News, Reflections and Ideas

Introduction

In the last blog we looked at rare events and how notions of averages can be misleading. The issue we confront as humans is that we are bombarded with information that we have to filter (and this has increased exponentially since the start of the internet) when making decisions. We don’t know how reliable the information is, whether it can be trusted (and this is a topic for another blog) and how up to date and relevant it might be to the decisions we are facing. Due to pressures (time, family, business, etc.) we may often face making decisions with relative ignorance, and even without such pressures, how much of the information we are confronted with is truly relevant is open to question. We all know individuals who struggle to make decisions, and there can be many reasons for this, but one obvious one is that decisions are inherently difficult given the uncertainties we all face.

In this blog we will look at two issues that intertwine – the issue of ignorance and how we deal with it and its consequences; and the issue of complexity. The more complexity we have, the more difficult is decision making and we often develop complex solutions in organisations to help individuals deal with decisions but all we do is make matters worse. In the last blog we mentioned how large organisations tend to fail because they spend all of their time dealing/coping with complex internal processes and bureaucracies rather than getting on with the business. This applies to all organisations – public, private, govt, etc. Another topic for a future blog is the perpetuation of bureaucracies and how they eventually suffocate organisations and staff. An example of this issue close to our hearts is the centralisation trend going on in universities. Academic life and its workings are very simple and with decisions and support offered at local levels, they can be very lean, efficient organisations – that is how they were for many hundreds of years. Sadly, the drive to centralisation has led to many layers of management and administration, and processes that consume inordinate amounts of time with no positive effect. This blog is being written on a laptop that had a problem that took 10 weeks of dealing with a clunky, unresponsive centralised system that wasted many hours of people’s time. The laptop was eventually fixed when it was physically taken down and plonked on an IT worker’s desk – it took 15 minutes to fix!!! This is what we are talking about in this blog – how organisations have the ability to make the simple, difficult. But before we get there, we need to look at the issue of ignorance and decision making – this is, after all, what partially allows the development of inefficient, organisational systems.

The one takeaway of this blog is to keep matters simple – the simpler the better. And this applies to both individuals and organisations. We have to find ways of cutting through the ‘dross’ that clogs up so much of modern-day life.

Ignorance

We are ignorant of many things in life and perhaps the most surprising is how ignorant we are of ourselves. At any one point in time and across time we often do not know what we want – to consume, to experience, to invest in, etc. Our wants and needs are pliable and formable through the lives we live and the experiences we share and what we see. We often struggle to make sense of ourselves, we take crazy decisions that we live to regret, we don’t do things we know we should, etc. Individuals are often portrayed as single dimension entities but we are far more than that, with many aspects to our personalities and we often surprise ourselves (and others) with our actions. Another issue here is that while we do learn about ourselves, we do change, to a degree, across our lives – noting, however, that our basic personalities are formed early on in childhood and parts seem to be formed in the womb.

This ignorance of self becomes ever more ‘difficult/complex’ when we expand the situation to others and organisations. We rarely make decisions in isolation and we normally have to relate and make decisions in the context of others (families, clubs, etc) and within organisational structures. We have to bring the often ill-defined and poorly communicated objectives of others together to try to understand what we want to do as a ‘collective’ – and in virtually all situations the ‘voices’ are rarely equal, depending on the nature of the relationships/power structures, etc. We are familiar with these types of negotiations and we often wonder ‘how the the devil did we get to this point?’ It is the coming together of the ignorance of objectives at various levels within ill-defined structures. The more complex and layered the structures/processes, the more chance of poor and slow decisions. Organisations often have to purposefully reset ‘the objectives’ of the organisation and communicate these across the various depts and layers – this in itself is open to all kinds of vagaries and interpretations. Given the various layers, processes and depts within large organisations – the very process of aligned objectives can become ever more tortuous and there are limits to how effective large organisations can be, hence the need for markets of smaller competing units. Finally, we need to be aware of the many processes (marketing, politics, lobbying, persuasion, etc.) that are used to influence the ‘objectives’ of individuals and organisations. These processes can change the ranking of objectives and even create new ones.

The next issue concerning ignorance is what actions might be used to deliver the objectives once they are defined and made clear. There is rarely just one way to achieve an outcome, and often there are many. The problem here is that the actions will not be equally efficient and they are rarely taken in isolation – actions connect in all kinds of ways – to other actions, to other people and depts, etc. The problem we have as decision makers is that we are often ignorant/uncertain how the actions will pan out for ourselves, others and through time. We can all look back on decisions that we have taken and be amazed at the path they have taken with all kinds of unforetold consequences – from the banal of forgetting to buy an item and having to make a return trip, to deciding to prune a tall tree and ending up with life changing injuries.

The trouble with actions (and this partly applies to malleable objectives) is that they are often path dependent (the consequences of some actions cannot be reversed) and we are unable to fully know the various paths that our lives can take through time. More importantly, there are key decisions (change of job, country, partner) that have all kinds of unknown consequences. This applies to organisations as well as individuals – consider the companies, universities, etc. that have been built/destroyed by the appointment/promotion of individuals – we should also not forget countries!

We also have a habit trying to bundle together objectives and actions in the vain hope of being efficient – often the so called efficiency leads to high levels of inefficiency and confusion (especially in organisations).

The penultimate part of this ignorance is to do with consequences. We undertake actions to meet our objectives but the outcomes of actions are themselves not always apparent nor immediate. The consequences of actions will often depend on the reactions of others. We are currently living in “Broken Britain’ and the consequences of any action are becoming ever more difficult to predict. We book a holiday – will we get to the airport? How long will we be queuing? Will we catch Covid on the plane? And it goes on – never mind trying to book the holiday in the first place. Rather than write endlessly on why consequences are difficult to predict and often to even understand their various ramifications, we ask the reader just to reflect on some of the difficult decisions they have undertaken that have led to unexpected consequences.

The final part of ignorance is to do with risk and uncertainty. Most actions will lead to a range of possible consequences. Sometimes we are able to assign reasonably well-defined probabilities to the outcomes, sometimes we have no feel for what they might be – this is when risk (defined probabilities) is replaced by uncertainty (unknown probabilities). There are many decisions that are new to us and for these, we will have, at best, ill-defined probabilities. And then we get into Donald Rumsfeld's territory of known unknowns, and unknown unknowns.

Given all of the above it is not surprising that we have developed methods to deal with decisions – heuristics, processes, strategies – some more effective than others. We will deal with some of these in the next section. How we deal with all of the above varies – there are individuals who seem to go through life making good decisions, and then there are others that seem to make one bad decision after the other (often with terrible consequences). And the differentiation between good and bad decision makers often has nothing to do with intelligence – it is more to do with the inability to think through and deal with all of the above. We now turn to complexity.

Complexity

This is being written while one of the authors is watching the costs of modern-day contracting spiralling out of control. It is really quite a simple situation – windows being repaired and painted. In the past, this would often have involved a single man pricing up the job and getting on with it. Not in this situation. There is an overall contractor who priced up and estimated the job. He then subcontracted the repairs to another company and the painting to a separate company. If everything goes to plan, all is well and good – ignoring the transaction costs of agreeing between the various parties. Of course, matters do not always go to plan and this is when the costs ‘explode’. The repairs are more difficult than anticipated by the main contractor and there is a negotiation taking place between the main and subcontractors. This is then leading to issues with painters – who had planned to follow on tomorrow. This can no longer happen and will have to be rescheduled but this will then leave the new wood open to the elements, etc. We are sat watching a number of conversations taking place between the various sub-parties. This is modern-day contracting at its worst – it is a level of complexity that is just not needed.

Complexity often cannot be avoided but it is having the level of complexity to suit the purpose. Let us take wrist watches as an example. We can all marvel at the beautiful, craftsmen made watch from Switzerland. Here all the components (and there are many) have to work in unison so the watch will work. It is, however, possible to make a watch out of a small number of sub-assemblies – each one self contained. These are a lot cheaper to make and faults can be more easily identified in the sub components and replaced without having to take apart the whole watch – this logic applies to many machines (cars, planes, etc.) and to organisations.

What is being argued here is that it is easier to work with and in simpler structures, where the purpose and activities can be clearly defined. We know that organisations become large and unwieldly, and they often need drastic surgery (through the many types of organisational restructuring that are possible). Decisions taken and actioned at local levels can be both effective and timely. Unfortunately, the natural tendency of organisations, through issues of status, power and a sheer lack of understanding, is for them to become centralised and layered. This gives the impression of organisational simplicity but it is a chimaera – the organisational boxes may look less on the chart but what is ignored are the endless processes needed to communicate and action eventual decisions – the 10 weeks of dealing with a centralised IT system springs to mind.

A further issue with complex organisations is motivation – if it is a daily struggle to action decisions and deal with faceless bureaucracy, then even the most go ahead employee will suffer motivational issues. There have been legions of articles and books written on organisations and their structures, and this is not the place to rehearse the various arguments – what is, however, plain is that simpler, more direct structures have many benefits from a clarity of objectives to delivering action. THE BIG ISSUE, however, is how these can be achieved when all the forces of power, status, etc. push for ever larger organisations.

Idea – acknowledging our ignorance and recognizing the complexity of our investments

The first relevant lesson about investment is to acknowledge our ignorance: know what we don’t know. Investment decisions follow a similar general pattern of decision making: setting objectives, implementation and evaluation. This is covered in the investment process that we teach our students. For individual investors, we should try to adopt this process to understand what is our objective and what resource we have to achieve those objectives. To reduce the influence of ignorance and regret. Learning from the experts and adapting them with backtesting is one of the best alternatives as we introduced in our book “The Experts and the Evidence”. It is important to note that history may not repeat itself. Every time, especially now, we feel that uncertainty is the largest in our lifetime. But what we can do is learn from our own limited and others’ experiences to improve our chances.

Another example of acknowledging our ignorance is to understand that there is a limit to what data and analytical techniques can do. While the market is not always efficient, it is driven by the news, especially large movements. By definition, the news is not known to most or all market participants. It will be unrealistic to build a strategy that anticipates news unless it is scheduled and there is a channel of leakage (company and economic news that market participants may know).

On the complexity side, there is strong empirical evidence that shows that there is a complexity discount. Companies that have multiple segments are often traded at a discount should their segments operate and trade as stand-alone companies (The Diversification Discount and Inefficient Investment | NBER). There is also evidence showing that investors take longer to understand the implication of news about these complicated firms (Complicated firms - ScienceDirect). That is why companies may consider splitting off some of the segments of their business. A recent example is Volkswagen listing its Porsche unit. Often the reduced complexity creates value for the parent company (Divestitures and Divisional Investment Policies - Dittmar - 2003 - The Journal of Finance - Wiley Online Library).

Finally, the clarity of a company’s vision can often be summarised via its slogan. As an interesting fact rather than a serious analysis, we illustrate the effect of the simplicity of the slogan and a company’s quality (measures by accounting performance). There is an early academic study showing a general delayed positive market reaction to a company’s slogan change. See for example The effect of advertising slogan changes on the market values of firms. - PsycNET (apa.org). Here we collect a list of 334 companies’ slogans among the S&P 500 stocks. The famous ones are “Don’t be evil” of Google, “Just Do It” of Nike. The following phase cloud represents the key phases used in these slogans.