“It is better to be roughly right than precisely wrong.” - John Maynard Keynes
Charles Munger, vice-chairman of Berkshire Hathaway, is well-known for advocating a multi-disciplinary approach for problem solving purposes. What this means is acquiring an understanding of the big ideas in many disciplines such as psychology, economics, and mathematics amongst others. This results in the development of mental models in which “….you hang your actual experience and your vicarious experience (that you get from reading and so forth), on this latticework of powerful models” and “things fit together in a way that enhances cognition.”
One of the profound gifts of worldly wisdom and hence, mental models, is they can be used to take general, qualitative information, massage it a bit, and make it semi-quantitative in the mind, thus bringing insight and connections where none existed before. This is profound as the human mind does not process superficial, opaque information well.
“He that builds before he counts the cost, acts foolishly; And he that counts before he builds, finds he did not count wisely.” -Benjamin Franklin
An old model that has been dormant for some time will re-establish itself in a manner that is unfamiliar to most. This model is called opportunity cost. Opportunity cost can be defined as the value of benefits foregone by selecting one decision alternative over another, adjusted for risk (if properly done). This concept surfaces predominantly in business where the project with the highest spread between the cost of capital and return on capital is accepted and others rejected (given capital constraints). In reality, all decisions have an opportunity cost (whether realized or not) but its recognition is fundamental to assessing the true cost of any course of action.
For the past two-plus decades we have only had to make “soft” decisions, if any at all, due to the unabridged availability of cheaper credit over time. For example, most businesses could compete where and when they chose, municipal and state entities received funding as needed, and individuals could have what they wished.
But opportunity cost can also contain “hard” decisions whereby the decision alternative is substantially increased in significance. In other words, the decision is based on “needs” rather than “wants”. Take the business that must decide whether to lay off a few or many workers now or later given the possibility of a lack of credit availability and deteriorating business conditions. For the family, the decision may be between a mortgage payment and credit card payment in order to put food on the table for the next month . It’s important to note that one decision is always better than another even if it may appear negative. At the extreme, the decision is between survival and significant pain. Welcome to the new environment.
“A full understanding that investment in one project implies investment forgone in another is a lesson that many individuals find hard to learn.” -Whitman and Shubik, The Aggressive Conservative Investor
Capitalism, in the new environment, will not luxuriate in the malformation of “competition for competitions’ sake” that was a hallmark of the old environment.
Rather, it will be reduced to the most basic level: the competition for capital. Capitalism knows no truer environment.
Why will the opportunity cost “model” be so hard to learn? An explanation, in part, may be found in the behavioral psychology principle known as “anchoring”. Anchoring is the tendency to make future decisions based on a previous, fixated reference point. In essence, the fallacy lies in a failure to adjust for subsequent information (changes) in the decision-making process. In applying this to our discussion, we can see where future decision-making will be based on inputs and options featured in the previous soft period environment. In fact, many are woefully unprepared and unskilled in hard-decision assessment due to being lulled into a conditioned state for so long.
If the above assessment is roughly correct and we have indeed reached a tipping a point, then a failure to adapt will lead to consequences. Consequence tends to feed on itself and those dependent on the previous period’s softness will not appreciate the fiscal prudence restoration process. What are the consequences to an individual/family, a business, an industry, and a system if the main ingredient to its functionality becomes scarce, or even eliminated?
“We understand life backwards but live it forwards.” -Soren Aabye Kierkegaard
Mr. Munger is fond of saying “Invert. Always invert”. In understanding the possible environment going forward one needs to first understand the previous period of excess by using simple models and what dynamics came together to enable it. Some years in the future we may look back and realize just how unique a period it was.
Capitalism can be disguised as a beautiful maiden that brings wonderful fulfillment and joy (increases in the standard of living) or a merciless beast that maims, or worse, destroys the inefficient. For the past twenty five years, we have enjoyed a wonderful relationship with our beautiful maiden. This morning, the maiden awoke and left her den…without any makeup on.
__________
Michael T. Daniels works in the energy industry and resides in Sacramento, California. He is currently pursuing an MBA with a concentration in Finance from California State University, Sacramento and holds B.A. degrees in Economics and Environmental Studies. Michael welcomes your feedback at [email protected]
Also check out:
Charles Munger, vice-chairman of Berkshire Hathaway, is well-known for advocating a multi-disciplinary approach for problem solving purposes. What this means is acquiring an understanding of the big ideas in many disciplines such as psychology, economics, and mathematics amongst others. This results in the development of mental models in which “….you hang your actual experience and your vicarious experience (that you get from reading and so forth), on this latticework of powerful models” and “things fit together in a way that enhances cognition.”
One of the profound gifts of worldly wisdom and hence, mental models, is they can be used to take general, qualitative information, massage it a bit, and make it semi-quantitative in the mind, thus bringing insight and connections where none existed before. This is profound as the human mind does not process superficial, opaque information well.
“He that builds before he counts the cost, acts foolishly; And he that counts before he builds, finds he did not count wisely.” -Benjamin Franklin
An old model that has been dormant for some time will re-establish itself in a manner that is unfamiliar to most. This model is called opportunity cost. Opportunity cost can be defined as the value of benefits foregone by selecting one decision alternative over another, adjusted for risk (if properly done). This concept surfaces predominantly in business where the project with the highest spread between the cost of capital and return on capital is accepted and others rejected (given capital constraints). In reality, all decisions have an opportunity cost (whether realized or not) but its recognition is fundamental to assessing the true cost of any course of action.
For the past two-plus decades we have only had to make “soft” decisions, if any at all, due to the unabridged availability of cheaper credit over time. For example, most businesses could compete where and when they chose, municipal and state entities received funding as needed, and individuals could have what they wished.
But opportunity cost can also contain “hard” decisions whereby the decision alternative is substantially increased in significance. In other words, the decision is based on “needs” rather than “wants”. Take the business that must decide whether to lay off a few or many workers now or later given the possibility of a lack of credit availability and deteriorating business conditions. For the family, the decision may be between a mortgage payment and credit card payment in order to put food on the table for the next month . It’s important to note that one decision is always better than another even if it may appear negative. At the extreme, the decision is between survival and significant pain. Welcome to the new environment.
“A full understanding that investment in one project implies investment forgone in another is a lesson that many individuals find hard to learn.” -Whitman and Shubik, The Aggressive Conservative Investor
Capitalism, in the new environment, will not luxuriate in the malformation of “competition for competitions’ sake” that was a hallmark of the old environment.
Rather, it will be reduced to the most basic level: the competition for capital. Capitalism knows no truer environment.
Why will the opportunity cost “model” be so hard to learn? An explanation, in part, may be found in the behavioral psychology principle known as “anchoring”. Anchoring is the tendency to make future decisions based on a previous, fixated reference point. In essence, the fallacy lies in a failure to adjust for subsequent information (changes) in the decision-making process. In applying this to our discussion, we can see where future decision-making will be based on inputs and options featured in the previous soft period environment. In fact, many are woefully unprepared and unskilled in hard-decision assessment due to being lulled into a conditioned state for so long.
If the above assessment is roughly correct and we have indeed reached a tipping a point, then a failure to adapt will lead to consequences. Consequence tends to feed on itself and those dependent on the previous period’s softness will not appreciate the fiscal prudence restoration process. What are the consequences to an individual/family, a business, an industry, and a system if the main ingredient to its functionality becomes scarce, or even eliminated?
“We understand life backwards but live it forwards.” -Soren Aabye Kierkegaard
Mr. Munger is fond of saying “Invert. Always invert”. In understanding the possible environment going forward one needs to first understand the previous period of excess by using simple models and what dynamics came together to enable it. Some years in the future we may look back and realize just how unique a period it was.
Capitalism can be disguised as a beautiful maiden that brings wonderful fulfillment and joy (increases in the standard of living) or a merciless beast that maims, or worse, destroys the inefficient. For the past twenty five years, we have enjoyed a wonderful relationship with our beautiful maiden. This morning, the maiden awoke and left her den…without any makeup on.
__________
Michael T. Daniels works in the energy industry and resides in Sacramento, California. He is currently pursuing an MBA with a concentration in Finance from California State University, Sacramento and holds B.A. degrees in Economics and Environmental Studies. Michael welcomes your feedback at [email protected]
Also check out:
