In the mid-1980s, The Coca-Cola Company (NYSE:KO) made what has gone down in business history as one of the biggest mistakes of all time; here’s how that decision was described by former President of The Coca-Cola Company and current Berkshire Hathaway (NYSE:BRK.B) board member Don Keough:
“I’ve become very wary of all studies related to marketing and business management. They have their place, but I’m convinced that we are often measuring the wrong variables and the wrong people are evaluating the measurements.
The classic example for The Coca-Cola Company was the infamous introduction of New Coke in 1985. In blind taste tests that involved little sips of product A versus product B, the sweeter product won. This led us to the erroneous conclusion that Coca-Cola was not sweet enough.
But blind taste tests completely fail to portray the full dimensionality of the product Coca-Cola – its total image and cultural context.”
In a speech entitled “Practical Thought about Practical Thought?” Charlie Munger addressed this event, saying the following:
“The brilliant and effective executives who, surrounded by business school and law school graduates, have run the Coca-Cola Company with glorious success in recent years, also did not understand elementary psychology well enough to predict and avoid the “New Coke” fiasco, which dangerously threatened their company. That people so talented, surrounded by professional advisers from the best universities, should thus demonstrate a huge gap in their education is also not a satisfactory state of affairs…
Academia, by and large, continues in its balkanized way to tolerate psychology professors who mis-teach psychology, non-psychology professors who fail to consider psychological effects obviously crucial in their subject matter, and professional schools that carefully preserve psychological ignorance coming in with each entering class and are proud of their inadequacies.”
I point to this information because finance is largely suffering from this failure to consider such obviously crucial subject matter. One of the better know examples is Value at Risk, or VAR, models; here’s what David Einhorn had to say about VAR during an interview with the Financial Crisis Inquiry Commission:
“The other major thing with the investment banks that you didn’t allude to is the use of the value-at-risk models which made no sense from my judgment because they cut off the tail. And the whole point in my view with risk management is to prepare yourself for what happened in tail events [as he’s said in the past, that’s the equivalent of having air bags that always work unless you get into an accident]. And second, because the people who are running the banks or who were involved with the banks, understood that the risks in the tails were being cutoff, they effectively were able to game the system by buying securities that in the model showed no tail risk and therefore required no capital or almost no capital.”
Another area where this is apparent is the efficient market hypothesis (EMH), which is a cornerstone of academic financial theory; in its strongest form, EMH suggests that even insiders, with hidden information, would not be able to consistently achieve risk-adjusted returns in excess of the market. The assumptions required for this to hold are truly laughable; on the other hand, the fact that academia still uses EMH as a crutch (for example, beta as a measure of risk) for financial education at our nation’s top universities is a disgrace and a disservice to those looking to enter the field (as a relatively recent college grad, I can attest first hand that this is still the order of the day).
This article doesn’t really have a point: It’s simply a call to those interested to address deficiencies that may exist in your current financial education. As directed by Mr. Munger, I believe two critical areas of focus are behavioral finance (which I’ve researched extensively and will write about more in the future) and multidisciplinary learning (something I’m personally lacking in a big way); over time, I’ll attempt to learn more in these areas and write articles that may (hopefully) help us all to collectively move closer to a better understanding of that which is needed to be a successful investor and businessman/businesswoman.
If any readers have a suggested starting point on this trek, I would love to hear your thoughts.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.