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More Than You Know

More Than You Know: Finding Financial Wisdom in Unconventional Places (Updated and Expanded)

Michael J. Mauboussin
Copyright Date: 2008
Pages: 320
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  • Book Info
    More Than You Know
    Book Description:

    Since its first publication, Michael J. Mauboussin's popular guide to wise investing has been translated into eight languages and has been named best business book by BusinessWeek and best economics book by Strategy+Business. Now updated to reflect current research and expanded to include new chapters on investment philosophy, psychology, and strategy and science as they pertain to money management, this volume is more than ever the best chance to know more than the average investor.

    Offering invaluable tools to better understand the concepts of choice and risk, More Than You Know is a unique blend of practical advice and sound theory, sampling from a wide variety of sources and disciplines. Mauboussin builds on the ideas of visionaries, including Warren Buffett and E. O. Wilson, but also finds wisdom in a broad and deep range of fields, such as casino gambling, horse racing, psychology, and evolutionary biology. He analyzes the strategies of poker experts David Sklansky and Puggy Pearson and pinpoints parallels between mate selection in guppies and stock market booms. For this edition, Mauboussin includes fresh thoughts on human cognition, management assessment, game theory, the role of intuition, and the mechanisms driving the market's mood swings, and explains what these topics tell us about smart investing.

    More Than You Know is written with the professional investor in mind but extends far beyond the world of economics and finance. Mauboussin groups his essays into four parts-Investment Philosophy, Psychology of Investing, Innovation and Competitive Strategy, and Science and Complexity Theory-and he includes substantial references for further reading. A true eye-opener, More Than You Know shows how a multidisciplinary approach that pays close attention to process and the psychology of decision making offers the best chance for long-term financial results.

    eISBN: 978-0-231-51347-0
    Subjects: Finance, Business

Table of Contents

  1. Front Matter
    (pp. i-viii)
  2. Table of Contents
    (pp. ix-xvi)
    (pp. xvii-xx)
    (pp. 1-4)

    More Than You Know’s core premise is simple to explain but devilishly difficult to live: you will be a better investor, executive, parent, friend—person—if you approach problems from a multidisciplinary perspective. It’s the difference between moving into a fixer-upper home with a full set of power tools versus a simple screwdriver. You are going to be a lot more successful and efficient if you have the proper tool for each job at hand.

    The reality is that the majority of us end up with pretty narrow slices of knowledge. Most occupations encourage a degree of specialization, and some...

  5. PART 1: Investment Philosophy

      (pp. 7-8)

      Out of the blue one day, I received a complimentary e-mail from a guy who had read one of my essays. I was appreciative but didn’t think much of it until I noticed he had found the piece on a Web site dedicated to traders. Given that my focus is almost exclusively on long-term investing, I found it odd that a trader would find use for these ideas.

      So I looked to see what else was out there and found something that surprised me even more: one of the essays was highlighted on a gambling Web site. While I study...

    • 1 Be the House: Process and Outcome in Investing
      (pp. 9-14)

      Paul DePodesta, a baseball executive and one of the protagonists in Michael Lewis’s Moneyball, tells about playing blackjack in Las Vegas when a guy to his right, sitting on a seventeen, asks for a hit. Everyone at the table stops, and even the dealer asks if he is sure. The player nods yes, and the dealer, of course, produces a four. What did the dealer say? “Nice hit.” Yeah, great hit. That’s just the way you want people to bet—if you work for a casino.

      This anecdote draws attention to one of the most fundamental concepts in investing: process...

    • 2 Investing—Profession or Business? Thoughts on Beating the Market Index
      (pp. 15-22)

      To prepare to win, most sports teams scout their competition. The objective is to create a game plan that exploits the competition’s weaknesses and neutralizes its strengths. Teams generally consider intelligent scouting vital to their long-term success.

      So what’s the competition for a money manager? Investors with particular objectives can typically invest either with active managers or with index funds. For example, an investor seeking exposure to large-capitalization stocks can place money with a large-cap active manager or with an index fund that mirrors the S&P 500.

      Accordingly, we can consider an appropriate index’s return to be a measure of...

    • 3 The Babe Ruth Effect: Frequency Versus Magnitude in Expected Value
      (pp. 23-28)

      Hang around a brokerage office and it will only be a matter of time before you hear one of those great-sounding lines, “Hey, if I can be right 51 percent of the time, I’ll come out ahead.” If this thought seems sensible to you, read on. You’re about to discover one of the most important concepts in investing.

      First off, let’s acknowledge that the idea that an investor should be right more than wrong is pervasive and certainly comes with intuitive appeal. Here’s a portfolio manager’s story that illuminates the fallacy of this line of thinking.

      This well-known investor explained...

    • 4 Sound Theory for the Attribute Weary: The Importance of Circumstance-Based Categorization
      (pp. 29-34)

      You’d probably guess it isn’t too hard to categorize slime mold, the somewhat yucky stuff you see on walks through cool, damp parts of the forest. But you’d be wrong. As it turns out, slime mold has some strange behavior—so strange, in fact, that it stumped scientists for centuries.

      When food is abundant, slime mold cells operate as independent single-celled units. They move around, eat bacteria, and divide to reproduce. When food is in short supply, however, the slime-mold cells converge and form a cluster of tens of thousands of cells. The cells literally stop acting as individuals and...

    • 5 Risky Business: Risk, Uncertainty, and Prediction in Investing
      (pp. 35-39)

      Cognitive scientist Gerd Gigerenzer noted something unusual when he took a guided tour through Daimler-Benz Aerospace, maker of the Ariane rocket. A poster tracking the performance of all ninety-four launches of Ariane 4 and 5 showed eight accidents, including launches sixty-three, seventy, and eighty-eight. Curious, Gigerenzer asked his guide what the risk of accident was. The guide replied that the security factor was around 99.6 percent.

      When Gigerenzer asked how eight accidents in ninety-four launches could translate into 99.6 percent certainty, the guide noted that they didn’t consider human error in the computation. Rather, DASA calculated the security factor based...

    • 6 Are You an Expert? Experts and Markets
      (pp. 40-45)

      If you enter a hospital with chest pains, doctors will quickly administer an electrocardiogram (EKG) test. The EKG measures electrical impulses in your heart and translates them into squiggles on graph paper. Based in part on the readout, the doctor determines whether or not you’re having a heart attack. Sometimes the readouts are clear. But often they’re equivocal, which means you are relying on the doctor’s expertise to come to a proper diagnosis.

      So how good are doctors at reading EKGs? In a 1996 showdown, Lund University researcher Lars Edenbrandt pitted his computer against Dr. Hans Ohlin, a leading Swedish...

    • 7 The Hot Hand in Investing: What Streaks Tell Us About Perception, Probability, and Skill
      (pp. 46-51)

      Humans are natural pattern seekers. One well-known example is the hot hand in basketball. A player who makes a few baskets in a row is considered to have a hot hand, which implies that he has a higher-than-normal chance of sinking his next shot. Research shows that sports fans, and the athletes themselves, believe in the hot hand phenomenon.

      There’s only one problem: The hot hand does not exist. Scientists studied a season’s worth of shooting statistics of the Philadelphia 76ers and free-throw records of the Boston Celtics and found no evidence for the hot hand. Players did make successive...

    • 8 Time Is on My Side: Myopic Loss Aversion and Portfolio Turnover
      (pp. 52-59)

      In the early 1960s, economist Paul Samuelson offered his lunch colleagues a bet where he would pay $200 for a correct call of a fair coin toss and he would collect $100 for an incorrect call. But his partners didn’t bite. One distinguished scholar replied, “I won’t bet because I would feel the $100 loss more than the $200 gain. But I’ll take you on if you promise to let me make 100 such bets” (emphasis added).

      This response prompted Samuelson to prove a theorem showing that “no sequence is acceptable if each of its single plays is not acceptable.”...

    • 9 The Low Down on the Top Brass: Management Evaluation and the Investment Process
      (pp. 60-66)

      “Is assessing management important in the investment process?” is one of the most frequent questions I get from clients and students.

      The answer is a qualified, but emphatic, yes. I suggest three areas for careful consideration: management’s leadership, incentives, and capital allocation skills. I do not purport that this discussion is all encompassing—indeed, dedicated scholars have written countless articles and books on each of these topics. My more modest goal is to stimulate thought in this vital, yet often overlooked, area.

      When is management assessment unnecessary? Understanding management’s motivation is not particularly important for investors—perhaps more accurately, speculators—...

  6. PART 2: Psychology of Investing

      (pp. 69-70)

      Cigar-chomping Puggy Pearson was a gambling legend. Born dirt poor and with only an eighth-grade education (“that’s about equivalent to a third grade education today,” he quipped), Pearson amassed an impressive record: he won the World Series of Poker in 1973, was once one of the top ten pool players in the world, and managed to take a golf pro for $7,000—on the links.

      How did he do it? Puggy explained, “Ain’t only three things to gambling: Knowin’ the 60–40 end of a proposition, money management, and knowin’ yourself.” For good measure, he added, “Any donkey knows that.”¹...

    • 10 Good Morning, Let the Stress Begin: Linking Stress to Suboptimal Portfolio Management
      (pp. 71-76)

      What would be tops on a zebra’s list of things that cause stress? Well, a zebra certainly worries about physical stressors. A lion has just attacked you, you’ve succeeded in escaping, but the lion is still after you with lunch on its mind. Evolution has assured that zebras, like most animals including humans, respond very effectively to these types of emergencies.

      Now draw up the list of things you find stressful. There probably isn’t much overlap with the zebra’s list. For the most part, the kinds of things we worry about are not physical, but mental—work deadlines, the performance...

    • 11 All I Really Need to Know I Learned at a Tupperware Party: What Tupperware Parties Teach You About Investing and Life
      (pp. 77-82)

      Nearby my old office building, the window of a shoe store advertised the generous offer of a free shoe shine. I walked by this store dozens of times and thought nothing of it. One day, though, with my shoes looking a little scuffed and some time on my hands, I decided to avail myself of this small bounty.

      After my shine, I offered the shoeshine man a tip. He refused. Free was free, he said. I climbed down from the chair feeling distinctly indebted. “How could this guy shine my shoes,” I thought, “and expect nothing?”

      So I did what...

    • 12 All Systems Go: Emotion and Intuition in Decision Making
      (pp. 83-88)

      Neuroscientist Antonio Damasio describes how early in his career he realized that traditional views on rationality had to be wrong. He saw a patient with all the faculties for rational behavior intact—attention, memory, logic. But brain damage had eviscerated the man’s ability to experience feelings, and this had robbed him of the ability to make successful decisions day to day. Damasio saw the link: impaired feelings and flawed decisions go hand in hand.¹

      Damasio’s later work confirmed his observation. In one experiment, he harnessed subjects to a skin-conductance-response machine and asked them to flip over cards from one of...

    • 13 Guppy Love: The Role of Imitation in Markets
      (pp. 89-93)

      At first blush, biologist Lee Dugatkin appears to be a guy with way too much time on his hands. The focus of his research is the apparently esoteric question of how female guppies select mates. As it turns out, female guppies have a genetic preference for bright-orange males. But when Dugatkin arranged for some females to observe other females choosing dull-colored males, the observing females also selected the dull males. Surprisingly, in many instances female observers overruled their instincts and chose instead to imitate other females.¹

      Why should anyone care about how female guppies pick their partners? The answer gets...

    • 14 Beware of Behavioral Finance: Misuse of Behavioral Finance Can Lead to Bad Thinking
      (pp. 94-98)

      Classical economic theory assumes that all people have the same preferences, perfect knowledge of all alternatives, and an understanding of the consequences of their decisions. In short, people behave rationally. No one really believes that this idyllic state exists. In fact, ample empirical research and anecdotal evidence show that people are not perfectly rational. This gap between theory and practice has spawned the relatively new field of behavioral finance.¹ Behavioral-finance researchers seek to bridge the gap between classical economics and psychology to explain how and why people, and markets, do what they do.

      Behavioral finance raises a couple of important...

    • 15 Raising Keynes: Long-Term Expectations, the El Farol Bar, and Kidding Yourself
      (pp. 99-103)

      Mark Twain defined a classic as something everyone wants to have read and nobody wants to read. One classic that deserves the attention of all investors is John Maynard Keynes’s General Theory of Employment, and more specifically chapter 12, “The State of Long-Term Expectation.” Expectations are embedded in all the decisions we make, especially investment decisions, but we rarely step back and consider how and why we form our expectations. Keynes guides this reflection.

      Let’s take a deeper look at two facets of expectations. The first distinguishes expectations built on deductive processes from those based on inductive processes: deductive processes...

    • 16 Right from the Gut: Investing with Naturalistic Decision Making
      (pp. 104-109)

      As part of his Marine Corps training, retired lieutenant general Paul Van Riper learned classical decision making: frame the problem, formulate alternatives, and evaluate the options. Not surprisingly, he also taught the classical rational approach as the head of the Marine leadership and combat development program in the 1990s. But Van Riper realized that in combat simulations, the rational decision-making approach didn’t work the way it was supposed to.

      Van Riper turned to cognitive psychologist Gary Klein, who had studied how firefighters really make decisions in complex settings. Klein’s research found that firefighters don’t weigh options at all—they use...

    • 17 Weighted Watcher: What Did You Learn from the Last Survey?
      (pp. 110-116)

      Not all bits of information are created equal. Saying “I do” wearing a tuxedo in front of clergy and congregation carries greater significance than replying “I do” when your host asks if you take milk with your coffee. An ability to properly weight information is very useful in life and especially important for investors.

      An investment process requires gathering and analyzing information. Investors have historically emphasized either the gathering or the analyzing piece as their source of competitive advantage. But gaining an informational edge has become much more difficult in recent years as the direct result of technological advances and...

  7. PART 3: Innovation and Competitive Strategy

      (pp. 119-120)

      Just to give you some sense of how much change we’ve seen in the past hundred years or so, take a gander at the first list of industrial stocks Charles Dow assembled in May 1896:

      The only company that’s still around is General Electric, and today it’s a lot more general than electric. These were the blue chip companies of their day and reflected the commodity-based economy in which they competed. It’s hard to imagine that Distilling and Cattle Feeding and American Cotton Oil were hot stuff, but future generations might get similar chuckles from Microsoft and Merck.

      Do the...

    • 18 The Wright Stuff: Why Innovation Is Inevitable
      (pp. 121-129)

      On December 17, 1903, Orville Wright made history when he controlled his engine-powered plane for a sustained flight, covering 120 feet in twelve seconds (see exhibit 18.1). With that, the Wright brothers launched multiple industries and forever altered the nature of long-distance travel.

      How did the Wright brothers achieve their world-changing feat? They neither relied on divine inspiration nor started with a clean slate. You could best describe the first plane as a recombination of known ideas and technologies.¹ As management professor Andrew Hargadon says, all innovations represent some break from the past, built from pieces of the past. The...

    • 19 Pruned for Performance: What Brain Development Teaches Us About Innovation
      (pp. 130-136)

      Whenever I start to feel smart, I take a good look at a three-year-old child. That child is learning at a staggering pace. Research shows that preliterate children learn a new word every two hours they are awake on their way to knowing approximately 45,000 words by high school graduation.¹ Young children have a remarkable ability to learn what is useful given their environment.

      Adults, on the other hand, have a more difficult time absorbing so much new information. Learning a second language, for instance, is much more challenging for a middle-aged adult than for a young child. Why? The...

    • 20 Staying Ahead of the Curve: Linking Creative Destruction and Expectations
      (pp. 137-142)

      It’s a familiar scene to anyone who’s watched a nature show on TV. A young and brash lion challenges the pride’s imposing but aging leader. The elder lion, using intimidation and measured force, succeeds in keeping the insurgent in check for a while. Eventually, though, the leader succumbs and the younger and stronger lion succeeds him.¹

      One obvious observation is that while not all challengers become the pride’s new leader, the new leader of the pride is always a challenger.² In business, as in the savanna, there is a never-ending struggle for leadership. Success in nature means passing your genes...

    • 21 Is There a Fly in Your Portfolio? What an Accelerating Rate of Industry Change Means for Investors
      (pp. 143-147)

      Geneticists and biologists love to work with Drosophila melanogaster, a common fruit fly, and have made it a staple of biological study. Indeed, insights from Drosophila research helped a trio of scientists win the 1995 Nobel prize in medicine. Thousands of researchers continue to study the Drosophila to better understand various genetic and developmental issues.

      Drosophila is attractive to scientists because they understand its features and it is easy to handle. But the fly has another essential feature that scientists covet: its life cycle. Drosophila go from embryo to death in about two weeks. This rapid rate of reproduction allows...

    • 22 All the Right Moves: How to Balance the Long Term with the Short Term
      (pp. 148-152)

      At a business forum I attended, a senior executive of a Fortune 100 company proclaimed that his company manages “not for the next quarter, but for the next quarter century.” Ugh. Such platitudes do not instill confidence in investors. Most managers don’t have any idea what’s going to happen in the next five years, much less the next twenty-five years. How do you manage for an ambiguous future?

      Yet managers must clearly strike some balance between the short term and the long term. It’s like speeding down the highway in a car. If you focus just beyond the hood, you’re...

    • 23 Survival of the Fittest: Fitness Landscapes and Competitive Advantage
      (pp. 153-158)

      In the spring of 1997, Tiger Woods didn’t just win the prestigious Masters golf tournament; he dominated it. Competing with the best golfers in the world, he sprinted away from the pack, winning by a record twelve strokes. To put this achievement in perspective, Woods had joined the tour less than a year earlier, and was still the tender age of twenty-one. He had already won four of the fifteen PGA Tour tournaments he had entered. Golf aficionados started favorably comparing him to Jack Nicklaus, widely considered the best golfer ever.

      How did Woods react to his extraordinary success? He...

    • 24 You’ll Meet a Bad Fate If You Extrapolate: The Folly of Using Average P/Es
      (pp. 159-164)

      Ernest Ackerman was one lucky hombre. The first reported applicant for Social Security payment, Ackerman retired one day after the program was launched in 1937. During his day of participation in Social Security, his employer withheld one nickel from his pay. Upon retirement, Ackerman collected a lump-sum payment of seventeen cents.

      Future Social Security recipients may not be as fortunate. Even though the government has made significant changes to Social Security over the past sixty-plus years, the system faces severe challenges. In large part, these challenges reflect a change in the demographics of the U.S. population.

      For example, the government...

    • 25 I’ve Fallen and I Can’t Get Up: Mean Reversion and Turnarounds
      (pp. 165-170)

      Finance professor Josef Lakonishok argued that the stock market had many “pockets of craziness” in a 2004 New York Times article.¹ Lakonishok’s case was based on the relationship between growth and price-earnings ratios, and he suggested that the market was implying unrealistically rapid earnings-growth rates for some companies with lofty price-earnings multiples. Research he conducted with a pair of colleagues showed that very few companies sustain high growth rates.²

      But what really determines a price-earnings ratio? A company’s value is a function of the market’s expectations for its growth rate and its economic returns. This fundamental concept explains why looking...

    • 26 Trench Cooperation: Considering Cooperation and Competition Through Game Theory
      (pp. 171-175)

      Executives and investors often use war metaphors to describe business.³ You hear discussions of “winning the market share battle,” “make a killing,” “locking up customers,” and “outflanking the competition” all the time. In fact, the word strategy comes from the Greek strategia, which means “command of a general.”

      We generally think of business, like war, as zero-sum: One side’s victory is the other side’s loss. And many games of strategy—like chess and checkers—are zero-sum. Not surprisingly, early researchers focused their efforts on the best way to play these games. That thinking also spilled over to competitive strategy, which...

    • 27 Great (Growth) Expectations: On the Limits of Corporate Growth
      (pp. 176-182)

      Managers and investors generally consider growth to be an absolute good. Managers routinely discuss stretch objectives and sometimes even embrace “big, hairy audacious” goals to motivate their employees and to impress their shareholders. Growth investors routinely seek companies that promise rapid, sustainable increases in sales and earnings.

      But most investors do not intuitively understand the power, and onus, of compounding. To see how you stack up, take this little quiz:

      One dollar today becomes how much when compounded over twenty years? Write the amount in the space provided.

      For most of us, these calculations do not come naturally. A 2...

  8. PART 4: Science and Complexity Theory

      (pp. 185-186)

      One of my first calls after the major East Coast power blackout in August 2003 was to my friend Duncan Watts, then a Columbia University sociology professor. I peppered him with questions about the failure: what might have caused it, how it progressed, and by what means could we avoid future similar events.

      Now you might ask, why would you call a sociologist to answer questions about a power failure? Watts, who has a Ph.D. in theoretical and applied mechanics, is one of the world’s experts in network theory. It so happens he practices his craft in a social science...

    • 28 Diversify Your Mind: Thoughts on Organizing for Investing Success
      (pp. 187-192)

      In the fall of 2000, I gathered a small group of leading investors to hear from various finance, strategy, and business luminaries. While these presenters were terrific, none got the award for creating the most buzz. That honor went to Los Alamos National Laboratory scientist Norman Johnson, who opened his talk in a seemingly inauspicious way: “I’ve been asked here to talk about what’s wrong with experts—as an expert in this area—in a subject area, finance, that I know almost nothing about.”¹

      What did Johnson say to cause these smart investors to slide forward in their chairs? Simply...

    • 29 From Honey to Money: The Wisdom and Whims of the Collective
      (pp. 193-197)

      In his wonderful book The Wisdom of the Hive, Cornell biologist Thomas Seeley explains that returning honey bee foragers do a little dance to tell their colony mates where the food is. But what’s remarkable is that the duration of the dance reflects not only the richness of the foraging site the bees are advertising but also the colony’s need for the commodity in question.

      In other words, each bee’s communication dance considers both the colony’s opportunities and its needs. As a result, a bee colony’s overall allocation pattern is appropriate even though no one bee is in control.¹


    • 30 Vox Populi: Using the Collective to Find, Solve, and Predict
      (pp. 198-202)

      Most investors do not associate group behavior with sparkling outcomes. An Amazon book review crows that Charles MacKay’s classic Extraordinary Popular Delusions and the Madness of Crowds “shows that the madness and confusion of crowds knows no limits, and has no temporal bounds.” Throwing vital problems at a diverse group doesn’t look like an obvious way to generate satisfactory solutions.

      But in recent years social scientists have started to gain a greater appreciation for the information-aggregation ability of markets. Recognition of this ability, when combined with the Internet’s connectivity, has opened up new ways to find solutions to hard-to-answer questions,...

    • 31 A Tail of Two Worlds: Fat Tails and Investing
      (pp. 203-208)

      In his 2001 letter to shareholders, Warren Buffett distinguishes between experience and exposure. Although Buffett’s comments are in the context of Berkshire Hathaway’s insurance business, his point is valid for any exercise with subjective probabilities. Experience, of course, looks to the past and considers the probability of future outcomes based on occurrence of historical events. Exposure, on the other hand, considers the likelihood—and potential risk—of an event that history (especially recent history) may not reveal. Buffett argues that in 2001 the insurance industry assumed huge terrorism risk without commensurate premiums because it was focused on experience, not exposure....

    • 32 Integrating the Outliers: Two Lessons from the St. Petersburg Paradox
      (pp. 209-215)

      Competent investors take great pride in their ability to place an appropriate value on a financial claim. This ability is the core of investing: markets are just vehicles to trade cash for future claims, and vice versa.

      OK, here’s a cash-flow stream for you to value: Say the house flips a fair coin. If it lands on heads, you receive two dollars and the game ends. If it lands on tails, the house flips again. If the second flip lands on heads, you get four dollars; if it lands on tails, the game continues. For each successive round, the payoff...

    • 33 The Janitor’s Dream: Why Listening to Individuals Can Be Hazardous to Your Wealth
      (pp. 216-220)

      Where does consciousness come from? This question has bedeviled philosophers and scientists for centuries. We have cured diseases, put men on the moon, and probed many details of our physical world. Yet even the best thinkers today have difficulty defining consciousness, let alone explaining it. Why have we had so much success in some scientific realms and so little in others, such as unveiling the mysteries of consciousness?

      Not all systems are alike, and we can’t understand the workings of all systems on the same level. Let’s start with the systems that we do understand. Many of science’s triumphs over...

    • 34 Chasing Laplace’s Demon: The Role of Cause and Effect in Markets
      (pp. 221-228)

      Most people know that the human brain has a left and a right hemisphere. The right hemisphere is superior at performing visual and spatial tasks, and the left brain specializes in language, speech, and problem solving. Right-brain-dominant people are known for their creativity, while the left brainers are the analytical types.

      But the left-brain system does more than just calculate; it is constantly working to find relationships between events it encounters in the world. Dubbed “the interpreter” by neuroscientist Michael Gazzaniga, the left brain tries to tie life together in a coherent story.¹

      The corpus callosum, a bridge of nerve...

    • 35 More Power to You: Power Laws and What They Mean for Investors
      (pp. 229-234)

      Here’s an activity to offset ennui on a rainy afternoon. Take a text—say, James Joyce’s Ulysses—and for all the words plot the rank (from the most widely used words to the least-used) and frequency (how often each word occurs).¹ If you express this word distribution on a proportional log scale, you will find a straight line from the upper left hand of the chart to the bottom right hand of the chart.²

      George K. Zipf, a Harvard linguist, noticed this relationship in a number of systems in the 1930s and summarized them in his famous book Human Behavior...

    • 36 The Pyramid of Numbers: Firm Size, Growth Rates, and Valuation
      (pp. 235-242)

      On the surface, the size and frequency distribution for species, cities, and company sizes may not seem like they would have a lot in common. Yet each follows a power law, which looks like a straight line when plotted on a log-log scale. Power laws indicate that there are lots of small occurrences and very few large ones.¹ In nature, there are lots of ants—the combined weight of ants is larger than the combined weight of humans—but very few elephants. Similarly, we have many small companies and a modest number of huge ones. Exhibit 36.1 shows examples of...

    • 37 Turn Tale: Exploring the Market’s Mood Swings
      (pp. 243-248)

      Sales of Hush Puppies, the nerdish suede shoes with crepe soles, hovered around 30,000 pairs in 1994. Indeed, the manufacturer of the once-popular shoes was considering phasing them out. But then, something remarkable happened: Hush Puppies suddenly became hip in downtown Manhattan. Sales of classic Hush Puppies reached 430,000 pairs in 1995 and over 1.7 million in 1996. Within a couple of years, Hush Puppies shook off their label as the dog of the footwear world and became a must-have item for the fashion cognoscenti.¹

      What does the story about Hush Puppies have to do with the stock market? In...

    • 38 Stairway to Shareholder Heaven: Exploring Self-Affinity in Return on Investment
      (pp. 249-254)

      Life magazine created a stir in the late 1940s when it openly questioned whether Jackson Pollock (1912–1956) was “the greatest living painter in the United States.” Pollock wasn’t a standard paint-and-palette guy—he created his abstract art by dripping paint onto huge canvases. While some of his pieces sold for millions, one skeptic suggested his art is like “a mop of tangled hair I have an irresistible urge to comb out.”¹ Some critics deridingly implied that they could recreate Pollock’s work by randomly splashing paint on a surface.² Exhibit 38.1 shows a Pollock painting from the late 1940s.


  9. Conclusion: The Future of Consilience in Investing
    (pp. 255-258)

    Since 1993, I have taught a course called Security Analysis at Columbia Business School. As you would expect, the course covers basic investing issues like valuation, financial-statement analysis, and competitive-strategy frameworks. However, in the first class of the semester every year I sound a warning for the students: this class will raise a lot more questions than it will answer.

    For example, we don’t really know how markets aggregate information and what that means for stock price efficiency. Our concept of risk remains incomplete, although we do know that the standard measure of risk is wrong. Most competitive strategy frameworks...

  10. NOTES
    (pp. 259-290)
    (pp. 291-314)
  12. INDEX
    (pp. 315-332)