StoneTablet

Founding Assumptions of Finance

2010-02-01T10:15:00.000-08:00

Fred Wilson is promising to add a regular schedule of MBA lessons to his blog. I think it is a terrific idea. I'd like to add my small input to this effort by sharing the first lesson of my first day of Finance class.

The most profound lesson I learned in this class (and a point that Fred mentions, but doesn't expand on in his post) was what my instructor called "The 4 Founding Assumptions of Finance." I think that if you get these conceptually, everything else is just the mechanics of how to calculate or apply them. Here they are:

1. A dollar today is worth more than a dollar tomorrow.

2. Investors are risk averse. (You have to pay them to take a risk).

3. More money is better than less money. (Not in a greedy way, just in a "I'd rather make money than lose money" way.)

4. People are rational and markets are competitive.

These ideas were really important to me, because they really do encompass all of modern finance. All of the complex quantitative methods you read about in the Wall Street Journal are just ways of applying these four principles to complex situations. Any math you do in Finance is just to convert one or several of these ideas into a specific number that you can compare to a number from another project (or company, or deal).

Fred's first lesson is on the Time Value of Money, where he starts to talk about how to determine the value of an investment. What he is really talking about is points 1 and 3. If you are going to invest money today, in the hopes of getting some money tomorrow (or every year for the next few years), you want to add up all the future money and see if it is more or less than the money you are investing (Hint: you don't want to invest $100 in a deal that will only return $90 - see point 3). Less obvious is that you need to apply a discount to the money you will get next year (point 1). Fred's lessons on Present Value answer these two questions so that you can be sure that you are getting a good deal, in line with the points above.

Think of investors as customers in a store. If some of the stuff has scratches and dents, they will ask for a discount. Think of all the points above as potential dents. So if the investment opportunity (a stock, or a piece of real-estate, or a start-up business) wants to take your investment today, but wants to pay you back over time, see point 1 - we need to get a discount on how much we invest (or, equivalently, get a higher return). If there is some uncertainty about how much return we will get in any given month or year, we want a discount for that. We certainly won't invest if we don't think we will get all our investment back - and prefer investments that seem likely to return more (point 3).

Point 4 has taken some hits in the media lately; marketers and psychologists remind us that we don't always make rational decisions, and the recent market events have made people re-think the idea that markets are efficient. But the premise is that if one deal is better than another, people will notice this, and if there is a limited supply of those better deals, people will compete for them. What this ultimately means is that there is no source of free money in investing - if there was, people would see it, and quickly bid up the price of it until it was just an ordinary good deal.

I am looking forward to Fred's posts - hopefully he will do a better job of making things simple than I have (so far, he has been great at this!).

1,000 Words of Nonesense is Still Nonesense

2009-10-08T09:00:00.000-07:00

I really love the good infographics that illustrate the relationship between complex data. A picture really is worth a thousand words. But like good written journalism, good infographic journalism requires some understanding of the subject matter, and an effort to remove bias. Most of my training in critical thinking focused on looking for loaded words in an article; but didn't cover images in much detail, so this is an area that may be ripe for abuse (through malice or incompetence).

Fast Company's article on CEO Pay infographics (the graphics were actually commissioned and ranked by Good Magazine) really illustrates this point. The graphics are very attractive, and do a great job conveying a point. But they don't actually make any sense - they are like a well written article written by someone who has no understanding of the subject.

For example, the first graphic, which was judged best by Good Magazine, and which I agree is the most compelling and information rich image, make no rational point that I can discover. It compares CEO pay with the number of minimum wage employees it could support. Why not compare CEO pay with the number of oranges it could buy? I think it would be just as meaningful. I doubt that anyone really believes that a company could exchange its CEO for a whole pile of minimum wage employees and get the same results, so why compare them?

To me, the only metric that makes any sense for measuring CEO pay, is to ask "would the company be better off if it didn't spend the money?" For example, you wouldn't compare the most expensive machine in a factory to the least expensive machine, and you certainly wouldn't wonder how many of the inexpensive machines you could buy for the price of the expensive one. The only consideration you would have when purchasing a $10M machine is whether the business will benefit by at least (and hopefully more) than $10M.

The second graphic compares the CEO pay to their company's profits. This gets closer to the mark, but of course, since the CEO's actions may take time to benefit the company, you have to consider their pay and the company benefit over time - one year is not nearly long enough. Moreover, you still don't know how the company would have done without paying the CEO, or more practically, by spending half as much on the CEO. If spending an extra $1.00 on the CEO makes the company more valuable by $1.10, this is a good deal, and you should pay as much as you can, until the effect wears off.

Finally, the last graphic is nice for promoting the idea that CEOs are back-room, cigar smoking, old cronies, but it doesn't do a good job of presenting the data - it completely wastes the horizontal axis. The graphic purports to compare age with salary, but it just slaps an age label next to the salary amount - there is no graphical comparison between those two numbers. If, for example, the artist had made the horizontal axis indicate age (the vertical already indicates salary), then we could have looked for a trend or a grouping. As it is, I have to read all the numbers (which are inconveniently written sideways) to determine even the simplest concepts, like does the oldest person make the most money, and does the youngest person make the least? From the data, it appears that there is no relationship between age and salary, although the graphic doesn't highlight this fact either.

I really like good infographics, because they have tremendous power to make complex relationships obvious. I really hate bad infographics, because they give nonexistent relationships tremendous credibility. If we are going to have a contest for the best, we should be judging them on their ability to make the truth apparent, not to make misinformation more appealing. Good magazine is making infographics worse by honoring bad images. Fast Company is making itself look like a business magazine that doesn't understand business when it highlights these as good examples of how to understand CEO pay.

Cool but Useless?

2009-09-25T09:19:00.000-07:00

A Voice in the Wilderness sent me this video about a Segway-like unicycle. He thought it was cool, but not very useful. Most of the comments under the video suggest that anyone who rides one of these is just lazy – why can’t they just walk? I disagree.

I think the point of these is not to ride from the parking lot into the building, or to ride from office to office at work, but to enhance public transportation. If I want to ride the subway, I have to walk from my house to the station, then walk from the station to my office. I may also be faced with a walk for lunch(1). Of course, I am capable of walking; I can even walk long distances. But when I am wearing a suit, and carrying a 25lb briefcase (2), and worried about what time I get there, a half-mile is about as far as I want to walk. Lunch during working hours is an even bigger deal, because every minute I spend walking to my destination has to come out of my lunch time, or my work day, or my personal time at the end of the day. That creates a limited circle of places I can go, which limits my choices for lunch – maybe forcing me into the dreaded McDonald's that so offended commenters.

The point of the Segway, and of this similar unicycle device is not to let you be lazy and do less, but to let you go farther and do more. I can walk a mile in 20 minutes. Maybe in those same 20 minutes I can go 5 or 10 miles (and not be exhausted when I get there), or maybe I can travel that same mile in 2 minutes, and create 18 minutes (or 36 minutes, round trip) in my day. If I am a commuter, a device like this can make the difference between being able to use public transportation and preferring to drive my car. The unicycle shown in the video seems much smaller than the Segway, so more practical on subways and buses. (Plus, people apparently won’t laugh at you as much on the unicycle, compared to the Segway - http://www.paulgraham.com/segway.html)

Finally, for the crowd that thinks I should revel in the walk for fitness sake, I agree with the ideal, but I have lots of goals in my life, including how much work I get done during business hours, what time I leave my family in the morning and what time I get home at night, and how I look (and smell) to the people I work with. For the most part, I get my exercise on my own time (3).

I am not sure what the real limit to the adoption of the Segway was (or is), so I don't know whether a unicycle will fare any better. Technology is making the world smaller, and this helps solve the problem of moving people more efficiently over the last mile between public transportation and their destination.

Notes:
1. I actually work out of my home office, so I don't commute. But I do face these decisions whenever I travel to a major city with good public transportation - I like to use it, but look carefully at the "last mile" walking distances. This always limits my choices on hotels and restaurants, and often forces me to rent a car.

2. When I was in business school (and traveling as part of my full-time job), weighed my bag at 25 lbs. It typically contained one or two laptops, two or three large books, lots of accessories, and all the miscellaneous junk you need when you are trying to get a lot done while you are away from home, like gum, breath mints, extra batteries, lots of business cards (two versions of mine, plus everyone I have met in the last week or two), etc. It adds up fast, and by the end of the week, you notice which shoulder you have been using the most.

3. And if you think I should quit being such a sell-out workaholic, and become a forest ranger so I can wear shorts, walk around and commune with nature all day long - I'll bet you don't give the same advice to your doctor, or your lawyer, or the airline pilot on your plane. You probably hope those guys are really focused and good at their job. You don't know what I do for a living, but I don't think you would be happier if I stopped doing it well. I know I wouldn't.

Outsourcing - Good or Evil?

2009-08-24T09:01:00.001-07:00

All my life, I have heard people talk about off-shoring in very polarizing terms. Depending on who you ask, the feeling was either that you had to outsource to build things at a low cost, or you were an unamerican traitor if you bought something foreign-made.

I always thought that there had to be a more rational approach than that. And I further assumed that people spending a bunch of money on outsourcing were making a well studied, rational decision. I now suspect that there is a lot of politics, emotion, and short-term thinking attached to most of these decisions - on both sides of the issue.

To me, the off-shore / on-shore decision is just an extension of the build vs. buy decision. If I am building a machine, and need a special clamp, do I make the clamp myself, or do I hire a machine shop to do it for me? Do I use my brother's machine shop next door, or do I use one in the next state, because their larger operation lets them make them cheaper? What about using a factory in Mexico? Holy cow - this Chinese firm says they can do it so inexpensively that it makes up for shipping the parts half-way around the world!

How do you make this decision? Well, of course you consider price. The price of the part becomes part of your Cost of Goods Sold, which directly affects your price, which affects the number of units you can sell, your revenue, and your profit. Price is a big deal. By the way, I think quality goes (almost) without saying. I am just assuming that you would never outsource any part to someone who couldn't produce it to your specifications - even if it was your brother.

The next most obvious thing is administrative costs. These may be harder to quantify, but they are easy to imagine. If the parts suddenly start coming out wrong, somehow, do you walk next door, or fly to China? Do you have a translation problem for documents and specifications? It may be hard to estimate these exactly, but it seems obvious that building something farther away will have higher admin costs than something more local. Still, we can use analytical methods like decision trees and sensitivity analysis to determine when it is worth the hassle.

As we move farther away from the per-part issues like price, it gets harder to estimate the effects. In general, we know that a more specialized shop will be able to produce better quality at a lower price, because that is what they focus on. This s one of the ways that society gains productivity, and therefore economic growth. But there are obvious consequences to outsourcing and off-shoring that must be considered.

When you outsource, you give up the expertise of how to make the part well. You also, inevitably, share that knowledge with others. Remember that hard problems are good in business, because that makes solving them valuable. If you hire someone else to solve your hard problem, they own that value. If you outsource all the hard problems, and save only a simple problem for yourself, like final assembly, or retail sales, you are not entitled to keep much of the total value of the product.

None of this says definitively that outsourcing (or off-shoring) is automatically good or bad, it just says that it is a serious business decision that must be made using the best tools and thought processes available. Seeing masses of businesses polarize into the "all manufacturing must be done in China, because it is low cost" or "I only buy American" camps doesn't make me feel good about the thought processes behind the decision.

This guy, on the other hand, makes me feel good. He tried it in China, and it worked for a while, but found the hassles to be too great, and is moving back to a US manufacturer. Not "great because he has come back to the US", and not "great because the US seems competitive", but great because he is making a rational choice, and the decision could have (and did) go either way.

I am not predisposed toward or away from outsourcing (or off-shoring). But I get very frustrated talking to people who think there is only one right answer. In principle, picking heads for every coin toss lets you win half the time. But in business, guessing and winning half the time is the same as loosing all the time. If you think there is only one right answer to the outsourcing question - you are wrong all the time.

2009-07-09T09:36:00.000-07:00

EyeWonder says:

Publishers are looking to create premium placements to sell to advertisers while also keeping ad clutter off their home pages

Translation: Advertisers are desperately looking for more and more annoying techniques to highjack your attention. Contrast this with The DECK advertising network (as seen here, here, and many other places).

I don't have any data on what methods generate more attention, or in the final analysis, more money. But I can tell you which method pissed me off, and which one encourages my interest. There is definitely something to be said for proven results, but I would be very afraid of any advertising strategy that was based on annoying my customers.

I'll tell you what's great about the Tesla. . .

2009-03-26T20:11:00.000-07:00

It's like a concept car that somebody wants to actually build and sell.

You would think it would be easier

2009-03-12T08:44:00.000-07:00

So I finished my MBA program in August 08. Now that I have all this "free" time on my hands, you would think I would write more for the blog. You'd think.

Crisis du Jour

2008-09-23T17:38:00.000-07:00

I am not the biggest current-events junkie you will ever meet. In fact, most of the time, I have no idea what is going on. However, the current financial crisis is a big enough deal that I have been trying to pay attention. Plus, considering that I just graduated with an MBA, and took many finance and economics classes, I sort of feel a duty to understand what is happening. Having said that, I gotta say, I am really confused.

Here is the way I understand the problem:

Too-cheap credit, and government pressure to increase home ownership lead to mortgages that were too cheap, too easy to get, and eventually, cheap up front, but expensive later on, and required no proof that you could repay. (These are the so-called "sub-prime" mortgages.) Unsurprisingly, this lead to many more people buying houses, including some that could not really afford them (both speculators and over-eager buyers). This sudden, big demand lead to a bubble in the housing market. At this point in the story, we have over-priced houses, many of which are owned by people who cannot afford them. Again unsurprisingly, this bubble eventually burst. (I use the word "unsurprisingly" only in retrospect - I certainly didn't see this coming.)

Now, I own a house, and I benefited from the run-up in prices, and I suffered paper losses from the burst, but since I can afford my mortgage, and intend to stay in my house for a while, this didn't really affect me. However, people who bought at the peak, and now need to move (for work reasons, or what ever), and people who couldn't really afford their mortgages in the first place, they are affected. A large number of people cannot afford their house payment, and cannot sell their house to cover the debt, so they default, or are at a great enough risk of default that everyone (including their banker) knows that it is just a matter of time.

The bank that gave you the loan doesn't really want to wait out the 30 years it will take for you to pay back the mortgage, so they sell the mortgage to another kind of bank. That bank puts a bunch of mortgages together, and sells the whole thing as a bond. The idea is that you buy a share in the bond, and the bond (using the mortgage payments from homeowners) makes monthly payments to you over the next 30 years. And it shouldn't be that risky, because although someone could default on their home loan, most people don't, and the house is there for collateral, so the money can get recovered anyway. Unless. . . an unusually large number of these mortgages are extra risky, because the homeowners can't really afford them, and unless the value of the houses is actually about to go way down when the bubble bursts.

That is the basic sub-prime mess, as I understand it. Because there are so many of these bonds, nearly every financial institution owns some. And now, no one knows what they are worth. If we don't know what they are worth, they are risky, which makes them worth even less. So now lets suppose that you are a big financial firm, and you have a bunch of these bonds that you have on your books at say, $100M, but are now worth something much less. Lets also suppose that you have debts of your own, that you qualified for by pointing to all of your non-cash assets. Now that some of those assets are worth much less, you don't really qualify for your loans. People who lent money to you, who probably have troubles of their own, start to get nervous. Maybe somebody says that the short-term loans that you have to renew next week, won't be renewed. Now you have a very large, very profitable, very old, very successful bank that has all its short-term cash dry up, and cannot pay the bills tomorrow.

This is called a liquidity crisis, and in most cases, could also be called a confidence crisis. You are having a problem because someone got nervous. Of course, maybe they had good reason to be nervous, and you deserve the problem you are about to have. If you really are a good bet, the government could step in and offer to lend you the money, and put you back on track. On the other hand, if you are a bad bet, then the government just bought a shit sandwich.

Now we get to the problems of financial contagion and moral hazard, also known as "damned if you do, damned if you don't". If this hypothetical financial institution, run by the best and brightest financial minds of the generation, got themselves into this mess, then maybe they should fail. This certainly teaches those guys and their competitors not to do business like that again, and it also makes people who do business with similar banks to be a little more wary and demanding. These are all good things for the economy. Unless. . .the sudden and unexpected failure of your bank puts enough pressure on the next bank to create a liquidity crisis for them, and the dominos keep falling until the whole economy is plunged into darkness. Could this really happen? It has happened in entire regions of the world, where one country has a currency crisis that cripples its economy, and infects all its neighbors and trading partners. That is the contagion part. The moral hazard part is that if you keep paying for your kid's mistakes, he will keep making them. If we keep a big firm from failing due to bad management, why should it change its management?

So, here we are, wanting to spend $700B to keep the dominos from falling. You can make an argument that it is necessary, and you can make an argument that it is bad. Frankly, I was taught that the financial professionals in the Wall St. firms know what they are doing, and that if they didn't, a smarter competitor would run them out of business. I don't just hate the idea of bailing out all of them at once, it undermines my fundamental view of the world. If I cannot trust good management to succeed, and bad management to fail, then what can I trust? Why should I even try to be a good manager?

What if we do something different?

Let us assume that things are indeed bad enough for the government to intervene, but lets try to avoid propping up any broken financial institution. Instead, lets start at the bottom, propping up the homeowner. Now I believe that a homeowner, or real-estate speculator who got in over his head deserves to loose his investment just like the big guys. But if you want to say that someone should have known what they were doing when they got into this mess, it seems like we should point at the big institutions before we point at the individual home buyer. When I sign the papers for my home and mortgage, I really should know what I am doing. When Bear-Stearns buys a bunch of mortgage-backed bonds, they damn well better know what they are doing. And if someone is going to pay the price for screwing up, they should probably pay first.

Here is the plan:

If the fundamental problem is that a bunch of mortgages are likely to default, then lets fix it at that level. Anyone who is planning to stay in their home, but has a problem with an increasing variable rate mortgage, can qualify for a government sponsored low-interest rate loan. And the loan is good for your original loan amount, regardless of the current value of your house. This means that far fewer of the mortgage-backed bonds will fail, because home owners who would otherwise default will just refinance with the government. The bonds might loose a little value, because paying a bunch of them off early might be worth less than running the full term, but this has to be worth much more than the defaults everyone is currently expecting. And, reducing the uncertainty improves the value of the bonds as well. Now, banks that hold these bond no longer have this trouble on the books, and should be able to go back to business as usual. If that means that a few of them still fail, so be it. But we shouldn't be talking about wholesale failure of the entire financial system. Plus, the bond holders feel at least some pain, which will make bad bonds harder to sell in the future.

There is still some moral hazard in this plan. A guy who cannot afford his house will probably get a government loan and extend his time a little, then default anyway. But there are two benefits, even in that scenario. First, a subsidized interest rate stretches out the defaults. Having everyone default at once is a much bigger problem that having the same number of people default over a 3 year period. Second, the guy who is going to default will lose his house, and probably any down payment that he made, so he has some incentive to at least try to make this work. I still will hate the idea of some jerk speculator getting a subsidized mortgage for buying houses that he never could afford. But I can live with that guy being forced to live in an expensive house longer than he planned more than I can live with the CEO of a major Wall St. firm taking my tax money and saying "well, it was really your fault, all along. . ."

I am probably exactly wrong on several points here, so someone please straighten me out.

Counting the days

2008-05-14T09:31:00.000-07:00

Truemors reports that IBM has build a computer that can do 1 petaflop, which is 1e15 (1 with 15 zeros after it) calculations per second. According to the commenter on the same article, the human brain is estimated to have a capacity of about 2e16 calculations per second, or 20 petaflops. So this machine has a theoretical capacity of about 1/20th of a human brain. Big deal.

On the other hand, Moore's law tells us that processing power doubles about every 18 months. About four-and-a-half doublings gets you to 20x, which works out to just under seven years.

In my last post, I talked about John Gruber's calculations that we moved computing technology from desktop to smart phone in about 7 years. For rough numbers, lets call that $2100 down to $700. And the size went down much more than that.

Ray Kurzweil has done the complete math on this, but basically we can count the days until you can have a computer in your pocket that is as smart as you, for a few hundred dollars.

Not your father's phone

2008-05-13T16:50:00.000-07:00

My 6-year-old daughter was practicing lines for a play she will be in, and one line was “Radio was at the peak of popularity in that day.” I tried to help her understand what that meant, and asked her if people listen to the radio today. She said “yes”. I asked what was more popular than radio – expecting to hear “TV”. Instead, she said “computer”.

John Gruber estimates that today’s iPhone is about as powerful as an 8 year-old computer. When my daughter is 14, and needs her own cell phone and computer, they might be the same thing - or at least the thing she carries in her pocket will be as powerful as what I have on my desk today.

It would never occur to me to go to a physical dictionary or phone book to look something up, and I rarely look at a paper map. She will have a device in her pocket with a processor fast enough to edit video, over 100GB of storage capacity, and a full-time, high-speed Internet connection to a much improved world-wide network filled with applications (that run in the web – not on her phone) designed from the ground up for mobile use.

If current trends are any indication, she will know where her friends are, what they are doing, and if they are available to talk or meet. She will always know where she is – and not in a “here is your address” kind of way; she is likely to have at her fingertips the intimate knowledge normally reserved for a native of her immediate surroundings – even if this is the first time she has been there. How far to the nearest bathroom, coffee shop, power outlet? Is the subway running on time, or should I just (electronically) summon a cab? What is the trade-off in time and cost of those two choices?

Maybe her phone will slurp down the menu and interior and exterior pictures of every restaurant or café she walks past on a street, just in case she wants to come back and try one later. If she sees a cute boy in Starbucks, her social network system will figure out if they have any friends in common – and maybe get them an on-line introduction right away.

Speaking of Starbucks, she probably won’t have to order with a live person. When she walks in, Starbucks will recognize her phone, look up her typical order, and ask her phone if she wants one of her recent drinks, or maybe today’s special. She can just confirm what she wants, the phone will pay the bill, and maybe buzz her when it is ready.

For the older generation, this stuff will feel like a gizmo to figure out. For her it will feel like an automatic transmission – learning to do things the manual way will seem hard.

Exactly Right

2008-01-03T11:12:00.000-08:00

John Gruber captures one of my core beliefs about the world:

Focus solely on current events and it’s all too easy to despair at the state of the world. But science and progress march ever forward, and the world is a better place today than it used to be.

Balance

2007-12-03T09:40:00.000-08:00

Great quote from the assistant dean of my business school:

"I think of my job description now as having two lines: one, to create structure for sustainability and growth and two, resist structure.”

What is this design thing, anyway?

2007-11-28T12:06:00.001-08:00

I have been interested in design lately. For the last few years, I have thought of design as this subtle art of making things aesthetically pleasing. As in "interior design". Now, my interior design skills are limited to my recent realization that, one: I like walls that are painted a color other than white, and two: crown molding looks kind-of cool. Other than that, I am completely lost.

So when people talk about the importance of design in consumer products, I can definitely tell what I like, but I have no idea how to do it myself. I feel like this is important, but I feel helpless, so I feel frustrated. I look at products from Apple, and I agree that they are beautifully designed, but I cannot explain why. I read websites about design, and apparently the beauty is because this corner is rounded, and the other corner is square, and the bright-white power cord creates a cognitive dissonance. I really, really, don't get it.

Then I read this article in Fast Company about how all of Apple's products are flawed, and suddenly, I got it. I am not saying that their products are not flawed - I use several Apple products on a daily basis, and know exactly what I am getting and what I am giving up with this choice. I am saying that the description of what was wrong with the iPhone completely misses the point of design. In fact it missed the point in such an obvious way that it helped shine a light on exactly what good design is.

Design is not the art of making a corner round or square, or picking exactly the right color. Well, it is, but that is a small part of design.

Michael Fitzgerald thinks that the iPhone is a pretty box, but that it is missing a bunch of features, and that pretty boxes are easy to copy. "Fashionistas" (who apparently only care about the pretty box) will buy the iPhone for its looks, but the general population wants all those features. He lists a whole bunch of features that could be in the phone, but aren't, and labels them as fatal design flaws. And this is where design enters the picture.

A well designed product is not a bunch of features thrown into a box. For every feature available, there is a clear trend toward "better". For memory, battery life, network bandwidth, and free beer, more is always better. For weight and cost, less is generally better. We know this already. Just saying that there is a technology available that is better than the one we have is not the same as designing a better product.

Early in my career, a senior colleague told me that "Engineering is fundamentally about compromise". I didn't like this when I first heard it, but I quickly understood that he was right. Faster processors cost more money, consume more battery power, and generate more heat. Getting rid of the heat requires bigger heat-sinks (more size and weight), and / or more active cooling (more size, weight, and power). The bigger batteries demanded by the bigger processor and its cooling system take up size and weight, cost more, and require a bigger, more expensive charger. Aside from the functional requirements (what the gizmo being designed is supposed to do), a designer is typically working within power, weight, and physical envelope (size and shape) budgets.

Design is about making the trade-offs between faster this, slower that, and heavier overall package. I wouldn't be at all surprised to hear that Apple designers sweated over decisions that would have made the iPhone one or two millimeters thicker, or a few grams heavier.

The user interface and the aesthetics of the phone are part of these decisions. Apple didn't think that the iPhone virtual keyboard is better than a physical keyboard, they just thought that it was a worth while trade-off to be able to hide the keyboard when you didn't need it (and without making the phone twice as thick so it could slide). They could have made the iPhone bigger and uglier, and harder to use, so that they could fit in all the biggest, fastest features on the market, but lots of people already make that phone.

The definition of a disruptive technology is that it is inferior to the state-of-the art. Telephone calls made over the Internet (VOIP) were, and perhaps still are inferior to those made over traditional circuit switched networks. But we love them, because they add convenience, are low cost, and can integrate with other technologies much better than my desk phone can. Disruptive technologies are disruptive because they change the competition away from the old metrics (e.g. fastest network access or typing speed), and begin competing on new metrics (e.g. easiest to use, or tightest integration). Kodak went from being a company with 90+ years of industry dominance to nearly irrelevant when we removed film from our cameras. Digital cameras had inferior image quality compared to Kodak film, but when was the last time you bought a roll of film?

So what is design? It is about creating a complete solution to a customer's problem. It is about making the trade-offs between all the possible features, and making the selected features work perfectly together. Design is like cooking: The best apples don't guarantee the best apple pie, but a great chef can make a great desert, even with average ingredients.

Best paragraph ever

2007-11-20T12:03:00.000-08:00

"A few years ago, the company I work for decided that I was such a good programmer that I had to stop doing it immediately. I was now to tell other programmers what to do, using all the social delicacy and interpersonal self-confidence I’d built up over two decades sitting in a dark room and staring at a monitor. I was being promoted into management."

Full posting

Hoping for better from Harvard

2007-11-13T11:57:00.000-08:00

From Harvard Business School prof. John Quelch, talking about the iPhone launch:

First, the reviews were mixed. At that retail price and with that level of hype, the critics were going to be tough but a raft of concerns from delayed activation and sluggish email (AT&T's responsibility as the exclusive network provider) to feature shortfalls began to dampen marketplace enthusiasm.

I don't really care whether professor Quelch thinks the iPhone is a good phone or a bad phone, or even if it is good or bad for any particular use-case. Instead, I am pretty annoyed at his sloppy analysis of the iPhone launch. My first criticism is about language, and his use of the word "hype" regarding the marketing activities surrounding the launch. I am perfectly fine with his use of the word "promote" (earlier in his article), but nearly all of the definitions of "hype" suggest some form of trickery, deception, or dubious methods. When I hear "hype", I think "hyperbole", which is an "obvious and intentional exaggeration". I don't think I am picking nits here, because the conclusion of his article points directly to this:

Hype can hurt stock prices and investor confidence when expectations are not met.

Almost every product is advertised with this "obvious and intentional exaggeration", and I find it tiring, even though I understand the reasons. If I pay attention to an ad, I am looking for clues as to whether the product being advertised might be suitable for my needs; when hyperbole is routinely used, I cannot tell.

The striking thing about the iPhone ads was that they engaged in no hyperbole whatsoever. They showed someone using the phone to perform a series of tasks, in real time. There wasn't a cut, or a special effect, or a "your mileage may vary". In fact, any iPhone user could duplicate any of the ads on their own, with no special training. When you perform an experiment that anyone, anywhere can reproduce and get the same results, this is called science. To me, this is the antithesis of hype.

In the same spirit, and moving on the the rest of my complaint with Prof. Quelch, I don't think there was a single feature or capability that was promised that was not delivered. Anyone who was unhappy with their iPhone shouldn't have been surprised. We routinely expect companies to mislead us about the performance of their product - usually around measures that are hard to pin down, like gas mileage or battery life. But even in this area, I hear no one complaining that the iPhone doesn't live up to its published specifications. All the complaining I heard was that the iPhone didn't have a feature that the complainer wished it had.

Just to stay on track, my points so far are that 1: the iPhone was not hyped, and 2: the iPhone did not disappoint expectations.

As for the price cut - every cell phone ever made (that may be a bit of hyperbole) has gone through the "rapid skimming" marketing model, where it is launched at a high price to capture high margins from early adopters, and then is reduced in price to capture additional revenue farther down the demand curve. The only unusual thing about the iPhone was that the price cut came so soon after launch. This might mean that the initial price was set too high, or it might mean that Apple and AT&T sold so many phones into the early adoptor market in the first few weeks that they could now target more price sensitive buyers.

The other thing that was unusual about this situation is that normally, a cell phone manufacturer would come out with a new phone, which would push down the price of the previous market leader. If Apple had done this, people still might have been surprised by how fast it happened, but not surprised at all that the old phone had to be discounted in the face of the newer phone. The unusual thing is that the iPod Touch, which is not a cell phone, is still a competitor to the iPhone. Many customers who were considering a iPhone might switch to the new iPod Touch. Apple probably made some rational calculations about how much an iPhone customer was worth to them compared to an iPod Touch customer, and adjusted the price of the phone to match. When new products are released into the market, the demand curve for the old product shifts.

Apple stock was at $144 on September 4, the day before the launch of the iPod Touch. It did dip on the launch news, but by September 25, it was $153. That is a 6.25% increase in 20 days. Annualized, that is equivalent to a 114% increase. The NASDAQ rose less than 4% during that same period. I won't go into the calculation here, but even accounting for this increase, and Apple's sensitivity to the market (beta), this is a real gain by Apple.

If I were doing an event study on this, my conclusion would probably be that the market reacted to the news as if it were bad news, then over the next couple of weeks figured out that it was actually good news. Benjamin Graham used to say that in the short term, the stock market is a voting machine; but in the long term it is a weighing machine.

So let's revisit our good professor's conclusion:

Hype can hurt stock prices and investor confidence when expectations are not met.

My assessment is that Apple did not hype their product, did not fail to meet expectations, and except for a short-term blip (less than 20 days), did not have their stock price or investor confidence hurt. The truth is, I agree with professor Quelch - hype is a dangerous thing. I just think he picked a horrible example in Apple and the iPhone launch. And from Harvard, I was hoping for better.

10,000 hours

2007-11-07T16:32:00.000-08:00

Apparently, it takes about 10,000 hours of study to master any complex subject. But, with that study, and a few friends, you can solve problems that are so complex that they border on impossible. In this video, Malcolm Gladwell argues that a dozen disciplined, smart people are more valuable today that one bona-fide genius.

http://www.newyorker.com/online/video/conference/2007/gladwell

Addendum:
In your job, you might be able to focus 6 hours per day on an important area of expertise, yielding 30 - 40 hours per week of focused effort. Outside of work, you might be able to devote 20 - 30 hours per week on a serious hobby. Of course this will vary for each person, but it seems likely that most people could devote between 20 and 40 hours per week to the study of a particular subject, and still be a normal person. At that rate, it takes between 5 and 10 years to really master a subject. (Mr. Gladwell makes the same estimate in his presentation.) If you could get a job that aligned with your interest, so you could spend a significant part of your work day learning more about it, and you spend some of your off-hours working on the same subject, you might get 50 hours per week of focused study - resulting in 10,000 hours of study after only 4 years.

4 or 5 or 10 years might seem like a long time. It is a long time. My 8 year-old little girl will be going to college in 10 years (eek!). But the time will pass, regardless. And at the end of that long 4 or 5 or 10 years, you can be a world-class master of something. Or you can look back at that long time and wonder where it went.

What are you going to master in your next 10,000 hours?

It doesn't matter what you think

2007-11-01T10:01:00.000-07:00

In an article for Fast Company, Zach Nelson (CEO of NetSuite), talks about the worderfullness of the iPhone. I don't know about you, but I followed the iPhone frenzy pretty closely since the January announcement, and I was surprised by all the strong opinions, and even more surprised about all the wrong opinions.

It seemed to me that the fastest way to get noticed in a blog, or in a magazine, or on TV, was to find something wrong with the iPhone. You didn't have to have experienced a problem (since almost no one had actually, you know, touched the new phone yet), and you could rule out entire classes of users (like people with jobs) based on how you imagined yet another group of people (like IT managers) would feel. For example, a common theme was that because the iPhone didn't work exactly like a RIM Blackberry, it could not, would not, and should not be used by any business person, ever. Or else. Don't say we didn't warn you.

Look, I used to be an IT manager, and I completely understand the desire to have things running in a nice, controlled, orderly way. I had lots of conversations with users about what technology they wanted to use, and whether that fit into our plan. The trouble was that every time I told someone they couldn't use something with our network, I was making my job easier, not theirs. And the trouble with that was that they were probably generating revenue for the company, and I wasn't.

This wasn't supposed to be an article about the iPhone, or about IT managers, or about bloggers who complain about technology they don't like. It was supposed to be about Zach's insight into the iPhone, which was really about new technology in general. So maybe I should get right to the point.

It doesn't matter what you think. It doesn't matter if you think the iPhone is good or bad for business users. Even if you are an IT manager. Even if you are the CIO. Even if you are the CEO. Not even if you are very well respected and widely read journalist.

If you still aren't convinced, just wait, and the decision will be made for you by your best and brightest new hires. Never lose sight of what the college students of today are accustomed to.
Zach Nelson, from the FC article.

Right now, college students might seem unimportant in the grander scheme of things. But next year, they (as a group) will be working in every segment of the economy. And after a couple of years, they will be doing most of the work. And a few years after that, they will be running the business. The communication tools and techniques they are getting used to now, will define how we work over the next decade.

The serious business phone - the Blackberry, is interesting because it does email so well. The Blackberry exploded in the late 1990s because of all the people who got hooked on communicating over the new medium of email in the early 1990s. The real power of the Blackberry is it's integration with the Microsoft Exchange corporate mail server. The iPhone doesn't do this integration very well; instead, it is much better at browsing the web than a Blackberry (or any other pocket device). Given that the biggest threat to Microsoft right now seems to be Google, and since Google's mail system uses a web browser, where do you think things will be in 10 years? Still not sure? Ask a newly hired college graduate which mail system he prefers.

Good Question

2007-10-02T11:17:00.000-07:00

ars technica wrote an article yesterday that basically says Nintendo will not be able to ship its popular Wii game console fast enough to meet Christmas demand. John Gruber asks "What is wrong with Nintendo?"

This is a good question. In business, the problem generally is to find or create a product that customers are willing to pay more for than it costs you to make and deliver. Oh yeah, it also has to be better or cheaper than your competitor's product. In the simplest examples, we think about how much the parts costs, slap a little margin on for development costs, and maybe a little profit, and decide that is how much the product should cost.

In business school, we dig into this quite a bit, and find that there are lots of ways to optimize your business so it is more efficient, which translates into a lower price (and more sales), or to higher margins. Since there are lots of ways to improve efficiency, it follows that there are an equal number of ways to screw up efficiency, thus increasing the price (and reducing sales) or reducing margins.

With that in mind, here is a quote from the ars technica article:

"They ought to stop by on a frequent basis. We're going to flow hardware. It's not that it's going to show up only on one occasion. It's going to be constantly flowing in."
Nintendo of America President Reggie Fil-Aime

The phrase "constantly flowing in" stands out to me. Toy manufacturers have a classic problem related to the Christmas buying season. First, their revenues all come at one time during the year. If Nintendo sells 50% of their annual demand for their game console in one month, this means they will sell very little during all the other months. Second, the factory has to deal with this same spike.

Although this is a supply chain problem, lets talk about it in terms of our own lives. Imagine that you have a large extended family that includes 12 other households. That is, there are 12 other families that might want to come visit you in your house. Now you love your family, and you want them to stay with you when they visit, so you buy a house with a guest room. If they each visit one month per year, you are all set. But what if they all want to visit during the holidays? Should you build a house with 12 guest rooms, and leave them empty for 11 months out of the year? That is certainly not an efficient way to entertain relatives, and it is not an efficient way to run a business.

Nintendo is just saying that they cannot run their business efficiently by designing it to meet seasonal spikes. "Well, since you can never find a Wii on the shelf now, surely they can increase production another 10% or so." Another good point. But to do this, Nintendo will have to invest money -maybe a lot of money. For example, what if they are currently running at full capacity on one manufacturing plant, and to increase just a little, they will have to bring another plant on-line?

In any case, any change will probably require Nintendo to invest some money, and the first question to ask is "will we get that investment back?" There is lots of uncertainty in consumer goods - especially toys, but I am pretty sure that Nintendo has thought about this, and they are thinking that retooling their business for last-minute shoppers is not a good investment.

Doing things the Hard Way

2007-10-02T09:48:00.000-07:00

I like to do things the hard way. Well, it's not so much that I like it, but after I have done something, it usually turns out to be the hard way. Part of the problem is that I have a pathological need to understand how things work. For example, in high school, I could never memorize the the rule-based procedures for solving a problem. Instead, I tried to understand the relationships at work, and then re-create the method as needed. This was cool for explaining the concept to the girls in the class, but it was murder on exam day. Eventually I realized that you just don't have time to reinvent the wheel on every problem. Still, I was never satisfied to have memorized a procedure that would produce the correct answer, without understanding all the moving parts.

A few years ago, I realized that this problem shows up in other areas of my life. I know that most men don't like to read instructions, but apparently I take this to an extreme. I didn't go to college right out of high school for a number of reasons, some good, some not so much. (As I get older, I move more of my reasons from the former category into the latter.) What I eventually realized was that deep in the dark crevasses of my subconscious, I believed that taking a class was an admission of failure. If I was really as smart as I thought I was, I should be able to figure things out for myself. You know, stuff like chemistry, and physics, and solid-state semiconductor theory. I'm not kidding. I worked on military and space-grade electronic systems for nearly 10 years with nothing but an associates degree. And not one of those trade-school degrees where they actually taught me some technical stuff - no, I studied Anthropology, Ecology, Psychology, History, and English. Sure, I took about 3 classes from the Electronics department, and a bunch of math, but half the math was to make up for what I didn't do properly in high school, and the other half was only sort-of useful.

From a fundamental perspective, Calculus was cool, but I am pretty sure that I have never had to calculate an integral outside of the classroom.

The funny thing is, most of my colleagues consider me to be a pretty hard-core engineer. Anyway, after 20 years of reasonable success in my career, I decided that maybe there was something to this whole idea of letting a teacher show me how to do something, instead of reinventing it for myself. So I found a reasonably good university that didn't laugh too hard at my previous attempt at an education, and managed to earn a BA degree. Of course, after significant work experience, a BA degree seems like pretty entry-level stuff, so my pathology of having to understand how things really work kicked in, and forced me into graduate school.

All of this is just a long-winded way of explaining how an uneducated, stubborn guy like me finds himself in top-tier MBA program. Some of the comments in this blog will come from the uneducated, stubborn guy, and some will come from a seasoned professional with a top-notch education. Which comments are which will be left a an exercise for the reader.