8 Richard Foster and Sarah Kaplan, Creative Destruction: Why Companies that are Built to Last Underperform the Market—and How to Successfully Transform Them (New York: Doubleday, 2001); and John Y. Campbell, Martin Lettau, Burton G. Malkiel, and Yexiao Xu, “Have Individual Stocks Become More Volatile?” Journal of Finance 54 (February 2001): 1-43.
9 J. Bradford DeLong and Lawrence H. Summers, “The ‘New Economy’: Background, Historical Perspective, Questions, and Speculations”, Federal Reserve Bank of Kansas City Economic Review, Fourth Quarter 2001. See http://www.kc.frb.org/PUBLICAT/ECONREV/Pdf/4q01delo.pdf.
10 Alfred Rappaport and Michael J. Mauboussin, Expectations Investing: Reading Stock Prices for Better Returns (Boston: Harvard Business School Press, 2001), 26-27, 36-38.
22. All the Right Moves
1 See “Frequently Asked Questions: Deep Blue,” http://www.research.ibm.com/deepblue/meet/html/d.3.3.html.
2 Katie Haffner, “In an Ancient Game, Computing’s Future,” New York Times, August 1, 2002.
3 Anna Muoio, “All The Right Moves,” Fast Company, May 1999; see http://www.fastcompany.com/online/24/chess.html.
4 This is reminiscent of Puggy Pearson’s advice to gamblers. See Michael J. Mauboussin and Kristen Bartholdson, “Puggy Pearson’s Prescription,” The Consilient Observer 1, no. 11 (June 4, 2002).
5 Kathleen M. Eisenhardt and Donald N. Sull, “Strategy as Simple Rules,” Harvard Business Review (January 2001): 107-16.
23. Survival of the Fittest
1 Dan Goodgame, “The Game of Risk: How the Best Golfer in the World Got Even Better,” Time, August 14, 2000.
2 Stuart Kauffman, At Home in the Universe (Oxford: Oxford University Press, 1996).
3 Steve Maguire, “Strategy Is Design: A Fitness Landscape Framework,” Managing Complexity in Organizations: A View in Many Directions (Westport, Conn.: Quorum Books, 1999), 67-104.
4 Eric D. Beinhocker, “Robust Adaptive Strategies,” Sloan Management Review 40, no. 3 (Spring 1999): 95-106.
5 Daniel C. Dennett, Darwin’s Dangerous Idea: Evolution and The Meanings of Life (New York: Simon & Schuster, 1995).
6 Robert Loest, “Fitness Landscapes and Investment Strategies, Parts 1 and 2,” Portfolio Manager Commentary—IPS Funds (July and August 1998).
7 Clayton M. Christensen, The Innovator’s Dilemma: When New Technologies Cause Great Companies to Fail (Boston: Harvard Business School Press, 1997).
8 Michael J. Mauboussin and Alexander Schay, “Innovation and Markets: How Innovation Affects the Investing Process,” Credit Suisse First Boston Equity Research, December 12, 2000.
9 These can be recast as “exploit” versus “explore” strategies. See Robert Axelrod and Michael D. Cohen, Harnessing Complexity (New York: Free Press, 1999), 43-58.
10 W. Brian Arthur, “Increasing Returns and the New World of Business,” Harvard Business Review (July-August 1996): 101-9.
11 General Electric, on Jack Welch’s watch, effectively combined optimization with risk taking. For example, Welch gave the leaders of GE’s largest businesses several hundred million dollars for discretionary spending with “no questions asked.” See Warren Bennis, “Will the Legacy Live On?” Harvard Business Review (February 2002): 95-99.
12 Michael J. Mauboussin, “Get Real,” Credit Suisse First Boston Equity Research, June 23, 1999.
13 Shona L. Brown and Kathleen M. Eisenhardt, Competing on the Edge: Strategy as Structured Chaos (Boston: Harvard Business School Press, 1998).
24. You’ll Meet a Bad Fate If You Extrapolate
1 See http://www.socialsecurity.gov/history/hfaq.html.
2 Richard Roll, “Rational Infinitely-Lived Asset Prices Must be Non-Stationary,” Working Paper, November 1, 2000; Bradford Cornell, The Equity Risk Premium: The Long-Run Future of the Stock Market (New York: Wiley, 1999), 45-55; Eugene F. Fama and Kenneth R. French, “The Equity Premium,” Journal of Finance 57 (2002): 637-59; Jonathan Lewellen, “Predicting Returns with Financial Ratios,” MIT Sloan Working Paper 4374-02, February 2002.
3 Kenneth L. Fisher and Meir Statman, “Cognitive Biases in Market Forecasts: The Frailty of Forecasting,” The Journal of Portfolio Management 27, no. 1 (Fall 2000): 72-81.
4 Alfred Rappaport, “How to Avoid the P/E Trap,” Wall Street Journal, March 10, 2003.
5 Cornell, The Equity Risk Premium, 59.
6 See http://www.econ.yale.edu/~shiller/.
25. I’ve Fallen and I Can’t Get Up
1 Lakonishok, quoted in Mark Hulbert, “The Five-Year Forecast Looks Great, or Does It?” New York Times, January 25, 2004.
2 Louis K. C. Chan, Jason J. Karceski, and Josef Lakonishok, “The Level and Persistence of Growth Rates,” The Journal of Finance 58, no. 2 (April 2003): 644-84. Also see chapter 30.
3 Michael J. Mauboussin and Kristen Bartholdson, “Whither Enron: Or—Why Enron Withered,” The Consilient Observer 1, no. 1 (January 15, 2002).
4 Michael J. Mauboussin and Kristen Bartholdson, “Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation,” Credit Suisse First Boston Equity Research, December 16, 2002.
5 Michael J. Mauboussin, Alexander Schay, and Patrick J. McCarthy, “Competitive Advantage Period (CAP): At the Intersection of Finance and Competitive Strategy,” Credit Suisse First Boston Equity Research, October 4, 2001.
6 Ibid., 7-9.
7 Todd Erickson, Carin Cooney, and Craig Sterling, “US Technology Sector: Mean Reversion Analysis,” CSFB HOLT Research, February 2, 2004.
8 HOLT analysts Christopher Catapano, Katie Dunne, and Craig Sterling performed the retail industry analysis.
9 To illustrate, we created a model with two companies that had 8 percent operating-income growth rates, initial returns on incremental invested capital of 100 percent, and identical costs of capital. We faded the first company’s returns to zero over ten years, and the second company’s returns to zero over twenty years. The second company—again, with identical growth—was 33 percent more valuable than the first, representing more than six price-earnings points.
10 W. Brian Arthur, “Increasing Returns and the New World of Business,” Harvard Business Review (July-August 1996): 101-9.
11 See chapter 1.
26. Trench Cooperation
1 Robert Axelrod, The Complexity of Cooperation: Agent-Based Models of Competition and Collaboration (Princeton, N.J.: Princeton University Press, 1997), 6.
2 Robert Axelrod, The Evolution of Cooperation (New York: Basic Books, 1984), 74.
3 George Lakoff and Mark Johnson, Metaphors We Live By (Chicago, Ill.: The University of Chicago Press, 1980).
4 Axelrod, The Evolution of Cooperation, 73-87.
5 Ibid., 81. Axelrod quotes S. Gillon, The Story of the 29th Division (London: Nelson & Sons, n.d.). Eventually, the British, French, and German high commands undermined the live-and-let-live system by forcing raids, undermining the stability necessary to support the tacit agreements.
6 “Stern Stewart EVA Roundtable,” Journal of Applied Corporate Finance 7, no. 2 (Summer 1994): 46-70.
7 For an excellent discussion, see William Poundstone, Prisoner’s Dilemma (New York: Anchor Books, 1992).
8 The choice to add capacity gets both companies to the Nash equilibrium.
9 Axelrod, The Evolution of Cooperation, 27-54.
10 David Besanko, David Dranove, and Mark Shanley, Economics of Strategy, 2nd ed. (New York: John Wiley & Sons, 2000), 289-90.
11 Ibid., 293-302.
12 Adam M. Brandenburger and Barry J. Nalebuff, Co-opetition (New York: Currency, 1996), 120-22.
27. Great (Growth) Expectations
1 Warren Buffett and Charlie Munger, “It’s Stupid the Way People Extrapolate the Past—and Not Slightly Stupid, But Massively Stupid,” Outstanding Investor Digest, December 24, 2001.
2 Chris Zook with James Allen, Profit from the Core (Boston: Harvard Business School Press, 2001), 11-13.
3 I mention this because voluminous evidence suggests
that mergers and acquisitions are a value negative or, at best, a value neutral activity. So growth via acquisition is often not value creating.
4 Firm sizes and cities follow a Zipf distribution. See Robert L. Axtell, “Zipf Distribution of U.S. Firm Sizes,” Science 293 (September 2001): 1818-1820.
5 This is an inappropriate use of the term “law of large numbers.” For a further explanation, see Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (New York: John Wiley & Sons, 1996), 122-23.
6 Jeremy J. Siegel, Stocks for the Long Run, 3rd ed. (New York: McGraw Hill, 2002), 150-56.
7 Joseph Fuller and Michael C. Jensen, “Dare to Keep Your Stock Price Low,” The Wall Street Journal, December 31, 2001.
8 Alfred Rappaport, “The Economics of Short-Term Performance Obsession,” Financial Analysts Journal 61, no. 3 (May-June 2005): 65-79.
28. Diversify Your Mind
1 See Norman L. Johnson, “What a Developmental View Can Do for You (or the Fall of the House of Experts),” talk at CSFB Thought Leader Forum, September 2000, Santa Fe, N.M., http://www.capatcolumbia.com/CSFB%20TLF/2000/johnson00_sidecolumn.pdf.
2 Michael J. Mauboussin, “Revisiting Market Efficiency: The Stock Market as a Complex Adaptive System” Journal of Applied Corporate Finance 14, no. 4 (Winter 2002): 47-55.
3 Norman L. Johnson, “Diversity in Decentralized Systems: Enabling Self-Organizing Solutions,” LANL, LA-UR-99-6281, 1999. For more on this, see http://ishi.lanl.gov.
4 James Kennedy and Russell C. Eberhart, Swarm Intelligence (San Francisco: Morgan Kaufmann, 2001), 105.
5 William H. Calvin, “The Emergence of Intelligence,” Scientific American Presents 9, no. 4 (November 1998): 44-51.
6 Gary Klein, Sources of Power: How People Make Decisions (Cambridge, Mass.: MIT Press, 1998).
7 Michael T. Kaufman, Soros: The Life and Times of a Messianic Billionaire (New York: Knopf, 2002), 141.
8 See “Informal Learning in the Workplace,” http://www.learning-org.com/98.01/0331.html.
9 Arthur Zeikel, “Organizing for Creativity,” Financial Analyst Journal 39 (November-December 1983): 25-29.
29. From Honey to Money
1 Thomas D. Seeley, The Wisdom of the Hive: The Social Physiology of Honey Bee Colonies (Cambridge, Mass.: Harvard University Press, 1995), 259. Also, see http://www.pbs.org/wgbh/nova/bees.
2 Cited in Steven Johnson, Emergence: The Connected Lives of Ants, Brains, Cities, and Software (New York: Scribner, 2001), 33.
3 Seeley, The Wisdom of the Hive, 240-62; also see http://www.nbb.cornell.edu/neurobio/department/Faculty/seeley/seeley.html.
4 Eric Bonabeau, Marco Dorigo, and Guy Theraulaz, Swarm Intelligence: From Natural to Artificial Systems (New York: Oxford University Press, 1999), 39-55. Also see Edmund Burke and Graham Kendall, “Applying Ant Algorithms and the No Fit Polygon to the Nesting Problem,” University of Nottingham Working Paper, 1999, http://www.asap.cs.nott.ac.uk/publications/pdf/gk_ai99.pdf.
5 See Iowa Electronic Markets Web site, http://www.biz.uiowa.edu/iem.
6 James Surowiecki, “Decisions, Decisions,” The New Yorker, March 28, 2003, available from http://www.newyorker.com/archive/2003/03/24/030324ta_talk_surowiecki.
7 See Hollywood Stock Exchange Web site, http://www.hsx.com.
8 See Betfair Web site, http://www.betfair.com.
9 Alfred Rappaport and Michael J. Mauboussin, Expectations Investing (Boston: Harvard Business School Press, 2001), 132-34.
10 Howard Rheingold, Smart Mobs: The Next Social Revolution (New York: Perseus, 2002).
11 Ken Brown, “Stocks March to the Beat of War, Weak Economy,” Wall Street Journal, March 31, 2003.
30. Vox Populi
1 Michael Idinopulos and Lee Kempler, “Do You Know Who Your Experts Are?” The McKinsey Quarterly 4 (2003): 60-69; see http://www.mckinseyquarterly.com/article_abstract.asp?ar=1358&L2=18&L3=31&srid=6&gp=1.
2 Nancy Weil, “Innocentive Pairs R&D Challenges with Researchers,” Bio-IT World, May 29, 2003.
3 Some companies are trying to create an internal mechanism to match questions with answers. For example, Hewlett-Packard has a system called SHOCK (Social Harvesting of Community Knowledge); see http://www.hpl.hp.com/research/idl/projects/shock.
4 Francis Galton, “Vox Populi,” Nature 75 (March 7, 1907): 450-451; reprint, 1949. Also, James Surowiecki, The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations (New York: Random House, 2004).
5 Norman L. Johnson, “Collective Problem Solving: Functionality beyond the Individual,” LA-UR-98-2227 (1998); Jack L. Treynor, “Market Efficiency and the Bean Jar Experiment,” Financial Analysts Journal (May-June 1987): -53; Sherry Sontag and Christopher Drew, Blind Man’s Bluff: The Untold Story of American Submarine Espionage (New York: Perseus Books, 1998), 58-59.
6 Kay-Yut Chen, Leslie R. Fine, and Bernardo A. Huberman, “Predicting the Future,” Information Systems Frontiers 5, no. 1 (2003): 47-61, http://www.hpl.hp.com/shl/papers/future/future.pdf.
31. A Tail of Two Worlds
1 This process is know as Brownian motion. Albert Einstein pointed out that this motion is caused by random bombardment of heat-excited water molecules on the pollen.
2 See GloriaMundi, “Introduction to VaR,” http://www.gloriamundi.org/introduction.asp.
3 Edgar E. Peters, Fractal Market Analysis (New York: John Wiley & Sons, 1994), 21-27.
4 Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000), 72. Lowenstein is quoting Jens Carsten Jackwerth and Mark Rubinstein, “Recovering Probability Distributions from Option Prices,” Journal of Finance 51, no. 5 (December 1996): 1612. Jackwerth and Rubinstein note that assuming annualized volatility of 20 percent for the market and a lognormal distribution, the 29 percent drop in the S&P 500 futures was a twenty-seven-standard-deviation event, with a probability of 10−160.
5 Per Bak, How Nature Works (New York: Springer-Verlag, 1996).
6 See chapter 22.
7 Sushil Bikhchandani and Sunil Sharma, “Herd Behavior in Financial Markets,” IMF Staff Papers 47, no. 3 (September 2001); see http://www.imf. org/External/Pubs/FT/staffp/2001/01/pdf/Bikhchan.pdf.
8 Michael S. Gibson, “Incorporating Event Risk into Value-at-Risk,” The Federal Reserve Board Finance and Economics Discussion Series, 2001-17 (February 2001); see http://www.federalreserve.gov/pubs/feds/2001/200117/200117abs.html.
32. Integrating the Outliers
1 Daniel Bernoulli, “Exposition of a New Theory on the Measurement of Risk,” Econometrica, 22 (January 1954): 23-36. Originally published in 1738. Daniel’s cousin, Nicolaus, initially proposed the game.
2 See The Stanford Encyclopedia of Philosophy, s.v. “St. Petersburg Paradox,” http://plato.stanford.edu/entries/paradox-stpetersburg.
3 Much of this section relies on Larry S. Liebovitch and Daniela Scheurle, “Two Lessons from Fractals and Chaos,” Complexity, Vol. 5, 4, 2000, 34-43. See http://www.ccs.fau.edu/˜liebovitch/complexity-20.html.
4 See chapter 29.
5 Benoit B. Mandelbrot, “A Multifractal Walk down Wall Street,” Scientific American, February 1999, 70-73. Also see, Benoit B. Mandelbrot, Fractals and Scaling in Finance: Discontinuity, Concentration, Risk (New York: Springer Verlag, 1997).
6 If you assume that you flipped a coin nonstop sixteen hours a day (estimating eight hours of sleep), and if each coin flip takes three seconds, it would take 14.3 years to complete 100 million coin tosses.
7 Didier Sornette, Why Stock Markets Crash: Critical Events in Complex Financial Systems (Princeton, N.J.: Princeton University Press, 2003); also see Sornette’s Web site, http://www.ess.ucla.edu/faculty/sornette/.
8 See another classic article: Peter L. Bernstein, “Growth Companies Vs. Growth Stocks,” Harvard Business Review (September-October 1956): 87-98.
9 Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (New
York: Wiley, 1996), 107-109.
10 David Durand, “Growth Stocks and the Petersburg Paradox,” Journal of Finance 12 (September 1957): 348-63.
11 Stephen R. Waite, Quantum Investing (New York: Texere, 2003), 129.
12 Michael J. Mauboussin, Bob Hiler, and Patrick J. McCarthy, “The (Fat) Tail that Wags the Dog,” Credit Suisse First Boston Equity Research, February 4, 1999.
33. The Janitor’s Dream
1 Quoted in Sandra Blakeslee, “Scientist at Work: John Henry Holland; Searching for Simple Rules of Complexity,” New York Times, December 26, 1995.
2 William H. Calvin, How Brains Think: Evolving Intelligence, Then and Now (New York: Basic Books, 1996).
3 John H. Holland, Hidden Order: How Adaptation Builds Complexity (Reading, Mass.: Helix Books, 1995), 10-37.
4 See chapter 11.
5 Michael J. Mauboussin, “Revisiting Market Efficiency: The Stock Market as a Complex Adaptive System,” Journal of Applied Corporate Finance 14, no. 4 (Winter 2002): 47-55.
6 Norman L. Johnson, “Diversity in Decentralized Systems: Enabling Self-Organizing Solutions,” LANL, LA-UR-99-6281, 1999.
7 Max Bazerman, Judgment in Managerial Decision Making, 4th ed. (New York: Wiley, 1998), 6-17.
34. Chasing Laplace’s Demon
1 See Michael Gazzaniga, “Whole Brain Interpreter,” http://pegasus.cc.ucf.edu/~fle/gazzaniga.html.
2 Joseph LeDoux, The Emotional Brain: The Mysterious Underpinnings of Emotional Life (New York: Touchstone, 1996), 32-33.
3 As per Wolpert’s Faraday lecture at the Royal Society, 2001. Also see Lewis Wolpert, Six Impossible Things Before Breakfast: The Evolutionary Origins of Belief (New York: W. W. Norton, 2007); Gilles Fauconnier and Mark Turner, The Way We Think: Conceptual Blending and the Mind’s Hidden Complexities (New York: Basic Books, 2002), 76; and Paul R. Ehrlich, Human Natures: Genes, Cultures, and the Human Prospect (Washington, D.C.: Island Press, 2000), 132.
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