Wednesday, December 23, 2009

Airplanes and Brodmann Area 10


There is an area of your brain that lights up on a functional MRI scan whenever you consider buying something cool.  It's called Brodmann Area 10.  So if you're a guy who's just won the lottery and you're perusing new Ferraris for a test drive, that area of your brain is going nuts.  If you were buying say, mousetraps or toilet paper, then it would be comparatively inactive.




Some researchers believe that Brodmann Area 10 contains the part of the brain that is focused on making us interesting to potential mates.  That certainly correlates to our common sense notion of coolness.  And it makes sense that there is a part of our brain's real estate dedicated to such endeavors.

In case you are wondering, many areas of the brain are highly consistent between people.  So consistent in fact that you can show one group of people a set of images (say a hammer, apartment building, etc) while scanning their brains and then extrapolate from that set onto a whole new set of people to predict what they are seeing.  Funny huh?  When you look at a hammer your brain is doing about the same thing that mine is doing-- and we can see it in an fMRI brain scan and even predict when I'm looking at a hammer.  Wow, that activates Brodmann Area 10 in my brain (okay that statement officially rebuts itself).

If you have an hour to kill, and you want to hear more about this topic of fMRI mapping to the brain, check out the Google Tech Talks video below.




You probably know where this is going.  Quick: Would you rather own a high-tech company or a pest control service?  Without more information, your answer depends largely on which one of these activates Brodmann Area 10 the most.  But even when you have more information... say the profit and loss statements for these hypothetical companies... I believe that things are not all equal.  Let's say, for instance, that you could make $500,000 per year running a high-tech company and $501,000 per year running a pest control service working the exact same number of hours, putting forth the same effort, and both companies have the same prospects for growth.

You would likely choose the one you think is cooler even without knowing the details of your day to day job.  At some point, of course, the monetary spread becomes wide enough to tip the balance.  I call this the Coolness Premium.  It is the monetary penalty you assume when you choose to engage in something cool.  I think every company in existence and also every available job has a Coolness Premium.  The spread may be small in some cases, but it is still there.  Most people want to spend their lives doing something interesting.  And what do we find interesting?  Cool stuff.

I think most people underestimate both the size of The Coolness Premium and the impact it has.  Did you know that the airline industry in the United States has lost money on aggregate since its inception?  All of the revenues flowing into every airline in existence for the last 100 years have not offset the cost of running those companies.

Why?  It's simple.  Because it's cool to own planes.  Every magnate that was worth his salt wanted to have something to do with airplanes back in the day.  I'm certain that many otherwise nice dinners were ruined by some aristocrat regaling the table with stories of how he and his comrades were changing the world with these new flying machines.  And it's still true to a certain extent today in the airline industry.

Of course, making money is cool too, so it can work in reverse.  The computer industry went through this.  It really wasn't cool at all to be a computer nerd in the 80s.  Then, in the 90s, those nerds were suddenly called CEOs and the money they made caused Brodmann Area 10 to activate in many people at the mere mention of tech.  Then, the market crashed and people's anterior insular cortex became activated when the term 'dotcom' was mentioned-- that's the brain's area for disgust.

Do you remember LBO (leveraged buyouts) from the 80s?  Junk bonds, Ivan Bosky, Michael Milken, Barbarians at the Gate, and all that.  After the public learned that most of the buyouts (53%) led to bankruptcies, lost jobs, and hundreds of millions in profits to the LBO firms such as KKR, Forstmann Little and later Clayton, Dubilier & Rice, it was no longer cool to be involved in LBOs.  So they went away, right?

Hardly.  Making money is still really cool.  They underwent a marketing makeover and starting calling themselves Private Equity Companies.  Then they were cool again.  In a few years, you'll probably feel disgust for that name too, but that's another topic.

Nevertheless, I think it is important for the entrepreneur to come to terms with the fact that he or she has to pay a premium to work on something cool.  So if you're working on the next social networking site, you need to know that competition is fierce and customer loyalty is zero.  Just ask Friendster, the pre-Facebook Facebook.  Sun says there are 6 million Java programmers.  I'd estimate that at least 1/3rd of these spend time thinking about some way to parlay their knowledge into a new tech start-up.  That's 2 million really smart people looking at tech in every way they can think of and maybe 200 people looking at new and innovative ways to run a pest control service.
Posted by at

Monday, October 5, 2009

IQ verses Determination

Chris Langan is purportedly the smartest person in the world (IQ 190-210).  What can we learn from him?



If you get far enough into this video series (video 3), you will hear this dialogue:

Interviewer: "Say you had the opportunity to run the world.  How would you do it?"


Langan: "Well one of the first things that I would do is I would institute something like the Manhattan project for a safe long-lasting means of birth control.  Simply implant that in all children at age 10.  That would solve our population problem right off the bat and it would also enable us to practice a benign form of eugenics.  Or I should probably say anti-dysgenics.  Prevent undesirable mutations in the human genome.  People who wanted to have children would apply to make sure they had no disease.  Either we have to do it through genetic engineering or we have to let only the fit breed.  We like to think that it is our right to breed as incontinently as we want to... have as many kids as we want with whomever we want to.  Future generations of mankind are being saddled with the results of what we do or don't do.  Freedom is not necessarily a right.  It is a priviledge that we have to earn.  A lot of people abuse their freedom and that is something that people have to be trained not to do."

He goes on to say that he'd be happy to train people... just put him in charge.


Thanks, Hitler, we'll keep that in mind.  So what role does IQ play in entrepreneurship?  Langan has an advantage over you in business like the large gentleman pictured to the left has an advantage over you in golf.  They are two entirely different things-- unless you are in the business of selling IQ tests.  I admit that I kind of like Langan though.  You have to admire somebody who went through everything he has and now dedicates his life to saving humanity, albeit through eugenics.

Further, IQ does not equal intelligence in my view.  I actually think it does a good job of testing certain abilities, but it leaves out a number of very important ones, such as creativity, which I think most people believe is probably the most important ability.  There are cases where a stroke in a certain area of the frontal cortex increases IQ by 15 or more points in some patients.  Clearly, it cannot be measuring all mental ability accurately when severe damage can increase your score.  Some people who are born with only half a brain (only a left or right hemisphere) or with an organic disease, such as autism, perform conspicuously well at certain tasks that we associate with intelligence.  They sometimes have phenomenal memories, can perform mind-blowing math skills, or can calendar count (see these videos; Daniel Tammet, Stephen Wiltshire ).  These are amazing abilities, but I think they also demonstrate how powerful a normal brain can be.  It may be that our definition of intelligence needs to be rethought.

If you could measure someone's determination, creativity and persistence, then I'd think you'd be on to something.




Sure, you have to be smart to be a good entrepreneur, but with persistence you get smart-- and you get smart in the right places.  By persistence, I don't mean stiffly reapplying your efforts to the same tasks and problems over and over.  I mean rethinking the problem, coming at it from different angles, and trying new things until you get it right.  The brain is highly plastic and adapts a lot more than you may have been led to believe.  Norman Doidge has written a great book on this subject of neuroplasticity called The Brain That Changes Itself (the first few chapters it read like an infomercial for Fast Forward, but it's good after that).

How your brain actually changes


Our focus on intelligence in entrepreneurship probably arises from the belief that technology start-ups founders are typically very smart-- which is true.  So, the smarter you are the more likely you are to develop a better product and be successful.  After all, smarter people receive more Nobel Prizes and invent more innovative products.

Right?  Well, no.  Once you get above a certain IQ (around 125-130) there is no correlation at all.  It turns out that what you need to receive a Nobel Prize, cure a disease, or invent a great product is sufficient understanding of the field and a lot of imagination, not pure virtuosity.  It is also the case that what we consider to be inborn talents, such as playing the piano and math, are correlated very highly with the amount of time that you practice them.  In fact, there is even a number-- 10,000 hours-- under which, purportedly, there are no cases in the world of expert ability in any field.  This was true even for Mozart who I think most people assume was given the innate ability to compose music with virtually no practice.  It isn't true.  Sure, he was born with a lot more ability than almost everybody else, but he had to hone his ability like anybody else would.

If you are skeptical of these claims, then you should read Outliers by Malcolm Gladwell.  Gladwell argues that the year and even month that you were born are, in many cases, critical factors in success.  His basic point is that, although genetics and personal environment do play a huge role in what we're capable of doing, our actual success also depends on a lot of factors that are out of our control-- such as the year in which we were born. One example is that a grossly disproportionate number of Canadian hockey players are born in January, February, and March and almost none are born in December.  Another is that Bill Gates, Bill Joy, Steve Jobs and a number of other famous software entrepreneurs were all born within 6-12 months of each other.  I'll let you find out why in the book.

Gladwell's book is a case study for the entrepreneur to learn how to catch the zeitgeist.  If you've gotten this far in a post this dry, then I'm convinced that you have the intelligence and persistence necessary to be a great entrepreneur.  I think the most effective thing you can do is think about how you can use your current skills and existing technologies to solve new types of problems that aren't being addressed.  Relax.  Take something you're interested in and have a talent for and play around with it.

How can you put together things that already exist in a new way to solve a problem that people may not even recognize as a problem?
Posted by at

Saturday, October 3, 2009

How To Raise Venture Capital


Here's a good summary of what is involved with raising VC money for a company.



Posted by at

Where To Apply Your Focus (2)


It does 'appear' that Greenspan's self--or perhaps under-- regulation failed us in a big way. But regulation is expensive and can weigh down a company as anyone familiar with Sarbanes-Oxley can attest. So how do you get companies to play fair without needlessly hampering our productivity? Do you change some entities to operate as a government or psuedo-government entity, NGO, GSE(like Fannie Mae), 501c? If so, which ones? Or how and what do you regulate?

In The Age of Turbulence, which Greenspan wrote before the crisis, he elaborates on the philosophies (he was a logical-positivist turned objectivist by Ayn Rand) which help guide his belief system for interpreting the data and issuing policies. Greenspan, if not heavily influenced by, was at least somewhat congruent with the work of libertarian economist Milton Friedman (see him on Donahue), and Friedman's rep has taken a hit lately too.  But Milton Friedman disagreed with Greenspan on one key aspect of monetary policy-- that the money supply should be tightly controlled (see article).  Sadly, he recanted this belief just before he died.  If he were alive today, he might recant that recant.

Greenspan answers questions (note the contentious title)



In the Donahue interview below, Friedman discusses his hands-off approach to economics.  Note that he says there is no case for the government to mandate air bags in cars. I don't disagree with this per se, but there is a case actually-- it is when you injure yourself such that you have to be put on a ventilator at someone else's expense (called a collection action problem). This happened enough in the 80s, 90s, and 00s (though mostly due to not wearing a motorcycle helmet) that it has caused some noticable medical expenses for the public.



Where to draw the line with regulation in the free markets has always been a main source of contention with Friedman's theories, and the House of Cards video (see Environs) examines the recent problems that have arisen from lax regulation.  It appears, to many, that the theory that individuals pursuing their own self-interests leads to prosperity for all may need to be refined a little. I've often wondered if we should turn to the field of game theory for some answers to this type of question as the unbridled pursuit of self-interest does have some fallout.

On that note, Napoleon Hill, of Think and Grow Rich (1937), wrote: "The path of least resistance makes all rivers, and some men, crooked." Napoleon (Hill not Boneparte) was from my neck of the woods, and from the same area my orphaned grandfather grew up in tiny houses, sometimes with no roof, and no guardians-- only his siblings. As such, Hill's highly abstract question "In what do I truly believe?" has always had a very tangible feel to me; I guess because images of my father's family and culture so easily come to mind. That place is quite a long way from Wall Street in 2009.

So what is the point of all this economy stuff?  Learn how it works and then don't get caught up in it.  That path of least resistance is crowded. If you feel an exuberant greed and passion for money brewing inside of you, I recommend avoiding entrepreneurial endeavors unless you are willing to wait potentially a long time for your money.  There are easier ways to make money.  It's far simpler, and I believe more natural and fulfilling, for an entrepreneur to pursue goals that he believes in rather than ideas that he thinks will make money. Of course money is good, but as Warren Buffet said: "It's kind of like saving sex up for your old age.  At some point you've just got to do what you enjoy."


Posted by at

Friday, October 2, 2009

Venture Capital: IPOs


Another misconception among entrepreneurs involves the IPO which is often the ultimate goal of all parties involved. In the past 10 years or so, many VC funds have gotten large enough to hold and finance most private companies without the need for an IPO. If you are a stock investor you should know that many IPOs come at a time when the VC firm has milked the income growth out of a company and now just wants to unload it, when the private owners want to cash out, or when either party wants to throw a Hail Mary. Obviously, this is not always the case. But if you have been involved with or closely followed an IPO, you know that the underwriting bank gets 7% of the entire capitalization, the owners get a bunch of stock they can sell on the secondary market, and a select few unattached rich investors get richer. And the stock holders? Well, the stock typically enjoys a "run-up" of an average of 105 days, and then within ten-years about 63% of them are gone (source)

"Doesn't that mean I get rich?  What's wrong with that?" you say.  Nothing at all.  If your company's stock can hang on during the time you're restricted on selling your shares-- typically 6 months-- you'll do well.  The problem is now, in 2009, the IPO market has evaporated due to the reasons I mentioned earlier.  Also, the macro environment for high-tech has changed.  There just aren't as many easy opportunities as there used to be.  So, if you're going to commit your time and effort to the company in the hopes of an IPO you should be aware that the recent past is not a good indication of what's in store for you for years to come.  That's especially true if you're focusing your efforts on the highly saturated and maturing Internet/Software industry as new industries, such as Green-Tech have become the new focus.  As an alternative, you can always consider growing your company organically (with revenue growth) and keeping it private.

Earlier I said that the VC market is in a slump. That was an understatement. It has likely been irrevocably damaged. Part of the reason is the massive deleveraging of our financial system as a whole. Banks, hedge funds, and other investment entities were highly leveraged (some European banks were leveraged 35:1 when historically 9:1 to 12:1 is acceptable). When the dust settles in a year or two, the massive influx of VC investor money since globalization took hold in the early 90s will likely slow considerably-- probably by at least half.  Expect that $29 billion VC market to be $15 billion and 3000 new companies to be 2000 smaller and less revenue aggressive companies.

That's not necessarily a bad thing. I have a theory. When people talk about 'leveraged money' they are really talking about someone else's money. This holds true even for banks who literally create money through fractional-reserve banking (see Federal Reserve).   When you take out a loan, the bank asks the government to create more digital money so that they can loan it to you. I know that sounds ridiculous, but that's how it works. Leveraged money is fun to play with, especially when it's non-recourse, but 'my money' is not. When 'my money' is involved, all of a sudden I get serious.  As banks de-leverage, the highly risky VC market will appear less attractive which will force the VC funds to focus on more conservative companies with more realistic outlooks.

It turns out that most companies, not just start-ups, spend the majority of their money on employee compensation.  You can see where compensating employees using someone else's money could create a type of moral hazard for the even the most well-intentioned entrepreneur. It also instills a sense of urgency and expediency which may or may not be good for a young company. Even if a company defies huge odds and has an IPO, we've seen they only have a 37% change of making it even 10 years.  I think that less aggregate money will actually benefit the vast majority of entrepreneurs.  It gives everyone more time and leeway to create a thoughtful, competitive product without having to worry as much about a competitor buying the pot with a cash infusion and forcing you to fold or go all in.

Posted by at

How Venture Capitalists Operate




In the following video provided by the Computer History Museum, industry pioneers Pitch Johnson and Reid Dennis talk about how the venture capital industry came about.





Now let's take a look at how venture capitalists operate today. Venture capital funds can be public or private (see Google Finance list of about 1000 funds). Some of the larger funds invest in 50 or more start-ups per year, and many of the private funds invest in roughly 5-30 companies per year.  In Guy Kawasaki's presentation, he estimates that roughly 3000 companies receive venture capital in a given year, as opposed to millions of companies that get funded in other ways.  VC funding comes from a lot of different sources-- pension funds, private investors, hedge funds, investment banks, etc.

Today, most of these sources, especially hedge funds who were way over-committed to risk with credit default swaps, are having serious issues in the current financial crisis.  Those 3000 funded companies represented an aggregate of roughly $29 billion in 2008 and that will almost certainly decline going forward.  As the industry unwinds its massive leverage to more reasonable ratios, the Angel and VC market will likely be smaller for quite a long time (see recent article).  The good news is that many of those companies that were funded had similar business plans and this created an unnecessary redundancy within the start-up market.

John Talbott (see post) made an interesting observation regarding venture capitalists in his latest book The 86 Biggest Lies on Wall Street: "The number of success stories is so low in each case that to reward someone who has a 0.7 percent success ratio and to punish someone who has a 0.2 percent success ratio seems excessive."

If you are a statistics buff, you might be interested in the degrees of freedom and statistical significance of the success ratios of these funds-- if you're able to calculate it, please let me know.  But the notion that a few funds are simply luckier than others does seem to gibe with common sense.  There is an interesting book on this topic called Fooled by Randomness which is one man's (apparent) rationalization on why he didn't succeed-- which has led to his success.  If you were an investor choosing among these VC funds, you may find that a quantitative approach to determine risk profiles is next to impossible because it is unclear which funds are better and which are luckier.

Having said that, I believe there are good funds out there though which have produced viable vetting processes and valuation techniques and who seem to find winners more often than the others. Typically, these funds have one or a few people involved who really know what they're doing. The bad funds are essentially legalized gambling-- with other people's money, of course. These funds often have one or two people who have 'made it' as an entrepreneur and supposedly know what they're doing too (again, see Fooled by Randomness). Many of these bad funds basically troll for companies. They parade through conferences, groups, and schools and offer complicated and sometimes usurious terms to unwitting do-gooders who are often just happy to have someone show interest in their idea.

VCs use essentially two methods to determine valuation: 1) the unimaginatively named 'Venture Capital Method', 2) the much more commonly used 'Comparables Method'. The former is really an intuitive guess backed up with a complicated report, and the latter is an intuitive guess backed up by someone else's analysis. It's kind of like a 'comp' for houses in your neighborhood where the venture capitalists look at similar deals to get an idea of how to value the company.

Some "venture capital" companies really act more like banks than the historical venture capitalists that Pitch Johnson and Reid Dennis talk about above.  These funds focus on fairly well-established companies with good revenue who need an infusion of cash to take on larger contracts or gain market share.  In these cases, the valuation methods do hold merit. But when you are talking about a company in the prototype or early stage without little or no revenues, then you are basically talking about guesses-- or bets-- backed up almost entirely with intuition.

Talbott goes on to describe venture capitalists like this: "Venture capitalists are the classic example of a middleman. They really try not to benefit anyone other than themselves. If you have a good high-tech idea that you think will make you a lot of money and you bring it to a venture capital firm for a small infusion of capital, they will most likely end up grabbing a controlling position in the company and will eventually end up owning as much as 80 to 90 percent of your company. Your status will very quickly go from founder and owner to paid employee."

Sadly, this is true, but there are two sides to the story. The other side is entrepreneurs are seeking non-recourse money with sweat equity as collateral. It's a match made in heaven. If they take out a real loan, they have to pay it back or declare bankruptcy. Both the venture capitalist and the entrepreneur are using other people's money to gain potential upside value with little financial risk. The downside risk for both is that they close up shop and head on to something else which is exactly what is happening right now to a large number of peripheral firms. It is for this reason that I suggest that if you must get involved with venture capital, you do it with a firm that has a great reputation at stake. The same goes for an IPO-- choose an underwriter with a good reputation because they're less likely to jack up your starting price (more on that later). Probably the people who would most benefit from VC money are those who already have a viable, rapidly growing business but have hit a growth ceiling and don't have enough assets for a standard loan.


Posted by at

Thursday, October 1, 2009

n% of market

One thing that never ceases to amaze me is the sheer number of internet company ideas that I see even now in 2009. I do think this is a growing global market, particularly for mobile, but some of the valuations, based on P/E ratios for public companies, IPO valuations, and especially recent Series A VC funding for small companies, seem to contradict common sense. Having said that, I wouldn't have predicted that there would be 255 million mobile phones in a country that has a 12% poverty rate and a labor force of 155.2 million people (The United States, 2008). Ref and more facts  here.

The United States comprises about 4.58% of the world's 6.7 billion people. So I think it's easy to imagine a world in which even if these companies only maintain market share that their consumer base will grow exponentially. But Warren Buffet would likely not agree with that type of thinking. As he points out in this MBA Talk, "I am not a macro guy."  I don't think the plan of getting n% of a $20 billion market works very well.  You have to offer something better or fill some niche in the market that your competitors can't.  It makes more sense to get every customer in a niche market that no one else can and to show how you can do it in your business plan.



So What Makes A Company Great? To Buffet, it's basically a good product and a 'moat' (protection from competitors). Buffet has a great quote near the end of this video: "We buy businesses we think we can understand. There's no one here that can't understand the Coca-Cola Company. I would say there's no one here that can understand some new Internet company. I said at the annual meeting this year that if I were teaching a class in business school, on the final exam, I would pass out the information on an internet company and ask each student to value it. And anybody that gave me an answer, I'd flunk them. I don't know how to do it! But people do it every day. It's more exciting. "

I think high-tech entrepreneurs, at some point, need to come to terms with how people and businesses spend their money. It doesn't matter how innovative or brilliant your idea is if it doesn't generate sufficient revenue from some source. And it doesn't matter how big the market is either. If you don't believe me, take a look at the airline industry. Airplanes were truly an amazing invention that I'm sure inspired some lofty business ideas. If you saw the potential of airplanes and successfully predicted how big the market would eventually be, say in the mid 1920s (about where we are with the commercialized Internet), I think you'd find it difficult to believe that the industry as a whole would lose money consistently.

Yet: "The airline industry as a whole has made a cumulative loss during its strenuous history, the costs include subsidies for aircraft development and airport construction. Because of increasing fuel prices and new industry standards the airlines have raised ticket prices as a compensation for the high cost of operating. Going hand-in-hand with these increasing prices, the effects of 9/11 have added more strain to the already existing problem of debt that the airline industry faces." source

So you just have to decide who you're going to sell to-- consumers, businesses, or the government-- and try to visualize how that revenue stream will come about.  n% of market doesn't work because the bigger the market, the more competitors.  It doesn't have to be clever or brilliant, it just has to be something people want-- to buy.

A lot of new internet companies seem to be focused on ad-stream revenue nowadays.  Can you visualize a market in which advertising is a multi-trillion dollar business in the United States anytime soon?  I can't.  But it would have to be to support the valuations of all the new businesses whose plan consists of getting tens of millions of users and charging companies for advertising. If it gets that big, just think how expensive the products they're selling will be.  Advertising needs to stay right where it is-- 1-2% of GDP.

Let's look at How Americans Spend Their Money


This pie chart isn't going to change that much in the foreseeable future, but  the small amount that it does change is important.  Health care costs have  been increasing lately, for instance.  Thinking of a way to reduce health care costs for companies in that business would be a popular idea (but EMRs probably aren't the way to go).  Creating a new brand of cigarette would probably be an unpopular idea.



How Will The Government Spend The Stimulus Money?  This is a little dated, but you can see exactly where the money is being spent at Recovery.Gov






You can look here to see How Businesses Spend Their Money, but it's pretty boring.  I think it's more useful to think about how you can save some specific businesses money and work out from there.

Posted by at

Wednesday, September 30, 2009

Do you need Venture Capital?


I think one of the biggest misconceptions among entrepreneurs about venture capital is that you need it.

Okay, there are cases where a VC is critical to a company's success. Wait, I should say 'money' is critical. That the VC is critical is true only if he is the only one who could have provided it.  I'm not sold on the value-add proposition that the VC offers market knowledge that you couldn't get elsewhere.  Sometimes that is the case and sometimes not.

Below, Guy Kawasaki of Garage Technology Ventures talks about VC 

Guy Kawasaki Part 2     Guy Kawasaki Part 3
  • Guy didn't seek VC as an entrepreneur 
  • Don't seek VC unless your company will do > 75-100MM in revenue
  • Present A Clean Deal- no legal issues, nepotism, IP issues, etc 
  • Use Power Point
  • Doesn't invest in 'great teams'; Louis Borders' WebVan as an example
  • Wants to fund tech companies that need money to scale; not to prototype
  • Guy's Web Site
In the video below, the notorious ChurchHill Club of Silicon Valley discusses some current (2009) insights into the venture capital, angel, and private equity markets.



Jay Hoag, Co-founder, Technology Crossover Ventures
Reid Hoffman, Chairman and CEO, LinkedIn
Matt Murphy, Partner, Kleiner Perkins Caufield & Byers

Moderator: Geoffrey Yang, Founding Partner, Redpoint Ventures


Also see The National Venture Capital Association
Welcome Alabama Launchpad!

Posted by at

Saturday, September 26, 2009

Food For Thought


James Burke- Connections Burke explains history through the inter-related connections of different types of technologies through time, and how many, perhaps almost all, 'inventions' are simply extensions of previous technologies. Learning how James Watt didn't really invent the steam engine and how historic technologies actually come into the market can give you insight into how to create your own inventions.
Posted by at

Wednesday, September 9, 2009

Where To Apply Your Focus

One step in deciding where you stand as an entrepreneur is to make sense of the financial environment in which you will be competing and in which you choose to compete. This post shows how individuals in the free market can make completely rational decisions that lead them astray.  In other words, once you choose certain paths, even smart decisions lead to disaster.

The recent financial crash started with the subprime mortgage crisis, but this was not the cause. In House of Cards, CNBC reporter David Faber breaks down the components that led to the housing crisis. It is fascinating how the banks, mortgage companies, rating agencies, investment banks, consumers, and even sovereigns came together to create what is described in the show to be massive Ponzi scheme.  In my view, what Faber presents below is an exaggerated depiction of what happens in every business.  Individuals act rationally (from their point of view) and the free market takes you on a ride-- either up or down.



In July 2009, a writer for The Federal Reserve Bank of New York magazine presented an entirely different angle on the housing crisis here.  He says that a decline in labor productivity growth (not increasing as fast as it was) which began in 2004 was really a major underlying cause of the financial crisis.  There is no doubt that over-leveraged banks and poor regulation caused serious issues, but if James Kahn is correct, then productivity growth decline was probably an equal or larger factor.

In 2003, I read the book The Coming Crash In The Housing Market (John R. Talbott, 2003) which I found so convincing that I eventually sold my house in 2005. There were other pessimists back then, of course, but most argued that the bubbles were location-specific.  I tried for a number of years (2003-2006) to convince numerous colleagues, many of whom were in commercial and residential real estate, that the end may be near. Not one person-- not even one among dozens-- agreed with me (well, effectively with Talbott). The best I got was that the market would slow some. Such is the nature of bubbles.

Incidentally, I read Talbott's 2003 book because he had written a book in 1999 called Slave Wages in which predicted the Dot Com Crash of 2000. He later wrote a book (in 2006) called Sell Now! The End of The Housing Bubble. He has a habit of being right. His latest book, Contagion (2009), is pretty insightful as well but was not as persuasive to me as his past books.

Talbott and many others have targetted Alan Greenspan as one ingredient in the crisis for encouraging self-regulation among market participants. Greenspan has also taken some heat for admittedly not understanding or properly regulating Collateralized Debt Obligations (CDOs), the rating agency system, and Credit Default Swaps, and for overly aggressive monetary policy. But irrespective of who is to blame for the crisis, the result is that the nation's populace is polarized between the types of solutions that we should implement to fix our apparently broken system. The sanctity of Adam Smith's 'free market', which lifted a billion people out of subsistence poverty since the fall of the Berlin Wall, is under attack.

"The superior man understands what is right; the inferior man understands what will sell." - Confucius (ref)

Posted by at
Subscribe to: Posts (Atom)