More Than You Know

by Michael J Mauboussin

  4 Michael J. Mauboussin, “Revisiting Market Efficiency: The Stock Market as a Complex Adaptive System,” The Journal of Applied Corporate Finance 14, no. 4 (Winter 2002): 47-55.

  5 Duncan J. Watts, Six Degrees: The Science of a Connected Age (New York: W. W. Norton, 2003), 204-7.

  6 David M. Cutler, James M. Poterba, and Lawrence H. Summers, “What Moves Stock Prices?” The Journal of Portfolio Management (Spring 1989): 4-12.

  7 Peter Coy, “He Who Mines the Data May Strike Fool’s Gold,” BusinessWeek , June 16, 1997.

  8 Gary Belsky and Thomas Gilovich, Why Smart People Make Big Money Mistakes—and How to Correct Them: Lessons From the New Science of Behavioral Economics (New York: Simon and Schuster, 1999), 137-38.

  35. More Power to You

  1 George Kingsley Zipf, National Unity and Disunity: The Nation as a Bio-Social Organism (Bloomington, Ind.: Principia Press, 1941), 398-99.

  2 For example, in log 10 the scale would be 101 (= 10), 102 (= 100), and 103 (= 1,000) versus the more familiar 10, 11, 12.

  3 Richard Koch, The 80/20 Principle: The Secret to Success by Achieving More with Less (New York: Currency, 1998).

  4 Rob Axtell, “Zipf ’s Law of City Sizes: A Microeconomic Explanation Far from Equilibrium,” presentation at a RAND workshop, Complex Systems and Policy Analysis: New Tools for a New Millennium, September 27-28, 2000, Arlington, Va.

  5 These modifications are lucidly explained in Murray Gell-Mann, The Quark and the Jaguar: Adventures in the Simple and the Complex (New York: W. H. Freeman, 1994), 92-100.

  6 Robert L. Axtell, “Zipf Distribution of U.S. Firm Sizes,” Science 293 (September 7, 2001): 1818-20; see http://www.sciencemag.org/content/vol293/issue5536/index.shtml.

  7 These include self-organized criticality, highly optimized tolerance (HOT), and the Gibrat process. Not all of these processes are mutually exclusive.

  8 Per Bak, How Nature Works: The Science of Self-Organized Criticality (New York: Springer-Verlag, 1996), 1-3.

  9 Robert Axtell, “The Emergence of Firms in a Population of Agents: Local Increasing Returns, Unstable Nash Equilibria, and Power Law Size Distributions,” Brookings Institution, Center on Social and Economics Working Paper 3, June 1999. Also see Robert L. Axtell and Richard Florida, “Emergent Cities: A Microeconomic Explanation of Zipf’s Law,” Brookings Institution and Carnegie Mellon University Working Paper, September 2000.

  10 Michael Batty, “Rank Clocks,” Nature, vol. 444, November 30, 2006, 592-596.

  11 Albert-László Barabási, Linked: The New Science of Networks (Cambridge, Mass.: Perseus, 2002), 69-72; Bernardo A. Huberman, The Laws of the Web: Patterns in the Ecology of Information (Cambridge, Mass.: MIT Press, 2001), 25-31; Lada A. Adamic, “Zipf, Power-laws, and Pareto—a Ranking Tutorial,” Information Dynamics Lab, HP Labs, Working Paper, http://ginger.hpl.. hp.com/shl/papers/ranking/ranking.html.

  36. The Pyramid of Numbers

  1 See chapter 35.

  2 Paul Colinvaux, Why Big Fierce Animals Are Rare (Princeton, N.J.: Princeton University Press, 1978), 10-31.

  3 James H. Brown and Geoffrey B. West, eds., Scaling in Biology (Oxford: Oxford University Press, 2000).

  4 Robert L. Axtell, “Zipf Distribution of U.S. Firm Sizes,” Science 293 (September 7, 2001): 1818-20.

  5 Eugene Stanley et al., “Scaling Behavior in Economics: I. Empirical Results for Company Growth,” Journal de Physique (April 1997): 621-33.

  6 Axtell, “Zipf Distribution.”

  7 Corporate Strategy Board, “Stall Points: Barriers to Growth for the Large Corporate Enterprise,” Corporate Strategy Board (March 1998).

  8 Steven Klepper, “Entry, Exit, Growth, and Innovation Over the Product Life Cycle,” American Economic Review 86, no. 3 (1996): 562-83. Also see Bartley J. Madden, CFROI Valuation: A Total System Approach to Valuing the Firm (Oxford: Butterworth-Heinemann, 1999), 18-21.

  9 Louis K. C. Chan, Jason Karceski, and Josef Lakonishok, “The Level and Persistence of Growth Rates,” The Journal of Finance 58, no. 2 (April 2003): 671.

  10 At the time this essay was written, the upcoming year (T + 1), embedded-asset growth is 8.8 percent for the fifty largest market-capitalization companies versus 5.6 percent for the S&P 500, and CFROI is 8.8 percent against 7.6 percent. For 2008 (T + 5), the large companies reflect asset growth and CFROI of 8.9 percent and 10.9 percent, respectively. For the S&P 500, the corresponding numbers are 7.2 percent and 9.0 percent.

  11 Financial services stands out as a sector that has increased significantly as a percentage of S&P 500 earnings (about 30 percent, excluding finance arms) and as a percentage of the GDP (roughly 21 percent versus 15 percent in 1980). Historically, sectors that have risen to such levels (energy and technology) have seen their importance wane. For more on this, see Paddy Jilek, Bradford Neuman, and Arbin Sherchan, “U.S. Investment Digest: Five Tidbits,” Credit Suisse First Boston Equity Research, September 5, 2003.

  37. Turn Tale

  1 Malcolm Gladwell, The Tipping Point: How Little Things Can Make a Big Difference (Boston, Mass.: Little, Brown and Company, 2000), 3-4.

  2 Michael J. Mauboussin, Alexander Schay, and Stephen G. Kawaja, “Network to Net Worth: Exploring Network Dynamics,” Credit Suisse First Boston Equity Research, May 11, 2000.

  3 Benjamin Graham, “Stock Market Warning: Danger Ahead!” California Management Review 11, no. 3 (Spring 1960): 34.

  4 Duncan J. Watts, Small Worlds (Princeton, N.J.: Princeton University Press, 1999).

  5 Christopher D. Carroll, “The Epidemiology of Macroeconomic Expectations,” Johns Hopkins Working Paper, July 9, 2002, http://www.econ.jhu.edu/people/ccarroll/EpidemiologySFI.pdf. Also, 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 See Joseph de la Vega’s Confusion de Confusiones (1688), Charles MacKay’s Extraordinary Delusions and the Madness of Crowds (1841), and Edwin Lefevre’s Reminiscences of a Stock Operator (1923).

  7 Warren E. Buffett, Berkshire Hathaway Annual Letter to Shareholders, 1987, http://berkshirehathaway.com/letters/1987.html.

  8 Benjamin Graham and David L. Dodd, Security Analysis (New York: McGraw Hill, 1934), 11.

  9 Irving Lester Janis, Groupthink: Psychological Studies of Policy Decisions and Fiascoes (New York: Houghton Mifflin, 1982).

  38. Stairway to Shareholder Heaven

  1 Jennifer Quellette, “Jackson Pollock—Mathematician,” The Fine Arts Magazine , January 25, 2002.

  2 One example is the children’s book character, Olivia. See Ian Falconer, Olivia (New York: Atheneum Books for Young Readers, 2000).

  3 Benoit B. Mandelbrot, “A Multifractal Walk Down Wall Street,” Scientific American (February 1999): 71.

  4 Richard P. Taylor, B. Spehar, C.W.G. Clifford, and B.R. Newell, “The Visual Complexity of Pollock’s Dripped Fractals,” Proceedings of the International Conference of Complex Systems, 2002, http://materialscience.uoregon.edu/taylor/art/TaylorlCCS2002.pdf.

  5 Richard P. Taylor, “Order in Pollock’s Chaos,” Scientific American, December 2002, http://materialscience.uoregon.edu/taylor/art/scientificamerican.pdf.

  6 Robert L. Axtell, “Zipf Distribution of US Firm Sizes,” Science 293 (September 2001): 1818-1820; Youngki Lee, LuÌs A. Nunes Amaral, David Canning, Martin Meyer, and H. Eugene Stanley, “Universal Features in the Growth Dynamics of Complex Organizations,” Physical Review Letters 81, no. 15 (October 1998): 3275-3278, http://polymer.bu.edu/hes/articles/lacms98.pdf.

  7 Mandelbrot, “A Multifractal Walk Down Wall Street.” Stock price changes are more accurately described as multifractal. Multifractals accommodate some adjustments to get to statistical similarity on various levels. For example, for asset prices, time (the horizontal axis) is lengthened or shortened to show level similarity.

  8 Bartley J. Madden, Michael J. Mauboussin, John D. Lagerman, and Samuel T. Eddins, “Business Strategy/Life Cycle Framework: Po
sitioning Firm Strategy as the Primary Cause of Long-Term CFROIs and Asset Growth Rates,” Credit Suisse First Boston Equity Research, April 22, 2003.

  9 Alfred Rappaport and Michael J. Mauboussin, Expectations Investing (Boston: Harvard Business School Press, 2001).

  10 Michael J. Mauboussin, Alexander Schay, and Patrick McCarthy, “Competitive Advantage Period: At the Intersection of Finance and Competitive Strategy,” Credit Suisse First Boston Equity Research, October 4, 2001.

  11 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.

  Conclusion: The Future of Consilience in Investing

  1 J. Doyne Farmer and Fabrizio Lillo, “On the Origin of Power Law Tails in Price Fluctuations,” Quantitative Finance 4, no. 1 (2004): 7-11.

  2 Duncan J. Watts, Small Worlds: The Dynamics of Networks Between Order and Randomness (Princeton, N.J.: Princeton University Press, 1999).

  3 James H. Brown and Geoffrey B. West, eds., Scaling in Biology (Oxford: Oxford University Press, 2000).

  REFERENCES AND FURTHER READING

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