Why I stopped reading Antifragile at page 43

I am a big fan of Fooled by Randomness and The Black Swan. I however decided to give up on Taleb’s new book, Antifragile (which I borrowed from library) , after just 43rd page.

It is likely I am not able to appreciate the dense matter the author presents in this book. It is also possible, the author may mention other factors like choosing easy over hard. Or that I am happy to give up because I only borrowed the book from the library and didn’t buy it (although I would do the same because the cost of book is sunk).

It is also possible I was put-off by the offensive stance the author takes in defending his idea against the establishment and al those who according to him refuse to understand antifragile is the correct opposite of fragile (and ot robust).

I cannot also rule out that the theory of antifragile is supported only by the every data that is used to develop it.

But the real reason is what I read on page 43. Here are some snippets, my peeves with those and hence my decision to return the book.

They say best horses lose when they compete with slower ones and win against better rivals

Where is the data? How can a statement like “they say” find its place in a book proposing a new theory?

many do  better in Calculus 103 than Calculus 101

Isn’t there selection bias here? Isn’t it likely that very few move on to take Calculus 103 and hence are likely more interested in it?

If I find these problems in subjects I remotely understand what if I do not find other such bigger problems in subject areas I do not understand?

Hence my decision to punt on the book.

It costs 6-7 times more to acquire new customers over retaining existing ones …

No my account was not hacked (not yet, at least). I deliberately let this commonly repeated statement be the title without qualifying it.  Of course statements like these, (this particular one made famous by Loyalty Effect) cannot stand by themselves regardless of how popular the Guru who said this is.

Let us look at this closely

1. Let us assume this statement is true. So shall we fire our sales team, shut down all marketing spend, stop product innovations and get rid of business development?  After all this statement indicates new customers are far more expensive. Then why bother?
2. Let us take it to the extreme. Shall we stop after the first customer?
3. Extending this even further, say you acquired the first customer at a cost of $1 and second at the cost of $7. Then by this logic does it cost $49, $343 etc to acquire third and fourth customer?
4. What if you are essentially in a transactional business where you really need new customers every day because the current ones won’t be there tomorrow?
5. How do you know it is 6-7 times or only 6-7 times? What are the data and metrics used? Was it based on experimental study?
6. How generally applicable is this to your businesses – small and large, early stage vs. mature? Is the cost the same to all businesses?
7. What about profits from new customers, is that 6-7 times as well?

You can see how ridiculous the statement sounds now. Here is a further breakdown of problem with this retention vs. acquisition costs statement.

First it is framed around cost and does not base it on marginal benefit and opportunity cost. I also doubt that the proponents know how cost accounting is done and most likely are allocating all kinds of fixed cost share to new customers. You need to have a costing system that can correctly capture only truly incremental costs for both acquiring and retaining. Simply distributing all costs to all customers won’t cut it.

Second it suffers from sunk cost bias. The fact that you spent some money to acquire a customer in the past does not matter in the decision to do everything to retain them. If you cannot recover the acquisition cost it is sunk. You should only look at future unearned marginal profit from each customer – existing or new. At decision time of spending capital on retention vs. acquisition you need to compute the opportunity cost and truly incremental profit from each path, not encumbered by the money you have already spent on existing customers.

Third, if the cost of acquisition is indeed high don’t you think you have a marketing problem? Is it likely that you are targeting wrong customers in wrong places with wrong product, versions, messaging and prices and hence wrong low value customers are self-selecting themselves to your service? Don’t you want to spend your resources fixing this strategic problem vs. worrying about retention?

Lastly the Innovator’s Dilemma.  What if the current customers are NOT the representation of future?  By choosing to focus your resources on them instead of new customers do you lose sight of new market opportunities, how the customer needs are evolving and how their choices for the job to be done are impacted by market trends and innovations?

Does the retention vs. acquisition pronouncement sound as profound as it did before?  I hope not.

How do you make business decisions?

If you are asking entrepreneurs to be rational

What is the biggest resource an entrepreneur can waste? According to Kevin Ready, author of  “Startup: An Insider’s Guide to Launching and Running a Business, it is not money. Ready says it is time spent trying to keep a start-up live long after its viability has been discredited.

Kevin Ready says,

I call this creature a “zombie start-up.”
… many intrepid entrepreneurs hold on and continue the vision — sometimes for years. Herein lies the true cost and risk of start-ups: Time.

When you hold on to a dead idea at the expense of other possibilities, even though you are not burning cash to keep it alive you are keeping yourself away from what you could be doing elsewhere.

Time is the one resource that we can never recover. The opportunity cost for chasing the wrong idea is immeasurable. What is the cost of a lost year? How about two years? A decade?

Kevin Ready makes a very good point. (Although he says we can’t put a price tag on time lost. We can.)

I would also add a close relative of opportunity cost,  sunk cost. Many are not able to walk away because they have already sunk so much of their time and money into the venture. Doing so may seem like they are wasting their “investment”.

But recognizing sunk cost bias, walking away from what is sunk and taking into account opportunity cost before making choices are rational behaviors.  If entrepreneurs are wired to do scenario analysis, calculate expected value over all possible options, consider opportunity cost of leaving their current job, etc.,  they would not be entrepreneurs at all. (See The Mind of an Entrepreneur and that of an Analyst.)

It  takes an irrational sense of optimism to believe their venture will be a big success when the base rate says less than 3% of the ventures live past their third year.

It is the irrational sense of optimism that makes an entrepreneur.

Don’t ask those irrational optimists to look at opportunity cost.

Mental Accounting and Other Errors in Home Buying

Image via Wikipedia

Homeownership –  the American Dream. The one that contributed significantly to the Great Recession and is still responsible for the slow recovery we are seeing. There is some change in this love to own a home, among some demographics,  but not much to call it a shift.

To explain why we still prefer buy vs. rent will take a book, so let us keep it brief and look at the errors we commit in our thought process. There was an article in The Washington Post that wrote about a research that found, “Average American’s don’t think like Economists”.

Are economists average? – "Average Americans don’t think like economists" – The Washington Post http://t.co/Q6AAaaCF via @alexpozin

— Rags Srinivasan (@rags) January 28, 2012

That explains a lot about our love for buying homes.  I should add, when it comes buying or selling their own homes most economists don’t think like economists.

1.  The Seller pays all the realtor fees– The first thing any realtor will tell a prospective homebuyer is, “you don’t pay me anything, the seller pays me“. Conflict of interests aside, how does the seller really pay? It does not come from a different pot the seller has. The seller pays by including it in the price of the house.A moment’s reflection will convince  you that the day you sign the 2564th document they thrust in front of you during closing, you are down 5-6%. In other words even if you sold the house the next day you will lose 5-6% of the price you paid.
2. Rent is down the toilet – Rent is an expense. By extension every expense we make is down the toilet. Besides this ignores the fact that your interest payments, most of your monthly mortgage payments are just that in the first few years, are down the toilet too. Interest is the rent you pay to use the bank’s capital to buy the house.
3. Interests are tax deductible, rent is not – True and this could be used as a another point to bolster the case, “rent is down the toilet”.  First there are limits on mortgage interest tax deductions. Second, renters indirectly get the advantages of the tax deduction.
   When you rent a home or apartment recognize that they are owned by somebody who is paying mortgage interest on that property. Because of the tax deduction the cost to own is reduced and hence  more are willing to get into the renting business. As more such owners buy to rent it out, the supply of rental properties increases and hence the price decreases. If there were no deductions fewer people may own rental properties and the decrease in supply will push up rent. Either way renters get part of the benefits of mortgage tax deduction.
4. Prices will always go up –  There is enough data published by Case-Shiller that says prices don’t go any faster than rate of inflation. We all suffer from optimism bias, ignoring the downside and giving higher likelihood to favorable scenarios.
   Even if it did, what does it mean to us to take advantage of the new higher prices? We need to sell the house first. Where would we live then and what would be the costs? If your home price went up so did the whole neighborhood, city,  and state. Unless you are ready to move to a low-cost state there is no upside to the home price increase.
5. Opportunity cost of down payment – This is huge for those buying houses in Bay Area. When you sink 20% of the price of the home in one illiquid asset you are losing out on the opportunity cost of investing the same capital in any diversified fund.
   While realtors tell you, “when stock market goes down you are left with nothing to show for but even when your home prices go down you have a place to live”, you need to ask
   – will my mortgage payments stop? No.
   – Is my down payment safe? No, that is wiped out with just 10-20% down swing in home prices.
   –  will i still have job in the same neighborhood? Unlikely.
   If the stock market is wiped out, will be home market be any better? They are not completely uncorrelated. At least you get diversification when you invest your down payment in a broader market.
6. Locking in my “rent” for next 30 years – This is usually stated as post-purchase rationalization, “at least I know what my payments will be for the next 30 years”.  If the economy goes south, you are liable for the same level of payments even if the market prices for rent are lower.
   If indeed rent goes up, then you need to realize that you are maintaining the same quality of life at a higher cost even though there is no additional money flow. In other words you could rent the home out to take advantage of higher rent and reduce your standard of living by renting a lower quality place for you.  The net is there is no advantage in locking in payments.
7. Unlocking  equity – Homeowners repeat this phrase as if it were a self-evident truth. They speak as if they sold part of the house and cashed out without really giving up that part of the house. The basic accounting equation is
   Assets = Liabilities   + Equities
   When you buy the home it is added to the asset column at the price you paid and the mortgage you took is added to the liabilities. The down payment is added to equities column. The two sides of the equation are matched.
   When market price for homes goes up it does not really do anything to the asset side unless you are doing mark-to-market accounting (which we don’t). If we did that then the assets column will go up. The increase in left side of the equation is balanced by adding the same amount to the equities column.
   What you do when you take out a home equity loan is move some or all of that increased equity to liabilities column.
   The net is, you are liable for the additional loan you take out.  It is not like you are issuing new stocks to convert the asset class to cash.

There you have it, the seven errors in our thinking that leads us to prefer buy over rent.

Other articles:

1. Home Staging – Why our willingness to pay is higher with staged homes?
2. Ignoring the downside – Prices will always go up
3. Slow decline in home prices – why prices are slow to fall
4. Home Prices – Value gap

Living Example of Mental Accounting

We are big fans of Harry Potter books and love seeing the movie version as well. Today was our movie day to see the The Deathly Hallows Part-1.

I am not the most spontaneous of human beings so I had the AMC discount tickets purchased at $7 a ticket. As you might know the rules of such tickets, these are not valid for the first two weeks of the movie unless you are willing to pay an additional $1.50.

I reasoned, the $21 I spent on pre-purchased discount tickets are sunk and the only decision was whether or not to spend the additional $4.50 to see the movie today. I decided to go any way to make use of the rare weekend break.

At the box office I found out that the tickets were actually $6 for the show time we went to. Regardless of that  low price, the kid at the box office said that if I wanted to use my discount ticket I still should pay $1.50 more per ticket.

The $7 tickets have unlimited life but can only be redeemed at AMC.

What is the rational move?

Pay just $4.5 and use the pre-paid discount tickets?  OR

Pay $18 and buy the ticket at current price?

Pricing Always Comes First

In the Japanese animated movie, Kiki’s Delivery Service*(see note below), the little witch, Kiki, decides to start a delivery business using her broomstick flying skills. For one thing, that was the only magical power and there was no other witch in the town. That’s a very good start,

• playing to her strength
• delivering a magical (pun intended) and innovative service
• picking a market where there are no competitors.

Is that enough? What is the plan for monetization?

Her very first interaction with a customer goes like this,

Customer: So what do you charge for your service?
Kiki: I don’t know. I have not thought about pricing yet.
Customer: (stuffing some cash in Kiki’s hand) I think this ought to cover it.
Kiki: (pleasantly surprised) Oh this much for delivery!

Be it a delivery service on a flying broomstick or a product that will change the way we do XYZ, pricing it cannot be an afterthought – a chore to take care of after the fun part of product development.

When you neglect to find the price customer segments are willing to pay before you go to market you end up doing pricing based on cost. Simply tack on a percentage margin to wrongly calculated cost per unit and you have a price. To quote from Henry Ford’s autobiography,

what earthly use is it to know the cost if it tells you you cannot
manufacture at a price at which the article can be sold?

Or paradoxically you act rationally yet not profitably by correctly viewing the cost you have already spent on your data center, product development etc. as sunk cost and decide “free” is the best price. This is based on the assumption that, “customers don’t know they need this product yet. Once they start using, they will fall in love and will pay for it”.

Most definitely price is not something you let your customers decide.  While the narratives we read about customers falling in love with products and paying what they value may capture our imagination, it is not realistic, scalable or repeatable.

The benefits you deliver creates value to your customers and pricing lets you get a fair share of the value created.

If we do not fully understand how our product adds value and hence price it accordingly how can we expect our customers to know what price to pay?

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Note on the Kiki’s story: Used only to set the stage, for illustration and not as generalization. The need for effective pricing and how to do it is amply researched, documented and practiced. We do not need a movie for our pricing lessons. That said, it is a great movie, not just for children.