30 January 2015

Why Corporations Could Get Higher Returns Than VCs

Daniel Kahneman is the only psychology professor to have won a Nobel Prize in Economics. His studies with Adam Tversky on how people value things is one of the reasons. They suggest something counter-intuitive about risk.

In one study, Kahneman ran a few scenarios with coffee mugs from a person’s alma mater. In one scenario, he gave people the mug and let them “take ownership” before offering to buy it back from them. In the other study, he let people buy the mug that was not yet in their possession. On the surface, you would think that they would value the mug the same way in both instances, but they didn’t. He had to pay, on average, $7 and some change to buy the mugs back from people. By contrast, he had to sell the mug for about $3 and change to get them to buy when they did not already own it. Kahneman’s conclusion was that people put a higher price on loss than they do gain. It is more painful to lose what you have than never get something comparable. He had to pay people twice as much to give up their mugs as they were willing to pay to buy them.

This makes sense. You might feel the pang of a relationship that fails to materialize but that is nowhere near as devastating as a divorce. Not getting the job is rarely as painful as being laid off. Loss is painful and we put a premium on avoiding the loss of valuable things.
This is one reason that Warren Buffet is worth so much. He sells insurance. People pay a premium to avoid loss. Richard Thaler discovered that people would not pay more than $200 to avoid the 1 in 1,000 chance of immediate death, which suggests they value this added probability about the same as a smart phone. But if you offer to pay someone to accept 1 in 1,000 odds of immediate death, they refuse it even for $50,000.[1]

Just to be clear on this oddly paradoxical approach to risk, here are the scenarios.

Scenario 1: You have a choice between two pills to cure what ails you. The $1 pill has a one in a 1,000 chance of killing you immediately. The premium pill eliminates this chance. How much extra will you pay for the premium pill?
Research suggests that the average person will not pay more than $200 for the premium pill.

Scenario 2: You are offered pay to be in a research study, testing the $1 pill that carries a one in a 1,000 chance of killing you immediately. How much will you demand to take this risk?
Research suggests that the average person will not do it even for $50,000. 

Oddly, this does not result from a difference in the probability of death: in both cases, it is one in 1,000. These two scenarios offer the exact same risk, the exact same chance of death. One measures how little you are willing to lose to avoid the risk and the other measures how much you have to gain to accept the risk. The pain of loss is much greater than the allure of gain. We do not feel so bad about losing out on big gains but we desperately try to avoid even small losses.

These differences in how we value risk help to explain why the derivatives, junk bond and futures markets are worth trillions. Smart investors will buy risk from people at a discount. Now that would just be interesting if it were not for something really fascinating that it suggest about how corporations could use behavioral psychology and the popularization of entrepreneurship to earn returns that venture capitalists would envy.

The prime candidates for entrepreneurial ventures are actually people in their 30s and 40s. Their startups are less likely to fail and reasonably so. They have more experience than people in their 20s and more drive than people in their 50s. They have learned about processes, products and people and typically know at least one industry reasonably well. But they have one major disadvantage in comparison to the twenty-something crowd: they have so much to lose.

Imagine a 40 year old who has been in the industry – any industry – long enough to have a potentially lucrative idea. He knows a cheaper way to make an old product or has an idea for an innovative new product or how to create a new market. He also knows that executing this idea will require capital. And leaving his job. And working at risk for at least a year – more often 3 to 7 years. It is not hard to imagine that at 40, he has been married for 10 or 12 years. His children are 9 and 7 and he has a small amount saved for their college. He is 8 years into his 30-year mortgage. He is 10 years into his job and now gets 4 weeks of vacation and is fully vested in the 401(k), which is just starting to seem sizable – but still not enough for retirement. The man has a lot to lose. Most importantly, he puts more weight on the cost of losing all that than he does on the potential gain from his entrepreneurial venture.
The twenty-five year old, by contrast, has almost nothing to lose. For this reason alone, she might be the better candidate for entrepreneurship.

If Kahneman’s studies are right, our 40 year old values what he has now vs. what he could have at a rate of about 2 to 1. If Thaler is right, he values it at a rate of at least 250 to 1. In any case, the emotional cost of losing what he already has is great. He would be sick to wake up at 47 with no 401(k), no business, no money for college for his 16 and 14 year old children, and no equity in his home. The prospect of this is more terrifying than the hope of waking up at 47 to a net worth of $5 or 10 million and the expectation of doubling that every 2 to 5 years. His preference for the second scenario is not as great as his desire to avoid the first. Loss is more sharply felt than gain.

This suggests that corporations have a great deal to make by offering entrepreneurial opportunities to their employees. Countless employees who could be great entrepreneurs shy away from the prospect because they have something to lose. What a corporation would have to offer as a percentage of returns would be less – perhaps considerably less – than what a venture capitalist or traditional banker would have to offer. A successful venture could return considerably more to the corporation than it might to the venture capitalists simply because the employee as entrepreneur would have so much less to lose than the employee who leaves his job to become an entrepreneur.

[1] Peter L. Bernstein, Capital Ideas Evolving [John L. Wiley & Sons, Hoboken, New Jersey, 2007] p. 15.

Stay tuned. This is an excerpt from an update to The Fourth Economy: Inventing Western Civilization, soon to be released with revisions. In the 20th century, we popularized knowledge work. In this generation we will popularize entrepreneurship. This is going to be big.

20 January 2015

Why Financial Bubbles Are Becoming More Common (and Dangerous)


“Between June 1998 and June 2008 the notional[1] value of outstanding over-the-counter derivatives exploded from $72 trillion to $673 trillion … just under eleven times global gross product.”[2]
“The gross debt of the US financial system grew from 20 percent of GDP in 1979 to 120 percent in 2008. In the UK, the gross debt of the financial system reached two and a half times GDP in 2007.”[3]

How is it possible to have so much capital?

One theory offered by people like former Fed Chairman Ben Bernanke and Europe’s most respected financial commentator, Martin Wolf, is that we have a savings glut. There is no way to distinguish between a savings glut and an investment dearth but in either case, the supply of capital is great enough that interest rates hit zero. (When something is scarce, its price goes up. When there is a glut of it, the price goes down. Interest rates are the price of capital and interest rates have been at or near zero for most of this new century.)

A glut of capital would have seemed like a fantasy to people living in the second economy (1700 to 1900) when capital was the limit in the same way that an all-you-can-eat buffet would have seemed like a dream come true to medieval peasants. But excess can bring its own problems and the financial crisis of 2008 that triggered the Great Recession was a reminder that a financial system can be weakened by either too little or too much capital. 

Capital was the limit to progress in the second economy. Capital made the biggest difference and was the source of the most new jobs and wealth. In most – but not every – instance, more or better capital was the answer to the question of how to make progress. If we imagine the economy as requiring four factors of production, the second economy looked like this.

During the second economy, to make more capital was to make more progress. Limits define the output of a system. The two-lane stretch of highway  determines how many cars pass through in rush hour, not the three-lane stretch beyond it. In 1700, there were hardly any machines able to do work. Instead, work was  manual. More machines, more factories, and more stocks and bonds to finance them all increased total economic output.

But with an investment dearth, capital is no longer the limit. In the fourth economy, the new limit is entrepreneurship. Our economy looks more like this now.

To create more credit, to generate more capital, is like building up a glut of products between your second and fourth machine in the factory. It is the equivalent of increasing the capacity of the capital without a corresponding increase in knowledge workers or entrepreneurs. In the bubble leading up to the financial crisis of 2008,  financial markets were wildly productive. That would have been a good thing had entrepreneurs been hiring workers at record levels, but they were not. The result was a huge bump in capital that simply bid up the price of existing assets (like homes and stocks) rather than creates them.

This is akin to an increase in the rate at which we build up inventory (the product that passes through machine two) without increasing the rate of products that leave the factory (product that passes all the way through machine four). Inventory can only stack up for so long before the second machine has to halt production. This becomes the cycle of booms and busts when the second machine is capital. More capital at the dawn of the fourth economy created bubbles. Once we popularize entrepreneurship, this rise in capital output will be hugely beneficial.

For now, though, we have trillions in capital sloshing about the globe in search of returns that, like waves in a bathtub, can only go so far in one direction before it will reverse direction. In the late 1990s, it flowed into the stock market and drove up prices there, first creating a bubble and then a bust in 2000 when it left. In the mid-2000s, it flowed in the housing market, driving up prices there, first creating a bubble and then a bust in 2008 when it left. Capital has become dangerous, driving up the price of assets every time it sees one as key to returns and then driving down their price once it realizes the gains are the result of a surplus of capital bidding up the price of a scarcity of assets.
That dynamic was at work in the 2008 financial meltdown. When markets fell, assets as varied as real estate and stocks dropped tens of trillions of dollars. About 30 million people around the world lost their jobs and millions lost their homes.

Until we get better at developing entrepreneurs and making employees more entrepreneurial, we will have an investment dearth. We continue to get better at making capital but that is no longer the limit. Once we get better at making employees more entrepreneurial, we will have a good use for such huge amounts of capital. At that point, we might even shift from an investment dearth to an investment glut (or savings shortage). At that point, there will be an abundance of opportunities for capital. Until then, an excess of capital will continue to create a series of bubbles and busts.

[1] Notional value inevitably exceeds the market value of a derivative. You might have a derivative based on a $100 stock price but would reasonably expect its value to move only 5 to 20% of that, a fraction that would set the market value. “Still, the market value of derivatives rose from $2.6 trillion to $35.3 trillion in December 2008, itself more than half global output,” Wolf writes.
[2] Martin Wolf, The Shifts and the Shocks: What We’ve Learned – and Have Still Yet to Learn – From the Financial Crisis, [Penguin Press, Kindle Version, 2014] p. 128.
[3] Wolf, The Shifts and the Shocks, p. 129.

09 January 2015

This Decade's Extraordinarily Good Job Creation Performance

December's job report completes the fifth year of this decade. So far, this has been an extraordinarily good decade.

First, a simple fact. The economy has now created more jobs in the first half of this decade than it did in all of the 1950s.

First, measured by jobs created, 2014 is the best year yet for the decade. This recovery is not slowing. Not yet.

The unemployment rate, too, dropped last year at an impressive rate, the second year in a row in which it dropped by more than 1 point. At 5.6%, it is back to what it was in the summer before Lehman Brothers' bankruptcy in 2008. Remember that in December of 2009, it was 9.9%. 

So how does this compare to past decades? It stands out.

Not only has the American economy created more jobs in the first half of this decade than it did in all of the 1950s, it has easily outperformed the first five years of every decade since. 10.7 million jobs is nearly double what the economy created in the first half of the 1980s.

I wonder if the pundits will change their tune about this terrible economy before the decade is over or if they're just going to leave that to historians.