Wednesday 30 November 2011

The Thames Super-sewer: There Must Be Another Way

This week the British government announced support for a range of new infrastructure projects designed to boost the economy. Many of these will be greeted with broad support. However one planned piece of new infrastructure that causes much consternation is the ‘Thames Tideway’ Super-sewer.

By way of explanation, the Super-sewer is required because London’s existing sewer network is (literally) full to overflowing, as it carries both sewerage and rain water in the same system. This means that every time it rains heavily, excess waste water including raw sewerage gets dumped in the Thames. Because the Thames is tidal, it can take weeks to flow downstream, making for an unpleasant and environmentally harmful body of water running through our capital. The Super-sewer that has been proposed by the region’s sewerage company, Thames Water, would prevent the overflows by adding an extra tunnel running from West London to East London where waste water could be processed. Current estimates of the cost are £4.1bn, which would be recouped by increasing the mandatory sewerage charges paid by Thames Water’s customers.

The scheme is described as ‘essential’ if the UK is to meet its environmental targets set by the EU. It has already been under consideration for years, but looks like it may soon get the green light. There are plenty of reasons to believe that would be a mistake. Construction work would destroy several of London’s green spaces, and worsen the already terrible congestion on the roads. The impact on residents’ bills would be dramatic. But what worries me most of all is the scale of the project, and how the risks involved in such a big project would be dealt with.

Let us imagine, hypothetically, what would happen if the project suffered major cost overruns. The likelihood of this happening is debatable, but the precedent set by another giant tunnelling project, Boston’s ‘Big Dig’ should leave us pessimistic. The Big Dig was expected to take 16 years and cost $6bn*. Instead it took 27 years and cost $22bn. In the event such a cost overrun occurred, who would be liable? In the first instance, Thames Water should be expected to shoulder the risk. But an overrun of several billion could force the company into bankruptcy. But you cannot just ‘wind up’ a utility – it delivers water to 14m people after all - and so it would likely be bailed out by the government. And so in the end the project risk would fall on Thames Water bill payers and the British taxpayers.

The contractors and project managers engaged to undertake the project would not be blind to this fact. It would set up the perverse incentive for firms to underestimate the costs initially, but not to control them properly later. This has happened before when Metronet, the Public Private Partnership tasked with upgrading parts of London’s Underground went spectacularly bust.

If a mega-project is by its nature untenable, then what are the alternatives? In my opinion, the way this question is framed could be critical in coming up with innovative solutions. When the problem is sewers overflowing, it is easy to conclude ‘we need more sewers.’ But that is like seeing congested roads and saying ‘let’s build more of them,’ an idea that was discredited first in 1962 and now by more recent research. How about finding ways to reduce the volumes that go into the sewers in the first place? Or developing micro-scale sewerage treatment plants (analogous to micro-generation) and build several hundred around London? How about finding a way to siphon rain-water into the Thames? Or increasing capacity by installing more pumps? More and better ideas like these might be discovered if the problem was opened up to wider debate in the public and in engineering departments around the world.

Thursday 27 October 2011

Energy firms' profits are a sign of the impending supply crunch - and the need to build more power plants

The rising price of energy supplies has been much in the news recently, with the high profits of energy supply companies causing a lot of controversy. The regulator, Ofgem, is preparing rules which it intends to stimulate more competition in the market, while energy companies are warning that vital investment in energy infrastructure could be put at risk if the regulation is too heavy handed.

The energy industry is typical example of a sector where competition does not work particularly well.

The business of distributing energy from power plant to end user is a natural monopoly, meaning only one set of infrastructure ever needs to be built. Market mechanisms are of no use here, so the regulator sets the prices that transmission and distribution companies are allowed to charge. This system has encouraged the spending needed to maintain the networks of power lines and substations required to keep the country running. However, it leaves limited incentives for the companies to invest with a time horizon beyond the next five-year price control period.

The business of building power stations and generating electricity is more amenable to the use of market mechanisms. In theory, if generation capacity is constrained, electricity prices tend to rise. In the short term, more generation capacity will come online to increase supply. In the long term, new capacity will be built as companies see the investment in power plants as yielding an attractive return on capital. In reality, the lead time for building new generation capacity is between 3 and 15 years depending on the type of plant you build. Energy companies won’t authorise the investment unless they are sure they will get a good return – so they wait until prices are already elevated before building new capacity. This is what is happening now in the UK electricity market.

Old power plants, in particular nuclear plants, are being shut down and decommissioned. At the same time, demand for electricity is slowly but steadily growing. Prices have risen, allowing energy companies to make higher profits, but new capacity has not yet been installed.

This is the natural course of events you would expect in a system based on market mechanisms, but it leaves an uncomfortable feeling in a lot of people’s stomachs. After all, electricity is pretty much an essential good, so it feels wrong that someone can profit from people’s most basic needs – but that is a fundamental aspect of a market-based economy. The most obvious alternative – nationalised energy companies – is not really a viable answer – so we may just have to get used to energy companies making high profits over the next few years.

Thursday 29 September 2011

Is the Scalability Principle behind increasing inequality in the UK?

At the Liberal Democrats’ party conference last week, Vince Cable highlighted the growing level of income inequality in the UK. While on average, the economy is growing, the benefits are disproportionately going to those who are already at the top of the ladder.

I thought I would dig into the topic of inequality a little deeper and I found this website with informative data on income and wealth disparity in the UK. It was quite shocking to learn that the poorest 10% of the population have not seen a rise in their average real incomes in the last decade, and two fifths of the real increase in incomes went to the people who were already in the richest 10%.

This trend isn’t just affecting the UK. According to Wikipedia, the Gini coefficient (an econometric measure of income inequality), has been rising since the 1980s in the USA, China, India and Brazil as well as the UK.

Why might this be happening?

One contributing factor could be the ‘Scalability Principle’ which I wrote about earlier this year. Scalability is a quality of certain tasks which means once they are performed once they can be replicated (‘scaled up’) millions of times with little marginal cost. A hundred years ago there were relatively few scalable professions. But technological advances in general, and computing in particular, has greatly increased the number of scalable professions. In this sense technology has increased the number of fields with a ‘winner takes all’ reward structure.

We need to think carefully as a society about what level of wealth disparity we are willing to accept. And if we feel things are already too unequal, perhaps we need a new approach towards what we think of as ‘progress?’

Tuesday 6 September 2011

'Multi-layered' problems are best solved with a touch of Obliquity

On a recent flight across Europe I read John Kay’s recent book Obliquity. Short and easy-going, the book focuses on the idea that solving problems using ‘direct’ methods based on logical deduction and algorithms often results in an imperfect solution. In many cases, he points out, an indirect or ‘oblique’ method arrives at a better solution.

As an example, someone travelling across London may, out of habit, look at the Tube map and travel from their starting point to the station closest to their destination. However, this direct method may be inappropriate in the cases where it is actually quicker to walk than take the Tube*. Kay relates how he once took the Tube from Paddington to Lancaster Gate because he didn’t realise how close the two are above ground (Londoners reading this should be smiling at this point).

He applies this ‘Obliquity’ principle to many problems with varying degrees of abstraction. For example, he suggests that ‘the most profitable companies are not the most profit-oriented’ and ‘the wealthiest people are not the most materialistic.’ He goes on to attempt to explain reasons why indirect solutions beat direct ones so often, bringing the concepts of complexity, incompleteness, abstraction and pluralism into the narrative.

To Kay’s list of reasons why direct, supposedly-rational approaches to problem solving fail I would like to add one contributor: the ‘multi-layered’ nature of most tricky problems. Often we approach a problem with one line of thinking, but as we investigate further we find further layers of complication in the problem. In that sense, tricky problems are like onions. However, as you peel away layers of an onion you can tell when you’ve found the core. Problem-solving is not like that: you never know whether you have reached the ultimate level of understanding or whether there is another level of complexity beyond your grasp.

One of my favourite examples of the ‘multi-layering’ of problems is the debate over energy efficient light bulbs (abbreviated to EE bulbs henceforth). Let’s start with the proposition ‘anyone who switches to EE bulbs will save energy.’

At the most basic level one might conclude that this is true, as by definition EE bulbs use less energy to produce the same amount of light as normal bulbs. But let’s look a level deeper. The additional energy used by non-EE bulbs is released as heat. This is normally considered to be wasted. But what if you get your heating from electrical heaters anyway? If you do, then switching to EE bulbs will mean you need to put your electric heating on more, thus you do not save energy. You may even end up using more.

I’ve seen this debate play out several times. Going a level deeper, one could argue that lightbulbs tend to be near the ceiling, and heat released at ceiling height just stays there, and is therefore wasted. But going a level deeper, one could argue that heat is mostly released by radiation and reaches all parts of the room. Ultimately the debate never gets resolved.

As John Kay points out in the conclusion of ‘Obliquity,’ the recent past is littered with examples of poor decision making by people in power. Clearly there is a long way to go before we really understand where we are going wrong. In the meantime, the pursuit of better problem-solving methods is a worthy goal.

*I love this innovative re-design of the Tube map, which depicts relative geographic lay-out of stations more accurately.

Monday 15 August 2011

What Baseball has to Teach Us About Business Success - a Review of Michael Lewis' Moneyball

I’ve just finished reading Moneyball by Michael Lewis, a writer made famous by his banking classic ‘Liar’s Poker.’ One of the modern classics of sports writing, Moneyball follows the story of a baseball team, the Oakland Athletics, which employed the unorthodox tool of statistics to pick players and win games.

The way Lewis describes it, the vast majority of the baseball industry relies on experience, intuition, and tradition to make these choices. In a sport that generates a vast trove of statistics on players’ and teams’ performances, only a small group of fans, known as ‘sabermetricians,’ used to bother subjecting the data to hard analysis. This changed in the late 1990s when Billy Beane, general manager of the Oakland A’s, realised that to stand a chance against wealthier teams he would have to organise his team differently. Together with Harvard graduate Paul de Podesta he set about analysing baseball to determine, amongst other things, how you can use historic performance statistics to value players (and work out which attributes are underpriced in the market), and which tactics help you win games. On both these questions the conventional wisdom was wrong, and using their analysis Beane and de Podesta put together a successful team on a low budget.

I myself am not a big baseball fan, but I was drawn to the book by references to it in a number of modern business books. The story Lewis tells has some wider messages that resonate far beyond the baseball diamond.

1. When used properly, statistics can be a goldmine

The rest of the industry were not ignoring statistics. They were simply focussing on the wrong ones. They had never subjected the raw data to a statistically valid analysis using the tools of probability, hypothesis testing and regression analysis. This attitude – taking basic statistics such as means, medians and ranges – leads to simplistic conclusions and overlooks the value of deeper analysis. Proper use of statistics can give a business an advantage over its competitors. It can also have great effect in non-competitive sectors such as public services or international development.

2. When a competitor is being unexpectedly successful, don’t dismiss this as an aberration

This is a mistake big businesses make all too often. They assume that a competitor’s success is down to luck, temporary trends, or the unique success of a single initiative or product. While this might be true, a competitor which consistently outperforms is probably doing something substantially better than you. There is no denying that baseball contains a strong element of luck. So when the Oakland A’s had a couple of good seasons, competitors were not too concerned. However even when the A’s continued to outperform year after year, with ‘winning streaks’ of historic length few competitors stopped and questioned how they did it. Even after Moneyball was published, much of the industry remained in denial about the power of statistics.

3. Don’t just accept the conventional wisdom – and don’t be afraid to look for a new way

The conventional wisdom in baseball was that you need to hire star players to make a team better. Billy Beane did not have the budget to hire stars – but he didn’t accept the conventional wisdom either. He looked for another route to success – one his competitors would have overlooked – and he found it. This is a step that many successful businesses, investors and entrepreneurs have taken, ranging from Toyota reinventing the way car production is organised to Apple’s launch of the iPad, a product in an entirely new category overlooked by every other electronics firm in the world.

As a book Moneyball has a great deal to offer sports fans in general and baseball fans in particular. But it also contains lessons that are useful to a wider audience, namely: look to the numbers, and if they conflict with the conventional wisdom, then the conventional wisdom is probably wrong.

Monday 25 July 2011

Why I'm a fan of 'The Seven Habits'

A few weeks ago I had dinner with an old friend. Having noticed my reviews of several business books, he asked me to recommend my favourite ever book on ‘personal effectiveness.’ I didn’t have to think for long before responding: the book I have found most compelling has been ‘The Seven Habits of Highly Effective People’ by Stephen Covey.

I’m not an expert on the ‘success’ and ‘self-improvement’ literature, but I’m not a cynic either. Several of my friends would never pick up a book of this genre, believing that they’re aimed at people who have low self-esteem, who lack confidence or who otherwise feel that they are in some way flawed. While some proportion of self-improvement books is aimed at this kind of audience, I have found many titles with a lot to offer readers who are already confident and well-adjusted individuals.

‘The Seven Habits’ is one of these. It has several great things going for it:

  • Stephen Covey is an expert in what he is writing about. He has a thorough knowledge of the existing success literature which he has studied at length. His depth of knowledge shows through in what he writes.
  • Covey acknowledges up front the low quality of much of the self-improvement literature. He has a clear disdain for books that promise a ‘quick fix.’ This honest approach make much of what he recommends that bit more compelling.
  • His writing style is very accessible; he illustrates all his points with anecdotes either from his own experiences of those related to him by others. This puts all of his ‘Seven Habits’ into context and prevents the book becoming dry and overly theoretical. He includes some ‘thought exercises’ which engage the reader, but not to the point it reads like an instruction manual.
  • The content itself makes a lot of sense, but without coming across as something obvious. Each of the ‘Habits’ stands up by itself as useful advice. Added together, they mesh into a sensible structure giving an overall picture which is more than the sum of its parts.

The one thing I can see putting off some readers (particularly English ones) is Covey’s earnest tone. To quote Kate Fox’s classic, ‘Watching the English:
“At the most basic level, an underlying rule in all English conversation is the proscription of ‘earnestness ’… seriousness is allowed, earnestness is prohibited. …To take a deliberately extreme example, the kind of hand-on-heart, gushing earnestness and pompous, Bible-thumping solemnity favoured by almost all American politicians would never win a single vote in this country.”
With this health-warning aside*, I would highly recommend ‘The Seven Habits.’ Even if you have never thought of reading a ‘self-improvement’ book in your life, I think you would find it accessible, practical, stimulating and altogether a worthwhile read.

Notes: *In writing this I realise that this blog is sometimes guilty of excessive 'earnestness' (!)

Thursday 21 July 2011

How a Trip to the Pub Reminded Me, ‘There’s No Such Thing as a Free Lunch’

I’m always on the look-out for articles that educate, stimulate and generally challenge my view of the world. This week I found one in an unexpected place: the JD Wetherspoon pub chain’s company magazine. Sitting in the pub, leafing through the magazine, I was anticipating finding commentary on their latest pub openings and newest real ales. Instead I found myself reading an intelligent editorial piece on the troubles in the Eurozone by Tim Martin, Chairman of JD Wetherspoons.

While criticising the Euro is now in fashion due to the sovereign debt crisis, Tim Martin has long been opposed to the idea of the single European currency. He recounts in his article how he campaigned, in his capacity as a business leader, against its introduction in the UK. At the time, the accepted wisdom in intellectual circles was that the Euro would strengthen trade with Europe and would be an asset to the UK economy. He came up against politicians, economists and financial journalists all clamouring for its acceptance. But, along with hundreds of other citizens who rejected the idea of surrendering more powers to bureaucrats on the continent, he vocally rejected the Euro.

He characterises the debate over the Euro as pitting the intellectual elite, with their neoliberal economic agenda, against the ordinary citizen who values local freedoms (such as the control over our own currency) more highly than the theoretical benefits of global integration. And in the case of the Euro, his side appears to have won.

This got me thinking whether simple, unsophisticated, folk wisdom might triumph over complex theorising in other areas of business and finance. For example, how much management theory applies in real life? Do economic models include too many assumptions to really reflect reality? Is all the effort we spend making quantitative forecasts really much better going with your gut feeling?

One piece of folk wisdom that the world of business and finance would do well to learn from is “you can’t get something from nothing” (or, more familiarly, “there’s no such thing as a free lunch”). This simple maxim seems to have been forgotten in the pursuit of quick profits – but the profits prove illusory when the hidden costs are taken into account. For example, in business, switching to a cheaper supplier might seem like an easy win – but no switch comes without risks that might end up costing you. In finance, increasing your leverage is an easy way to flatter your return on equity – until a crunch arrives and you wind up with nothing. In economics, keeping interest rates low seems like an easy win in terms of stimulating the economy – but excess credit sows the seeds of the next bubble.

How the Eurozone debt crisis plays out will be fascinating and potentially terrifying to watch. As such, I am thankful to Tim Martin and others for opposing the Euro in the UK. And I am also grateful to him for reminding me that even the best theoretical ideas frequently fall flat on their faces when confronted by reality.

Tuesday 12 July 2011

The Trouble with Financial Services: Why Regulators Fail

Last year I wrote about the difficulties inherent in organising healthcare services. Another industry with in-built instability is financial services. Several characteristics of this sector make it especially difficult to regulate effectively. I have explored some of these below.

Financial regulation is in a constant state of tension between two approaches. The ‘Laissez-faire’ (i.e. hands-off) approach advocates minimal interference, based on the assumption that the best interests of society are served through free markets. The alternate approach (‘interventionist’) suggests that free markets often act irrationally; they require close supervision and restrictions to avoid damaging financial crashes, amongst other problems.

The decision of where in the regulatory continuum between these two extremes a particular regulator should sit is fraught with difficulty. I’d like to draw attention to four particular problems.

1.) Complexity
Financial systems are full of feedback mechanisms that we don’t completely understand. The actions of millions of market participants combine to set asset prices, provide capital and transfer risks. What happens in the markets affects their behaviour, which in turn has an effect on the markets. George Soros calls the feedback patterns ‘reflexivity’ and blames the recent financial crisis on it.

Complexity in the markets might be seen as a good reason not to intervene, as regulators’ actions are liable to have ‘unintended consequences’. However it could also justify interventions which prevent increases in complexity (such as restrictions on derivative products). Regulatory rules may also help companies deal with the unexpected (such as capital requirements for banks). Market complexity is a double-edged sword that makes regulators’ jobs extremely difficult.

2.) Revolving Doors
The Oscar-winning documentary ‘Inside Job’ highlights how top roles in financial regulators are frequently filled by ex-bankers. This isn’t surprising, given the specialised knowledge these roles require. However it can reasonably cause concerns about conflicts of interest. Social ties, political contributions, and the ‘revolving doors’ between jobs in regulation, banking, and lobbying create strong disincentives to individual regulators taking hard line.

3.) Race to the Bottom
Financial services firms can base themselves where they like. As a result, some countries try to attract them by offering low regulatory burdens. The risk that firms will flee financial centres such as New York or London is a major disincentive to regulators in the US and UK from tightening up their supervisory regime.

4.) Financial Innovation
As Merton H. Miller explained in his 1986 paper on Financial Innovation, “the major impulses to successful financial innovations have come from regulations and taxes.” More specifically, financial institutions use new products as a way to get around regulatory restrictions, rendering them ineffective. (As an example, the US withholding tax on interest payments remitted abroad triggered the creation of the market for Eurobonds, to allow US firms to raise money outside of the US.) In addition, continuous financial innovation makes it extremely difficult for regulators to stay up-to-date with the latest financial instruments being created.

This is a very cursory treatment of a subject that could inspire whole volumes. I am sure I have missed out other important reasons behind the difficulty of regulating financial services. Ultimately, it will be the widespread recognition of these potential roadblocks to effective regulation that allows us to make progress overcoming them.

Wednesday 22 June 2011

Too Big To Fail - The British Brains Behind the US Response to the 2008 Financial Crisis

I’ve recently read Andrew Ross Sorkin’s book on the Global Financial Crisis, “Too Big To Fail,” often described as the definitive account of how the events unfolded. It starts with the emergency rescue of Bear Stearns in March 2008, then plots the series of decisions which ultimately led to the collapse of Lehman Brothers, the takeover of Merrill Lynch by Bank of America and the bail-out of the banking system.

While I lived through these events and followed the press coverage eagerly at the time, the book sheds a fascinating light on the behind-the-scenes manoeuvring of the Wall Street CEOs and the government regulators. It has changed my perspective on some of the decisions that were made and reminded me of the magnitude of the task that was asked of the leaders in the banks, the regulators and the government.

One of the biggest changes in my view on the matter is a new-found respect for how effectively the British regulators reacted to the crisis, in comparison to their American counterparts. On a long list of issues, the British government and regulatory bodies took decisive action that the American regulators would not stomach – yet in many cases were later forced into copying.

  • In the weekend before Lehman Brothers collapsed, Barclays was in negotiation to take it over. I didn’t realise before that this was blocked by the UK government. If a deal had gone through, Barclays could ultimately have been jeopardised, so it seems in hindsight to have been the right call.*
  • In late 2008, when it became clear that wide-scale action was needed to help banks survive the write-downs on bad debts, the US government was planning to buy the poor-quality loans directly from the banks. This was the plan that was ‘sold’ to Congress. However, in practice it is barely workable – the government just does not know how much to pay for the loans. The solution was instead to make capital injections directly to the banks in exchange for an equity stake: the US chose this route after it had been successfully implemented in the UK.
  • In a twist of irony, the UK bail-out was optional and several banks (including Barclays) were sufficiently strong they did not need to take government funds. In the US, which loathes government interference with ‘free enterprise,’ the top nine banks were forced to take bail-out funds (so that the weaker among them didn’t look bad).

The UK has a long history of showing leadership in the fields of economics and finance (I’m thinking in particular of the great economist J.M.Keynes). Reading this book made me realise that the UK still has an edge in these fields – one that will be required going forward as the country faces continuing challenges from fiscal tightening at home, the Eurozone debt crisis, and many other problems on the horizon.

*Barclays later acquired the US broker-dealer unit of Lehman Brothers out of administration, getting the bit of the business they wanted at a knock-down price

Sunday 12 June 2011

Why we shouldn't follow America's lead, as far as "justice" is concerned

A series of pieces in the media have focussed my attention in recent weeks on the shockingly high proportion of US citizens who are incarcerated. It started with an article in The Economist about high rates of repeat offending:

“One in every 100 American adults is in prison or jail, one in 31 is under correctional supervision – and after their release, most will find themselves back behind bars. According to a new Pew report, 43% of American offenders are returned to their state prison within three years of their release.”

The article goes on to describe a number of programmes which are having varying degrees of success at cutting re-offending rates. It also points out the enormous cost of the prison and jail system - $60 billion per year: “a year’s stay at a state prison costs about $45,000 – Harvard would be cheaper.”

A few weeks later I noticed this fascinating documentary by Louis Theroux, in which he visits Miami’s biggest jail and interviews several of the inmates. This is the establishment where alleged criminals are held prior to trial, so from a legal standpoint every inmate is innocent (until proven otherwise). Nevertheless they are subject to abysmal living conditions with twenty people to a cell, and a brutal dog-eat-dog culture where beatings are an everyday occurrence. Those convicted then face a further stint in prison. Given the casual aggression which is part of the daily life in jail, it is easy to see why parolees trying to re-enter society have trouble fitting in.

Another facet of the ‘prison dilemma’ was described in a cover article in last weekend’s Financial Times. Economist Martin Wolf wrote about a new report by the Global Commission on Drug Policy which calls for an end to the escalating, destructive war of drugs and adoption of a policy of treatment rather than criminalisation.

“The policy on which the world has engaged for decades, at the behest of the US, is a disaster. While failing to reduce the ills of drug use at which it is addressed, [the ‘war on drugs’] has created massive collateral damage: the spread of avoidable diseases; use of drugs in dangerous forms; mass criminalisation and incarceration; a gigantic waste of public resources; corruption; creation of a cross-border network of organised crime; and the subversion of states.”

Prohibition, he points out, simply doesn’t work: where there is demand, there will be supply, and waging a war against the supply chain is pointless when the root of the problem is in your own back-yard.

Clearly something is amiss with the American system of so-called justice. As Martin Wolf, Louis Theroux and the Economist make clear, the system which the US has constructed is not one which the rest of the world ought to imitate. And it is one that, over time, most Americans will surely realise is economically and socially unsustainable.

Tuesday 31 May 2011

Sunk Costs, Trashy Novels and Good Behaviour

Anyone working in finance is likely to be familiar with the concept of a ‘sunk cost,’ but the idea has some interesting wider applications.

The term describes an expense that has already occurred and should therefore not be considered when appraising the costs and benefits related to a possible investment or project. For example, if a pharmaceutical company has spent £500m developing a drug which would then cost £100m to manufacture and generate £400m in sales, the decision over whether to manufacture would be based only on the latter two figures: £400m sales less £100m costs would give a £300m profit. The £500m spent on development is considered a ‘sunk cost’ and so doesn’t form part of decision over whether to proceed. While in this example the outcome is clear, the concept of a ‘sunk cost’ is somewhat non-intuitive.

Outside of finance, the idea gets little recognition, but it can be just as useful in making decisions. Often people ignore the fact that an expense already incurred is a sunk cost, and as a result may not make the best use of their time or their cash. Have you ever done the following?

  • Been to a show or event or on a holiday just because you had bought the tickets, even when you didn’t feel like doing it anymore?
  • Sat through a movie you realised was rubbish or finishing read a book you weren’t enjoying, just for the sake of getting to the end?
  • At an ‘all-you-can-eat’ buffet, eaten so much you felt sick?

A clear indicator of someone ignoring a sunk cost is when they say, “but… I want to get my money’s worth.” But this is a logical fallacy if it means continuing with something you wouldn’t otherwise do.

On the flip side, the concept of a sunk cost can be used to encourage positive behaviour. In fact by realising that we feel compelled to “get our money’s worth” we can manipulate ourselves into healthy or beneficial activities. My favourite example of this is my monthly gym membership. Based on my average attendance at the gym twice a week, it would cost the same to either pay a monthly subscription (with unlimited use) or pay individually for session I attend.

From one point of view, paying ‘per session’ gives me added flexibility by not being tied into a monthly contract (in economic terms I have “option value”). However, I know that if I pay a marginal sum for each session this gives me a disincentive to go to the gym. And if I pay a monthly subscription, I feel compelled to go, in order to “get my money’s worth,” and so I'm using this little behavioural bias in my favour.

So next time you go to a buffet, just remember it’s “eat as much as you like” and not “eat as much as you can:” it’ll save you the indigestion and won’t cost you a penny more…

Monday 16 May 2011

The Four Hour Work Week: redefining success

Further to my last post on Richard Koch’s “The Star Principle,” I have also recently read a much more widely known book, “The Four Hour Work Week” by Timothy Ferriss.

The Four Hour Work Week (aka The 4HWW) takes a more revolutionary approach to seeking success than The Star Principle. It describes in detail the four steps you need to take in order to free up your time, yet maintain an income level that will let you live comfortably (preferably travelling the world). The book’s subtitle is “Escape the 9 to 5, Live Anywhere and Join the New Rich” and as unlikely as that sounds, the text is an audacious step-by-step how-to guide to do just that.

Step 1 Definition: Start out by getting rid of your preconceptions about what is and what is not possible. Define your dreams – and define what is ‘worst thing that could happen’ if you gave up your job to go and pursue them. If the subsequent steps go right, you won’t need to give up your income. But you have to realise that you could start again from scratch if you needed to.

Step 2 Elimination: This is a set of tips and techniques to multiply your productivity. Much of this will be familiar ground to people who’ve read other business classics – the “80:20” principle makes an appearance, as does the importance of not mistaking urgency for importance and the amount of time that can be saved by not reading the news. Ferriss is an advocate of ‘batching’ activities like checking email, voicemail and social networks – cut it down to once a day at first, then once a week.

Step 3 Automation: Ferriss’s sees the aim of entrepreneurship as ‘Income Automation’ rather than building a business empire. This is a notable divergence from Koch’s approach in The Star Principle, which is about building the biggest business possible. This step outlines how to start an online business with relatively little risk, using Pay-per-click advertising to assess demand for a product, then outsourced production and distribution to scale it up. For a budding entrepreneur it contains lots of hints and tips and although it doesn’t make it sound easy, it does come across as achievable.

Step 4 Liberation: This section of the book addresses the part of the title ‘Escape the 9-5 and Live Anywhere.’ Ferriss gives some tips on negotiating a remote working arrangement, and then how to live abroad on a low budget. He recommends taking successive ‘mini-retirements,’ on the basis of ‘why save it up to the end of your life?’

Rather than set out to make you wealthy, the main aim of Tim Ferriss’s method is to free up your time. It is less about becoming a millionaire than about living like a millionaire.

“$1,000,000 in the bank isn’t the fantasy. The fantasy is the lifestyle of complete freedom it supposedly allows. The question is then, how can one achieve the millionaire lifestyle of complete freedom without first having $1,000,000?”

I am more sceptical about this book than I am about The Star Principle. But this message – that the success should be defined in terms of lifestyle and not net worth – is a powerful one that it is easy to forget.

Wednesday 11 May 2011

Richard Koch's The Star Principle: the Business of Winning

I recently read “The Star Principle” by Richard Koch, (businessman and the author of “The 80/20 Principle,” one of my favourite books). In it, he describes a powerful and convincing recipe for identifying successful businesses. I can recommend reading the book but for those who don’t have the time here’s my summary of it:

A star is defined as a business which is the #1 player in its market niche, and its market is growing fast (at least 20% - 30% per year). These two simple characteristics, set apart the business success stories, which make their backers tens of millions of pounds, from the run-of-the-mill businesses that just about breakeven but never make anyone rich.

  • If you are founding a business, look for a gap in the market where you will be number one from the beginning. And look for a niche big enough that you can sustain rapid growth for many years. Once you establish a leadership position, do everything you can to retain it. More importantly, if you fail to get a leadership position, or you find your niche is not as big as you thought, it is better to cut your losses and direct your efforts elsewhere.
  • If you are an investor, look for embryonic star businesses that you can back, where you can have an active say in their management (and ensure they remain stars).
  • If you lack the resources to found or invest in a business, try your utmost to find a star business and go to work for them – the ‘first 20 people’ in on the ground floor can reap the benefits later on by getting shares or options. What’s more, working for a star business is much more fun and a much better learning experience than working for big corporates.
Koch exhorts every reader to try one of these three: found, invest in or work for a star business.
“Between 95% and 99% of businesses are not stars. For every 20 ideas you have, you can confidently junk 19 of them, because they won’t be ideas for a star venture. This saves an awful lot of money, sweat, toil and tears. Star ventures are rare...but they contribute over 95% of long-term value and probably at least 120% of the cash ever generated.”
Now every ‘recipe book for success’ needs to be read from a critical perspective (with ‘a pinch of salt’ if you will). Most importantly, if someone has found a foolproof method to ‘get rich quick’, you would reasonably expect them to spend their time executing their method, not writing about it. Well Richard Koch has already proved his entrepreneurial and investment credentials. As he describes in the book, it was his experiences with a diverse range of start-up businesses that allowed him to refine his idea of a ‘star business.’ He has been involved in five successful start-ups and made over £100m. “Koch is someone worth listening too,” wrote the Independent; this book is worth a read, as soon as you get the chance.

Saturday 30 April 2011

Think Globally, Act Locally

This week I almost did not write a blog post. I have spent time instead on writing to a building contractor about safety problems at a nearby roadworks site. I’m not a prolific ‘letter-writing’ individual, but I observed a lack of safety procedures which I could see was putting cyclists at risk, and I felt the need to tell the company about it. Thankfully the contractor has now corrected the main safety problem, and has written on their website about an updated safety policy to avoid the same problem recurring.

The reason for me relating this, is that it reminded me of maxim that I first came across about 6 years ago: “Think globally, act locally.”*

I read this when (aged 17) I was trying to find out what ‘postmodernism’ means**. It was used in the context of the struggle of the individual to have an impact on the world. We all learn about the world and wish there were ways we could change it, but only a very few ever accumulate the power required to have a significant impact on ‘the world stage.’

This is where the imperative “act locally” becomes so powerful. If we do what we can to improve our communities, to hold our leaders to account, and to generate positive change on a local level, we can live in hope that others elsewhere in the world will do the same. It is important to “think globally” to develop an idea of what our society ought to be like, and that is one of the aims of this blog. But it is equally important not to neglect to act, when we get the chance, and to try and make our local realities a bit closer to the ideals we aspire to.

*A quick google search reveals that the phrase has its own Wikipedia page, and is attributed originally to the Town Planning profession. Since then it has become a recurring theme in discussions about globalisation.

**for the record, I’m still trying

Wednesday 20 April 2011

Should employees provide financing to their employers?

John Lewis recently made the headlines by raising £50m from offering savings bonds to their own staff and the general public. In exchange for investments of between £1k and £10k, bondholders will receive 4.5% p.a. cash interest, and 2.0% p.a. in shopping vouchers.

There is a clear rationale for borrowing from customers. Last year I wrote a post applauding Hotel Chocolat’s financial innovation when they raised capital using ‘chocolate bonds.’ The razor blade manufacturer King of Shaves employed a similar method to raise finance, offering bondholders free shipments of razors in addition to interest payments. As long as customers realise that these are (somewhat) speculative investments with a high return on capital, they bring benefits to both parties.

The John Lewis bond is a good opportunity for regular customers to get extra value out of their savings. However I am less sure of the wisdom of raising capital from your own staff. The very first topics I chose to write about when I started this blog last year was the collapse of Enron, which was brought down by widespread accounting fraud. A large number of Enron employees had invested their life savings in Enron shares (encouraged by its CEO Jeff Skilling) and when it went bust they were left with nothing: no income and no savings.

For senior executives, tying up large amounts of their savings in company shares is the norm, as it gives other investors confidence that they are incentivised to maximise the value of the company. If the business fails, they lose a lot, but they will typically have a some of their (high) net worth in cash, and will reasonably be able to ‘start over.’ For regular employees, this is not necessarily the case. The link between their personal performance and the company’s performance is weak-to-non-existent, so the ‘incentive’ effect of investing does not hold. If the business fails, they have everything to lose. My last post on the retail sector explains just how easy it is for some companies to run into financial difficulties.

One of the first rules of investing is to diversify your holdings to spread the risk. An employee is already heavily exposed to their employer’s growth or decline. Perhaps investing their savings as well just puts too much risk in one place?

Monday 11 April 2011

Retail woes and the 'Working Capital Trap'

The retail sector has made the headlines for all the wrong reasons in the past month. Sainsbury’s has missed sales forecasts, HMV in trouble with its banks, and Oddbins has gone into administration.

Wondering what is behind these kinds of problems, I decided to take a look at HMV’s financial statements. An inspection of HMV’s capital structure at April 2010 is quite revealing:
Total Equity: £100m
Total Liabilities: £605m
-------Of which: Interest bearing debt: £96m
--------------------Trade payables:£442m
-------------------------Other liabilities: £67m

The capital that sits behind a company is like the structural support holding up a skycraper. Equity capital is like the foundations on which the company is based; debt finance the reinforced steel beams allowing the tower to reach for the sky. The balance between equity and debt is critical. If you build too high without solid foundations there’s a risk the whole building could collapse – especially if the wind blows too strongly.

Retail businesses are unusual as their largest source of capital financing is their suppliers (‘trade payables’ above). Big retailers don’t pay their suppliers for 60 to 90 days after receiving goods, but when customers buy products they often get the money immediately. In effect, the suppliers are providing interest free loans. It is a form of ‘leverage’ which allows management to build a company on a thin slice of equity capital.

This business model works perfectly well as long as sales volumes are growing. The cash coming in from sales in any given month is higher than the amounts owed to suppliers for sales in the previous month. Sales can grow without the need for any additional equity investment. However, if sales stop growing, suddenly the amounts owed to suppliers exceeds the cash received from sales. The company finds itself in a ‘working capital trap’ where it suddenly needs to find a lot of extra cash, either in the form of an equity injection or a bank loan.

In its Annual report in April 2010, HMV was still showing revenue growth. But in its interim report in October 2010 it reported an 11.5% drop in like-for-like sales. The urgent need to find more working capital is what's thrown doubt on its ability to meet banking covenants, and caused it to seek further financing from its suppliers. I will be watching with interest to see how this story progresses - but I don’t plan on investing in HMV shares any time soon.

Tuesday 29 March 2011

Earthquakes vs Automobiles: which to worry about more?

At the time the earthquake, tsunami, and nuclear disaster in Japan began, I was travelling in the US. The images of devastation were horrifying, and the video footage of the wall of water washing away buildings was particularly harrowing. Like many people around the world I have been asking myself ‘what if a disaster like that hit my city?’

Interestingly, much of the media coverage in the US focussed on the nuclear reactors. After the tsunami knocked out their cooling systems, they began overheating and several explosions and significant radioactive leakage followed. (As I write this, the efforts to stabilise the reactors are ongoing and the extent of the radiation pollution is unclear.) The American newspapers were speculating over whether such an event could occur in the US and talkshows were filled with opinion pieces suggesting that nuclear energy should now be phased out.

In my opinion, this focus on the risks posed by nuclear reactors puts a distorted view on the matter. The BBC website published a good article on mis-perception of risk, and why ‘radiation’ is seen as inherently dangerous despite the fact we utilise it safely in everyday life. The fact is, in this tragedy the number of deaths from the earthquake and tsunami greatly outnumbers the casualties from the nuclear disaster (at least, so far). If there is one important message from this it is to prepare for natural disasters, even if they are infrequent. Japan’s high structural standards for buildings prevented the earthquake damage from being much worse; many Pacific rim countries have much more lax standards.

Moreover, the risks posed by natural disasters are orders of magnitude lower than more mundane risks involved in everyday life. Road deaths, of drivers, passengers and pedestrians, greatly outnumber the deaths caused by large scale disasters (E.g., in the US there are c.40k traffic fatalities each year*). While I was in the States, I was reflecting on how their grid-based layout for cities requires pedestrians to cross a great number of roads. And in urban areas such as Manhattan (pictured) there is no distinction between major roads, where cars can drive fast, and minor ones; as a result most cars drive fast most of the time. If pedestrian safety took a higher priority (e.g. by lowering and enforcing speed limits, and pedestrianising city centres) more people might walk rather than drive in US cities making it a win for public health as well as safety.

In the wake of traumatic events it is easy to overreact. However a level-headed approach to assessing risks is critical if we are to make the right decisions to prepare for tomorrow’s emergencies.

*Automobile risks are discussed by Steven Levitt and Stephen Dubner in their book Superfreakonomics, in which they describe Robert McNamara’s efforts to get seat belt use enforced. ”Since 1975, [seat belts] have saved roughly 250,000 $25 a pop, [they] are one of the most cost-effective lifesaving devices ever invented.”

Sunday 20 March 2011

The Three Routes to Mass Customisation

A major area of innovation in the 20th Century was the development of ‘Mass Production.’ A mixture of technological advances and managerial methods came together to enable the cheap manufacture of consumer products. This enhanced the quality of life throughout the world and had a strong influence on social trends and culture. [A typical Mass Produced product is the McDonald’s cheeseburger; each one is identical and economies of scale make them cheap to produce (further catering analogies will follow!)]

In the 21st Century it looks as though an extension of this trend is occurring, though with a new twist: ‘Mass Customisation.’

Getting products tailored especially for oneself has always been possible for wealthy or powerful individuals, while the majority had to make do with the most basic options. A new set of trends are making it possible to provide everyone with customised products. There are three important routes to mass customisation – and I will mention in turn the progress being made in each.

The first and most obvious route is customised manufacture: the bespoke, ‘one-off’ designed especially for one person. If we think of McDonalds as the archetypal ‘mass-production’ catering service, the Custom-Made foodservice would be a Wedding Caterer. The buyer gets to be creative and individualistic in what they order, and no two end products are quite alike (Bespoke suits and medical implants are two further examples.) Traditionally, Custom-Made meant ‘more expensive,’ however a recent Economist article on 3D printing highlighted the advancement of this revolutionary technology. The game-changing attribute of 3D printing is that making every product slightly different has zero impact on the cost of manufacturing. If the cost of this production method decreases to make it competitive with traditional methods (which The Economist suggests is already happening) then Custom-Made will become a possibility for everyone*.

The second route to a customised product is not at the manufacturing stage but at the assembly stage. All the components are standardised, but the configuration is selected by the customer. The catering analogy I would use for this is Subway, where you choose a filling, salads and sauce from a pre-defined menu of options. The number of possible permutations is vast, but not infinite (as it is with customised manufacture). This route is also used by Dell computers, who gained a valuable edge on their competitors by using an ‘Assemble-to-order’ business model, thus reducing the costs of obsolescence and increasing customer satisfaction. This method of customising products is a relatively recent phenomenon and still has a long way to run.

Thirdly, customisation can happen at the point of use. From a manufacturers’ point of view this has the advantage that they can turn out standardised products, and leave the cost of customisation up to the customer. The relevant catering illustration of this would be a buffet restaurant: the kitchen churns out lots of dishes and every diner can then ‘design’ the meal they want from the options available. The product that is consumed (the food chosen on the plate) is uniquely tailored to the particular customer, but the customisation has been done by the customer and not the restaurant. In the pre-digital era, there were not many products falling into this category. However digital devices such as personal computers, smartphones, and tablets are all highly customisable; their capabilities depend strongly on the software that is loaded on them. From a user’s point of view, an iPhone is tailored to their specific requirements, by virtue of the apps they have installed - this is a strong part of their appeal. But Apple has not borne the costs of this customisation.

Developments at these three stages – Manufacture, Assembly and Use – are allowing much greater choice at much reduced cost. As a result, Mass Customisation is a trend that could come to define the 21st century.

*As for bespoke clothing, this is already within economic reach of the majority of the Western population. As I discovered in Shanghai, a good custom-made shirt can be bought for c.£10 and a suit for c.£70. I believe that all it will take to bring bespoke clothing to the British high-street is an entrepreneur with the right approach.

Monday 28 February 2011

Does the future of capitalism lie in Creating Shared Value?

It has been the mainstream view for some time that the primary aim of a business should be to make money. But a recent article in Harvard Business Review has questioned this perspective. And it’s possible it heralds a wider re-thinking of business fundamentals.

In the Jan/Feb 2011 HBR, Michael Porter and Mark Kramer have written a landmark article on “Creating Shared Value,” which they herald as “The Next Evolution in Capitalism.” The main thesis of the piece is that companies have defined markets narrowly in terms of individuals’ conventional economic needs and overlooked broader ‘Societal Needs.’

Societal Needs include the need for a clean environment, a thriving local community, an educated population, and meaningful work. These things, Porter and Kramer argue, have been left up to governments and charities to worry about, or for CSR programs to address, peripheral to a company’s core mission. They point to examples of companies that have taken on some of these societal challenges and generated positive economic benefits from doing so. They encourage every business to redesign its value chain around creating shared value for both the company and society.

As I read the article I was at first sceptical that it represents anything particularly new in business thinking. Indeed, many scholars and activists have spent years lobbying business to take on greater social responsibility. But what this article may represent is shift in perspective within the mainstream. Michael Porter is considered one of the founding fathers of corporate strategy and this high-profile article is a rallying cry for change - one that just might be heeded.

Sunday 20 February 2011

What Ai Weiwei can tell us about the valuation of Facebook

When Goldman Sachs purchased a c.1% stake in Facebook for $500m, the figure that hit the headlines was the $50bn valuation for the whole of Facebook that the sale implies. But is the company really worth that much? Is it really fair to extrapolate from the valuation of a small stake to the fair value of an entire company?

Interestingly, the art world can shed some light on this. There is currently an installation in the Tate Modern by the Chinese artist Ai Weiwei made up of 100 million handmade pottery sunflower seeds. It is an imposing sight, with a mixture of possible symbolic meanings. It could be a commentary on China’s powers of mass production, or the scale of its population and relative insignificance of the individual. It might be a reflection on the power of nature or the beauty of simplicity. It’s probably about something else entirely. Luckily the symbolic meaning of the art is tangential to its relationship with Facebook.

When it was first opened the installation could be walked on by the public. It was later closed off, ostensibly for safety reasons. But with tightened security, it meant it was no longer possible to walk off with a pocket full of pottery sunflower seeds. Given the high profile nature of the installation it was clear that the seeds would become collectors items – and unsurprisingly there have been several seeds changing hands on Ebay. It was reported in the press that a single sunflower seed had been sold at auction for £28. This is where the link to Facebook comes in: If we apply the same valuation calculation to Ai Weiwei’s artwork, the whole work would be worth £2.8 billion, making it the most valuable artwork ever created*.

This valuation is clearly absurd! What it shows, though, is that the laws of supply and demand operate not just for commodities, but for fractional ownership stakes in a larger whole. Where demand to own a stake is high and the supply of stakes for sale is low, the price is naturally bid upwards. In my opinion it is this effect that lead to the high price for a small stake in Facebook. If the whole company were to be sold, for example in an IPO, I would expect a lower valuation than the $50bn+ reported in the press. But while its stock is privately held, the demand for it is so high that it will change hands for inflated prices. Fractional sales are a good way to create the illusion of a high valuation (see also Zynga, Twitter) - but as Ai Weiwei’s sunflower seeds demonstrate, this can’t be taken at ‘Face’ value.

*In an auction at Sotheby’s on 15th February, a pile of 100,000 seeds was sold for £350k. Based on this unit value of £3.50 per seed, the whole work is worth £350 million, still a record breaking valuation.

Saturday 12 February 2011

Updates on blog topics from 2010: 3D Cinema, Privacy and iPad adverts

Some recent news stories have added some new perspective to blog posts I wrote in the last year.

In May 2010 I wrote a post complaining about the terrible quality of the 3D visual effects in movies such as ‘Clash of the Titans’ where the decision to make it 3D film was taken at a late stage in the production process. Judging by this FT article on cinema revenues, it seems I was not the only one to be aware of poor 3D quality. My fears over 3D quality made me reticent to see several of the movies in the second half of the year. In my post, I wrote about the risk that studio execs would “kill 3D cinema” before it has been given time to find its place in the media landscape. This is a risk they still need to comprehend: the 3D fad in the 1950s faded into obscurity; it would be a shame to see history repeat itself.

In August I wrote a post discussing the decline of privacy in a socially networked world. Although this controversial issue is far from settled, the News of the World phone-hacking scandal has drawn a clear line in the sand. Celebrities are the leaders and trend-setters of society when it comes to balancing self-promotion with retaining some level of privacy. Through regular interviews, TV programs and paparazzi shoots we get to know the intimate details of many celebrities’ lives and for the most part they put up with it. But the press, in the form of NoTW reporters, have overstepped the boundary and are facing serious consequences, in the form of law suits, job losses, and jail terms. The upshot of this: it is reassuring to know that at some level, our privacy is still sacrosanct.

Finally in June I wrote a post praising the simplicity and sophistication of iPad adverts, which use screen shots of cultural content (e.g. Facebook, The Guardian) to convey the personality of their target consumers (e.g. young tech-savvy trend-setters). In 2011, a new set of iPad adverts can be found around London, with the same concept but different screen-shots. Most notable among this new crop of images is a shot from the website TED. Much like this blog, TED is dedicated to the propagation of interesting ideas. It is a non-profit organisation which videos lectures and performances by some of the world’s top thinkers and talents in a variety of fields. TED talks from the likes of Steve Jobs, Al Gore and Malcolm Gladwell (to name but a few) are free to view online. Historically these kinds of talks would only have been by conference attendees or MBA classes; now they are available to the world. With this advert, Apple have done it again, and given TED Talks a useful leg-up in the process.

Sunday 30 January 2011

The Search for Symmetry: How bankers' bonuses can set-up the wrong incentives

In my last post I described how the Scalability of transactions allows banks to pay large sums to attract the best people. But there is another feature of the bonus system that is equally fascinating, and goes some way to explain why banks suffered such massive losses in the 2008-09 financial crisis.

Bonuses are, by their nature, asymmetric. Employees get paid a base salary. Then those who perform particularly well may get a bonus on top. The ones who perform particularly poorly do not, as a rule, get a fine, or an ‘anti-bonus.’ The worst that can happen to them is they lose their jobs.

In non-financial jobs this asymmetry is not such a problem, as the contribution the employee makes to their company is also asymmetric. A great employee can create a lot of value for their firm, but a bad employee doesn’t destroy equivalent amounts of value. Take a law firm for example: highly productive associates may work lots of billable hours doing quality work. Their firm benefits from the work and pays them a large bonus to try and retain them. A poor associate, who works few billable hours and does poor quality work, will get no bonus, and may get the boot. But the poor performer is unlikely to lose the law firm a lot of money, as the work is quality-checked before it goes to a client – the deficiencies are noticed and rectified by the good performers.

However the financial sector, or more particularly the trading sector, doesn’t work this way. On investment banks’ trading desks, the banks’ own funds are put at risk by traders taking positions on the financial markets. If the desk makes a profit, the traders get a cut, which can lead to multi-million pound bonuses for ‘top performers’. However, if the desk makes a loss, the traders are not exposed to the downside. They may lose their jobs, but it is the bank that has to foot the millions or billions of pounds of losses. This asymmetry gives traders an incentive to make large and risky bets, whether or not they are the best thing for the investment bank’s bottom line.

This kind of behaviour is a key cause of trading scandals such as Jerome Kerviel’s €4.9bn loss at Société Générale. But moreover, it led to an accumulation of risky assets (such as securitised loans) on banks’ balance sheets, and helped sustain the over-valuation of these assets in the run up to the recent financial crash.

In the wake of the crash, banks and regulators are looking hard at how performance ought to be rewarded. Multi-year guaranteed signing-on bonuses for star performers are being phased out. More bonuses are being issued as restricted stock, which becomes worthless if a trader leaves the firm; this gives them a financial penalty if they lose their job, a kind of ‘anti-bonus’ if they perform particularly badly. Likewise with ‘clawback clauses’ that can retrospectively reduce a trader’s bonus if the positions they take turn out to make a loss in the long-term. These kinds of a reforms are a promising step in avoiding a repeat of the crisis; though they also add an element of the unknown and untried: I would not be surprised if the new set of incentives for bankers leads to some unintended consequences further down the line.

Sunday 23 January 2011

How the Scalability Principle can lead to a massive bonus

It’s bonus season again, so the media have rolled out their usual commentary on whether bankers really deserve the millions of pounds or dollars they are likely to be awarded. Alongside the emotional opinion pieces (both pro- and anti- the bonus culture) there are a few more analytical columns, trying to get underneath just why such large bonuses get paid and whether they work.

I find the easiest way to understand bonuses is the concept of ‘scalability’ which is explained very well in Nassim Taleb’s book The Black Swan. In most jobs, Taleb points out, the economic value produced is proportional to the ability of employee and the time they put in. A shelf stacker who is 10% faster than average can stack 10% more shelves in a one day shift, or finish an ‘average’ day’s work in 90% of the time. This is a job that isn’t scalable: even if you were much better than average you could not re-stock a whole store in less than one minute due simply to the physical constraints of the situation. It’s not just low-skilled jobs that fit in this category: Accountants, Lawyers and Management Consultants all do non-scalable work as the fees they are paid depend on the time they put in.

Scalability means that the work you do can be magnified or replicated many times over with no additional cost. A classic example of this would be an author, who, once they have written a book, can sell it thousands or millions of times over. However: people are picky about what they read, and only the very best authors are commercially successful. An average writer may not make enough money to live on. But one who is much better than average can make millions from a single book. This replicability is why singers, actors and footballers can earn such vast sums of money in relatively short periods of time. It is also why bankers can earn such large bonuses.

All the activities carried out by the ‘front office’ staff at an investment bank involve organising financial transactions. Transactions are easily scalable: if bond trader is able to make a profit by trading a volume of £10,000 then they could make one thousand times the profit just by multiplying the size of their trades. Similarly, in merger and acquisition activity, the effort required in a £10 billion deal is much less than 1000 times the effort required in a £10 million deal. This means that a banker who is only slightly better than average can make a massive difference to a bank’s bottom line.

Because all the banks understand this principle, the forces of supply, demand, and competition then kick in. The ‘going-rate’ for talented and experienced staff is established, and banks that don’t keep up with it will see their best performers jump ship to a competitor. This is the justification for bonuses most frequently cited by CEOs such as Bob Diamond. However without an understanding of the principle of scalability, it can be difficult to comprehend.


Nassim Taleb writes about the scalability of professions with the following health warning:
"If I myself had to give advice, I would recommend someone pick a profession that is not scalable! A scalable profession is good only if you are successful; they are more competitive, produce monstrous inequalities, and are far more random, with huge disparities between efforts and rewards – a few can take a large share of the pie, leaving other out entirely at no fault of their own."

Sunday 9 January 2011

Next generation entrepreneurs: coupling the growth of emerging markets with business ideas from the West

How do you become a successful entrepreneur? Amongst the many answers to this question, one thing that undoubtedly helps is starting your business in a growing market. Nearly all of the biggest entrepreneurial success stories involve rapidly growing markets: think of Microsoft (founded 1975) and Apple (1976) growing in the 1980s Computing boom; Amazon (1994) and EBay (1995) in the 1990s eCommerce boom, and Skype (2003) and Facebook (2004) in the 2000s Social Networking boom. Success in tackling mature industries is much rarer, though not impossible as proved by Sir Richard Branson, whose Virgin group has had major successes in both the Retail and Airline industries.

Many growth markets (those growing over 20% p.a.) in the Western world are the result of technological innovation. Except when a new technology triggers a wave of entrepreneurial activity, most business in the West is done by old and well-established firms (which typically grow less than 10% p.a.). The business hierarchy and supply chain structure is well understood; most corporate strategies are honed and fairly constant, and winners and losers emerge over decades. As a result, success as an entrepreneur is, for the most part, limited to the tech-savvy.

In comparison, in emerging markets the economic order is in a state of flux. A whole host of industries which are mature in the West are still in the process of being formed. In many cases, there are no ‘old and well-established firms,’ with new entrants appearing regularly. The winners and losers in these markets are far from clear.

One particular opportunity is to introduce business ideas that have proved successful in the West but do not exist in the emerging market you are targeting. For example, the most popular search engine in China is Baidu, a company often seen as an imitating Google’s successful search functionality. Last year the FT published an article about a group of entrepreneurs in Shanghai setting up a bar with the ‘Cheers’ theme, taken from Western popular culture. To me these are both effective examples of ‘Cross Cultural Arbitrage,’ where the value-add is in transferring a business model from one locality to another. It doesn’t involve doing anything ground-breaking, but it can lead to strong success. It requires a familiarity with several cultures, which a growing proportion of young people are developing through an education that spans two or three continents. I expect to see a great deal more of these kinds of business success stories, a positive impact of ever-increasing globalization.