Showing posts with label information. Show all posts
Showing posts with label information. Show all posts

Thursday, March 1, 2012

Are Your Friends Making You Fat?


Are Your Friends Making You Fat?

Published: September 10, 2009
EILEEN BELLOLI KEEPS very good track of her friends. Belloli, who is 74, was born in Framingham, Mass., which is where she met her future husband, Joseph, when they were both toddlers. (“I tripped her and made her cry,” recalls Joseph, a laconic and beanpole-tall 76-year-old.) The Bellolis never left Framingham, a comfortable, middle-class town 25 miles west of Boston — he became a carpenter and, later, a state industrial-safety official; and after raising four children, she taught biology at a middle school. Many of her friends from grade school never left Framingham, either, so after 60 years, she still sees a half dozen of them every six weeks.
Carin Goldberg
Miles of Smiles

Related

Letters: Is Happiness Catching?(September 27, 2009)

Julia Hasting
Smokers United
CatalogTree
Forces of Gravity
Nomoco
Birds of a Feather
Rumors
Mood Rings
I visited the Bellolis at their home in Framingham last month, and when I asked Eileen about her old friends, she jumped up from her rose-colored rocking chair, ran to her cabinet and pulled down a binder filled with class photos and pictures from her school reunions. Every five years, she told me, she helps organize a reunion, and each time they manage to collect a group of about 30 students she has known since elementary and junior high school. She opened the binder and flipped through the pictures, each one carefully laminated, with a label on the back listing each classmate’s name. “I’m a Type A personality,” she said.
As I leafed through the binder, I could see that the Bellolis and their friends stayed in very good health over the years. As they aged, they mostly remained trim, even as many other Framingham residents succumbed to obesity. The fattening of America annoys Eileen — “people are becoming more and more accustomed to not taking responsibility for their actions,” she said — and she particularly prides herself on remaining active. Almost every day she does a three-mile circuit inside the local mall with her husband and a cluster of friends, though she speed walks so rapidly that some gripe about her breakneck pace. Her one vice used to be smoking, usually right after her teaching day ended. “I would take myself to Friendly’s with a book, and I would sit there and have two cups of coffee and two cigarettes,” she said. At the time, her cigarette habit didn’t seem like a problem; most of her friends also smoked socially. But in the late 1980s, a few of them began to quit, and pretty soon Eileen felt awkward holding a cigarette off to one side when out at a restaurant. She quit, too, and within a few years nobody she knew smoked anymore.
In the reunion photos, there is only one person who visibly degrades in health as the years pass: a boyish-faced man sporting mutton-chop sideburns. When he was younger, he looked as healthy as the rest of the crowd. But each time he showed up for the reunion, he had grown steadily heavier, until the 2003 photograph, when he looked straightforwardly obese, the only one of his size in the entire picture. Almost uniquely among the crowd, he did not remain friends with his old classmates. His only point of contact was the reunions, which he kept attending until he didn’t show up last year. It turned out he’d died.
The man’s story struck me as particularly relevant because Eileen and Joseph are part of a scientific study that might actually help explain his fate. The Bellolis are participants in the Framingham Heart Study, the nation’s most ambitious project to understand the roots of heart disease. Founded in 1948 by the National Heart Institute, the study has followed more than 15,000 Framingham residents and their descendants, bringing them in to a doctor’s office every four years, on average, for a comprehensive physical. Each time the Bellolis are examined, every aspect of their health is quantified and collected: heart rate, weight, blood levels and more. Over the decades, the Framingham study has yielded a gold mine of information about risk factors for heart disease; it was instrumental, for instance, in identifying the positive role of “good” cholesterol.
But two years ago, a pair of social scientists named Nicholas Christakis and James Fowler used the information collected over the years about Joseph and Eileen and several thousand of their neighbors to make an entirely different kind of discovery. By analyzing the Framingham data, Christakis and Fowler say, they have for the first time found some solid basis for a potentially powerful theory in epidemiology: that good behaviors — like quitting smoking or staying slender or being happy — pass from friend to friend almost as if they were contagious viruses. The Framingham participants, the data suggested, influenced one another’s health just by socializing. And the same was true of bad behaviors — clusters of friends appeared to “infect” each other with obesity, unhappiness and smoking. Staying healthy isn’t just a matter of your genes and your diet, it seems. Good health is also a product, in part, of your sheer proximity to other healthy people. By keeping in close, regular contact with other healthy friends for decades, Eileen and Joseph had quite possibly kept themselves alive and thriving. And by doing precisely the opposite, the lone obese man hadn’t.
FOR DECADES, SOCIOLOGISTS and philosophers have suspected that behaviors can be “contagious.” In the 1930s, the Austrian sociologist Jacob Moreno began to draw sociograms, little maps of who knew whom in friendship or workplace circles, and he discovered that the shape of social connection varied widely from person to person. Some were sociometric “stars,” picked by many others as a friend, while others were “isolates,” virtually friendless. In the 1940s and 1950s, social scientists began to analyze how the shape of a social network could affect people’s behavior; others examined the way information, gossip and opinion flowed through that network. One pioneer was Paul Lazarsfeld, a sociologist at Columbia University, who analyzed how a commercial product became popular; he argued it was a two-step process, in which highly connected people first absorbed the mass-media ads for a product and then mentioned the product to their many friends. (This concept later bloomed in the 1990s and in this decade with the rage for “buzz marketing” — the attempt to identify thought-leaders who would spread the word about a new product virally.) Lazarsfeld also studied how political opinions flowed through friendship circles; he would ask a group of friends to identify the most influential members of their group, then map out how a political view or support for a candidate spread through and around those individuals.
By the 1980s and 1990s, alarmed by the dangers of smoking among young Americans, health care workers began to do the same work on groupings of teenagers to discover exactly how each individual was influenced to pick up the habit. The language of contagion is part of pop culture today, thanks in part to the influence of Malcolm Gladwell’s best-selling book “The Tipping Point.” It’s now common to speak of social changes as epidemics (like the “obesity epidemic”) and to talk about “superconnectors” who are so promiscuously well linked that they exert an outsize influence in society, ushering trends into existence almost single-handedly.
Yet the truth is, scientists have never successfully demonstrated that this is really how the world works. None of the case studies directly observed the contagion process in action. They were reverse-engineered later, with sociologists or marketers conducting interviews to try to reconstruct who told whom about what — which meant that people were potentially misrecalling how they were influenced or whom they influenced. And these studies focused on small groups of people, a few dozen or a few hundred at most, which meant they didn’t necessarily indicate much about how a contagious notion spread — if indeed it did — among the broad public. Were superconnectors truly important? How many times did someone need to be exposed to a trend or behavior before they “caught” it? Certainly, scientists knew that a person could influence an immediate peer — but could that influence spread further? Despite our pop-cultural faith in social contagion, no one really knew how it worked.
Sociologists began hunting for ongoing, real-life situations in which better data could be found. A 2000 study of dorm mates at Dartmouth College by the economist Bruce Sacerdote found that they appeared to infect each other with good and bad study habits — such that a roommate with a high grade-point average would drag upward the G.P.A. of his lower-scoring roommate, and vice versa. A 2006 Princeton study found that having babies appeared to be contagious: if your sibling has a child, you’re 15 percent more likely to have one yourself in the next two years. These were tantalizing findings, but again, each was too narrow to really indicate whether and how the effect worked in the mass public. What was needed was something more ambitious, some way of mapping out the links between thousands of real-life people for years — decades, even — to see whether, and how, behaviors spread.
NICHOLAS CHRISTAKIS BEGAN taking a new look at this question in 2000 after an experience visiting terminally ill patients in the working-class neighborhoods of Chicago. Christakis is a medical doctor and sociologist at Harvard; back then, he was posted at the University of Chicago and, at the age of 38, he had made a name for himself studying the “widowhood effect,” the well-known propensity of spouses to die soon after their partners’ deaths. One of his patients was a terminally ill elderly woman with dementia who lived with her daughter as her main caregiver. The daughter was exhausted from caring for her mother for months; the daughter’s husband, in turn, was becoming ill from coping with his wife’s extreme stress. One night after visiting the dying mother, Christakis arrived back at his office and got a phone call from a friend of the husband, asking for help, explaining that he, too, was feeling overwhelmed by the situation. The mother’s sickness had, in effect, spread outward “across three degrees of separation,” Christakis told me. “This illness affects the daughter, who spreads to the husband, who spreads to the friend, the guy who calls me up,” he added. He began talking to colleagues, wondering how he could further study the phenomenon.
In 2002, a common friend introduced him to James Fowler, at the time a Harvard political-science graduate student. Fowler was researching the question of whether the decision to vote in elections could spread virally from one person to another. Christakis and Fowler agreed that social contagion was an important area of inquiry and decided the only way to settle the many unanswered questions surrounding it was to find or compile a huge data set, one that tracked thousands of people. At first, they figured they would mount their own survey. They asked for $25 million from the National Institutes of Health to track 31,000 adults for six years, but the N.I.H. said they had to find some preliminary evidence first. So they went on the hunt for an existing collection of data. They weren’t optimistic. While several large surveys of adult health exist, medical researchers have no tradition of thinking about social networks, so they rarely bother to collect data on who knows whom — which means there’s no way to track whether behaviors are spreading from person to person. Christakis and Fowler examined study after study, discarding each one.
Christakis knew about the Framingham Heart Study and arranged a visit to the town to learn more. The study seemed promising: he knew it had been underway for more than 50 years and had followed more than 15,000 people, spanning three generations, so in theory, at least, it could offer a crucial moving picture. But how to track social connections? During his visit, Christakis asked one of the coordinators of the study how she and her colleagues were able to stay in contact with so many people for so long. What happened if a family moved away? The woman reached under her desk and pulled out a green sheet. It was a form that staff members used to collect information from every participant each time they came in to be examined — and it asked them to list all their family and at least one of their friends. “They asked you, ‘Who is your spouse, who are your children, who are your parents, who are your siblings, where do they live, who is your doctor, where do you work, where do you live, who is a close friend who would know where to find you in four years if we can’t find you?” Christakis said. “And they were writing all this stuff down.” He felt a jolt of excitement: he and Fowler could use these thousands of green forms to manually reconstruct the social ties of Framingham — who knew whom, going back decades.
Over the next few years, Christakis and Fowler managed a team that painstakingly sifted through the records. When they were done, they had a map of how 5,124 subjects were connected, tracing a web of 53,228 ties between friends and family and work colleagues. Next they analyzed the data, beginning with tracking patterns of how and when Framingham residents became obese. Soon they had created an animated diagram of the entire social network, with each resident represented on their computer screens as a dot that grew bigger or smaller as he or she gained or lost weight over 32 years, from 1971 to 2003. When they ran the animation, they could see that obesity broke out in clusters. People weren’t just getting fatter randomly. Groups of people would become obese together, while other groupings would remain slender or even lose weight.
And the social effect appeared to be quite powerful. When a Framingham resident became obese, his or her friends were 57 percent more likely to become obese, too. Even more astonishing to Christakis and Fowler was the fact that the effect didn’t stop there. In fact, it appeared to skip links. A Framingham resident was roughly 20 percent more likely to become obese if the friend of a friend became obese — even if the connecting friend didn’t put on a single pound. Indeed, a person’s risk of obesity went up about 10 percent even if a friend of a friend of a friend gained weight.
“People are connected, and so their health is connected,” Christakis and Fowler concluded when they summarized their findings in a July 2007 article in The New England Journal of Medicine, the first time the prestigious journal published a study of how social networks affect health. Or as Christakis and Fowler put it in “Connected,” their coming book on their findings: “You may not know him personally, but your friend’s husband’s co-worker can make you fat. And your sister’s friend’s boyfriend can make you thin.”
Obesity was only the beginning. Over the next year, the sociologist and the political scientist continued to analyze the Framingham data, finding more and more examples of contagious behavior. Smoking, they discovered, also appeared to spread socially — in fact, a friend taking up smoking increased your chance of lighting up by 36 percent, and if you had a three-degrees-removed friend who started smoking, you were 11 percent more likely to do the same. Drinking spread socially, as did happiness and even loneliness. And in each case one’s individual influence stretched out three degrees before it faded out. They termed this the “three degrees of influence” rule about human behavior: We are tied not just to those around us, but to others in a web that stretches farther than we know.
WHEN I FIRST MET Christakis and Fowler last spring, at a downtown Manhattan cafe, they seemed like a living example of their theory: even their conversational style appeared to be contagious, each of them bursting in in the middle of a sentence to complete the other’s thought. Christakis, an intense and jovial man with bristling eyebrows and a booming voice, wore a suit with no tie and sipped a coffee. Fowler, who is 39, looked like a boyish wunderkind, wearing a T-shirt and jeans and a constant broad smile. In the two years since they published their first work, they had become relatively famous and highly controversial. People — and late-night comics — were drawn to a theory that seemed to offer a scientific basis for some exquisitely calculating behavior, like avoiding your friends if they get fat. (Or avoiding your friends merely because some of their friends’ friends gained a couple of pounds.) Newspapers splashed Christakis and Fowler’s obesity findings across front pages, and the study penetrated into corners of the popular culture generally untouched by social-science research. “My favorite was the ‘Cathy’ cartoon,” Fowler told me; in it, Cathy and two friends sit in a restaurant, chatting about the obesity paper; when the waiter comes, each woman points to another and says, “She’ll have a small dry salad and a cup of water.”
Fowler told me their work had inspired him to lose five pounds and to listen to upbeat music before he arrives home from work so he will be in a good mood when he greets his family. “I try to get myself in a mental space where I’ll be happy,” he says. “Because I know that I’m not just having an impact on my son, I’m potentially having an impact on my son’s best friend’s mother.”
But how, exactly, could obesity or happiness spread through so many links? Between one immediate peer and another, some contagious behaviors — like smoking — seem pretty commonsensical. If lots of people around you are smoking, there’s going to be peer pressure for you to start, whereas if nobody’s smoking, you’ll be more likely to stop. But the simple peer-pressure explanation doesn’t work as well with happiness or obesity: we don’t often urge people around us to eat more or implore them to be happier. (In any case, simply telling someone to be happier or unhappier isn’t likely to work.) Instead, Christakis and Fowler hypothesize that these behaviors spread partly through the subconscious social signals that we pick up from those around us, which serve as cues to what is considered normal behavior. Scientists have been documenting this phenomenon; for example, experiments have shown that if a person is seated next to someone who’s eating more, he will eat more, too, unwittingly calibrating his sense of what constitutes a normal meal. Christakis and Fowler suspect that as friends around us become heavier, we gradually change our mental picture of what “obese” looks like and give ourselves tacit permission to add pounds. With happiness, the two argue that the contagion may be even more deeply subconscious: the spread of good or bad feelings, they say, might be driven partly by “mirror neurons” in the brain that automatically mimic what we see in the faces of those around us — which is why looking at photographs of smiling people can itself often lift your mood.
“In some sense we can begin to understand human emotions like happiness the way we might study the stampeding of buffalo,” Christakis said. “You don’t ask an individual buffalo, ‘Why are you running to the left?’ The answer is that the whole herd is running to the left. Similarly, you can see pockets of unhappy and happy people clustered in the network. They don’t even know each other necessarily,” but their moods rise and fall together.
The subconscious nature of emotional mirroring might explain one of the more curious findings in their research: If you want to be happy, what’s most important is to have lots of friends. Historically, we have often thought that having a small cluster of tight, long-term friends is crucial to being happy. But Christakis and Fowler found that the happiest people in Framingham were those who had the most connections, even if the relationships weren’t necessarily deep ones.
The reason these people were the happiest, the duo theorize, is that happiness doesn’t come only from having deep, heart-to-heart talks. It also comes from having daily exposure to many small moments of contagious happiness. When you frequently see other people smile — at home, in the street, at your local bar — your spirits are repeatedly affected by your mirroring of their emotional state. Of course, the danger of being highly connected to lots of people is that you’re at risk of encountering many people when they are in bad moods. But Christakis and Fowler say their findings show that the gamble of increased sociability pays off, for a surprising reason: Happiness is more contagious than unhappiness. According to their statistical analysis, each additional happy friend boosts your good cheer by 9 percent, while each additional unhappy friend drags you down by only 7 percent. So by this logic, adding more links to your network should — mathematically — add to your store of happiness. “If you’re at the center of a network, you are going to be more susceptible to anything that spreads through it,” Fowler said. “And if happiness is spreading more reliably, then on average you’re going to be catching happy waves more often than you catch sad waves.”
The Framingham findings also suggest that different contagious behaviors spread in different ways. For example, co-workers did not seem to transmit happiness to one another, while personal friends did. But co-workers did transmit smoking habits; if a person at a small firm stopped smoking, his or her colleagues had a 34 percent better chance of quitting themselves. The difference is based in the nature of workplace relationships, Fowler contends. Smokers at work tend to cluster together outside the building; if one of them stops smoking, it reduces the conviviality of the experience. (If you’re the last smoker outside on a freezing afternoon, your behavior can seem completely ridiculous even to yourself.) But when it comes to happiness, Fowler said, “people are both cooperative and competitive at work. So when one person gets a raise, it might make him happy, but it’ll make other people jealous.”
Obesity had its own quirk: Spouses didn’t appear to have as big an effect on each other as friends. If a male Framingham subject had a male friend who became fat, his risk doubled, but if his wife became obese, his risk was increased by only 37 percent. This, Christakis and Fowler say, is because when it comes to body image, we compare ourselves primarily to people of the same sex (and in the Framingham study, all spouses were of the opposite sex). In fact, different-sexed friends didn’t transmit any obesity to one another at all. If a man became fat, his female friends were completely unaffected, and vice versa. Similarly, siblings of the same sex had a bigger impact on one another’s weight than siblings of the opposite sex.
When it came to drinking, Christakis and Fowler found a different kind of gender effect. Framingham women were considerably more influential than Framingham men. A woman who began drinking heavily increased the heavy-drinking risk of those around her, whereas heavy-drinking men had less effect on other people. Why? In the age of frat-party binge drinking, you might imagine that hard-partying men are the most risky people to be around. But Fowler says he suspects women are more influential precisely because they tend to drink less. When a woman starts drinking heavily, he says, it sends a strong signal to those around her that it’s O.K. to start boozing too.
Christakis and Fowler’s strangest finding is the idea that a behavior can skip links — spreading to a friend of a friend without affecting the person who connects them. If the people in the middle of a chain are somehow passing along a social contagion, it doesn’t make sense, on the face of it, that they wouldn’t be affected, too. The two researchers say they don’t know for sure how the link-jumping works. But they theorize that people may be able to pass along a social signal without themselves acting on it. If your friends at work become obese, even if you don’t gain weight yourself, you might become more accepting of obesity as a normal state — and unconsciously transmit that signal to your family members, who would then feel a sort of permission to gain weight themselves, knowing they wouldn’t face any sort of censure from you.
Christakis and Fowler postulate that our ability to affect people three degrees away from us may have evolutionary roots — and so may the very shape of human social networks. Tribal groups that were tightly connected were likely more able to pass along positive behaviors than those that weren’t. Christakis and Fowler say social contagion could even help explain the existence of altruism: if we can pass on altruism to distant points in a network, it would help explain why altruistic people aren’t simply constantly taken advantage of by other members of their community. Last year, to test this theory, they conducted a laboratory experiment in which participants played a “cooperation game.” Each participant was asked to share a sum of money with a small group and could choose to be either generous or selfish. Christakis and Fowler found that if someone was on the receiving end of a generous exchange, that person would become more generous to the next set of partners — until the entire larger group was infected, as it were, with altruistic behavior, which meant the altruist would benefit indirectly.
CHRISTAKIS AND FOWLER’S work has produced a variety of reactions from other scientists. Many health care experts are thrilled. After years of observing patients, they suspected that behaviors spread socially; now there was data that appeared to prove it. “It was an aha! moment,” James O. Hill, a pioneering obesity researcher at the University of Colorado, Denver, said about the time in 2007 when he read the researchers’ first obesity paper. Tom Valente, the director of the master’s of public health program at the University of Southern California and an early investigator of the role of social networks in smoking behavior, was similarly excited. “The Christakis and Fowler work is fantastic,” he told me. Among public-health practitioners, he said, their theories have “had amazing acceptance.”
But many of those who study networks are more cautious in their reactions. Unlike medical experts, these scientists specialize in the study of networks themselves — anything ranging from neighborhoods linked via the power grid to teenagers linked on Facebook — and they are familiar with the difficulty of ascertaining cause and effect in such complex constructs. As they point out, the Framingham study has found intriguing correlations in people’s behavior. Christakis and Fowler can show what appear to be waves of obesity or smoking moving across the map. But that doesn’t prove social contagion is causing the spread.
There are at least two other possible explanations. One is “homophily,” the tendency of people to gravitate toward others who are like them. People who are gaining weight might well prefer to hang out with others who are also gaining weight, just as people who are happy might seek out others who are happy. The other possible explanation is that the shared environment — and not social contagion — might be causing the people of Framingham to change in groups. If a McDonald’s opens up in a Framingham neighborhood, it could cause a cluster of people living nearby to gain weight or become slightly happier (or sadder, depending on what they think about McDonald’s). The cluster of people would appear as though they are sharing a contagious form of behavior, but it would be an illusion.
Because of the confounding factors, as they are called, of homophily and the environment, many social scientists find themselves caught in an emotional bind when it comes to Christakis and Fowler’s work. As Alex Pentland, former academic head of the M.I.T.Media Lab and an expert in unconscious social signals, told me, “You couldn’t prove what they say, but I happen to believe it.” I heard precisely the same thing from many of Pentland’s peers. They have all long suspected that human behavior is widely contagious; they just don’t think Christakis and Fowler have proved their case.
One of Christakis and Fowler’s most prominent critics is Jason Fletcher, an assistant professor of public health at Yale University. Last year, he and an economist named Ethan Cohen-Cole published two papers arguing that Christakis and Fowler had not successfully stripped out all possible homophily effects from their calculations. Fletcher initially wanted to replicate Christakis and Fowler’s analysis of the data, but he didn’t have access to their source; Christakis and Fowler have not published their network data, arguing that doing so would violate the privacy rights of the participants in the Framingham Heart Study. Faced with that obstacle, Fletcher and his colleague decided instead to test Christakis and Fowler’s mathematical techniques on a different set of data: the Add Health study, a federal-government project that tracked the health of 90,118 students at 144 high schools and middle schools between 1994 and 2002. Among the questionnaires the researchers distributed was one that asked students to list up to 10 of their friends. This allowed Fletcher to build maps of how the friends at each school were linked, school by school, giving them a set of small social networks upon which to test Christakis and Fowler’s math. (Before they stumbled upon the Framingham data, Christakis and Fowler themselves had considered using the Add Health surveys to look for social contagion. But they decided the data sets were too limited — each of the schools had only several hundred students interlinked — to produce results in which they could have confidence. They also wanted to study adults, figuring that the peer effects among teenagers are qualitatively different.)
When Fletcher analyzed the student cliques using statistical tools that he says are similar to those used by Christakis and Fowler, he found that social contagion indeed existed. But the behaviors and conditions that were apparently contagious were entirely implausible: they included acne, height and headaches. How could you become taller by hanging around with taller people? This, Fletcher concluded, called into doubt whether Christakis and Fowler’s statistical techniques really removed homophily or environmental effects — and he says this means the Framingham results are just as dubious. When I spoke to Fletcher, he said that he, too, believes social-contagion effects are real. “We are on board with the idea that they exist and they’re important,” he added. But he simply isn’t impressed by Christakis and Fowler’s evidence.
Other scientists have pointed out another important limitation in Christakis and Fowler’s work, which is that their map showing connections between the people of Framingham is necessarily incomplete. When the Framingham participants checked in every four years, they were asked to list all their family members — but only one person they considered a close friend. This could arguably mean that those eerie three-degree effects might be an illusion. For example, if John lists Allison as his friend, and Allison lists Robert as her friend, and Robert lists Samantha as his friend, then Christakis and Fowler could conclude that John is three links away from Samantha. But what if John and Samantha actually know each other from church, but didn’t have a way to indicate this on the Framingham forms? Then if John and Samantha both become slightly fatter, it might look like a social contagion is spreading through three social ties, via Allison and Robert, when in fact it’s only spreading through one link, via church.
When I raised this concern with Christakis and Fowler, they agreed that their map of friendships isn’t perfect. “This is a general problem with our study and with any similar study,” Christakis said. But he said he believes their map of the Framingham connections has far fewer holes than critics charge. When he and Fowler tallied up the green sheets, they often were able to deduce relationships between two people who didn’t explicitly list each other as acquaintances — reducing the number of false three-degree links. (One helpful fact was that many participants listed more than one friend, despite the instructions on the green sheets.) “We are not overreaching our data,” Christakis insisted.
He and Fowler also acknowledged that it is impossible to completely remove the problems of homophily and environmental effects. This doesn’t mean they agree with Fletcher; in fact, they point out that in his height-and-acne paper, he used a somewhat looser mathematical model, one that makes it easier to produce spurious correlations between people — which is why, they say, Fletcher found that acne and height were contagious. When they ran their own statistical technique on the Add Health data, they found that obesity followed precisely the same three-degree pattern of contagion as they found in Framingham.
And Christakis and Fowler point to two other findings to bolster their case for social contagion over environmental effects. One is that in the Framingham study, obesity seemed to be able to jump from friend to friend even over great distances. When people moved away, their weight gain still appeared to influence friends back in Massachusetts. In such cases, the local environment couldn’t be making both gain weight, Christakis and Fowler say.
Their other finding is more intriguing and arguably more significant: They discovered that behaviors appear to spread differently depending on the type of friendship that exists between two people. In the Framingham study, people were asked to name a close friend. But the friendships weren’t always symmetrical. Though Steven might designate Peter as his friend, Peter might not think of Steven the same way; he might never designate Steven as a friend. Christakis and Fowler found that this “directionality” mattered greatly. According to their data, if Steven becomes obese, it has no effect on Peter at all, because he doesn’t think of Steven as a close friend. In contrast, if Peter gains weight, then Steven’s risk of obesity rises by almost 100 percent. And if the two men regard each other as mutual friends, the effect is huge — either one gaining weight almost triples the other’s risk. In Framingham, Christakis and Fowler found this directionality effect even among people who lived and worked very close to each other. And that, they argue, means it can’t be the environment that is making people in Framingham fatter, since the environment ought to affect each of these friends equally.
“If a McDonald’s opens up nearby, it should make both of us gain weight simultaneously,” Christakis adds. “It shouldn’t matter whether I nominate you as a friend or you nominate me.” In fact, though, the directionality effect seems to matter very much, and that fact, in turn, buttresses the case for social contagion.
Duncan Watts, a social-network pioneer and a researcher for Yahoo, has reservations about some of Christakis and Fowler’s findings — for example, he thinks the fact that most of the Framingham participants listed only one friend “really casts some doubt” on the three-degrees theory. But he told me that the directionality effect is one finding that none of Christakis and Fowler’s critics have been able to rebut. It is, for him, the strongest evidence that the Framingham results aren’t just caused by the environment or by people flocking to others like them. “I don’t see how that can be explained any other way,” he said.
IF YOU LOOK AT A CHART showing the change in smoking rates in the United States since the 1970s, it is a picture of early public-health success that soon tails off. In 1970, the smoking rate for adults was 37 percent. It fell to 33 percent by 1980 and then fell even more precipitously between 1980 and 1990. But after that, the rate at which people quit smoking began to slow. Between 2004 and 2005, in fact, the smoking rate stayed steady; on balance, nobody quit smoking those years. Antismoking forces successfully pushed the number of smokers down to one in five people, but they now seem stuck. Smoking-cessation experts have debated why it has become so hard to get the final holdouts to quit. Perhaps, some said, it was because the average cost of a pack of cigarettes remains largely unchanged nationally since 2002.
But there might be another, hidden reason: the shape of a smoker’s social ties. When Christakis and Fowler mapped out the way Framingham people quit smoking during roughly the same period — 1971 to 2003 — they found that the decline was not evenly distributed across the town. Instead, clusters of friends all quit smoking at the same time, in a group. It was like a ballroom emptying out one table at a time. But this meant that by 2003, the remaining smokers were also not evenly distributed: instead, they existed in isolated, tightly knit clusters of like-minded nicotine fiends. Worse, those clusters had migrated to the edges of the social network, where they were less interlinked with the mass of Framingham participants. In their everyday social lives, Christakis and Fowler say, the town’s remaining smokers are thus mostly surrounded by people who still smoke, and they rarely have strong connections with nonsmokers. Nonsmoking may be contagious, but the smokers don’t appear to be close to anyone from whom they could catch the behavior.
The federal government has officially set a goal of reducing the number of smokers in the country to 12 percent of the population by 2010. But the very shape of our social networks is working against that goal, Fowler says, and this poses a potential public-health challenge. Meanwhile, public-health strategists who want to counteract obesity face the opposite problem. Since the country is gradually becoming more and more obese, when individual people do lose weight, they are more likely to be surrounded by people who are still heavy. If it’s true that obesity can affect people even three links away, that may be one reason that people have such trouble keeping weight off. Even if they form a weight-loss group to lose weight with their close friends, they will still be influenced by obese people two or three links away — people they barely know. “We know that people are wildly successful in losing weight and wildly unsuccessful in keeping it off,” Hill, the obesity researcher, says; he believes Framingham offers an important explanation of why this is.
In essence, Christakis and Fowler’s work suggests a new way to think about public health. If they’re right, public-health initiatives that merely address the affected individuals are doomed to failure. To really grapple with bad behaviors that spread, you have to simultaneously focus on individuals who are so distant they don’t even realize they’re affecting one another. Hill says this is possible with obesity. Last year, he collaborated with David Bahr, a physicist at Regis University in Denver, to construct a computer model of society that replicates the way obesity spreads. They created a simulation of hundreds of thousands of individuals, each programmed to influence one another in precisely the same way that Christakis and Fowler documented in Framingham. To test whether their model accurately mimicked reality, they seeded it with a few obese people and set it running. The virtual society slowly became obese in the same pattern and at the same rate as Framingham. If they could accurately copy the way Framingham became obese, they figured, they could then use the model to test different ways that the spread might be halted. They began trying different experiments — like focusing on specific individuals and seeing whether or not they could use them to create a counterepidemic of skinniness.
One solution jumped out at them. In theory, the best way to fight obesity, the model predicted, isn’t to urge people to diet with a cluster of close friends. It is to encourage them to skip a link and to diet with friends of friends. That way, in your immediate social network, everyone would be surrounded on at least one side by people who are actively losing weight, and this would in turn influence those other links to begin losing weight themselves. When Hill and Bahr ran the simulation with this sort of staggered dieting, it worked: the virtual society began slimming down, and the obesity epidemic reversed itself. “It’s like you have bridging dams to try and stop the flow,” Bahr told me. (Bahr also found that the obesity epidemic could be reversed quickly, with only 1 percent of the entire population losing weight, so long as the dieters were placed in precisely the right spots. “You don’t need a lot of people, but you do need the right ones,” he said.)
In reality, of course, this sort of intervention would be quite difficult to pull off. You would have to figure out some way to persuade friends of friends to form dieting groups together. But other scientists have used Christakis and Fowler’s work to inspire more potentially practical public-health projects, some of which are now being implemented. Nathan Cobb, a smoking-cessation expert and researcher at the Schroeder Institute for Tobacco Research and Policy Studies, is designing an application that Facebook users can install on their pages when they’re trying to quit smoking. The application will publicly display how long they’ve gone without cigarettes, whether they are using a nicotine patch and how much money they have saved by not smoking. The idea, Cobb says, is to take your invisible, internal battle to quit smoking and make it visible so that it can influence your friends (and friends of friends) who are still puffing away.
IT’S TEMPTING TO think, confronted by Christakis and Fowler’s work, that the best way to improve your life is to simply cut your ties to people with bad behavior. And obviously this is possible; people change their friends often, sometimes abruptly. But reshaping your social network may be more challenging than altering your behavior. There’s also compelling evidence in their research that we do not have as much control as we might think we do over the way we’re linked to other people: our location in a social network, say, or how many of our friends know each other. These patterns in our life are relatively stable, and they might, weirdly, be partly innate.
Christakis and Fowler first noticed this effect when they examined their happiness data. They discovered that people who were deeply enmeshed in friendship circles were usually much happier than “isolates,” those with few ties. But if an isolate did manage to find happiness, she did not suddenly develop more ties and migrate to a position where she was more tightly connected to others. The reverse was also true: if a well-connected person became unhappy, he didn’t lose his ties and become an isolate. Your level of connectedness appears to be more persistent than even your overall temperament. “If you picked up someone who’s well connected and dropped them into another network, they’d migrate toward the center,” Christakis said. Your place in the network affects your happiness, in other words, but your happiness doesn’t affect your place in the network.
Christakis and Fowler began to wonder if a person’s connectedness is to some degree fated from birth — a product, at least in part, of DNA. To test the idea, they conducted a study of twins. Using the Add Health school data, they located more than 500 sets of twins and analyzed where they were located in their friendship clusters. Employing statistical techniques traditionally used to parse out how much of twins’ lifestyles are attributable to their genes as opposed to their environment, they found that almost half — 46 percent — of the difference between two twins’ levels of connectedness could be explained by DNA. “On average,” they wrote, “a person with five friends has different genes than a person with one friend.” More oddly still, twins also tended to have the same “transitivity”: their friendship groupings had a strikingly similar degree of interlinking, which is the number of friends who knew one another. By and large, the people who were most tightly clustered in Framingham tended to be better off — healthier, happier and even wealthier. (Several other economic studies have also found that better-connected people make more money.) But if half the reason these people were so well positioned is related to the accident of DNA, then you could consider connectedness a new form of inequality: lucky and unlucky cards, dealt out at birth.
Social-network science ultimately offers a new perspective on an age-old question: to what extent are we autonomous individuals? “If someone does a good thing merely because they’re copying others, or they do something bad merely because they’re copying others, what credit do they deserve, or what blame do they deserve?” Christakis asks. “If I quit smoking because everyone around me quits smoking, what credit do I get” for demonstrating self-control? If you’re one of the people who are partly driven by his DNA to hang out on the periphery of society, well, that’s also where the smokers are, which means you are also more likely to pick up their habit.
To look at society as a social network — instead of a collection of individuals — can lead to some thorny conclusions. In a column published last fall in The British Medical Journal, Christakis wrote that a strictly utilitarian point of view would suggest we should give better medical care to well-connected individuals, because they’re the ones more likely to pass on the benefits contagiously to others. “This conclusion,” Christakis wrote, “makes me uneasy.”
Yet there is also, the two scientists argue, something empowering about the idea that we are so entwined. “Even as we are being influenced by others, we can influence others,” Christakis told me when we first met. “And therefore the importance of taking actions that are beneficial to others is heightened. So this network thing can cut both ways, subverting our ability to have free will, but increasing, if you will, the importance of us having free will.”
As Fowler pointed out, if you want to improve the world with your good behavior, math is on your side. For most of us, within three degrees we are connected to more than 1,000 people — all of whom we can theoretically help make healthier, fitter and happier just by our contagious example. “If someone tells you that you can influence 1,000 people,” Fowler said, “it changes your way of seeing the world.”

Clive Thompson, a contributing writer for the magazine, writes frequently about technology and science.


LETTERS

Is Happiness Catching?

Published: September 24, 2009
Someone dubbed the theory of social contagion the “High-School Cafeteria Theory”: if you hang out with the “right” crowd, you’ll do O.K.; if you hang out with the “wrong” crowd, you won’t. The problem is that the idea of social contagion reifies a metaphor. You can catch a virus without free will; you can’t “catch” smoking without it. Mirror neurons activate feelings and impulses; free will keeps them going. Thank God Copernicus, Freud, Einstein, Columbus and Emily Dickinson were not unduly influenced by this theory.

Related

Are Your Friends Making You Fat? (September 13, 2009)

ELIZABETH STRINGER
New York
Clive Thompson writes that Nicholas Christakis and James Fowler “suspect that as friends around us become heavier, we gradually change our mental picture of what ‘obese’ looks like.” In a forthcoming article in Obesity, we find that perceptions of what it means to be overweight became more lenient in the United States from 1988 to 2004, a period during which the population grew significantly heavier. The share of overweight (but not obese) individuals ages 17 to 74 who described themselves as “overweight” fell by 6 percentage points between two surveys conducted, respectively, during the periods 1988-94 and 1999-2004.
The decline in overweight self-perception was roughly equivalent for women and men, and is not explained by changes in population characteristics, such as age and racial composition, between the survey periods. The findings agree with the notion that we judge our weight in relation to others around us rather than according to fixed standards.
MARY A. BURKE
Senior Economist
CARL NADLER
Research Assistant
Federal Reserve Bank of Boston

FRANK HEILAND
Assistant Professor
School of Public Affairs
Baruch College
New York

Your article on the research of social-network science brings new meaning to the old saying “Tell me who your friends are, and I’ll tell you who you are.” Ultimately, we are all products of our environment, some of us more than others.
As highly social and adaptable creatures, we do conform to our immediate environment as shaped by those we spend lots of time with and thus share similar ideas.
This is an evolutionary advantage that enabled our early ancestors to cooperate with each other, form immediate communes and collectively survive the natural harshness of their existence. This is indeed a primitive and core behavior and, without it, none of us would be here today.
MICHAEL HADJIARGYROU
Associate Professor of Biomedical Engineering, Genetics and Orthopedics
Stony Brook University
Stony Brook, N.Y.

Wednesday, February 29, 2012

A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business

A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business 
Charles Munger, USC Business School, 1994 

I'm going to play a minor trick on you today because the subject of my talk is the art of stock picking as a subdivision of the art of worldly wisdom. That enables me to start talking about worldly wisdom—a much broader topic that interests me because I think all too little of it is delivered by modern educational systems, at least in an effective way.
And therefore, the talk is sort of along the lines that some behaviorist psychologists call Grandma's rule after the wisdom of Grandma when she said that you have to eat the carrots before you get the dessert.
The carrot part of this talk is about the general subject of worldly wisdom which is a pretty good way to start. After all, the theory of modern education is that you need a general education before you specialize. And I think to some extent, before you're going to be a great stock picker, you need some general education.
So, emphasizing what I sometimes waggishly call remedial worldly wisdom, I'm going to start by waltzing you through a few basic notions.
What is elementary, worldly wisdom? Well, the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form.
You've got to have models in your head. And you've got to array your experience—both vicarious and direct—on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You've got to hang experience on a latticework of models in your head.
What are the models? Well, the first rule is that you've got to have multiple models—because if you just have one or two that you're using, the nature of human psychology is such that you'll torture reality so that it fits your models, or at least you'll think it does. You become the equivalent of a chiropractor who, of course, is the great boob in medicine.
It's like the old saying, "To the man with only a hammer, every problem looks like a nail." And of course, that's the way the chiropractor goes about practicing medicine. But that's a perfectly disastrous way to think and a perfectly disastrous way to operate in the world. So you've got to have multiple models.
And the models have to come from multiple disciplines—because all the wisdom of the world is not to be found in one little academic department. That's why poetry professors, by and large, are so unwise in a worldly sense. They don't have enough models in their heads. So you've got to have models across a fair array of disciplines.
You may say, "My God, this is already getting way too tough." But, fortunately, it isn't that tough—because 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person. And, of those, only a mere handful really carry very heavy freight.
So let's briefly review what kind of models and techniques constitute this basic knowledge that everybody has to have before they proceed to being really good at a narrow art like stock picking.
First there's mathematics. Obviously, you've got to be able to handle numbers and quantities—basic arithmetic. And the great useful model, after compound interest, is the elementary math of permutations and combinations. And that was taught in my day in the sophomore year in high school. I suppose by now in great private schools, it's probably down to the eighth grade or so.
It's very simple algebra. It was all worked out in the course of about one year between Pascal and Fermat. They worked it out casually in a series of letters.
It's not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it's fundamental truth. So you simply have to have the technique.
Many educational institutions—although not nearly enough—have realized this. At Harvard Business School, the great quantitative thing that bonds the first-year class together is what they call decision tree theory. All they do is take high school algebra and apply it to real life problems. And the students love it. They're amazed to find that high school algebra works in life....
By and large, as it works out, people can't naturally and automatically do this. If you understand elementary psychology, the reason they can't is really quite simple: The basic neural network of the brain is there through broad genetic and cultural evolution. And it's not Fermat/Pascal. It uses a very crude, shortcut-type of approximation. It's got elements of Fermat/Pascal in it. However, it's not good.
So you have to learn in a very usable way this very elementary math and use it routinely in life—just the way if you want to become a golfer, you can't use the natural swing that broad evolution gave you. You have to learn—to have a certain grip and swing in a different way to realize your full potential as a golfer.
If you don't get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a onelegged man in an asskicking contest. You're giving a huge advantage to everybody else.
One of the advantages of a fellow like Buffett, whom I've worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations....
Obviously, you have to know accounting. It's the language of practical business life. It was a very useful thing to deliver to civilization. I've heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention.
And it's not that hard to understand.
But you have to know enough about it to understand its limitations—because although accounting is the starting place, it's only a crude approximation. And it's not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn't make it anything you really know.
In terms of the limitations of accounting, one of my favorite stories involves a very great businessman named Carl Braun who created the CF Braun Engineering Company. It designed and built oil refineries—which is very hard to do. And Braun would get them to come in on time and not blow up and have efficiencies and so forth. This is a major art.
And Braun, being the thorough Teutonic type that he was, had a number of quirks. And one of them was that he took a look at standard accounting and the way it was applied to building oil refineries and he said, "This is asinine."
So he threw all of his accountants out and he took his engineers and said, "Now, we'll devise our own system of accounting to handle this process." And in due time, accounting adopted a lot of Carl Braun's notions. So he was a formidably willful and talented man who demonstrated both the importance of accounting and the importance of knowing its limitations.
He had another rule, from psychology, which, if you're interested in wisdom, ought to be part of your repertoire—like the elementary mathematics of permutations and combinations.
His rule for all the Braun Company's communications was called the five W's—you had to tell who was going to do what, where, when and why. And if you wrote a letter or directive in the Braun Company telling somebody to do something, and you didn't tell him why, you could get fired. In fact, you would get fired if you did it twice.
You might ask why that is so important? Well, again that's a rule of psychology. Just as you think better if you array knowledge on a bunch of models that are basically answers to the question, why, why, why, if you always tell people why, they'll understand it better, they'll consider it more important, and they'll be more likely to comply. Even if they don't understand your reason, they'll be more likely to comply.
So there's an iron rule that just as you want to start getting worldly wisdom by asking why, why, why, in communicating with other people about everything, you want to include why, why, why. Even if it's obvious, it's wise to stick in the why.
Which models are the most reliable? Well, obviously, the models that come from hard science and engineering are the most reliable models on this Earth. And engineering quality control—at least the guts of it that matters to you and me and people who are not professional engineers—is very much based on the elementary mathematics of Fermat and Pascal:
It costs so much and you get so much less likelihood of it breaking if you spend this much. It's all elementary high school mathematics. And an elaboration of that is what Deming brought to Japan for all of that quality control stuff.
I don't think it's necessary for most people to be terribly facile in statistics. For example, I'm not sure that I can even pronounce the Poisson distribution. But I know what a Gaussian or normal distribution looks like and I know that events and huge aspects of reality end up distributed that way. So I can do a rough calculation.
But if you ask me to work out something involving a Gaussian distribution to ten decimal points, I can't sit down and do the math. I'm like a poker player who's learned to play pretty well without mastering Pascal.
And by the way, that works well enough. But you have to understand that bellshaped curve at least roughly as well as I do.
And, of course, the engineering idea of a backup system is a very powerful idea. The engineering idea of breakpoints—that's a very powerful model, too. The notion of a critical mass—that comes out of physics—is a very powerful model.
All of these things have great utility in looking at ordinary reality. And all of this cost-benefit analysis—hell, that's all elementary high school algebra, too. It's just been dolled up a little bit with fancy lingo.
I suppose the next most reliable models are from biology/ physiology because, after all, all of us are programmed by our genetic makeup to be much the same.
And then when you get into psychology, of course, it gets very much more complicated. But it's an ungodly important subject if you're going to have any worldly wisdom.
And you can demonstrate that point quite simply: There's not a person in this room viewing the work of a very ordinary professional magician who doesn't see a lot of things happening that aren't happening and not see a lot of things happening that are happening.
And the reason why is that the perceptual apparatus of man has shortcuts in it. The brain cannot have unlimited circuitry. So someone who knows how to take advantage of those shortcuts and cause the brain to miscalculate in certain ways can cause you to see things that aren't there.
Now you get into the cognitive function as distinguished from the perceptual function. And there, you are equally—more than equally in fact—likely to be misled. Again, your brain has a shortage of circuitry and so forth—and it's taking all kinds of little automatic shortcuts.
So when circumstances combine in certain ways—or more commonly, your fellow man starts acting like the magician and manipulates you on purpose by causing your cognitive dysfunction—you're a patsy.
And so just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations. And this knowledge, by the way, can be used to control and motivate other people....
So the most useful and practical part of psychology—which I personally think can be taught to any intelligent person in a week—is ungodly important. And nobody taught it to me by the way. I had to learn it later in life, one piece at a time. And it was fairly laborious. It's so elementary though that, when it was all over, I felt like a fool.
And yeah, I'd been educated at Cal Tech and the Harvard Law School and so forth. So very eminent places miseducated people like you and me.
The elementary part of psychology—the psychology of misjudgment, as I call it—is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important.
Terribly smart people make totally bonkers mistakes by failing to pay heed to it. In fact, I've done it several times during the last two or three years in a very important way. You never get totally over making silly mistakes.
There's another saying that comes from Pascal which I've always considered one of the really accurate observations in the history of thought. Pascal said in essence, "The mind of man at one and the same time is both the glory and the shame of the universe."
And that's exactly right. It has this enormous power. However, it also has these standard misfunctions that often cause it to reach wrong conclusions. It also makes man extraordinarily subject to manipulation by others. For example, roughly half of the army of Adolf Hitler was composed of believing Catholics. Given enough clever psychological manipulation, what human beings will do is quite interesting.
Personally, I've gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things—which by and large are useful, but which often misfunction.
One approach is rationality—the way you'd work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions—many of which are wrong.
Now we come to another somewhat less reliable form of human wisdom—microeconomics. And here, I find it quite useful to think of a free market economy—or partly free market economy—as sort of the equivalent of an ecosystem....
This is a very unfashionable way of thinking because early in the days after Darwin came along, people like the robber barons assumed that the doctrine of the survival of the fittest authenticated them as deserving power—you know, "I'm the richest. Therefore, I'm the best. God's in his heaven, etc."
And that reaction of the robber barons was so irritating to people that it made it unfashionable to think of an economy as an ecosystem. But the truth is that it is a lot like an ecosystem. And you get many of the same results.
Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as animals flourish in niches, similarly, people who specialize in the business world—and get very good because they specialize—frequently find good economics that they wouldn't get any other way.
And once we get into microeconomics, we get into the concept of advantages of scale. Now we're getting closer to investment analysis—because in terms of which businesses succeed and which businesses fail, advantages of scale are ungodly important.
For example, one great advantage of scale taught in all of the business schools of the world is cost reductions along the so-called experience curve. Just doing something complicated in more and more volume enables human beings, who are trying to improve and are motivated by the incentives of capitalism, to do it more and more efficiently.
The very nature of things is that if you get a whole lot of volume through your joint, you get better at processing that volume. That's an enormous advantage. And it has a lot to do with which businesses succeed and fail....
Let's go through a list—albeit an incomplete one—of possible advantages of scale. Some come from simple geometry. If you're building a great spherical tank, obviously as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel.
And there are all kinds of things like that where the simple geometry—the simple reality—gives you an advantage of scale.
For example, you can get advantages of scale from TV advertising. When TV advertising first arrived—when talking color pictures first came into our living rooms—it was an unbelievably powerful thing. And in the early days, we had three networks that had whatever it was—say 90% of the audience.
Well, if you were Procter & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so many cans and bottles. Some little guy couldn't. And there was no way of buying it in part. Therefore, he couldn't use it. In effect, if you didn't have a big volume, you couldn't use network TV advertising which was the most effective technique.
So when TV came in, the branded companies that were already big got a huge tail wind. Indeed, they prospered and prospered and prospered until some of them got fat and foolish, which happens with prosperity—at least to some people....
And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30 cents, am I going to take something I don't know and put it in my mouth—which is a pretty personal place, after all—for a lousy dime?
So, in effect, Wrigley , simply by being so well known, has advantages of scale—what you might call an informational advantage.
Another advantage of scale comes from psychology. The psychologists use the term social proof. We are all influenced—subconsciously and to some extent consciously—by what we see others do and approve. Therefore, if everybody's buying something, we think it's better. We don't like to be the one guy who's out of step.
Again, some of this is at a subconscious level and some of it isn't. Sometimes, we consciously and rationally think, "Gee, I don't know much about this. They know more than I do. Therefore, why shouldn't I follow them?"
The social proof phenomenon which comes right out of psychology gives huge advantages to scale—for example, with very wide distribution, which of course is hard to get. One advantage of Coca-Cola is that it's available almost everywhere in the world.
Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup—which is slowly won by a big enterprise—gets to be a huge advantage.... And if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you.
There's another kind of advantage to scale. In some businesses, the very nature of things is to sort of cascade toward the overwhelming dominance of one firm.
The most obvious one is daily newspapers. There's practically no city left in the U.S., aside from a few very big ones, where there's more than one daily newspaper.
And again, that's a scale thing. Once I get most of the circulation, I get most of the advertising. And once I get most of the advertising and circulation, why would anyone want the thinner paper with less information in it? So it tends to cascade to a winnertakeall situation. And that's a separate form of the advantages of scale phenomenon.
Similarly, all these huge advantages of scale allow greater specialization within the firm. Therefore, each person can be better at what he does.
And these advantages of scale are so great, for example, that when Jack Welch came into General Electric, he just said, "To hell with it. We're either going to be # 1 or #2 in every field we're in or we're going to be out. I don't care how many people I have to fire and what I have to sell. We're going to be #1 or #2 or out."
That was a very toughminded thing to do, but I think it was a very correct decision if you're thinking about maximizing shareholder wealth. And I don't think it's a bad thing to do for a civilization either, because I think that General Electric is stronger for having Jack Welch there.
And there are also disadvantages of scale. For example, we—by which I mean Berkshire Hathaway—are the largest shareholder in Capital Cities/ABC. And we had trade publications there that got murdered where our competitors beat us. And the way they beat us was by going to a narrower specialization.
We'd have a travel magazine for business travel. So somebody would create one which was addressed solely at corporate travel departments. Like an ecosystem, you're getting a narrower and narrower specialization.
Well, they got much more efficient. They could tell more to the guys who ran corporate travel departments. Plus, they didn't have to waste the ink and paper mailing out stuff that corporate travel departments weren't interested in reading. It was a more efficient system. And they beat our brains out as we relied on our broader magazine.
That's what happened to The Saturday Evening Post and all those things. They're gone. What we have now is Motocross—which is read by a bunch of nuts who like to participate in tournaments where they turn somersaults on their motorcycles. But they care about it. For them, it's the principal purpose of life. A magazine called Motocrossis a total necessity to those people. And its profit margins would make you salivate.
Just think of how narrowcast that kind of publishing is. So occasionally, scaling down and intensifying gives you the big advantage. Bigger is not always better.
The great defect of scale, of course, which makes the game interesting—so that the big people don't always win—is that as you get big, you get the bureaucracy. And with the bureaucracy comes the territoriality—which is again grounded in human nature.
And the incentives are perverse. For example, if you worked for AT&T in my day, it was a great bureaucracy. Who in the hell was really thinking about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-basket into somebody else's in-basket. But, of course, it isn't. It's not done until AT&T delivers what it's supposed to deliver. So you get big, fat, dumb, unmotivated bureaucracies.
They also tend to become somewhat corrupt. In other words, if I've got a department and you've got a department and we kind of share power running this thing, there's sort of an unwritten rule: "If you won't bother me, I won't bother you and we're both happy." So you get layers of management and associated costs that nobody needs. Then, while people are justifying all these layers, it takes forever to get anything done. They're too slow to make decisions and nimbler people run circles around them.
The constant curse of scale is that it leads to big, dumb bureaucracy—which, of course, reaches its highest and worst form in government where the incentives are really awful. That doesn't mean we don't need governments—because we do. But it's a terrible problem to get big bureaucracies to behave.
So people go to stratagems. They create little decentralized units and fancy motivation and training programs. For example, for a big company, General Electric has fought bureaucracy with amazing skill. But that's because they have a combination of a genius and a fanatic running it. And they put him in young enough so he gets a long run. Of course, that's Jack Welch.
But bureaucracy is terrible.... And as things get very powerful and very big, you can get some really dysfunctional behavior. Look at Westinghouse. They blew billions of dollars on a bunch of dumb loans to real estate developers. They put some guy who'd come up by some career path—I don't know exactly what it was, but it could have been refrigerators or something—and all of a sudden, he's loaning money to real estate developers building hotels. It's a very unequal contest. And in due time, they lost all those billions of dollars.
CBS provides an interesting example of another rule of psychology—namely, Pavlovian association. If people tell you what you really don't want to hear what's unpleasant—there's an almost automatic reaction of antipathy. You have to train yourself out of it. It isn't foredestined that you have to be this way. But you will tend to be this way if you don't think about it.
Television was dominated by one network—CBS in its early days. And Paley was a god. But he didn't like to hear what he didn't like to hear. And people soon learned that. So they told Paley only what he liked to hear. Therefore, he was soon living in a little cocoon of unreality and everything else was corrupt—although it was a great business.
So the idiocy that crept into the system was carried along by this huge tide. It was a Mad Hatter's tea party the last ten years under Bill Paley.
And that is not the only example by any means. You can get severe misfunction in the high ranks of business. And of course, if you're investing, it can make a lot of difference. If you take all the acquisitions that CBS made under Paley, after the acquisition of the network itself, with all his advisors—his investment bankers, management consultants and so forth who were getting paid very handsomely—it was absolutely terrible.
For example, he gave something like 20% of CBS to the Dumont Company for a television set manufacturer which was destined to go broke. I think it lasted all of two or three years or something like that. So very soon after he'd issued all of that stock, Dumont was history. You get a lot of dysfunction in a big fat, powerful place where no one will bring unwelcome reality to the boss.
So life is an everlasting battle between those two forces—to get these advantages of scale on one side and a tendency to get a lot like the U.S. Agriculture Department on the other side—where they just sit around and so forth. I don't know exactly what they do. However, I do know that they do very little useful work.
On the subject of advantages of economies of scale, I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power—which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization.
If one little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he's going to make a lot of poor decisions. But if your buying is done in headquarters for a huge bunch of stores, you can get very bright people that know a lot about refrigerators and so forth to do the buying.
The reverse is demonstrated by the little store where one guy is doing all the buying. It's like the old story about the little store with salt all over its walls. And a stranger comes in and says to the storeowner, "You must sell a lot of salt." And he replies, "No, I don't. But you should see the guy who sells me salt."
So there are huge purchasing advantages. And then there are the slick systems of forcing everyone to do what works. So a chain store can be a fantastic enterprise.
It's quite interesting to think about Wal-Mart starting from a single store in Bentonville, Arkansas against Sears, Roebuck with its name, reputation and all of its billions. How does a guy in Bentonville, Arkansas with no money blow right by Sears, Roebuck? And he does it in his own lifetime—in fact, during his own late lifetime because he was already pretty old by the time he started out with one little store....
He played the chain store game harder and better than anyone else. Walton invented practically nothing. But he copied everything anybody else ever did that was smart—and he did it with more fanaticism and better employee manipulation. So he just blew right by them all.
He also had a very interesting competitive strategy in the early days. He was like a prizefighter who wanted a great record so he could be in the finals and make a big TV hit. So what did he do? He went out and fought 42 palookas. Right? And the result was knockout, knockout, knockout—42 times.
Walton, being as shrewd as he was, basically broke other small town merchants in the early days. With his more efficient system, he might not have been able to tackle some titan head-on at the time. But with his better system, he could destroy those small town merchants. And he went around doing it time after time after time. Then, as he got bigger, he started destroying the big boys.
Well, that was a very, very shrewd strategy.
You can say, "Is this a nice way to behave?" Well, capitalism is a pretty brutal place. But I personally think that the world is better for having Wal-Mart. I mean you can idealize small town life. But I've spent a fair amount of time in small towns. And let me tell you you shouldn't get too idealistic about all those businesses he destroyed.
Plus, a lot of people who work at Wal-Mart are very high grade, bouncy people who are raising nice children. I have no feeling that an inferior culture destroyed a superior culture. I think that is nothing more than nostalgia and delusion. But, at any rate, it's an interesting model of how the scale of things and fanaticism combine to be very powerful.
And it's also an interesting model on the other side—how with all its great advantages, the disadvantages of bureaucracy did such terrible damage to Sears, Roebuck. Sears had layers and layers of people it didn't need. It was very bureaucratic. It was slow to think. And there was an established way of thinking. If you poked your head up with a new thought, the system kind of turned against you. It was everything in the way of a dysfunctional big bureaucracy that you would expect.
In all fairness, there was also much that was good about it. But it just wasn't as lean and mean and shrewd and effective as Sam Walton. And, in due time, all its advantages of scale were not enough to prevent Sears from losing heavily to Wal-Mart and other similar retailers.
Here's a model that we've had trouble with. Maybe you'll be able to figure it out better. Many markets get down to two or three big competitors—or five or six. And in some of those markets, nobody makes any money to speak of. But in others, everybody does very well.
Over the years, we've tried to figure out why the competition in some markets gets sort of rational from the investor's point of view so that the shareholders do well, and in other markets, there's destructive competition that destroys shareholder wealth.
If it's a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world—safe travel, greater experience, time with your loved ones, you name it. Yet, the net amount of money that's been made by the shareholders of airlines since Kitty Hawk, is now a negative figure—a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business.
Yet, in other fields—like cereals, for example—almost all the big boys make out. If you're some kind of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make 40%. But why are cereals so profitable—despite the fact that it looks to me like they're competing like crazy with promotions, coupons and everything else? I don't fully understand it.
Obviously, there's a brand identity factor in cereals that doesn't exist in airlines. That must be the main factor that accounts for it.
And maybe the cereal makers by and large have learned to be less crazy about fighting for market share—because if you get even one person who's hell-bent on gaining market share.... For example, if I were Kellogg and I decided that I had to have 60% of the market, I think I could take most of the profit out of cereals. I'd ruin Kellogg in the process. But I think I could do it.
In some businesses, the participants behave like a demented Kellogg. In other businesses, they don't. Unfortunately, I do not have a perfect model for predicting how that's going to happen.
For example, if you look around at bottler markets, you'll find many markets where bottlers of Pepsi and Coke both make a lot of money and many others where they destroy most of the profitability of the two franchises. That must get down to the peculiarities of individual adjustment to market capitalism. I think you'd have to know the people involved to fully understand what was happening.
In microeconomics, of course, you've got the concept of patents, trademarks, exclusive franchises and so forth. Patents are quite interesting. When I was young, I think more money went into patents than came out. Judges tended to throw them out—based on arguments about what was really invented and what relied on prior art. That isn't altogether clear.
But they changed that. They didn't change the laws. They just changed the administration—so that it all goes to one patent court. And that court is now very much more pro-patent. So I think people are now starting to make a lot of money out of owning patents.
Trademarks, of course, have always made people a lot of money. A trademark system is a wonderful thing for a big operation if it's well known.
The exclusive franchise can also be wonderful. If there were only three television channels awarded in a big city and you owned one of them, there were only so many hours a day that you could be on. So you had a natural position in an oligopoly in the pre-cable days.
And if you get the franchise for the only food stand in an airport, you have a captive clientele and you have a small monopoly of a sort.
The great lesson in microeconomics is to discriminate between when technology is going to help you and when it's going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does.
For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles—which are a real commodity product. And one day, the people came to Warren and said, "They've invented a new loom that we think will do twice as much work as our old ones."
And Warren said, "Gee, I hope this doesn't work because if it does, I'm going to close the mill." And he meant it.
What was he thinking? He was thinking, "It's a lousy business. We're earning substandard returns and keeping it open just to be nice to the elderly workers. But we're not going to put huge amounts of new capital into a lousy business."
And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners.
That's such an obvious concept—that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that's still going to be lousy. The money still won't come to you. All of the advantages from great improvements are going to flow through to the customers.
Conversely, if you own the only newspaper in Oshkosh and they were to invent more efficient ways of composing the whole newspaper, then when you got rid of the old technology and got new fancy computers and so forth, all of the savings would come right through to the bottom line.
In all cases, 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 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 themselves in three years. And after 20 years of doing it, somehow you've earned a return of only about 4% per annum. That's the textile business.
And it isn't that the machines weren't better. It's just that the savings didn't go to you. The cost reductions came through all right. But the benefit of the cost reductions didn't go to the guy who bought the equipment. It's such a simple idea. It's so basic. And yet it's so often forgotten.
Then there's another model from microeconomics which I find very interesting. When technology moves as fast as it does in a civilization like ours, you get a phenomenon which I call competitive destruction. You know, you have the finest buggy whip factory and all of a sudden in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you're dead—you're destroyed. It happens again and again and again.
And when these new businesses come in, there are huge advantages for the early birds. And when you're an early bird, there's a model that I call "surfing"—when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallows....
But people get long runs when they're right on the edge of the wave—whether it's Microsoft or Intel or all kinds of people, including National Cash Register in the early days.
The cash register was one of the great contributions to civilization. It's a wonderful story. Patterson was a small retail merchant who didn't make any money. One day, somebody sold him a crude cash register which he put into his retail operation. And it instantly changed from losing money to earning a profit because it made it so much harder for the employees to steal....
But Patterson, having the kind of mind that he did, didn't think, "Oh, good for my retail business." He thought, "I'm going into the cash register business." And, of course, he created National Cash Register.
And he "surfed". He got the best distribution system, the biggest collection of patents and the best of everything. He was a fanatic about everything important as the technology developed. I have in my files an early National Cash Register Company report in which Patterson described his methods and objectives. And a well-educated orangutan could see that buying into partnership with Patterson in those early days, given his notions about the cash register business, was a total 100% cinch.
And, of course, that's exactly what an investor should be looking for. In a long life, you can expect to profit heavily from at least a few of those opportunities if you develop the wisdom and will to seize them. At any rate, "surfing" is a very powerful model.
However, Berkshire Hathaway , by and large, does not invest in these people that are "surfing" on complicated technology. After all, we're cranky and idiosyncratic—as you may have noticed.
And Warren and I don't feel like we have any great advantage in the high-tech sector. In fact, we feel like we're at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies.
Again, that is a very, very powerful idea. Every person is going to have a circle of competence. And it's going to be very hard to advance that circle. If I had to make my living as a musician.... I can't even think of a level low enough to describe where I would be sorted out to if music were the measuring standard of the civilization.
So you have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don't, you're going to lose. And that's as close to certain as any prediction that you can make. You have to figure out where you've got an edge. And you've got to play within your own circle of competence.
If you want to be the best tennis player in the world, you may start out trying and soon find out that it's hopeless—that other people blow right by you. However, if you want to become the best plumbing contractor in Bemidji, that is probably doable by two-thirds of you. It takes a will. It takes the intelligence. But after a while, you'd gradually know all about the plumbing business in Bemidji and master the art. That is an attainable objective, given enough discipline. And people who could never win a chess tournament or stand in center court in a respectable tennis tournament can rise quite high in life by slowly developing a circle of competence—which results partly from what they were born with and partly from what they slowly develop through work.
So some edges can be acquired. And the game of life to some extent for most of us is trying to be something like a good plumbing contractor in Bemidji. Very few of us are chosen to win the world's chess tournaments.
Some of you may find opportunities "surfing" along in the new high-tech fields—the Intels, the Microsofts and so on. The fact that we don't think we're very good at it and have pretty well stayed out of it doesn't mean that it's irrational for you to do it.
Well, so much for the basic microeconomics models, a little bit of psychology, a little bit of mathematics, helping create what I call the general substructure of worldly wisdom. Now, if you want to go on from carrots to dessert, I'll turn to stock picking—trying to draw on this general worldly wisdom as we go.
I don't want to get into emerging markets, bond arbitrage and so forth. I'm talking about nothing but plain vanilla stock picking. That, believe me, is complicated enough. And I'm talking about common stock picking.
The first question is, "What is the nature of the stock market?" And that gets you directly to this efficient market theory that got to be the rage—a total rage—long after I graduated from law school.
And it's rather interesting because one of the greatest economists of the world is a substantial shareholder in Berkshire Hathaway and has been for a long time. His textbook always taught that the stock market was perfectly efficient and that nobody could beat it. But his own money went into Berkshire and made him wealthy. So, like Pascal in his famous wager, he hedged his bet.
Is the stock market so efficient that people can't beat it? Well, the efficient market theory is obviously roughly right—meaning that markets are quite efficient and it's quite hard for anybody to beat the market by significant margins as a stock picker by just being intelligent and working in a disciplined way.
Indeed, the average result has to be the average result. By definition, everybody can't beat the market. As I always say, the iron rule of life is that only 20% of the people can be in the top fifth. That's just the way it is. So the answer is that it's partly efficient and partly inefficient.
And, by the way, I have a name for people who went to the extreme efficient market theory—which is "bonkers". It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality.
Again, to the man with a hammer, every problem looks like a nail. If you're good at manipulating higher mathematics in a consistent way, why not make an assumption which enables you to use your tool?
The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what's bet. That's what happens in the stock market.
Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it's very hard to beat the system.
And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you've got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work.
Given those mathematics, is it possible to beat the horses only using one's intelligence? Intelligence should give some edge, because lots of people who don't know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical could have a very considerable edge, in the absence of the frictional cost caused by the house take.
Unfortunately, what a shrewd horseplayer's edge does in most cases is to reduce his average loss over a season of betting from the 17% that he would lose if he got the average result to maybe 10%. However, there are actually a few people who can beat the game after paying the full 17%.
I used to play poker when I was young with a guy who made a substantial living doing nothing but bet harness races.... Now, harness racing is a relatively inefficient market. You don't have the depth of intelligence betting on harness races that you do on regular races. What my poker pal would do was to think about harness races as his main profession. And he would bet only occasionally when he saw some mispriced bet available. And by doing that, after paying the full handle to the house—which I presume was around 17%—he made a substantial living.
You have to say that's rare. However, the market was not perfectly efficient. And if it weren't for that big 17% handle, lots of people would regularly be beating lots of other people at the horse races. It's efficient, yes. But it's not perfectly efficient. And with enough shrewdness and fanaticism, some people will get better results than others.
The stock market is the same way—except that the house handle is so much lower. If you take transaction costs—the spread between the bid and the ask plus the commissions—and if you don't trade too actively, you're talking about fairly low transaction costs. So that with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things.
It is not a bit easy. And, of course, 50% will end up in the bottom half and 70% will end up in the bottom 70%. But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking.
How do you get to be one of those who is a winner—in a relative sense—instead of a loser?
Here again, look at the pari-mutuel system. I had dinner last night by absolute accident with the president of Santa Anita. He says that there are two or three betters who have a credit arrangement with them, now that they have off-track betting, who are actually beating the house. They're sending money out net after the full handle—a lot of it to Las Vegas, by the way—to people who are actually winning slightly, net, after paying the full handle. They're that shrewd about something with as much unpredictability as horse racing.
And the one thing that all those winning betters in the whole history of people who've beaten the pari-mutuel system have is quite simple. They bet very seldom.
It's not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it—who look and sift the world for a mispriced be—that they can occasionally find one.
And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple.
That is a very simple concept. And to me it's obviously right—based on experience not only from the pari-mutuel system, but everywhere else.
And yet, in investment management, practically nobody operates that way. We operate that way—I'm talking about Buffett and Munger. And we're not alone in the world. But a huge majority of people have some other crazy construct in their heads. And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they'll come to know everything about everything all the time.
To me, that's totally insane. The way to win is to work, work, work, work and hope to have a few insights.
How many insights do you need? Well, I'd argue: that you don't need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that's with a very brilliant man—Warren's a lot more able than I am and very disciplined—devoting his lifetime to it. I don't mean to say that he's only had ten insights. I'm just saying, that most of the money came from ten insights.
So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced something or other. And you're probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It's just that simple.
When Warren lectures at business schools, he says, "I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all."
He says, "Under those rules, you'd really think carefully about what you did and you'd be forced to load up on what you'd really thought about. So you'd do so much better."
Again, this is a concept that seems perfectly obvious to me. And to Warren it seems perfectly obvious. But this is one of the very few business classes in the U.S. where anybody will be saying so. It just isn't the conventional wisdom.
To me, it's obvious that the winner has to bet very selectively. It's been obvious to me since very early in life. I don't know why it's not obvious to very many other people.
I think the reason why we got into such idiocy in investment management is best illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, "My God, they're purple and green. Do fish really take these lures?" And he said, "Mister, I don't sell to fish."
Investment managers are in the position of that fishing tackle salesman. They're like the guy who was selling salt to the guy who already had too much salt. And as long as the guy will buy salt, why they'll sell salt. But that isn't what ordinarily works for the buyer of investment advice.
If you invested Berkshire Hathaway-style, it would be hard to get paid as an investment manager as well as they're currently paid—because you'd be holding a block of Wal-Mart and a block of Coca-Cola and a block of something else. You'd just sit there. And the client would be getting rich. And, after a while, the client would think, "Why am I paying this guy half a percent a year on my wonderful passive holdings?"
So what makes sense for the investor is different from what makes sense for the manager. And, as usual in human affairs, what determines the behavior are incentives for the decision maker.
From all business, my favorite case on incentives is Federal Express. The heart and soul of their system—which creates the integrity of the product—is having all their airplanes come to one place in the middle of the night and shift all the packages from plane to plane. If there are delays, the whole operation can't deliver a product full of integrity to Federal Express customers.
And it was always screwed up. They could never get it done on time. They tried everything—moral suasion, threats, you name it. And nothing worked.
Finally, somebody got the idea to pay all these people not so much an hour, but so much a shift—and when it's all done, they can all go home. Well, their problems cleared up overnight.
So getting the incentives right is a very, very important lesson. It was not obvious to Federal Express what the solution was. But maybe now, it will hereafter more often be obvious to you.
All right, we've now recognized that the market is efficient as a pari-mutuel system is efficient with the favorite more likely than the long shot to do well in racing, but not necessarily give any betting advantage to those that bet on the favorite.
In the stock market, some railroad that's beset by better competitors and tough unions may be available at one-third of its book value. In contrast, IBM in its heyday might be selling at 6 times book value. So it's just like the pari-mutuel system. Any damn fool could plainly see that IBM had better business prospects than the railroad. But once you put the price into the formula, it wasn't so clear anymore what was going to work best for a buyer choosing between the stocks. So it's a lot like a pari-mutuel system. And, therefore, it gets very hard to beat.
What style should the investor use as a picker of common stocks in order to try to beat the market—in other words, to get an above average long-term result? A standard technique that appeals to a lot of people is called "sector rotation". You simply figure out when oils are going to outperform retailers, etc., etc., etc. You just kind of flit around being in the hot sector of the market making better choices than other people. And presumably, over a long period of time, you get ahead.
However, I know of no really rich sector rotator. Maybe some people can do it. I'm not saying they can't. All I know is that all the people I know who got rich—and I know a lot of them—did not do it that way.
The second basic approach is the one that Ben Graham used—much admired by Warren and me. As one factor, Graham had this concept of value to a private owner—what the whole enterprise would sell for if it were available. And that was calculable in many cases.
Then, if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you've got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety—as he put it—by having this big excess value going for you.
But he was, by and large, operating when the world was in shell shock from the 1930s—which was the worst contraction in the English-speaking world in about 600 years. Wheat in Liverpool, I believe, got down to something like a 600-year low, adjusted for inflation. People were so shell-shocked for a long time thereafter that Ben Graham could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on.
And in those days, working capital actually belonged to the shareholders. If the employees were no longer useful, you just sacked them all, took the working capital and stuck it in the owners' pockets. That was the way capitalism then worked.
Nowadays, of course, the accounting is not realistic because the minute the business starts contracting, significant assets are not there. Under social norms and the new legal rules of the civilization, so much is owed to the employees that, the minute the enterprise goes into reverse, some of the assets on the balance sheet aren't there anymore.
Now, that might not be true if you run a little auto dealership yourself. You may be able to run it in such a way that there's no health plan and this and that so that if the business gets lousy, you can take your working capital and go home. But IBM can't, or at least didn't. Just look at what disappeared from its balance sheet when it decided that it had to change size both because the world had changed technologically and because its market position had deteriorated.
And in terms of blowing it, IBM is some example. Those were brilliant, disciplined people. But there was enough turmoil in technological change that IBM got bounced off the wave after "surfing" successfully for 60 years. And that was some collapse—an object lesson in the difficulties of technology and one of the reasons why Buffett and Munger don't like technology very much. We don't think we're any good at it, and strange things can happen.
At any rate, the trouble with what I call the classic Ben Graham concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and it wouldn't click.
But such is the nature of people who have a hammer—to whom, as I mentioned, every problem looks like a nail that the Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they'd always done. And it still worked pretty well. So the Ben Graham intellectual system was a very good one.
Of course, the best part of it all was his concept of "Mr. Market". Instead of thinking the market was efficient, he treated it as a manic-depressive who comes by every day. And some days he says, "I'll sell you some of my interest for way less than you think it's worth." And other days, "Mr. Market" comes by and says, "I'll buy your interest at a price that's way higher than you think it's worth." And you get the option of deciding whether you want to buy more, sell part of what you already have or do nothing at all.
To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct. And it's been very useful to Buffett, for instance, over his whole adult lifetime.
However, if we'd stayed with classic Graham the way Ben Graham did it, we would never have had the record we have. And that's because Graham wasn't trying to do what we did.
For example, Graham didn't want to ever talk to management. And his reason was that, like the best sort of professor aiming his teaching at a mass audience, he was trying to invent a system that anybody could use. And he didn't feel that the man in the street could run around and talk to managements and learn things. He also had a concept that the management would often couch the information very shrewdly to mislead. Therefore, it was very difficult. And that is still true, of course—human nature being what it is.
And so having started out as Grahamites which, by the way, worked fine—we gradually got what I would call better insights. And we realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other.
And once we'd gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses.
And, by the way, the bulk of the billions in Berkshire Hathaway have come from the better businesses. Much of the first $200 or $300 million came from scrambling around with our Geiger counter. But the great bulk of the money has come from the great businesses.
And even some of the early money was made by being temporarily present in great businesses. Buffett Partnership, for example, owned American Express and Disney when they got pounded down.
Most investment managers are in a game where the clients expect them to know a lot about a lot of things. We didn't have any clients who could fire us at Berkshire Hathaway. So we didn't have to be governed by any such construct. And we came to this notion of finding a mispriced bet and loading up when we were very confident that we were right. So we're way less diversified. And I think our system is miles better.
However, in all fairness, I don't think a lot of money managers could successfully sell their services if they used our system. But if you're investing for 40 years in some pension fund, what difference does it make if the path from start to finish is a little more bumpy or a little different than everybody else's so long as it's all going to work out well in the end? So what if there's a little extra volatility.
In investment management today, everybody wants not only to win, but to have a yearly outcome path that never diverges very much from a standard path except on the upside. Well, that is a very artificial, crazy construct. That's the equivalent in investment management to the custom of binding the feet of Chinese women. It's the equivalent of what Nietzsche meant when he criticized the man who had a lame leg and was proud of it.
That is really hobbling yourself. Now, investment managers would say, "We have to be that way. That's how we're measured." And they may be right in terms of the way the business is now constructed. But from the viewpoint of a rational consumer, the whole system's "bonkers" and draws a lot of talented people into socially useless activity.
And the Berkshire system is not "bonkers". It's so damned elementary that even bright people are going to have limited, really valuable insights in a very competitive world when they're fighting against other very bright, hardworking people.
And it makes sense to load up on the very few good insights you have instead of pretending to know everything about everything at all times. You're much more likely to do well if you start out to do something feasible instead of something that isn't feasible. Isn't that perfectly obvious?
How many of you have 56 brilliant ideas in which you have equal confidence? Raise your hands, please. How many of you have two or three insights that you have some confidence in? I rest my case.
I'd say that Berkshire Hathaway's system is adapting to the nature of the investment problem as it really is.
We've really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money's been made in the high quality businesses. And most of the other people who've made a lot of money have done so in high quality businesses.
Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result.
So the trick is getting into better businesses. And that involves all of these advantages of scale that you could consider momentum effects.
How do you get into these great companies? One method is what I'd call the method of finding them small get 'em when they're little. For example, buy Wal-Mart when Sam Walton first goes public and so forth. And a lot of people try to do just that. And it's a very beguiling idea. If I were a young man, I might actually go into it.
But it doesn't work for Berkshire Hathaway anymore because we've got too much money. We can't find anything that fits our size parameter that way. Besides, we're set in our ways. But I regard finding them small as a perfectly intelligent approach for somebody to try with discipline. It's just not something that I've done.
Finding 'em big obviously is very hard because of the competition. So far, Berkshire's managed to do it. But can we continue to do it? What's the next Coca-Cola investment for us? Well, the answer to that is I don't know. I think it gets harder for us all the time....
And ideally and we've done a lot of this—you get into a great business which also has a great manager because management matters. For example, it's made a great difference to General Electric that Jack Welch came in instead of the guy who took over Westinghouse—a very great difference. So management matters, too.
And some of it is predictable. I do not think it takes a genius to understand that Jack Welch was a more insightful person and a better manager than his peers in other companies. Nor do I think it took tremendous genius to understand that Disney had basic momentums in place which are very powerful and that Eisner and Wells were very unusual managers.
So you do get an occasional opportunity to get into a wonderful business that's being run by a wonderful manager. And, of course, that's hog heaven day. If you don't load up when you get those opportunities, it's a big mistake.
Occasionally, you'll find a human being who's so talented that he can do things that ordinary skilled mortals can't. I would argue that Simon Marks—who was second generation in Marks & Spencer of England—was such a man. Patterson was such a man at National Cash Register. And Sam Walton was such a man.
These people do come along—and in many cases, they're not all that hard to identify. If they've got a reasonable hand—with the fanaticism and intelligence and so on that these people generally bring to the party—then management can matter much.
However, averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager.
But, very rarely, you find a manager who's so good that you're wise to follow him into what looks like a mediocre business.
Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you're going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum.
In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15%—or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.
Even with a 10% per annum investment, paying a 35% tax at the end gives you 8.3% after taxes as an annual compounded result after 30 years. In contrast, if you pay the 35% each year instead of at the end, your annual result goes down to 6.5%. So you add nearly 2% of after-tax return per annum if you only achieve an average return by historical standards from common stock investments in companies with tiny dividend payout ratios.
But in terms of business mistakes that I've seen over a long lifetime, I would say that trying to minimize taxes too much is one of the great standard causes of really dumb mistakes. I see terrible mistakes from people being overly motivated by tax considerations.
Warren and I personally don't drill oil wells. We pay our taxes. And we've done pretty well, so far. Anytime somebody offers you a tax shelter from here on in life, my advice would be don't buy it.
In fact, any time anybody offers you anything with a big commission and a 200-page prospectus, don't buy it. Occasionally, you'll be wrong if you adopt "Munger's Rule". However, over a lifetime, you'll be a long way ahead—and you will miss a lot of unhappy experiences that might otherwise reduce your love for your fellow man.
There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: You're paying less to brokers. You're listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded.
And you think that most of you are going to get that much advantage by hiring investment counselors and paying them 1% to run around, incurring a lot of taxes on your behalf'? Lots of luck.
Are there any dangers in this philosophy? Yes. Everything in life has dangers. Since it's so obvious that investing in great companies works, it gets horribly overdone from time to time. In the "Nifty-Fifty" days, everybody could tell which companies were the great ones. So they got up to 50, 60 and 70 times earnings. And just as IBM fell off the wave, other companies did, too. Thus, a large investment disaster resulted from too high prices. And you've got to be aware of that danger....
So there are risks. Nothing is automatic and easy. But if you can find some fairly-priced great company and buy it and sit, that tends to work out very, very well indeed—especially for an individual,
Within the growth stock model, there's a sub-position: There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices—and yet they haven't done it. So they have huge untapped pricing power that they're not using. That is the ultimate no-brainer.
That existed in Disney. It's such a unique experience to take your grandchild to Disneyland. You're not doing it that often. And there are lots of people in the country. And Disney found that it could raise those prices a lot and the attendance stayed right up.
So a lot of the great record of Eisner and Wells was utter brilliance but the rest came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies.
At Berkshire Hathaway, Warren and I raised the prices of See's Candy a little faster than others might have. And, of course, we invested in Coca-Cola—which had some untapped pricing power. And it also had brilliant management. So a Goizueta and Keough could do much more than raise prices. It was perfect.
You will get a few opportunities to profit from finding underpricing. There are actually people out there who don't price everything as high as the market will easily stand. And once you figure that out, it's like finding in the street—if you have the courage of your convictions.
If you look at Berkshire's investments where a lot of the money's been made and you look for the models, you can see that we twice bought into twonewspaper towns which have since become onenewspaper towns. So we made a bet to some extent....
In one of those—The Washington Post—we bought it at about 20% of the value to a private owner. So we bought it on a Ben Grahamstyle basis—at onefifth of obvious value—and, in addition, we faced a situation where you had both the top hand in a game that was clearly going to end up with one winner and a management with a lot of integrity and intelligence. That one was a real dream. They're very high class people—the Katharine Graham family. That's why it was a dream—an absolute, damn dream.
Of course, that came about back in '73-74. And that was almost like 1932. That was probably a once-in-40-yearstype denouement in the markets. That investment's up about 50 times over our cost.
If I were you, I wouldn't count on getting any investment in your lifetime quite as good as The Washington Post was in '73 and '74.
But it doesn't have to be that good to take care of you.
Let me mention another model. Of course, Gillette and Coke make fairly lowpriced items and have a tremendous marketing advantage all over the world. And in Gillette's case, they keep surfing along new technology which is fairly simple by the standards of microchips. But it's hard for competitors to do.
So they've been able to stay constantly near the edge of improvements in shaving. There are whole countries where Gillette has more than 90% of the shaving market.
GEICO is a very interesting model. It's another one of the 100 or so models you ought to have in your head. I've had many friends in the sick business fixup game over a long lifetime. And they practically all use the following formula—I call it the cancer surgery formula:
They look at this mess. And they figure out if there's anything sound left that can live on its own if they cut away everything else. And if they find anything sound, they just cut away everything else. Of course, if that doesn't work, they liquidate the business. But it frequently does work.
And GEICO had a perfectly magnificent business submerged in a mess, but still working. Misled by success, GEICO had done some foolish things. They got to thinking that, because they were making a lot of money, they knew everything. And they suffered huge losses.
All they had to do was to cut out all the folly and go back to the perfectly wonderful business that was lying there. And when you think about it, that's a very simple model. And it's repeated over and over again.
And, in GEICO's case, think about all the money we passively made.... It was a wonderful business combined with a bunch of foolishness that could easily be cut out. And people were coming in who were temperamentally and intellectually designed so they were going to cut it out. That is a model you want to look for.
And you may find one or two or three in a long lifetime that are very good. And you may find 20 or 30 that are good enough to be quite useful.
Finally, I'd like to once again talk about investment management. That is a funny business because on a net basis, the whole investment management business together gives no value added to all buyers combined. That's the way it has to work.
Of course, that isn't true of plumbing and it isn't true of medicine. If you're going to make your careers in the investment management business, you face a very peculiar situation. And most investment managers handle it with psychological denial just like a chiropractor. That is the standard method of handling the limitations of the investment management process. But if you want to live the best sort of life, I would urge each of you not to use the psychological denial mode.
I think a select few—a small percentage of the investment managers—can deliver value added. But I don't think brilliance alone is enough to do it. I think that you have to have a little of this discipline of calling your shots and loading up—you want to maximize your chances of becoming one who provides above average real returns for clients over the long pull.
But I'm just talking about investment managers engaged in common stock picking. I am agnostic elsewhere. I think there may well be people who are so shrewd about currencies and this, that and the other thing that they can achieve good longterm records operating on a pretty big scale in that way. But that doesn't happen to be my milieu. I'm talking about stock picking in American stocks.
I think it's hard to provide a lot of value added to the investment management client, but it's not impossible.