Sunday, April 11, 2010

Freakonomics: Chapter 3

Charlie Munger says the most important rule in management is "Get the incentives right". Munger argues that the power of incentives is constantly underestimated. In Freakonomics, Steven Levitt shows us how pervasive incentives are in society, and what we can learn from that. Value investors who can grasp the power of incentives put themselves in a position to understand which companies are utilizing the full potential of their managements.

John Kenneth Galbraith coined the term "conventional wisdom", calling it a convenient and comfortable point of view that is often false. Indeed, Levitt argues, much of what we accept to be true really isn't, and only by asking the right questions can we know this.

Levitt believes sloppy or self-interested thinking leads to common beliefs that are actually untrue. Individuals with vested interests will often permeate untruths in the hope of effecting change. Levitt cites examples where advocates for the homeless and women's rights have been known to inflate their numbers to make their causes more significant.

Ideally, we would count on the media to scrutinize the info before it is brought to air, but Levitt argues that the media is a willing participant. They too rely on the self-interested to fill papers with jarring pieces of wisdom that few are going to question. A little creative lying can draw attention and money, for both the expert supplying the data and the media enterprise that helps spread the message. Working together, journalists and experts create much of what comes to be known as conventional wisdom, argues Levitt.

Every day, experts and journalists fill the business news with an explanation for what happened in the market, but are their explanations true, or just taken as such?

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