Seeking Wisdom

by Peter Bevelin

  is needed to classify him as high or low risk. If the patient displays sinus tachycardia he is classified as high risk. Thus, the doctor needs to answer three yes no questions to reach a decision. The method is more accurate in classifying high risk heart attack patients than complex statistical classification methods.

  At a press conference in 2001, when Warren Buffett was asked how he evaluated new business ideas, he said he used 4 criteria as filters.

  Can I understand it? If it passes this filter,

  Does it look like it has some kind of sustainable competitive advantage? If it passes this filter,

  Is the management composed of able and honest people? Ifit passes this filter,

  Is the price right? If it passes this filter, then we write a check

  What does Warren Buffett mean by "understanding?" Predictability: "Our definition of understanding is thinking that we have a reasonable probability of being able to assess where the business will be in 10 years." He continues:

  The only way we know how to make money is to try and evaluate businesses. And if we can't evaluate a carbon steel company, we don't buy it. It doesn't mean it isn't a good buy. It doesn't mean it isn't selling for a fraction of what its worth. It just means that we don't know how to evaluate it. If we can't evaluate the sense of putting in a chemical plant or something in Brazil, we don't do it...

  We understand the product. We understand what it does for people. We just don't know [what its economics will be] 10 years from now... You can understand steel. You can understand homebuilding. But if you look at a homebuilder and try to think where the economics of it is going to be in five or 10 years, that's another question. It's not a question

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  of understanding the product they turn out, the means they use to distribute it- all of that sort of thing - it's the predictability of the economics of the situation 10 years out.‌

  Let's take an example where we combine rules and filters. Reality often shows that one cause of problems is getting involved with wrong people. A rule could therefore be: "Avoid low quality people." As a consequence a filter may be: "Good track record and character traits." Then we look for dues and ask questions designed to answer the question: "High or low grade individual?"

  Elimination

  Elimination is a great conservator of effort. For example, place the burden of proof on statements that contradict basic scientific ideas. Eliminate situations that may cause great sorrow, what is not important or knowable, what can't happen or be achieved, what can't usefully be predicted or explained, what can't be tested, what is already disproved, the easy decisions, the wrong assumptions, what we can't do something about or problems where we don't have any competence.

  Science works by elimination. To avoid drowning in low-information observations or experiments, scientists think in advance about what the most important and conclusive experiments would be: What are we trying to achieve or prove, and how can we reach these ends? What can't happen? This way, they narrow down the possibilities. It is similar to what Warren Buffett told us in Part One - eliminate possibilities and get down to the few that have any chance of success. Look for certain things that narrow down the possibilities.

  Checklist procedures

  Air carrier cockpit checklists to be reviewed in an effort to ensure that each list provides a means of reminding the crew, immediately prior to takeoff, that all items critical for safe flight have been accomplished.

  - National Transportation Safety Board, 1969

  In 1987, Northwest Airlines flight 255 crashed shortly after take-off All 155 persons aboard expect one were killed A federal report concluded that the probable cause of the accident was the flight crew's failure to use the taxi checklist to ensure that the flaps and slats were extended for takeoff. Contributing to the accident was the absence of electrical power to the airplane's takeoff warning system, which consequently could not warn the flight crew that the airplane was not configured properly for takeoff. Use checklist procedures. Together with other tools they help us reduce the

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  chance of harm. Concentrate on the critical items. If we don't check for them we may get harmed. Pilots call these the "killer items."

  Charles Munger suggests using models in a checklist fashion:

  Generally speaking, I think you need mental models - and what I call checklist procedures

  where you take a worthwhile list of models and run right down them: "Is this here? Is that here?" and so on and so on ... Now if there are two or three items that are very important chat aren't on your checklist - well, if you're an airplane pilot, you can crash. Likewise, if you're trying to analyze a company without using an adequate checklist, you may make a very bad investment.

  Some issues to think about when designing checklists are:

  Different issues need different checklists.

  A checklist must include each critical item necessary for "safety'' and avoiding "accidents" so we don't need to rely on memory for items to be checked.

  Readily usable and easy to use.

  Agree with reality.

  Contributing to the accident was the captain's over-reliance on automated flight systems.

  Avoid excessive reliance on checklists. They may sometimes give us a false sense of security. Checklists work well as long as what may happen can be foreseen. But the unexpected sometimes happens. An unmentioned item may be the core cause of a problem.

  Doing something according to pre-established rules, filters and checklists often makes more sense than doing something out of pure emotion. But we can't have too many rules, filters or items without thinking. We must always understand what we're trying to accomplish.

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  - FIVE -

  GOALS

  Our plans miscarry because they have no aim. When a man does not know what harbor he is headingfor, no wind is the right wind.

  - Lucius Annaeus Seneca

  "Why doesn't our employee, Tom, perform well?"

  Often we are surprised when people don't perform as we expect.

  How does Tom perceive he is being measured and rewarded? What does he perceive is expected of him? Do we give him mixed messages? What skills, knowledge and information does he need? Does he have those? What response do we give him about his performance?

  Tom: "I have the right knowledge and understand the goal. I also know how to achieve the goal and why my way makes the most sense. I have the authority to make the relevant decisions and can measure the outcome continuously. If I achieve the goal, I will be rewarded. I decide the amount of reward I will get. If I don't accomplish the goal, I lose my job. Since I have the responsibility, it is only right that I face the consequences."

  Have goals that cause what we want to accomplish. Do we know what we want to achieve and why? fu Aristotle said: ''Are we not more likely to hit the mark if we have a target?" How can we make the right decision if we don't know what we want to achieve? Even if we don't know what we want, we often know what we don't want, meaning that our goal can be to avoid certain things.

  Meaningful goals need to be backed by reasons as a way of testing that we set the right goal. Goals should be:

  Clearly defined. Don't say: "I want to have a better life." Be concrete. For example: "I want a new Volvo."

  Focused on results.

  Realistic and logical - what can and can't be achieved? Low goals may produce low performance and unrealistic goals may cause people to cheat. Lucius Annaeus Seneca said we should: "Never work either for useless goals, or impossible ones."

  Measurable.

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  Tailored to our individual needs.

  Subject to change. Ask: Given our current objective, what is the best course of action to take?

  Goals also need target dates and control stations measuring the degree to which the goal is being achieved.

  Do we know what causes our goal to be achieved? We can't achieve what we want if we don't understand what makes it happen. And are we sure o
ur goal is the right one for what we finally want to achieve?

  Warren Buffett and Charles Munger elaborated on the issue of the energy crisis at the 2001 Berkshire Hathaway Annual Meeting:

  In power systems we need surplus of capacity. And how do we get that? By giving people an incentive for having extra capacity. A power business can't be punished for not having excess capacity and can't be rewarded for having less then what is needed.

  We need three things for this not to happen again. One is that we need reasonable efficiency in operations. Secondly, since it does tend to have in many situations monopoly characteristics, we want something that produced a fair return, but not a great return, on capital - enough to attract new capital. And third, we need a margin of safety or a little more capacity than needed. And we need the whole equation.

  Always ask: What end result do I want? What causes that? What factors have a major impact on the outcome? What single factor has the most impact? Do I have the variable(s) needed for the goal to be achieved? What is the best way to achieve my goal? Have I considered what other effects my actions will have that will influence the final outcome?

  When we solve problems and know what we want to achieve, we need to prioritize or focus on the right problems. What should we do first? Ask: How serious are the problems? Are they fixable? What is the most important problem? Are the assumptions behind them correct? Did we consider the interconnected ness of the problems? The long-term consequences?

  Since big effects - bad or good - happen when we optimize some factors or combine many factors, we should use whatever factors necessary to achieve our goal.

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  - SIX -‌

  ALTERNATIVES

  Ifyou've got two suitors who are really eager to have you and one is way the hell better than the other, you do not have to spend much time

  with the other. And that's the way we filter out buying opportunities.

  - Charles Munger

  "Allocate the money to us!"

  How should we best allocate our scarce resources? TransCorp has ten different projects to choose from. Should they invest in all? Should each project get the same amount of funding? People, money, time, talent and other resources are limited. They also have alternative uses. Some options are also better than others.

  Opportunity cost

  "I weigh my use of capital and time against other available alternate uses. "

  One filter that can be used to measure choices against each other is our own personal opportunity cost. Our time and money are limited. If we make a decision to do one thing we are deciding not to do some other available thing. Every minute we choose to spend on one thing is a minute unavailable to spend on other things. Every dollar we invest is a dollar unavailable for other available investments. If we decide to spend money today instead of investing for the future we give up the opportunity to spend more in the future. Ifl decide to play golf today I miss the opportunity to finish this book on time. If I write, I miss the opportunity to spend time with my children. Since children grow up, this opportunity has a time limit.

  Choices have costs. Even understanding has an opportunity cost. If we understand one thing well we may understand other things better. The cost of using a limited resource like time, effort and money for a specific purpose, can be measured as the value or opportunity lost by not using it in its best available alternative use (assuming it achieves the same purpose).

  Do you choose to work or go to college?

  What is the real cost of choosing one alternative in favor of another? To use a

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  somewhat changed example from Warren Buffett: What is the real cost of not having a college education? What is the difference in income over a lifetime between having an education or not? If we ignore the non-economic benefits of having an education, this difference in income discounted to graduation day is the value of the education or the real cost of not having an education.

  What is our time worth? Do we spend ten hours doing repairs on our house or do we use a carpenter? The real cost of doing the repairs ourselves is the money that we would have earned doing something else.

  Does "free health care" mean it is really ftee?

  No, had it not been free, the resources used for providing free health care could have been used for something else. Often we only see the benefits of government spending. We don't see what is prevented from happening or that resources are diverted from alternative uses.

  "Employ 3 more sales representatives in Montana. "

  Should TransCorp take the time, money and talent to build a market presence in Montana? The real cost of doing that is the value of the time, money and talent used in its best alternative use. Maybe increasing their presence in a state where they already have a market share is creating more value. Sometimes it is more profitable to marginally increase a cost where a company already has an infrastructure. Where do they marginally get the most leverage on resources spent? Always ask: What is the change of value of taking a specific action? Where is it best to invest resources from a value point of view?

  john's return ftom the investment was a meager I%.

  The 10-year $100,000 investment in the private partnership promised a yearly return of 15%. John's next best available investment at the time was a long-term

  U.S. government bond yielding 6%. 10 years later reality kicked in. He got back

  $110,000. His yearly return was only 1%. If he hadn't made the investment back then, but had earned returns comparable with the government bond, John would now have $179,000 (pretax) instead of the $110,000 (pretax). His real cost of doing this investment was $69,000. The money invested tied him in other ways. This doesn't include the mental stress he experienced during the ride.

  We all have a lot of things we like: our spouse, job, house, car, investments, etc. When we decide whether to change something, we should measure it against the best of what we already have.

  A complementary filter to evaluate alternatives is to list their respective pros

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  and cons and then weigh all the points. Charles Darwin did this in order to decide whether to marry. Warren Buffett tells us what to look for in a spouse: "Look for someone who will love you unconditionally and will subtly encourage you to be better than you thought you can be."

  We can also weigh alternatives the way Benjamin Franklin did. Make up a list of reasons for and against and assign them weights.

  All decisions are not equally important. Some decisions have a greater influence on our lives. A decision we make today that will influence our lives ten years from now is far more important than one that will influence us only today. If we make a mistake in choosing the wrong vacation, the consequences over time will most likely be minor. But if, for example, we choose the wrong spouse, the wrong education, career, friends, or investment, it may haunt us a long, long time.

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  - SEVEN -

  CONSEQUENCES

  The key thing in economics, whenever someone makes an assertion to you, is to always ask, "And then what?" Actually, it's not such a bad idea to ask it about everything. But you should always ask, "And then what?"

  - Warren Buffett

  John told the CEO of TransCorp: "We see the immediate benefits of investment in machines. We don't see competitive actions and that all the benefits go to the customer."

  "In the department of economy, an act, a habit, an institution, a law, gives birth

  not only to an effect, but to a series of effects," wrote the French journalist economist Claude Frederic Bastiat in his 1850 essay, ThatWhich is Seen, and That Which is Not Seen. He continues:

  Of these effects, the first only is immediate; it manifests itself simultaneously with its cause

  - it is seen. The others unfold in succession - they are not seen... Between a good and a bad economist this constitutes the whole difference - the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those w
hich it is necessary to foresee.

  Consider secondary and long-term effects of an action. Charles Munger points out that in a commodity business or in a business earning substandard returns,

  All of the advantages from great improvements are going to flow through to the customers ... the people who sell the machinery - and, by and large, even the internal bureaucrats urging you to buy the equipment - show you projections with the amount you'll save at current prices with the new technology. However, they don't do the second step of the analysis-which is to determine how much is going to stay home and how much is just going to flow through to the customer.

  I've never seen a single projection incorporating that second step in my life. And I see them all the time. Rather, they always read: "This capital outlay will save you so much money that it will pay for itself in three years." So you keep buying things that will pay for