09 Oct That Which Grows, Slows
One of the most consistently problematic decision-making biases is the overweighting of recent data and personal experiences. Psychologists Daniel Kahneman and Amos Tversky attributed this tendency to what they called the “availability” heuristic (rule of thumb): our minds give inordinately heavy weighting to the most readily available/recent/vivid data and experiences. This causes us to believe that the future will likely resemble the most recent past. As a result, we tend to extrapolate prior trends into future estimates in many domains, ranging from career and compensation expectations to global macroeconomic projections. Unfortunately, it is usually when conviction in these expectations is highest (i.e. the trend has been intact for a while) that mis-estimation is most likely to end with violent disappointment.
This is especially true with exponential growth. The fact is, all growth is unsustainable. I encourage anyone doubting this statement to view the video by physicist Al Bartlett on YouTube, which has been modestly labeled “The Most Important Video You’ll Ever See” and has been viewed more than four million times. The approximately 80-minute lecture highlights how exponential growth interacts with population and energy dynamics to create a disturbing outlook for the future of our planet. Might our inability to understand the inherent nature of growth as unsustainable also be affecting our ability to navigate investing, economic, and career uncertainty?
Consider the value of Facebook as both a private and public company, as chronicled recently by the Wall Street Journal. In the summer of 2004, Peter Thiel’s initial investment in the just-started company valued it at $4.9 million. In May 2006, Facebook raised money at a $500-million valuation. By May 2009, the company was being valued at $10 billion. By the time Facebook went public last May, the number had surged to more than $100 billion. Might it have been that investors were willing to suspend analytical reasoning (i.e. valuation) in favor of trend extrapolation? That seems like a good bet; since the IPO, Facebook’s share price has fallen meaningfully.
Another example can be found with projections for Chinese economic growth, which I believe continue to be higher than warranted. The Chinese economy is slowing drastically, leaving huge excess capacity in its wake. Take the steel industry. China today represents approximately 50% of global steel production and consumption. Most of this steel is being used as an input into infrastructure and real estate construction. Iron ore is a key input in the steel production process, and one that China regularly imports. Why is it that iron ore capacity continues to grow today, despite strong evidence of a slowdown in demand for steel? One possible reason is that mining companies extrapolated prior Chinese growth when making multi-billion-dollar, multi-year expansion decisions. Due to the lag between a decision to expand a mine and actual increases in capacity, today’s growth is based on yesterday’s assumptions of Chinese growth. The forthcoming bust in iron ore may be in part due to analysts blindly extrapolating historical growth rates.
A final example comes from the domain of career management. I recently had a drink with a friend who has been in the investments business (broadly defined) for two decades. Before 2008, annual pay increases of 25% were commonplace (he says they averaged 18% per year). Since then, his pay has gone down 10% a year. While he acknowledges that he likely was overcompensated during the good years, and that his current compensation is still objectively generous, he remains fixated on the prior trajectory. He ratcheted his expectations, assuming that his income and responsibilities would continue to rise.
Given his compensation was approaching the seven-figure mark in 2007, how much growth should he really have expected? To assume his prior compound annual growth rate of 18% would have implied a doubling in his compensation every four years. It also implies he would be earning more than $125 million per year by the time of his retirement. Again, I’m not suggesting such projections are definitely wrong, but they do appear to be statistically unlikely. By having more realistic expectations, he would likely have avoided the negative morale shock that has been weighing on his sense of career satisfaction lately. Better yet, more modest projections would likely have driven greater satisfaction and a grander sense of accomplishment if/when reality exceeded them.
Nothing has ever grown forever. As such, it should be obvious, as the mutual fund disclaimers regularly warn, that “past performance is no guarantee of future results.” Perhaps the time has come to modify the disclaimer to be more reflective of underlying reality: “future performance will likely not resemble past results.”