Letter to Learners, July 2019
Incentives, Focus, and Developing Your Circle of Competence
I started circleofcompetence.co nearly a year and a half ago, and since then, I have been on a weekly reading and learning binge. There are worse things in life to binge on than good reading material, but even so, most days I don’t take enough time to just sit and think. As Charlie Munger once opined, ‘most people calculate too much and think too little.’ Thus, the idea for a less frequent “letter to learners” was born out of the need for time to sit and think about what I’ve been learning. The best way I have found to keep a personal promise is to go public with it. The social pressure (whether real or perceived) can be a heavy, but positive behavioral bias if you’ve gone public with a goal, so here’s to structuring personal incentives in a positive direction!
Business involves people, people have drives and emotions, and these drives can be largely swayed by the set of incentives in place in society and at work. I have moved beyond the idea that a company is a set of numbers to be analyzed rationally on paper. These numbers represent the collective efforts of people who are anything but rational. While in school, you learn so many theoretical concepts relating to financial analysis, strategy, market dynamics, but one concept you hardly ever focus on is how incentives are structured. Let’s look at a few examples.
Wells Fargo’s incentive structure was based solely on new account sales and the pressure was slowly raised to pressure-cooker levels. I have found that incentives mixed with other social pressures almost always results in behaviors in the direction of least resistance and/or highest reward. The sales members had three options: either upsell their clients (who had no interest in opening 5 checking accounts), get laid off (“I can’t afford not to feed my family”), or open fake accounts (“Everyone else is doing it…”) You get what you incentivize.
Facebook prioritized and incentivized growth over every other metric. Google’s YouTube did the same. And now, facing unintended consequences of radical user generated content and user polarization as a result of their reinforcement algorithms at play, they are under the regulators’ microscope. You get what you incentivize.
Seth Klarman, the CEO of Baupost Group, gave a speech to Harvard Business School students warning them of the pitfalls of short term thinking in business and encouraging them to be part of the solution not the problem. The current public markets system is set up on a quarterly timeline, which can lead to some very bizarre, if not downright fraudulent behavior by executive teams. You get what you incentivize.
Too often, we forget that people are driven by the incentive structure set before them both from an employment as well as societal perspective. What is always harder to understand is how the incentive structure will play out – did Facebook set out to undermine democratic ideals using its growth algorithms and newsfeed content? Did Wells Fargo set out to open millions of fake checking accounts? I doubt it. But when you prioritize and incentivize certain outcomes without moral checks in place, you can see how incentive structures can produce deeply disturbing outcomes. Conversely, when you have simple incentives in play with clear moral boundaries, the outcomes can be a beautiful synthesis of good business and rational human psychology.
Related to incentives bias: Charlie Munger on behavioral biases and the causes of human misjudgment
Earlier this year, I wrote a longer piece on focus so I won’t rehash what I said there, but want to make a couple additional points.
1. Focus is merely the investment of attention.
2. It is better to invest your attention in a small handful of skillsets that you do well than in too many in which you are mediocre.
Buffett and Munger (and many other famous investors) are known for holding concentrated portfolios of good companies in their early careers rather than spreading bets over tens or hundreds of various companies. Much like focusing on a handful of good companies, focusing on a few useful skills and activities early on in life results in similar compounding returns on your time invested.
In today’s over stimulated society, there are two ways we can do better in the area of focus. The first is to decide what skillsets and activities are most meaningful to you, and progressively eliminate others that do not fall under the ‘essentials’ category. Second, the best way to start focusing on those skillsets and activities is by eliminating the sources of over-stimulation (iPhones, TV, extraneous news sources, etc.).
Guy Spier, in his book The Education of a Value Investor, describes how he spends hours at a time in a room removed from his phone just to focus on reading and researching investment ideas. I have begun challenging myself with ‘sprints’ of 2-6 hours of uninterrupted time with no screen time and it has helped me accomplish far more in those windows than I would otherwise because I remove the all-too-familiar craving to check the latest notification.
Quote from relating focus and solitude (sitting and thinking):
“Focus without solitude does not allow for deep development, and solitude without focus leads to aimless pursuits.”
In order to focus, it is essential to pare down your choices in order to make decisions and avoid the paradox of choice (Barry Schwartz).
“Remember that if you don’t prioritize your life, someone else will.” – Greg McKeown, author of Essentialism: The Disciplined Pursuit of Less
Developing your Circle of Competence
Finally, I've been thinking a lot about how to know and how to develop one's Circle of Competence. What follows is a framework for thinking about your own circle of competence, specifically how your circle of competence develops, and how to make decisions using the framework.
Developing your Circle
After retracing my steps in the development of my own areas of competence, I began to grasp an emerging pattern - a progression that every one of my deepest skills traced before I reached confident competence in the area. To be clear, this framework can be applied not only within the realm of investing but also generally as a good decision-making tool.
Can you remember how you started learning about a subject like, say, investing? I'll tell you. Your curiosity was sufficiently piqued. What happened next? This led to a process of knowledge gathering. You picked up a Warren Buffett shareholder letter or Klarman's Margin of Safety or a biography of a legendary investor, and the subject simply came alive.
“It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find you can talk to him for years, and show him records, and it just doesn’t make any difference... It is instant recognition or it is nothing.” -Warren Buffett
Now, can you remember a subject where your curiosity was piqued, but quickly waned after pursuing knowledge within that space? If so, you will understand necessarily that sufficient curiosity is a prerequisite for building a base of knowledge in an area. Curiosity flows over into a pursuit of knowledge. If there is not an overabundance of it, the desire to learn the given skill or area will cease.
When curiosity is sufficient, knowledge begins to grow, just as sufficient nutrients in a garden leads to an abundance of growth. But how does knowledge grow? I want to posit that it is not linear, but exponential. It is very common, in the beginning stages of knowledge or skill accumulation, that progress is slow. Concepts are difficult. Confusion abounds. Over a very limited timeline, a linear process tends to outpace an exponential process. Humans tend to be terrible at extrapolating exponential processes into the future, and in the case of knowledge accumulation, this can be the sole reason curiosity wanes - development of a particular skill or area of expertise simply isn't occurring fast enough. Hang with it. The exponential process is slow at first, but will eventually reach an inflection point.
In fact, the exponential learning process takes place in 3 steps.
Level 1 - Grasping in the Dark
One of the biggest risks and cognitive biases in the beginning stages of knowledge accumulation is what is known as the Dunning-Kruger Effect. Have you ever known someone who thought they were an expert in an area, only to find out later that they've read a popular book on the subject and simply regurgitated the high points? This is the essence of the Dunning-Kruger Effect: the idiot expert. He summits Mt. Stupid (see above) and roars in triumph.
To avoid this bias, the best thing to do is for the learner to keep humility and Socrates in mind:
"I know one thing; that I know nothing." – Socrates
In the beginning, as stated above, progress is slow. You don't know what you don't know. Press on.
Level 2 - Walking in the Light
Here, you begin to understand the map of the area of expertise. You begin to know what you don't know, and pursue it. As the graphic above shows, you begin to truly understand the depths of the subject or skill you are studying, and realize how much you have left to learn.
Level 3 - Performing Blindfolded
You know the map of the territory so well, that you can 'perform blindfolded', metaphorically speaking.
After reaching Level 3 knowledge expertise in a subject area, you develop a conviction around the idea, philosophy, or skillset. Conviction represents the tipping point. It is built slowly throughout the knowledge accumulation process, but the rubber meets the road when you are willing to put your own skin in the game - your time, your efforts, your capital. This applies the same way to finding your spouse as it does to investing in a business. Are you convicted that, based on your knowledge and experience, you are willing to invest time and effort into the relationship? Are you convicted, based on your knowledge accumulation, that this particular company is worth your capital? Are you convicted, based on your skill set and knowledge of the industry, that this start up idea is worth your time, effort, and capital? Intelligent conviction follows a long buildup of curiosity that overflows into a knowledge building process.
To be clear, sometimes resource limitations - namely limits of capital and time - can limit your step from conviction to action. What to do? If capital is the constraint, I'm a firm believer that capital finds competence and vice versa. If time is your constraint, is there a way to leverage others with the same level of conviction and competence as you? You merely need time or capital, along with a healthy dose of competence, to proceed to action in an intelligent manner.
As we think about how to proceed from conviction about an idea or investment or decision, I want to point out (as Munger always preaches) the need to invert the idea to truly understand it. Here is how NOT to generate conviction about a particular subject.
Per the Dunning-Kruger Effect (see above), a novice sometimes develop the cognitive bias that, because he knows a little about a subject, he thinks he knows all about it. This is how knowledge turns into action prematurely.
When one person takes action based on conviction developed from insufficient knowledge, this is a small tragedy. But when a large number of people form convictions with insufficient knowledge, well, this is how a bubble forms. Rising prices tempt more and more ignorant retail investors to purchase an asset. It's agonizing to watch your neighbor get rich off of [fill in the blank with: tech stocks | real estate | cryptocurrencies ], so you jump in. Think of all the house flippers pre-2008 that got into the ‘game’ because everyone else was making easy money. The people left holding the bag as the markets fell off a cliff were case #1 for how premature knowledge leading to premature action can be financially devastating. I can't put it more clearly: develop sufficient knowledge about a subject (i.e. make sure it is well within the circle of competence) before you take actions that are potentially life-altering.
Once convicted about a subject, decision, or idea, the need for action becomes apparent. Whether this is purchasing a stock, buying a piece of real estate, taking a job, deciding to marry a spouse – the decision framework of curiosity, knowledge, conviction, and action applies the same way.
“A few major opportunities clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind, loving diagnosis involving multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past."- Charlie Munger
To sum up, curiosity begets knowledge which builds exponentially. More knowledge eventually leads to a tipping point of conviction, whereby one believes the subject area (or person or idea) is worth their time, talents, and capital. This conviction leads to action when resource constraints are lifted. In general, I think that this framework of curiosity, knowledge, conviction, and action is representative of how one’s circle of competence is developed. Each step is a prerequisite for the next, and competence in any area cannot be reached without sufficient time spent at each step along the way.
Have I missed something? I appreciate any comments, feedback, and resources in the areas I’ve discussed above. Feel free to drop me a line at firstname.lastname@example.org.