Tuesday, May 26, 2015

Review: Why Most Things Fail: Evolution, Extinction and Economics by Paul Ormerod

The mathematical relationship that describes the link between the frequency and size of the extinction of companies is virtually identical to the relationship for the extinction of species in the fossil record. Both follow a power-law distribution: a low background frequency of extinctions punctuated by huge extinction events.

When a wave of extinctions sweeps corporations, it is a recession. Falkenstein's theory predicts that many of the corporate failures will be mimics which copy a set of key characteristics that investors believe are sufficient attributes of success.

In Why Most Things Fail, Ormerod asks,

"how can it be that not just failure, but the patterns of failure, are so similar in biology and human organization when there is such a sharp contrast between the abilities to act with the conscious intent of improving one's prospects for survival?"
This pattern makes it seem as if firms act at random, as if they are unable to act with intent, the way species are unable to consciously change evolutionary strategy.

His answer to this puzzle is that "the massive uncertainty that often exists even in apparently simple situations means quite simply that intent is not the same as outcome." In other words, a system such as an economy is too complex, with too many variables, for an actor to accurately model the effects of its plans and actions. One reviewer put it well:
"given the complexity of the world, there are limits to how much corporations can control their fate or governments can control the success of their policies. Governments, firms and households lack complete information. They do not have the cognitive power to process the available information to determine the optimal choice. As a result, when you look at their success, the outcomes look more like the result of chance than of rational strategic decisions."
What are oil prices going to be in twenty years? Who knows. But if you're buying oil properties with a 5% IRR to today's prices, you had better believe that the average price over the next twenty years will be equal or greater than the current price.

This relates nicely with the topic of selection bias inherent in business biographies (see How To Be A Billionaire and The Problem With Business Hagiography). Ormerod quotes a Microsoft history called Barbarians Led by Bill Gates,
"There was a great disconnect between the view from inside that my compatriots and I were experiencing down in the trenches, and the outside view... in their quest for causality [outsiders] tend to attribute any success to a Machiavellian brilliance rather than to merely good fortune."
So if it is very difficult to know anything about the world and the future - which the statistical evidence shows - what does one do?

One nice thing about being an investor is that you operate at the highest level of abstraction. Unlike an operating business, cash has no barrier to exit. You can change your mind at any time.

As an investor, cash as the default position seems to be an essential rule. Then it is an epistemological question of what sorts of situations can one have better knowledge than the market?


Scale and Scope: The Dynamics of Industrial Capitalism
The Transformation of Corporate Control
Machine Dreams: Economics Becomes a Cyborg Science
Also by Ormerod
Butterfly Economics: A New General Theory of Social and Economic Behavior
The Death of Economics


Mr. Gotham said...

Some of the same notions of lack of perfect information and constraints on action are discussed on this piece on the disruption of Blackberry's business model:

Disruption has a couple of characteristics that make it fun to talk about. While it is happening even with a chorus of people claiming it is happening, it is actually very difficult to see. After it has happened the chorus of “told you so” grows even louder and more matter of fact. After the fact, everyone has a view of what could have been done to “prevent” disruption. Finally, the description of disruption tends to lose all of the details leading up to the failure as things get characterized at the broad company level or a simple characteristic (keyboard v. touch) when the situation is far more complex. Those nuances are what product folks deal with day to day and where all the learning can be found.


Unknown said...

Some of the same notions of lack of perfect information and constraints on action are discussed on this piece on the disruption of Blackberry's business model

That article is really interesting, thanks.

Mr. Gotham said...

A little more from Steve. Highlights how hard it is to transition a platform in response to disruption. See this over and over again in tech.