Tag: capital

Investors, Gamblers, and Rules

Yesterday I was talking with my brother Levi who runs a highly successful financial services company about different types of investors.  As sometimes happens, a 2×2 matrix began to emerge.

This not only describes different investor types but also different types of gamblers.  If you know anyone really into either gambling or investing (this goes for both stock investors and VC’s) you’ve probably picked up some variation of these four basic types.

The types are about the way rules and systems are viewed.  I’ve spoken with a great many investors who live by them.  They tell me their sound rules built on solid theory and insight are the only thing that keeps them disciplined and keeps emotion in check to sustain long run returns.

Others say that if rules worked everyone could be rich.  It’s only by breaking rules and being unbound by rigid formulas that you can win big.

I suspect that both of these are true and the key might be to discover your own personality, risk tolerance, and unique intelligence or insight that you do (or do not) bring to the table.  Some people need rules.  Some people would be hampered by them.

Here’s a rough attempt to show some archetypes in the investor world that might illustrate the four categories:

Archetypes

If you don’t recognize some names or you’re not sure what is meant by them, here’s a chart that describes the characteristics of each:

Description

If you recognize these categories, which are best to work with?  Say you are seeking funding for some project or startup.  Some investors have very tight criteria for who they’ll work with.  It can be good and it can be bad, depending upon what you want and what the criteria are.  Many people imagine that the best case would be an investor with no rules, who they could win over on gut instinct and then have a smooth, easy process of getting funding and using it.  This may be true, but it could also mean a) you get no valuable insight from the investor or, b) you get weird, unpredictable phases of meddling and odd requests for pivots.

This chart gives a little description of what working with each category might be like:

Working with

I don’t pretend to have a lot of experience working with investors or gamblers, but I’ve been around enough to see these types pretty clearly.  I’m probably missing some big things and offending some people, and my descriptions may not be reflective of your experience.  This is the result of one short conversation, not a lot of study.

If you strongly disagree or see something I’m missing, hit me up with your take!

Where Are All the Factories?

My wife and I recently watched a few seasons of Stargate Atlantis on Netflix. (Go ahead, say it.) Something that always bugs me about the show and many like it is the incredibly unrealistic way in which alien societies are portrayed.

There are countless episodes where the team finds a new planet with a thriving civilization. No matter what period of development the people are in, they always have a vast array of highly produced goods. Villages have houses with uniform, manufactured bricks, panes of glass, ornate wood and metal work, produce and meat, cooking utensils, tools, textiles, weapons, and on and on. These items require an expansive division of labor, a high degree of specialization, and a very deep or “round about” capital structure. Yet there is rarely any indication of these things. Most societies only have raw materials, like land and some farms or pastures, and consumer goods. It’s seems these societies magically convert raw materials into serviceable items with none of the complex, multi-layered in-between processes required in the real world.

It’s possible the writers cannot portray these features due to constrained budgets. After all, we see the same set re-purposed with a few small tweaks to represent several different villages. When the plot-line isn’t about the structure of society, it doesn’t make sense to spend a lot to show the way it works. But often the plot is built around the way the society works.

One episode had cities that followed orders from a computer screen, and structured their way of life to fit exactly what they were told, a la Sim City. They’d switch from making furniture to steam engines overnight. Somehow the invisible capital, labor and knowledge markets seamlessly switch course, and no major shortages or surpluses result. The childish absurdity of this is hard to fathom.

If it’s not because of budget, perhaps the simplistic portrayals are a reflection of the economic ignorance of the writers. It’s sad that so many intelligent people are utterly unaware of how the market works. It’s sad that so few have tried to contemplate the incredible complex dance of unplanned coordination required to produce a single, simple consumer item. Yet the fact that so many can be so ignorant of the workings of the market is also one of the things that makes true capitalism so great.

These writers are showing the world as they experience it. A huge marketplace of end-products, available everywhere you look in dizzying array. Their experience is one in which they have access to the products of the free market, without having to understand or even be aware of the incredible process that took raw materials, capital, ideas, and labor, and transformed them. No one has to be an economist or an expert in any field or industry to participate in a capitalist system; indeed to meaningfully contribute to that system through their actions.

As much as I’d love Hollywood writers and everyone else to understand the full-fledged spontaneous beauty of the market, I’m even more excited that they don’t have to in order for the market to serve them.

Was Adam Smith Wrong?

Here’s an article I originally wrote for the Prometheus Institute.

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Disagreeing with a man whose face appears on the necktie of many a freedom-lover is perhaps dangerous, but sound reason can’t be sacrificed on the altar of great men – and Smith was a great man.

Indeed, Adam Smith, in his depiction of the division of labor in a pin factory and his timeless prose on the invisible hand and the self-interest of the butcher, offers some of the greatest explanations and defenses of capitalism ever written, even some 230 years later. I consider Smith a great thinker, and a hero of liberty. That doesn’t mean he was never wrong; particularly when it comes to the question of value.

Smith’s thoughts on the derivation of value in his Wealth of Nations laid the groundwork in this area for later thinkers like David Ricardo (another brilliant mind who was right about many other things) and eventually Karl Marx. In the case of the latter we have clearly seen how bad ideas can have horrific real-world consequences. As John Maynard Keynes famously remarked,

“Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

I might add too the bad ideas of otherwise good economists.

Smith essentially, though somewhat confusedly, argued that the value of any good was ultimately derived from the amount of labor it took to produce. Money or commodity prices reflected only the nominal but never the real value of a good. In this way he described the different prices of different goods as a simple formula:

“If among a nation of hunters, for example, it usually costs twice the labor to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer.” (The Wealth of Nations, Book I, Chapter VI)

Smith elaborated further by describing other costs of producing a good, including the role of the entrepreneur and capitalist and the profits they require. Unlike Marx, Smith never denigrated the role of the capitalist or the profits they earned, but his conception of value resulting from the cost of production (ultimately labor) opened the door for the idea that anything charged or earned above the cost of real inputs is unnecessary; excellent fodder for anyone anxious to obtain power by appealing to an envious middle class.

The problem with Smith’s analysis is not that the cost of production has no link to the value or money price of a good – indeed, the two are closely connected. He merely had the relationship backwards.

In reality, prices reflect the money equivalent of the value a buyer places on a good. That is to say, an individual who wishes to have a good places an entirely subjective value upon that good as compared to other goods, and the difference is typically expressed in terms of money. If in Smith’s example no one cared for beavers, the cost of killing a beaver wouldn’t matter; the beaver would sell for little or nothing. There is no one value of a good, but each individual values each good differently, as compared to other goods. It is the same for Smith’s supposedly changeless measure of value, labor. An hour of the same kind of labor may be valued (or disdained) to different degrees by different people.

It is for this reason that price is merely the reflection of the amount of money an individual was willing to give up to obtain a given good in the most recent exchange.

However, Smith was correct in seeing a relationship between the cost of production and price: Once a producer or entrepreneur has an indicator of what someone was willing to pay for a good, he can speculate how much others will be willing to pay in the future. He may be incorrect, but he will start with an estimate based on past experience and hope to get an equal or higher price. It is the estimated price (which reflects the value others place on the good) that will dictate how much he can spend on production. If a producer expects a good to sell for $1, he will be willing to spend up to $0.99 to produce it. (This is obviously a simplification, as he may be willing to take short term loss if he expects long term gains, he may want more than a $0.01 profit, etc.) In other words, the amount of labor and other costs of production flow from the expected sale price of the good, not the other way around. No one will spend more to produce an item than they believe others will be willing to pay to buy it.

Smith correctly saw that the various costs which go into production must be paid by the sale price of the final good. What he failed to see is that the costs of production do not create the price of the final good or imbue it with some objective value, but that the subjective value that each consumer places on the good sends signals backwards to producers and tells them how much they can expend on production without suffering a loss.

That Smith saw the factors which go into the production of a good as the cause of the price, rather than the effect, may seem like a small error. But economics, like all attempts to study the behavior of human beings, is a subtle science which requires great attention to the correct logical progression of actions. A misunderstanding between cause and effect can be fatal.

A slight adjustment to the angle of a satellite signal can, when extrapolated over thousands of miles, result in a beam nowhere near its target location. Likewise, looking at an economic phenomenon, such as the price of a good, from an even slightly incorrect angle can result in consequences far greater than imagined when spread over time and by different minds in different cultures. I would never single-handedly blame Adam Smith for the horrors of socialism. But his backwards theory of value contributed, over time and space, to a set of ideas which laid the theoretical groundwork for socialism – a philosophy completely contrary to the views of Smith.

I still admire and respect Adam Smith as one of the world’s great minds and a positive force in the battle for liberty. His conclusions and prescriptions were correct, even though his methodology was sometimes flawed. However, the lessons to be gleaned are to never let admiration for a great mind blind you to areas in which they are in error; and that even correct conclusions, if based on incorrect reasoning, can be dangerous.