Tuesday, November 22, 2011

Socialists Probably Hate Sports....

Currently, many people are protesting in the streets against the phantom "1%" of elite earners that consume the majority of wealth in our country. Fashioning their agenda loosely on socialist principles, it seems strange that many of these people have no problem with how sports are run in our country. In many professional sports, a top-tier athlete (Michael Jordan, Lebron James) might earn 20x what starting players make on the same team.

Similar unfairness exists in the way the contests are decided. If a basketball team loses a close contest by the score of 100-98, it is simply recorded in binary fashion as Win=0, Loss=1. The losing team scored nearly the same amount as the winning team, yet receives 100% of the assigned losses. A "fair system" would reward the winning team with a .51-.49 record The distribution of win-loss records is completely skewed and fails to reward the loser for their skill and effort. Our "unfair" sports system has become accepted methodology that we have no problem with as a society (at amateur or professional level).

People hate to lose, especially when it feels like they are losing all the time.  At the same time, it is crucial to realize that people accept the concept of "winner-take-all" competitions, provided that they have a fair chance at being that winner (who "takes all"). This basic idea of fair-play is twisted by those that attempt to relate fair-playing fields with a "fair" distribution of outcomes. Just because people want fair competition does mean that they want a fair and balanced outcome.

Take football for example, the sport demands a basic set of rules that are enforced by neutral officials. Basic rules outlining what areas are "out of bounds", a touchdown, or a penalty are what defines the competition.

While fans demand an objective set of playing rules that apply to all teams, this does not mean they desire equal outcomes. For instance, Chicago Bears fan wants their team to win 100% of games against the Green Bay Packers, by any method allowed in the rules. If there are subjective calls by the officials, they want to see 100% of them decided in favor of Chicago. If there are unfortunate injuries, the Chicago supporter wants to see 100% of them occur to Green Bay players. There is nothing "fair and balanced" about this distribution of outcomes desired by the Chicago fan, even though the process itself is fair.

Similarly, most sport fans suffer no moral dilemna or quandary when their favorite team has a disproportionate talent advantage versus its peers. Such examples include the NBA (Chicago Bulls had Michael Jordan/Pippen/Rodman on roster), NFL (Dallas Cowboys had Troy Aikman/Emmitt Smith/Michael Irvin), or MLB (New York Yankees with highly-paid all-star roster). While fans of these teams enjoy watching them win multiple championships, they admire them for succeeding on objective playing fields with objective rules. The Bulls had to dribble up-and-down the court like every other NBA team, much the same as the Cowboys had to drive a full 100-yard field like every other NFL team. Very few people would celebrate their team's win if it came about from a referee-bribe or clearly rigged match.

So what is the point of this? Fair rules and processes do not always lead to fair outcomes. When they do lead to "fair outcomes", such outcomes are not always deemed desirable, regardless of how random they are.  At the end of the day, they don't split championship trophies into 1/2s or 1/4ths.

Friday, November 11, 2011

Danger from the Pursuit of Fairness...

Academics often confuse fair-play with fair outcomes.An example of confusing fair-play with fair outcomes is economist Noreena Hertz, who wrote an editorial in the FT titled, "Women Still get a raw deal in business and finance". In her article, she states,

"That banks could be discriminating against women customers should not come as a complete shock. In the US, banks deemed single women poor credit risks until the 1968 Fair Housing Act. Until the Equal Credit Opportunity Act of 1974, women had to have a co-signor to become mortgage borrowers and before the 1975 Sex Discrimination Act in the UK, banks were legally able to reject a woman’s loan request because they were not seen as a good risk. In the absence of clear legislation and a commitment to enforce it, discrimination historically has been the default"
The thesis of the article is that banks unfairly discriminate against women and refuse them loans. Her examples ignore historical context entirely. For example, Ms. Hertz cites US/UK bank refusal to lend to single women in the 1960’s. But women were worse credit risks in the 1960’s, due primarily to the active discrimination against them in the workplace and in schools. The lack of maternal-leave and sexual discrimination laws hampered women’s ability to achieve sustainable employment that fairly compensated them for their skills. This societal discrimination impaired women’s creditworthiness by limiting their capacity to repay a loan. (What would Ms. Hertz say to the hypothetical Saudi banker that refuses a woman a business loan, due to the fact that she is not allowed to drive herself to work every day? Is the credit officer supposed to ignore the barriers that Saudi laws and society have imposed upon her? While unfair to women, it is difficult to blame the banker for not making the loan)

Without a doubt, sex discrimination is unfair and has impeded the progress of many capable women. However, it is equally unfair to blame the bank lender for the fault of wider societal bias. Banks are supposed to be in the business of making loans that will be repaid, not social engineering to fix broader societal bias (look no further than subprime CRA lending in the US, it hasn’t worked out so well for us). If Ms. Hertz really wants bank lenders to open their checkbook, she would do better to plead the case of how profitable/safe such lending can be, rather than demanding fairness (which only comes from broader political and social changes).

Summary- While people generally want a society that is fair and provides ample opportunity to succeed, but fairness will never come by expecting other human beings to act against their best interest. The good intentions of such socialistic ideas create a conflict, as lenders are forced to fund marginal-ideas that crowd out more innovative and interesting business ideas. As a result, the playing field is skewed towards whichever special-interest group has the ear of the country's leader, rather than who has the best idea.


Wednesday, November 02, 2011

Eric Falkenstein on Chance, Effort, and Ability

Excellent post at Falkenblog on the critical linkage between Chance, Effort, and Ability-
"Success is the result of randomness, effort, and ability. If you omit one of these, you will be miserable. A lot of growing up is about finding what you like that you are good at, and usually you like things you are relatively good at. Then practice that skill until you become excellent at it. The rest you can't really worry about even though that too is important, especially in explaining things like why certain people are really rich, which is often being in the right place at the right time. This should make us content because it's all we can control."
Falkenstein's post was a rebuttal of the argument that most wealth attainment is the result of simple luck and randomness (versus skill, hard work, ingenuity). The key point is that success is most-often the result of a combination of elements: Chance, Effort, and Ability. On the other side of the spectrum, many institutional investors fail to understand this concept as well. Funds chase recent performance trends and managers promoting themselves with buzzwords like "portable alpha". More often than not, their returns are due to financial leverage or assuming risks their investors are not aware of. The investment process is the only thing that investors truly control, not the outcome!

Be extremely wary when someone promises a certain outcome with respect to markets or macro-events that are beyond their control. Hide your wallet, voting proxy, etc. and run the other way. An easy example might be a Presidential candidate promising the following:
     1) I will reduce the price of gasoline to $2/gallon, 
     2) I will reduce unemployment, 
     3) I will ensure that mothers do not have their homes foreclosed upon
     4) I will get government out of the way and let the free market work

This short list of contradictory promises/statements were all made by same politician (Rep. Bachmann). Take Promise #1: While $2 gasoline sounds like a great outcome, there is no substantive process for how it would be accomplished. Based on current technology, the most logical path to $2 gasoline would be a combination of crippling deflation, higher unemployment (lower demand for gas), or outright government intervention (price controls or banning automobiles). Each of these processes to achieve the desired outcome ($2/gallon gas) are clearly bad and have very negative side effects. This is why the process is so much more important than focusing strictly on outcomes! 

Even when you implement a "good process" does not guarantee a good outcome. Some of this is explained concisely in a chart created by Michael Mauboussin for his book "Think Twice",


The lesson to take away is:  implement a good process that you can consistently repeat and employ in both good and badtimes, along with not getting a big head over your success (it may be partly due to luck!) For investments, that means avoid being over-leveraged and concentrated in positions that you are not a control investor in.  This allows you to take advantage of future opportunities that do not exist and cannot be foreseen. In the words of Louis Pasteur, "Chance favors the prepared mind"...and portfolio.