The innovative and the incremental

Morgan Housel writing for Collaborative Fund:

Things that are instantly adored are usually just slight variations over existing products. We love them because they’re familiar. The most innovative products – the ones that truly change the world – are almost never understood at first, even by really smart people.

It happened with the telephone. Alexander Graham Bell tried to sell his invention to Western Union, which quickly replied:

This `telephone’ has too many shortcomings to be seriously considered as a practical form of communication. The device is inherently of no value to us. What use could this company make of an electrical toy?

It happened with the car. Twenty years before Henry Ford convinced the world he was onto something, Congress published a memo, warning:

Horseless carriages propelled by gasoline might attain speeds of 14 or even 20 miles per hour. The menace to our people of vehicles of this type hurtling through our streets and along our roads and poisoning the atmosphere would call for prompt legislative action. The cost of producing gasoline is far beyond the financial capacity of private industry… In addition the development of this new power may displace the use of horses, which would wreck our agriculture.

It happened with the index fund – easily the most important financial innovation of the last half-century. John Bogle launched the first index fund in 1975. No one paid much attention to for next two decades. It started to gain popularity, an inch at a time, in the 1990s. Then, three decades after inception, the idea spread like wildfire.

A worthwhile reminder for an industry that conflates the innovative and the incremental.

Confirmation bias

Nassim Nicholas Taleb, writing in The Black Swan:

“Cognitive scientists have studied our natural tendency to look only for corroboration; they call this vulnerability to the collaboration error the confirmation bias.

The first experiment I know of concerning this phenomenon was done by the psychologist P. C. Wason. He presented the subjects with the three number sequence 2, 4, 6, and asked them to try to guess the rule generating it. There method of getting us to produce other three number sequences, to which the experimenter would respond “yes” or “No” depending on whether the new sequences were consistent with the rule. Once confident with their answers, the subjects would formulate the rule. … with the correct rule was “numbers in ascending order,” nothing more. Very few subjects discovered it because in order to do so I had to offer a series in descending order (what the experimenter word say “no” to). Wason noticed that the subjects had a role in mind, but gave him examples aimed at confirming it instead of trying to supply series that were inconsistent with their hypothesis. Subjects tenaciously kept trying to confirm the rules that they had made up.”

Peter Cathcart Wason‘s 2-4-6 problem proved that we have a tendency to seek out evidence which confirms our ideas rather than that which falsifies them.

Alvin Toffler echoed a sentiment, and borrowed a fair amount from Leon Ferstinger‘s concept of cognitive dissonance, 10 years later.

Nate Silver writing in The Signal and The Noise:

“Alvin Toffler, writing in the book Future Shock in 1970, predicted some of the consequences of what he called “information overload”. He thought our defence mechanism would be to simplify the world in ways that confirmed our biases, even as the world itself was growing more diverse and more complex.”

Silver later sums up the bias succinctly:

“The instinctual shortcut that we take when we have ‘too much information’ is to engage with it selectively, picking out the parts we like and ignoring the remainder.”

Extreme aversion

William Poundstone writing in his book Priceless:

“Extending the work of Huber and Puto, A 1992 the paper by [Amos] Tversky and Itamar Simonson laid down two commandments of manipulative retail. One is extreme aversion. They showed through surveys (involving Minolta cameras, Cross pens, microwave ovens, tyres, computers, and kitchen roll) that when consumers are uncertain, they shy away from the most expensive item offered or the least expensive; the highest quality or the lowest quality; the biggest or the smallest. Most favour something in the middle. Ergo, the way to sell a lot of £500 shoes is to display some £800 shoes next to them.”

Products that don’t sell effect those that do.

Zipf’s law

Nassim Nicholas Taleb writing in his book Black Swan:

“During the 1940s, a Harvard linguist, George Zipf, examined the properties of language and came up with an empirical regularity now known as Zipf’s law, which, of course, is not a law (and if it were, it would not be Zipf’s). It is just another way to think about the process of inequality. The mechanisms he described were as follows: The more you use a word, the less effort for you will find it to use that word again, so you borrow words from your private dictionary in proportion to their past use. This explains why out of the sixty thousand main words in English, only a few hundred constitute the bulk of what is used in writings, and even fewer appear regularly in conversation.”

Priming

William Poundstone writing in his book Priceless:

“‘Priming’ is a fairly new term for phenomena that have long been part of the world’s store of knowledge, not necessarily of the scientific kind. Have you ever bought a car and suddenly noticed that ‘everyone’ on the motorway, practically, is driving that model? Have you ever learned a new word (or heard of an obscure sea mammal or an ethnic dance) and then encountered it several times in the space of a few days? You come across it in the news, you overhear it mentioned on the bus and on the radio, and the old issue of National Geographic your summing through falls open to an article on it…

This is priming (fortified with a few low-grade coincidences). When you skim the newspaper, half-listen to TV, or drive on the motorway, you ignore most of what’s going on around you. Only a few things command attention. Paradoxically, it is unconscious processes that choose which stimuli to pass on to full consciousness. Prior exposure to something (priming) lowers the threshold of attention, so that that something is more likely to be noticed. The upshot is that you have probably encountered your ‘new’ word or car many times before. It’s just that now you’re noticing.”

The problem of induction

Nassim Nicholas Taleb writing in his book Black Swan:

“The überphilosopher Bertrand Russell presents a particularly toxic variant of my surprise jolt in his illustration of what people in his line of business call the Problem of Induction or Problem of Inductive Knowledge.

How can we logically go from specific instances to reach general conclusions? How do we know what we know? How do we know what we have observed from given objects and events suffices to enable us to figure out their other properties? There are traps built into any kind of knowledge gained from observation.

Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race “looking out for its best interests,” as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.

How can we know the future, given knowledge of the past; or, more generally, how can we figure out the properties of the (infinite) unknown based on the (finite) known? Think of the feeding again: what can our turkey learn about what is in store for it tomorrow from the events of yesterday? A lot, perhaps, but certainly a little less than it thinks, and it is just that “little less” that may make all the difference.

Let us go one step further and consider induction’s most worrisome aspect: learning backward. Consider that the turkey’s experience may have, rather than no value, a negative value. It’s learned from observation, as we are all advised to do (hey, after all, this is what is believed to be the scientific method). Its confidence increased as the number of friendly feedings grew, and it felt increasingly safe even though the slaughter was more and more imminent. Consider that the feeling of safety reached its maximum when the risk was at the highest! But the problem is even more general than that; it strikes at the nature of empirical knowledge itself. Something has worked in the past, until – well, it unexpectedly no longer does, and what we have learned from the past turns out to be at best irrelevant or false, at worst viciously misleading.”

The past cannot always predict the future.

No wonder economic predictions usually fail

Tournament effect

Nassim Nicholas Taleb writing in his book Black Swan:

Let me start with the economist Sherwin Rosen. In the early 80s, he wrote the papers about “the economics of superstars.” In one of the papers he conveyed his sense of outrage that a basketball player could earn $1.2 million a year, or a television celebrity could make $2 million. To get an idea of how this concentration is increasing – i.e., of how we are moving away from Mediocristan – considerate that television celebrities and sports stars brackets (even in Europe) get contracts today, only two decades later, where in the hundreds of millions of dollars! The extreme is about brackets (so far) 20 times higher than it was two decades ago!

According to Rosen, this inequality comes from a tournament effect: someone who is marginally “better” can easily win the entire pot, leaving the others with nothing. Using an argument from chapter 3 people prefer to pay $10.99 for a recording featuring Horowitz to $9.99 for a struggling pianist. Would you rather read Kundera for $13.99 or some unknown author for $1. So it’s looks like a 20 minutes, where the winner grabs the whole thing – and he does not have to win by much.

Two ways to position a brand

Mark Ritson writing on LinkedIn:

“That’s a shame because there are two ways to position a brand: about and versus. In the ‘about’ approach we promote the features and, occasionally, the benefits of our brand to target customers. Positioning is all about the company C, us, and the customer C, them.

The versus position is one in which we make it clear what we stand for to customers by highlighting the differences between ourselves and others.

In the other approach, the less common ‘versus’ approach, we still focus on what the customer wants that we can deliver. However, to communicate the message more strongly, we pick out a specific competitor and position our brand against them as overly and aggressively as possible. The point of the ‘versus’ positioning is not simply to aggressively slight your rivals; it’s more nuanced than that.

The versus position is one in which we make it clear what we stand for to customers by highlighting the differences between ourselves and others.”

The three different types of error

Tim Harford writing in his book Adapt:

James Reason, The scholar of catastrophe who uses Nick Leeson and Barings Bank as a case study to help engineers prevent accidents, is careful to distinguish between three different types of error. The most straightforward are slips, when through clumsiness or lack of attention you do something you simply didn’t mean to do. In 2005, a young Japanese trader tried to sell one share at a price of ¥600,000 and instead sold 600,000 shares at the bargain price of ¥1. Traders call these slips ‘fat finger errors’ and this one cost £200 million.

Then there are violations, which involve someone deliberately doing the wrong thing. Bewildering accounting tricks like those employed at Enron, or the cruder fraud of Bernard Madoff, are violations, and the incentives for them are much greater in finance than in industry.
Most insidious are mistakes. Mistakes are things you do on purpose, but with unintended consequences, because your mental model of the world is wrong. When the supervisors at Piper Alpha switched on a dismantled pump, they made a mistake in this sense. Switching on the pump was what they intended, and they followed all the correct procedures. The problem was that their assumption about the pump, which was that it was all in one piece, was mistaken.

Group think

Tim Harford writing in his book Adapt:

Irving Janis’s classic analysis of the Bay of Pigs and other foreign policy fiascoes, Victims of GroupThink, explains that A strong team – a ‘kind of family’ – Can quickly forward into the habit of reinforcing each other’s prejudices out of simple teen spirit and a desire to bolster the group.

This reminds me of the concept of Echo Chambers, where a person’s beliefs are strengthened when they are exposed only to opinions that align with their own.

To break free of GroupThink and Echo Chambers we need to seek out contradictory, contrarian or disconfirmatory opinions. We need to try and falsify our current position in order to progress towards a truth.

Harford continues:

Janis details the way in which John F. Kennedy fooled himself into thinking that he was gathering a range of views and critical comments. All the while his team of advisors where unconsciously giving each other a false sense of infallibility. Later, during the Cuban Missile Crisis, Kennedy was far more aggressive about demanding alternative options, exhaustively exploring risks, and breaking up his advisory groups to ensure that they didn’t become too comfortable.