More than you know

Finding
Financial Wisdom
In Unconventional
Places
MICHAEL J. MAUBOUSSIN
MORE THAN
YOU KNOW
Finding Financial Wisdom
in Unconventional Places
MORE THAN YOU KNOW
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MORE THAN YOU KNOW
Finding Financial Wisdom in Unconventional Places
Columbia University Press New York
610-037-cmp2-001-r01.indd 2 3/14/06 11:10:41 AM
MORE THAN YOU KNOW
Finding Financial Wisdom in Unconventional Places
Michael J. Mauboussin
610-037-cmp2-001-r01.indd 3 3/14/06 11:10:46 AM
Columbia University Press
Publishers Since 1893
New York Chichester, West Sussex
Copyright © 2006 Michael J. Mauboussin
All rights reserved
Library of Congress Cataloging-in-Publication Data
Mauboussin, Michael J., 1964–

More than you know : fi nding fi nancial wisdom in unconventional places /
Michael J. Mauboussin.
p. cm.
Includes bibliographical references and index.
ISBN 0–231–13870–9 (cloth : alk. paper)
1. Investments. 2. Investments—Psychological aspects. 3. Finance, Personal.
I. Title.
HG4521 .M365 2006
332.6—dc22 2005034238
A
Columbia University Press books are printed on permanent and durable
acid-free paper.
Printed in the United States of America
c 10 9 8 7 6 5 4 3 2 1

A balanced perspective cannot be acquired by studying disci-
plines in pieces but through pursuit of the consilience among
them. Such unifi cation will come hard. But I think it is inevi-
table. Intellectually it rings true, and it gratifi es impulses that
rise from the admirable side of human nature. To the extent
that the gaps between the great branches of learning can be
narrowed, diversity and depth of knowledge will increase.
—Edward O. Wilson, Consilience

To my parents
Who always stood behind me but were never too close


contents
Acknowledgments xvii

Introduction 1
PART 1: Investment Philosophy
Introduction 7
1 Be the House: Process and Outcome in Investing 9
Hit Me 9
From Treasury to Treasure 11
Prioritizing Process 14
2 Investing—Profession or Business?
Thoughts on Beating the Market Index 15
The Scouting Report 15
Evaluating the Winners 17
The Investing Profession Versus the Investment Business 19
3 The Babe Ruth Effect:
Frequency Versus Magnitude in Expected Value 23
Batting with the Babe 23
The Downside of Hardwiring 24
Bulls, Bears, and Odds 25
From OTC to OTB 26
A Useful Analogy 27
4 Sound Theory for the Attribute Weary:
The Importance of Circumstance-Based Categorization 29
Circumstance Over Attributes 29
The Three Steps of Theory Building 30
When, Not What 33
5 Risky Business: Risk, Uncertainty, and Prediction in Investing 35
Rocket Science 35
From Uncertainty to Probability 36
How Predictions Change Future Payoffs 39
6 The Hot Hand in Investing:
What Streaks Tell Us About Perception, Probability, and Skill 40

Finding the Hot Shot 40
Streaks and Skill 41
Toss Out the Coin Toss 42
Streaks and Luck 44
7 Time Is on My Side: Myopic Loss Aversion and Portfolio Turnover 46
One or One Hundred 46
Explaining the Equity-Risk Premium 47
The Value of Inactivity 49
Pictures Worth a Thousand Words 53
PART 2: Psychology of Investing
Introduction 57
8 Good Morning, Let the Stress Begin:
Linking Stress to Suboptimal Portfolio Management 59
Why Zebras Don’t Get Ulcers 59
Why Money Managers Do Get Ulcers 60
Shortening Horizons 61
Imitating Ulysses 64
9 All I Really Need to Know I Learned at a Tupperware Party:
What Tupperware Parties Teach You About Investing and Life 65
A Tip from Shining Shoes 65
You Can Fool Mother Nature 66
CONTENTS
x
All I Really Need to Know . . . 68
The Psychology of Investing 69
10 All Systems Go: Emotion and Intuition in Decision Making 71
Emotions and Decisions 72
Two Follows One 72
The Affect Heuristic 74
When the Experiential Fails 76

Affect: Individual Versus the Collective 76
11 Guppy Love: The Role of Imitation in Markets 77
Guppy See, Guppy Do 77
Feedback—Negative and Positive 78
Follow the Ant in Front of You 78
Herding from the Grapevine 81
12 Beware of Behavioral Finance:
Misuse of Behavioral Finance Can Lead to Bad Thinking 82
Sorry Syllogism 82
Mug’s Game? 84
Bombs Away 85
Money See, Money Do 85
13 Raising Keynes: Long-Term Expectations, the El Farol Bar,
and Kidding Yourself 87
What Do You Expect? 87
Speculation and Enterprise 88
Visiting El Farol 89
Kidding Yourself 90
PART 3: Innovation and Competitive Strategy
Introduction 95
CONTENTS
xi
14 The Wright Stuff: Why Innovation Is Inevitable 97
Take Off with Recombination 97
How Does Wealth Happen? 99
Sic Itur ad Astra (This Is the Way to the Stars) 102
Creative Destruction—Here to Stay 105
15 Pruned for Performance:
What Brain Development Teaches Us About Innovation 106
Too Clever by Half 106

The Dynamics of Innovation 107
Investors: Use the Brain 110
16 Staying Ahead of the Curve:
Linking Creative Destruction and Expectations 113
Losing Pride 113
Goldilocks Expectations: Too Cold, Too Hot, Just Right 114
Out with the Old, In with the New 115
The Mind Makes a Promise That the Body Can’t Fill 117
Expectations and Innovation 118
17 Is There a Fly in Your Portfolio? What an Accelerating
Rate of Industry Change Means for Investors 119
Fruit Flies and Futility 119
Speed Trap? 120
Investor Evolution 123
18 All the Right Moves:
How to Balance the Long Term with the Short Term
124
Managing for the Long Term 124
Deep Blue’s Lessons 125
Strategies for Winners 125
Strategy as Simple Rules 127
CONTENTS
xii
19 Survival of the Fittest:
Fitness Landscapes and Competitive Advantage 129
A Peek at Another Peak 129
Fitness Landscapes 130
Look Before You Leap? 132
Tools of the Trade-Off 133
20 You’ll Meet a Bad Fate If You Extrapolate:

The Folly of Using Average P/Es 135
Social Versus Security 135
Nonstationarity and Historical P/Es 136
Why the Past May Not Be Prologue 137
Bounded Parameters 139
Unpacking the (Mental) Baggage 140
21 I’ve Fallen and I Can’t Get Up: Mean Reversion and Turnarounds 141
Returns and Growth 141
Death, Taxes, and Reversion to the Mean 142
I’ve Fallen and I Can’t Get Up 144
PART 4: Science and Complexity Theory
Introduction 149
22 Diversify Your Mind: Thoughts on Organizing for Investing Success 151
Ant Brain 151
A-Mazing 152
Getting a Diversity Degree 154
Creativity and Investing 155
23 From Honey to Money: The Wisdom and Whims of the Collective 157
Smart Ant 157
Traveling Salesman? Follow the Ant . . . 158
CONTENTS
xiii
Delphic Decision Markets 159
The Stock Market—the Ultimate Hive? 160
Swarm Smarts 161
24 Vox Populi: Using the Collective to Find, Solve, and Predict 162
The Accuracy of Crowds 162
Needle in a Haystack 163
Weighing the Ox with the Vox 164
Estimating Printers with Populi 165

And Now, For the Real World 166
25 A Tail of Two Worlds: Fat Tails and Investing 167
Experience Versus Exposure 168
Tell Tail 169
What Fat Tails Mean for Investors 171
26 Integrating the Outliers:
Two Lessons from the St. Petersburg Paradox 173
Bernoulli’s Challenge 173
What’s Normal? 174
St. Petersburg and Growth Stock Investing 178
Integrating the Outliers 179
27 The Janitor’s Dream: Why Listening to Individuals Can Be
Hazardous to Your Wealth 180
Beyond Newton 180
Sorting Systems 181
The Stock Market as a Complex Adaptive System 183
Using What You’ve Got 184
28 Chasing Laplace’s Demon:
The Role of Cause and Effect in Markets 185
Evolution Made Me Do It 185
Laplace’s Demon 187
CONTENTS
xiv
Interpreting the Market 188
Investor Risks 190
29 More Power to You: Power Laws and What They Mean for Investors 193
Zipf It 193
The More Things Change . . . 194
Catch the Power 197
30 The Pyramid of Numbers: Firm Size, Growth Rates, and Valuation 199

Why Big Fierce Animals Are Rare 199
Find Your Niche 201
Dear CEO: We’ve Made It to the Fortune 50! You’re Fired 201
Extrapolative Expectations 204
Conclusion. The Future of Consilience in Investing 207
Notes 211
References and Further Reading 237
Index 257
CONTENTS
xv

acknowledgments
I wrote the original versions of these essays while I was at Credit Suisse (for-
merly Credit Suisse First Boston). In my dozen years at CSFB, management
consistently offered me marvelous opportunities for professional develop-
ment. Allowing me to launch The Consilient Observer —the offbeat offering
that provided the basis for More Than You Know —is a tribute to the fi rm’s
open-mindedness and support. In particular, I am indebted to Brady Dougan,
Al Jackson, Terry Cuskley, Steve Kraus, and Jim Clark. Credit Suisse was
also gracious in granting me the copyrights to these works.
Two names were listed on The Consilient Observer ’s original masthead.
The other belonged to my research associate, Kristen Bartholdson, who
made signifi cant contributions in research, editing, number crunching, and
producing exhibits. Smart and talented, Kristen is also a delightful person
to work with.
Dan Callahan, my research associate at Legg Mason Capital Manage-
ment, picked up where Kristen left off, working tirelessly on all aspects of
this book. He was instrumental in updating the material, getting the exhib-
its and manuscript in shape, and coordinating all communication. Dan is
resourceful, productive, and bright. He’s also a great guy, and I’m really

pleased he is on my team.
All of my coworkers at Legg Mason Capital Management have been ter-
rifi c, providing valuable support and cooperation. Thanks to all of you.
Two people have had a major professional infl uence on me. The fi rst is
Al Rappaport, with whom I wrote Expectations Investing . I have learned an
enormous amount from Al, and he remains a tremendous source of inspira-
tion and constructive feedback.
The other is Bill Miller, whom I now have the honor of calling a col-
league. Bill stimulated many of the ideas in these essays, either directly or
indirectly. It’s one thing to write about how the mental-models approach
helps investors, it’s quite another to use the approach to generate excess
returns. Bill has done both, and for that he deserves all of the admiration
he receives.
Both Al and Bill have always been gracious with their time, and have
taught me with patience. They are great role models, and I feel privileged to
be associated with both of them.
These essays draw from the work of many fabulous scientists, too many
to list individually. But a handful of thinkers deserve special mention,
including Clayton Christensen, Paul DePodesta, Norman Johnson, Jim
Surowiecki, and Duncan Watts. Thanks to each of you for sharing your
ideas with me so generously. Steve Waite’s suggestions were also of great
benefi t to me.
I’d like to thank Myles Thompson, my publisher and editor at Columbia
University Press, for his boundless enthusiasm and unwavering belief in the
power of these ideas. Assistant editor Ann Young has also been an immense
help in all aspects of the project. Michael Haskell improved the book’s fl ow
with his thoughtful edits and supplied the new, comprehensive title. Nancy
Fink Huehnergarth was instrumental in shaping the manuscript, providing
both valuable editorial input and a fantastic sense of humor. Laurie Harper
at Sebastian Agency offered constructive guidance and input.

I also appreciate Sente Corporation’s very talented Jay Smethurst and
Bryan Coffman for their artistic contributions. They were with me from
the very beginning of the consilient journey. At CSFB, Marian Toy and
Ann Funkhouser were great editors to work with: effi cient, constructive,
and thoughtful. My administrative assistant at CSFB, Melissa Little, also
helped in key areas such as exhibit production and distribution.
My wife, Michelle, is a constant source of love, support, and counsel. My
mother-in-law, Andrea Maloney Schara, is the rare grandmother who can
explain systems theory and throw a football. Finally, I thank my children
Andrew, Alex, Madeline, Isabelle, and Patrick for allowing me to see diver-
sity fi rsthand.
ACKNOWLEDGMENTS
xviii
MORE THAN YOU KNOW

introduction
I remember the exact moment the idea for The Consilient Observer hatched.
It was the summer of 2000, and my wife’s beloved grandfather handed me
an issue of Time magazine featuring a story about how Tiger Woods retooled
his golf swing. As I read the article, the term “fi tness landscape” kept fl ash-
ing in my mind. Biologists developed fi tness landscapes to help understand
evolution—about as far from a golf course as you can imagine—and here I
was thinking that these landscapes are the only way to understand the trans-
formation of Tiger’s swing.
At that moment, I decided to write about these types of connections
and investing. What does guppy mate selection tell us about stock mar-
ket booms? Why does it matter to investors that different things stress out
zebras and humans? How do Tupperware hostesses get you to buy lots of
stuff that you don’t want and what does that mean for your stock selection
process?

What followed were fi fty short essays, each trying to identify useful links
between seemingly disparate ideas. A handful of those essays, substantially
revised and updated, constitute this book. While investors are the primary
audience for this book, my hope is that people from all walks of life will
fi nd the concepts provocative and profi table.
More Than You Know ’s core premise is simple to explain but devilishly
diffi cult to live: you will be a better investor, executive, parent, friend—
person —if you approach problems from a multidisciplinary perspective. It’s
the difference between moving into a fi xer-upper home with a full set of
power tools versus a simple screwdriver. You are going to be a lot more suc-
cessful and effi cient if you have the proper tool for each job at hand.
The reality is that the majority of us end up with pretty narrow slices
of knowledge. Most occupations encourage a degree of specialization, and
some vocations, like academia, insist on it. And there are the time con-
straints. We are all so busy talking on the phone, answering e-mails, and
going to meetings that we don’t have any time left to read, think, and play
with ideas.
A quick word on the original title of the organ and the where the essays
fi rst appeared. I have had scores of people tell me they enjoy the essays, but
come on, “consilient” isn’t even in the dictionary (not in most, at least).
I adapted the title from biologist Edward O. Wilson’s celebrated book, Con-
silience , because no other word describes the idea as well. Consilience liter-
ally means the “jumping together” of knowledge. Wilson argues that we
can unify knowledge across diverse disciplines—physics, biology, econom-
ics, and the arts, for instance—at a fundamental level. Indeed, you have to
think across disciplines to deepen your understanding of how things work.
So More Than You Know celebrates learning about the world with an eye
toward building and refi ning the best possible analytical toolbox.
Two sources in particular have inspired me on my journey. The fi rst is the
mental-models approach to investing tirelessly advocated by Berkshire

Hathaway’s Charlie Munger. The second is the Santa Fe Institute, a New
Mexico–based research community dedicated to multidisciplinary collabo-
ration in pursuit of themes in the natural and social sciences.
Charlie Munger’s long record of success is an extraordinary testament
to the consilient approach. For Munger, a mental model is a tool—
a framework that helps you understand the problem you face. He argues for
constructing a latticework of models so you can effectively solve as many
problems as possible. The idea is to fi t a model to the problem and not, in
his words, to “torture reality” to fi t your model.
Certain character traits encourage the mental-models method to blos-
som. Fortunately, these are mostly traits you can choose: intellectual
curiosity, integrity, patience, and self-criticism. Problem-solving success
is not just a matter of IQ. As Munger notes, the great naturalist Charles
Darwin’s worldview-changing results refl ect more his working method
than his raw intellect. On the fl ip side, examples abound of smart people
making bad decisions, often showing infl exibility or a failure to appreci-
ate psychology.
A mental-models approach does not come without a cost, though. You
need to spend substantial time and effort learning about various disciplines.
Without a doubt, too, your learning may not be useful right away (in fact,
it may never be useful). The good news is there are typically only a few big
ideas in each discipline that you’ll need to master.
INTRODUCTION
2
I have learned a great deal from Munger’s musings over the years, and
his infl uence is clear throughout these pages. Fortunately, Peter Kaufman
assembled Munger’s background and speeches in Poor Charlie’s Almanack , a
terrifi c book offering plenty of insight on the mental-models approach.
The Santa Fe Institute sprung from a group of like-minded scientists
who decided the world needed a new kind of academic institution. These

scientists, each distinguished in his fi eld, recognized that universities often
operate in academic isolation; professors spend a lot of time with colleagues
in their fi eld but rarely cross disciplinary boundaries. The founders felt
strongly that much of the fertile scientifi c ground was between disciplines,
and they were determined to cultivate it. Spend some time at SFI’s campus,
and you are likely to see physicists, biologists, and economists all chiming
in with their diverse perspectives on a topic of interest.
The unifying theme at SFI is the study of complex systems. In both the
physical and social sciences, lots of systems emerge from the interaction
of many heterogeneous parts. Examples include human consciousness, the
immune system, and the economy. SFI scientists were early in identifying
the salient features of these systems and in considering the similarities and
differences across disciplines.
The SFI-inspired idea that has most deeply infl uenced me is viewing
the stock market as a complex adaptive system. Embracing this mental
model compelled me to revisit and question almost everything I learned in
fi nance; agent rationality, bell-shaped price-change distributions, notions
of risk and reward. I believe the complex-adaptive-systems framework is
not only a much more intuitive way to understand markets but also more
consonant with the empirical record.
SFI has sparked my interests in disparate topics—sprinkled throughout
the following essays—including ant colonies, power laws, human cogni-
tion, and the role of feedback mechanisms. The best way to describe how I
feel following an SFI symposium is intellectually intoxicated.
You can read about the Santa Fe Institute’s history in Mitchell Waldrop’s
Complexity . While the book came out during the fi rst decade of the insti-
tute’s existence, it captures much of SFI’s spirit.
Finally, a word on how to read this book. Unlike a best-selling thriller, you
can read More Than You Know from back to front just as easily as from
INTRODUCTION

3
front to back. But I recommend you simply go to the table of contents, fi nd
something that interests you, and jump in.
While the essays cover a range of topics, I categorize them into four
parts—investment philosophy, psychology of investing, innovation and
competitive strategy, and science and complexity theory. Consider these
compartments in a toolbox, each addressing a distinct facet of investing.
That said, every essay is meant to stand by itself.
More Than You Know leverages the research of many top-fl ight academ-
ics. But given the book’s format, there is no way to give those academic ideas
their full due. That’s why I assembled a detailed reference section, includ-
ing suggestions for further reading. Hopefully, the references will give you
plenty to dig in to should you chose to follow up on an idea or theme.
My sincerest wish is that More Than You Know provides readers with
some intellectual fun—a new perspective, a cool idea, or a path to self-
improvement. I hope you get a fraction of the satisfaction from reading the
essays that I got from writing them.

INTRODUCTION
4