Berkshire Hathaway’s Culture of Trust

“Buffett trusts me so much with Berkshire’s money that I am even more careful in handling Berkshire capital than in handling my own.”

Bruce Whitman, former CEO of FlightSafety International

Trust takes a long period of time to fully develop but can be destroyed in an instant. This asymmetry is inherent in a world where trust continues to be the foundation of all human societies. The stakes could not be higher and, as a result, a sense of wariness is built into our evolutionary instincts. Misplaced trust is extremely costly, but the flip side is that attempting to live your life in a culture of constant skepticism regarding the intentions of others is both exhausting and likely to lead to many missed opportunities. Finding the right balance is imperative in both personal and business relationships. In order to strike that balance in a business context, it makes sense to closely examine the successful trust-based culture of Warren Buffett’s Berkshire Hathaway.

Few writers are more familiar with the intricacies of Berkshire Hathaway than Lawrence A. Cunningham whose unique perspective was shaped by a 1996 symposium he organized in which Warren Buffett and Charlie Munger discussed Berkshire’s business and culture at great length. Shortly thereafter, Cunningham released his first compilation of Berkshire shareholder letters organized by topic and, more recently, he published a book specifically regarding Berkshire’s management succession plans. In Margin of Trust, Cunningham and co-author Stephanie Cuba take an in-depth look at the unique management philosophy that has made Berkshire so successful over the years and continues to allow an enormous conglomerate to operate without the type of command-and-control bureaucracies that exist at almost all large firms, and especially at large conglomerates. By demystifying how Berkshire ticks, Cunningham and Cuba uncover generic concepts that could help other organizations improve their culture.

Charlie Munger

Charlie Munger often speaks about how a “seamless web of deserved trust” represents the highest form a civilization can reach. Why is this? Quite simply, when you have a culture in which the key participants can be trusted implicitly to do the right thing and act in the interests of the organization, you do not need to put in place the endless systems of controls that would be required in a culture where no one trusts each other. In other words, a company can run much more efficiently when trust is presumed to exist. The flip side is that in such a culture, a rogue individual can do a great deal of harm until he or she is finally detected. Clearly, some balance is required to harness the benefits of trust while protecting an organization from severe harm if that trust proves to be misplaced.

The culture of Berkshire Hathaway is one of extreme decentralization and autonomy, with power over operational matters delegated from the holding company run by Buffett to subsidiary CEOs. Until recently, nearly all subsidiary managers reported directly to Buffett who maintained compensation arrangements with the subsidiary CEOs personally. Recently, Buffett has put in place two Vice Chairmen, Ajit Jain and Greg Abel, to oversee all insurance and non-insurance subsidiaries, respectively. However, Berkshire remains extremely decentralized with no corporate-wide central functions and a bare-bones headquarters staff of about two dozen employees.

Trust is an extremely effective motivator, as we can see from Bruce Whitman’s quote leading this article. When one is given a great deal of trust, the level of perceived responsibility increases commensurately. It is often thought that personal loyalty to Buffett drives subsidiary CEOs to not want to disappoint him, but it is also the fact that they have been given remarkable power and trust and they seek to reciprocate by providing excellent results.

The Pillars of Berkshire Hathaway

Cunningham and Cuba set out to dissect Berkshire’s structure and what makes the company tick by examining the individuals presently involved in managing the company, the partnership mindset that permeates everything that managers do, and the specific methods used to achieve outstanding results. At present, the key players are Buffett, Munger, Abel, and Jain, individuals who have been with Berkshire for decades. The board is structured not to oversee management but to provide an advisory role and nearly all board members have significant skin in the game in the form of Berkshire stock that they purchased on the open market. Berkshire’s shareholders are an unusually stable and knowledgeable group, as evidenced by the tens of thousands who attend annual meetings every year. Berkshire shareholders are so devoted to the company that Munger often jokingly refers to them as “cult members“.

The partnership structure, which is not empty happy talk as is the case at many companies, completely permeates how Buffett has run the firm for decades. Cunningham and Cuba note that Buffett’s partnership model goes well beyond the legal definition of an equity owner in that he actually views shareholders as owners of the underlying business rather than merely the claimants on the residual after liabilities are subtracted from assets. This might seem like a distinction without a difference, but it represents a mindset. The fact that many of Buffett’s partners have an unusually large stake in Berkshire as a percentage of their net worth clearly has influenced Buffett’s willingness to take on leverage and driven his preference for leverage in the form of insurance float and deferred taxes rather than explicit debt on the balance sheet. Much of the debt on Berkshire’s balance sheet is attributable to the railroad and energy subsidiaries and, importantly, are non-recourse to Berkshire itself.

Berkshire has grown through acquisitions over the years, necessitated by Buffett’s policy of retaining all earnings. Buffett is famous for making pledges to leave the firms that he is acquiring alone in terms of operational decisions and only requiring a subsidiary CEO to consult with him on matters of capital allocation and management succession. Additionally, Buffett pledges to the selling shareholders that Berkshire will be a permanent home for their business, and he has followed through on this commitment even in cases where the acquisition failed to live up to its promise. All of this builds the culture of trust which is vital when a family is selling a long held business and cares about what will happen to its customers and employees.

Compliance

In recent years, high profile scandals at individual companies as well as the effects of corporate mismanagement on the entire economy have led policymakers to put in place laws and regulations, such as the Sarbanes-Oxley and Dodd-Frank Acts, designed to improve corporate governance. These rule-based regulations seek to define, in much detail, exactly how companies must comply from a corporate governance perspective. As Cunningham and Cuba note, this trend is exactly the opposite of the approach taken at Berkshire Hathaway.

One key change is that regulators want corporate boards to take on the role of monitoring company management to a much greater degree than in the past. In order to accomplish this, standards have been set defining board member “independence”, among other things. In Warren Buffett’s view, a qualified board member must have business savvy and a substantial personal investment in Berkshire Hathaway. However, it is possible for such a board member to be deemed “not independent” by regulators if there are certain personal or business relationships involved.

It is easy to be cynical regarding Buffett’s intentions here because clearly he does not want Berkshire’s board to oversee his activities. Instead, he seeks an advisory board comprised of intelligent and engaged members who have skin in the game via Berkshire ownership and he trusts that that incentive is enough to ensure effectiveness. If not for the permeation of trust throughout Berkshire, cynicism might be warranted but, taken it its totality, Berkshire’s culture and board structure is congruent and has proven effective.

The Risk of Rogue Actors

Any organization that runs on the concept of a “seamless web of deserved trust” will inevitably be vulnerable to a rogue actor who is able, temporarily, to deceive the organization and proceeds to take actions that are not consistent with the culture. Buffett and Munger are not naive when it comes to this risk but consider it a risk worth taking given the many benefits that their culture provides.

Cunningham and Cuba go into some detail regarding the sad case of David Sokol who resigned from Berkshire in March 2011 amid controversy over the Lubrizol acquisition. Sokol took an ownership interest in Lubrizol prior to suggesting that Berkshire acquire the company and made contradictory statements subsequent to his resignation that caused many shareholders to voice concern regarding management controls.

The authors suggest that Sokol’s violations of company policy were relatively minor compared to the outcome, wherein Sokol lost his job and the potential opportunity to succeed Buffett as Berkshire’s CEO. However, disproportionate reactions to violations of Berkshire’s culture may be a form of immunization against future attacks on the culture. Sokol was cleared of legal wrongdoing by the Securities and Exchange Commission but Buffett’s standards were higher than merely what was required by law. By eventually speaking out forcefully against Sokol’s actions, Buffett sent a very clear message to other managers at the company.

Time Will Tell

As of early 2020, Warren Buffett is 89 years old and Charlie Munger recently turned 96. Both men have had remarkable runs and their careers are not yet over as they have stated their intention to continue to be involved at Berkshire for the remainder of their lives or until they can no longer serve. Anyone who has attended an annual meeting will note that these men are able to answer questions for five hours in a format that would exhaust most executives half their age. The last chapter has yet to be written.

But what will eventually happen when Buffett and Munger are no longer on the scene? Will Berkshire’s unique culture of trust continue or will it be attacked by outsiders who seek short term gain or wish to exploit the trusting culture for their personal benefit?

Ajit Jain

The truth is that we do not know for certain. It seems very likely that the culture of trust will prevail for at least a decade after Buffett and Munger depart the scene because the executives they have designated to succeed them are equally immersed and committed to the culture. Ajit Jain and Greg Abel will be responsible for maintaining this culture and passing it on to a new generation of managers who will one day succeed them. They both have very significant personal stakes in Berkshire Hathaway and can be said to have “skin in the game” in addition to the trust of Buffett and Munger. The management succession that is most worrisome is not from Buffett to Abel and Jain, but from Abel and Jain to whoever takes over after them.

It is likely that we are fifteen to twenty years away from the point where Abel and Jain turn the reins over to new managers. Obviously, who their successors will be is unknown at this point. The 2040s rather than the 2020s may be the decade when we discover whether Berkshire’s Margin of Trust will prevail or fall under attack.

Disclosures: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway. The Rational Walk LLC received a review copy of Margin of Trust from Columbia Business School Publishing.

Book Review: The Ride of a Lifetime

“The decision to disrupt businesses that are fundamentally working but whose future is in question—intentionally taking on short-term losses in the hope of generating long-term growth—requires no small amount of courage.”

— Robert Iger

The risk of potential disruption strikes fear in the hearts of corporate executives in long-established and highly profitable industries. Basic economic theory has long held that consistent profits well in excess of the cost of capital will inevitably attract additional investment in the long run which will tend to drive down returns over time. Comfortable industries such as newspapers and network television enjoyed high profitability for decades due to economic moats that led to natural oligopolies. Until close to the end of the twentieth century, such industries seemed nearly immune from serious disruptive pressures. The economic moats around businesses in the media industry did not eliminate competition by any means, but competition was well defined and predictable. The internet forever changed this dynamic as the twenty-first century began and formerly comfortable executives have been scrambling ever since.

Robert Iger has been running The Walt Disney Company since 2005 and has published an interesting account of his business career in The Ride of a Lifetime. The first half of the book is a relatively slow account of Iger’s early years moving up the management ladder at ABC which was acquired by Capital Cities in 1985. During those early years of his career at Cap Cities, Iger worked for Dan Burke and Tom Murphy who encouraged a decentralized and spartan organizational structure. Iger thrived in this culture, finally rising to President and COO of Cap Cities in 1994, just before the company was acquired by Disney. At Disney, Iger found himself working for Michael Eisner in a much more centralized corporate structure. Iger provides a dramatic account of his rise to the top of Disney which finally took place in 2005 and the narrative runs all the way to the remarkably well received introduction of Disney+ in 2019.

Michael Eisner was one of the most highly regarded CEOs in America at the time he turned over the reins to Bob Iger in 2005, but by the end of his tenure, there were significant areas of conflict with Disney’s board as well as with important business partners, including Steve Jobs. Disney had a longstanding relationship with Pixar, which Jobs controlled, but a series of business disputes led to a near dissolution of the relationship by the time Iger took over as CEO of Disney. Iger believed that it was essential to repair the relationship with Pixar due to the poor state of Disney’s animation business. Iger needed a better relationship with Jobs, and reached out to him immediately after becoming CEO.

Jobs was initially cautious but he and Iger hit it off and they were soon collaborating on providing content for the first version of Apple’s Video iPod which was released in October 2005. That collaboration increased the level of trust between the two men and soon they were in discussions for Disney to acquire Pixar. Iger was still very early in his tenure and did not have a great deal of political capital with Disney’s board, but he decided to bet his future on the $7.4 billion acquisition. Perhaps more important than the addition of Pixar to Disney, Steve Jobs became a very large Disney shareholder after the acquisition and his influence on Iger was apparent from this point forward.

Acquiring Content and Talent

Steve Jobs was a fanatic and a perfectionist when it came to product design, and his innovations ended up disrupting many industries. The rise of the iPhone, accompanied by the destruction of the seemingly impregnable mobile phone incumbents, is the most obvious example. Iger developed a close friendship with Jobs and he was one of the first people outside of Jobs’s family to learn about the return of his cancer in 2005. Jobs thought it was important to let Iger know about his diagnosis prior to moving forward with selling Pixar, but Iger declined to pull out of the deal. Jobs would end up being a key member of Disney’s board until his death in 2011.

In addition to the Pixar acquisition, Iger made two additional transformational acquisitions with the purchase of Marvel Entertainment and Lucasfilm. In both cases, the acquisition of these companies allowed Disney to greatly expand its library of content and, perhaps more importantly, acquire human capital that would drive future content forward. Iger learned a great deal about managing creative talent by watching how Jobs handled the Pixar sale.

Steve Jobs was known as a mercurial manager and he had little patience for mediocrity, but the flip side is that when he found talent that he felt was indispensable, he showed it and this created tremendous loyalty from those who worked for him. This was a lesson Iger took to heart when he saw how Jobs treated John Lasseter and Ed Catmull:

Steve told me he would seriously consider it [Disney buying Pixar] only if John and Ed were on board. After we talked, he contacted them to say that he was open to a negotiation, and to promise them that he would never make a deal without their blessing. We planned that I would meet with each of them again, so I could explain in more detail what I was imagining and could field any questions they had. Then they would decide if they were interested in going forward with a negotiation.

The Ride of a Lifetime, p. 140

It is extraordinary for a controlling shareholder of a company to give his employees effective veto power over selling the business. However, in creative fields, a company is often highly dependent on the talents of a few individuals and, without those individuals, future prospects would look bleak. Iger obviously came to the same realization and would likely not have wanted to acquire Pixar without Lasseter and Catmull on board. The reader gets the sense that Iger learned critical lessons from watching how Jobs interacted with creative talent.

The Courage to Disrupt Yourself

In Chapter 12, entitled “If You Don’t Innovate, You Die”, Iger outlines the major challenges facing media companies in the 2010s. Traditional distribution of content was still highly profitable for Disney and there did not appear to be a need to change course immediately. Iger believed that Disney needed to get ahead of the curve by developing a technology platform that would allow the company to start delivering its own content without intermediaries. Iger had seen the type of disruption that had already affected newspapers and his business relationship and friendship with Jobs clearly played a role in his aggressive posture. He was convinced that Disney could either disrupt itself or find itself disrupted anyway.

In mid 2017, Iger decided that Disney needed to buy a controlling stake in BAMTech and use that company’s technology platform to launch Disney and ESPN streaming services directly to consumers. This was the original genesis behind the Disney+ rollout that took place in 2019. Iger announced the decision in Disney’s August 2017 earnings call:

That announcement marked the beginning of the reinvention of The Walt Disney Company. We would continue supporting our television channels in the traditional space, for as long as they continued to generate decent returns, and we would continue to present our films on the big screens in movie theaters all over the world, but we were now fully committed to also becoming a distributor of our own content, straight to consumers, without intermediaries. In essence, we were now hastening the disruption of our own businesses, and the short-term losses were going to be significant.

The Ride of a Lifetime, p. 192

Iger was choosing to accept short-term losses with the expectation that future growth will more than make up for it. Although Wall Street is often ultra-short term oriented, Disney stock reacted favorably to Iger’s August 2017 announcement. But Iger had additional work to do in order to make this radical change work. He had to revise compensation policies that incentivized executives to protect the old model. Iger ended up making executive compensation more subjective than it used to be in order to be in a position to reward executives who made progress with streaming even if it came at the expense of short term profits.

As of early 2020, it appears that Iger’s bet on Disney+ will be a success. The $6.99 per month price point for the service is very aggressive and Disney has spared no expense in making compelling original content that is available exclusively on Disney+. Iger leveraged the Star Wars franchise acquired with Lucasfilm to develop The Mandalorian, an eight episode series about a bounty hunter that includes an unexpected star popularly referred to as Baby Yoda.

Pick Your Poison

One of the key takeaways from Bob Iger’s memoir is that it is not possible to hide from disruption. Sometimes, disruption comes from out of the blue leaving executives with little time to react, but at other times one can see that changes are coming far ahead of time. If you are leading a dominant company in an industry that appears vulnerable to disruption, you can choose to either ignore the threat, take defensive steps, or go on the offense using the strength of your current position as a springboard to turn the tables on your new competitors.

The final verdict on Iger’s tenure as CEO of Disney is yet to be determined. He still has two years left on his contract and it is likely that we will have a better idea of the progress made in the streaming initiatives by the time he departs. However, he does deserve credit for having the foresight to accept the fact that streaming of content is the future and taking concrete steps to be relevant in this new environment. He understood that owning not only the content but also the distribution channel would be critical to success. Ten years from now, we will be in a much better position to evaluate the outcome of his strategic moves.

The Man Who Solved The Market

“Higher mathematics may be dangerous and lead you down pathways that are better left untrod.”

— Warren Buffett, 2009 Berkshire Hathaway Annual Meeting

Success in most areas of life requires having a clear and coherent view of reality along with the mental fortitude to pursue your goals consistently over a long period of time. From an economic standpoint, doing things that are easy to implement and obvious to everyone else is unlikely to yield more than middling results. Whether you are opening a new restaurant, writing a book, or trying to achieve superior results in financial markets, you need to establish an edge of some kind if you hope to enjoy above average results. The world is simply too competitive to bestow great success on people who never stray from doing what everyone else is doing.

It is important to recognize that there is no single path to success in most fields because every human being is born with unique attributes and develops further strengths and weaknesses over time based on the environment in which they live. Innate intelligence and talent combined with the circumstances of the first two decades of our lives plays a huge role in how we see the world and the manner in which we go about trying to achieve our goals. New skills and talents can certainly be developed, but underlying temperament and interests drive and define us from a relatively early age. Someone who is obsessed with business and making money from an early age is likely to approach investing with a different perspective than an equally intelligent person who had an early obsession with mathematics and science.

In 1959, Jim Simons was a twenty-one year old newly married graduate student at the University of California, Berkeley with a $5,000 wedding gift1 that he was eager to turn into a greater fortune. After an initial foray into stocks that barely moved and bored Simons, his broker suggested buying soybean futures. Simons quickly earned thousands of dollars in profit, only to lose the gains within a few days. This experience was enough to hook the young mathematician who became fascinated with financial markets and the possibility of scoring short-term profits. Simons, who is now a 81 year-old multi-billionaire, went on to achieve goals beyond his wildest expectations from that modest start sixty years ago. Although Simons was not eager to have his story told, Gregory Zuckerman managed to uncover many fascinating details regarding Simons and the firm he founded. The Man Who Solved The Market is a riveting account of how Simons used his mastery of mathematics to achieve enormous success in financial markets.

“It’s nice to be very rich”

Jim Simons had no interest in business during his formative years, but he did have an interest in money. He grew up in a family of fairly modest means, but was exposed to wealth at an early age and observed that “it’s nice to be very rich”. However, his natural inclination was to pursue science and mathematics rather than business. Like Warren Buffett, Simons had very unusual skills with numbers as a young boy but, unlike Buffett, Simons was attracted to the elegance and beauty of pure mathematics and intellectual life. The problem with the intellectual life of an academic is that it can lack adventure, and Simons soon had an “existential crisis” at the age of twenty-three wondering whether he would be stuck in an academic rut for the rest of his life.

Simons had a meteoric early rise in academia and accepted a position at Harvard in 1963 where he established himself as a popular professor, but he was not satisfied with the pay and taught additional courses on the side at a community college. Simons “hungered for true wealth” and saw how money can buy influence and independence. He soon left Harvard to join the Institute for Defense Analysis (IDA) where he doubled his academic salary and, perhaps more importantly, began his lifelong quest to come up with a system to profit in financial markets.

Simons was a code breaker at IDA focused on cracking Russian codes and ciphers that had been impenetrable for over a decade. Simons would spend his days creating algorithms based on mathematical models designed to interpret patterns in the data. Simons did not have expertise in programming but proved to be a master at developing algorithms that others would encode. He achieved a breakthrough that leveraged an error in the Soviet code to gain insight into the construction of the system and developed the means of exploiting it.

Why Ask Why?

Inspired by his success in code-breaking, Simons used the flexibility he enjoyed at IDA to develop a unique stock trading system on the side, along with his colleague Lenny Baum:

Here’s what was really unique: The paper didn’t try to identify or predict these states using economic theory or other conventional methods, nor did the researchers seek to address why the market entered certain states. Simons and his colleagues used mathematics to determine the set of states best fitting the observed pricing data; their model then made its bets accordingly. The why’s didn’t matter, Simons and his colleagues seemed to suggest, just the strategies to take advantage of the inferred states.

The Man Who Solved The Market, p. 29

Simons approached financial markets in a manner diametrically opposed to the fundamental analysis practiced by investors such as Warren Buffett. Simons did not care about the underlying economics of the financial instruments he sought to trade. He did not scrutinize macroeconomic variables such as GDP growth, inflation, housing starts, or rail shipments, nor did he analyze microeconomic variables specific to individual businesses. Simons focused exclusively on what he could learn by observing market data and detecting hidden patterns in that data that could be exploited for short term gain. It would have been just as impossible for Simons to adopt Buffett’s approach as it would have been for Buffett to adopt Simons’s approach. Simons had no interest in business and Buffett had no interest in attempting to understand the minute-by-minute gyrations of financial markets. Each brought to the game their own personal proclivities and talents.

Simons returned to academia when an opportunity came up to lead the mathematics department at SUNY Stony Brook on Long Island. His work on predicting financial markets was still fairly crude and he did not implement it for several years but the seed had been planted in his mind. By 1978, Simons decided to leave academia for good and founded what would eventually become Renaissance Technologies.

A Pure System

“I don’t want to have to worry about the market every minute. I want models that will make money while I sleep. A pure system without humans interfering.”

Jim Simons quoted in The Man Who Solved the Market, p. 56

Readers of Zuckerman’s book will never get a true sense of how the systems Simons and his colleagues built actually work. For one thing, the mathematics behind the systems are no doubt penetrable only to experts. These are models developed over decades by dozens of PhDs who worked with Simons to perfect his trading models. In addition, the models are obviously proprietary and Zuckerman’s sources were mostly bound by nondisclosure agreements. So readers looking for magic formulas will be disappointed but those of us looking for a fascinating story will enjoy the details nonetheless.

The early efforts of Simons, Lenny Baum, and James Ax led to success in developing models for various commodity, bond, and currency markets with positions generally held for a day or less. The system provided encouraging early results but it took on a life of its own and made strange decisions that no human could discern, leading to odd situations like nearly cornering the global market for potatoes. In the early 1980s, Baum shifted to a more traditional fundamental style of investing and Simons branched out into venture capital. Baum in particular began to take positions using intuition and instinct and started to make significant money for the firm.

A pattern seems to emerge in the book where Simons and his colleagues develop systems with a high degree of automation but they never seem to fully trust these systems, often falling back on intuition and instinct which eventually fails. Baum ran into trouble in 1984 with a bet on bonds that was poorly timed and caused a rift with Simons and Baum’s departure from the firm. Years later, James Ax would come to rely on his instincts for a portion of the portfolio he managed, leading to his departure in favor of a more automated system put in place by Elwyn Berlekamp. It seemed like the mathematicians did not fully trust their own models.

Medallion Fund

In 1988, Simons founded the Medallion Fund but he did not experience immediate success and, within six months, the fund was suffering. However, by the end of the year, the fund was up 16.3 percent before fees and 9 percent after fees. Medallion was small initially with assets of just $20 million. Simons was well beneath the radar of Wall Street and Medallion was destined to remain a small player for several years.

Over the next five years, Medallion strung together several years of impressive performance, culminating in an amazing 93.4 percent gross return in 1994. However, Medallion had problems scaling up in size because its trading strategy was limited in terms of the amount of capital it could successfully employ without moving the market. Simons closed the fund to new investors in 1993 when assets reached $280 million due to worries that it was becoming too large.2

Simons realized that he would have to extend Medallion’s portfolio to equities in order to grow the business beyond its traditional focus on commodity, currency, and bond markets. A key turning point came in 1993 when Simons hired Peter Brown and Robert Mercer, both computer scientists recruited from IBM. Mercer and Brown used their coding skills to build a system that would implement a single trading model for all of its investments rather than specific models for different investments and market conditions. Their model was built to handle complications that previous models could not handle or simply ignored.

Even geniuses make mistakes and one amusing part of the story involves a bug in Mercer’s code discovered by David Magerman:

Early one evening, his eyes blurry from staring at his computer screen for hours on end, Magerman spotted something odd: A line of simulation code used for Brown and Mercer’s trading system showed the Standard & Poor’s 500 at an unusually low level. This test code appeared to use a figure from back in 1991 that was roughly half the current number. Mercer had written it as a static figure, rather than as a variable that updated with each move in the market.

The Man Who Solved The Market, p. 194.

Magerman’s insight marked a turning point. Medallion’s equity team started to post better results, but equities were still providing only 10 percent of the firm’s profits in 1998. By 2003, however, Brown and Mercer’s stock trading group’s profits were twice as large as the profits from Medallion’s other trading strategies. Zuckerman goes into some detail regarding how this was accomplished through the use of basket options and substantial leverage. With the equity market puzzle solved, Medallion was able to grow significantly reaching about $5 billion by 2002.

Returning Capital

Medallion’s amazing performance in later years must be understood in the context of the policy of returning capital to investors on an annual basis. The size of the fund remained nearly static from 2002 through 2009 at $5 billion while net returns ranged from 22 to 82 percent over that span. Obviously, retaining these gains and reinvesting in Medallion’s strategy was not possible. If it had been possible, the size of Medallion would have grown exponentially. Instead, capital had to be returned to investors who, by this point, were mostly comprised of current and former Renaissance employees.

In an appendix to the book, Zuckerman presents a chart comparing the returns of Medallion with the records of George Soros, Steven Cohen, Peter Lynch, Warren Buffett, and Ray Dalio. Simons trounces all of these men in the table Zuckerman presents. However, there are problems with this direct comparison. For one thing, the period during which the returns were generated vary greatly with some investors having much longer track records than others. More importantly, Warren Buffett’s Berkshire Hathaway posted the 20.5 percent annualized returns from 1965 to 2018 while retaining all of the capital generated over the decades.3 Additionally, Zuckerman does not include Simons’s record prior to Medallion fund, which was not as impressive, while excluding Buffett’s early record which was even more impressive than his record at Berkshire.

Many Ways to Win

Intellectual humility requires us to recognize that there are many ways to succeed in any given field. For a value investor, the manner in which Jim Simons generated his wealth might seem like casino gambling and, indeed, it does share some characteristics with the economics of the “house” in a casino. By developing models that predict human behavior, Simons can be right just slightly more than half the time and still grow fabulously wealthy. He used his innate talents and interests to “solve the market” in his own way.

A value investor like Warren Buffett, on the other hand, takes exactly the opposite approach and scrutinizes businesses looking for enduring competitive advantages and then holds those investments for years or decades. Buffett’s temperament lends itself to this style of investing and it is arguable that Buffett’s approach is far more comprehensible for the vast majority of investors. Most of us are not math geniuses like Simons. Most of us are also not business geniuses like Buffett. But we can at least comprehend Buffett’s strategies and the manner in which he built his wealth is more accessible because he did so in the form of a public company. We can also invest alongside Buffett whereas we cannot invest with Simons given restricted access to his investment vehicles.

Ultimately, we all need to decide how we will approach investing. First, we have to decide whether to try to beat the market at all. Once we decide to make that attempt, we need to figure out what our edge is. Can we compete with men like Jim Simons at his game? The prospect of doing so seems very unlikely. But we can compete with Warren Buffett, especially since Buffett can no longer play in smaller opportunities given Berkshire’s massive size. And if we do not want to compete with Buffett, we can at least invest along with him, and we can do so in an investment vehicle that carries minimal fees and, thus far, has been able to reinvest all of its capital.

Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

Note to Readers: The Rational Walk will launch a free periodic newsletter named Rational Reflections on January 1, 2020. You can subscribe by clicking on the link and entering your email address which will not be sold or shared, and you can unsubscribe at any time. If you already subscribe to Rational Walk articles via email, you will be automatically subscribed to Rational Reflections and you do not need to sign up. Full articles after this one will no longer be distributed via email, but all new articles will be mentioned in the newsletter with a link provided to the full article.

  1. $5,000 in 1959 dollars is nearly $44,000 in 2019 dollars due to the effects of inflation. Simons was playing with a substantial sum of money for a young, newly married graduate student. When reading about dollar amounts in the 1950s, one can simply add a zero to the figure to approximate the ravages of inflation over six decades. []
  2. Zuckerman provides detailed performance data for Medallion in Appendix 1 to the book. The net performance is even more remarkable in light of the extremely high fees. Medallion has always carried a 5 percent management fee. The performance fee was initially 20 percent but was later raised to an astounding 44 percent! Despite the burden of these fees, Medallion had 39.1 percent average returns from its founding in 1988 through the end of 2018. []
  3. With the exception of a single ten cent dividend paid by Berkshire Hathaway in 1967 []

The Case for Balanced Skepticism

Social norms govern how individuals interact with each other and with society at large. Many norms have been incorporated into legal systems but most continue to be informal conventions. A significant percentage of the population will fail to adhere to established social norms despite the penalties that exist for those who fall out of line and are discovered. The worst offenders are those who, on the surface, appear to be exemplars of society but successfully flout our rules with impunity, often operating in subtle and nearly undetectable ways. Such serial offenders typically have charismatic attributes that mask underlying sociopathic tendencies.

Society cannot function at all in an environment where there is no trust, so we do not have the option of adopting a cynical attitude toward everyone and everything we encounter in day-to-day life. We cannot assume that everyone transacting with us is out to cheat us. We cannot form any meaningful relationships with others if we default to believing that they are acting disingenuously from the outset. At the same time, we have to take intelligent steps to avoid being the patsy at the poker table. We must find a way to willingly expose ourselves to a certain degree of vulnerability but, especially when the stakes are high, we would be ill advised to do depart very far from the concept of “trust, but verify”.

Letting Your Guard Down

Fortunately, life does not have to be so grim. Most of time, in day to day life, we can behave in a manner that gives everyone the benefit of the doubt whether the interaction is commercial or personal in nature. We benefit from the mental shortcuts that flow from acting in a manner that assumes that others are behaving in keeping with our society’s social mores. The downside of occasionally being taken advantage of in small matters is outweighed by the many positive interactions and ease of living with a positive and trusting attitude. Life is more pleasant when we are not constantly on guard.

The time to adopt an attitude of informed skepticism is when the stakes are high. It should go without saying that consumers are well served to be on guard when making transactions such as purchasing a vehicle or buying a home. In fact, any time there is a major asymmetry of information and experience, it pays to be very skeptical regarding the motives and strategy of the person on the other side of the table. Understanding how those with malign intent attempt to deceive us can be invaluable when it comes to defending against such attempts.

How to Lie with Statistics holds the strange distinction of being a book about … statistics that is nevertheless very amusing and informative for the general reader. Written by Darrell Huff in 1954, the book somehow avoids getting bogged down in math. Huff instead resorts to clever illustrations and cartoons to make his points regarding the myriad ways in which statistics can be used to deceive. The 1954 price and salary information he uses is unadjusted for inflation over the past sixty-five years, which only adds to the charm of the narrative.1 Huff is well aware that the techniques he discusses could become a “manual for swindlers” but notes that “the crooks already know these tricks; honest men must learn them in self-defense.” The tricks that Huff describes were fooling people back in the 1950s and the same techniques continue to work wonders today. It seems like little has changed in terms of lack of basic numeracy over the decades.

One of the most pernicious aspects of using statistics to mislead is that most people take mental shortcuts as soon as they see numerical figures in an article. When used in certain ways, statistics can serve as a sort of trump card for bad actors. Through manipulative choices, numbers can be developed to “prove” all sorts of disingenuous arguments.

Huff covers many of the straight forward fallacies that most of us are very familiar with, such as the confusion between the use of median and mean averages which can be particularly misleading when it comes to data sets that are not normally distributed, such as wealth in the United States. Of the methods described by Huff, two jump out as interesting enough to discuss at further length: The Semi-Attached Figure and The Gee-Whiz Graph.

“Compared to What?”

If you are selling something that has no proven benefits, or making an argument that has no intrinsic merit, not all is lost if you are willing to engage in a deceptive slight-of-hand that Huff refers to as the semi-attached figure:

If you can’t prove what you want to prove, demonstrate something else and pretend that they are the same thing. In the daze that follows the collision of statistics with the human mind, hardly anybody will notice the difference. The semi-attached figure is a device guaranteed to stand you in good stead. It always has.

How to Lie with Statistics, p. 76

Let’s say that you are the marketing manager responsible for coming up with an ad copy for a product that isn’t demonstrably better than its competitors. Huff uses the example of a juice extractor. The marketing manager cannot come up with any data to show that the juice extractor is more efficient or easier to use than competing products, but it would be easy to prove that the juicer is much better than using an old fashioned hand reamer. There would be no explicit lie in the statement that the device “extracts 26 percent more juice as proved by laboratory tests”. The deception rests in the act of omission: compared to what?

A similar trick is common within the investment management industry. An investment manager with a mediocre track record can easily present misleading data that is technically true. For example, let’s say that an investor made a public call that happened to “bottom tick” a particular stock, or catch the exact point at which the stock stopped falling and started to rise. The investor can say something like “after I called the bottom on Company XYZ and purchased shares, the stock went up over 2000 percent over the next two years!” This might technically be true. But it doesn’t mean that the investor had the foresight to hold that stock for that stellar gain. He could very well have sold it after it went up just five or ten or fifty percent!

Chart Crime!

Although Huff does not use the term “chart crime” in the book, he does have a full chapter dedicated to the “Gee Whiz Graph”. The reason charts and graphs are used so frequently in the media and in sales presentation is because most people are very visual and numbers naturally “come to life” when put into a drawing. However, a chart can be technically true but still provide grossly misleading impressions. For example, presenting only a portion of a chart can make changes look more dramatic than they really are. If you are showing data that ranges between 16 and 18, the variations will look much more dramatic if the y-axis ranges from 15 to 20 than if the y-axis ranges from 0 to 100. Of course, in some cases, small variations are meaningful. If the data from 16 to 18 represents the range of a company’s net margin over a decade, a tighter y-axis will show meaningful variations over time. The designer of the graph has the responsibility to present the data in a way that is not only accurate but meaningful.

“Map crime” is closely related to chart crime. It involves using a map to represent data to suit a particular agenda. For example, say that you want to represent the share of national income collected by the government in the form of taxes. Huff shows two ways in which this could be represented on a map of the United States:

How to Lie with Statistics, p. 105

Both the western and eastern style maps show an accurate representation of federal spending that is equal to the total incomes of the people living in the shaded states. The large area shaded in the western style map is due to the fact that, in 1954, the western states had vastly smaller aggregate income compared to eastern states. The eastern map merely demonstrates that a few eastern states had very high income. While both maps are accurate, someone who wanted to present a threatening picture of big government would opt for the western map while his political opponent favoring a larger state would choose the eastern map.

A similar effect exists when one looks at the results of a presidential election based on geography rather than population. For example, the map below shows the results of the 2016 election by county. If you wanted to present the impression that nearly everyone in the country voted Republican, you could use this map even though the reality is that the majority of the population actually voted for the Democratic candidate. Using land area rather than population density presents a misleading image.

Source: http://metrocosm.com/election-2016-map-3d/

As Jason Zweig wrote in his review of the book, Huff provides invaluable guidance for readers who are trying to figure out if they are being manipulated through the clever use of statistics. For those of us who took statistics in college, there isn’t much of anything that is new from a mathematical perspective. However, the book serves well as an introduction for those who are not familiar with the subject and is also a great refresher for the rest of us.

Robert Cialdini’s classic book Influence: The Psychology of Persuasion is one of Charlie Munger’s favorite books, and for many good reasons. Mr. Munger has long been focused on developing a better understanding of the psychology of human misjudgment. Human beings have developed many psychological tendencies over thousands of years and, normally, these tendencies serve as useful shortcuts that allow us to make quick and efficient decisions. However, in certain contexts, our instincts can lead us astray especially when we are being manipulated by experts. Just as Huff did not intend his book on statistics to serve as a roadmap for deceit, Cialdini wrote his book not to empower corrupt behavior but to warn the public against falling into avoidable traps. By publicizing the methods that “compliance professionals” utilize, Cialdini does the general public a service by highlighting situations in which we should exercise informed skepticism.

Over a decade ago, I wrote a brief article applying Cialdini’s ideas to Bernie Madoff’s Ponzi scheme.2 Madoff used the principles of social proof, authority, and scarcity to manipulate his clients for decades despite many warning signs. People who should have known better simply looked the other way. They were not sufficiently skeptical.

Uncomfortable Obligations

Reciprocity is one of the most powerful human tendencies and it has actually served us very well throughout human history. Without reciprocity, society would not function very well. Cialdini emphasizes the competitive advantages provided by the reciprocity rule:

Make no mistake, human societies derive a truly significant competitive advantage from the reciprocity rule, and consequently they make sure their members are trained to comply with and believe in it. Each of us has been taught to live up to the rule, and each of us knows about the social sanctions and derision applied to anyone who violates it. The labels we assign to such a person are loaded with negativity — moocher, ingrate, welsher. Because there is general distastes for those who take and make no effort to give in return, we will often go to great lengths to avoid being considered one of their number. It is to those lengths that we will often be taken and, in the process, be “taken” by individuals who stand to gain from our indebtedness.

Influence, p. 20

The almost universal instinct to reciprocate when someone does something that puts us in their debt allows compliance professionals to easily manipulate us. This can be fairly obvious, such as when we are presented with a “free gift” in a setting like a timeshare sales presentation, or when a local stock broker offers a “free lunch” to those who agree to listen to his presentation. The recipients naturally feel an obligation after receiving something of value. Many people will, in fact, reciprocate just to cancel out their obligation even if they do not want whatever is being sold.

Compliance professionals also exercise more subtle pressures that harness the reciprocation tendency. Cialdini points out that a concession in a negotiation normally creates a psychological need for the other party to also make a concession. This is why it is extremely dangerous to let anyone else control the terms of a negotiation. If a used car salesmen starts a negotiation from an inflated sticker price, he can make a fake initial “concession” that doesn’t come close to lowering the price to the car’s blue book value. The buyer can be manipulated into agreeing to pay more simply by the act of the salesman making a fake concession.

Skepticism, Not Cynicism

The risk we face when we learn about these psychological tendencies is to guard vigilantly against falling into traps even at the risk of flouting social conventions that are useful and bind people together in positive ways. When you are dealing with a used car salesman, informed skepticism and even cynicism might be warranted. It is probably a good idea to avoid accepting any “gift” from the salesman, even something as trivial as a free can of soda. Similarly, it is probably best to not allow a realtor to buy your lunch between visiting homes. That’s simply prudent.

But should you act with suspicion when you move into a new home and your neighbor brings over a casserole or a bottle of wine to welcome you to the neighborhood? It is true that by accepting you will likely feel a need to reciprocate in some way, but this is a healthy form of reciprocation. You’ll get to know your new neighbors as part of the process. It is possible that your neighbor may try to sell you life insurance the next time you see her, but it is more likely that she’s just being friendly. As Cialdini points out, we will always encounter people who are authentically generous. Refusing the kindness of all people, regardless of the context in which it occurs, will result in isolation.

Malcolm Gladwell’s latest book, Talking to Strangers, was all about the risk of miscommunication when we interact with people who we do not know well.3 We often make the mistake of thinking that other people are transparent when, in fact, we cannot really see into their minds. Giving people the benefit of the doubt and assuming benign intent is a good way to live our day to day lives, especially in cases where the stakes are low. However, when the stakes are high, defaulting to a skeptical outlook is only prudent. We must be vigilant regarding avoiding the traps that compliance professionals set out for us. At the same time, we should know when to let our guards down, even if only temporarily and in settings where a worst case outcome will not hurt us too badly.

  1. Federal Reserve Chairman Powell might consider low inflation to be “one of the major challenges of our time“, but the nearly ten-fold increase in the price level since 1954 leads one to believe this challenge is “solvable”. The reader can just add a zero to the 1954 prices to approximate the effects of inflation. []
  2. The article on Madoff in February 2009 was actually the sixth article to appear on The Rational Walk. []
  3. We reviewed Talking to Strangers in November. []

The Financial Illiteracy Epidemic

Money cannot guarantee happiness but grinding poverty can almost certainly guarantee misery. It is difficult to be happy when you know, in the back of your mind, that you are one small misfortune away from being unable to pay next month’s rent without resorting to payday lenders or the friendly neighborhood loan shark. Poverty is a complex topic and those of us who have never experienced it should not throw around simple platitudes regarding how to escape it. However, for a certain subset of those who find themselves in constant anxiety regarding money, the problem is almost certainly compounded by a lack of financial literacy.

Living on the Edge

According to a recent report, 66 million Americans have absolutely no savings available to cover a financial emergency.  This shocking figure is nearly one-third of the roughly 206 million Americans between the ages of 15 and 64 which makes up the age group most likely to lack a safety net to deal with emergencies.  A survey published by Standard & Poor’s revealed that only 57 percent of Americans are financially literate.  Although it isn’t a good idea to unfairly stereotype individuals in large groups, it seems very likely that the Americans lacking savings also have a general lack of understanding of basic personal finance.

Why is this the case and what can be done about it?

One of the problems is that human beings do not seem to naturally understand non-linear systems, and this deficiency prevents us from automatically understanding what is perhaps the most important topic in personal finance:  compound interest.

Here is one of the questions asked in the financial literacy survey:

Suppose you had $100 in a savings account and the bank adds 10% per year to the account. How much money would you have in the account after five years if you did not remove any money from the account: more than $150, exactly $150 or less than $150?

It is likely that most people would understand that 10 percent of $100 is $10 which represents the first year of interest.  The account will be open for five years, so many people will be tempted to simply multiply the $10 by 5 and come up with $50 in total interest which is added to the initial $100 balance for a total of $150.  However, this ignores the fact that you earn interest on interest which is the essence of compounding.  Assuming annual compounding, the balance of the account would look like this over the five year span:

A simple formula can be used to determine the ending result of a sum invested at a certain rate over a certain period of time:

Ending Balance = Starting Balance * (1 + Periodic Interest Rate) ^ Number of Periods

The formula can be applied to this example as follows:

$161.05 = $100 * (1 + 0.1) ^ 5

Compound interest is an example of an exponential equation and the results do not neatly fit our natural intuitions.  It is much more intuitive to think that the $100 deposit will earn $50 over five years than to figure out the actual result which is significantly more than $50.  However, it is important to realize that this particular exponential function is very simple and should be understandable to the vast majority of people if explained clearly as part of a basic education.

The Longer View

To make the effect of compound interest more clear, let’s extend the period of time that the $100 is kept on deposit at a rate of 10%.  Rather than assuming five years, let’s assume that the money is left alone for fifty years instead.  If we apply the same “gut instinct” (but incorrect) logic that would have led someone to believe that the $100 deposit would only earn $50 over five years to this longer example, the answer would be that the fifty year deposit should earn a total of $500, which is 50 years multiplied by $10 per year.

Let’s see what the correct result is:

Ending Balance = Starting Balance * (1 + Periodic Interest Rate) ^ Number of Periods

This formula can be applied to this example as follows:

$11,739.09= $100 * (1 + 0.1) ^ 50

Instead of earning the $500 that “gut instinct” might have led us to believe, the $100 deposit earns a shocking $11,639.09 in interest!

This unintuitive result is due to the exponential nature of compound interest, as we can see from the graph below:

We can see that progress is slow at first, which we already knew based on the first five years of the investment.  However, over time, earning interest on interest becomes the driving force behind the overall value of the account and we can really see the line start to explode upward over the second twenty-five year period.

What Applies to Savings Also Applies to Debt

How many people truly understand the horrible compounding effects of credit card debt?  Although paying 15 to 20 percent interest on a $1,000 sofa might seem like an annoyance over the first year, making minimum monthly payments while taking on additional debt will cause the problem to snowball over time in just the same way that savings multiplied like crazy in the previous example.  Actually, the snowball will be much worse. Compounding at 15 to 20 percent results in a much, much larger snowball than compounding at 10 percent.

Although credit card disclosure requirements have improved over the past several years and people are now clearly told how long it will take to retire debt based on minimum monthly payments, few people are going to pay much attention to the details on a credit card statement or stop using the credit card while paying it down.

Low Interest Rates Make Compounding Less Obvious

The example in the survey uses a rate of 10 percent for a savings account which is obviously unrealistic in today’s world of minuscule savings rates.  However, low interest rates are probably not going to be a permanent phenomenon over the long run.  The problem is that people have been trained to not appreciate the power of compound interest over the past several years because it is even less apparent than it otherwise would be.

Using a rate of 1 percent, which one would have been fortunate to get on a savings account over the past several years, the $100 deposit would have grown to only $105.10 over five years.  In this case, the “intuitive” answer of believing that the total interest would be only $5 is hardly different from the correct answer of $5.10.  In fact, it is so trivial that if we used the 1 percent rate in an example, people would laugh if we tried to claim that compound interest is actually important!

Multi-Disciplinary Education

Financial education is severely lacking in the United States and the fact that over half of Americans lack basic financial literacy is a national disgrace.  The place to remedy the problem has to be the public school system.  Ideally, parents would educate their children on personal finance but too many adults are financially illiterate themselves and we do not want to have a society where this perpetuates through multiple generations.

It should not be difficult to incorporate an appreciation for compound interest into the public school system.  Basic exponential functions are routinely taught at the middle school level and, if not, certainly as part of a high school curriculum.  Rather than using esoteric examples that students might not relate to, teachers could incorporate compound interest directly into basic math education covering exponential functions.

But is it the job of math teachers to cover personal finance?  The better question is why not?

There need not be a special course in personal finance (although such an offering has obvious merits as well).  Disciplines like mathematics should incorporate subject matter from other disciplines, particularly when doing so reinforces the math that is being taught.  All young people are concerned with having enough money to spend.  They might be too impulsive to care about long term growth of savings, but if they are at least aware of the potential of compound interest, that might prevent the accumulation of unwise debt in college or when starting out in the workforce.

Parents who are fully aware of the power of compound interest might try bypassing today’s low interest rate environment by setting up a family “bank” where their children can make “deposits” at rates that are far above market and possibly compound at a more frequent pace.  For example, parents could offer their children an “account” that compounds at a rate of 5 percent every quarter.  At that rate, a $100 deposit would grow to almost $150 over two years, well within the time frame that a teenager should appreciate.

Not a Panacea, But a Start

Even if every American left high school with a solid understanding of compound interest, we will still have people who fail to save because they lack self-control or fall into really hard times through no fault of their own.  However, it is hard to believe that wide dissemination of this very basic principle would not dramatically reduce human misery.  Not being able to cover the cost of a broken refrigerator, a tire blow-out, or a traffic ticket should be preventable for almost everyone.

There are enough truly difficult problems in life that do not lend themselves to simple solutions, so we should adopt simple ideas that have little or no downside such as teaching students about compound interest as part of their existing math programs.  It might be overly optimistic to hope that all Americans will automatically think in terms of exponential functions rather than using their linear intuitions in everyday life.  But when faced with major life decisions, the default should be to think in terms of compound interest when it comes to spending and saving money.

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