Observations and stories

2007-01-03T06:25:00.001-08:00

Hedge funds... friends or foes?

2006-12-19T14:01:00.000-08:00

Foreign affairs have a good article about the role of hedge funds. The article also points that even though hedge funds have received a lot of heat over the years they actually perform an important role with regards to liquidity and risk management. Here is a brief summary:

The massive growth of hedge funds has sparked warnings of instability and demands that the industry be regulated. But the fear of hedge funds is overblown, based on a misunderstanding of their role in the international Þnancial system. In reality, hedge funds do not increase risk; they manage it -- and policymakers, rather than clamping down, should make sure hedge funds have the tools to perform this function well

Are PE firms actually conglomerates? And is it actually a problem?

2006-12-19T13:49:00.000-08:00

A recent article in the economist argues that PE firms are looking very much like conglomerates. However, according to a study by BCG, this does not seem to be a problem, as diversified firms, e.g. conglomerates, are increasingly able to achieve superior returns by doing exactly what PE firms are doing.

ARE private-equity firms the new conglomerates? The two look more and more alike. The dozen or so top private-equity firms have taken positions in an extraordinarily diverse range of operating companies, much as big conglomerates have done.
...
But the comparison is one that the private-equity firms have discouraged. After a fashion for industrial conglomerates peaked in America in the early 1970s, the term became a pejorative one among students of business. It came to signify inefficient management; a failure to master the demands of wildly different businesses; an absence of focus.
...
The private-equity firms might want to know, however, that just as they are shunning the label of “conglomerate”, the term may be on the way back into fashion. A well-run conglomerate may be admirable after all. That, at least, is the message of a new study by the Boston Consulting Group, “Managing for Value: How the World’s Top Diversified Companies Produce Superior Shareholder Returns”.
...
The study looks at 300 of the world’s biggest firms, some 30 of which are classic diversified conglomerates. It finds that most of the diversified firms outperformed stockmarket averages in the past five years, many by a significant margin. An average focused company in the study did even better, but this result was distorted by a handful of exceptional performers. Most of the focused companies failed to perform as well as the diversified companies.
...
How did the better conglomerates do so well? For the most part, by behaving rather like private-equity firms. A successful conglomerate had a lean organisational structure; it had a consistent strategy for its portfolio companies, viewing them as trading assets, or holding and managing them for the long-run. And it was extremely efficient at allocating capital. It invested most heavily in its profitable units. That might sound like common sense. But over-investing in underperforming subsidiaries was a common problem among weak conglomerates in the study.

Risk and return

2006-12-07T00:44:00.000-08:00

The example is from the Economist

The failure of torcetrapib is also a reminder that drug development is an extremely high cost, high-risk activity, and that the most promising new drugs can go wrong even at a late stage. In 2004 Pfizer pledged to spend $800m getting torcetrapib to market, an investment that may now be worthless. And such failures are hardly unusual. In the heart disease area, recent disappointing examples include AstraZeneca’s blood-thinner, Exanta, and Bristol-Myers Squibb’s blood-pressure-reducing drug, Vanlev. Merck is caught up in a costly legal battle following the withdrawal of its pain-killer, Vioxx, in 2004. Side-effects were discovered after Vioxx had gone to market. That failure cost Merck’s then-boss, Raymond Gilmartin, his job

This high failure rate explains why drug firms need to earn huge profits, for a while, on those drugs that do reach the market successfully. It explains why anyone who wants the drugs industry to be as innovative as possible―which is all of us, surely?―should oppose moves to impose limits on the pricing of new drugs, an idea now being actively considered in Washington, DC, by politicians who seem more desperate to cut the cost of health care than to improve its quality.

It's all about scarcity of resources

2006-12-06T09:57:00.000-08:00

There has been rumours going on for quite sometime that Google has started to lower their requirements to new hires(unfortunately I cannot remember where;)), but as it is apparant from this article it seems that Google still have some of the "smartest guys in the room". Nevertheless, as it is apparent from the citation below to many smart people may cause problems...

Every company wants to hire the smartest people possible, and Google has clearly succeeded. But you know what you get when you get too many smart people in one room? You get the corporate equivalent of the U.S. Olympic basketball team.
Think about it: there can only be one smartest person in every room. There are dozens of trophy hires and incredibly smart, entrepreneurial minds buried inside Google who are fast-becoming frustrated with their inability to accomplish anything. And while Google motors along, minting money with its AdSense and AdWords programs, these brilliant minds are getting antsy.
Armed with seven-figure bank accounts and professional networks of dozens of other equally brilliant and rich new friends, those frustrated Googlers are bound to
set out on their own and ignite a son-of-Google wave of innovation.

Small vs. big

2006-11-27T13:21:00.000-08:00

A discussion about the pros of joining start-ups and cons of joining a large firm from venturebeat:

Big companies are losing their “A” players and they’re struggling to attract “B” players. In an industry where everything is about people, large tech companies are in trouble because they are losing the talent war. And keep in mind, an “A” player in an organization can usually produce the same results as three “B” players.
Joining a big company is irrational in today’s market
Why would you want to join a big high tech company (Yahoo, Microsoft, eBay, HP, Oracle, or Cisco) when you can join a cool startup? [Disclosure: Auren is NOT a shareholder in any public high-tech company] At a big company you’re stuck with corporate politics, paralysis decision making, and a lack of getting things done. At a small company you’re having fun, pursuing your dream, and actually getting things done.
...
In today’s hot startup market, it is essentially irrational to join a big company. That means that big companies are only attracting “B” and “C” players or they are attracting irrational A players. And they are losing all those great “A” players they hired in the dog days of 2002 (most of which now have fully vested stock-options).

Reasons why Private equity firms have been able to create superior returns

2006-11-21T06:52:00.000-08:00

Fortune has a quite good article about the reasons why Private Equity firms have been able to create superior returns for their investors. According to the article the main reasons are that Private Equity firms are able to :

attract and keep the world's best managers,
focus them extraordinarily well
provide them with strong incentives
free them from distractions
give them all the help they can use
let them do what they can do

As it is obvious it is therefore mainly the alignment of interest between owners and managers combined with empowerment of the managerial role that creates an environment that enables the manager to focus (almost) solely on creating value for the owners of the firm.

With regards to the superior returns we will of course briefly forget such issues as survivorship bias with regards to PE-returns and the higher systematic risk of PE-investments which could explain the superior performance;)

Nevertheless, the following presents some excerpts from the article:

Look inside the companies owned by major private-equity firms, talk to the executives who run them, and you'll find a distinctive way of managing that's sharply different from what goes on in most publicly traded companies or most private companies under conventional ownership. Investigation shows why privately held firms - at least if they're owned by one of the major buyout shops - have important advantages over competitors, and why they're regrading the playing field in several industries. Many of the lessons apply to virtually any organization.

The differences begin at the most fundamental level, with new objectives. Private-equity firms want to buy companies for their portfolio, fix them, grow them and sell them in three to five years. The eventual buyer could be another company in the portfolio company's industry, another private-equity firm or the public, through an IPO. The holding period is occasionally less than a year or as long as ten years. But always the goal from day one is to sell the company at a profit.

Facing a goal like that changes a manager's mindset - usually in positive ways. No longer seeing a corporate future that stretches indefinitely into the distance, executives realize that they gain nothing by resisting change: With the exit looming, driving change is their only hope.
...
Pay is a whole different concept in PE-owned companies. Don't come to play unless you're prepared to put significant skin in the game. While public companies talk a lot about aligning executive pay with performance, they typically award stock options and restricted stock on top of already substantial pay packages, giving executives lots to gain but little to lose.
And in big companies those options reflect the fortunes of the overall corporation, not the specific business a manager is running. By contrast, private-equity firms make the game much more serious. Not only is a far larger share of executive pay tied to the performance of an executive's business, but top managers may also be required to put a major chunk of their own money into the deal.
At Dunkin' Brands (home of Dunkin' Donuts), which is co-owned by private-equity firms Bain Capital, Carlyle, and Thomas H. Lee Partners, CEO Jon Luther says, "I insisted that all officers invest personally. Management has a substantial amount of their personal money in this. It makes a huge difference in the 40 officers of the company when they show up for work" they have an ownership mentality rather than a corporate mentality." Luther says the resulting difference in behavior is clear: "There's now a very different discipline in how you spend money," he explains. "If it doesn't grow the business, why would you do it?"
...
Private-equity firms don't always bring in star outside managers to run the companies they buy. In fact, they much prefer to buy a company with strong management in place, as Luther was at Dunkin' and Bhasin was at Genpact. "The strong preference is to use the talent in the company," says General Atlantic chairman Steven Denning. "You want to back a superb management team and liberate them."
But if PE owners decide that they need to bring in an outsider, they hold a valuable advantage over public companies: No one will know how much they've paid. Public companies have to report executive pay in SEC filings.
Private companies don't. In this era of outrage at grossly overpaid executives, any public company that paid, say, a $20 million signing bonus or offered a package with a potential nine-figure payout would be pilloried by governance activists and the press. But the reality is that some executives are worth that kind of money, and when private-equity firms offer it - as they do - no one knows.
...
The trend has changed the high-stakes game of executive recruiting. "Top candidates are no longer waiting around to be recruited to a public company," explains über-headhunter Gerard Roche of Heidrick & Struggles. "Instead they're jumping to a private-equity firm and watching for the right opportunity to become a CEO. It wasn't like this ten years ago."
...
Freedom to pay is just one example of an advantage that many PE veterans consider critical: general freedom from the pressures of the stock market, media and Wall Street analysts. Remember, these companies have strong incentives to act quickly - but acting quickly often produces volatile quarterly earnings, which Wall Street doesn't like.
Making a big new investment or taking a write-off for a plant closing may be the best thing for the business, but many public companies hesitate because such actions could cause the stock to tank.
PE-owned firms don't have to worry about it. "In private equity, you don't need to go from quarter to quarter," says von Krannichfeldt. "You can take write-offs, you can make investments that aren't accretive in year one or year two. It's a very different dynamic."
One often hears that freedom from public markets carries another boon for privately held companies - no more compliance with Sarbanes-Oxley or the many other regulations on public firms.
But PE executives say that supposed advantage isn't such a big deal. After all, the companies may be reentering the public markets in just a few years. "It's not about accounting compliance," says Luther. "We treat ourselves like we're public."
What makes a huge difference is the release of managerial time from trying to placate and massage the public markets. Talking to shareholders, analysts and the media may be important jobs for a public-company CEO, but they're massive distractions from the company's operations. In practice, a public-company CEO is lucky if he spends 60 percent of his time actually running the place. In a PE-owned firm those distractions disappear, and the CEO is free to spend close to 100 percent of his time focused on the business.
Increased managerial attention comes to many PE-owned companies in another way as well. Several of these companies were initially parts of much larger outfits where they were not central to the mission. The parent firm focused top-management time and corporate resources elsewhere, which not only was bad for the stepchildren financially but also demoralized the managers.
...
Much of that attention in PE-owned companies comes from a source that makes some public-company CEOs uncomfortable: the board. Because they're corporations, even privately held companies must by law have boards of directors. But the
boards of PE-owned companies are fundamentally different from the public boards that are the focus of governance activists. They're typically smaller and consist only of representatives of the PE owners plus industry experts whose explicit job is to help management create and execute strategy; many directors fulfill both roles. "The board is far more involved in assisting the company," says General Atlantic's Denning.
Besides furnishing heavy-hitting directors, large PE firms also bring a world of connections to the companies they own. "Our three partners are able to connect us with people we otherwise couldn't meet," says Luther of Dunkin'. "For example, the Carlyle folks introduced us to one of their investors in Taiwan, and we soon had an agreement for 100 Dunkin' Donuts stores there."
...
Clarity is a running theme in why PE-owned companies on average perform so well. They suffer no confusion about the role of the board, who's ultimately in charge (the PE firm is), and the eventual goal. They benefit also from a clear view of what they're managing along the way: It's cash.
...
Public companies often get caught up in disagreements over what to measure - earnings per share, return on equity, Ebitda, return on net assets. PE-owned firms generally bypass that debate. They're managed for cash, the ultimate business reality.

However a few caveats still exists:

Warren Buffett has criticized private-equity firms as "deal flippers" uninterested in building long-term value. Some firms extract exorbitant fees from their portfolio companies.

Continued abuses could attract federal regulation; the Justice Department is already investigating possible collusion in bidding for companies. This industry is filled with some of the world's smartest people; now it needs leadership to start self-policing to make such intrusions unnecessary.

But a longer-term threat to the private-equity industry could be a development that would actually be good news for the economy. Consider: The most fundamental question raised by today's private-equity boom is, Why can't public companies do all these things themselves?

Yachts and hedge funds

2006-11-20T13:13:00.000-08:00

From the economist:

THERE is an old Wall Street story that can be adapted for the modern world of hedge funds. A young hedge-fund trainee is taken to the harbour. “Here”, says his boss, “are the partners' yachts. And over there are the yachts of the bankers who lend to us.” The naive youth replies: “But where are the customers' yachts?”

Peanut manifesto

2006-11-20T12:13:00.000-08:00

Seems like change is coming from within in the case of Yahoo. A very interesting internal document made it to the WSJ.

The reliance on debt financing

2006-11-20T11:59:00.000-08:00

thestreet.com has an interesting piece about the complexities PE firms face due to their heavy reliance on debt financing:

"There is a price of admission," says Brian Hessel, managing partner at Stonegate Capital Management. Indeed, these private equity firms' names recur on the announcements of nearly every deal. "If the private-equity firms disappoint high-yield investors, they will have a harder time later getting good execution on deals," says Hessel, among the potential investors for said deals. "The high-yield debt market for LBO'd companies is "like a huge raw material that they need access to, to go forward."
...
Because the private-equity investors are making a huge outlay to take an entire company private, the size of the financing is large; that means the company piles on a lot more debt, which often reduces its credit rating and increases its interest costs. Typically, bond investors don't like LBOs because if the company already has debt outstanding, the new debt is typically senior to the existing debt, which means the "old" bonds those investors might already hold decline in value.
...
Private-equity firms aren't going to be generous to bondholders, but they don't want to fall on their face either," says Martin Fridson, CEO of research firm FridsonVision and publisher of Leverage World. "To have a big visible deal like HCA's trade to a discount [i.e., a price below its sale price] would be hugely damaging."
Using a back-of-the-envelope calculation, if the HCA deal were priced at the yields the bonds currently trade, HCA might have "saved" roughly $50 million in interest expense per year for the life of the bonds. Making such claims is a bit misleading, because no one knows if investors would have bought the bonds at those elevated prices from the get go.
...
Strong demand in the high-yield bond market puts the private equity firms and the companies somewhat in the driver's seat. But the nature of the LBO deal and their reliance on the high-yield bond market means these private equity firms must walk a tightrope. The balance of power gives the bond investor some room to play hard-to-get, and they force the private equity players to exercise some manners. So, even though the high-yield bond market is already frothy, with low risk premiums compared to Treasury bonds, the rally may have more room to go as new deals price at such attractive yields.

A primer to the history of Silicon Valley

2006-11-20T11:45:00.000-08:00

Fortune gives a primer into the early dynamics of Silicon Valley in their relatively interesting piece about the Silicon Valley Lawyer Larry Sonsini:

Though most Boalt graduates joined big commercial firms in New York, Los Angeles or San Francisco, Jennings suggested to Sonsini that he look at a tiny outfit in Palo Alto. "Dick said to me, "There's something going on down in the Valley. There are a lot of young businesses starting, and they're companies that are going to have to go public."

At that time Santa Clara Valley was already home to a handful of mature tech companies, including Hewlett-Packard (Charts) and Fairchild Semiconductor. Hewlett-Packard - launched from a garage and dedicated to innovation - was serving as an inspiration and paradigm for many young entrepreneurs. Early venture capitalists were providing seed capital. Thanks to liberal intellectual-property policies, Stanford and Berkeley were letting their engineering graduates try to commercialize inventions they'd come up with while still in school. "It was still early," Sonsini says, "but you could see it. Something unique was happening."
...
"So we started to develop the recipe for how to build companies," Sonsini recalls. The recipe required entrepreneurialism, capital and infrastructure, and Wilson's law firm was part of the infrastructure. "I was becoming a piece of the recipe," Sonsini says. "What I was learning very early on," he continues, "was that I could build an enterprise too. In fact, I had to." Wilson and Sonsini both wanted to continue to represent their clients as they grew, rather than handing them off to larger firms when they went public.

The determination of the rigth level of monitoring is not easy

2006-11-14T11:23:00.000-08:00

The Economist runs an article that highligths some of the trade-offs that have to be considered when investigating the role of CEOs. As it is obvious; monitoring of managers is on the outset beneficial.... but there are always externalities.

Becoming the boss used to be a cushy number. Pay without performance was the
rule. You got to pick your own board; not surprisingly, that board was unlikely
to kick you out. Things were a little different in Germany, but not too much.
Its two-tier board system was, in effect, the ultimate gentleman's club.
Now the boss’s pay is under growing public scrutiny. Reforms in corporate
governance mean that board members, though often still approved by the chief
executive, are less inclined to back him when the going gets tough. Indeed, as
the spotlight is increasingly turned on the performance of non-executive board
members, firing the chief executive, rather than giving him the backing he may
deserve, may nowadays strike many directors as the easiest way to deflect
criticism from themselves.
...
But there may be unforeseen consequences of this change. Bosses will feel under pressure to deliver dramatic improvements fast. More decisions may be taken in haste, only to be regretted later. More talented executives may decide that the short-term focus of the stock market and the media, combined with a trigger-happy mood in the boardroom, is an unacceptable risk. They may opt for the lower-profile but equally lucrative life of running a firm owned by private-equity investors. Those that do stay with public companies will want to be handsomely compensated for the extra risk. One result of the increased rate of chief executive turnover, The Economist confidently predicts, is that bosses’ pay in public companies will soar even higher

The role of consultants

2006-11-13T00:35:00.000-08:00

Ian Davis from McKinsey on the "new" role of consultants in Knowledge@wharton:

The new demands on business are changing the consulting industry, too, said Davis. Companies like McKinsey can no longer get away with offering only analytical solutions. Client firms are now filled with MBAs and former consultants who can do much of that work in house. Companies still need consultants, however, to provide an independent, objective analysis, according to Davis. Successful consultants must also continue to provide specialized expertise but with a fully integrated approach. Finally, he said, consultants should begin to develop teaching skills to reach their clients.
The future of the consulting industry is secure, he added. The profession has been around for centuries, with consultants performing the same job under other names, including courtiers, academics or lawyers. "I think there is a deep human need for advice," said Davis. "If I have a personal problem, I talk to a friend."
As a consultant, Davis is the one companies turn to for advice. "Other people's problems are easier," he said.

Supply and Demand: Lebanese version

2006-11-05T11:33:00.000-08:00

From NYT:

BEIRUT, Lebanon, Nov. 1 — This is a city of nightclubs, but the nightlife is something else these days, and not just because of the feverish edge sharpened by the war last summer.
By 8 p.m., women in their 20s and early 30s are prowling in packs of five and six, casting meaningful glances at any and all passing men. In the bars the women dance for hours — often on top of the bar — and legs, midriffs, bare shoulders and barely covered bosoms are offered for public admiration.
Samir Khalaf, a professor of sociology at the American University of Beirut, said the
scene astonished his American colleagues. “They are just shocked,” he said. “ ‘This is Lebanon, the Middle East?’ they say. They can’t stop talking about all the belly buttons, about all these highly eroticized bodies. You see it everywhere here, this combination of consumerism and postmodernism and female competition.”
For a few weeks twice a year, after Ramadan and before Christmas, thousands of Lebanon’s young men return from jobs abroad — and run smack into one of the world’s most aggressive cultures of female display. Young women of means have spent weeks primping and planning how to sift through as many men as possible in the short time available. The austere month of Ramadan ended a week ago.
The country’s high rate of unemployment pushes the young men to seek work elsewhere, sometimes in Western countries like France and Canada, but mainly in the United Arab Emirates, Saudi Arabia and the other oil states on the Persian Gulf. The women, inhibited by family pressures, are generally left behind. “The demographic reality is truly alarming,” Professor Khalaf said. “There are no jobs for university graduates, and with the boys leaving, the sex ratios are simply out of control. It is now almost five to one: five young girls for every young man. When men my sons’ age come back to Lebanon, they can’t keep the girls from leaping at
them.”

CSR built into the business model

2006-10-30T09:45:00.000-08:00

Particant productions present an intriguing example of how CSR is built into the business model. From Fastcompany

Participant Productions is the first film company to be founded on a mission of social impact through storytelling. But it's no charity. It's a pro-social commercial operation, a hybrid emblematic of the social-entrepreneurship movement. "Ultimately, the goal here is to build a brand around social relevance in media," Skoll says. He staked the company $100 million for its first three years; every script is evaluated equally on its creative and commercial potential and its ability to boost awareness of one of six issues: the environment, health, human rights, institutional responsibility, peace and tolerance, and social and economic equity. For each project, Participant execs with nonprofit backgrounds reach out to public-sector partners, from the ACLU to the Sierra Club, for their opinions. If those partners don't think they can build an effective action campaign around the film, it's a no-go. At the same time, "It can't be good-for-you spinach, or it's not going to work," says Participant's president, Ricky Strauss, a former production and advertising exec at Columbia and Sony Pictures Entertainment. "The more mainstream the story, the more opportunity to make an impact."

"Love of power over men is a base instinct no less petty or universal than greed. "

2006-10-26T09:30:00.000-07:00

The CAPM has always been a troubled child. Even though its explanatory power is relativly small it has been a natural part of the basic curriculum at business school for quite a while. However, this working paper from ERIC G. FALKENSTEIN presents an explanation for why it fails to explain reality.

The following excerpt is from mahalanobis:

In the paper, my alter-ego explains this as a consequence of people caring about their relative status, rather than absolute wealth. In such an environment, nondiversifiable risk becomes like diversifiable risk in the traditional CAPM, avoidable, so unpriced. All you have to do is assume people care about relative wealth and using arbitrage or utility theory, risk is not related to returns. A beta=0 asset has the same risk as a beta=2 asset to someone benchmarked against the market. The paper presents a simple model, and goes over the empirical evidence with copious references.

There’s actually been quite a few models using a relative status approach for various parochial problems, so it’s not novel in that aspect, it just takes the approach to the general problem of risk and return. And all the general normative implications for volatility retain, including the desire to hedge, or buy insurance (though not, say, Global Warming insurance). There is one big seemingly counterfactual implication: that the equity risk premium is zero. I address this by noting that the equity risk premium used to be estimated at around 8%, and is now generally estimated around 3.5%, so another 3.5% is not farfetched. Further, that estimate ignores transaction costs, and peso-problems in equity indices, which takes this to zero (is the marginal investor the Vanguard500 investor? A high volume/expense day trader? A 5% front-load paying granny?). It should be noted that the traditional model generates only a 0.35% risk premium for plausible parameters, so this isn't as contrary as it seems (any outside-the-box refinement to the traditional model could well be applicable to this one).

Love of power over men (and the implied greater access to women regardless of aggregate wealth) is a base instinct no less petty or universal than greed. Economists should not shirk the implication because as dismal scientists, we draw the line at greed, not envy. It’s not a normative theory, just a positive one (ie, descriptive, not prescriptive). Not only can a relative status utility function explain the absence of the risk aether’s effects in markets, but it can potentially explain other issues, such as the home bias (people are more concerned about their income relative to their countrymen, not the world), endogenous instability (a world where ‘no risk’ is defined as what everyone else is doing has some arbitrariness), and why aggregate happiness is stagnant in countries 5 times as wealthy as 70 years ago (the rat race is unaffected). Rick Harbaugh has a paper where a similar approach generates the utility function of Prospect theory, which is typically just asserted as a funky preference. So there's much to be gained, and only empirical embarrassment to lose (plus all those canned presentation about CAPM given to students).

The abstract of the original articel :

This paper presents a utility function refinement that explains the empirical irrelevance of risk to returns. The key is that in an environment where people care about relative wealth, risk is a deviation from what everyone else is doing, and therefore becomes like diversifiable risk in the CAPM, avoidable. Using an equilibrium or an arbitrage argument, a relative status oriented utility function creates a zero risk-return correlation via a market model that implies a zero risk premium. This approach is described as being theoretically consistent, intuitive and a better description of the data.

Remember the costs of information acquisition

2006-10-26T09:19:00.000-07:00

When thinking about how to invest your portfolio additional information is not necessarily a good thing as this illustrates:
Seen at Mhalanobis:

A paper by Guiso and Jappelli looked at Information Acquisition and Portfolio Performance. They develop a theoretical model that shows how an overconfident investor is actually made worse off, because they overestimate the precision of their signal. The really interesting part of their paper is a novel set of survey data from an Italian bank that shows people who are confident are generally worse investors than those who are ignorant. Investors experienced a lower Sharpe ratio the more they invest in investment information. It seems people use information to rationalize risk taking that is not commensurate with greater returns; a simple strategy of basic naïve asset allocation dominates the average active investor.

"Gluttons at the gate"

2006-10-22T12:09:00.000-07:00

A quite good article about the development in PE can be found at businessWeek

Three weeks after giant private-equity firm Thomas H. Lee Partners agreed to buy an 80% stake of Iowa Falls ethanol producer Hawkeye Holdings in May, Hawkeye filed registration papers with the Securities & Exchange Commission to go public. The buyout deal hadn't even closed yet, but Thomas H. Lee was already looking forward to an initial public offering expected to generate a huge profit on its $312 million investment. The firm didn't just cross its fingers and wait, however: It took $20 million from Hawkeye as an advisory fee for negotiating the buyout and a $1 million "management fee"--and will soon take about $6 million to meet its own tax obligations. All told, Thomas H. Lee will collect payments of around $27 million by yearend--despite Hawkeye's having earned just $1.5 million in the six months through June.

These are crazy times in the private-equity business. It used to be that buyout firms would spend 5 to 10 years reorganizing, rationalizing, and polishing companies they owned before filing to take them public. Thomas H. Lee couldn't have created much lasting economic value in the three weeks before the filing, but that didn't stop it from writing itself huge checks from Hawkeye's ledger. Thomas H. Lee and Hawkeye declined to comment.

Buyout firms have always been aggressive. But an ethos of instant gratification has started to spread through the business in ways that are only now coming into view. Firms are extracting record dividends within months of buying companies, often financed by loading them up with huge amounts of debt. Some are quietly going back to the till over and over to collect an array of dubious fees. Some are trying to flip their holdings back onto the public markets faster than they've ever dared before. A few are using financial engineering and bankruptcy proceedings to wrest control of companies. At the extremes, the quick-money mindset is manifesting itself in possibly illegal activity: Some private equity executives are being investigated for outright fraud.Taken together, these trends serve as a warning that the private-equity business has entered a historic period of excess. "It feels a lot like 1999 in venture capital," says Steven N. Kaplan, finance professor at the University of Chicago. Indeed, it shares elements of both the late-1990s VC craze, in which too much money flooded into investment managers' hands, as well as the 1980s buyout binge, in which swaggering dealmakers hunted bigger and bigger prey. But the fast money--and the increasingly creative ways of getting it--set this era apart. "The deal environment is as frothy as I've ever seen it," says Michael Madden, managing partner of private equity firm BlackEagle Partners Inc. "There are still opportunities to make good returns, but you have to have a special angle to achieve them."

Decreases in the attention span leads to new ad strategy

2006-10-19T11:35:00.000-07:00

The example below concerns the reduction of the length of a radio ad.
from knowledge@wharton

On its website, Clear Channel discusses how it has cut down on the number of ad minutes per hour and on the number of ads in each commercial pod in an attempt to create a better experience for commercial-weary listeners and a better advertising environment. "When the music stops, the listening shouldn't," says the website, adding: "With fewer commercial breaks, shorter pods and shorter, more creative copy, spots get more share of voice and higher recall."

According to Wharton marketing professor Patricia Williams, "there is an increasing recognition that consumers just tune out ads. So the likelihood that you're going to keep consumers engaged for a 60-second or 30-second ad is minimal, especially on radio and TV when people will channel-flip as soon as the ads appear. There's also recognition that a good amount of the time advertisers are buying in a traditional 30- or 60-second ad might be a waste anyway because consumers aren't paying attention."

Joseph Turow, a professor and associate dean for graduate studies at Annenberg, agrees. "So many people are using iPods and going on the web to get music," he says. "And radio stations are seeing that a lot of people are leaving because they can't stand the number of ad minutes. So Clear Channel is trying to cut down [on ad minutes] to get more [listeners]."
...
"When advertisers went from 60-second to 30-second commercials and from 30-second to 15-second commercials, they said, 'Wow, I can reach twice as may people with shorter spots,'" says Reibstein. "But that ignored the question of whether a shorter ad has the impact of a longer ad. Clearly that's not the case. However, if all you want to do is get your name out there, shorter is fine. But if you have to explain something, or visually show something more complex and with more content, you can't do it with a little blip."
...
What is the best way for an advertiser to take advantage of super-short ads on either radio or TV? The Wharton marketers say five- or two-second ads may work well in reinforcing an existing brand with a high level of consumer awareness or announcing an upcoming event at an established retailer or a new product by a well-known manufacturer.

"Ads that remind people to 'Do something now' and basic brand-awareness ads work great on billboards," Schmittlein says, and probably they will on radio, too. Here are some examples: A computer company is introducing a new desktop model and uses a short ad to direct consumers to its website, where they can learn all about the model's functionality. A supermarket chain informs viewers that their stores will be open all day on an upcoming holiday. A TV network urges listeners to tune in tonight to the season premiere of last year's top-rated crime drama. A chain of convenience stores tells consumers during a July heat wave that its popular iced drink is available at a reduced price.

Say It with a Song

Several of those interviewed say adlets or blinks that use melodies, sound effects or well-known taglines -- or a combination of the three -- can be especially effective in keeping a brand or product top-of-mind. Examples of notable audio signatures include the Southwest Airlines 'ding', the "Intel Inside" tinkling audio tag, Fox's thumping theme music for National Football League games, or Coca-Cola's famous jingle, "It's the Real Thing."
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One thing to avoid in scheduling super-short ads on radio or TV is clutter. According to Schmittlein, airing too many brief ads back to back would be a disservice to all the advertisers because their individual messages could get lost in the jumble. "It's just like billboards: if you have 10 billboards lined up next to one another, that's a problem," he says.

Another risk with five- and two-second ads -- but particularly the two-second spots -- is that listeners and viewers may miss them altogether. "If it's easy for consumers to avoid a 30-second message by changing the station, it's really easy to tune out a two-second message," suggests Williams.

At the same time, though, Williams says a two-second ad may work well, not in spite of its brevity, but because of it. When an ad comes on the air, it takes most people a couple of seconds to change the radio station or TV channel, and even TiVo recordings jump back a bit when programs are replayed. So viewers may see a couple seconds of commercial content they did not necessarily wish to view.

Reliability and sample sizes

2006-10-19T11:14:00.000-07:00

It seems that somebody forgot that we need sufficiently large sample sizes when we try to conduct out-of-sample statistical inference. Especially in the case of cluster sampling where the assumption of random observations are questionable.

From WSJ

655,000 War Dead?
A bogus study on Iraq casualties.

BY STEVEN E. MOORE
Wednesday, October 18, 2006 12:01 a.m. EDT
After doing survey research in Iraq for nearly two years, I was surprised to read that a study by a group from Johns Hopkins University claims that 655,000 Iraqis have died as a result of the war. Don't get me wrong, there have been far too many deaths in Iraq by anyone's measure; some of them have been friends of mine. But the Johns Hopkins tally is wildly at odds with any numbers I have seen in that country. Survey results frequently have a margin of error of plus or minus 3% or 5%--not 1200%.
The group--associated with the Johns Hopkins Bloomberg School of Public Health--employed cluster sampling for in-person interviews, which is the methodology that I and most researchers use in developing countries. Here, in the U.S., opinion surveys often use telephone polls, selecting individuals at random. But for a country lacking in telephone penetration, door-to-door interviews are required: Neighborhoods are selected at random, and then individuals are selected at random in "clusters" within each neighborhood for door-to-door interviews. Without cluster sampling, the expense and time associated with travel would make in-person interviewing virtually impossible.
However, the key to the validity of cluster sampling is to use enough cluster points. In their 2006 report, "Mortality after the 2003 invasion of Iraq: a cross-sectional sample survey," the Johns Hopkins team says it used 47 cluster points for their sample of 1,849 interviews. This is astonishing: I wouldn't survey a junior high school, no less an entire country, using only 47 cluster points.
Neither would anyone else. For its 2004 survey of Iraq, the United Nations Development Program (UNDP) used 2,200 cluster points of 10 interviews each for a total sample of 21,688. True, interviews are expensive and not everyone has the U.N.'s bank account. However, even for a similarly sized sample, that is an extraordinarily small number of cluster points. A 2005 survey conducted by ABC News, Time magazine, the BBC, NHK and Der Spiegel used 135 cluster points with a sample size of 1,711--almost three times that of the Johns Hopkins team for 93% of the sample size.

What happens when you don't use enough cluster points in a survey? You get crazy results when compared to a known quantity, or a survey with more cluster points. There was a perfect example of this two years ago. The UNDP's survey, in April and May 2004, estimated between 18,000 and 29,000 Iraqi civilian deaths due to the war. This survey was conducted four months prior to another, earlier study by the Johns Hopkins team, which used 33 cluster points and estimated between 69,000 and 155,000 civilian deaths--four to five times as high as the UNDP survey, which used 66 times the cluster points.
The 2004 survey by the Johns Hopkins group was itself methodologically suspect--and the one they just published even more so.
Curious about the kind of people who would have the chutzpah to claim to a national audience that this kind of research was methodologically sound, I contacted Johns Hopkins University and was referred to Les Roberts, one of the primary authors of the study. Dr. Roberts defended his 47 cluster points, saying that this was standard. I'm not sure whose standards these are.
Appendix A of the Johns Hopkins survey, for example, cites several other studies of mortality in war zones, and uses the citations to validate the group's use of cluster sampling. One study is by the International Rescue Committee in the Democratic Republic of Congo, which used 750 cluster points. Harvard's School of Public Health, in a 1992 survey of Iraq, used 271 cluster points. Another study in Kosovo cites the use of 50 cluster points, but this was for a population of just 1.6 million, compared to Iraq's 27 million.
When I pointed out these numbers to Dr. Roberts, he said that the appendices were written by a student and should be ignored. Which led me to wonder what other sections of the survey should be ignored.
With so few cluster points, it is highly unlikely the Johns Hopkins survey is representative of the population in Iraq. However, there is a definitive method of establishing if it is. Recording the gender, age, education and other demographic characteristics of the respondents allows a researcher to compare his survey results to a known demographic instrument, such as a census.
Dr. Roberts said that his team's surveyors did not ask demographic questions. I was so surprised to hear this that I emailed him later in the day to ask a second time if his team asked demographic questions and compared the results to the 1997 Iraqi census. Dr. Roberts replied that he had not even looked at the Iraqi census.
And so, while the gender and the age of the deceased were recorded in the 2006 Johns Hopkins study, nobody, according to Dr. Roberts, recorded demographic information for the living survey respondents. This would be the first survey I have looked at in my 15 years of looking that did not ask demographic questions of its respondents. But don't take my word for it--try using Google to find a survey that does not ask demographic questions.

Without demographic information to assure a representative sample, there is no way anyone can prove--or disprove--that the Johns Hopkins estimate of Iraqi civilian deaths is accurate.
Public-policy decisions based on this survey will impact millions of Iraqis and hundreds of thousands of Americans. It's important that voters and policy makers have accurate information. When the question matters this much, it is worth taking the time to get the answer right.

Valuation of social networks sites

2006-10-09T12:07:00.001-07:00

In line with the recent rumors that google migth buy youtube Knowledge@wharton
presents a quite good dicussion about valuation of these sites:

Less than three years after emerging from nowhere, the hot social networking website MySpace is on pace to be worth a whopping $15 billion in just three more years. Or is it?
Is the much smaller Facebook, run by a 22-year-old, really worth the $900 million or more Yahoo is reported to have offered for it? Maybe. Or maybe this is Dot-Com Bubble, Part II, with MySpace, Facebook, YouTube and the other new Internet phenoms destined for oblivion when the fad fades.

"What makes this hard is that these companies seem to be so many years away from the kind of earnings that the valuation numbers are forecasting for them," says Andrew Metrick, finance professor at Wharton. The $15 billion MySpace figure "would imply that a lot more people will be on MySpace than are currently on it."

While the social networking sites vary considerably, each relies heavily on content provided by users who can post personal profiles and build networks among friends and others with shared interests. For the most part, these users have free access and the sites are funded with advertising revenue. To lure advertisers, young sites typically offer deep discounts that make profitability elusive, and it is unclear when they will be able to push ad rates higher, if ever.

The problem, as Wharton accounting professor Robert W. Holthausen sees it, is a dearth of information to plug into the standard valuation models. "You have little data on what kind of revenues they can generate and what their cost structure is."

Valuing advertising-driven sites is particularly hard because the same numbers -- such as the number of users or page views -- can mean different things depending on how the advertisers are billed, Holthausen adds. "How often do they get paid for that advertising? Is it just when the advertisement appears? Or does there have to be a click through?" Similarly, not every user has the same value. That depends on how much the typical user is likely to spend and what he or she is likely to buy. Finally, Holthausen notes, a site will be more valuable if it uses a proprietary technology than if it simply offers services competitors can easily duplicate.

The $15 billion MySpace prediction was issued late in September by RBC Capital analyst Jordan Rohan, fresh from a meeting with Fox Interactive, the News Corp. unit that acquired MySpace's parent company, Intermix Media, about a year ago for a then-astounding $580 million. Rohan cited MySpace's phenomenal growth. It now has more than 90 million active users, twice as many as a year earlier, making it a magnet for advertisers. It recently signed a deal with Google to display search results and sponsored advertising links in exchange for $900 million over three years. In setting the $15 billion forecast, Rohan pointed to Google, which also relies on ad revenue, and which has a market capitalization of $120 billion.

But is Google a good benchmark? Google is without question the premier Internet search service, while MySpace is one of a number of competitors scrambling for market share in a new industry. Google has a proven track record of profitability, while MySpace does not.

Moreover, even Google's $120 billion market cap may reflect some irrational exuberance, making it a misleading model. Its shares sell for about 55 times annual earnings, roughly triple the price-to-earnings ratio of the average Standard & Poor's 500 company. Using the same 55-times-earnings figure, MySpace would need about $270 million in annual profit to justify a $15 billion value. Can it do that in three years, given it is expected to generate only about $200 million in revenue this year? It looks like a reach.

Consider some of the figures bandied about for Facebook. Last January, Facebook founder Mark Zuckerberg, now 22, reportedly turned down a $750 million offer from Viacom, holding out for $2 billion, according to news accounts. This fall he is said to be mulling over a $900 million offer from Yahoo. Those are big numbers considering that the business, started early in 2004, has a modest nine million users and is believed to have annual revenue of around $50 million, though some experts expect that to double soon. If Facebook were valued at 55 times earnings, it would need a $16 million profit to justify a $900 million price.

"Discounted Cash Flow"

Still, there are sure to be some winners in social networking, and sites that are already pulling in significant revenue must certainly have an edge over the dozens of lesser-known competitors. "That's a lot of revenue," Metrick says, noting that this distinguishes Facebook from the dot-com bubble firms. "There were a lot of Internet companies in 1999 that had no revenue.... That kind of [$900 million valuation] doesn't seem so crazy if you believe there is a lot of growth built in." But, he adds, "There are a whole lot of examples of firms like Netscape which grew -- and then eventually lost."

The market-capitalization method of valuation is typically used with a public company -- a free standing entity that sells stock to the public. And it's best for stating a current value rather than a future one. Analysts also like to factor in a company's future prospects, using any number of calculations to derive a figure for "discounted cash flow." Essentially, they look at expected revenues over a given number of years and subtract expenses to arrive at a figure for "free cash flow." Then, using various assumptions about interest rates, they determine what money received in the future is worth in today's terms.

Analysts can never be sure about any company's future revenues and expenses, but the problem is even worse when dealing with a young company in a fledgling industry. The assumptions used in any valuation model are ideally based on experience of at least six or seven competitors, Metrick says. But there is no good peer data in the new social networking business.

With older industries, analysts often value a company on some ratio, such as a multiple of revenues. "But the problem is you are assuming the valuations put on these are rational," says Holthausen, arguing that expectations for new industries are often not rational. During the dot-com bubble, some companies that did have substantial revenues were valued far beyond what any standard analysis would say they were worth, he adds. "You totally had to suspend belief."

After the bubble burst, valuing the survivors did become more sensible, and some are assessed fairly easily with standard approaches, according to Wharton marketing professor Peter Fader. That's especially true of publicly traded companies involved in ordinary commerce, such as bookseller Amazon.com and auction site eBay. Their stocks trade at 45 and 39 times earnings, respectively.

"You're not going to see an Amazon being overvalued like [Internet stocks] used to be," he says, "but these social network sites are the Wild West. This is an area where it has been notoriously fickle. It's not like search engines, where you can really compare them on objective criteria," he suggests, referring to established players like Google and Yahoo.

Among the unknowns: How well can social networking sites hold on to their users? One player, Friendster, burst onto the scene a few years ago, then largely deflated. On the other hand, users go to considerable trouble to upload information and images to these sites, and to establish elaborate networks of friends for electronic sharing. They are not likely to abandon all that effort as casually as they would switch from one online bookseller to another. "It does seem to me there is some stickiness to the model," Holthausen says.

Networks Based around Products

Metrick believes social networking sites will not be a passing fad. But there's no guarantee that MySpace, Facebook or any of the other current players will be the big winners in the end. Fader, too, believes social networking is here to stay, but he thinks it may work best not as a freestanding function but as an additional feature on sites that draw users for other reasons. Hence, the winners may turn out to be other sites that adopt social networking features. Or they may be new players, or current networking sites that broaden their offerings.

Many sites may ultimately be acquired in the way MySpace was bought by publicly traded News Corp., the enormous multi-national media company run by Rupert Murdoch. Part of the News Corp. strategy is to let advertisers link users into networks based around products, such as movies or music groups. More than a million bands have profiles on MySpace, for example.

If MySpace becomes the model, social networking sites will be quite different from the classic dot-com bubble companies which tried to cash in big by going public while staying independent. The risks are not the same when an iffy venture is part of something bigger, says John R. Percival, adjunct professor of finance at Wharton. "This is kind of like the oil and gas business. The risk might not be as great as you think, and a high valuation might be justified."

A small, independent oil driller faces a huge risk in drilling a new hole, which may be dry, he says. Compared to that, risks from changing oil prices and demand are relatively small. But the situation is reversed when the driller is part of a bigger enterprise that drills many wells. A dry hole here and there doesn't matter, but changes in oil prices and demand do.

Social networking sites may be risky for their founders and the venture capital firms that fund them in the early years, but they don't appear to be pumping huge amounts of risk to the marketplace the way tech firms did in the late 1990s. "If you have a little bit of money invested in this and you're already invested in other things," says Percival, "frankly the risk is not as big as you think."

Recalling the first dot-com bubble six years ago, Fader notes, "We all look back and laugh and say we will not go through that exercise again, but this could easily be a case of history repeating itself."

Segmentation

2006-10-09T11:56:00.000-07:00

So is this the result of better segmentation by the networks?
The example is from the Freakonomics blog

We mention in passing in Freakonomics that blacks and whites in the United States have very different TV viewing habits (see page 182 of the book). Monday Night Football is the only TV show that historically has been among the top ten in viewership for both blacks and whites. Seinfeld, one of the most popular white shows ever, was never in the top 50 for blacks.

So I was intrigued when I happened to catch USA Today’s recap of last week’s prime-time Nielsen ratings in its Wednesday issue.

The top 10 shows for whites last week:

1) CSI
2) Grey’s Anatomy
3) Desperate Houswives
4) Dancing with the Stars
5) CSI: Miami
6) Sunday Night Football
7) Survivor
8) Criminal Minds
9) Ugly Betty
10) CSI:NY

And for Blacks:

1) Grey’s Anatomy
2) Dancing with the Stars
3) CSI: Miami
4) Ugly Betty
5) Sunday Night Football
6) Law and Order: SVU
7) CSI: NY
8) CSI
9) Next Top Model
10) Without a Trace

If this one week of data is a good indicator (and I think it is), there has been a remarkable convergence in television viewing habits. A few years ago almost all the top black shows featured predominately black characters and most were not even on the big four networks. Now, there is almost a perfect match between what blacks and whites are watching and while many of these shows have black characters, none feature a predominately black cast. (As an aside, I thought it was interesting that in the box in USA Today that listed the top shows among black viewers they put a picture of Chandra Wilson from Grey’s Anatomy.)

Does this convergence in TV viewing signal a broader pattern in cultural convergence? Probably not, but it is worth keeping an eye on.

Amidst all the change, however, one thing seems to be as certain as death and taxes: both blacks and whites will watch football if you put in on in primetime.

Expected utility

2006-10-05T11:45:00.000-07:00

Risk aversion is an important thing.... The example of warranties... From washingtonpost

"All you have to do is see how aggressively these things are sold at the point of sale," said Jean Ann Fox, director of consumer protection for the Consumer Federation of America, a District-based nonprofit association of 300 consumer groups. "It's not a good buy under most circumstances."
..
The instinct to protect what we have and forgo the obvious benefits of another course is one long studied by behavioral economists. Kevin McCabe, an economist and director of the Center for the Study of Neuroeconomics at George Mason University, said that even without knowing from experience that a product will break, many people insure it anyway.
...
That reliance on gut instinct points to an inherent disadvantage for consumers in the purchase process, economists and consumer advocates say. Buying an extended warranty is vastly different from selecting most other insurance products. When buying car insurance, for instance, it's relatively easy to make an informed decision by comparing terms and prices among different carriers. The power struggle between buyer and seller is relatively balanced.
But when deciding whether to buy an extended warranty, it is nearly impossible to comparison shop from the checkout counter. And, because the insurance and service companies are invisible at the time of sale, consumers can't verify their financial health or reliability.
...
Warranty Week, an industry publication, last year estimated that of the $15 billion in premiums charged consumers in 2004, $7.5 billion went straight into the pockets of the stores that sell warranties as their cut.
Of the remaining $7.5 billion, the publication estimated that $3 billion was paid in claims by the insurance companies that back the plans. On the other hand, according to the Insurance Information Institute in 2004, the U.S. auto insurance industry paid out $66 in claims for every $100 in premiums.

Neither Circuit City nor Best Buy discloses how much of its bottom line comes from extended warranty sales. But analysts have estimated that at least 50 percent and in some lean years 100 percent of profits at the electronics retailers come from extended warranty sales.

so where is the value:

But even Consumer Reports has made a few exceptions. Last year, for the first time, the magazine found that repairs on some products -- laptop PCs, treadmills and plasma TV sets -- were common enough and expensive enough that a decently priced extended warranty would make sense. Plasma televisions, the magazine said, run hot and are still considered a relatively new consumer technology.
Plus, dragging bulky, large-screen televisions into a repair shop is impractical for most consumers. Many extended service warranty programs offer in-home repairs.

Options are not always valuable?

2006-10-02T11:35:00.000-07:00

Dan Gilbert has a great talk about the determinants of happiness at the TED blog. Notice especially the time inconsistency with regards to the choice of the photographers... You can get it at the following link

Immigration gone wrong?

2006-10-01T08:35:00.000-07:00

Harvard Magazine presents interesting results about the propensity for immigrants to be violent.

First-generation immigrants are more likely to be law-abiding than third-generation Americans of similar socioeconomic status, reports Robert Sampson, Ford professor of the social sciences. These new findings run counter to conventional wisdom, which holds that immigration creates chaos. The prevailing “social disorganization theory” first gained traction in the 1920s and ’30s, after the last big wave of European immigrants poured into the United States. Scholars have maintained that the resulting heterogeneity harmed society. “They weren’t saying that this was caused by any trait of a particular group,” Sampson explains. “Rather, they were saying that lots of mixing would make communication accross groups difficult, make it hard to achieve consensus, and create more crime.”

Yet in Sampson’s recent study, first-generation Latino immigrants offer a particularly vivid counterexample to this common assumption. “They come into the country with low resources and high poverty, so you would expect a high propensity to violence,” Sampson says. But Latinos were less prone to such actions than either blacks or whites—providing the latest evidence that Latinos do better on a range of social indicators, a phenomenon sociologists call the “Latino paradox.”

Furthermore the author reaches an interesting conclusion about the costs and benefits of parallel societies:

The study also revealed that neighborhoods matter. “Kids living in neighborhoods with a high concentration of first-generation immigrants have lower rates of violence,” he explains, “even if they aren’t immigrants themselves.”

What makes new arrivals more law-abiding? Sampson theorizes that people who relocate here for the sake of greater opportunity come with a strong work ethic: “They may have a certain motivation to work and not get arrested,” he says. The young Latinos in Sampson’s study were also more likely to live with married adults, which correlated with a lower risk of violence, and to hold conservative opinions regarding drug use and crime, all of which might deter them from breaking the law. Finally, living in a neighborhood with many first-generation immigrants—who appear to bond over their shared experience—generates a dense social network that may steer young people away from crime. It’s likely, Sampson adds, that many of these immigrants are in the country illegally, which may give them “extra incentive to keep a clean record and not commit crimes, in order to avoid deportation.” After a few generations here, however, America’s tradition of “frontier justice” may prompt greater violence, he speculates. “It’s that notion of reacting to insults and taking the law into your own hands,” he says. “You would expect more exposure to that over time.”

A gorilla went by...

2006-10-01T07:35:00.000-07:00

Knowledge@wharton has an entry about the difference between vigilant and operational leaders. It is descently written, but the following example says it all:

In one classic experiment, people failed to notice a gorilla walking through a basketball court because they were instructed to count how often the ball was being passed. The simple task of counting bounces and passes restricts their vision so much that they don't see the gorilla at all. This is what happened to Coke and Pepsi: They missed the gorilla amid the technical, legal and PR problems of the pesticide charge."

The use and abuse of technical analysis

2006-09-24T02:59:00.000-07:00

The economist has a quite good review article about the development and performance of technical analysis.

As promising as technical analysis sounds (with regards to asset allocation risk is generally bad news, so what is wrong with predictability?) it is important to remember the various biases that migth cause the apparant abnormal performance by technical analysis: Survivorship bias, confirmation bias, disconfirmation bias, procedural bias etc.

PRACTICAL traders, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct mathematician. That is what Keynes might have said had he considered the faith placed by some investors in the work of Leonardo of Pisa, a 12th and 13th century number-cruncher.

Better known as Fibonacci, Leonardo produced the sequence formed by adding consecutive components of a series—1, 1, 2, 3, 5, 8 and so on. Numbers in this series crop up frequently in nature and the relationship between components tends towards 1.618, a figure known as the golden ratio in architecture and design.
If it works for plants (and appears in “The Da Vinci Code”), why shouldn't it work for financial markets? Some traders believe that markets will change trend when they reach, say, 61.8% of the previous high, or are 61.8% above their low.

Believers in Fibonacci numbers are part of a school known as technical analysis, or chartism, which believes the future movement of asset prices can be divined from past data. Some chartists follow patterns such as “head and shoulders” and “double tops”; others focus on moving averages; a third group believes markets move in pre-determined waves. The Fibonacci fans fall into this last set.
Buttonwood, who is daringly defying the tide of history by moving from Economist.com into the newspaper, has bad news for the numerologists. A new study* by Professor Roy Batchelor and Richard Ramyar of the Cass Business School, finds no evidence that Fibonacci numbers work in American stockmarkets. The academics looked at the Dow Jones Industrial Average over the period 1914-2002 and found no indication that trends reverse at the 61.8% level, or indeed at any predictable milestone.

This research may well fall on stony ground. Experience has taught Buttonwood that chartists defend their territory with an almost religious zeal. But their arguments are often anecdotal: “If technical analysis doesn't work, how come so-and-so is a multi-millionaire?”. This “survivorship bias” ignores the many traders whose losses from using charts drive them out of the market.

Furthermore, the recommendations of technical analysts can be so hedged about with qualifications that they can validate almost any market outcome. As Professor Batchelor writes: “The root of the problem is the failure of technical analysts to specify their trading rules and report trading results in a scientifically acceptable way. Too often, rules are so vague and complex as to make replication impossible.”

Fibonacci numbers at least have the virtue of creating a testable proposition; one that they appear to fail. But chartists will not be completely discouraged. A review of the academic literature** finds that, of 92 modern studies of technical analysis, 58 produced positive results (although the researchers say some of these studies may be flawed and that the best results occurred before the early 1990s).

If the efficient market theory is correct, technical analysis should not work at all; the prevailing market price should reflect all information, including past price movements. However, academic fashion has moved in favour of behavioural finance, which suggests that investors may not be completely rational and that their psychological biases could cause prices to deviate from their “correct” level.

Chartism probably holds most sway in the foreign-exchange market. Although currency markets are liquid and transparent, many participants (such as central banks) are not “profit-maximising”. So it is possible that currency prices are not completely efficient. Furthermore, some technical predictions may be self-fulfilling; if everyone believes that the dollar will rebound at ¥100, they will buy as it approaches that level.

Technical analysts also make the perfectly fair argument that those who analyse markets on the basis of fundamentals (such as economic statistics or corporate profits) are no more successful. Nevertheless, Buttonwood urges extreme caution in relying on their claims.

All that talk of long waves is distinctly mystical and seems to take the deterministic view of history that human activity is subject to some pre-ordained pattern. Chartists fall prey to their own behavioural flaw, finding “confirmation” of patterns everywhere, as if they were reading clouds in their coffee futures.

Besides, technical analysis tends to increase trading activity, creating extra costs. Hedge funds may be able to rise above these costs; small investors will not. As illusionists often proclaim, don't try this at home.

Mortgage hedging

2006-09-24T02:56:00.000-07:00

The introduction of a new instrument that links the size of the mortgage with the development in house-prices. From the economist

FOR most homeowners, their house is their biggest single financial asset and their mortgage is their biggest single liability. House-price inflation has normally made this a good bet. But it makes little sense in financial theory for investors to borrow a lot to speculate on a single asset class. This is particularly true when high house prices in many nations have forced many buyers to take on debts that are a substantial multiple of their incomes.

The answer, according to Zurich Cantonal Bank, is to link the value of the loan to that of the property. On September 18th it launched a new product that offers two ways of doing so. One version includes a put option (a kind of insurance) linked to Zurich's house-price index. At a cost of around 0.5% a year, this option ensures that, if regional house prices fall, the size of the loan will decline in tandem. The second version links the level of the mortgage rate to the house-price index.

The efficient markets hypothesis can land you in jail

2006-09-24T02:43:00.000-07:00

The use and abuse of the effecient markets hypothesis in the legal system is illustrated in the following example from the economist.

It seems that the legal system in this case is subject to the same limitations as journalists:

Keep it simple and
ignore any criticque of the assumptions behind the methods.

JAMIE OLIS knows better than most people that the ideas conjured up by economists in their ivory towers can have a big effect on the real world. The tax accountant, found guilty of committing fraud while working for Dynegy, an energy-trading firm, has been doing time since March 2004, in large part thanks to a controversial economic theory, the efficient markets hypothesis. Last October an appeals court threw out Mr Olis's 24-year jail term, because Judge Sim Lake, who sentenced him, got his economics wrong. But Mr Olis stayed in prison pending resentencing, again by Judge Lake. That will follow a hearing, due on September 12th, that is likely to be dominated by a debate over market efficiency.

In essence the efficient markets hypothesis, which was developed in the 1950s and 1960s, says that subject to certain conditions, the market price of a security—a share, say—fully and accurately reflects all the available information relevant to its value. In an efficient market the only reason why a price changes is that new information comes to light.
This hypothesis has been hugely influential in the world of finance, becoming a building block for other theories on subjects from portfolio selection to option pricing. Of more relevance to Mr Olis, it also has the rare distinction, for an economic theory, of the approval of America's Supreme Court. In 1988, in Basic Inc v Levinson, the court endorsed a theory known as “fraud on the market”, which relies on the efficient markets hypothesis. Because market prices reflect all available information, argued the court, misleading statements by a company will affect its share price. Investors rely on the integrity of the price as a guide to fundamental value. Thus, misleading statements defraud purchasers of the firm's shares even if they do not rely directly on those statements, or are not even aware of them.
That ruling has proved a goldmine for America's trial lawyers, who have won fortunes by suing firms for damages when news (often, in practice, a restatement of their accounts) is followed by a sharp fall in their share prices. The fall is treated as proof of overvaluation due to the initial, wrong statement.

Increasingly, a similar logic has been used in criminal cases, as Mr Olis discovered. His 24-year sentence stemmed from a calculation of the financial loss caused to investors in Dynegy by Project Alpha, an accounting fraud in which he took part. That financial loss was estimated using the fall in Dynegy's share price on the news that Project Alpha was fraudulent. According to Judge Lake, it was so big that, under sentencing guidelines then in place, Mr Olis had to go to jail for a long time.

In rejecting that sentence, the appeals court ruled that Judge Lake had attributed far too much of the fall in Dynegy's share price to Project Alpha and too little to other news. Next week the prosecution and defence will each use economists as expert witnesses to debate exactly how much of the loss was due to Project Alpha. This will highlight several tricky technical issues that arise when applying the efficient markets hypothesis to fraud.

Exhibit Alpha

According to the prosecution's expert, Frank Graves, of the Brattle Group, a consultancy, Project Alpha was responsible for $4.45 of the $11.13 decline in Dynegy's share price on April 25th and 26th 2002, after the firm announced that it had reduced its reported profits because of the fraud. According to the prosecution, that justifies a sentence of up to 15 years for Mr Olis.

But in a paper filed on behalf of Mr Olis, Joseph Grundfest, a Stanford law professor and a former commissioner at the Securities and Exchange Commission (SEC), claims that Mr Graves has made numerous technical errors. Correct these, writes Mr Grundfest, who is working pro bono, and a quite different conclusion follows: Mr Graves, he says, “fails to establish that Project Alpha inflated Dynegy's stock on any date by any amount” or that “any portion of Dynegy's stock price decline” on the dates in question can be attributed to Project Alpha.

Among other things, Mr Grundfest notes that the markets were also digesting far more serious news: of a pending SEC investigation into aspects of Dynegy's business that were unrelated to Project Alpha; and of threats by California's governor, Gray Davis, to try to reclaim profits made by energy traders, including Dynegy and its rival, Enron, by exploiting flaws in California's energy regulations.

More fundamentally, Project Alpha was designed to bring forward the date at which some profits were recognised in Dynegy's accounts; but its overall effect on the firm's cashflow over time was neutral. Surely in an efficient market investors would look past the accounts to the underlying economic reality, argues Mr Grundfest, so that the effect on the share price would be negligible. Indeed, he notes, Dynegy's share price did not fall on April 3rd, when the press first commented on problems with Project Alpha, a fact dismissed out of hand by Mr Graves.

None of these objections challenges the use of the efficient markets hypothesis. Yet for years the hypothesis has been under increasingly fierce attack in academia, unnoticed by the legal system. In a recent paper, Bradford Cornell, of California Institute of Technology, and James Rutten, of Munger, Tolles and Olson, a Los Angeles law firm, argue that even highly developed financial markets such as the New York Stock Exchange are not efficient enough to allow courts to use declines in share prices to calculate the financial damage caused by a fraud. In particular, markets often react disproportionately to news, especially bad news. They therefore conclude that estimates of damages based on the hypothesis and on share-price movements will be overstated. If Judge Lake has been spending the summer getting up to date on economics, perhaps Mr Olis will be out of prison much sooner than he must once have feared.

Government support and alcohol consumption

2006-09-24T02:34:00.000-07:00

Denmark is usually known as a country with one of the highest levels of alcohol-consumption by teenagers and student. According to the following article from the ft, this might all be due to the high level of governmental allowances:

As a new crop of freshers departs for university, will they be spending more time in the library or the student union bar? History suggests the bar, but something has been changing in the world of lectures and mortar boards. For two decades the cost of a university education has grown ever less subsidised, and there are reasons to think that this trend will make the library look more attractive.
A recent study led by Nick Foskett, professor of education at the University of Southampton, looked at the experience of fee-paying students in Australia and New Zealand, as well as asking British students about their plans and expectations. Among a number of broader conclusions, they expect an outbreak of sobriety in the student body.
This is partly for social reasons. As students pay higher fees, they become more likely to have some kind of job and more likely to be living at home. Neither trend is conducive to heavy boozing.
But there is another, more direct, channel of causation. Booze costs money, even at the Leeds student union bar. Students with less disposable income may, rather than mugging old ladies or turning to prostitution, simply drink less.
Two economists have tried to be a bit more precise about this sort of thing. Sara Markowitz and John Tauras, both based in the US, recently released a paper titled “Even for teenagers, money does not grow on trees.” Examining the spending patterns of 9,000 US teenagers, they found evidence of both direct and indirect effects.
An example of the indirect effect comes from the price of petrol. When it is more expensive, teenagers drink less but smoke more. This suggests that drinking and driving go hand-in-hand - possibly because kids need to drive to a friendly bar - but that they can smoke anywhere and if immobilised by high transport costs, they probably will.
The direct effects are always mixed in with the indirect. Richer teenagers spend more money on everything, including booze, fags and weed. Yet this is not purely an effect of extra spending power. The source of the money counts too. A teenager who earns an extra $1,000 through a job is 1.1 per cent more likely to smoke and 1.6 per cent more likely to drink and 0.6 per cent more likely to use marijuana. But when the same sum comes from pocket money, the effects are more than five times greater: a teenager with an extra $1,000 annual allowance is 6.2 per cent more likely to smoke, 9.6 per cent more like to drink and 4.5 per cent more likely to use marijuana.
It is not clear whether this difference is because part-time workers have less time to indulge, whether they come from different backgrounds (some effort is made in the research to allow for this) or whether there is a difference in character between the workers and the pocket-money scroungers. Still, the conclusion is clear enough: cut off pocket money for teenagers and lower the minimum wage at once. It’s the only way to keep our teenagers living clean lives.
Perhaps things shouldn’t be allowed to rest there. After all, these results are not totally convincing. For example, Markowitz and Tauras cannot find any evidence that when the price of beer falls, teenagers drink more beer. That has to raise questions as to how much weight we can put on any of this.
It is too early to say, then, whether higher tuition fees really will empty out the student union bars. Is cheap beer really no more popular than expensive beer? Clearly some intensive field research is now required.

Walmart

2006-09-20T00:38:00.000-07:00

The role of wal-mart in the US described in the WP:
Notice Wal-marts share in raising the productivity in the US(if the numbers are rigth). If they would be able to do the same in Europe, we could catch up in no time...

The median household income of Wal-Mart shoppers is under $40,000. Wal-Mart, the most prodigious job-creator in the history of the private sector in this galaxy, has almost as many employees (1.3 million) as the U.S. military has uniformed personnel. A McKinsey company study concluded that Wal-Mart accounted for 13 percent of the nation's productivity gains in the second half of the 1990s, which probably made Wal-Mart about as important as the Federal Reserve in holding down inflation. By lowering consumer prices, Wal-Mart costs about 50 retail jobs among competitors for every 100 jobs Wal-Mart creates . Wal-Mart and its effects save shoppers more than $200 billion a year, dwarfing such government programs as food stamps ($28.6 billion) and the earned-income tax credit ($34.6 billion).
People who buy their groceries from Wal-Mart -- it has one-fifth of the nation's grocery business -- save at least 17 percent. But because unions are strong in many grocery stores trying to compete with Wal-Mart, unions are yanking on the Democratic Party's leash, demanding laws to force Wal-Mart to pay wages and benefits higher than those that already are high enough to attract 77 times as many applicants than there were jobs at this store.

Experience economy

2006-09-20T00:14:00.000-07:00

There has been a lot of focus on the rise of the experience economy lately. However, remember that this entroduces a whole new perspective on the trade off between innovation and efficiency compared to what we saw in the late 90's. In the experience economy it is satisfying customers that counts as this article from fastcompany also illustrates:

In the course of this year's Customers First research, no company produced a more polarizing debate than Apple and its Apple Stores. Some people lauded Apple's in-store service desks, called Genius Bars, for spinning an experience out of customers' problems with their iWhatevers. An equal number argued that Genius Bars mask the fact that Apple products don't always get the job done.
The divide cut to the heart of a larger question: Do you have to master the basics before you create meaningful customer experiences? Or can experiences, in effect, ameliorate any underlying troubles in your business? To us, the answer is clear--which is why Apple Stores isn't among our winners. "Are you delivering on the promise of your business?" asks Phil Terry, CEO of experience consultancy Creative Good. "Once you get that right, then you can innovate and do exciting stuff."

Certainly, it can be tempting to ignore the nuts and bolts in the rush to create experiences. "The idea of getting basics in place is about efficiencies," says Lewis Carbone, CEO of Experience Engineering. "That's not indicative of growth. We need a huge shift from 'make and sell' to creating powerful experiences." Hell, let's make it even more tempting: A great experience can bake poor service right in. Think of every velvet-rope nightclub or snooty boutique hotel where the staff lords its cool over you. Why not heed the call? Creating experiences is fun. The hard stuff of satisfying customers isn't.
....
When Jeanne Bliss, a 25-year veteran of the customer-experience wars and the author of Chief Customer Officer, worked at Lands' End at the beginning of her career, she realized, "You've got to do reliability first: 24-hour delivery and answering the phone on the second ring 99.9% of the time. Then you've earned the right to do more." Get the package there on time, and you can add a holiday poem to the box--which is what Lands' End did. Then, because kids often have as much fun with the box as they do with their gift, the company included instructions for turning the cartons into cows, sheep, or horses.

Suddenly, getting a mail-order package is an experience, from the inside out. But Lands' End (and UPS) had to deliver first, and play games second. It knew it would take more than a genius to fix a Christmas present that showed up on December 28.

You want knowledge sharing... look at the markets.

2006-09-19T23:01:00.000-07:00

A lot of posts have recently been about prediction markets, and I guess it is because of my background in finance However, the thing about markets is that if they are allowed to work freely they are one of the easiest ways to share knowledge. This is also obvious from the statement by Ed Faubert in this article from fastcompany

To the untrained eye, the coffee futures ring is a pretty unlikely arrangement: 250 people hopping up and down hysterically. Looking down on the tumult from the eighth-floor gallery at the New York Board of Trade (NYBOT) in Lower Manhattan, however, Ed Faubert sees only order. "It's the collective wisdom of the entire coffee world asserting itself," he says. "All the coffee knowledge on the planet at this moment is being channeled into one place. Co-op farmers in their fields in Guatemala are monitoring what's going on with pagers; there are people in Japan calling in contracts in the middle of the night. It's amazing how well it works."
...
As with other commodities, the process of "discovering" the daily price for coffee is built on hand signs and even lip-reading; each contract accounts for 37,500 pounds of the estimated 16 billion pounds of coffee grown annually worldwide. Faubert and the other 47 NYBOT-licensed cuppers determine which coffee gets sold at the open-market price and which at a punitive discount because of inferior quality. So when the traders in the pit that morning were buying arabica futures for March 2007, they were betting not only on the size of the October 2006 harvest in, say, Antigua, Guatemala, but on what Faubert and his fellow cuppers would think of it.

finally this comment about Vietnams entry into the coffee market:

The Vietnamese "strategy," Faubert explains, was to dump 16 million bags of low-quality robusta into a world market with only 1.2% annual growth, promptly crushing the world's robusta price: "They haven't entirely figured out capitalism yet"

The value of shareholders vs. employees

2006-09-19T02:22:00.000-07:00

Morch et.al., 1989, "Alternative mechanisms for corporate control", The American Economic Review, vol 79 (4) pp. 842-852

On the other hand, when the whole industry is suffering, the board is reluctant to make changes that raise market value. In particual, even when board members know how to raise value, they may refuse to do so because the required changes in a declining industry (layoffs, investment cutbacks, and divestitures) harm employees, who are considered more important to the organization than shareholders who are only " out for speculative profit"

Prediction markets in the US

2006-09-19T00:33:00.000-07:00

As a financial guy I like the concept of markets, but as we all know: markets only work if people actually have to put their money where their mouth is.
The legal stand in the US is therefore saddening as the following excerpt from the new yorker also illustrates:

Lotteries and most casino games are games of pure chance; the house has an ineradicable advantage and, over time, the inevitable outcome is that gamblers lose. Mathematically speaking, as the saying goes, no one wins the lottery. Sports betting, by contrast, involves skill, and it is possible, although very difficult, to consistently win money on it. Sports bettors are closer to stock or commodities buyers than to people who buy lottery tickets. How much difference is there, after all, between betting on the future price of wheat (an activity banned in some states in the nineteenth century) and betting on the performance of a baseball team?
...
In the past few years, a host of prediction markets, as they’re usually called, have appeared online, offering people the chance to speculate on subjects ranging from the box-office performance of Hollywood films to the outcome of Presidential elections and the spread of bird flu. These markets’ forecasts have proved remarkably accurate—just as bettors collectively do an exceptionally good job of predicting sports results. (In 2004, for instance, Tradesports, a Dublin-based prediction market, called thirty-three out of thirty-four races in the Senate correctly, and called all fifty states correctly in the results for the electoral college.) But in the U.S. these markets have to use play money, because using real money would constitute gambling. The online gambling ban prevents these markets from getting bigger and more accurate.
That might seem an acceptable cost if the war on Internet betting looked set to accomplish its goals. Instead, it’s likely to make the problems it was designed to solve worse. Online bookmakers have been portrayed as shady operators, but the biggest of them are far more transparent and easy to regulate than illegal bookies, many of whom have ties to organized crime. David Carruthers, before he was arrested, had been actively calling for the regulation of his industry. Congress may think that driving bettors back underground can curb underage gambling and money laundering, but don’t bet on it.

Small is beautiful

2006-09-18T05:35:00.000-07:00

Seth godin has a nice little blog covering the benefits of being small

This is the giant advantage of the small. Small organizations have the privilege of looking their customers in the eye. Small doesn't necessarily mean small in numbers. It's an attitude. Does your organization require a form to get something done, or does one human choose to interact with another? Does bad news come in the form of memos that obfuscate the truth, or is it delivered face to face?

Conference Calls Unlimited has gone so far as to practically ban email in communication with clients. They call you after each call to see how it went. When I went to Stanford, the director of admissions called every single person they admitted to share the news. Compare that to the anonymous ALL CAPITAL LETTERS notes you get from your car insurance company.

The efficiency of loyalty programs

2006-09-13T09:05:00.000-07:00

from knowledge@wharton

When making a purchase, a consumer has a choice between using frequent-flier miles, cash, or some combination thereof. Which will he or she choose? Another consumer has an opportunity to participate in a special program to get a free car wash after paying for a certain number of washes. What's the best way for the car-wash owner to motivate the customer to participate?
...
For example, a consumer may be indifferent as to whether he spends $500 or 25,000 miles on an airline ticket, but prefers paying $400 plus 5,000 miles rather than paying either of the single-currency alternatives. "At $0.02 per mile, the combined-currency price brings in the equivalent revenue to the airline, yet inflicts a smaller psychological cost to the consumer," the researchers write.

It is important to note, they add, that this consumer's preference for the combined-currency price indicates that each mile or dollar spent is not valued equally. The perceived cost of paying more dollars and/or miles increases as the payment in that currency increases. As a result, it will be best for a company to charge a combined-currency price for, say, an airline ticket when two conditions exist: The consumer does not value each unit within a currency equally and the perceived cost function for one of the currencies is said to be "convex." Convexity means, for example, that 25,000 miles appears to be worth more to the consumer than twice as much as 12,500. Why? "Twenty-five thousand miles will get you a free round-trip ticket within the United States, while 12,500 miles might only get you an upgrade," says Drèze.
...
"You would think that if people were offered money and miles, they would always take the money, but a lot of people want the miles instead," Dreze says. "Their feeling is, 'Money is only money and if I take money instead of miles, I'll just use the money to pay a bill.' There's nothing special about paying a bill. But when they take frequent-filer miles as a reward instead of cash, they will use them to take trips and that gives them memories. That makes the miles special. The airlines consider their programs 'aspirational' as fliers earmark their miles for special trips. There's a lot going on psychologically when it comes to taking miles or some other kind of rewards points. People don't consider miles or points to be the same thing as money."

"Artificial Advancement"

In another paper, "The Endowed Progress Effect: How Artificial Advancement Increases Effort," Nunes and Drèze outline how companies can structure certain rewards programs to make them more attractive to customers and hence more profitable. Endowed progress means that people who are provided with artificial advancement toward a goal show greater persistence towards reaching the goal than they otherwise would. By artificial advancement, a company advances a customer toward a goal while simultaneously moving the goal further away, so that the task requirements and the reward remain unchanged.

and a caveat... the always returning causality:

But Nunes points out that the long-term impact of loyalty programs is not yet completely understood. For instance, an online study by Maritz, a market research and consumer loyalty program consulting and implementation company, found that members of programs spend more. But it was unknown whether the program drives spending or whether big spenders are just more prone to join programs and get rewards for their spending.

and finally the never-ending quest for status:

Drèze and Nunes are continuing their research into loyalty programs. Among other issues, they are currently exploring the use and effectiveness of "status" -- gold cards, platinum cards and the like -- in loyalty programs. "A lot of loyalty programs endow customers with status, which they earn through purchases or other actions," Nunes explains. "Our research is looking into how stratifying customers and endowing some with status makes them feel different and thus behave differently."

The researchers have just begun investigating the topic. But from what they have discovered so far, it appears that assigning a customer to a category -- such as gold status -- may put them in the top 5% of all customers but it does not necessarily make the customer feel special. It turns out that gold customers feel much more distinctive and apt to spend more if they know that there is another class of people -- those endowed with 'silver' status, for instance -- below them. This paper is tentatively titled, "A Cut Above: Exclusivity and Status in Consumer Loyalty Programs."

"If you go back 10 or 15 years, a gold card was really special," Drèze says. "Today, if you don't have a platinum card, which confers greater status than gold, you're nobody. The interesting thing is that what has evolved over time is that more and more customers need status. Marketers need to find ways to separate one class of customer from another."

Product diffusion and sales modelling

2006-09-13T08:41:00.000-07:00

As an econometrician developments like these are always amusing. Data mining always reveals
interesting things, and if companies want to figure out the costs and benefits of their marketing effort they need to do the number crunching.

from knowledge@wharton

Two Wharton researchers have developed a mathematical model that they say will allow companies, for the first time, to predict at what pace new products will gain acceptance in markets where purchasing decisions by knowledgeable, influential customers sway the buying habits of others.

Wharton marketing professor Christophe Van den Bulte and doctoral student Yogesh V. Joshi say their model can be put to use in industries as diverse as movies, music, pharmaceuticals and high-technology. It is possible the model may also be a way to identify directors and actors who are ready to make the leap from small films to the Hollywood mainstream, they add....
Marketers have long tried to deepen their understanding of how new products gain acceptance among customers, a process known as product diffusion. Companies are especially interested in diffusion in markets that consist of two segments: "influentials" (knowledgeable people who keep abreast of product innovations and readily accept them) and "imitators" (people whose purchasing decisions are swayed by their savvier counterparts). Targeting influential prospects who are more in touch with new developments than most people and converting them into customers, the thinking goes, allows companies to benefit from a "social multiplier" or "social contagion" effect in marketing campaigns.
...
Van den Bulte and Joshi confirm Moore's findings that there can indeed be a drop in sales of a new product between the time it is introduced and bought by influentials to its diffusion among imitators. But in contrast to what Moore claims, the Wharton paper says that "it need not always be necessary for firms to change their product to gain traction among later adopters and [for] the adoption curve to swing up again."

Another important insight is that the proportion of adoptions stemming from influentials need not decrease at a steady pace but may first decrease and then increase. The management implication is that, while it may make sense for a company to shift the focus of its marketing efforts from independent-minded influentials to imitators shortly after launch, it may want to revert its focus back to independents later in the process. "Frankly, we were surprised by this mathematical result. It seems counterintuitive at first and flies in the face of the current consensus taught in most business schools," says Van den Bulte. However, the paper not only explains why this can happen, but also backs up the claim with actual data on adoptions of a new drug from a study originally sponsored by Pfizer.
That insight has important implications for targeting and resource allocation. "Managers who confuse the distinction between influentials and imitators with that between early and late adopters -- and ignore our results and others' empirical evidence that the bulk of the late adoptions may stem from people not subject to social contagion -- may end up wasting money by poor targeting," the Wharton researchers write.

ROI on celebrity endorsements?

2006-09-13T08:32:00.000-07:00

Seems like a good research project if you're interested in marketing.

from knowledge@wharton

Like much in marketing, athlete and celebrity endorsements are as much art as science. Research makes clear, for example, that stars can create halos around brands, giving consumers good feelings about a company, says Wharton marketing professor Americus Reed. What's less clear is whether, on average, endorsements lead to greater sales -- or at least big enough jumps to justify the hefty sums that companies cough up, Reed adds. Among stock-car racing fans, for example, they clearly do. "I have videotape of a focus group where Nascar fans are saying, 'If my driver endorses such-and-such oil, then I'm going to buy that product, too, because doing that supports my driver and helps him win.'"

But in other fields, consumers won't buy something just because of an athlete's or celebrity's halo. "When you sit down and do the math and you're trying to come up with a return-on-investment number, sponsorships can be a real crap shoot," says Jennifer Miller, director of marketing for Seven Cycles, a high-end bicycle maker in Watertown, Mass.

...

Some appear to be moving away from endorsements, at least in traditional American sports like football, basketball and baseball. "They were tired of giving away 'X' percent off the top when they knew something like what happened to Kobe could happen again," says Dan Levy, a sports agent at Octagon.
"There is a select group of athletes who can break through the clutter -- a dozen to 25 can do that," he says. Instead of lavishing money and gear on less recognizable athletes in the traditional sports, companies have begun to spend more on nontraditional ones like soccer -- women's soccer star Mia Hamm is a Levy client -- and on online and grassroots campaigns.

Despite the recent scandals, Levy adds, companies' approaches to negotiating individual endorsement deals haven't changed. "People always had morality clauses in agreements." If an endorser violates the provision, a company has a legal right to end the contract. The prohibitions "can include everything from felony charges to just disparaging the brand," he notes.

Companies can avoid having to exercise such clauses by thoroughly researching any potential endorser, he points out. Levy's division at Octagon, for example, does that before it agrees to represent someone. "We make sure that their reputation is in line with the culture," he says. Once an athlete becomes a client, "we stress that every decision you make can impact your ability to work with people off the field and on the field."

If a client does land in trouble, the basic principles of crisis communication apply, he says. "It's important to get out in front of it and not to be reacting. People make mistakes and are forgiven all the time. If they continue to do the right thing in the future and take care of their business on the court, the other stuff will eventually come back. You're never going to please everybody anyway."

Retirement saving in the US

2006-09-12T04:56:00.000-07:00

from the Journal of Political economy:

We solve each household's optimal saving decisions using a life cycle model that incorporates uncertain lifetimes, uninsurable earning and medical expenses, progressive taxation, government transfers, and pension and social security benefits. With optimal decision rules, we compare, household by household, wealth predictions from the life cycle model using a nationally representative sample. We find, making use of household-specific earnings histories, that the model accounts for more than 80 percent of the 1992 cross-sectional variation in wealth. Fewer than 20 percent of households have less wealth than their optimal targets, and the wealth deficit of those who are undersaving is generally small.

a comment from MR:

In other words, most Americans are saving enough for their retirements.

Rainfall vs. conflict

2006-09-12T04:52:00.000-07:00

First seen at MR

Abstract

Estimating the impact of economic conditions on the likelihood of
civil conflict is difficult because of endogeneity and omitted variable
bias.We use rainfall variation as an instrumental variable for economic
growth in 41 African countries during 1981–99. Growth is strongly
negatively related to civil conflict: a negative growth shock of five
percentage points increases the likelihood of conflict by one-half the
following year. We attempt to rule out other channels through which
rainfall may affect conflict. Surprisingly, the impact of growth shocks
on conflict is not significantly different in richer, more democratic, or
more ethnically diverse countries.

Wikipedia' legal role disappears

2006-09-05T14:34:00.000-07:00

User generated content come in many forms - stock markets, prediction markets, wikipedia , etc. - and is basically just a result of a "market".

However, one must always remember that markets may be a good thing in general, but even if they function relatively efficient markets may encounter deviations from their equilibrium or true levels. These deviations means that markets only shows the "truth" on average.

It should therefore not come as a surprise that the legal role of wikipedia has disappeared as it is illustrated in the Freakonomics blog

For the record, I like Wikipedia just fine, as long as people understand what it is and what it isn’t. What it is: a useful and engaging enterprise in user-generated content about a mind-blowingly diverse range of subjects. What it isn’t: a dependable substitute for a reference work, at least not in many cases. We have touched on this dichotomy here and here and here and here.

The argument in defense of Wikipedia that I find most troubling is that it is self-correcting and self-policing, which is to say that, Hey, in the end all the mistakes and vendettas get fixed by caring and level-headed people. The problem, of course, is that if someone happens to read or cite a Wikipedia entry at a moment when all those things haven’t been fixed, which is obviously a vast, vast, vast majority of the time, then the mistakes get promulgated as fact.

So I was surprised to read in the 9/4/06 issue of Business Week that the U.S. Patent & Trademark office had been using Wikipedia as a source to help determine the validity of patent applications. According to the BW article, “Wikipedia has been cited in patent decisions on everything from car parts to chip designs.”

But as of August 15, the patent office pulled the plug on Wikipedia. “We’ve taken Wikipedia off our list of accepted sources of information,” said Patents Commissioner John Doll. The article also quotes Greg Aharonian, who publishes a patent newsletter and is a longtime critic of the patent office: “I’ve been complaining about this for years. From a legal point of view, a Wiki citation is toilet paper.”

Children's intelligence

2006-09-05T14:15:00.000-07:00

Brain development impacted by temperature?
this is from bps:

Countless studies have found that children’s intelligence appears to be related to the time of year they were born in. Some investigators have argued this is because seasonally varying environmental factors like temperature and infections can affect brain development. But now Debbie Lawlor and colleagues have analysed data from 12,150 children born in Aberdeen between 1950 and 1956, and they’ve concluded that the effect of season of birth is almost entirely explained by the age children happen to be when they start school.

Reading ability at age 9 and arithmetic ability at age 11 were both related to season of birth (children born in late Winter or Spring performed better), but this association virtually disappeared once age at starting primary school and age relative to class peers were taken into account. That is, season of birth was only related to later intelligence because it affected the age children started school, with those who started school younger or older than the average tending to score less well on later intelligence tests.

It is not always necessary to make things too advanced. Sometimes there is a simple solution, such as the one found in my earlier post about equality in the quality of students:

Prediction markets (again)

2006-09-05T13:36:00.000-07:00

Prediction markets are currently getting more and more attention, since they allow investors to hedge risks they couldn't do before.

This example is from mySA.com

HedgeStreet.com, an online futures exchange, has opened up a hurricane predictions market where people can wager on the financial damages caused by a specific hurricane — or by the whole hurricane season.

The California-based exchange, regulated by the Commodity Futures Trading Commission, launched the hurricane market two weeks ago. While it may seem like a morbid novelty aimed at gamblers or weather junkies, company officers tout the new market as much more.

They claim it offers hurricane-weary residents a way to hedge their risk, and could develop into a powerful tool for predicting storm damage.
...

The exchange sells small contracts in an effort to attract individual as well as institutional investors. Contracts cost something less than $100, depending on what the market bears. If you're right, they pay out $100. If you're wrong, you get nothing.

For example, if you think the damage from this year's hurricane season, as calculated by the Insurance Services Office, will top $10 billion, you can, as of close of business Friday, buy a contract on HedgeStreet for $32.80. If damage tops $10 billion, you get $100 back. If it doesn't, you get nothing.

but remember two things that are important in determining the efficiency of markets: they work best with lots of liquidity and neglible transaction costs:

Borghesi, however, isn't sold on the ability of the new market to allow people to hedge against hurricane risk.

"If you own a house and a hurricane is heading towards you, you would have to bet a lot of money to hedge your risk," he said.
...
Although futures markets can be good predictors, there are no guarantees, Strumpf said. A good way to judge such markets is by how close the asking price and the bidding price are. Within a dollar or two is best, Strumpf said.

By that measure, HedgeStreet has a ways to go with its hurricane market.

People haven't exactly flocked to it yet. Trades over the first couple weeks are measured in the dozens, and there's commonly a $5 or $10 difference, or even more, between a bidding price and an asking price.

finally mickslam has a good comment about prediction markets on marginal revolution

It is possible that this market doesn't have enough volatility on a daily basis to attract the ecosystem of traders required for a vibrant market. Or enough data points to attract traders. I think thats one of the problems with Robert Shillers take on things, that for many of the markets that might be good (ok very, very good) for the economy, it would be difficult, if not impossible to create the necessary critical mass for these markets that would make them viable tools for risk managers.

I am very encouraged that we are seeing these markets. I am skeptical that these markets can be fully used. For example, Jason Ruspini and I have talked about the problems inherent in GDP contracts for example, and his favorite idea, tax futures, has the problem that implementing them would very likely be prohibitied, for very good reasons.

It will be a long winding road. The confluence of quantitative risk management, widespread recognition that markets really do work and the ability to dream is creating opportunities that didn't exist just a few years ago.
Something else I am starting to think on again is the Nassim Taleb critique - "we don't know what the real risks are". The odds are pretty high that for some events and styles of markets, we will never know enough for people to feel informed enough to trade them. Trading these would not be trading, but gambling. Any cogent person looking at these markets will demand a wide spread to trade them - which will work against the the very point of having a market in the first place.

Made to break

2006-08-28T09:45:00.000-07:00

An example of the dynamic inconsistency of consumer choises from knowledge@wharton.

By 2002, more than 130 million still-working cell phones had been "retired" in the U.S. Today, about 250,000 tons of discarded but still usable cell phones sit in stockpiles in America, awaiting disposal....

Is there a solution? Slade touches on design alternatives outlined in another book, The Green Imperative, which suggests that manufacturers simply charge a bit more for durable goods that are more easily taken apart and reused. He adds that such green design measures are beginning to fill the agendas of electronics institute meetings -- a hopeful sign of a sea change. But in spite of this, Slade says in one interview about Made to Break, "A lot of really sophisticated people devoted a lot of time and thought to developing this system" of constant consumption. "We need to look at the problem creatively and rethink it. Our whole economy is based on buying, trashing and buying again. We need to rethink industrial design."

You want something. You buy it. You use it for a time. And then the externality kicks in.
Always remember that disposal is also a part of the product.
You can also check out my earlier post on the topic.

Markets in everything

2006-08-28T09:39:00.000-07:00

bodyparts... from Knowledge@wharton

As the cultured host of PBS' long-running "Masterpiece Theater," Alistair Cooke was an emblem of American taste and refinement. Since his death in 2004, Cooke has also become emblematic of a macabre and little-known market: America's distinctly shady traffic in human remains. Unbeknownst to his family, Cooke's bones were cut out before he was cremated and sold for $7,000 to two companies that prepare human tissue for transplant. Cooke's fate was ghoulish in the extreme -- but what is even more disturbing is that it was not at all unusual.
...
The government regulates the procurement of organs and transplantable tissue, but it does not regulate human remains used for research and education. According to the 1968 Uniform Anatomical Gift Act, Cheney notes, it is illegal to buy and sell the dead. But according to this same law, it's legal to recuperate costs involved in securing, transporting, storing and processing cadavers. "Costs," Cheney notes, is an enormously expansive, exploitable term. It can and does mean whatever suppliers and brokers want it to mean.
In practice, the loophole in the Uniform Anatomical Gift Act means that bones, tissue, organs, joints, limbs, heads, and even entire torsos are hot commodities in a marketplace where the demands of researchers, product developers, and doctors far exceed the supply. Heads currently sell for upwards of $900, legs for close to $1,000, hands and feet and arms for several hundred dollars apiece. Fully dismembered and eviscerated, a human corpse can generate close to $10,000 on the open market

Mission statement bashing

2006-08-26T06:46:00.000-07:00

from Guy Kawasakis blog:

Who among us has not had the horrible experience of an corporate offsite to build teamwork and to craft a mission statement? The offsite usually went like this:
Day 1: Teambuilding. Selection of cross-functional teams so that, God help us, engineering has to work with sales. A day of exercises such as, “Each of you will come up to the front of the group, turn your back to the group, close your eyes, and fall backwards into the arms of your colleagues. This will teach you to trust your fellow employees.”

Day 2: Crafting the mission statement. A hot, crowded room with easels of white paper and a facilitator who knows nothing about your business. Everyone who is a director level and above in the company is there—that’s sixty people. You each figure you get one word, so at the end of the day, you have a sixty word mission statement like this:

“The mission of Wendy’s is to deliver superior quality products and services for our customers and communities through leadership, innovation, and partnerships.”

Don’t get me wrong. I love Wendy’s, but I’ve never thought I was participating in “leadership, innovation, and partnerships” when I ordered a hamburger there. The root cause of mission statement-itis is that most organizations are run by people who have either gotten an MBA or worked for McKinsey—or both.
give up trying to get people to create short, different, and meaningful mission statements, so go ahead and spend the $25,000 for the offsite, facilitator, and consultants to create one. However, you should also create a mantra for your organization. A mantra is three or four words long. Tops. Its purpose is to help employees truly understand why the organization exists.
If I were the CEO of Wendy’s, I would establish a corporate mantra of “healthy fast food.” End of story. Here are more examples of corporate mantras to inspire you:

Federal Express: “Peace of mind”
Nike: “Authentic athletic performance”
Target: “Democratize design”
Mary Kay “Enriching women’s lives”

The ultimate test for a mantra (or mission statement) is if your telephone operators (Trixie and Biff) can tell you what it is. If they can, then you’re onto something meaningful and memorable. If they can't, then, well, it sucks.

If you still insist on doing a mission statement, then at least let me help you save a lot of time and money. Just go to the Dilbert Mission Statement Generator. There, without a consultant, facilitator, and offsite, you can get the mission statement of your dreams.

Crowdsourcing... Another name for User-generated content

2006-08-21T10:26:00.000-07:00

From BusinessWeek

Every business has customers who are sure they could design the products better themselves. So why not let them? Crowdsourcing is the unofficial (but catchy) name of an IT-enabled business trend in which companies get unpaid or low-paid amateurs to design products, create content, even tackle corporate R&D problems in their spare time.

Also check out the Lego story

Prediction markets in companies

2006-08-21T10:20:00.000-07:00

From BusinessWeek

But can groups working in a system like that really make better decisions than a few well-informed individuals? It's a radical notion for many in the corporate world, where CEOs and a handful of other executives are paid top dollar for presumed expertise.

And yet the idea is commonly accepted in the stock market. "Firms are comfortable with markets; it's a bit puzzling why they don't use them more often internally," says Todd Henderson, a professor of law at the University of Chicago.

Experts say prediction markets can work well for companies because they give a voice to employees who might not otherwise speak up. The markets are particularly useful in areas such as consumer goods or technology, where change is rapid and companies need to adapt quickly or get left behind.

The importance of names ... Now also for IPOs

2006-08-21T09:48:00.000-07:00

Seen at Mahalanobis

The ease of pronouncing the name of a company and its stock ticker symbol influences how well that stock performs in the days immediately after its initial public offering, two Princeton University psychologists have found.

A new study of initial public offerings (IPOs) on two major American stock exchanges shows that people are more likely to purchase newly offered stocks that have easily pronounced names than those that do not, according to Princeton's Adam Alter and Danny Oppenheimer. The effect extends to the ease with which the stock's ticker code, generally a few letters long, can be pronounced -- indicating that, all else being equal, a stock with the symbol BAL should outperform one with the symbol BDL in the first few days of trading.

Here's the abstract from news@princeton:

Three studies investigated the impact of the psychological principle of fluency — that people tend to prefer easily processed information — on short term share price movements. In both a laboratory study and an analysis of naturalistic real world stock market data, fluently named stocks robustly outperformed stocks with disfluent names in the short term. For example, in one study, an initial investment of $1000 yielded a profit of $112 more after one day of trading for a basket of fluently named shares than for a basket of disfluently named shares. These results imply that simple, cognitive approaches to modeling human behavior sometimes outperform more typical, complex alternatives.

Nobody makes you shop at Wal-Mart...

2006-08-21T09:18:00.000-07:00

In the book No one makes you shop at Wal-Mart by Tom Slee some of the dynamics of choise is presented...

First of the classical view:

It is now conventional wisdom that individual choice tames the wild tigers of private industry, and that free markets provide the mechanism for it to do so. Our ability to walk away, to choose not to buy what they are trying to sell, is the ultimate source of power in a free-enterprise society. The economy is a great democracy in which we cast our votes not once every few years, but each and every time we make a purchase. In the face of our choices, business has no choice but to respond to our demands, or even to our whims. Adam Smith's "invisible hand" of the market guides them to carry out our bidding. Brand-name companies, for example, are powerless in the face of individual choice. The British business magazine The Economist points out that "Brands do not rule consumers; consumers rule brands." According to one corporate consultant the magazine quoted, "When we like a brand we manifest our loyalty in cash. If we don't like it, we walk away. Customers are in charge."
...choice is useful only if it helps you to get what you want. And the thing is, it often doesn't.

The book presents a good example of the dynamic inconsistency that may arise with regards to choises:

Jack lives in Whimsley. Some time ago Jack used to do most of his shopping in the downtown area--of course, he no longer does--and he also used to walk through the downtown before crossing Whimsley Park on his way to work.

Jack shares an eccentric trait with the other inhabitants of Whimsley: he has an odd way of making choices. As he goes about his daily life, when faced with a decision he assigns numerical points to the benefits and costs of the available options, and he chooses the option that gives the most points.

Let's follow Jack's reasoning as he thinks about what life was like when he shopped in the downtown area.

Value. I did much of my shopping at the two downtown department stores. They provided reasonable selection and price. They were worth two satisfaction points per week.

Variety. I liked the variety of the two stores. Sometimes I went to one store, sometimes the other, depending on what I needed, how much time I had, what other errands I had, and so on. The variety of having two stores was worth an additional two points.

Atmosphere. I assigned myself another two points each week from my enjoyment of the thriving downtown as I walked through it on the way to work.

Jack was happy to the tune of six points per week: two for selection and price, two for the variety of shopping options he had available, and two for the atmosphere of the thriving downtown.

A few years ago Wal-Mart opened a new store on the outer edge of Whimsley. Wal-Mart has huge economies of scale and tremendous bargaining power with its suppliers, and thus is able to offer the lowest prices. Like any consumer, Jack likes low prices. So Jack started shopping mainly at Wal-Mart.

For a while things were pretty good. Jack was happier because of Wal-Mart's arrival in town. Here is his reasoning.

Value. By shopping mainly at Wal-Mart I not only continue to have a reasonable selection but I also get lower prices. So I give myself three points per week for price and selection, instead of the two I used to get by shopping at the downtown stores.

Variety. What's more, Wal-Mart has extended my range of options: I assign myself an additional satisfaction point for the extra variety that Wal-Mart introduces, because on the days I don't feel like trekking out to Wal-Mart I can still visit one of the other stores and get what I need.

Atmosphere. There is no change to the atmosphere of the city, so I still get my two points for atmosphere.

Soon after Wal-Mart arrived, then, Jack was getting eight points per week: three from Wal-Mart's selection and everyday low prices, three from the expanded variety he has available, and, as before, two from walking through the lively downtown to work. Jack was happier than before Wal-Mart built its store.

* * *

Of course, Jack was not the only person in Whimsley to be making choices, and that is where his problems started. Like him, many other people started to shop at Wal-Mart. The smaller department stores downtown started to have troubles, and gradually they went out of business.

Wal-Mart became the only department store in Whimsley. Jack had to shop at Wal-Mart all the time, like it or not. As a result, Jack's points for variety moved down to just a single point. Jack wanted more variety, but instead he got less. With the closing of the downtown department stores, Jack was down to six points per week again. He was as happy as before Wal-Mart came, but no happier. That's not too bad. At least Jack was no worse off than he was before.

But Jack's problems did not stop there. Once the downtown department stores closed, the slower customer traffic in the area meant that other stores closed too. Now downtown is not so interesting anymore: a number of shops are boarded up, others have been replaced by dollar stores, and the buildings are shoddy. Jack does not enjoy walking past the rundown area on the way to work. It gives him no pleasure. No points.

Now Jack has only four points per week. He is less happy than he was before Wal-Mart came.

In the beginning Jack made a choice that he believed would make him happier, but now he finds that he is less happy.

Stock market dynamics vs. counterterrorism

2006-08-21T09:06:00.000-07:00

First seen at mahalanobis...
Zussman and Zussman (2005) Assassinations: Evaluating the Effectiveness of a Counterterrorism Policy Using Stock Market Data:

Abstract: Assassinating members of Palestinian terrorist organizations was a major element in Israel’s counterterrorism effort during the Palestinian uprising which started in 2000. We evaluate the effectiveness of this policy indirectly by examining Israeli stock market reactions to assassinations. Our approach relies on the assumption that the market should react positively to news of effective counterterrorism measures but negatively to news of counterproductive ones. The main result of the analysis is that the market reacts strongly to assassinations of senior members in Palestinian terrorist organizations: it declines following attempts to assassinate political leaders but rises following ttempts to assassinate military ones.

Beaty vs. Supply and Demand

2006-08-05T00:25:00.000-07:00

From the freakonomics blog

Why Do Beautiful Women Sometimes Marry Unattractive Men?
It may be that the unattractive man has a lot of money, or some other compelling attribute.
But a new study by Satoshi Kanazawa, an evolutionary psychologist at the London School of Economics, suggests it may be a simple supply-and-demand issue: there are more beautiful women in the world than there are handsome men.
...
According to this news article, “Selection pressure means when parents have traits they can pass on that are better for boys than for girls, they are more likely to have boys. Such traits include large size, strength and aggression, which might help a man compete for mates. On the other hand, parents with heritable traits that are more advantageous to girls are more likely to have daughters.”

Beauty is apparently just one “female” trait. Kanazawa has done previous research suggesting that nurses, social workers and kindergarten teachers—those with “empathic” traits—also had more daughters than sons. Meanwhile, he found that scientists, mathematicians and engineers are more likely to have sons than daughters.

Another reason why wars are inefficient...

2006-08-02T08:32:00.000-07:00

Alex Tabarrok at marginal revolution:

In Fiasco Thomas Ricks' says the war on Iraq and subsequent occupation was ill-conceived, incompetently planned and poorly executed. I have no quarrel with that. What dismays me is that anyone expected any different. All wars are full of incompetence, mendacity, fear, and lies. War is big government, authoritarianism, central planning, command and control, and bureaucracy in its most naked form and on the largest scale. The Pentagon is the Post Office with nuclear weapons.

The question is then...
- What if wars were fought by private contractors?
- If they were, would they be more efficient?

Is the music industry finally pursuing the long tail?

2006-08-01T06:51:00.000-07:00

Lower fixed costs reduce the breakeven level of sales. So isn’t the long tail really just a hedging strategy that seeks to reduce the risk of the cash flows?

from knowledge@wharton

EMI Music announced on July 6 that it would back a yet-to-be-named record label, started by a management company called The Firm, that abandons the recording industry's traditional royalty payment system for what EMI terms a more "artist-friendly" profit sharing scheme. Instead of paying artists upfront and taking the bulk of the profits later, The Firm will split profits with artists signed to the venture. In theory, this arrangement should lower the risk and upfront costs of finding new talent and encourage more innovative promotion. "You have to give the recording industry credit for realizing that the barriers to entry are lower," says Kendall Whitehouse, senior director of information technology at Wharton. "The industry no longer has a chokehold on distribution. Indie bands promoting their music on [websites like] MySpace are changing the rules."

Customer life time value

2006-07-31T00:23:00.000-07:00

A quite good example of the application of Customer life time value measures can be found at consumerist.com:

A customer service source inside Cingular sends us some interesting internal documents and says the cellphone company has a new policy that's got the headset set in a bind. He reports that Cingular will, "no longer discount equipment for customers that are not profitable for us, no mater where they stand contractually. I have received several calls from customers attempting to upgrade, only to have to inform them that although yes, they are out of contract, we will not offer them discounted equipment. "

But wait, how does a lowly Cingular rep determine how profitable you are as a customer? Luckily, there's a handy box on the operator's screen showing a computerized calculation.

If you threaten to leave Cingular for a wireless provider that doesn't suck, the degree to which they try to lure you back into the fold will depend on how green your mercury is.

Next step in outsourcing?

2006-07-27T02:59:00.000-07:00

The outsourcing of "Coolness" is discussed in Fastcompany

When Hasbro wanted a hand lifting its decades-old My Little Pony toy line out of the realm of kitsch last year, it turned to a tiny Brooklyn, New York, creative agency called Thunderdog Studios. The result: a New York gallery show full of Ponies, each uniquely decorated by a different woman artist.

Now, that was cool. Which is exactly what Hasbro was after. ...

We should've seen this coming. For decades, business pundits (and, okay, we) have lauded the merits of lean, flexible organizations: Embrace the activities that truly add value; jettison everything else. And companies have done so, outsourcing their IT departments, human resources, copy shops, even manufacturing and distribution.

But this is something different, and more sinister. Companies are outsourcing cool. They're paying other companies--smaller, more-limber, closer-to-the-ground outsiders--to help them keep up with customers' rapidly changing tastes and demands. Talk about a core competency! It's like farming out your soul--or at least, asking someone what you should wear in the morning.
...
There's something ageless about this: One generation has looked to the next for advice on cool for as long as there have been out-of-it parents. But seeking advice is one thing; letting an outsider set your agenda is another. Doing so forfeits control of your brand to someone who doesn't own it; it turns you from a creator into a distributor, which is a pretty low-value activity to base a business on. Martin Lindstrom, whose 25-person consulting firm, Brandsense, helps 11 of the world's 100 largest companies keep their brands cool, says, "I'm surprised when they come to us, because they should have structures built in to inform and shape their brand in those fundamental ways."

They don't because staying cool is difficult work. It requires constantly scanning the horizon and taking gambles. And that's scary. "People in huge corporations are afraid of being fired," says Lindstrom. "They don't dare take those risks anymore. The only way they can get a mandate to do this is by taking the risk outside of the company."

ESOPs

2006-07-27T02:46:00.000-07:00

Adam Lashinsky debates the role of employee stock options in Fortune:

Stock options were invented as a way to align the interests of employees with shareholders.
...the system began to crack... in the 1990s, when companies with falling stock prices began to re-price their stock options in order to retain their employees.
...
the system of awarding options has gone from an incentive program to an entitlement. Companies that can't or don't offer rich options are at a disadvantage to those that do. Executives - with the complicity of their accountants, lawyers, compensation consultants and boards of directors - game the system to ensure not that employees are working for the shareholders, but rather that employees will make extra money in all but the gravest of circumstances. Options were considered so sacrosanct that Silicon Valley bigwigs fought tooth and nail to avoid having them accounted for as a compensation expense.
...
So here's a radical proposal: Scrap the whole system...
True entrepreneurs, by the way, the kind that drop out of school, max out their credit cards, eat ramen noodles and risk everything for a dream, won't mind this at all. They don't need stock options to get stinking rich. They have the stock of the companies they start.
True entrepreneurs don't need to play games to become wealthy. It's the executives - the people the shareholders hire to look after their interests - who've been reaping entrepreneurial returns that need to be stopped.

The importance of blogging("marketing") for universities

2006-07-26T04:03:00.000-07:00

Brad Delong discuss the importance of blogging for academic institutions...

Next step... Viral academia?

A lot of a university's long-run success depends on attracting good undergraduates. Undergraduates and their parents are profoundly influenced by the public face of the university. And these days, a thoughtful, intelligent, well-informed Web logger like Juan Cole or Dan Drezner is an important part of a university's public face. Michigan gains in reputation and mindshare from having a Cole on its faculty. Yale loses from not having an equivalent.
A great university has faculty members who do a great many things — teaching undergraduates, teaching graduate students, the many things that are "research," public education, public service, and the turbocharging of the public sphere of information and debate that is a principal reason that governments finance and donors give to universities. Web logs may well be becoming an important part of that last university mission.

Me-media and the quest for ever increasing social networks

2006-07-24T01:24:00.000-07:00

From NYT:

My life goes like this: Every morning, before I brush my teeth, I sign in to my Instant Messenger to let everyone know I’m awake. I check for new e-mail, messages or views, bulletins, invitations, friend requests, comments on my blog or mentions of me or my blog on my friends’ blogs.
Next I flip open my phone and check for last night’s Dodgeball messages. Dodgeball is the most intimate and invasive network I belong to. It links my online community to my cellphone, so when I send a text message to 36343 (Dodge), the program pings out a message with my location to all the people in my Dodgeball network. Acceptance into another person’s Dodgeball network is a very personal way to say you want to hang out.
I scroll through the messages to see where my friends went last night, and when, tracking their progress through various bars and noting the crossed paths. I check the Google map that displays their locations and proximity to one another. I note how close Christopher and Tom were last night, only a block away, but see that they never met up.
I log on to my Friendster, Facebook, MySpace and Nerve accounts to make sure the mail bars are rising with new friend requests, messages and testimonials.
I am obsessed with testimonials and solicit them incessantly. They are the ultimate social currency, public declarations of the intimacy status of a relationship. “I miss running around like crazy w/you in the AM and sneaking away to grab caffeine and gossip,” Kathleen commented on my MySpace for all to see. Often someone will write, “I just posted to say I love you.”
I click through the profiles of my friends to the profiles of their friends (and their friends of friends, and so on), always aware of the little bar at the top of each profile indicating my multiple connections. A girl I know from college is friends with my friend from college’s best friend from Minnesota. They met at camp in seventh grade. The boyfriend of my friend from work is friends with one of my friends from high school. I note the connections and remind myself to IM them later. On Facebook, I skip from profile to profile by clicking on the faces of posted pictures. I find a picture of my sister and her boyfriend, click on his face and jump right to his page.

From popmatters

The essence of friendship is its immeasurablility, not its publicity. I don’t want a database for an identity, nor do I want it for a community. I don’t want to run statistics on my social life. I don’t want Nielsen ratings for my friendships, I don’t want to apply marketing tools to them to see how they might be tweaked, to see how I might reach a better demographic, socially. I don’t want to meter the amount of attention I receive. All of that seems counterproductive, unless I decide to run my personal life like a firm and decide that I need to promote myself the way Proctor and Gamble promotes its toothpastes.

Know your customers

2006-07-21T23:29:00.000-07:00

How much do you know about your customers?
From fastcompany

Mothers in the small Swiss village of Bulach may have been wary of the man with a goatee staring at them as they strug-gled to navigate an ATM, grocery bag in one hand, fractious child in the other. But the man didn't care what their PIN numbers were or how much money they had in their accounts. He wanted to know, Why didn't they just put the bag down?

The answer: The bags were paper, and when the ground is wet--it rains a lot in Switzerland--putting them down means getting the contents soggy. Now, thanks to the man with the goatee, Stephan Kubler, the moms using the ATM at the Credit Suisse branch in Bulach can keep their groceries dry, by resting them on an inch-high grille.

The long tail

2006-07-21T07:32:00.000-07:00

slate presents a good discussion abou the concept of the long tail:

"What are the Long Tail's limits? As a business model, it matters most 1) where the price of carrying additional inventory approaches zero and 2) where consumers have strong and heterogeneous preferences. When these two conditions are satisfied, a company can radically enlarge its inventory and make money raking in the niche demand.
...
it's important to remember that many industries don't rely on the weird economics of information products.
...
The Long Tail also sometimes doesn't work in its home category: the information-technology industries. The key issue is the question of standardization. Sometimes consumers want a diverse set of product offerings. But sometimes they prefer a standard or compatible product. Most of Anderson's examples are content firms, where product diversity is almost always a good thing. But in the information-transport industry, standardization is usually more important. Do people want 10 different types of (incompatible) Internet connections? Or just the fastest one they can get? How about 30 types of (incompatible) Ethernet cables?
...
for every diverse Long Tail there's a "Big Dog:" a boring standardized industry that isn't sexy like Apple or Amazon but that delivers all that niche content you're hungry for.

Game Theory

2006-07-18T12:08:00.000-07:00

Rick Harbaugh presents a lot of interesting articles and working papers such as:

Cheap Talk Comparisons by a Clearly Biased Expert
False Modesty: When Disclosing Good News Looks Bad
Early Round Upsets and Championship Blowouts
Cheap Talk Comparisons in Multi-Issue Bargaining
Too Cool for School? Signaling and Countersignaling
Does Copyright Enforcement Encourage Piracy?

investing, diversification, and human capital

2006-07-17T06:03:00.000-07:00

Remember the importance of human capital when trying to figure out what to invest in. From allfinancialmatters

'I talked to two friends who worked in i-banking recently and asked what they invested in. One invested in index ETFs and a few actively managed, low-expense mutual funds in small-cap and foreign sectors, mostly because of the reasons stated above. The other said his 401-k was invested in, of all things, fixed-income and gold, which really surprised me. But his reasoning made sense: his job is in researching in Asian small-cap equities, meaning his salary and bonus was already tightly tied to a highly risky asset class, so by putting his retirement account in essentially the opposite type of investment, he was diversifying across all his current and future income sources. This is actually a very common practice in i-banking.

The clash of civilizations

2006-07-17T05:33:00.000-07:00

A quite good analysis of mr. Huntingtons book by Lars hvidberg (sorry but it is in danish)

income equality

2006-07-17T04:46:00.000-07:00

Tyler Cowen and Brad Delong has a very good discussion about the development in income equality in the US.

inductive inferences

2006-07-15T02:46:00.000-07:00

Always remember to discuss the confirmation bias

other important cognitive biases

Reversal of priorities?

2006-07-12T00:26:00.000-07:00

The rules have changed in Corporate america. From Fortune

New Rules vs. Old Rules

1 Agile is best; being big can bite you. Big dogs own the street.

2 Find a niche, create something new. Be No. 1 or No. 2 in your market.

3 The customer is king. Shareholders rule.

4 Look out, not in. Be lean and mean.

5 Hire passionate people. Rank your players; go with the A's.

6 Hire a courageous CEO. Hire a charismatic CEO.

7 Admire my soul. Admire my might.

	New Rules	vs.	Old Rules
1	Agile is best; being big can bite you.		Big dogs own the street.
2	Find a niche, create something new.	Be No. 1 or No. 2 in your market.
3	The customer is king.	Shareholders rule.
4	Look out, not in.	Be lean and mean.
5	Hire passionate people.	Rank your players; go with the A's.
6	Hire a courageous CEO.	Hire a charismatic CEO.
7	Admire my soul.	Admire my might.

....

and why did they do that?

Managing to create shareholder value became managed earnings became managing quarter to quarter to please the Street. "That meant a disinvestment in the future," says Khurana, author of "Searching for a Corporate Savior."
"It was a dramatic reversal of everyting that made capitalism strong and the envy of the rest of the world: the willingness of a CEO to forgo dividends and make an investment that wouldn't be realized until one or two CEOs down the road."

...

"How do you think about building shareholder value when a lot of people are really just going to hold the share for the moment?" says Jim Collins, a former Stanford Business School professor and the author of "Good to Great" and "Built to Last." "The idea of maximizing shareholder value is a strange idea when [many shareholders] are really share flippers. That's a real change. That does make the notion of building a great company more difficult."

A case for awareness marketing?

2006-07-11T03:55:00.000-07:00

From bps,
first seen at Marginal revolution

Awareness creates new demand?

Patti Williams and colleagues recruited 167 undergrads and asked some of them about their intentions to take drugs, and the others about their intentions to exercise. Two months later, the students were contacted again, and those who had been asked about drugs reported taking drugs an average of 2.8 times in the intervening period, compared with an average of 1.1 times among the students previously asked about exercise.

Nope... Just increased demand by existing consumers

The effect was even more dramatic when those students who said they hadn’t taken any drugs at all were omitted from the analysis. Among the remaining students, those asked about their drug-taking intentions said they’d used drugs an average of 10.3 times over the past two months, compared with an average of 4 times among the students previously asked about their exercise intentions.

This observation, together with further analysis, suggested it wasn’t that new drug users had been created, but rather that the questioning had led to increased use among current users who presumably had a positive attitude towards drugs in the first place.

Pointers for starting your own company

2006-07-10T07:48:00.000-07:00

From blog.guykawasaki.com:

Focus on cash flow, not profitability
Forecast from the bottom up
Ship, then test
Forget the ”proven“ team
Start as a service business
Focus on function, not form
Pick your battles
Understaff
Go direct
Position against the leader
Take the “red pill

Power Point Pointers

2006-07-10T07:41:00.000-07:00

From blog.guykawasaki.com

A couple of tips for writing

2006-07-10T07:34:00.000-07:00

Active vs passive writing
from blog.guykawasaki.com

Income vs. happiness

2006-07-04T09:23:00.000-07:00

But what about wealth vs. income?...
People tend to work a lot in order to have a high income... You have to love your work a lot with high income, since leisure time goes down...
From news@princeton

"The belief that high income is associated with good mood is widespread but mostly illusory," the researchers wrote. "People with above-average income are relatively satisfied with their lives but are barely happier than others in moment-to-moment experience, tend to be more tense, and do not spend more time in particularly enjoyable activities."

Systematic vs. unsystematic risk

2006-07-04T00:06:00.000-07:00

Is biotech really that risky?
From Knowledge@wharton

Prior to the discussion, Wharton finance professor Andrew Metrick explained how financial economists view risk by citing two hypothetical companies -- Box Co., an established manufacturer of corrugated boxes, and Drug Co., a biopharmaceutical company. Box Co.'s returns rise and fall with the overall economy, while Drug Co. is working on a cure for a host of diseases, but has little probability of success. Assuming both companies have the same expected cash flow, which company would be expected to generate higher returns for investors? Metrick asked.

He explained that while the drug company has a high level of individual, or idiosyncratic, risk, the box company should offer a premium to investors willing to back it in bad times as well as good. "The box company does well when people are already doing well. It has poor returns when the economy is poor and people are hungry," Metrick noted. "If someone says, 'I will hold Box Co., which will not pay much exactly when I am most hungry,' then they need to be compensated."

Investors in the drug company could mitigate their risk by buying up shares of many drug companies, hoping at least one will come up with a hit product to justify the overall investment.

From the same article. The very important issue of interest versus capability...

He also explained why small venture capital firms take on so much more risk in backing long-shots than do large corporations that have more resources or appear to have the ability to absorb a swing and a miss. Executives and employees at a large company all share in the downside of problems when problems arise at the targeted firm, he said, but the benefits of hitting a home run with a new technology investment are diluted. He noted that even the largest venture capital firms have very few partners, allowing each to win big if a high-risk investment pays off. "These are small organizations. When they get too big, the incentives for any one person aren't so clear," said Metrick. "If someone is better than their partner, then they leave and start their own firm."

Cost benefit calculations

2006-07-03T23:52:00.000-07:00

Bilmes and Stiglitz has tried to estimate the cost of the war in Iraq. From Harvard Magazine

Before the United States invaded Iraq in 2003, Secretary of Defense Donald Rumsfeld and then-director of the Office of Management and Budget Mitchell Daniels (now governor of Indiana) put the likely costs at between $50 billion and $60 billion. Former undersecretary of defense Paul Wolfowitz (now president of the World Bank Group) claimed that increased Iraqi oil revenues would pay for the war. When President Bush’s economic adviser Lawrence Lindsey suggested that the actual costs might be closer to $100 billion or even $200 billion, the White House called those figures grossly exaggerated and swiftly fired him.

Those estimates now look Lilliputian. The Congressional Budget Office (CBO) currently projects past and future Iraq-related expenditures to surpass $500 billion, and even that figure severely underestimates the full outlay, according to Bilmes and Stiglitz, whose paper indicates that the war will eventually cost Americans in excess of $2 trillion. (A trillion is a thousand billions.) Speaking of those in Congress who agreed early on to appropriate $87 billion to finance the war, Bilmes says, “Every time someone casts a vote, they implicitly make a cost-benefit analysis. Would they have voted the same way if they knew the costs were 10 times as much as advertised?”

Size does matter?

2006-07-03T06:11:00.000-07:00

Is this a way to control consumption? A potential CSR strategy that should be incorporated into the 4Ps?
from BPS Research Digest

‘Unit bias’ – “…the sense that a single entity (within a reasonable range of sizes) is the appropriate amount to engage, consume or consider"

To test this, the researchers left a bowl of M&M sweets in the hallway of an apartment building with a sign that read “Eat Your Fill: please use the spoon to serve yourself”. Some days they left a tablespoon-sized scoop, other days they left a quartercup scoop that was four times as big. Passers-by could obviously help themselves to as little or as much as they wanted regardless of which spoon was provided, but on average, 1.67 times more M&M’s were taken on the days the big scoop was left compared with the tablespoon-sized scoop.

In another experiment, the researchers found that, measured by weight, significantly more pretzels were taken by passers-by when a complimentary bowl of 60 whole pretzels was left in an apartment building, compared with when a bowl of 120 half-pretzels was left. And it was a similar story when either a bowl of 80 small Tootsie rolls (an American snack bar) or a bowl of 20 large Tootsie rolls was left in an office building.

In other words, throughout the study, people took more food when the unit on offer was larger. “Consumption norms promote both the tendency to complete eating a unit and the idea that a single unit is the proper portion”, the researchers said. However, they also acknowledged that other factors must have been at play because the amount of food taken did not vary in direct proportion with the increase in unit size on offer.

Incentives and IT

2006-07-03T06:07:00.000-07:00

From Wired

Economics can actually explain many of the puzzling realities of internet security. Firewalls are common, e-mail encryption is rare: not because of the relative effectiveness of the technologies, but because of the economic pressures that drive companies to install them. Corporations rarely publicize information about intrusions; that's because of economic incentives against doing so. And an insecure operating system is the international standard, in part, because its economic effects are largely borne not by the company that builds the operating system, but by the customers that buy it.

A race to the bottom ?

2006-06-27T04:05:00.000-07:00

A note on competitive ads

From Knowledge@Wharton

Zhang, a Wharton marketing professor, has found that combative ads -- the sort of comparative spots that beer makers, particularly Anheuser-Busch and Miller, are famed for -- may backfire. Instead of pulling consumers to an advertiser, they may just make people indifferent to all offerings in a product category. And that, in turn, can lead to lower profits for everyone as businesses cut prices to lure these buyers.

And as a funny anecdote:

Presidents, or rather a presidential campaign, originally motivated Zhang to take a closer look at ads. He started scrutinizing them seriously six years ago, when George Bush and Al Gore squared off. He found that the negative ads that are so common in modern campaigns didn't draw him to one of the candidates, but made him uneasy about both. That got him wondering whether commercial claims might have the same effect. "Most of the political scientists say advertising doesn't play much of a role in people's voting choices," he says. "They just reinforce what people already believe, their preferences and partisanship. But sometimes you also observe that you feel a little more indifferent to the politicians after your hear their ads."

Working from home?

2006-06-27T03:56:00.000-07:00

It is typically argued that people that work from home (or away from the office) miss out on promotions etc.. Can this example be applied in a way that solves this?

From Knowledge@Wharton

One of Yakubovich's current research projects focuses on social networking at a real-life telemarketing company that he has dubbed the Virtual Call Center to ensure its anonymity. The agents who take telephone orders from viewers of television infomercials do not work in the same office; instead, each works out of her home (most of the call-takers are women). As independent contractors rather than employees, the agents have the flexibility to schedule their work at their convenience so that they have enough time to take care of their children and do chores.

As a result of the company's virtual nature and the way its incentive system is structured, it is a challenge for the firm to get agents to sign up for work and to keep them on their shifts. An agent may decide to stop working once she feels she has made enough money for the day, even though she can earn more if she keeps going.

But Yakubovich learned that agents tend to work more when they have an opportunity to engage in social interaction by talking with other agents in chat rooms at those times when they are not on the telephone with customers. Such a social network can hold great appeal for workers who desire a place for companionship in the same way that employees at a factory or office use break rooms to socialize.

"Even though they are geographically dispersed and this is a completely new kind of workplace, these agents create social networks," Yakubovich notes. "The social interaction becomes part of the work environment. People enjoy signing up for shifts and end up working longer when they do if they have a way to socialize" -- which turns out to be an unintended benefit for the company.

Portfolio management

2006-06-26T04:26:00.000-07:00

Diversification is always a good thing. From slate

There are some obvious differences between Van Gogh canvases and Verizon shares. Art is far less liquid than stocks: You can't simply push a button and sell a Picasso tomorrow. And while you might assume that the fortunes of the art market are closely to tied to the fortunes of the stock market, Moses found that fine art actually has a very low correlation with stocks and a negative correlation with bonds. "In some sense, it's a good portfolio diversifier," says Moses.

How to distribute students in classes?

2006-06-26T03:51:00.000-07:00

Excerpt from new study from NBER:

We find that students benefit from having higher achieving schoolmates and from having less variation in the quality of peers in their schools.... The marginal effect of a one percent increase in the quality of peers on student achievement is equivalent to between 8−15% of a one percent increase in one’s own earlier achievement.
We find that peer effects operate in a heterogeneous manner. High ability students benefit more from having higher achieving schoolmates and from having less variation in peer quality than students of lower ability.

And what is the long term effect? ( comment from Greg Mankiws blog)

One implication of this is that parents with smart kids will always find it more in their interest to have their kid in a school with other smart kids (given the complementarity); theyll always be more willing to outbid parents of less smart kids. So, we'll end up with a kind of separating equilbrium with smart kids together, which is, broadly speaking, what we see in reality.

In fact, some of the rise in inequality in the US is attributable to this kind of sorting in the workplace. Namely, with the entry of women into the workplace, we have smart men and women meeting and forming matches, thus raising household income inequality. As such, theres nothing sinister about inequality if this is a source. Indeed, inequality starting rising in the US when female labor force participation started rising.

Still problems with the fiduciary duties

2006-06-26T00:47:00.000-07:00

Sometimes signaling is all about covering up reality.
What can be done to alleviate the P/A problem between Investors and management?

from the age:

"Take for instance a recent University of Michigan study. Apparently there's a simple reason why annual reports are hard to read: managers, in many cases, are trying to hide something.
The study, Annual Report Readability, Earnings and Stock Returns, found that the annual reports of underperforming companies are harder to read than those of companies that are performing well."
...
"Opportunistic managers may have incentives to make the annual report harder to read, if good earnings of this year are not persistent or if poor earnings are very persistent"

A funny anecdote from the same page... :

"The old website of WorldCom, which emerged from bankruptcy due to accounting fraud as MCI Inc, is a case in point. It reportedly had a glossary of "essential terms and phrases" that included "wugga wugga" (the sound of a computer program), "blivit" (a bug in a sales pitch), "seedware" (promotional software) and WOMBAT (a bone-headed idea: a Waste Of Money, Brains And Time). "
....
"The link with deceit was made 60 years ago by George Orwell in his seminal essay, Politics And the English Language: "When there is a gap between one's real and one's declared aims, one turns, as it were, instinctively to long words and exhausted idioms, like a cuttlefish squirting out ink … Every such phrase anesthetises a portion of one's brain.""
...

So what's the effect on disclosure and the annual reports? Is increasing the demands for disclosure in the interests of investors (and society) or will it just give management another tool for covering up?

"According to deputy chairman Jeremy Cooper, issuers and advisers still had to get their heads around what disclosure actually meant. "So far, there's been a lot of 'over-disclosure' as a means of limiting liability," he said at the time."

Adaptive Markets Hypothesis - A more compelling story?

2006-06-17T01:52:00.000-07:00

How rational are investors actually?
From Yale Economic Review..

According to the theory, the market is a dynamic ecosystem, and investors make decisions based on past experience instead of solely optimizing utility. In this framework, behavioral biases are abundant but explainable. In trying to adapt, investors replicate past successes or abandon failed strategies. But they commit apparently irrational mistakes by trying to apply old strategies to new market situations. Natural selection can also change aggregate behavior by forcing unsuccessful investors out of the market.
In the market ecology, the value of scarce resources – prices – are determined by the interaction between environmental conditions and the number of investor “species” in the market. All else being equal, the more species present, the greater the level of competition, which leaves fewer opportunities to profit and makes the market more efficient. A lack of competitors causes slower incorporation of information into prices, yielding more and longer lasting profit opportunities. In the AMH framework, the EMH is the steady-state solution of a market with an unchanging environment, whereas the findings of behavioral finance reflect dynamic adaptations which may succeed or fail.
The AMH leads to fascinating implications for financial theory. Unlike in the EMH, “history matters,” Lo asserts. Risk preferences in the AMH, for example, change according to past market prices. Current investors’ average risk preference, for example, has decreased because risk-loving investors who suffered losses in the tech stock bubble of the late 1990s left the market after its fall in 2000 and 2001.
There are also important practical applications of the AMH. In contrast to the EMH, the AMH implies that portfolio research is not completely useless, because markets can be biased by past prices. To survive market changes, innovation is also essential for survival, so investment managers must develop diverse methods suited to different environmental conditions. Knowing that behavioral biases are inevitable, good financial advisors should seek to point out harmful biases to their clients.

Efficient markets?

2006-06-16T05:37:00.000-07:00

Does FED statements actually have any informational value? Or should they have?
A comment by Greg Mankiw

Fundamentally, Fed watching is a symptom of ambiguity in monetary policymaking. Fed insiders do not have significantly more data on the economy than everyone else. When financial markets react to Fed statements, therefore, they are not incorporating news about the economy. Instead, they are incorporating news about policymakers' intentions. So if a speech or testimony by a Fed official moves financial markets, it means that the intentions of monetary policymakers were not clear before the speech or testimony.
...
Macroeconomic data would move markets; remarks by Fed officials would not.

The ideal would be a completely boring Fed chairman whose speeches are regularly ignored by financial markets. Apparently, we are not there yet.

Further applications... The value of stock analysts etc.

Markets in everything... so you've got a guilty conscience?

2006-06-16T05:05:00.000-07:00

An interesting business idea for private consumers... From Slate

If you're feeling guilty about driving your giant sport utility vehicle (but not so guilty that you'd ever give it up), salvation is at hand. For a yearly fee of around $80, a company called TerraPass will offset the damage your SUV does to the atmosphere by spending your money to reduce industrial carbon emissions and to promote the spread of clean energy. They'll also send you a decal and a bumper sticker, so everyone in the neighborhood will know that your gas guzzler has been sanctified.
...
Buying a TerraPass is a little like voting—irrational for any individual, given that elections are almost never decided by one vote, but collectively beneficial indeed.

Stock market crashes vs. Rationaliy

2006-06-12T08:19:00.000-07:00

From Slate:

But conventional economics is not wrong—or at least, stock-market crashes are no evidence against it. Rational investors in an efficient market should produce frenzies and crashes from time to time. In fact, the more intelligent the investor, the more likely this is to happen.

The fundamental insight is that there is nothing irrational about trying to learn from what other people in the market are doing. Remember that shares have a true value based on the future stream of company profits. But nobody knows what that value is. Smart investors should realize that other smart investors will know things that they do not. If they don't take into account the private information held by other investors, they will make bad decisions, and they can learn only by watching what other people do.

Hedging of oil prices for consumers

2006-06-04T05:35:00.000-07:00

A cap on gazoline spending is now available in the US.

How to prepare your kid for an ivy league college?

2006-06-04T04:20:00.000-07:00

Start visiting museums...

found at

Appreciation of the market economy in cold war Russia

2006-05-31T10:28:00.000-07:00

From david Warsh: Knowledge and the Wealth of nations

The Cold War is entering its climatic phase. There are war fears at the highest levels of government. In London, KGB agents have been directed to track the spot price offered by blood banks by officials worried that a sharp rise would be a signal that the West was preparing to mount a surprise attack.

A cool tool

2006-05-31T10:15:00.000-07:00

Fun with charts and maps

Its al about timing

2006-05-29T09:30:00.000-07:00

The following exerpt from the New York Times shows that it's not just the skills or hours you put in that count when you're going to the bank...
And that's not just for investment bankers...

Consider the evidence uncovered by Paul Oyer, a Stanford Business School economist, in his recent paper, "The Making of an Investment Banker: Macroeconomic Shocks, Career Choice and Lifetime Income" (National Bureau of Economic Research Working Paper 12059, February 2006. http://faculty-gsb.stanford.edu/oyer/wp/mba.pdf). Dr. Oyer tracked the careers of Stanford Business School graduates in the classes of 1960 to 1997.
He found that the performance of the stock market in the two years the students were in business school played a major role in whether they took an investment banking job upon graduating and, because such jobs pay extremely well, upon the average salary of the class. That is no surprise. The startling thing about the data was his finding that the relative income differences among classes remained, even as much as 20 years later.
The Stanford class of 1988, for example, entered the job market just after the market crash of 1987. Banks were not hiring, and so average wages for that class were lower than for the class of 1987 or for later classes that came out after the market recovered. Even a decade or more later, the class of 1988 was still earning significantly less. They missed the plum jobs right out of the gate and never recovered.
And as economists have looked at the economy of the last two decades, they have found that Dr. Oyer's findings hold for more than just high-end M.B.A. students on Wall Street. They are also true for college students. A recent study, by the economists Philip Oreopoulos, Till Von Wachter and Andrew Heisz, "The Short- and Long-Term Career Effects of Graduating in a Recession" (National Bureau of Economic Research Working Paper 12159, April 2006. http://www.columbia.edu/~vw2112/papers/nber_draft_1.pdf), finds that the setback in earnings for college students who graduate in a recession stays with them for the next 10 years.

Writing tips for PhDs

2006-05-29T09:02:00.000-07:00

A nice little pdf full of god advice about how to write your thesis...

If you don't have a topic yet...

The role of senior economists

2006-05-29T08:50:00.000-07:00

Citation from punditokraterne

"Jeg har haft en del deja vu‘er her på det sidste, for det har været “overophedning” mig her og “overophedning” mig der. Alvorlige, “respekterede” “cheføkonomer” (et andet ord for en af de mere poppede informationsmedarbejdere i en større bank) har talt i diverse medier om at overophedning truer den danske økonomi (økonomien generelt, ikke bare bestemte brancher (byggebranchen))"

Mobile phones and China

2006-05-16T01:28:00.000-07:00

Not much has changed in China has it?

From Wired: "Anonymity lost:"

China will soon require all mobile phone users to register with telecom providers or face a cutoff in service.

The new rule, announced by the Ministry of Information Industry, is part of a crackdown on telephone fraud and illegal text-messaging practices, and the country's thriving trade in counterfeit and otherwise illegally obtained mobile phones.

It is also expected to help authorities control "improper political commentary."

Many Chinese mobile phone users already are registered with major telecommunications companies such as China Mobile and China Unicom. But a large share use prepaid phone cards and buy the subscriber identity module, or SIM, device that activates the phone without any form of registration. Up to 200 million of China's 377 million mobile phone subscribers use prepaid cards.

Implementation of the new requirement is expected to begin by the end of the year, with customers having to comply within six months or lose their phone services."