A New Proposal for Entrepreneurs

Thinking, Slow and Fast is a remarkable book and I have written its review on a separate page on this blog. One of the very important implications of human biases the book refers to is the tendency of human beings to be overconfident as also to have conformity bias. The first one is easy to understand (even easier to prove - ask a group about how many of them think they are better than average drivers and you will typically get affirmative reply from far more than 50% of the population - a logical fallacy as in only half can be actually better than average!). The second one, stripped of its technicality, simply means that we like to seek and believe news, ideas, theories which conform with our views and ideas - if I think Dhoni has lost his form, I would pick up examples selectively which point to that; but using similarly biased selection of facts from the exactly same time period and matches played, someone else can prove her own bias that Dhoni has regained his form recently. Views matter even when - and probably most when - we watch and interpret news!

What's the connection with entrepreneurs? We will get to that soon enough! But before that, another very common aspect of overconfidence and conformity bias is the unwarrantedly high post-facto attribution of a firm's success to a man/woman's vision, charisma, grit or whatever else great leaders are touted to have. Fooled by Randomness (i just don't seem to be tired of quoting this book!) covers many instances of how random luck then gets covered by foresight some leader possessed and how people flock to interview him/her to understand the mantras of success. In reality luck does play a far larger role in any given individual's and company's "success" than most people - including leaders themselves - care to admit. However we are biased to favor a person-driven account of the greatness of the company and the randomness of the fate of individuals and companies is deeply unsettling for most of us to digest. Hence visionary halo to a successful leader is merely an act of completing what most of us would like to see anyway.

Coming back to entrepreneurs finally! It does not matter whether the big company CEO appreciates the role of luck in his/her success. Ultimately s/he goes home with a decent salary and perks even if the company does just ok. If it does very well, s/he goes home with much more and subsequently writes a book of generalities ("its about people!", "what's your moat?", "its about cashflows!", "its not about cashflows!" and such). For an entrepreneur, life is not as forgiving (I am speaking from personal experience). If you get it wrong, you wrap things up and go home. If you get it right, you are a hero. Numerous entrepreneurs understand and appreciate this - very well infact. They dont mind the odds and the experience is anyway rather enriching. However, the fate of the unsuccessful entrepreneur need not be becoming part of what Daniel Kahneman calls "The Engine of Capitalism" - i.e. successful or failed, an enterprise pushes forward the growth of the economy in its own way.

Entrepreneurs are by design (and self-selection) overconfident (again, been there!!) How can a rational and cool-thinking (and yet overconfident) entrepreneur account for this in her plans? I would propose the following (finally!)
Build to maintain a steady positive cash flow through a long period of time. Which means keep costs modest and revenue steady even if low. A priori one does not know which of the various small opportunities is the big break. Hence the prudent thing would be to maximize the number of such opportunities while not betting on any one with everyone one has got. Even something looks very very promising (which can't be all of the opportunities!) it is best to find a partner who can share risks and rewards of that specific opportunities. Then in exchange for the downside protection one gives up share (even if large) of the upside. This ensures that the enterprise has multiple shots at the big break. Post facto such a strategy would look stupid if things work out on that one nondescript idea. But then a priori one did not know which that one idea would be. One can even use the proceeds of the modest gains one would have made from this (owing to having given up much of the upside) to create even more breathing space to take on larger piece of the next few promising opportunities.
What's the trade-off? Well, like a VC firm one would like to try out a small number of highly promising but nascent ideas. But keeping that number at one, a la the conventional entrepreneurs, is to really try to take statistics head on!
What's the downside? For something like a potential google or facebook, in terms of the financial upside lost, its not much (in relative terms, not absolute). For a moderately successful enterprise, one is likely to feel some heartburn for not having taken that leap of faith, but it is still a high quality problem. For failed ventures, it is much better to have not risked the firm's existence on them - even post facto!!

Tidier than thou!!

One of the most profound ideas in the book i am reading currently (Thinking, Slow and Fast by Daniel Kahneman) is that we - humans - are hardwired to think of our world to be more coherent and tidy than it really is. That got me thinking.

We are forever looking for "explanations" and "causal" connections where there might be none. We are always looking for the proverbial "why" - which is undeniably at the root of all knowledge (and much hokum as well) but is also the cause of our oversimplification of the world. I have written in an earlier blog about the human obsession with easy generalities. Kahneman also observes the same theme and attributes most of it to (surprise, surprise) evolutionary forces. I agree with him. It can be easily demonstrated in a simulation or a controlled experiment that in conditions similar to those in the early human society (or actually even in proto-human era) the individuals which are inclined to find patterns and causalities are more likely to survive than those who are clearer in their understanding of the world but also by the virtue of that remain rather confused in general. It is better from a survival and progress point of view that one creates a questionable theory and then is guided by it than being directionless because of acknowledging the inherent complexity of the world and thus the unlikelihood of a given theory being accurate.

But progress and activity aside, this tendency to generalize and rationalize has also meant that we have an over-coherent model of the world. We see patterns where none exist and we see cause and effect where chance prevails.

That leads me into another scarier direction. It is believed in general that the natural sciences like physics and chemistry have a rather solid understanding of their domain while humanities and social sciences are lot less exact. This is based on the belief that natural world "follows" order and is governed by "laws" which may not be fully known to us but are "out there". If you look deeper however you would realize two things.
1. For one, our laws of nature picture does not really explain much. As a thought experiment if you freeze the world around you for a second and try to predict what happens next (in the physical non-living world) given the current state of the world, you will realize what i am referring to. Sure you can predict that things without support will fall and broken things wont reattach by themselves. But very soon you run out of laws-driven explanation of all occurances and most things thereafter are explained as "random" (a more accurate description of this is "random symmetry breaking" - beautifully explained in the book "Theories of Everything" by John D Barrow.)
Even at the cosmic or microscopic level, the laws-explained portion is limited. Much is explained (or "explained") by randomness. Its not even that we dont know those laws yet. We have acknowledged that these are not lawful occurances. They are just random.
So yes, we are far more evolved vis-a-vis our ancestors who thought sun went around earth (which by the way is not technically inaccurate in the post-relativity world!) but we are far from knowing how the world works. At best we have a decent handle on recurring patterns in interaction within the physical world. We call these laws of nature.
2. Secondly, what we might be overgeneralizing as laws can simply be transient patterns in this specific space-time coordinate set. These might be patterns mined out of data available to us. There might not be a Plank's constant out there. It might simply be that the way things are in recent years (millenia, billions of years whatever) can be modeled as if they had a constant like that.
Which can then hold for laws of nature in general. These are our constructs - and are far more stable than anything we have seen in the rest of the world, but are simply far slower to change, maybe at this time. In another time and another location in space, even the rate of change of these might be much higher. There if some sentient beings were out with their telescopes and microscopes they might end up with an entirely different set of laws because some other patterns are constant there.

Using Occam's razor is it not more sensible to believe that there are really no "laws" but simply a spectrum of less or more stable patterns - the most stable being labled "laws"?

Is there a todo here? Probably not. This is more of a realization if you will. Not very disturbing also if you realize that it does not change anything in the material sense per se. But it is definitely a more humble approach to understanding our world than attributing fancy "laws" to it!

And generalizing from the natural sciences to all human endeavours, i would state that dogma is intellectual paralysis and end of the road for building knowledge. In this sense, Friedman while stating that "inflation everywhere and always a monetary phenomenon" is no better than 17th century Church that gagged Galileo! In the true quest for knowledge, the least we can do is remain tentative - always!!

Europe - no disasters in the waiting but little hope after that!

There are two parts to the Europe question.
1. Will the Euro survive?
2. What happens to Europe in the medium term in case it does?
The caveat in the second question is because it is terribly difficult to predict what happens to Europe if Euro does not survive. Predictions range to as much as 25% loss of output across Europe.

To me, the first question seems moot, especially in the light of the rather widely known fallout of Euro's failure and the fact that the near term survival of Euro is actually pretty much on tap for the policymakers in Berlin, Paris and Frankfurt (where ECB is based out of). I believe that contrary to popular belief and most scenarios of doomsday, Euro as a currency is far from failure. Sure it is under threat and is beseiged from many sides. However, for Euro to fail, Germany and France will have to lose market access or the cost of saving Euro in terms of bailouts has to go way beyond their current and future bond market-funded balance sheets. Either of these is remote scenario.

What is Germany upto really? Angela Merkel has been painted black and grey and white in the last few weeks by analysts around the world. But what the Germans are really trying to get out of the rest of the Eurozone is actually a commitment to lead fiscal lives similar to Germany's. This in turn is based on a more productive workforce, longer hours, higher retirement age, less state doles and so on. In the bargain the peripheral countries get to enjoy being part of the Euro - certainly a privilege in the times of crisis. Italy would have lost market access long back had it not been for its currency i.e. Euro. Of course one can argue that it might not have been lent to as much as it has been if it had not been for the Euro. Very true. Precisely the sort of thing that Germans want to avoid in future. They seem to have correctly concluded that bond market investors are not as well informed and choosy as they are made out to be. They will lend to seemingly sound but actually bad credit in much the same way American banks lent to sub-prime individual borrowers. Greece was a major case in point for this. Post facto, it seems ridiculous that anyone lent to Greece - Euro-denominated bonds or otherwise! Presumably everyone was counting on the rescue or explicit underwriting by Germany and France - which was never really there and which never happened when the time came. Having seen the inability of bond investors to rein in fiscally imprudent countries, Germany has correctly understood that the future of Euro depends on a "no-bailout covenant". And hence, if the suppy of money is going to be there in the lax times (from over-enthusiastic investors), Germany wants the demand curbed at the source - through fiscal deficit limits and gross public debt limits. Prudent if you ask me!

Why do I believe that Euro does not have that much of survival threat? For one, rescue is one round of QE away! Very much as the Americans have been shouting from the rooftops to the Eurozone leaders for a while now. Eurobonds have been talked about enough by now for even an implicit acceptance of the same by Germany to send the bond market investors into risk-on mode! Lastly the leaders of the rest of the peripheral countries seem to be complying with the demands of fiscal prudence - which most realize are in their own interest even if Euro does not survive. Germany and Euro-saving are good outside factors to blame to overcome any internal resistance for most of these countries. Push is unlikely to come to shove and even if it does, a combination of ECB, IMF, EFSF and maybe even the Fed will figure out a good way forward. It is in Germany's interest to keep things muddling through rather than conclude them very positively in a sudden stroke of brilliance. The most that sort of heroism will achieve is massive risk-on trades around the world, positive sentiment all round and in effect loss of another chance for the well managed economies of Eurozone to establish some displine amongst the rest. Since it seems more or less coordinated brinkmanship, the only danger is that of an unforeseen financial accident. In absence of that Eurozone worries will eventually go but probably drag on for another couple of quarters - as the economies sort out the fine print of greater fiscal union and iron out inevitable differences.

Disaster hence is unlikely. That does not mean that the proverbial "aaaal" is well though! The reason Eurozone went into this crisis is fiscal profligacy of its peripheral economies and the loss of confidence amongst bond investors for the debt issued by those countries. The confidence may slowly return to make investors take some cautious bets. However, the fundamental productivity challenges of Euro-area economies will not go away. If anything the battling with the crisis has only diverted the attention of the economic policy makers from them. Last but not the least the unfavorable and worsening-by-the-year demographics of most of European countries is not helping at all in boosting productivity. While Spanish unemployment may come down and Irish banking sector may after all be restored to half decent health and the clouds over most of Europe's banks may go away, the painful process of adjusting to a new economic environment where money is neither cheap nor abundant, governments are not the welfare states they used to be and where everyone is required to work longer and more productively will take its toll on growth. Europe may lose its own decade a la Japan. That is a far bigger disaster - however slowly it bites!