Thursday, August 20, 2009

Munger: The Hammer Syndrome

From this Charlie Munger speech at UC Santa Barbara:

"The big general objection to economics was the one early described by Alfred North Whitehead when he spoke of the fatal unconnectedness of academic disciplines, wherein each professor didn't even know the models of the other disciplines, much less try to synthesize those disciplines with his own.

"The nature of this failure is that it creates what I always call, 'man with a hammer syndrome.' And that's taken from the folk saying: To the man with only a hammer, every problem looks pretty much like a nail. And that works marvelously to gum up all professions, and all departments of academia, and indeed most practical life. The only antidote for being an absolute klutz due to the presence of a man with a hammer syndrome is to have a full kit of tools.

A special version of this 'man with a hammer syndrome' is terrible, not only in economics but practically everywhere else, including business. It's really terrible in business. You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." - Charlie Munger

You can't quantify all the risks of an investment but those risks are there. In the footnote of yesterday's post regarding the capital asset pricing model (CAPM) I mentioned that:

My preference is to just discount using the U.S. Treasury rate then separately make a judgment on investment specific risks and uncertainties.

Plugging a risk premium into a formula and acting like that covers it is a sloppy way to deal with the responsibility of evaluating risk. It doesn't replace thinking through consequences of what Charlie calls "the hard-to-measure stuff".

Use of a higher discount rate to account for risk might give some false sense of comfort but that's about all.


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