Saturday, April 17, 2010

Freakonomics: Chapter 4

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.

In this chapter, Levitt illustrates a great number of economics-related lessons that can be learned from the national drop in crime that took place in the mid-1990s and the media reaction to it.

Certain members of the media will always extrapolate trends into the future without understanding the underlying causes of those trends. Crime was on the rise for several years preceding its peak, and "experts" were proclaiming that the worst was yet to come. When a stock or market rises or falls, the media will make headlines with scary and astonishing predictions of the future.

When "experts" are proven wrong, they will often remain overconfident in their abilities to predict, explaining away their faulty predictions with excuses. When crime did not rise as anticipated, many experts claimed it was the alarms they raised that put into motion counter-effects that helped quell crime. When stock market analysts are wrong, they use a range of excuses from ceteris paribus to if-only defenses.

When an event has occurred, the media and experts will all try to explain it, but many will do so on hypotheses without basis. To explain the drop in crime, the media cited several specific reasons. Levitt, however, goes on to show that only three could have contributed to the drop in crime, while the others cannot be shown to be effective from the data. Every day, we are offered explanations for why certain markets/stocks/commodities went up/down, when in reality very little evidence is offered up to back these claims.

Levitt also provides his own theory of the major reason for the crime drop in the mid-1990s, and backs it up with a great deal of data interpretation.

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