recipes, they tend to make the mistake when consciously comparing two variables.

About a decade after I exposed the Sharpe ratio problem, Nieuwenhuis et al. in 2011 found that 50% of neuroscience papers (peer-reviewed in “prestigious journals”) that compared variables got it wrong, using the single variable methodology.

In theory, a comparison of two experimental effects requires a statistical test on their difference. In practice, this comparison is often based on an incorrect procedure involving two separate tests in which researchers conclude that effects differ when one effect is significant (P < 0.05) but the other is not (P > 0.05).

We reviewed 513 behavioral, systems and cognitive neuroscience articles in five top-ranking journals (Science, Nature, Nature Neuroscience, Neuronand The Journal of Neuroscience) and found that 78 used the correct procedure and 79 used the incorrect procedure. An additional analysis suggests that incorrect analyses of interactions are even more common in cellular and molecular neuroscience.

Sadly, ten years after I reported the problem to investment professionals; the mistake is still being made. Ten years from now, they will still be making the same mistake.

Now that was the mild problem. There is worse. We were discussing two variables. Now assume the entire environment is random, and you will see that standard analyses of future events are doomed to underestimate tails. In risk studies, a severe blindness to multivariate tails prevails.

The discussions on the systemic risks of genetically modified organisms (GMOs) by “experts” falls for such butchering of risk management, invoking some biological mechanism and missing on the properties of the joint distribution of tails.

Steven Pinker:

As many Edge readers know, my recent work has involved presenting copious data indicating that rates of violence have fallen over the years, decades, and centuries, including the number of annual deaths in war, terrorism, and homicide.

Most people find this claim incredible on the face of it. Why the discrepancy between data and belief? The answer comes right out of Danny’s work with Amos Tversky on the Availability Heuristic. People estimate the probability of an event by the ease of recovering vivid examples from memory. As I explained, “Scenes of carnage are more likely to be beamed into our homes and burned into our memories than footage of people dying of old age.

No matter how small the percentage of violent deaths may be, in absolute numbers there will always be enough of them to fill the evening news, so people’s impressions of violence will be disconnected from the actual proportions.”

The availability heuristic also explains a paradox in people’s perception of the risks of terrorism. The world was turned upside-down in response to the terrorist attacks on 9/11.

But putting aside the entirely hypothetical scenario of nuclear terrorism, even the worst terrorist attacks kill a trifling number of people compared to other causes of violent death such as war, genocide, and homicide, to say nothing of other risks of death. Terrorists know this, and draw disproportionate attention to their grievances by killing a relatively small number of innocent people in the most attention-getting ways they can think of.

Even the perceived probability of nuclear terrorism is almost certainly exaggerated by the imaginability of the scenario (predicted at various times to be near-certain by 1990, 2000, 2005, and 2010, and notoriously justifying the 2003 invasion of Iraq).

I did an internet survey which showed that people judge it more probable that “a nuclear bomb would be set off in the United States or Israel by a terrorist group that obtained it from Iran” than that “a nuclear bomb would be set off.” It’s an excellent example of Kahneman and Tversky’s Conjunction Fallacy, which they famously illustrated with the articulate activist Linda, who was judged more likely to be feminist bank teller than a bank teller.

If somebody were to ask me what are the most important contributions to human life from psychology, I would identify this work [by Kahneman & Tversky] as maybe number one, and certainly in the top two or three.

In fact, I would identify the work on reasoning as one of the most important things that we’ve learned about anywhere. When we were trying to identify what any educated person should know in the entire expanse of knowledge, I argued unsuccessfully that the work on human cognition and probabilistic reason should be up there as one of the first things any educated person should know.

Read the other comments on Edge.org: How Did Daniel Kahneman Influence Your Work ?

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The Future of Berkshire (Lountzis Asset Management Annual Letter, 2013)

THE FUTURE OF BERKSHIRE HATHAWAY WITHOUT WARREN E. BUFFETT

Berkshire Hathaway remains our firm’s largest holding and, while we have discussed the company in the past, several clients have asked the question, “What is the future of Berkshire Hathaway should Mr. Buffett no longer be the CEO for a variety of reasons?”
In response, we would like to share our thoughts on this unique enterprise and the irreplaceable and extraordinary Warren Buffett who created and continues to guide the firm. As many of our clients may know, I have followed Mr. Buffett and Berkshire Hathaway for over four decades, though with more insight over the past three decades.

It has been an enormous privilege and pleasure watching him and Berkshire Hathaway evolve and grow in so many ways through the years. Today, Berkshire Hathaway represents the largest holding in our client portfolios, and we have never sold a share. As such a large holder on behalf of our clients, I have tried to think deeply about Berkshire Hathaway both in its current structure, but even more importantly, to when Mr. Buffett is no longer the CEO, for whatever reason.

I have tried to summarize some of my key thoughts below without going into great detail, as to some of my concerns regarding Berkshire Hathaway without Mr. Buffett. Despite these concerns which I discuss, I strongly believe Berkshire Hathaway is well positioned overall for a future without him.
While I hope Mr. Buffett finds the Methuselah gene, which he has often referred to as it would provide him another 885.5 years to live, and, if I find it, I will split the years with him equally extending each of our lives for 484.5 years. Based upon actuarial tables he will likely live into his early to mid-90’s.

I certainly hope it is even longer. I also believe a greater risk to Berkshire Hathaway than Mr. Buffett’s absence, would be a deterioration of his capabilities, rather than his passing. However, he has given the Board approval to “take away the keys” if he begins to lose his mental sharpness. In Mr. Buffett there is embedded a broad and deep multi-dimensional set of skills that are simply not found in any other single individual.

As the founder, builder and controlling shareholder of Berkshire Hathaway, his values and vision have been deeply integrated throughout the organization.

Furthermore, his unique, set of multi-dimensional skills, along with his history with the firm, provide him with an unparalleled capability to evaluate and assess the many subsidiaries, management teams and acquisitions. There are some deals, from the purchase of entire companies, as well as one-off deals such as during the financial crisis, that come to Berkshire Hathaway exclusively because of Mr. Buffett’s integrity, track record, reputation and so on, that will be irreplaceable.

Berkshire Hathaway remains an extraordinary company, with a Rock of Gibraltar balance sheet, a collection of many world class businesses, stable and growing cash flows from diverse sources, and an outstanding team of managers leading many of its businesses.

However, when Mr. Buffett (who is irreplaceable) is no longer the CEO, what will that mean for the future of Berkshire Hathaway? In assessing the future, I have tried to consider the historical evolution of both Mr. Buffett and Berkshire Hathaway to gain some insights as to how best to prepare for that future without him.

In Ralph Waldo Emerson’s words,“Every institution is the lengthened shadow of one man.” No organization better exemplifies that quote than Berkshire Hathaway. However, Mr. Buffett has done an outstanding job, fundamentally transforming the company over the years so that today the company is far less dependent upon him than ever before in preparation for when he is gone.

There are four areas of focus in my thoughts:

corporate governance, leadership, operating structure, and valuation, each of which I will address.

Under Mr. Buffett’s leadership, corporate governance has been exemplary on every count as measured by evaluating the following four areas: 1. Rights and equitable treatment of shareholders and all stakeholders; 2. Role and responsibilities of the Board of Directors; 3. Integrity and ethical behavior; 4. Disclosure and transparency.

Given Mr. Buffett’s demonstrated track record of excellence in each of these areas, Berkshire Hathaway’s corporate governance, while non-traditional, has been relatively unchanged. Given BRK’s current corporate governance, it will be more difficult to prevent changes in the future under new leadership due to government regulators and external forces that will not be as forgiving as they have been under Mr. Buffett. For example, Berkshire Hathaway’s disclosure and transparency based upon the firm’s SEC filings, and annual reports actually offer very little information relative to the enormity of the organization.

Continuing reading on page 4.

The Choice Of A Discount Rate: Excerpts From Seth Klarman’s ‘Margin Of Safety’

“Ultimately investors must choose sides. One side – the wrong choice is a seemingly effortless path that offers the comfort of consensus.” – Seth Klarman (TradesPortfolio)

I was fortunate enough to obtain a copy of Seth Klarman (Trades,Portfolio)’s “Margin of Safety” at the end of last week and read through most of it in one sitting. I found a few chapters very informative and worth sharing with others that may not have a copy themselves or have not read the book.

If you have read “The Intelligent Investor,” “Security Analysis” or the Berkshire letters you will see a lot of repetition, but the repetition has a modern touch from Klarman as it was published in 1991. The examples given are also different but the reoccurring themes are the same: margin of safety, intrinsic value, crowd behavior, competitive advantages, valuation tactics, etc.

Chapter 8 is “The Art of Business Valuation.” The chapter was one of my favorites (I will write a post or two about the others) and talks about the elusive precision of NPV, DCF and IRR, how a valuation range should be used, various ways of valuing a business, how to choose a discount rate and the reflexivity of market prices. The following is an excerpt from a section titled “The Choice of a Discount Rate,” as a question was recently received from a reader asking about the discount rate, specifically, should it be adjusted depending on both the certainty (or uncertainty) of future cash flows and the risk free rate? (Spoiler: Yes it should, but let us hear it from the horse’s mouth.)

“The other component of present-value analysis, choosing a discount rate, is rarely given sufficient consideration by investors. A discount rate is, in effect, the rate of interest that would make an investor indifferent between present and future dollars. Investors with a strong preference for present over future consumption or with a preference for the certainty of the present to the uncertainty of the future would use a high rate for discounting their investments. Other investors may be more willing to take a chance on forecasts holding true; they would apply a low discount rate, one that makes future cash flows nearly as valuable as today’s.

There is no single correct discount rate for a set of future cash flows and no precise way to choose one. The appropriate discount rate for a particular investment depends not only on an investor’s preference for present over future consumption but also on his or her own risk profile, on the perceived risk of the investment under consideration, and on the returns available from alternative investments.”

  • Klarman explains how we can essentially view a discount rate as an opportunity cost and that depending on the certainty of the opportunity (or lack of) we should adjust the discount rate up and down accordingly. An example of this may be discounting a company with relatively known cash flow like Wal-Mart or Coca-Cola at something like 6% to 8% while a company like Tesla or 3D Systems Corp. might be discounted at 13% to 14%.

“Investors tend to oversimplify; the way they choose a discount rate is a good example of this.A great many investors routinely use 10 percent as an all-purpose discount rate regard- less of the nature of the investment under consideration. Ten percent is a nice round number, easy to remember and apply, but it is not always a good choice.

The underlying risk of an investment’s future cash flows must be considered in choosing the appropriate discount rate for that investment. A short-term, risk-free investment (if one exists) should be discounted at the yield available on short-term U.S. Treasury securities, which, as stated earlier, are considered a proxy for the risk-free interest rate. Low-grade bonds, by contrast, are discounted by the market at rates of 12 to 15 percent or more, reflecting investors’ uncertainty that the contractual cash flows will be paid.

It is essential that investors choose discount rates as conservatively as they forecast future cash flows. Depending on the timing and magnitude of the cash flows, even modest differences in the discount rate can have a considerable impact on the present-value calculation.”

Take the table below illustrating the difference of $1 discounted at 6% through 14% over a 10-year period. The longer the time frame the larger the discrepancies become between the discount rate used — until a certain point.

To further illustrate this threshold being reached we can look at the difference of cash flows at years 15, 20, 25 and 35 discounted at 14%.

$1,000,000 discounted over 15 years is equal to roughly 14% or 140k.

$1,000,000 discounted over 20 years is equal to roughly 7.2% or 72k.

$1,000,000 discounted over 25 years is equal to roughly 3.8% or 38k.

$1,000,000 discounted over 35 years is equal to roughly 1% or 10k.

As we can see after about 15 years (at 14%), the bulk of the cash flow has already been discounted and our interpretation from there on out becomes negligible (from a DCF perspective, the durable moat still matters!)

Discount Rate 6% 7% 8% 9% 10% 11% 12% 13% 14%
Year
1 $0.94 $0.93 $0.93 $0.92 $0.91 $0.90 $0.89 $0.88 $0.88
2 $0.89 $0.87 $0.86 $0.84 $0.83 $0.81 $0.80 $0.78 $0.77
3 $0.84 $0.82 $0.79 $0.77 $0.75 $0.73 $0.71 $0.69 $0.67
4 $0.79 $0.76 $0.74 $0.71 $0.68 $0.66 $0.64 $0.61 $0.59
5 $0.75 $0.71 $0.68 $0.65 $0.62 $0.59 $0.57 $0.54 $0.52
6 $0.70 $0.67 $0.63 $0.60 $0.56 $0.53 $0.51 $0.48 $0.46
7 $0.67 $0.62 $0.58 $0.55 $0.51 $0.48 $0.45 $0.43 $0.40
8 $0.63 $0.58 $0.54 $0.50 $0.47 $0.43 $0.40 $0.38 $0.35
9 $0.59 $0.54 $0.50 $0.46 $0.42 $0.14 $0.36 $0.33 $0.31
10 $0.56 $0.51 $0.46 $0.42 $0.39 $0.35 $0.32 $0.29 $0.27

We can also see the large differences between the best case, the base case and the worst case. The best case results with a value of 56% of the original cash flow, while the worst-case results in 27% of the original cash flow. For simplicity a simple present value formula was used with $1 as the original cash flow. (Best, base and worst cases are bolded at year 10.)

“Business value is influenced by changes in discount rates and therefore by fluctuations in interest rates. While it would be easier to determine the value of investments if interest rates and thus discount rates were constant, investors must accept the fact that they do fluctuate and take what action they can to minimize the effect of interest rate fluctuations on their portfolios.

How can investors know the ‘correct’ level of interest rates in choosing a discount rate? I believe there is no ‘correct’ level of rates. They are what the market says they are, and no one can predict where they are headed. Mostly I give current, risk-free interest rates the benefit of the doubt and assume that they are correct. Like many other financial-market phenomenathere is some cyclicality to interest rate fluctuations. High interest rates lead to changes in the economy that are precursors to lower interest rates and vice versa. Knowing this does not help one make particularly accurate forecasts, however, for it is almost impossible to envision the economic cycle until after the fact.

At times when interest rates are unusually low, however, investors are likely to find very high multiples being applied to share prices. Investors who pay these high multiples are dependent on interest rates remaining low, but no one can be certain that they will. This means that when interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available, with a preference for either holding cash or investing in short-term holdings that quickly return cash for possible redeployment when available returns are more attractive.

Investors can apply present-value analysis in one of two ways. They can calculate the present-value of a business and use it to place a value on its securities. Alternatively, they can calculate the present-value of the cash flows that security holders will receive: interest and principal payments in the case of bondholders and dividends and estimated future share prices in the case of stockholders.”

  • A common stock is essentially a bond with a variable coupon and no maturity; figuring out what the coupon payments will be is the inherently tough part of the business.

“Calculating the present value of contractual interest and principal payments is the best way to value a bond. Analysis of the underlying business can then help to establish the probability that those cash flows will be received. By contrast, analyzing the cash flows of the underlying business is the best way to value a stock. The only cash flows that investors typically receive from a stock are dividends. The dividend-discount method of valuation, which calculates the present value of a projected stream of future dividend payments, is not a useful tool for valuing equities; for most stocks, dividends constitute only a small fraction of total corporate cash flow and must be projected at least several decades into the future to give a meaningful approximation of business value. Accurately predicting that far ahead is an impossibility.”

  • Although Klarman does not state an exact time frame to use when discounting cash flow, my assumption is that it would be in the five, 10 and 15-year intervals with various ranges (sensitivity analysis of cash flows), using various discount rates. He clearly does not use several decades, as he says it is an impossibility to predict and as our previous experiment has shown above, the cash flows become arguably negligible around years 15 to 20.

“Once future cash flows are forecast conservatively and an appropriate discount rate is chosen, present value can be calculated. In theory, investors might assign different probabilities to numerous cash flow scenarios, and then calculate the expected value of an investment, multiplying the probability of each scenario by its respective present value and then summing these numbers. In practice, given the extreme difficulty of assigning probabilities to numerous forecasts, investors make do with only a few likely scenarios. They must then perform sensitivity analysis in which they evaluate the effect of different cash flow forecasts and different discount rates on present value. If modest changes in assumptions cause a substantial change in net present value, investors would be prudent to exercise caution in employing this method of valuation.”

Best case, base case and worst case is all you need in terms of probabilities and expected values. Complexity does not usually produce a more accurate representation. There was a great write-up a week or two ago on GuruFocus by Grahamites about “Cultivating an Expected Value Mindset” where the reader will find additional information about components of the “subjectivity analysis” the value investor must conduct.

“Truth is ever to be found in the simplicity, and not in the multiplicity and confusion of things.” – Isaac Newton

When Carl Icahn Ran a Company: The Story of TWA.

Marc Andreessen

From “TWA – Death Of A Legend” by Elaine X. Grant in St. Louis Magazine, October 2005.
–––
Ask any ex-staffer what went wrong with the [bankrupt] airline, and you’ll get one answer: Carl Icahn, the corporate raider who took over TWA in 1985 and systematically stripped it of its assets…

In 1985, Icahn launched a sneak attack, buying up more than 20 percent of the airline’s stock…

Icahn, though he already had a fairly dark reputation for buying and breaking up companies, told TWA what it wanted to hear: He wanted to make it profitable…

But soon enough, the party was over. “It became more and more apparent that Carl was not interested in growing the airline but in using TWA as a financial vehicle to acquire wealth for himself,” [former TWA pilot Jeff] Darnall says.

In 1988, Icahn took what many consider the first step toward the airline’s…

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Spin-Offs vs. Distressed Debt with Phillip Ordway

Phillip Ordway talks about how spin-offs and distressed debt contrast each other at different times allowing the investor a nice balance between the two. He also talks about the built in margin of safety in distressed debt at 0.50 or less of par value. He also talks about how it is helpful to go through the distressed debt process with someone who is experienced and has knowledge in the parlance that is used.