Freakonomics: Chapter 6

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.

Levitt continues to use the economic tool of regression analysis to illustrate some correlations which are not widely known. Levitt notes that in the aggreggate, white and black parents give their children very different names. Therefore, he sets on the task of determining whether the names of children tend to affect their socioeconomic status later in life.

Some startling research has shown that job applicants with "black" names are less likely to get call-backs from potential employers (This research was done by sending out large resume samples to employers, some with black names and some with white names.) Furthermore, Levitt finds that an adult with a "black" name does end up with a lower socioeconomic status.

But using regression analysis, Levitt explains that after holding other factors constant (e.g. race, income, education etc.), a person's name actually matters not in his future success or lack thereof. Parents, however, spend great time and resources coming up with a name that will set their child up for success. In doing so, Levitt has found that popular names filter down the status levels, with popular names among high-income earners becoming popular names among the general population some years later.

People (illustrated here in the last two chapters using parents as an example) routinely put resources into factors that they cannot control. In doing so, they will often ignore factors that are important. Managers should seek to educate themselves so that they may apply their time towards efforts that yield positive results.

Freakonomics: Chapter 5

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.

Levitt makes an argument that we do not use data enough to come to the conclusions that we come to. We rely on our pre-determined beliefs and biases to draw conclusions, and rarely seek out objective information. Nowhere is this more apparent than in the management of offspring: parenting.

In a house that contains both a gun and a swimming pool, children are roughly 100 times more likely to die in the swimming pool than at the hands of a gun. But our beliefs about the dangers of guns ensures the focus is on the gun rather than the more apparent danger, drowning.

Levitt uses economic tools (namely, regression analysis) to figure out the role of various parent initiatives. A regression analysis is a statistical tool that allows the scientist to control several variables from within a mountain of data, thus allowing us to determine which variables have an effect on the output.

From this analysis, Levitt was able to determine that genetics plays a much larger role than it is given credit for. Furthermore, when holding all other variables constant (e.g. incomes, school quality etc.), a child's race does not determine its financial future. Specifically, these are the factors that are strongly correlated to a child's test score performance in the US:

1) Educated parents

2) Parents have high socioeconomic status

3) Mother was 30 or older at the time of her child's birth

4) Low birth weight (negative factor)

5) Parents speak English in the home

6) Child is adopted (negative factor)

7) Parents are involved with the PTA

8) Many books in the home

According to the data, the following factors do not matter:

1) Family is intact

2) Family recently moved to a better neighbourhood

3) Mother didn't work between child's birth and kindergarten

4) Attended Head Start

5) Is regularly taken to museums

6) Is spanked regularly

7) Watches television frequently

8) Is read to frequently

It's important to note that a regression analysis can only show correlation, not causation. That is, the first eight factors above may not cause higher test scores, as there could be another factor that causes both one of these eight factors and the higher test scores to occur simultaneously, or the causation could be reversed (e.g. higher test scores could cause a higher interest in books, leading to more books in the house).

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.

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?

Freakonomics: Chapter 2

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.

Even if incentives exist for a particular action, information assymmetries can cause destructive outcomes. Levitt discusses various corporate scandals, and how they were caused by certain groups possessing information that other groups did not have: research analysts Henry Blodget and Jack Grubman wrote positive research reports about stocks they knew to be junk; Frank Quattrone covered up investigations into his company, Credit Suisse; Sam Waksal and Martha Stewart dumped shares of ImClone on inside information; managements have fabricated billions of dollars in revenues.

All of these situations exist because one group has information that other groups don't have. They seek to profit not by normal means, but by exploiting this information differential. They do this by either promoting false information, or hiding true information.

Most types of crimes leave visible victims, such that even if the perpetrators aren't caught, it is known that a crime has been committed. Such is not the case with respect to crimes of information, which can go completely undetected.

You are more likely to listen to the advice of an expert. But because of information assymmetries, the expert may be acting in his own interest. The weapon of choice for such experts is often fear. "If you don't agree to this surgery", or "without this safer car", or "by not accepting this offer for your house", "the consequences may be dire".

The internet is a useful tool in reducing information assymmetries, but they will always exist to some extent. Readers may wish to follow the advice of Charlie Munger: "Fear advice that, if implemented, is good for the advisor. Learn the basic elements of your advisor's trade, and double-check/disbelieve much of what you're told."

Freakonomics: Chapter 1

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.

It is not easy to design incentive schemes, because the underlying behaviour such schemes encourage are more complex than they originally appear. Levitt argues that there are three types of incentives: economic, social, and moral. A scheme designed to provide an economic incentive can often cause havoc with the social and moral incentives, resulting in a surprising outcome.

Consider an experiment done at a daycare where parents would often pick up their children late. A small fine was instituted in order to discourage late pick-ups. The daycare expected on-time pickups to rise, but instead, the opposite happened, and late pick-ups soared! Levitt argues that this is because the economic incentive did not compare to the counteracting moral incentive that was now removed: with the fine, parents were implicitly told that it was okay to pick up their children late, as long as they paid the fine. When the fine was removed, late pick-ups did not drop back to their original levels. Now, parents no longer felt guilty about late pick-ups, as the moral incentive had been removed.

Would a larger fine have caused the economic incentive to be larger than the moral one it failed to substitute? Perhaps, but economic incentives that are too strong often have other unintended effects.

Cheating is an economic act: getting more for less. Levitt discusses a few examples where cheating has occurred because the economic incentives were so strong. He discusses data grabbed from school boards that appears to show teachers were actually changing student responses on standardized tests, as teachers whose students performed well were often awarded large bonuses.

Would massive option and bonus payments cause Wall Street executives to cheat? Obviously, we all respond to incentives, both negative and positive. If you touch a hot stove, you get burned. If you speed, you receive a fine. These are just two examples of every day occurrences that shape our behaviour as a result of the pain or rewards we receive in response to an act we commit. But sometimes incentives are so complex that they can result in unintended behaviour (including cheating, and a removal of other incentives) that can offset the intended benefits!

Freakonomics: Introduction

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.

While the tools of economics are often applied to understand data about jobs, real estate, banking and investment, economics is a science of measurement that can be applied to a range of other subjects. This book uses these economic tools to break down a wide variety of interesting topics, and is based on the following fundamental ideas:

1) Incentives are the cornerstone of modern life

2) The conventional wisdom is often wrong

3) Dramatic effects often have distant, even subtle, causes

4) Experts use their informational advantage to serve their own agenda

5) Knowing what to measure and how to measure it makes a complicated world much less so

To demonstrate these ideas in action, Levitt takes the reader through a few quick examples in the introduction. First, he discusses the crime wave in the United States of the early 1990s. Crime was on the rise, and all the experts were saying that it would continue to do so, for various reasons. Instead, crime - of all types - started to drop in dramatic fashion, and once again the "experts" had their explanatory, after-the-fact opinions (perhaps much like the media attempts to explain daily stock price movements). But Levitt argues that they all missed the boat. Instead, he argues that the legalization of abortion in 1973 (which occurred during Roe vs Wade) is the biggest reason that crime started to drop in the mid-1990s and continued to do so. Many of the people who were most likely to commit crimes (those born of poor, unmarried, teenage mothers) were not born!

Secondly, those who believe a real estate agent is on their side are sorely mistaken. On the surface, it seems as though an agent's incentives are aligned with those of a prospective seller. After all, the realtor's final commission is tied to selling price. Levitt demonstrates, however, that after expenses and sharing commissions and kicking up fees to the company, a real-estate agent doesn't make a whole lot for incremental increases in price. For example, on a $300K house, the seller would get $9400 for a 3% increase in price, but the agent's additional share is just $150. As a result, an agent just wants to get a deal done as quickly and effortlessly as possible, rather than put in a whole bunch of extra time and work to get the seller the best possible price.

Are real-estate agents simply a special breed of sleazy slime balls? Not really, as Levitt argues this type of thing is common to all professionals, including doctors, lawyers, auto mechanics, plumbers etc. The difference, though, is that real-estate data is abundantly available, and so it is easy to demonstrate this phenomenon with this particular group. Levitt separated real-estate data into two groups: in the first, the agents were selling their own homes, while in the second, they were selling other people's homes. Levitt found that agents left their own homes on the market for 10 days longer, and sold them for an extra 3% (all other factors equal).

Finally, Levitt tackles the issue of money and politics. While most people believe elections can be bought, Levitt argues that the data just doesn't support this. The winning party does spend more money than the losing party, but many confuse the cause-and-effect of this relationship (like the czar who heard that the most diseased region of his country had the most doctors...and subsequently ordered all doctors killed). Most campaign donors want to support a winner, which is why the winner spends the most money. To show this, Levitt looked at campaigns where the same two candidates went head to head and different amounts of money were spent. Levitt found that halving ones campaign spend resulted in only a 1 point drop in final performance.