Joshua Kennon » Charlie Munger

Mental Model: The Dunning–Kruger Effect

Joshua Kennon — Fri, 30 Jul 2010 19:40:13 +0000

The Dunning-Kruger Effect is when someone is so ignorant they lack the ability to realize just how ignorant they are, leading to a sort of delicious paradox.

Have you ever wondered why some people come to erroneous conclusions despite all the counter evidence, overestimate their abilities, and constantly make mistakes whereas other, more intelligent people often claim ignorance and throw things on the “too hard” pile?

I mean, the reality is that 49.99% of people must be below average at any given time at any given skill. Yet, studies have shown that 90% of Swedish drivers believe they are above average, which is absurd. Most people believe they are above average in physical appearance. Most people believe they are above average when it comes to intelligence. How do we explain this?

In psychology, there is a term for this particular type of cognitive bias and it makes for an excellent mental model and it is called the Dunning-Kruger effect.

The Dunning–Kruger effect is a cognitive bias in which an unskilled person makes poor decisions and reaches erroneous conclusions, but their incompetence denies them the metacognitive ability to realize their mistakes. The unskilled therefore suffer from illusory superiority, rating their own ability as above average, much higher than it actually is, while the highly skilled underrate their abilities, suffering from illusory inferiority. This leads to the perverse situation in which less competent people rate their own ability higher than more competent people. It also explains why actual competence may weaken self-confidence: because competent individuals falsely assume that others have an equivalent understanding. “Thus, the miscalibration of the incompetent stems from an error about the self, whereas the miscalibration of the highly competent stems from an error about others.”

In other words, the incompetent person is literally so incompetent that he doesn’t realize just how incompetent he is because he lacks the capacity to process that information.

Lack of Access to Performance Standards Data, or Ranking Systems, Explain Some of the Reason the Dunning-Kruger Effect Exists

Dunning and Kruger argued that the reason people feel this way is that many people don’t have access to performance standards data. In other words, they don’t have a way to rank themselves against other drivers, or professors, or chefs.

Personally, I think this mental model could be exasperated by the “birds of a feather” nature of human relationships which causes people to be attracted socially, romantically, and professionally to those who are similar. This could lead to an echo-chamber feedback that may explain things like a group of racists believing they are intellectually superior to other races despite the fact they would fail standardized tests and read at the equivalent of a third grade level. Since they are only surrounded by others who are of comparable, limited ability, they don’t realize just how bad off they are relative to everyone else. They literally lack the data and framework to come to this realization.

The Test for the Dunning-Kruger Effect

Kruger and Dunning believed that for any given skill, incompetent people will do four things:

tend to overestimate their own level of skill;
fail to recognize genuine skill in others;
fail to recognize the extremity of their inadequacy;
recognize and acknowledge their own previous lack of skill, if they can be trained to substantially improve.

The Cure for the Dunning-Kruger Effect

If a personal has the ability to be trained, meaning the defect isn’t due to limited brain power or some other factor, the cure for the Dunning-Kruger effect is knowledge and exposure to data performance standards.

Think about the people on television shows like Hell’s Kitchen in which regular cooks compete to be the head chef at one of Gordon Ramsay’s restaurants. Some go in believing, with all of their heart, that they are amazing, talented gourmands. However, it is clear to everyone around them within a few days that they are terrible in the kitchen or have no palate.

If they have the inherent ability to learn, the only way for these poor fools to overcome the Dunning-Kruger effect is to realize how inadequate they are by exposing them to real chefs who are the best in the world. They will then understand that they don’t even begin to stack up to them and can start remedial training to improve their skills.

This leads to a fantastic paradox: They must first realize they are ignorant before they can cease to become ignorant. That is the type of problem that would make Confucius smile.

Here Is One of My Secrets to Making Money (Or, How I Once Bribed Women to Code for Me with Diamonds, Rubies, and Chanel)

Joshua Kennon — Fri, 30 Jul 2010 08:57:07 +0000

The Secret: Strike Deals Where Everyone Has Limited Downside and Harness the Super Power of Incentive

Some of you have been writing to me privately and asking about the early days when we started out and were trying to build our companies. I thought it would be useful to share some of the things we did during that time that worked out well … and maybe I’ll even talk about those things that didn’t work out so favorably. I hope you find it useful in your own endeavors.

When Aaron and I started our first business years and years ago, we needed to get thousands of products coded and online. That would have taken tens of thousands of dollars in cash upfront with no promise of payout later. That was a risk we weren’t willing to take, so instead, we came up with an idea that mirrored Charlie Munger’s super power of incentive mental model.

We went to a jewelry store and department store to purchase a range of high-end gifts, which we knew would hold their value. This included a diamond and ruby tennis bracelet, bottles of Chanel perfume, a diamond watch, etc.

We then approached several close friends and family members and made them a deal: If they were able to code [x] products successfully within 90 days, and those products were done well enough that they reached [y] in sales, we would give them the items. We made it a competition. That way, they were working as entrepreneurs and knew that if it didn’t work out, they got nothing (no paycheck) but if it did, they won big.

The Moral of the Story

In other words, they had nothing to risk but time and had a shot at getting some fantastic gifts. We had virtually no financial risk because, if things went poorly, we could either return the items or sell them for what we paid. (Always have a financial backup plan.) If things went well (they did), we got to pay them out of profits and not use any of our own cash. Everyone wins.

In the end, everyone was happy. Giving those things away was one of the best experiences I’ve ever had because it felt good to reward those who worked hard and delivered results. I visited one of the workers a few hours ago and was reminded of this program when I saw the gifts. She let me take a photo with my iPhone. I had forgotten what some of the things looked like, but I have to say: Aaron and I have taste.

What I want you to learn from this is how you structure your business deals is almost as important as the investment itself. This is why Benjamin Graham said not to ask if “XYZ” was a good investment, but rather, “on what terms and at what price“. Had I added these people to payroll and created a fixed expense, it could have taken that company down before it got off the ground. We forced the firm to pay for its own expansion out of earnings.

A Secondary Financial Lesson: Know Your Target Audience

(This experience also taught me something that I truly didn’t understand because I was, to be honest, a clueless guy: Many (not all) women love jewelry. I mean love it. They were more excited to receive items like this than cash. I’d want the money. Or stock certificates. I grossly underestimated the power of stereotypes and was promptly rebuked by almost every female in my life with a giant, “duh”. Had I known this, I would have gotten far more pieces like the bracelet shown here, which caused two hardworking, very intelligent women to almost fight. The moral: Know what motivates your target audience. For me, getting paid in stock is a huge incentive. For other people, not so much.)

Years and years ago, Aaron and I came up with an incentive system that caused a group of hard working women to help us launch one of our first businesses. This is the diamond and ruby bracelet that served as one of the prizes to those who delivered the highest performance.

Voltaire the Investor

Joshua Kennon — Thu, 15 Jul 2010 07:23:52 +0000

How One of History’s Greatest Thinkers Amassed a Fortune

Voltaire led a life that is extraordinarily useful for those who want an example of how to contribute to the improvement of civilization, live extremely well, and follow your passion.

One of the people upon whom I have based the way I live my life is Francois Marie Arouet de Voltaire, or Voltaire for short. Born on November 21st, 1694, he passed away on May 30th, 1778 after a long and extraordinarily successful life pushing for social reform and a more enlightened society, harshly criticizing superstition and slavery. Besides the fact that we can thank him for heavily influencing the American Revolution and later, the French Revolution, we can look to his example for investing wisely.

Voltaire Generated Significant Sums of Passive Income Each Year from International Investments

As a young man, Voltaire was wise enough to realize that he would need to become financially independent if he were to speak the truth and remain unencumbered with the chore of making a living. Thus, he purposely cultivated friendships and relationships with the Paris brothers and other wealthy bankers, who taught him how to invest, speculate in currencies and commodities, and manage his money. As a result of his wisdom, Voltaire was a millionaire by the time he was 40 years old and maintained investments in ships that sailed the globe as part of international trade, art, and direct lending to customers (he was, in essence, a bank).

Furthermore, Voltaire stashed significant sums of money in many, many nations around the world, all earning profits, dividends, and interest in the local currency. He did this so he could continue to live in comfort if he had to escape due to his political and social ideas, plus to protect himself against dependence upon any one economy. In fact, he caused an enormous scandal because he betrayed his friend, the King, who had forbidden foreign bond ownership. Voltaire was loyal to his own financial house, first and foremost.

“God gave us the gift of life; it is up to us to give ourselves the gift of living well.”
- Voltaire on creating wealth and living off passive income.

Voltaire's Chateau in Ferney, France ... He clearly knew how to live well off his investments, especially considering he was self-made.

Voltaire’s Annual Passive Income

By the time Voltaire was 55 years old, his secretary, Longchamp, estimated that he was earning 80,000 francs annually from income, which is the equivalent to $600,000 today plus he was earning 45,000 francs a year from passive investments hidden throughout the world, which is roughly $337,500 in cash today. These passive earnings poured into his pocketbook as he proposed ideas on the French judicial system and the notion that society should be governed solely on the basis of reason and respect for nature, providing him with funds for reinvestment and a very comfortable lifestyle.

Voltiare and Benjamin Franklin

Furthermore, Voltaire was close friends with Benjamin Franklin, himself a financial genius who was extraordinarily wealthy due to his inventions and business holdings. (Franklin, as you know, is the hero to Charlie Munger, who has significantly influenced the way I live my life, especially through the use of so-called mental models.)

Mental Model: The Revolution of Satisfied Expectations

Why the iPhone Will Continue to Dominate the Smart Phone Market Even if It Doesn’t Have the Biggest Screen or Fastest Processor

Joshua Kennon — Thu, 01 Jul 2010 19:26:07 +0000

It All Comes Down to the Existing Investment Consumers Have Made in their iTunes Library of Music, Movies, Games, Apps, and Television Shows

It doesn't matter if the iPhone is the "best" compared to other smart phones when it comes to screen size, processor speed, etc. Much of the success is now due to the financial investment tens of millions of consumers have made in their media content, including music, television shows, movies, games, apps, and podcasts, most of which cannot be moved to a competing smart phone platform due to the propreitary iTunes format.

It seems that a handful of tech folks and business bloggers – and, in fact, even my own brother – don’t seem to understand that the reason people choose the iPhone over other smart phones, even if those other smart phones have bigger screens, more memory, and non-restricted applications, is because tens of millions of consumers now have a vested financial interest in their music, movie, television, and podcast libraries on the proprietary iTunes store.

In other words, the Apple iPhone was the market leader in smart phones as a result of its state-of-the-art debut in 2007. More than 50 million consumers switched to the iPhone and began buying music, movies, and apps through iTunes. Those intellectual assets have real value and won’t work with other formats or machines, at least not without some non-standard skills that most people don’t have. By being first to market, especially for those who bought an iPod almost ten years ago, Apple locked people into their closed economic system.

Thus, the ability to simply plug the iPhone in to your existing system, have it synced with your Mobile Me mail, calendar, apps, music, movies, and more without any additional work on your part is the primary reason that the iPhone will continue to dominate other smart phones, even the competitors release better models to market. A slightly larger screen or faster processor doesn’t compensate for losing access to the library that you’ve built up over years.

In my own case, right now I have nearly 3,000 songs, at about $1 each, so $3,000. I have probably 500 television shows and movies at an average of $2 each, so another $1,000. I have maybe another $300 to $400 worth of apps for both my iPhone and iPad. Thus, my investment is roughly $4,300 thus far in the iTunes format, and that doesn’t even include the new iBook program, which I have been using to purchase books from Apple (and will probably become bigger than my music budget before long).

Furthermore, it helps that the iPhone is a kick-ass product with a lot of great features that most people have never seen. This causes people to increase their media investment, and the cycle strengthens. It is one of the reasons I expect Apple to have a huge market share in the publishing industry for books in a few years, and why I am working to have my new upcoming book released in the iBook store before the printed publications are available.

The Wave Surfing Mental Model

In Charlie Munger mental model terms, this is known as “wave surfing” whereby one firm reaches market first, gathers market share, and gets consumers invested in maintaining their financial commitment to the company’s products so it becomes painful to switch to another brand. Charlie explains that it is predominately why Microsoft generated so much wealth for its owners. DOS and Windows were never the best operating system, but they were the first to enjoy widespread market acceptance, entrenching their dominance (to the dismay of some people who didn’t understand the underlying reasons behind this).

With the release of Apple’s video game platform expected later this year, which rumors compare to Microsoft’s Live network for the Xbox, I imagine that market power will be strengthened even further. I’ve already purchased some of the original Final Fantasy titles for my iPad, which were originally released on NES. My save files are native to the iPad and iPhone now … meaning if I move to a new platform, not only will I be forced to buy the content again, but I’ll have to start over and lose my progress.

Why Can’t People Do Basic Math?

Joshua Kennon — Mon, 26 Apr 2010 21:36:11 +0000

The archie cartoon isn't that big of a deal. Why are the newspapers freaking out? I mean, Snagglepuss was the biggest queen in cartoon land. Seriously, didn't everyone realize he was gay?

I was doing my daily newspaper reading and in the Chicago Sun or Tribune (I don’t recall which one), this guy was very upset about the fact that the comic strip Archie has a gay character. Since gays only make up 6% of the population (he rejected 10% and said the smaller number seemed more likely so I’ll take his number on faith, even though the Centers for Disease Control showed that a staggering 10% of married, self-described heterosexual men had engaged in sex with another male in the past 12 months despite being in a relationship with a woman … seriously, read the copy of the study WebMD has posted on their site), he demanded to know why “they” have to appear everywhere; isn’t “anywhere safe”?

Now, I don’t even care about the topic per se. I’m a privileged , rich, white, Christian guy who lives in the Midwest and pretty much can do anything I want as long as I continue to pay my taxes and avoid breaking the law. What I care about is the inability of most people to do basic math functions. He called 6% a “tiny, tiny minority”. Seriously?

Okay … 6% translates into 1 out of 16.67 people. (You just have to take 1 and divide it by 6 to perform the inversion!)

Still don’t get it? Let’s put it into terms you can understand:

It is estimated that the average person really knows about 250 people (not recognizes, but knows – who they are, where they work, what they do, etc.) That means that the average person knows 15 gay people, they just don’t realize it. (Case in point: Some of the gay people they know are married to the opposite sex according to the CDC study.)

Your child’s elementary school class probably has around 30 kids unless you go to a private school. That means that your child (if not your child themselves) have at least 2 gay classmates in every class.

When you walk into Wal-Mart Super Center, if there are 200 people in the store at any given time, 12 of them are gay. That is just how the math works.

Seriously, guys. This isn’t difficult. Just invert the question like Charlie Munger taught us. Ask, “what do my assumptions mean in a real-world context?” and you can see if they are rational or not. In this case, the notion that it is a political agenda to make a comic character reflect the broader world is absurd. It is the broader world. Thinking it’s not is just denial.

No wonder it is so easy to make money. Most people don’t think using numbers and statistics, meaning it’s like we are dueling and they are using a cardboard sword and I’m using a stealth bomber. The schools are failing! This has to be fixed.

People Who Are Drowning in Student Loan Debt

Mental Model: The Revolution of Satisfied Expectations

Joshua Kennon — Sat, 24 Apr 2010 19:06:39 +0000

By adding concepts to what Charlie Munger calls his "mental model" collection, one can take advantage of them (or guard against them) throughout life.

The Revolution of Satisfied Expectations: “Research conducted by Daniel Kahneman of Princeton University, and by others who have come to approximately the same conclusion, shows that most people judge their well-being not by measuring where they stand but rather based on whether they think their circumstances and income will improve in coming years. For example, in the 1950s, when most American families lived in small houses, owned one car, and few if any family members attended college, people were in good spirits because they expected soon to earn and possess more. Now most families live in larger houses, own at least two cars, and send most children to college – that is, they have what people of the 1950s dreamed of having. But because most now have so much, it’s hard to expect that the coming years will bring even more.” Source: The Progress Paradox by Gregg Easterbrook

In other words, most people would be happier earning $50,000 a year but seeing their income increase each year, improving their furniture, getting a slightly nicer car, etc., than they would be if they made $500,000 a year but never saw any increase in income and they already had all of the things they want. Again, it is completely and totally irrational.

This psychological tendency is one of the reasons the politicians of a nation are so successful at creating “back-door” tax revenue through inflation. By printing more money than population growth alone demands each year, a nation’s central bank can effectively transfer some purchasing power from its citizens to the government. Most people, whether talking about paychecks or social security benefits, would rather see an increase in the dollars they receive each year even if their purchasing power isn’t increasing. They would be unhappy if the dollars they received decreased even if their purchasing power increased due to deflation.

Put another way, if you are the ruler of a nation, it is difficult to do what is best for the average citizen because most would be happier receiving a 3% wage increase even if inflation were running 4% (so they lost 1% purchasing power for each hour worked) than they would be getting a 25% pay cut but seeing their purchasing power increase by 30%. Even though they would be far wealthier in the second situation, they would focus on the fact they were making $75 for every $100 they made before, even though their $75 now buys more.

This explains how we can have a nation full of people screaming about the demise of the middle class as they climb into their over-sized SUVs, return to homes that have fewer people living in them yet more rooms compared to their grandparents (on this metric, housing-per-person has doubled in real terms over the past 50 years), and listen to music anywhere they want on their iPhones as they make calls, book dinner reservations, and take their kids to soccer practice.

By virtue of the revolution of satisfied expectations, the Garden of Eden would cause most people to be miserable because of the lack of progress. People need to constantly be moving forward, no matter how successful they currently are in their personal or professional life.

The Cure: Always focus on absolute purchasing power, influence, or stature. Besides, if you want to experience an increase in life situation, invest and harness the power of compounding. By definition, your collective dividends, interest, rents, and profits should increase regularly, albeit sporadically and with a lot of volatility.

Note: Mental models are a technique espoused by Charlie Munger wherein one catalogs and studies models of behavior in psychology, economics, and other disciplines for the purpose of using them to your advantage or guarding against them in business or life. This approach has had an extraordinarily positive influence on my standard of living, the enjoyment I get out of life, and my effectiveness as an investor. From time to time, you will see me add new mental models to a category on the site for my own benefit. You are, of course, free to read them but they are primarily there for my own reference.

The Best Habit I Have …

Joshua Kennon — Tue, 30 Mar 2010 22:58:29 +0000

Charlie Munger said that he has never known a wise or success man that has stayed that way for very long unless he or she was a voracious reader and synthesizer of knowledge.

Another batch of books arrived from Amazon.com following my book buying binge at Borders the other night. That’s typically how it goes, though … I buy a few dozen books at a time, mostly in business, philosophy, psychology, investing, finance, history, and biography (all non-fiction – I’m not a big fiction reader).

Early in my career, books were my biggest expense. When my first business was making only $500 a month in profit, I probably spent $250 of it on buying books to learn. Today, I still try to buy a copy of anything that I think could teach me something or present a different opinion on a topic such as a political issue. I never presume that I am always correct and I attempt to “destroy my own best ideas”. By arguing against what I believe, and finding problems with a given thesis, I can better understand if my beliefs are rational and the best available option.

It could have to do with the fact that when I was much younger, I wrote a letter to Warren Buffett asking him a question. He emailed back through his secretary, Debbie Bosnak, explaining that most everything he knew came from self-taught reading and study. Even today, a single good idea from a book can help make huge profits for us because we look at the problem a different way.

The whole company is designed so I can sit in a room and read, drink coffee, play video games, or do whatever I feel like at the time. To this day, opening these packages feels like Christmas morning, even years after I can afford almost anything I want. It just doesn’t get old.

(Thank God my habits are relatively cheap … some people are addicted to cocaine and hookers.)

Health Care Reform Taxes Will Hit Top 1% of Households

Joshua Kennon — Tue, 23 Mar 2010 20:12:12 +0000

Investors making more than $250,000 per year per family (or $200,000 individually) will now have to pay Medicare taxes of 3.8% on dividends, interest, and real estate rental income as part of the health care reform that passed Congress and the President signed into law today. In addition, earned income such as wages and salaries, will be subject to a 4.7% Medicare tax instead of the old 2.9%.

I don’t think there is any reasonable chance health care will be overturned as unconstitutional because it is written in such a way that you aren’t technically required to buy health insurance, you will just be subject to a special excise tax if you don’t.

A lot of very, very expensive lawyers made sure the language would stand up to a challenge. That may seem like a small distinction but it has the effect of requiring everyone to do it through an incentive system and doesn’t actually invoke the state sovereignty issues people are discussing.

The Supreme Court has repeatedly ruled, especially in connection with social security, that Congress has the right to tax individual incomes however they see fit. (A national sales tax, on the other hand, should fail the test.)

Basically, the whole thing is being paid for by effectively doubling the Medicare tax for high income earners and charging it on dividend and interest income. That means that Aaron and I will begin to have to pay Medicare taxes on dividends, bond interest, and real estate rental whereas before, it was only income tax. Unless, of course, you structure your investment through SEP plans or other comparable vehicles (which we do … feel free to insert an evil laugh here). Nevertheless, somewhere, Mr. Monopoly is crying into his money bags. I wrote about this on the Investing for Beginners site at About.com, a division of The New York Times.

The bottom line is that unless you have household income of between $16,700 and $21,000 per month, you probably won’t be paying for the health insurance reform.

This underscores Charlie Munger’s point that a lot of good can be done for the investor by keeping as much money as possible in tax-efficient vehicles. Someone with $1,000,000 in a Roth IRA built up over decades of work, for example, will still collect his or her $60,000 per year in dividends and not pay taxes on it because the money stays in the account and compounds until retirement.

Mental Model: The Drunkard’s Search

Joshua Kennon — Sat, 20 Mar 2010 18:19:54 +0000

By adding concepts to what Charlie Munger calls his "mental model" collection, one can take advantage of them (or guard against them) throughout life.

The Drunkard’s Search: The tendency for people to search in the easiest places, rather than the ones that are the most likely to yield results. The name comes from the idea of a drunkard seeking his car keys under a street lamp because the light is better instead of where he most likely lost them.

The drunkard’s search manifests itself constantly.

I think there is an argument to be made that the drunkard’s search concept can be expanded into behavioral economics. For example, with the Great Recession of 2007-2009, one need look no further than the job market. Most people are looking for work in the same communities where the factories have closed, the businesses are shuttered, and the wealthy fled long ago. Why? Because it is convenient, their children are enrolled in the local school district, and they own a house in the community. Rather than looking for the best long-term solution to the problem and then moving across the country to areas where jobs are not scarce, they continue to hug the street lamp and insist there are “no jobs”. They refuse, either through ignorance, stupidity, or denial, to realize there are no jobs next to this particular street lamp but there are plenty elsewhere.

Likewise, studies have shown that many millionaires in the United States researched and sought out lucrative businesses before entering them, rather than just stumbling upon a profitable industry. This is unique because the human tendency is for individuals to look for industries they understand. For example, the AP story I wrote about several years ago where a group of steel mill workers bought a steel plant, couldn’t make it work, and then killed themselves. When they had escaped their former employer, instead of entering a more lucrative field, they went right back into a terrible industry where the odds were against them because it was “well illuminated” to them due to their experiences.

Life is better (and the economic rewards richer) when one grabs a flashlight and goes down the dark alley searching for treasure.

A Brief Flirtation with a Cinnabon Franchise

Joshua Kennon — Fri, 19 Mar 2010 18:57:47 +0000

I worked my way through the Cinnabon franchise disclosure document that the Focus brands company sent and the problem I'm having is two-fold: 1. It seems like the investment itself is a craps-shoot in the sense that there appear to be a few highly successful Cinnabon franchise locations but the others may not be (I can't tell, obviously, without speaking to individual Cinnabon franchise owners), and 2. It probably isn't worth the time investment relative to the potential profit payoff.

I mentioned yesterday in the article on Dairy Queen franchise owners that after graduating from college, Aaron and I had looked into putting capital to work by opening several franchises in the town where we grew up. We thought it would be a good place to invest the money we were earning from our other businesses without having to be involved on a day-to-day basis. In other cases, we thought it might be a good way to structure companies so that our immediate family members could make an investment alongside us and, in some cases, run the companies as managers / minority-owners.

One of the companies we researched was Cinnabon, the maker of (what I consider) to be the world’s best cinnamon rolls. The company’s owner, Focus Brands, sent us a franchise disclosure document and I began working my way through it. I love the Cinnabon brand and the idea of owning a local Cinnabon franchise is appealing because it would mean I could grab a cup of coffee each morning from my own business. It obviously wouldn’t be a large part of our holdings, but it would have a certain emotional appeal and bring jobs to the local community.

Here are our thoughts …

Cinnabon franchise owners sell Cinnabon cinnamon rolls, cupcakes, coffee, lattes, and bite-sized treats.

I cannot discuss what’s in the document itself, but suffice it to say that a quick Google search shows that the typical investment for a Cinnabon franchise ranges from $71,000 to $370,000 depending upon location and size. Since virtually all Cinnabons are on leased premises, the lease expense isn’t included in this figure because it counts as an on-going operating cost.

We had one of our companies contact the leasing agent at the local mall, who quoted us a price of roughly $1,500 to $2,200 per month for the premises. This particular mall is notorious in the community for attempting to charge higher rents than the market will bear (which is why a good portion of it remains vacant), so it’s possible we would have opened it in a neighboring community, instead.

Let’s presume that payroll costs and insurance would run $5,000 per month. This gets us up to $7,000 in fixed expenses. That is $84,000 per year.

Working the Cinnabon Franchise Numbers Backward, a la Jacobian Inversion

Here is where our Charlie Munger / Jacobian inversion comes into play …

Cinnabon franchise owners serve a special blend of Seattle's Best coffee, which is made by a subsidiary of Starbucks.

If a Cinnabon franchise can earn gross profit margins of 50% (I’m not exactly sure what they are), break-even would require sales of $168,000 annually. Furthermore, let’s presume that the average ticket is $5 (again, I don’t have exact figures so I have to estimate using what is available on the Internet). This means that in any given year, our theoretical Cinnabon franchise would have to complete 33,600 orders. If we are open 365 days per year, this is a bit more than 92 orders per day. If we are open from 10 a.m. to 9 p.m., that is 11 hours each day, meaning we must sell 8.36 Cinnabon orders per hour. That works out to one customer every 7.17 minutes. (Just to break even.)

That means that if we sell less than $168,000 per year, or $14,000 per month, in Cinnabon cinnamon rolls, we will be running red ink. I don’t do losses. They aren’t my style.

The corollary is that anything above this figure is gravy (or, er … cinnamon roll icing, to be appropriate). That’s where the investor profit originates.

To give you an idea of the way the math works, let’s imagine that I decided I could sell a Cinnabon cinnamon roll every 3 minutes (there is no way in the mall we were examining, but I want to provide you a contrast). Total revenue in this case would be $401,500. As an investor, I would be left with $116,750 in pre-tax profits. (The math: If we are open 11 hours a day, 365 days per year equals 240,900 “selling minutes” divided by one $5 ticket every 3 minutes = 80,300 total tickets – 33,600 “break-even” level tickets = 46,700 net tickets * $5 = $233,500 x 50% profit = $116,750 profit for owner / investor on total revenue of $401,500).

Side note: This is why it is so important to have the actual figures that matter – 1.) average ticket price, 2.) average gross profit margin, 3.) average operating profit margin, and 4.) expected conversion rate of customers walking by to Cinnabon customers who make a purchase. The figures for the profit scenario I gave you are totally unrealistic; I wanted you to see how when you cross a certain threshold, everything falls to the bottom line. In finance, this is called “operating leverage”. The higher the company’s operating leverage, the greater the profit when it exceeds its break-even point but the riskier it is because if it falls below it, things get really nasty, really fast.

Now, to be fair, the point here is that the payroll expense that is a “cost” to us as investors is, in many cases, profit to an owner-operator. In other words, if someone were to use their money to open a Cinnabon franchise and served as the full-time manager with their kids working after school with them, that money is flowing into their household so that has to be figured into the equation. For this type of person, a Cinnabon franchise is far more lucrative and offers better returns on capital. We, however, are looking at it from the point of view of a pure investor. It would not be a productive use of my time, for example, relative to the opportunity costs to put on an apron and make Cinnabon cinnamon rolls from customers all day. I’d enjoy doing it, but the hidden expense would be all of the foregone profits from our investing operations.

It All Comes Down to Opportunity Cost

Cinnabon remains a great brand and if we were to ever open a hotel or shopping center, we would almost certainly want a Cinnabon franchise.

Thus, the problem that we now face is opportunity cost. Let’s presume that in our market, the total expense of opening a Cinnabon franchise would be $250,000. Our calculus for determining the appropriateness of this as an investment is different from everyone else on the planet because we own different assets and have different income sources. (This is one of the reasons I don’t like when people ask me, “What is a good investment?” because so much of it comes down to what you own, the strength and diversity of your income sources, your own passions and interests, etc.)

In our case, if we were to put the $250,000 to work in our retail store, Kennon & Company and the online business, Kennon Home Accessories, we could expand into additional product lines and increase our selling square footage without a lot of additional cost structure. Even if we only turned our inventory 1x per year, that would be an additional $107,143 pre-tax profit at 30% operating margins on a $250,000 investment. Cash-on-cash, that is 42.8572%, a staggering figure.

In the end, our decision to reinvest in our own companies and not acquire a Cinnabon franchise had less to to do with the terms of the Cinnabon franchise itself and more to do with the relative returns available to us in our other businesses, which still have a lot of growth left in them before maturing and going into dividend mode. For a working married couple who hate their job and want to be their own boss, while earning a decent living, a Cinnabon franchise may or may not be more appropriate.

The Dairy Queen Franchisee Revolt

Joshua Kennon — Fri, 19 Mar 2010 03:50:27 +0000

Dairy Queen franchise owners are upset that the company and its parent, Berkshire Hathaway, and pushing the new Grill & Chill restaurant concept. They are balking at the capital expenditures that, you know, are a required part of doing business and standard in the DQ franchisee contract.

In the year following graduation from college, Aaron and I looked into opening several Dairy Queen franchises in Kansas City, Missouri or St. Joseph, Missouri near where we had grown up before leaving for the east coast. Even though we figured we’d end up in a no-income-tax state such as Texas, Washington, or Nevada (paying an extra 6% to 7% of your income in state income taxes per year starts to add up over time), we really liked the idea of owning local businesses that hired local employees and generated local sales tax and property tax for a community that we held in high regard.

It also didn’t help that we despised the Dairy Queen franchises in town because they didn’t offer food, still operated from the same edifices that had been built long before our parents were born, and even the most recent upgrade consisted of a larger building on the outskirts of town that only offered hot dogs and chicken. It made us angry that someone wouldn’t pour the money the brand deserved back into operations, especially since this particular family had owned the rights for several generations. Part of this was no doubt influenced by the fact that such a large portion of our net worth, as well as our family’s net worth, was invested in shares of Berkshire Hathaway, the parent company of Dairy Queen.

As I read the business news, it was deja vu all over again when I read about a revolt stirring in the ranks of the Diary Queen franchise owners. Apparently, a law suit is brewing …

The new Dairy Queen Grill & Chill franchise concept features a full menu of food and an expanding dining area with nicer interiors.

Dairy Queen has developed a new franchise concept called DQ Grill & Chill. It offers wraps, flame grilled cheeseburgers, french fries, chicken baskets, fresh panini sandwiches, premium salads, popcorn shrimp, and more. The interiors were also substantially upgraded, making it comparable to a nicer fast food concept that you would enjoy sitting in for an actual meal.

As part of the Dairy Queen franchise contract, Dairy Queen can require franchise owners to upgrade their restaurant to protect the brand and keep it relevant. The Dairy Queen company has capped the required investment at $75,000 for 2008, $85,000 for 2009, and $95,000 in 2010, giving the Dairy Queen franchise owners plenty of time to generate the earnings necessary to fund the expansion into the new Grill & Chill concept.

Most of the Dairy Queen franchise owners seem really excited about it (as I would be). A few, however, are … how do I put this without coming across as mean? … whining, entitled, and lazy. They are throwing an absolute fit over the fact that Dairy Queen is – horror of horrors – requiring them to reinvest in their stores!

Let me enlighten you as to what is really going on with the Diary Queen franchise system based on my perspective as an investor. You have a minority of the franchisee owners, who have likely drained a substantial portion of the profit from their Dairy Queen restaurants over years of ownership in the form of cash dividends and salaries, who are balking at the idea of coming up with $400,000 to improve the customer experience, offer actual food, and provide expanded capacity.

These are small-town, small-minded folks who, in many cases, either stepped into the role as a Dairy Queen franchiser through family ownership or who have been with the system since time eternal. As they see it, they have a good life and their Dairy Queen franchise provides them with a stream of earnings they use to live in a nice home, drive a nice car, and maybe even take a vacation or two each year.

They have, in other words, bought themselves a job and not a business. Instead of focusing on growing their assets so it is a business (I define a business as a “system that generates profit for its owners without the owners ever stepping foot in it or having any day-to-day involvement), they are angry that the big-bad executives at Dairy Queen and the parent company, Berkshire Hathaway, are actually making them do something and invest money to keep the brand relevant.

Shouldn't you love your business so much that you want to keep expanding it as long as you can earn good returns on capital?

Frankly, I don’t like the idea of living out of your business. I’ve never taken a salary from any of my companies. I like earnings to get plowed back into more assets that provide more cash earnings. If I were to suddenly develop an interest in franchising Dairy Queen restaurants, I can tell you that my nature is that within ten years, I’d want to own a dozen of them in a tight geographic area. It’s just my personality. I also wouldn’t be involved personally. Instead, I would find an honest, hardworking restaurant manager who had been in the industry for 20 years and was willing to take a minority stake by investing their own money along with mine. They take care of the company, and I expand the store count under their control. We both prosper as our shares of whichever limited liability company that owns the Dairy Queen franchise increase in value.

Maybe it’s because I follow Charlie Munger’s advice and keep a lot of “silly needs” out of my life. I avoid debt, I pay my taxes, and I try and live on a modest amount taken from my writing royalties, advertising earnings, and other comparable sources. In fact, the odds are very good that I live on less than many of the people reading this blog. I’d rather the money go into my businesses or investments. Is it really that difficult to live on, say, $65,000 or $100,000 per year and reinvest your profit? Really?

A Brief Flirtation with a Cinnabon Franchise

Mental Model: Satisficing

Joshua Kennon — Thu, 18 Mar 2010 04:59:30 +0000

By adding concepts to what Charlie Munger calls his "mental model" collection, one can take advantage of them (or guard against them) throughout life.

Satisficing: A psychological and economic phenomenon that results from consumers choosing a product that meets criteria at an adequate level, rather than expending a great deal more time to find a fully optimal solution.

Put another way, people are not looking for optimal solutions in their life. They are looking for a combination of “just good enough” or “better than average” weighted by the total effort or cost expenditure necessary to acquire said solution. People don’t want a better mouse trap, they want a mouse trap that works at the lowest price or effort.

This ties in with our mental models related to brands and marketing: For those who lack knowledge of a specific industry, such as fine watches or cars, brand names serve as a proxy to communicate information and serve as a type of insurance against making both errors of omission and commission. If one wants a fine watch and knows nothing about the industry, it is a fair bet that a Rolex is going to be wildly known, respected, and live up to its reputation. The newly wealthy, for example, would not be aware of brands such as A. Lange & Söhne. Likewise, a doctor who wants a good piano isn’t going to be able to tell the difference in touch and action from a row of piano brands so purchasing a Steinway & Sons is going to suffice for his needs, ensuring that he will be respected and get quality for his piano choice. Even though additional research could provide better savings or an even better brand of piano, satisficing results in him saying, “I want to be done with it and this works.”

Reference Source:

Smart shopping is also time-efficient shopping. For the wealthy, even more so than the rest of us, time is money, and we’ve seen how “more time” is the number one item on their wish list. In luxury retail categories, we asked why they purchased the specific items they chose. The number one reason, on a par with quality, brand, and self-expression, was that the item was good enough. In other words, they said, “I was satisfied so I didn’t want to spend more time shopping around”.

Psychologists and economists call it satisficing: choosing a product that meets criteria at an adequate level, rather than expending a great deal more time to find a fully optimal solution. Of course, the minimal requirements for adequacy among the wealthy may be quite high in absolute terms, or relative to those of the less well-off, but the principle of time savings as one element of smart decision making is a crucial one. – Page 86, The New Elite

Does Religion Have a Responsibility to Look to Science?

Joshua Kennon — Mon, 15 Mar 2010 18:55:51 +0000

Here’s an interesting question: Does religion have just as much responsibility to examine scientific evidence as it does religious tradition and scriptural text?

Responsible religion cannot ignore scientific discoveries. Do you think the Christian church thought they were wrong when they were punishing Galileo? Of course not. But it doesn't change the fact they were.

Put another way: Throughout history, religion taken as a whole has lagged behind scientific discovery and development, only to redefine itself decades, or even centuries, later. In the case of Christianity, the Bible, specific passages in it, as well as long religious tradition were used to justify:

Slavery (not only of whole races but the ability of fathers to sell their daughters, which still goes on in the world and is perfectly biblical)
The inferiority of women as evidenced by the prohibition of female preachers and female led households. Up until the 1970’s, a woman really couldn’t even open a bank account without her husband’s permission in the United States. That is a staggering thought.
The inferiority of different races. (We’ll talk about this in a moment.)
The inability to earn interest on money loaned. The entire American banking system and economy is directly in violation of biblical teaching. Every time you put money into a savings account or certificate of deposit, you are earning interest from your share of the interest charged to borrowers, in some case outright usury at 30%+ on credit cards.
Child abuse. There is absolutely nothing un-biblical about requiring 7 years olds to go to work to support the family (almost all of the children in the bible did), rebellious sons and daughters were stoned, and existed more for the benefit of the parents than having any real chance at self-actualization.
The torture, imprisonment, and murder of scientists. We all saw what happened to Galileo for daring to discover that the Earth is not only the center of the universe, it is circling a star, which itself is part of a solar system that itself is circling a galaxy that is circling the center of the universe, which we are nowhere near.

Cognitive Dissonance in the Christian Church

Racism and Christianity

For the longest time, race was probably the most powerful example of cognitive dissonance in the church. To this day, some misguided religious groups believe that African Americans are the cursed decedents of Cain.

From scientific evidence, however, we know that every human being on the planet started out as black. By extension, for those who believe in a 100% literal interpretation of the bible, Adam and Eve had to be black. There is no way around the DNA evidence because it shows that humans came from somewhere in Africa, close to where the Jews, Muslims, and Christians believe God created mankind, and that being “white” developed as people migrated north into areas with less sunlight and those with paler skin had the ability to absorb certain nutrients, making them healthier and more successful in a reproductive sense.

Thousands of years of in-breeding among these cultures then led to certain traits and looks – flaming red hair in the Vikings, porcelain skin, blond hair, and blue eyes in the Nordic people, etc.. It was a case of adaptation, not evolution. (This is why something like 75% of the world’s population is lactose intolerant except Anglo-Saxons! Why? Our ancestors lived off of cow milk and those who were better able to absorb the nutrients survived, while those that couldn’t died off and didn’t reproduce. It’s the same concept.)

When was the last time you saw a church have a stained glass window depicting Adam and Eve as they were – fully, completely, and totally black? I mean, 44% of the world is Asian, 17% is East Indian, 16% is White, 14% is Black, and 8% is Hispanic. So even if we didn’t have the DNA evidence, common sense would tell you it wasn’t likely Adam and Eve were white. I mean, even in the paintings showing the “end of days”, it’s ordinarily a see of white with multi-cultural tinges despite the white people would be a minority in heaven. When most Christians picture heaven, though, they probably think of being surrounded by white people. Statistics and common sense should inform us otherwise.

The same people who believe the Bible must be interpreted literally often have paintings or statues of angels around their home, many of which are female. Women only existed after being taken from Adam and were thus a part of humanity and every angel mentioned in the Bible is male. Thus, a literal interpretation means that there cannot be female angels. That sort of cognitive dissonance ticks me off - don't they realize they are also violating the rules against having images of the "things in heaven"? You cannot stake your soul on a book you're not willing to read, yet it seems like most people in the world do this every day without having any basis for their faith.

Furthermore, the same people who believe the bible is literal in every sense of the word will have paintings of female angels, despite the fact that every angel in the bible is male because females only came into existence because of God’s desire to give a partner to Adam. They also ignore the strict prohibition of having any artwork, statues, or other icons because God forbid it. So having a marble statue of an angel in your house? A sin according to the bible. It’s female? Total fantasy made up by European artists. I cannot stand intellectual laziness. This should be perfectly obvious to anyone who has ever read the book and has any common sense understanding of the world.

The Current “Big Two” Social Issues That Have Dominated the News Over the Past 10 Years

Now, let’s get to the so-called “big two”. Over time, these issues changes. For most of the 19th century, the issues were slavery and the role of women. Those having been resolved we’ve moved on to the following two:

Abortion

I could never participate in an abortion. I just couldn’t do it and sleep at night (with three notable exceptions, which are so statistically unlikely they are meaningless and merely theoretical so I don’t want to get into them here).

Nevertheless, we have to talk about the inherent cognitive dissonance on the issue in Christianity.

I mean, let’s take the belief that life begins at conception (it may very well). We know from biology that for every one child a woman has, at least one other egg was fully fertilized, began to divide, and started to develop. Unfortunately for the egg, it fails to attach the the wall of the uterus. Perhaps the mother was rock climbing and fell. Perhaps she ate something that caused a chemical reaction in her body. We don’t know all the reasons, yet. However, she menstruates like normal, never having realized that she has just had what amounts to an abortion if life begins at conception.

The implication of this would be that when she dies and gets to heaven, she will have twice as many children as she had on earth, and half of those children will have never experienced temptation and would have gotten a “free pass” to salvation.

Yet, if you were to ask a Christian woman, “How many children will you have when you get to heaven?” It’s unlikely she will factor in all of the unknown miscarriages she’s had scientifically despite absolutely protesting that “life begins at conception”. She also won’t discuss the religious and spiritual implications of fully fifty percent of humanity never going through any temptation at all, whatsoever, under any circumstances, and getting a free pass to eternal salvation.

In other words, most of the Church has not yet reconciled the gains in biology knowledge over the past 70 years with religious knowledge. (Many Jewish groups, on the other hand, teach that the fetus is nothing more than “water” until the 40th day when God gives it is a soul. This would solve almost all of the problems we just discussed.)

In other words, if life begins at conception as some Christians believe, then fully 50% of humanity will never be tempted and got a “get out of hell” free card. That means Jesus would have been incorrect when he said the way to the Kingdom of Heaven was a narrow gate because hell would be the minority. That is cognitive dissonance.

The same goes for Christians who attempt to have in vitro fertilization. Embryos are created and the “left overs” destroyed. You often see otherwise anti-abortion Christians perfectly willing to do this for their own selfish ends, namely have a child. I personally don’t have a problem with artificial insemination because it allows couples to have children who otherwise could not have. I do have a problem with cognitive dissonance. It makes me angry because refusal to resolve it is intellectual fear, cowardice, or laziness.

Gays and Lesbians

The same cognitive dissonance happens on the issue of gays and lesbians in the church, as well. My mother once said that “being gay is a choice.”

I asked her, using a Charlie Munger rational framework: “So you believe that if you took a gay man and strapped him down in a chair like Daniel Craig in James Bond, totally naked, and showed him film of the most beautiful drop-dead gorgeous women on the planet, that he would get sexually aroused and that he would choose not to do anything about it, showing remarkable restraint?”

She said she didn’t know. When you ask the question in reverse, as Munger said quoting the mathematician Jacobi (Invert, always invert!), you are often better able to understand a problem.

When discussing this particular cognitive dissonance in Christianity and religion with my family, I used the Daniel Craig analogy in James Bond. If being gay or lesbian is a choice, then people must believe that if a gay man were strapped to a chair and forced to watch film of beautiful women having sex, he would get aroused and want to join in the festivities; they just show a level of restrain most men don't and choose not to partake to make a political point. If they don't get aroused, then how can it be a choice? Married men are wired to want to turn their head when a beautiful woman walks by, but they have no interest when an ugly woman does. How is it any different?

For example, the belief that being gay is a choice implies several things:

Being straight is a choice and that you – the person making this claim – are equally sexually attracted to your own gender and just fight off those urges.
That gay people get sexually aroused by the opposite gender and show a level of self-control that most people don’t by refusing to indulge their sexual desires, instead making a choice to rebel to get attention or make a political statement.

Going one step further, if being gay is not a choice, most Christians would say it is a cross they have to suffer for salvation. Yet, do you really believe that if the situation were reversed and a fully heterosexual young man were told to marry another man because “that’s what God wanted”, he’d get any emotional fulfillment out of it or be willing to keep up the charade for long? Sure, he could force himself to have sex, but what kind of life is that?

By looking at the underlying assumptions of the statements the Church has made regarding this topic, none of them make sense in light of what we know from science and human experience. I mean, when my brother stole a Playboy from the grocery store at 8 years old (for which my parents made him go back and apologize to the older lady that ran the store!), he wasn’t “choosing” to be straight. His DNA, like the DNA of virtually all men on the planet, began to run the software sequence that started prepping for sexual maturity. Even today, he says he didn’t know why he wanted to look at the pictures of Jenny McCarthy naked he just knew it was right. If, instead, he had brought a Playgirl into the house, it requires a special level of stupidity and denseness denial to believe that he was making a choice any more than his hair color or eye color.

Personally, I think the obsession over homosexuality in the church is a primitive manifestation of the “fertility cults” that originated at the dawn of humanity in Africa and the Middle East. It is a genetic imperative to reproduce. Parents panic about the notion that their children won’t pass on their genetic material. It is visceral and in the “reptilian mind” as Dr. Clotaire Rapaille would say. As Ian and I were discussing in the comments of The Drunkard’s Search, maybe it does all go back to food and reproduction success.

Some Final Thoughts

Religion is clearly a vital part of the human experience (if it wasn’t necessary, it wouldn’t still be around because it unquestionably fills a need that nothing else does for billions of people). Responsible religion cannot ignore developments in the scientific world without becoming a mockery and something has to be done about the cognitive dissonance in religion.

I will go on record as saying that 50 years from now:

Abortion will have migrated into a more complicated issue because we will have the ability through somatic cell nuclear transfer to have children born from 3 or 4 different adults (even part animals), and genetic testing that creates ethical problems we cannot even comprehend.
Gays and Lesbians will be considered neither moral or immoral any more than blond hair or brown hair, tall or short, Asian or Indian will be. It will simply be another descriptive factor in the makeup of people that expresses itself at a consistent rate, affecting somewhere between 1 in 10 and 1 in 30 people to some degree on a varying scale of influence. Gay marriage will be fully legal and anyone who opposes it will be treated exactly like someone who uses the “n” word now to describe African Americans. The demographic data shows this based upon age groups. It’s inevitable.

My job as an investor is to anticipate the future based upon the evidence and research. It is nothing but investigative journalism with a lot of math. These conclusions were derived in the same matter. Mark my words and remember them. I’m willing to bet a substantial sum of money that I’m right, whether some people like it or not.

Department Store Sales Make Me Really Happy

Joshua Kennon — Sun, 14 Mar 2010 22:34:18 +0000

Department stores are now offering ties for less than $20. That's amazing!

Although I’m normally a Nordstrom’s guy myself, I have to say that after reading an article a few years ago (The Wall Street Journal or The Financial Times maybe?) about the vastly improved quality of department stores suits such as the J.C. Penny brand thanks to the use of expert tailors in Hong Kong for a fraction of the price and trying out the difference for myself, I have been genuinely shocked at how good the improvement is. I waited until a 50% off sale and bought a couple of suits for $179 each instead of the usual $360 and they were great. They now hang in my closet next to far more expensive Brooks Brothers and Burberry brands and, to be perfectly honest, I’m just as comfortable and content wearing either.

To be fair, since I’ve been back in the Midwest, I find myself wearing blue jeans, a cashmere sweater, and tennis shoes about 90% of the time. The suits have sort of languished in my closet because my primary job is now capital allocation, we’re entirely internally funded so I don’t have to meet with investors, and there’s no point in wearing anything except for the sake of comfort. (Today was actually the first day I had been dressed normally for a long time – a Brooks Brothers dress shirt with a blue Burberry, Ralph Lauren jacket, Johnston & Murphey shoes, Montblanc watch.)

Focus on quality and substance, not brands. Most people don't buy products for their utility, they buy them as "status symbols" that are meant to signal to other people, "I fall (insert class here) on the class system, I have (insert degree) educational credentials, and I am doing better than you. It is the same belief that causes some to think they can never be successful from a community college compared to a private school. That's ignorant and pathetic.

Anyway, J.C. Penny is having another suit sale and I am seriously considering buying several more. I’m sure the people at Halls Department Store and Barney’s would be aghast at the notion of private label store brands lining the shelves along with Ermenegildo Zegna and Hickey Freeman but, frankly, that’s just too damn bad. Charlie Munger taught me to focus on quality and substance, not marketing and illusion. The same part of me that gets excited about stocks trading at a 5x p/e ratio or selling a product for a 500% markup gets downright ecstatic about the idea of saving that kind of money.

It’s just how I’m built. I hardly ever pay full retail price for anything. I just can’t help myself. For example, at Nordstrom’s, if you wait until the Christmas sales when prices are nearly 50% off and use a Charles Schwab 2% cash back Platinum Visa (which you pay off in full, of course) so that part of your purchase gets credit back to your brokerage account as a dividend, you can usually get a fantastic suit from Burberry, Hickey Freeman, or Canali for only $300 to $700 (compared to the usual $600 to $1,500 per suit), plus find more money in your investment account with which you can buy stock!

Better yet, use American Express reward points gift certificates and your cost is zero. Someone who owned a small business that generated $500,000 in sales and put $250,000 of his cost of goods on an American Express Platinum Card would get the equivalent of $2,500 in gift certificates to the vendor of his choice by cashing in points. By waiting until the sale, you could get at least five really good suits that normally would cost $5,000 absolutely free. Seriously, even if you weren’t making any more profit than the guy down the street, you would be living much better because of how you bought. Hence, the old retail saying, “Well bought is well sold.” Buying correctly is more than half of the battle to building a successful business and your net worth.

So, if you happen to be in the sales department of the local department stores, there’s a good chance you’ll see me over the next few days.

Side Story: The Competition

To this day, Brooke Edwards remains the only person I know who can seriously challenge me when it comes to getting the most bang for the buck. She somehow has the ability to get free sofas and insanely nice merchandise for like, $3 or $7. I don't know how she does it. If there were a money saving Olympics, I would be nervous before she and I competed.

The only person who has ever matched my skills in the money saving department is a woman named Brooke Edwards. She has the ability, somehow, to get $300 worth of merchandise for like $7. (I’m not kidding – seriously.) She would just show up at college and have free sofas or furniture.

If you ever need anything purchased or procured, Brooke Edwards is the woman to see. Her skills are magical.

Why Income Inequality Will Always Exist as Part of the Post-Industrial Revolution Global Economy

Joshua Kennon — Fri, 23 Oct 2009 16:04:56 +0000

First: Before we begin, the education system in the United States over the past few decades has done such a poor job teaching basic logic that by virtue of the headline alone, it is statistically likely that you have already made a decision about whether or not this short essay on pay inequality is “good” or “bad”. You’ve done this without considering any of the factual data or evidence I’m going to offer by virtue of my own experiences in finance, based nothing more on your own political meme. Regardless of whether or not someone agrees with my facts, this inability for a citizen to carefully consider evidence instead of feeling is part of what is wrong with our Republic. As a civilization, we have to get away from fear mongering and sound bites.

Reasons Goldman Sachs Deserves the Bonus (No, Really … )

Businesses, like people, are different. Some people are tall, some are short. Some are black, some Asian. It’s the nature of the world. In the same way, some businesses require more employees than others as a result of the business model and industry in which a company operates.

Whether or not a business can lavish employees and owners with huge bonuses, paychecks, dividend checks, and profits depends upon one metric and one metric only: operating profit per employee.

For instance, Goldman Sachs has 34,738 full-time employees. Over the past 36 months, as the world has fallen apart and some of the biggest names in finance have collapsed, Goldman’s pre-tax profit from continuing operations was a staggering $34,500,000,000. In other words, after paying these huge bonuses, Goldman Sachs has earned an average operating profit of $331,050 per employee, per year, over the past three years. It’s amazing performance is evidenced by the fact that the stock is trading near the all-time high set before the market crash several years ago. Thanks to the management team, shareholders have emerged virtually unscathed as those around them have lost everything.

Wal-Mart Stores, on the other hand, has 2,100,000 employees. Over the past 36 months, it has earned pre-tax profits of $60,064,000,000. That works out to an average of only $9,534 in operating profits per employee, per year, over the past three years.

Put another way: On a per employee basis, after paying all compensation and these huge, “excessive” benefits, Goldman Sachs is 34.723 times more profitable than Wal-Mart on a per-employee basis. This explains why it’s able to offer far better pay and benefits for its employees. In fact, Goldman could give each one of its workers a $3,000 Christmas gift and it would shave just 1% off operating earnings. If Wal-Mart did the same by adding, say, $75 to everyone’s paycheck each week, it would cause a 31%+ drop in operating profit. People need to understand the numbers that drive these economics. Given that the company has a $200 billion market capitalization, that 31% drop in operating profits would result in a loss of $62 billion in stock market value as the lower earnings resulted in a lower valuation put on the company’s shares by pension funds, 401(k) investors, and mutual fund managers. The “loss” to the owners of Wal-Mart would be $29,524 in market value for this $3,000 per employee bonus. It would actually be much higher because of the additional payroll taxes and other factors that businesses pay on top of wages.

In fact, even if you own no stocks directly, you probably have a large chunk of your retirement invested in Wal-Mart if you have any sort of pension benefits at all, or you own any type of mutual fund or equity-based annuity. If you are a retired nurse with $500,000 in your 401(k) and you own an S&P 500 index fund, roughly 1.13% of your assets will be in Wal-Mart so your personal loss would be $1,751.50. If your pension pays you $1,800 per month, the plan likely has the same assets set aside to cover your distributions (it would take about $500,000 in earnings to generate a sustainable $1,800 per month pension payout) so its loss would be the same; although you wouldn’t need to worry about it because your old employer is on the hook for the money, the company has to make up the unfunded pension assets so it’s less money in their bank account for hiring new employees or offering their own bonuses.

Before the rise of our modern economy, it was virtually impossible for firms to earn high operating earnings per employee because of the huge investment in equipment, machinery, and physical labor (the exceptions were businesses such as commodity brokers, which were able to earn a profit without tying up their own capital).

An apple orchard, for instance, would have massive investments in land, dozens (if not hundreds) of hired men and women to walk the field and physically pick the apples, and a warehouse of people to prepare them for shipment. Today, much of that work has been replaced by machines but the savings went to the customer in the form of lower food prices, rather than to the business owner, because apples are a fungible product (you can’t tell an apple grown on one farm versus another if they are of comparable quality). The result is that apple farmers aren’t able to offer great medical benefits, new Mercedes, and signing bonuses. In banking, talent is anything but fungible. Someone like Warren Buffett, Charlie Munger, or Philip Fisher is exceedingly rare. If you could get Warren Buffett to work for you, paying him $1 billion a year would be a bargain because he’d likely earn that for your firm on a single transaction.

The moment our society moved beyond capital intensive industries, the fundamental laws of mathematics show that the pay difference between the richest and poorest (in terms of income) was going to widen because the new firms that arose such as advertising agencies, accounting practices, legal partnerships, and dentistry, earn high operating profits per employee. Old firms, such as steel manufacturing, garment production, and railroads do not. As a country moves from third world to second world, and later from second world to first world, a larger percentage of the population finds itself employed by these “high” return businesses because the needs of the population change. The result is an ever-widening increase in the pay differences between the bottom tier, which consists mostly of those without a high school diploma, and the top tier, which statistically contains those with advanced degrees and PhD’s in specialized fields such as medicine.

As a society, our concern should not be pay differential but rather, the absolute standard of living for the bottom 10% of the population. I’ve said it a million times and I’ll continue to say it: If we could double the gap between the rich and the poor but, in doing so, double the real, after-inflation income of the poorest 10% of Americans, I’d do it in a heartbeat. What matters is how they and their families are able to live.

As a society, we have a long way to go but I’m encouraged by our progress. Why? Because in the United States alone, changes in productivity and real standards of living over the past century have exceeded the sum of all recorded human history prior.

Being poor used to mean having no running water, no air conditioning, no central heating, not being able to buy clothes, or own a car. Today, the poverty line in the United States is high enough that those on it have all of those things – according to one study that examined the European Union to the United States (see EU vs. United States by Fredrik Bergström & Robert Gidehag), in 2007, 46% of poor households in the US owned their own homes, 30% had two or more cars, and 63% received cable or satellite TV.

Yes, there is still a lot of work to do but we cannot forget that in the macro-economic scheme of things, our grandparents, parents, and now us, have done an amazing job of building an economic engine that has better opportunities than virtually anywhere else in the world. I’m sorry, but if you own two (2!) or more cars, you can’t call yourself impoverished. I didn’t buy my first car – a Jaguar X-Type – until I was in my early twenties and had built up my savings and investments to very respectable levels because I knew that an automobile is one of the single biggest hurdles to achieving financial independence when you factor in all of the incremental costs. Do you think I wanted to wait that long? Do you think it was convenient to get around places without transportation? No, but I wanted to be independent and have enough money to not have to worry about a job. That takes sacrifice. You can’t have it both ways.

My hope for you, the reader, is you will now stop and remember, each time you read the news or hear an interview with a company or labor union, that the first metric you should check to determine which side likely has the better argument is operating profit per employee.

How to Make $10,000,000 After Taxes in a Few Years

Joshua Kennon — Tue, 11 Aug 2009 19:25:44 +0000

Making money online can be incredibly easy if you know which metrics are important and how to focus on the right things.

I’m sitting in my investing office, looking over the river behind the property, figuring out what I’m going to do for the day. I’ve got a cup of coffee in my Seattle’s Best mug from Border’s and am listening to Roosterspur Bridge by Tori Amos. The ideal would be to plow into a giant pile of stock reports but that isn’t going to be possible for a few days because the operating businesses need my attention. We have so many opportunities over the next twelve months to explode in revenues and profits by taking business from weakened competitors that I’m driving everyone pretty hard. Aaron, as always, has been patient, long-suffering, and wonderful.

One of the questions I often get asked is how, exactly, we make money. Moreover, most people want to know why we’ve succeeded when others have failed. To explain how easy it really is to create a large amount of wealth, I wanted to go through and work the problem backward (as Charlie Munger would say, follow the mathematician Jacobi to solve all of life’s problems: “Invert! Always invert!”). By seeing how we think about these things at our company, you can gain insight into whatever it is you are involved in yourself.

Let’s begin with a simple premise: You want to make $10,000,000 after taxes by selling your business and walking away when the deal closes. You own an online retail site. How do you do it?

The Three Metrics that Matter
In online e-commerce, there are three metrics that matter. Any good analytics program can provide this data by putting a bit of code on your pages – Google Analytics, which is free, is one of the best. These three metrics are:

Monthly Visits: This is the number of times a person comes to your site each month. It is not page views. It is not hits. If the same person comes to your site every week for four weeks, that would count as four visits. For a traditional retailer such as Wal-Mart or Target, it would be the number of times someone walks through the doors.
Conversion Rate: The conversion rate is the percentage of visits that result in a sale. If you have 100 visits and 2 orders, your conversion rate is 2% (2 ÷ 100 = .02, or 2%). The higher the conversion rate, the more likely you are meeting your customer’s needs. A “good” conversion rate is usually between 1% and 3% but it depends upon the nature of the ecommerce site. The easier it is to checkout, the more attractive your prices, the lower your shipping rates, the better your search engine optimization, the higher quality your product images, the more professional and informative your descriptions, the higher your conversion rate.
Average Basket Price: This is the average sales ticket for orders placed on your site. For a baby gift site, an $80 average order may be good. For a furniture site, $700 may be acceptable. If you try to increase the average basket price by increasing product prices, you could lower your conversion rate. Thus, the conversion rate and average basket price have a powerful, inter-connected relationship. Just realize that if you are targeting an average basket price of $150, you aren’t likely to get there if you only sell $19.95 products.

Those three metrics – monthly visits, conversion rate, and average basket price – determine the success of an online business. Going back to our earlier problem, let’s answer the question: How could I make $10,000,000 after taxes by selling the business?

The Math of Working Backwards
Working backwards, it becomes evident that you’d need to sell the company for $14,000,000 to end up with $10,000,000 after taxes. Once you’ve reached that size, most good businesses will sell for about 10x EBIT, which means earnings before interest and taxes. This would not be the case if you were a traditional retailer because you’d have fixed expenses, real estate, capital-intensive inventory requirements, and much lower profit margins due to the business model. For a successful, growing company with high margins, it’s reasonable. You may have to wait for a better economy, but it’s reasonable, especially if you can find a competitor that has a strategic reason for acquiring your business.

That means that you would need to make $1,400,000 in pre-tax income ($14,000,000 sales price ÷ 10x EBIT = $1,400,000 operating income). If your cost structure is right, you should be able to generate 28% operating margins with a successful e-commerce business. If you can’t do that, you’re doing something wrong. My guess is, you’ve become intoxicated with sales and forgotten that profits are what matter. Thus, to generate $1,400,000 in pre-tax profits would require sales of $5,000,000 per year ($1,400,000 ÷ .28 = $5,000,000).

If $5,000,000 in online sales sounds daunting to you, remember to go back to our three metrics. Monthly Visits. Conversion Rate. Average Basket Price. Once you play with those numbers, you realize just how do-able it is. To hit that sales level, it would require only 1,000,000 visits per year, a 2% conversion rate, and a $250 average basket price. To put it another way, you only need to build your site so that it’s large enough that 2,740 people visit you from search engines or shopping portal search day (1,000,000 annual visits ÷ 365 days = 2,740 visits per day). At a 2% conversion rate, you could expect this to yield 55 orders each day. At $250 per order, that’s $13,750 in daily sales, or $3,850 in daily pre-tax profit at 28% operating margins. That gets you to your goal of $1,400,000 in pre-tax profit in a year. Find the right buyer, and you can sell for $14,000,000, pay your $4,000,000 in taxes, and walk away with $10,000,000.

Change How You Think About the Problem
Thus, the problem is not, “How do I make $10,000,000?” so much as it is, “How do I get 2,740 to visit my site each day, convert 2% of them, and have an average basket price of $250?” You can change the numbers around depending on your product mix. If you only have an average basket price of $125, for instance, you would need to get 5,480 daily visitors. It is entirely your choice how you construct your business. The point is, that thinking of the problem like that makes it far easier. Almost anyone, with enough work and dedication, can create that kind of search engine traffic. This is the reason I moved from Princeton, NJ back to the Midwest to launch our Internet companies in 2009 following the success of the first in 2007. It’s a better business model.

In my case, we aren’t really interested in selling the companies. Instead, I want the businesses to pay their income taxes and then pay up the net profits to headquarters where I can use them to invest in stocks, bonds, mutual funds, real estate, options, acquisitions, startups, or whatever else I think offers us good value for our money. That is why I call my businesses the “cash generators”. They provide me with the funds necessary to compound. Someday, our objective is to take the company public so friends, family, and colleagues can own shares and grow wealthy along with us.

The Psychology of Human Misjudgment by Charlie Munger

Joshua Kennon — Tue, 25 Nov 2008 05:02:00 +0000

By Charlie Munger (Warren Buffett’s partner at Berkshire Hathaway)
Speech at Harvard Law School (1995)

Transcription, comments [in brackets] by Whitney Tilson

Charles Munger, Vice Chairman of Berkshire Hathaway

Munger: Although I am very interested in the subject of human misjudgment — and lord knows I’ve created a good bit of it — I don’t think I’ve created my full statistical share, and I think that one of the reasons was I tried to do something about this terrible ignorance I left the Harvard Law School with.

When I saw this patterned irrationality, which was so extreme, and I had no theory or anything to deal with it, but I could see that it was extreme, and I could see that it was patterned, I just started to create my own system of psychology, partly by casual reading, but largely from personal experience, and I used that pattern to help me get through life. Fairly late in life I stumbled into this book, Influence, by a psychologist named Bob Cialdini, who became a super-tenured hotshot on a 2,000-person faculty at a very young age. And he wrote this book, which has now sold 300-odd thousand copies, which is remarkable for somebody. Well, it’s an academic book aimed at a popular audience that filled in a lot of holes in my crude system. In those holes it filled in, I thought I had a system that was a good-working tool, and I’d like to share that one with you.

And I came here because behavioral economics. How could economics not be behavioral? If it isn’t behavioral, what the hell is it? And I think it’s fairly clear that all reality has to respect all other reality. If you come to inconsistencies, they have to be resolved, and so if there’s anything valid in psychology, economics has to recognize it, and vice versa. So I think the people that are working on this fringe between economics and psychology are absolutely right to be there, and I think there’s been plenty wrong over the years. Well let me romp through as much of this list as I have time to get through:

24 Standard Causes of Human Misjudgment

1. Under-recognition of the power of what psychologists call ‘reinforcement’ and economists call ‘incentives.’

Well you can say, “Everybody knows that.” Well I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.

One of my favorite cases about the power of incentives is the Federal Express case. The heart and soul of the integrity of the system is that all the packages have to be shifted rapidly in one central location each night. And the system has no integrity if the whole shift can’t be done fast. And Federal Express had one hell of a time getting the thing to work. And they tried moral suasion, they tried everything in the world,
and finally somebody got the happy thought that they were paying the night shift by the hour, and that maybe if they paid them by the shift, the system would work better. And lo and behold, that solution worked .

Early in the history of Xerox, Joe Wilson, who was then in the government, had to go back to Xerox because he couldn’t understand how their better, new machine was selling so poorly in relation to their older and inferior machine. Of course when he got there he found out that the commission arrangement with the salesmen gave a tremendous incentive to the inferior machine.

And here at Harvard, in the shadow of B.F. Skinner — there was a man who really was into reinforcement as a powerful thought, and, you know, Skinner’s lost his reputation in a lot of places, but if you were to analyze the entire history of experimental science at Harvard, he’d be in the top handful. His experiments were very ingenious, the results were counter-intuitive, and they were important. It is not given to experimental science to do better. What gummed up Skinner’s reputation is that he developed a case of what I always call man-with-a-hammer syndrome: to the man with a hammer, every problem tends to look pretty much like a nail. And Skinner had one of the more extreme cases in the history of Academia, and this syndrome doesn’t exempt bright people. It’s just a man with a hammer…and Skinner is an extreme example of that. And later, as I go down my list, let’s go back and try and figure out why people, like Skinner, get man-with-a-hammer syndrome.

Incidentally, when I was at the Harvard Law School there was a professor, naturally at Yale, who was derisively discussed at Harvard, and they used to say, “Poor old Blanchard. He thinks declaratory judgments will cure cancer.” And that’s the way Skinner got. And not only that, he was literary, and he scorned opponents who had any different way of thinking or thought anything else was important. This is not a way to make a lasting reputation if the other people turn out to also be doing something important.

2. My second factor is simple psychological denial.

This first really hit me between the eyes when a friend of our family had a super-athlete, super-student son who flew off a carrier in the north Atlantic and never came back, and his mother, who was a very sane woman, just never believed that he was dead. And, of course, if you turn on the television, you’ll find the mothers of the most obvious criminals that man could ever diagnose, and they all think their sons are innocent. That’s simple psychological denial. The reality is too painful to bear, so you just distort it until it’s bearable. We all do that to some extent, and it’s a common psychological misjudgment that causes terrible problems.

3. Incentive-cause bias, both in one’s own mind and that of ones trusted advisor, where it creates what economists call ‘agency costs.’

Here, my early experience was a doctor who sent bushel baskets full of normal gall bladders down to the pathology lab in the leading hospital in Lincoln, Nebraska. And with that quality control for which community hospitals are famous, about five years after he should’ve been removed from the staff, he was. And one of the old doctors who participated in the removal was also a family friend, and I asked him: I said, “Tell me, did he think, ‘Here’s a way for me to exercise my talents’” — this guy was very skilled technically– “‘and make a high living by doing a few maimings and murders every year, along with some frauds?’” And he said, “Hell no, Charlie. He thought that the gall bladder was the source of all medical evil, and if you really love your patients, you couldn’t get that organ out rapidly enough.”

Now that’s an extreme case, but in lesser strength, it’s present in every profession and in every human being. And it causes perfectly terrible behavior. If you take sales presentations and brokers of commercial real estate and businesses… I’m 70 years old, I’ve never seen one I thought was even within hailing distance of objective truth. If you want to talk about the power of incentives and the power of rationalized, terrible behavior: after the Defense Department had had enough experience with cost-plus percentage of cost contracts, the reaction of our republic was to make it a crime for the federal
government to write one, and not only a crime, but a felony.

And by the way, the government’s right, but a lot of the way the world is run, including most law firms and a lot of other places, they’ve still got a cost-plus percentage of cost system. And human nature, with its version of what I call ‘incentive-caused bias,’ causes this terrible abuse. And many of the people who are doing it you would be glad to have married into your family compared to what you’re otherwise going to get. [Laughter]

Now there are huge implications from the fact that the human mind is put together this way, and that is that people who create things like cash registers, which make most [dishonest] behavior hard, are some of the effective saints of our civilization. And the cash register was a great moral instrument when it was created. And Patterson knew that, by the way. He had a little store, and the people were stealing him blind and never made any money, and people sold him a couple of cash registers and it went to profit immediately. And, of course, he closed the store and went into the cash register business…

And so this is a huge, important thing. If you read the psychology texts, you will find that if they’re 1,000 pages long, there’s one sentence. Somehow incentive-caused bias has escaped the standard survey course in psychology.

4. Fourth, and this is a superpower in error-causing psychological tendency: bias from consistency and commitment tendency, including the tendency to avoid or promptly resolve cognitive dissonance. Includes the self-confirmation tendency of all conclusions, particularly expressed conclusions, and with a special persistence for conclusions that are hard-won.

Well what I’m saying here is that the human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in. The human mind has a big tendency of the same sort. And here again, it doesn’t just catch ordinary mortals; it catches the deans of physics. According to Max Planck, the really innovative, important new physics was never really accepted by the old guard. Instead a new guard came along that was less brain-blocked by its previous conclusions. And if Max Planck’s crowd had this consistency and commitment tendency that kept their old inclusions intact in spite of disconfirming evidence, you can imagine what the crowd that you and I are part of behaves like.

And of course, if you make a public disclosure of your conclusion, you’re pounding it into your own head. Many of these students that are screaming at us, you know, they aren’t convincing us, but they’re forming mental change for themselves, because what they’re shouting out [is] what they’re pounding in. And I think educational institutions that create a climate where too much of that goes on are…in a fundamental sense, they’re irresponsible institutions. It’s very important to not put your brain in chains too young by what you shout out.

And all these things like painful qualifying and initiation rituals pound in your commitments and your ideas. The Chinese brainwashing system, which was for war prisoners, was way better than anybody else’s. They maneuvered people into making tiny little commitments and declarations, and then they’d slowly build. That worked way better than torture.

5. Fifth: bias from Pavlovian association, misconstruing past correlation as a reliable basis for decision-making.

I never took a course in psychology, or economics either for that matter, but I did learn about Pavlov in high school biology. And the way they taught it, you know, so the dog salivated when the bell rang. So what? Nobody made the least effort to tie that to the wide world. Well the truth of the matter is that Pavlovian association is an enormously powerful psychological force in the daily life of all of us. And, indeed, in economics we wouldn’t have money without the role of so-called secondary reinforcement, which is a pure psychological phenomenon demonstrated in the laboratory.

Practically…I’d say 3/4 of advertising works on pure Pavlov. Think how association, pure association, works. Take Coca-Cola company (we’re the biggest share-holder). They want to be associated with every wonderful image: heroics in the Olympics, wonderful music, you name it. They don’t want to be associated with presidents’ funerals and so-forth. When have you seen a Coca-Cola ad…and the association really works.

And all these psychological tendencies work largely or entirely on a subconscious level, which makes them very insidious. Now you’ve got Persian messenger syndrome. The Persians really did kill the messenger who brought the bad news. You think that is dead? I mean you should’ve seen Bill Paley in his last 20 years. [Paley was the former owner, chairman and CEO of CBS; see http://www.kcmetro.cc.mo.us/pennvalley/biology/lewis/crosby/paley.htm for his bio.] He didn’t hear one damn thing he didn’t want to hear. People knew that it was bad for the messenger to bring Bill Paley things he didn’t want to hear. Well that means that the leader gets in a cocoon of unreality, and this is a great big enterprise, and boy, did he make some dumb decisions in the last 20 years.

And now the Persian messenger syndrome is alive and well. I saw, some years ago, Arco and Exxon arguing over a few hundred millions of ambiguity in their North Slope treaties before a superior court judge in Texas, with armies of lawyers and experts on each side. Now this is a Mad Hatter’s tea party: two engineering-style companies can’t resolve some ambiguity without spending tens of millions of dollars in some Texas superior court? In my opinion what happens is that nobody wants to bring the bad news to the executives up the line. But here’s a few hundred million dollars you thought you had that you don’t. And it’s much safer to act like the Persian messenger who goes away to hide rather than bring home the news of the battle lost.

Talking about economics, you get a very interesting phenomenon that I’ve seen over and over again in a long life. You’ve got two products; suppose they’re complex, technical products. Now you’d think, under the laws of economics, that if product A costs X, if product Y costs X minus something, it will sell better than if it sells at X plus something, but that’s not so. In many cases when you raise the price of the alternative products, it’ll get a larger market share than it would when you make it lower than your competitor’s product. That’s because the bell, a Pavlovian bell — I mean ordinarily there’s a correlation between price and value — then you have an information inefficiency. And so when you raise the price, the sales go up relative to your competitor. That happens again and again and again. It’s a pure Pavlovian phenomenon. You can say, “Well, the economists have figured this sort of thing out when they started talking about information inefficiencies,” but that was fairly late in economics that they found such an obvious thing. And, of course, most of them don’t ask what causes the information inefficiencies.

Well one of the things that causes it is pure old Pavlov and his dog. Now you’ve got bios from Skinnerian association: operant conditioning, you know, where you give the dog a reward and pound in the behavior that preceded the dog’s getting the award. And, of course, Skinner was able to create superstitious pigeons by having the rewards come by accident with certain occurrences, and, of course, we all know people who are the human equivalents of superstitious pigeons. That’s a very powerful phenomenon. And, of course, operant conditioning really works. I mean the people in the center who think that operant conditioning is important are very much right, it’s just that Skinner overdid it a little.

Where you see in business just perfectly horrible results from psychologically-rooted tendencies is in accounting. If you take Westinghouse, which blew, what, two or three billion dollars pre-tax at least loaning developers to build hotels, and virtually 100% loans? Now you say any idiot knows that if there’s one thing you don’t like it’s a developer, and another you don’t like it’s a hotel. And to make a 100% loan to a developer who’s going to build a hotel… [Laughter] But this guy, he probably was an engineer or something, and he didn’t take psychology any more than I did, and he got out there in the hands of these salesmen operating under their version of incentive-caused bias, where any damned way of getting Westinghouse to do it was considered normal business, and they just blew it.

That would never have been possible if the accounting system hadn’t been such but for the initial phase of every transaction it showed wonderful financial results. So people who have loose accounting standards are just inviting perfectly horrible behavior in other people. And it’s a sin, it’s an absolute sin. If you carry bushel baskets full of money through the ghetto, and made it easy to steal, that would be a considerable human sin, because you’d be causing a lot of bad behavior, and the bad behavior would spread. Similarly an institution that gets sloppy accounting commits a real human sin, and it’s also a dumb way to do business, as Westinghouse has so wonderfully proved.

Oddly enough nobody mentions, at least nobody I’ve seen, what happened with Joe Jett and Kidder Peabody. The truth of the matter is the accounting system was such that by punching a few buttons, the Joe Jetts of the world could show profits, and profits that showed up in things that resulted in rewards and esteem and every other thing… Well the Joe Jetts are always with us, and they’re not really to blame, in my judgment at least. But that bastard who created that foolish accounting system who, so far as I know, has not been flayed alive, ought to be.

6. Sixth: bias from reciprocation tendency, including the tendency of one on a roll to act as other persons expect.

Well here, again, Cialdini does a magnificent job at this, and you’re all going to be given a copy of Cialdini’s book. And if you have half as much sense as I think you do, you will immediately order copies for all of your children and several of your friends. You will never make a better investment.

It is so easy to be a patsy for what he calls the compliance practitioners of this life. At any rate, reciprocation tendency is a very, very powerful phenomenon, and Cialdini demonstrated this by running around a campus, and he asked people to take juvenile delinquents to the zoo. And it was a campus, and so one in six actually agreed to do it. And after he’d accumulated a statistical output he went around on the same campus and he asked other people, he said, “Gee, would you devote two afternoons a week to taking juvenile delinquents somewhere and suffering greatly yourself to help them,” and there he got 100% of the people to say no. But after he’d made the first request, he backed up a little, and he said, “Would you at least take them to the zoo one afternoon?” He raised the compliance rate from a third to a half. He got three times the success by just going through the little ask-for-a-lot-and-back-off.

Now if the human mind, on a subconscious level, can be manipulated that way and you don’t know it, I always use the phrase, “You’re like a one-legged man in an ass-kicking contest.” I mean you are really giving a lot of quarter to the external world that you can’t afford to give. And on this so-called role theory, where you tend to act in the way that other people expect, and that’s reciprocation if you think about the way society is organized.

A guy named Zimbardo had people at Stanford divide into two pieces: one were the guards and the other were the prisoners, and they started acting out roles as people expected. He had to stop the experiment after about five days. He was getting into human misery and breakdown and pathological behavior. I mean it was…it was awesome. However, Zimbardo is greatly misinterpreted. It’s not just reciprocation tendency and role theory that caused that, it’s consistency and commitment tendency. Each person, as he acted as a guard or a prisoner, the action itself was pounding in the idea. [For more on this famous experiment:

http://www.prisonexp.org/]

Wherever you turn, this consistency and commitment tendency is affecting you. In other words, what you think may change what you do, but perhaps even more important, what you do will change what you think. And you can say, “Everybody knows that.” I want to tell you I didn’t know it well enough early enough.

7. Seventh, now this is a lollapalooza, and Henry Kaufman wisely talked about this: bias from over-influence by social proof — that is, the conclusions of others, particularly under conditions of natural uncertainty and stress.

And here, one of the cases the psychologists use is Kitty Genovese, where all these people — I don’t know, 50, 60, 70 of them — just sort of sat and did nothing while she was slowly murdered. Now one of the explanations is that everybody looked at everybody else and nobody else was doing anything, and so there’s automatic social proof that the right thing to do is nothing. That’s not a good enough explanation for Kitty Genovese, in my judgment. That’s only part of it. There are microeconomic ideas and gain/loss ratios and so forth that also come into play. I think time and time again, in reality, psychological notions and economic notions interplay, and the man who doesn’t understand both is a damned fool.

Big-shot businessmen get into these waves of social proof. Do you remember some years ago when one oil company bought a fertilizer company, and every other major oil company practically ran out and bought a fertilizer company? And there was no more damned reason for all these oil companies to buy fertilizer companies, but they didn’t know exactly what to do, and if Exxon was doing it, it was good enough for Mobil, and vice versa. I think they’re all gone now, but it was a total disaster.

Now let’s talk about efficient market theory, a wonderful economic doctrine that had a long vogue in spite of the experience of Berkshire Hathaway. In fact one of the economists who won — he shared a Nobel Prize — and as he looked at Berkshire Hathaway year after year, which people would throw in his face as saying maybe the market isn’t quite as efficient as you think, he said, “Well, it’s a two-sigma event.” And then he said we were a three-sigma event. And then he said we were a four-sigma event. And he finally got up to six sigmas — better to add a sigma than change a theory, just because the evidence comes in differently. [Laughter] And, of course, when this share of a Nobel Prize went into money management himself, he sank like a stone.

If you think about the doctrines I’ve talked about, namely, one, the power of reinforcement — after all you do something and the market goes up and you get paid and rewarded and applauded and what have you, meaning a lot of reinforcement, if you make a bet on a market and the market goes with you. Also, there’s social proof. I mean the prices on the market are the ultimate form of social proof, reflecting what other people think, and so the combination is very powerful. Why would you expect general market levels to always be totally efficient, say even in 1973-74 at the pit, or in 1972 or whatever it was when the Nifty 50 were in their heyday? If these psychological notions are correct, you would expect some waves of irrationality, which carry general levels, so they’re inconsistent with reason.

8. Nine [he means eight]: what made these economists love the efficient market theory is the math was so elegant.

And after all, math was what they’d learned to do. To the man with a hammer, every problem tends to look pretty much like a nail. The alternative truth was a little messy, and they’d forgotten the great economists Keynes, whom I think said, “Better to be roughly right than precisely wrong.”

9. Bias from contrast-caused distortions of sensation, perception and cognition.

Here, the great experiment that Cialdini does in his class is he takes three buckets of water: one’s hot, one’s cold and one’s room temperature, and he has the student stick his left hand in the hot water and his right hand in the cold water. Then he has them remove the hands and put them both in the room temperature bucket, and of course with both hands in the same bucket of water, one seems hot, the other seems cold because the sensation apparatus of man is over-influenced by contrast. It has no absolute scale; it’s got a contrast scale in it. And it’s a scale with quantum effects in it too. It takes a certain percentage change before it’s noticed.

Maybe you’ve had a magician remove your watch — I certainly have — without your noticing it. It’s the same thing. He’s taking advantage of contrast-type troubles in your sensory apparatus. But here the great truth is that cognition mimics sensation, and the cognition manipulators mimic the watch-removing magician. In other words, people are manipulating you all day long on this contrast phenomenon.

Cialdini cites the case of the real estate broker. And you’ve got the rube that’s been transferred into your town, and the first thing you do is you take the rube out to two of the most awful, overpriced houses you’ve ever seen, and then you take the rube to some moderately overpriced house, and then you stick him. And it works pretty well, which is why the real estate salesmen do it. And it’s always going to work.

And the accidents of life can do this to you, and it can ruin your life. In my generation, when women lived at home until they got married, I saw some perfectly terrible marriages made by highly desirable women because they lived in terrible homes. And I’ve seen some terrible second marriages which were made because they were slight improvements over an even worse first marriage. You think you’re immune from these things, and you laugh, and I want to tell you, you aren’t.

My favorite analogy I can’t vouch for the accuracy of. I have this worthless friend I like to play bridge with, and he’s a total intellectual amateur that lives on inherited money, but he told me once something I really enjoyed hearing. He said, “Charlie,” he say, “If you throw a frog into very hot water, the frog will jump out, but if you put the frog in room temperature water and just slowly heat the water up, the frog will die there.” Now I don’t know whether that’s true about a frog, but it’s sure as hell true about many of the businessmen I know [laughter], and there, again, it is the contrast phenomenon. But these are hot-shot, high-powered people. I mean these are not fools. If it comes to you in small pieces, you’re likely to miss, so if you’re going to be a person of good judgment, you have to do something about this warp in your head where it’s so misled by mere contrast.

10. Bias from over-influence by authority.

Well here, the Milgrim experiment, as it’s called — I think there have been 1,600 psychological papers written about Milgrim. And he had a person posing as an authority figure trick ordinary people into giving what they had every reason to expect was heavy torture by electric shock to perfectly innocent fellow citizens. And he was trying to show why Hitler succeeded and a few other things, and so this really caught the fancy of the world. Partly it’s so politically correct, and over-influence by authority…

You’ll like this one: You get a pilot and a co-pilot. The pilot is the authority figure. They don’t do this in airplanes, but they’ve done it in simulators. They have the pilot do something where the co-pilot, who’s been trained in simulators a long time — he knows he’s not to allow the plane to crash — they have the pilot to do something where an idiot co-pilot would know the plane was going to crash, but the pilot’s doing it, and the co-pilot is sitting there, and the pilot is the authority figure. 25% of the time the plane crashes. I mean this is a very powerful psychological tendency. It’s not quite as powerful as some people think, and I’ll get to that later.

11. Bias from deprival super-reaction syndrome, including bias caused by present or threatened scarcity, including threatened removal of something almost possessed, but never possessed.

Here I took the Munger dog, a lovely, harmless dog. The only way to get that dog to bite you is to try and take something out of its mouth after it was already there. And you know, if you’ve tried to do takeaways in labor negotiations, you’ll know that the human version of that dog is there in all of us. And I have a neighbor, a predecessor who had a little island around the house, and his next door neighbor put a little pine tree on it that was about three feet high, and it turned his 180 degree view of the harbor into 179 3/4. Well they had a blood feud like the Hatfields and McCoys, and it went on and on and on…

I mean people are really crazy about minor decrements down. And then, if you act on them, then you get into reciprocation tendency, because you don’t just reciprocate affection, you reciprocate animosity, and the whole thing can escalate. And so huge insanities can come from just subconsciously over-weighing the importance of what you’re losing or almost getting and not getting.

And the extreme business case here was New Coke. Coca-Cola has the most valuable trademark in the world. We’re the major shareholder — I think we understand that trademark. Coke has armies of brilliant engineers, lawyers, psychologists, advertising executives and so forth, and they had a trademark on a flavor, and they’d spent the better part of 100 years getting people to believe that trademark had all these intangible values too. And people associate it with a flavor. And so they were going to tell people not that it was improved, because you can’t improve a flavor. A flavor is a matter of taste. I mean you may improve a detergent or something, but don’t think you’re going to make a major change in a flavor. So they got this huge deprival super-reaction syndrome.

Pepsi was within weeks of coming out with old Coke in a Pepsi bottle, which would’ve been the biggest fiasco in modern times. Perfect insanity. And by the way, both Goizuetta [Coke's CEO at the time] and Keough [an influential former president and director of the company] are just wonderful about it. I mean they just joke. Keough always says, “I must’ve been away on vacation.” He participated in every single decision — he’s a wonderful guy. And by the way, Goizuetta is a wonderful, smart guy — an engineer. Smart people make these terrible boners. How can you not understand deprival super-reaction syndrome? But people do not react symmetrically to loss and gain. Well maybe a great bridge player like Zeckhauser does, but that’s a trained response. Ordinary people, subconsciously affected by their inborn tendencies…

12. Bias from envy/jealousy.

Well envy/jealousy made, what, two out of the ten commandments? Those of you who have raised siblings you know about envy, or tried to run a law firm or investment bank or even a faculty? I’ve heard Warren say a half a dozen times, “It’s not greed that drives the world, but envy.”

Here again, you go through the psychology survey courses, and you go to the index: envy/jealousy, 1,000-page book, it’s blank. There’s some blind spots in academia, but it’s an enormously powerful thing, and it operates, to a considerable extent, on the subconscious level. Anybody who doesn’t understand it is taking on defects he shouldn’t have.

13. Bias from chemical dependency.

Well, we don’t have to talk about that. We’ve all seen so much of it, but it’s interesting how it’ll always cause this moral breakdown if there’s any need, and it always involves massive denial. See it just aggravates what we talked about earlier in the aviator case, the tendency to distort reality so that it’s endurable.

14. Bias from mis-gambling compulsion.

Well here, Skinner made the only explanation you’ll find in the standard psychology survey course. He, of course, created a variable reinforcement rate for his pigeons and his mice, and he found that that would pound in the behavior better than any other enforcement pattern. And he says, “Ah ha! I’ve explained why gambling is such a powerful, addictive force in this civilization.” I think that is, to a very considerable extent, true, but being Skinner, he seemed to think that was the only explanation, but the truth of the matter is that the devisors of these modern machines and techniques know a lot of things that Skinner didn’t know.

For instance, a lottery. You have a lottery where you get your number by lot, and then somebody draws a number by lot, it gets lousy play. You have a lottery where people get to pick their number, you get big play. Again, it’s this consistency and commitment thing. People think if they have committed to it, it has to be good. The minute they’ve picked it themselves it gets an extra validity. After all, they thought it and they acted on it.

Then if you take the slot machines, you get bar, bar, walnut. And it happens again and again and again. You get all these near misses. Well that’s deprival super-reaction syndrome, and boy do the people who create the machines understand human psychology. And for the high-IQ crowd they’ve got poker machines where you make choices. So you can play blackjack, so to speak, with the machine. It’s wonderful what we’ve done
with our computers to ruin the civilization.

But at any rate, mis-gambling compulsion is a very, very powerful and important thing. Look at what’s happening to our country: every Indian has a reservation, every river town, and look at the people who are ruined by it with the aid of their stock brokers and others. And again, if you look in the standard textbook of psychology you’ll find practically nothing on it except maybe one sentence talking about Skinner’s rats. That is not an adequate coverage of the subject.

15. Bias from liking distortion, including the tendency to especially like oneself, one’s own kind and one’s own idea structures, and the tendency to be especially susceptible to being misled by someone liked. Disliking distortion, bias from that, the reciprocal of liking distortion and the tendency not to learn appropriately from someone disliked.

Well here, again, we’ve got hugely powerful tendencies, and if you look at the wars in part of the Harvard Law School, as we sit here, you can see that very brilliant people get into this almost pathological behavior. And these are very, very powerful, basic, subconscious psychological tendencies, or at least party subconscious.

Now let’s get back to B.F. Skinner, man-with-a-hammer syndrome revisited. Why is man-with-a-hammer syndrome always present? Well if you stop to think about it, it’s incentive-caused bias. His professional reputation is all tied up with what he knows. He likes himself and he likes his own ideas, and he’s expressed them to other people — consistency and commitment tendency. I mean you’ve got four or five of these elementary psychological tendencies combining to create this man-with-a-hammer syndrome.

Once you realize that you can’t really buy your thinking — partly you can, but largely you can’t in this world — you have learned a lesson that’s very useful in life. George Bernard Shaw had a character say in The Doctor’s Dilemma, “In the last analysis, every profession is a conspiracy against the laity.” But he didn’t have it quite right, because it isn’t so much a conspiracy as it is a subconscious, psychological tendency.

The guy tells you what is good for him. He doesn’t recognize that he’s doing anything wrong any more than that doctor did when he was pulling out all those normal gall bladders. And he believes his own idea structures will cure cancer, and he believes that the demons that he’s the guardian against are the biggest demons and the most important ones, and in fact they may be very small demons compared to the demons that you face. So you’re getting your advice in this world from your paid advisor with this huge load of ghastly bias. And woe to you.

There are only two ways to handle it: you can hire your advisor and then just apply a windage factor, like I used to do when I was a rifle shooter. I’d just adjust for so many miles an hour wind. Or you can learn the basic elements of your advisor’s trade. You don’t have to learn very much, by the way, because if you learn just a little then you can make him explain why he’s right. And those two tendencies will take part of the warp out of the thinking you’ve tried to hire done. By and large it works terribly. I have never seen a management consultant’s report in my long life that didn’t end with the following paragraph: “What this situation really needs is more management consulting.” Never once. I always turn to the last page. Of course Berkshire doesn’t hire them, so I only do this on sort of a voyeuristic basis. Sometimes I’m at a non-profit where some idiot hires one. [Laughter]

16. Seventeen [he means 16]: bias from the non-mathematical nature of the human brain in its natural state as it deal with probabilities employing crude heuristics, and is often misled by mere contrast, a tendency to overweigh conveniently available information and other psychologically misrouted thinking tendencies on this list.

When the brain should be using the simple probability mathematics of Fermat and Pascal applied to all reasonably obtainable and correctly weighted items of information that are of value in predicting outcomes, the right way to think is the way Zeckhauser plays bridge. It’s just that simple. And your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge. Now, you notice I put in that availability thing, and there I’m mimicking some very eminent psychologists [Daniel] Kahneman, Eikhout[?] (I hope I pronounced that right) and [Amos] Tversky, who raised the idea of availability to a whole heuristic of misjudgment. And they are very substantially right.

I mean ask the Coca-Cola Company, which has raised availability to a secular religion. If availability changes behavior, you will drink a helluva lot more Coke if it’s always available. I mean availability does change behavior and cognition. Nonetheless, even though I recognize that and applaud Tversky and Kahneman, I don’t like it for my personal system except as part of a greater sub-system, which is you’ve got to think the way Zeckhauser plays bridge. And it isn’t just the lack of availability that distorts your judgment. All the things on this list distort judgment. And I want to train myself to kind of mentally run down the list instead of just jumping on availability. So that’s why I state it the way I do.

In a sense these psychological tendencies make things unavailable, because if you quickly jump to one thing, and then because you jumped to it the consistency and commitment tendency makes you lock in, boom, that’s error number one. Or if something is very vivid, which I’m going to come to next, that will really pound in. And the reason that the thing that really matters is now unavailable and what’s extra-vivid wins is, I mean, the extra-vividness creates the unavailability. So I think it’s much better to have a whole list of things that would cause you to be less like Zeckhauser than it is just to jump on one factor.

Here I think we should discuss John Gutfreund. This is a very interesting human example, which will be taught in every decent professional school for at least a full generation. Gutfreund has a trusted employee and it comes to light not through confession but by accident that the trusted employee has lied like hell to the government and manipulated the accounting system, and it was really equivalent to forgery. And the man immediately says, “I’ve never done it before, I’ll never do it again. It was an isolated example.” And of course it was obvious that he was trying to help the government as well as himself, because he thought the government had been dumb enough to pass a rule that he’d spoken against, and after all if the government’s not going to pay attention to a bond trader at Salomon, what kind of a government can
it be?

At any rate, this guy has been part of a little clique that has made, well, way over a billion dollars for Salomon in the very recent past, and it’s a little handful of people. And so there are a lot of psychological forces at work, and then you know the guy’s wife, and he’s right in front of you, and there’s human sympathy, and he’s sort of asking for your help, which encourages reciprocation, and there’s all these psychological tendencies are working, plus the fact he’s part of a group that had made a lot of money for you. At any rate, Gutfreund does not cashier the man, and of course he had done it before and he did do it again. Well now you look as though you almost wanted him to do it again. Or God knows what you look like, but it isn’t good. And that simple decision destroyed Jim Gutfreund, and it’s so easy to do.

Now let’s think it through like the bridge player, like Zeckhauser. You find an isolated example of a little old lady in the See’s Candy Company, one of our subsidiaries, getting into the till. And what does she say? “I never did it before, I’ll never do it again. This is going to ruin my life. Please help me.” And you know her children and her friends, and she’d been around 30 years and standing behind the candy counter with swollen ankles. When you’re an old lady it isn’t that glorious a life. And you’re rich and powerful and there she is: “I never did it before, I’ll never do it again.” Well how likely is it that she never did it before? If you’re going to catch 10 embezzlements a year, what are the chances that any one of them — applying what Tversky and Kahneman called baseline information — will be somebody who only did it this once? And the people who have done it before and are going to do it again, what are they all going to say? Well in the history of the See’s Candy Company they always say, “I never did it before, and I’m never going to do it again.” And we cashier them. It would be evil not to, because terrible behavior spreads.

Remember…what was it? Serpico? I mean you let that stuff…you’ve got social proof, you’ve got incentive-caused bias, you’ve got a whole lot of psychological factors that will cause the evil behavior to spread, and pretty soon the whole damn…your place is rotten, the civilization is rotten. It’s not the right way to behave. And I will admit that I have…when I knew the wife and children, I have paid severance pay when I fire somebody for taking a mistress on an extended foreign trip. It’s not the adultery I mind, it’s the embezzlement. But there, I wouldn’t do it like Gutfreund did it, where they’d been cheating somebody else on my behalf. There I think you have to cashier. But if they’re just stealing from you and you get rid of them, I don’t think you need the last ounce of vengeance. In fact I don’t think you need any vengeance. I don’t think vengeance is much good.

17. Now we come to bias from over-influence by extra-vivid evidence.

Here’s one that…I’m at least $30 million poorer as I sit here giving this little talk because I once bought 300 shares of a stock and the guy called me back and said, “I’ve got 1,500 more,” and I said, “Will you hold it for 15 minutes while I think about it?” And the CEO of this company — I have seen a lot of vivid peculiarities in a long life, but this guy set a world record; I’m talking about the CEO — and I just mis-weighed it. The truth of the matter was the situation was foolproof. He was soon going to be dead, and I turned down the extra 1,500 shares, and it’s now cost me $30 million. And that’s life in the big city. And it wasn’t something where stock was generally available. So it’s very easy to mis-weigh the vivid evidence, and Gutfreund did that when he looked into the man’s eyes and forgave a colleague.

18. Twenty-two [he means 18]: Mental confusion caused by information not arrayed in the mind and theory structures, creating sound generalizations developed in response to the question “Why?” Also, mis-influence from information that apparently but not really answers the question “Why?” Also, failure to obtain deserved influence caused by not properly explaining why.

Well we all know people who’ve flunked, and they try and memorize and they try and spout back and they just…it doesn’t work. The brain doesn’t work that way. You’ve got to array facts on the theory structures answering the question “Why?” If you don’t do that, you just cannot handle the world.

And now we get to Feuerstein, who was the general counsel with Salomon when Gutfreund made his big error, and Feuerstein knew better. He told Gutfreund, “You have to report this as a matter of morality and prudent business judgment.” He said, “It’s probably not illegal, there’s probably no legal duty to do it, but you have to do it as a matter of prudent conduct and proper dealing with your main customer.” He said that to Gutfreund on at least two or three occasions. And he stopped. And, of course, the persuasion failed, and when Gutfreund went down, Feuerstein went with him. It ruined a considerable part of Feuerstein’s life.

Well Feuerstein, [who] was a member of the Harvard Law Review, made an elementary psychological mistake. You want to persuade somebody, you really tell them why. And what did we learn in lesson one? Incentives really matter? Vivid evidence really works? He should’ve told Gutfreund, “You’re likely to ruin your life and disgrace your family and lose your money.” And is Mozer worth this? I know both men. That would’ve worked. So Feuerstein flunked elementary psychology, this very sophisticated, brilliant lawyer. But don’t you do that. It’s not very hard to do, you know, just to remember that “Why?” is very important.

19. Other normal limitations of sensation, memory, cognition and knowledge.

Well, I don’t have time for that.

20. Stress-induced mental changes, small and large, temporary and permanent.

Here, my favorite example is the great Pavlov. He had all these dogs in cages, which had all been conditioned into changed behaviors, and the great Leningrad flood came and it just went right up and the dog’s in a cage. And the dog had as much stress as you can imagine a dog ever having. And the water receded in time to save some of the dogs, and Pavlov noted that they’d had a total reversal of their conditioned personality. And being the great scientist he was, he spent the rest of his life giving nervous breakdowns to dogs, and he learned a helluva lot that I regard as very interesting.

I have never known any Freudian analyst who knew anything about the last work of Pavlov, and I’ve never met a lawyer who understood that what Pavlov found out with those dogs had anything to do with programming and de-programming and cults and so forth. I mean the amount of elementary psychological ignorance that is out there in high levels is very significant[?].

21. Then we’ve got other common mental illnesses and declines, temporary and permanent, including the tendency to lose ability through disuse.

22. And then I’ve got development and organizational confusion from say-something syndrome.

And here my favorite thing is the bee, a honeybee. And a honeybee goes out and finds the nectar and he comes back, he does a dance that communicates to the other bees where the nectar is, and they go out and get it. Well some scientist who is clever, like B.F. Skinner, decided to do an experiment. He put the nectar straight up. Way up. Well, in a natural setting, there is no nectar where they’re all straight up, and the poor honeybee doesn’t have a genetic program that is adequate to handle what he now has to communicate. And you’d think the honeybee would come back to the hive and slink into a corner, but he doesn’t. He comes into the hive and does this incoherent dance, and all my life I’ve been dealing with the human equivalent of that honeybee. [Laughter] And it’s a very important part of human organization so the noise and the reciprocation and so forth of all these people who have what I call say-something syndrome don’t really affect the decisions.