Tag Archives: Finance

Young Idealist Reply

I wrote:

Humans … slowly gain competence over a lifetime, usually reaching peak productivity in our forties and fifties. … When people get idealistic, they tend to forget this. … They want to know how to most help the world in the next few years, not over their lifetime. … Young folks … should expect to prepare and learn while young, and then have their biggest influence in their peak years.

Alex Waller disagrees:

When I’m 50 I don’t really want the world to be the way it is now. I don’t want to bide my time and merely learn and network idly for another decade or two while someone else is responsible for enacting positive change in the world.

News flash: you are just one of seven billion, so you aren’t going to personally make much difference. The world will have nearly as many problems worth solving then as now, with or without your help.

Let’s say I was the CEO of a small corporation that developed medical devices. … A sustainable revenue stream requires projects with a variety of timelines. Similarly, I shouldn’t only invest my company’s resources in a project with a huge payout that will take 15 years.

The world already has a big portfolio of idealistic projects. If you want your life to be one of those projects, you should accept that it has a natural timescale. There’s a best time to invest, and a best time to reap returns.

Hanson elicits skepticism in the idea that social changes enacted now will positively impact the future, without justification.

I’m not skeptical of future impacts, just of their typically growing in impact faster than financial investments.

However, I’d counter-argue that his position is just as weak: name someone who is making better-than-inflation on their investments in the last 11 years?

The last few years have been quite unusual in finance. Feasible long term financial rates of return are higher than economic growth rates.

If I am to put off charity for 20 years to compound interest, why not put it off 40 years to compound even more? Why not put it off for 100 years?

Why not indeed? If you think that your personal monitoring adds much value, you might want to spend before you die, so you can personally monitor your charities. Else you might instruct your charity fund to grow until it seems that worthy causes are about to run out, or that investments no longer grow.

Hanson totally misguides when he suggests that Young Idealism is sexually motivated.

I said “signal one’s attractiveness to potential associates.” I didn’t mention sex.

Then what explains extra altruism in the old?

I said “people tend more to form associations when young.” This implies only that old folks have a weaker need to signal, not that they have no need to signal.

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Impatient Idealism

Humans have long lives. We are unusually dependent on our parents when young, and we then slowly gain competence over a lifetime, usually reaching peak productivity in our forties and fifties. Most of the time we are aware of this. For example, we count on our peak earning years by taking out loans as young students, and later saving for retirement. And we prefer leaders at those peak ages.

But when people get idealistic, they tend to forget this. Young idealists often ask me and others what they can do to most help the world. Which is a fine question. But such folks tend to be impatient – they want to know how to most help the world in the next few years, not over their lifetime. So when they consider joining an idealistic project, they focus more on whether the project will succeed than on what skills and contacts they would acquire.

Yet young folks shouldn’t expect to have their biggest influence when young. Yes young folks have higher variance, and so sometimes get very lucky, but they should expect to prepare and learn while young, and then have their biggest influence in their peak years. Why such a short term focus? Especially since idealism should if anything induce a far view. Yes young folks are often short-sighted, but why be more so about altruism than about school, relationships, etc.?

This seems related to the puzzle of why people don’t leverage the power of compound interest to donate to help the future needy, instead of today’s needy. Some argue that the future won’t have any needy, or that helping today’s needy automatically helps future needy, at a rate growing faster than investment rates of return. I’m pretty skeptical about both of these claims.

One plausible explanation is that a habit of extra youthful altruism evolved as a way to signal one’s attractiveness to potential associates. People tend more to form associations when young, associations that they tend more to rely on when old. And potential associates like to see altruism, because it correlates with generosity and cooperation (as near-far theory predicts). But if you save money to help the future needy, or if you invest now in skills useful in future idealistic projects, that is less clearly a signal of altruism, because you might later change your mind and use that money or those skills for other purposes.

So to signal your youthful idealism to potential associates, you must spend the money and time now, even if such spending is less effective toward the idealistic cause. But hey, at least the cause gets something.

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Good friends can make bad business partners

A new NBER working paper suggests that similar venture capitalists (VCs) are worse at making or managing shared investments:

This paper explores two broad questions on collaboration between individuals. First, we investigate what personal characteristics affect people’s desire to work together. Second, given the influence of these personal characteristics, we analyze whether this attraction enhances or detracts from performance. Addressing these problems in the venture capital syndication setting, we show that venture capitalists exhibit strong detrimental homophily in their co-investment decisions. We find that individual venture capitalists choose to collaborate with other venture capitalists for both ability-based characteristics (e.g., whether both individuals in a dyad obtained a degree from a top university) and affinity-based characteristics (e.g., whether individuals in a pair share the same ethnic background, attended the same school, or worked for the same employer previously). Moreover, frequent collaborators in syndication are those venture capitalists who display a high level of mutual affinity. We find that while collaborating for ability-based characteristics enhances investment performance, collaborating for affinity-based characteristics dramatically reduces the probability of investment success. A variety of tests show that the cost of affinity is not driven by selection into inferior deals; the effect is most likely attributable to poor decision-making by high-affinity syndicates post investment. Taken together, our results suggest that non-ability-based “birds-of-a-feather-flock-together” effects in collaboration can be costly.

Given that homophily rather than heterophily remains the norm, it seems these investors are not learning this lesson, or value working and affiliating with similar peers over maximising profits. All very well for them. But if you have a project that you truly want to succeed, you may be better off doing it with a talented stranger rather than the college mates you clicked with on day one. And if you are letting others invest on your behalf, you should beware of handing your money over to a homogeneous friendship group.

I wonder if this kind of research influences the institutional investors who often fund VCs? If not, it would suggest that even this highly competitive investment market is falling short of its potential to fund and grow promising new companies.

Some research suggests that corporations with more female board members perform better, though the direction of causality is disputed. I doubt females are innately more talented board members, so the causation, if real, could be the result of female ‘outsiders’ generating better management than a clique of natural friends. Shareholders don’t share the benefits of board members enjoying each other’s company, so if they had effective control of  the companies they owned you might expect then to appoint a diverse ‘team of rivals’ to the board to closely scrutinise one another’s ideas.  My impression is that precisely the opposite is the norm.

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Private Firms Earn 3% More

More evidence that privately owned firms do better:

We present evidence on the performance of nearly 1400 U.S. private equity (buyout and venture capital) funds using a new research-quality dataset. … Average U.S. buyout fund performance has exceeded that of public markets for most vintages for a long period of time. The outperformance versus the S&P 500 averages 20% to 27% over the life of the fund and more than 3% per year. Average U.S. venture capital funds, on the other hand, outperformed public equities in the 1990s, but have underperformed public equities in the 2000s. … Within a given vintage year, performance relative to public markets can be predicted well by a fund’s multiple of invested capital and internal rates of return. (more)

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Econ Advice Confirmed

We … construct management data on over 10,000 organizations across twenty countries, … [and] use a new double-blind survey tool. … We define “best” management practices as those that continuously collect and analyze performance information, that set challenging and interlinked short-and long-run targets, and that reward high performers and retrain/fire low performers. … Our management scoring grid … was developed by McKinsey as a first-contact guide to firms’ management quality. … We also test (and confirm) that these practices are indeed strongly linked to higher productivity, profitability, and growth. (more)

Not a bad quick measure of the quality of management practices. They find:

In manufacturing American, Japanese, and German firms are the best managed. Firms in developing countries, such as Brazil, China and India tend to be poorly managed. American retail firms and hospitals are also well managed by international standards, although American schools are worse managed than those in several other developed countries. We also find substantial variation in management practices across organizations in every country and every sector, mirroring the heterogeneity in the spread of performance in these sectors. One factor linked to this variation is ownership. Government, family, and founder owned firms are usually poorly managed, while multinational, dispersed shareholder and private-equity owned firms are typically well managed. Stronger product market competition … [is] associated with better management practices. Less regulated labor markets are associated with improvements in incentive management practices such as performance based promotion. …

Publicly (i.e., government) owned organizations have worse management practices across all sectors we studied. … Multinationals appear able to adopt good management practices in almost every country in which they operate. … The level of education of both managers and nonmanagers is strongly linked to better management practices.

So, the world would get more productivity and growth if it had fewer government-owned organizations, less labor regulation, stronger product market competition, and more things run by multinational firms. Gee, sounds a lot like standard economists’ advice.

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Info Market Failure

Unless project gains can be very clearly proven to analysts, or perhaps so small and numerous to allow averaging over them, public firms are basically incapable of taking a loss on earnings this quarter in order to make gains several years later. … CEOs are strongly tempted to instead please analysts by grabbing higher short-term quarterly earnings. …

Private firms are 3.5 times more responsive to changes in investment opportunities than are public firms. … IPO firms are significantly more sensitive to investment opportunities in the five years before they go public than after. (more)

A month ago I said that these results imply that we need wealth inequality, to ensure we make the discretionary investments on which all our future wealth depends.

Today I want to admit that these results also imply that even thick speculative markets, full of lots of people trading lots of money, often have big info failures. While I am a big fan of using speculative markets to aggregate info, I must admit that they quite often fail to aggregate all relevant info, even when a lot of money can be won there.

CEOs at private firms choose investments based on private info on likely rates of return. If the same firm were to be made public, however, the above evidence suggests that CEOs would make less than 25% of those investments. In the other 75+% of cases, the CEO would estimate that market speculators would not credit the stock price for the value of those promising investments, but would instead punish the firm for lower short term earnings. It seems that market speculators cannot distinguish these investments from other less promising ones that CEOs would undertake if speculators were to credit these. CEOs typically know crucial investment details not available to speculators.

Now I can see ways to improve existing stock markets, so that they could aggregate more investment info. We could allow and even encourage “insider” stock trading by firm insiders like the CEO. And we could create decision markets, trading the stock value conditional on specific investment decisions. But while these changes should raise that <25% figure, i.e., the fraction of investments by private firms that would also be made by a public firm, they might not raise it by much.

Speculative markets can work info aggregation wonders, at least compared to common methods like surveys or committee meetings. But if you really want as much info as possible on big investments, we still know of nothing better than rich private investors with a lot on the line.

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You & The Distant Future

I spoke again yesterday to mostly retired folks at GMU’s lifelong learning institute, on “You & the Distant Future” (audio; slides). I talked on near-far theory, long-term bequests, and cryonics.

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Financial Mood

We care more about the future when happy:

We conduct a random-assignment experiment to investigate whether positive affect impacts time preference, where time preference denotes a preference for present over future utility. Our result indicates that, compared to neutral affect, mild positive affect significantly reduces time preference over money. … Happier respondents are [also] less likely to agree with the “live for today” statement than are less happy respondents. This holds even after controlling for covariates that have been shown to be related to happiness … High cognitive load increases time preference and … individuals with greater cognitive skills, as measured by IQ tests, exhibit lower time preference. (more)

This is predicted by near-far analysis, since happy is far, and the future matters more in far mode. This matters for finance today, as whatever sets discount rates, sets prices:

“All price-dividend variation corresponds to discount-rate variation.” … When it comes to broad price aggregates, such as stocks in general or land in general, price changes basically reflect crazily-changing [discount rate] values. (more)

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Status In Law, Finance

I recently suggested that a big part of what management consulting sells is status, to cow firm opponents into submission, and that this helps explain why consulting firms use so many inexperienced recent grads of elite colleges. JustMe commented:

There are basically three things available to graduates of elite colleges that other students, no matter how hard they work, have little or no access to: elite consulting jobs, investment banking, and corporate law.

Kids from elite colleges aren’t much smarter or harder working than those from the next tier, who are cheaper to hire. But elite grads do have much more polish, shine, etc. – in a word, status. If this helps explain an elite school focus in management consulting, can it also help explain a similar focus in investment banking and corporate law?

Corporate law seems easier. If, as I suggested, our inherited sense of who will tend to win a contest in coalition politics uses certain standard status markers, then the status of one’s corporate lawyers can influence attitudes about who will win a court case. So having a high status lawyer can help get folks within an organization to support standing firm, cow lower status opponents into backing down, and influence the verdict of a judge or jury.

For investment banking, a lot of that is about getting folks with deep pockets to open their wallets to back new ventures. The more it seems that important folks associated with a venture are high status, the more others may be willing to affiliate with that venture as customers, suppliers, investors, compliant regulators, etc. So there should be a big premium on having the key person who represents a venture to potential investors be high status.

I remember Bryan Caplan once suggesting that successful real estate agents tend to be the sort of people who were popular in high school, and that house buyers (especially women) prefer to affiliate with a locally popular person as they enter a new community. Investment banking could be similar, but on higher status scale.

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Too Much Consulting?

Last night I discussed the popularity of law, finance, and management consulting with Tyler and many somewhat-libertarian-leaning others. I was surprised that most were skeptical that firms get their money’s worth from consulting, more skeptical than for law or finance. I was also surprised that most focused on explaining why kids from elite schools work at such firms, rather than on why firms pay so much for this consulting.

To me, it is easy to understand why consulting firms attract so many elite students, given the wages, prestige, and job experience they offer. And it is also easy to see why firms might pay a ton for consulting, relative to law and finance – changing your basic business strategy can conceivably add enormous value, while minor changes to contract details and financing terms have limited value.

The puzzle is why firms pay huge sums to big name consulting firms, when their advice comes from kids fresh out of college, who spend only a few months studying an industry they previous knew nothing about. How could such quick-made advice from ignorant recent grads be worth millions? Why don’t firms just ask their own internal recent college grads?

Some say that consulting firms use their access to collect data on best practices, data that other firms are eager to pay for. But while this probably contributes, I find it hard to see as the main effect.

My guess is that most intellectuals underestimate just how dysfunctional most firms are. Firms often have big obvious misallocations of resources, where lots of folks in the firm know about the problems and workable solutions. The main issue is that many highest status folks in the firm resist such changes, as they correctly see that their status will be lowered if they embrace such solutions.

The CEO often understands what needs to be done, but does not have the resources to fight this blocking coalition. But if a prestigious outside consulting firm weighs in, that can turn the status tide. Coalitions can often successfully block a CEO initiative, and yet not resist the further support of a prestigious outside consultant.

To serve this function, management consulting firms need to have the strongest prestige money can buy. They also need to be able to quickly walk around a firm, hear the different arguments, and judge where the weight of reason lies. And they need to be relatively immune to accusations of bias – that their advice follows from interests, affiliations, or commitments.

All three of these functions seem to be achieved at a low cost by hiring good-looking kids from our most prestigious schools. These are the cheapest folks you can buy with our most prestigious affiliations, they are smart enough to judge where reason lies, and they have few prior affiliations to taint them with bias. They can not only “borrow your watch to tell you the time,” but can also cow you into submission in accepting that time.

Yes the information contained in consulting advice can be obtained elsewhere at a lower cost. Firms could hire most any smart independent folks, or set up a prediction market. But alas those sources don’t have the raw strength of status to cow opponents into submission, opponents who in practice can block changes no matter what a CEO declares.

So mine is a signaling and status story (surprise surprise). The weight of status often decides outcomes, no matter what the CEOs commands, and so CEOs often need to bring out status ringers, to cow opponents into submission.

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