Monday, August 6, 2012

Gladwell's Tipping Point

Lending credence to those who believe history constantly rhymes, financial bubbles pop-up again and again. Sometimes the asset class that has been gripped by speculative mania is a familiar one, and sometimes it is not. From tulip bulbs to real estate, however, every bubble eventually gets popped. To keep the mania going, a growing amount of money is needed to support it, and eventually there isn't enough.

In the non-financial world, there appear to be bubbles as well. But the currency is not money, but rather opinions and actions. As there are no shortage of those, such bubbles can persist for thousands of years. But what causes such bubbles? Enter Malcolm Gladwell's Tipping Point, which I recently had the opportunity to read.

In the book, Gladwell discusses what it is that causes dramatic changes in trends, such as the proliferation of smoking, fashion trends and crime rates to name a few. Of course, Gladwell doesn't call these trends by the financial term "bubble". That's the word that kept popping up in my mind, though. The processes by which speculative contagion take over asset classes doesn't appear dissimilar from the ones that cause non-financial trends.

The main idea Gladwell attempts to illustrate is that there are three causes of trends: a few powerful individuals (made up of information gatherers and proliferators and/or connectors who spread the word), the stickiness of the item itself (e.g. the appeal of an idea or the attractiveness of an object), and the environment of the time. Whether a trend such as "hush puppy" shoes takes off or not depends on how favourably they interact with these factors, according to Gladwell.

As always, I find that Gladwell tells a very good story. But I find the links tenuous between his conclusions and his evidence.

To take one example, Gladwell essentially argues that crime began to drop in NYC at the end of the 1980s because of certain actions taken by certain leaders that reduced the favourability of the "environment" (the third factor above) for criminality. He tells stories of the demoralization of criminals as a result of graffiti-cleaning efforts that had a ripple effect of eventually reducing violent crime.

While the story-telling is great, I'm not sure the facts support his conclusion. Gladwell's explanation doesn't explain why crime also fell in certain other states in the U.S. at the exact same time, for example. (For an evidence-based, statistical theory of why crime dropped in the U.S. beginning in the 1990s, see Chapter 4 of a book I highly recommend, Freakonomics)

The popping up of bubbles appears to be a constant. The more we can understand them, the more we can protect ourselves from falling prey to one. To that end, Gladwell provides an excellent framework in The Tipping Point for ways to think about how trends get started and grow. But this is a field where controlled experiments cannot be done. As such, true causes and effects are difficult to identify with any certainty, and I believe the conclusions of this book suffer from that limitation.

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