Monday, September 05, 2005

Jared Diamond's "Dam Fools"

Jared Diamond is one hell of a thinker. I really like the way he thinks. The ideas described by him in his talks and in his wonderful books are also portable i.e. their lessons can be applied in other fields like investments.

His book, "Guns, Germs, and Steel: The Fates of Human Societies" contains highly useful ideas about how to think correctly. It's no wonder that Mr. Charlie Munger has been recommending Diamond's book for years. Diamond's way of thinking is highly multidisciplinary, which I think, is exactly what Mr. Munger likes about him.

I've yet to start reading Diamond's other famous book, "Collapse: How Societies Choose to Fail or Succeed". However, a couple of days ago, I started watching the recently released DVD on Guns, Germs, and Steel. If you do not have the time or the inclination to read the book, watch the DVD.

You will also enjoy reading the transcripts of two of Diamond's talks from here and here.

The earlier of these two talks titled "How to Get Rich?" beautifully illustrates the role of competition in wealth creation rather than wealth destruction. This talk also wonderfully explains how innovation really works.

The second talk titled "Why Do Some Societies Make Disastrous Decisions?" could actually have easily been titled "Why Do Some Investors Make Disastrous Decisions?" In this talk, I loved Diamond's discussion of "Psychological Denial" one of the several mental models from psychology used by Mr. Munger. Here's a wonderful quote on psychological denial from that talk:

"Consider a narrow deep river valley below a high dam, such that if the dam burst, the resulting flood of water would drown people for a long distance downstream. When attitude pollsters ask people downstream of the dam how concerned they are about the dam's bursting, it's not surprising that fear of a dam burst is lowest far downstream, and increases among residents increasingly close to the dam.

Surprisingly, though, when one gets within a few miles of the dam, where fear of the dam's breaking is highest, as you then get closer to the dam the concern falls off to zero! That is, the people living immediately under the dam who are certain to be drowned in a dam burst profess unconcern. That is because of psychological denial: the only way of preserving one's sanity while living immediately under the high dam is to deny the finite possibility that it could burst."

How can the idea of psychology denial as explained by Diamond be applied to another field like investments? Diamond's example of what I call "dam fools" has a close parallel to what happens to most investors, the media, and the politicians at the peak of an asset price bubble. The most recent example was that of the dotcom bubble where most people were victims of sheer psychological denial. They were blissfully ignorant of the trouble ahead.

Another application of psychological denial which I have observed is when I meet with, or read the interviews of, the managements of some companies. For example, Steel executives were bullish when prices were at their peak. Why does this happen? I think part of the reason why it happens is that people are too close to the scene of the action, just like the "dam fools" in Diamond's example.

I think one the traits one needs to learn is the ability to "zoom out" and look at the big picture which is not easy when you are too close to the scene of the action.

Yet another example of psychological denial is seen when management is over-confident of its own abilities and under-confident of the abilities of its competition. Recently, I met with the management of a profitable Indian company which manufactures a commodity product at a low cost. However, a much bigger competitor is creating new capacity in China. If this new capacity comes on stream, it can destroy the profitability of the most of the players in the industry. The management of the company I met, however, feels that the Chinese player will not be able to stabilise the plant. When I come across such responses from managements, the "Dam Fool" example of Diamond pops up in my mind!

Why would a fellow who is spending hundreds of millions of dollars to build capacity in a growing industry not be able to stabilise a plant? Sure, it would cost money to poach some of the smartest engineers and technicians, but for a person who has already made that large size commitment, the incremental cost required to get the right people to get the job done will be really small, isn’t it? [Commitment and Consistency - Psychology, Contrast Effect - Psychology]

It's such a simple question, but the management of the Indian company would not like to ask it. Now that's psychological denial. So, psychological denial operates at a subconsious level in the minds of investors as well as company managers.

A marvelous example of psychological denial at both levels was depicted in the movie "Other People's Money". In this fantastic film, which I recommend watching, "Larry the Liquidator", played by the giant of American cinema, Danny DeVito, is trying to convince the shareholders of New England Wire & Cable Company to vote him into power so that he can liquidate the company because in his view it deserves to be liquidated. You can hear the speech of the incumbent manager, Andrew Jorgenson, played by Gregory Peck, from here and that of DeVito from here.

Here's a quote from DeVito's speech which beautifully illustrates psychological denial, both at the corporate as well as the investor level:

"This company is dead. I didn't kill it. Don't blame me. It was dead when I got here. It's too late for prayers. For even if the prayers were answered, and a miracle occurred, and the yen did this, and the dollar did that, and the infrastructure did the other thing, we would still be dead. You know why? Fiber optics. New technologies. Obsolescence. We're dead alright. We're just not broke.

And you know the surest way to go broke? Keep getting an increasing share of a shrinking market. Down the tubes. Slow but sure. You know, at one time there must've been dozens of companies makin' buggy whips. And I'll bet the last company around was the one that made the best goddamn buggy whip you ever saw. Now how would you have liked to have been a stockholder in that company? You invested in a business and this business is dead. Let's have the intelligence, let's have the decency to sign the death certificate, collect the insurance, and invest in something with a future."