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August 12, 2005

Deep Impact
by Gary Carmell

On July 4, 2005 a rocket traveling 23,000 miles per hour made a direct hit into the nucleus of the Tempel 1 comet that is 83 million miles from earth. Tempel 1 is 3 miles wide and 7 miles long. The rocket's name was Deep Impact. The Deep Impact mission was implemented to provide a glimpse beneath the surface of a comet, where material from the solar system's formation remains relatively unchanged. Mission scientists hoped the project would answer basic questions about the formation of the solar system by providing an in-depth picture of the nature and composition of comets. The University of Maryland is responsible for overall Deep Impact mission science, and project management is handled by JPL based in Pasadena. The program's leader is of Lebanese descent while one of its top scientists is an Iranian American. The Deep Impact mission lasts six years from start to finish. Planning and design for the mission took place from November 1999 through May 2001.

On July 7, 2005 four bombs exploded nearly simultaneously in London attacking the city's transportation system. While probably not nearly as long in the planning stages as Deep Impact, this mission still required impressive coordination and a level of technological sophistication. While not publicly stated, I surmise that the mission of the program's creators was to disrupt civilized life by creating enormous fear through the exploitation of western societies' Achilles Heel, freedom of movement. Capitalist societies require enormous freedoms to mobilize capital providers to respond to pricing signals to allocate capital to where it is most needed. Velocity of capital, people, and goods and services are critical for free economies to flourish and innovate. If any of these are stopped, then the system is at grave risk because individuals and businesses make financial commitments based on the assumption that this velocity will continue. If it does not, then financial chaos can result, as these financial commitments can no longer be met due to an unanticipated drop in revenues. Just think of the travel industry after September 11. When people stopped flying airlines, hotels, rental car companies, and tourist-related services suffered terribly.

I am struck by the fine line between the channeling of technology for good or bad. Powerful explosions, one motivated by man's unquenchable thirst for knowledge and the others, designed to destroy what modern civilization has built, differed in intent with radically different outcomes. One elicited joy and wonder around the country and much of the world, while the others horror. Equally intriguing, one of Deep Impact's leaders, as mentioned above, was from the Arab world (Lebanon) and another from a country deemed by President Bush as being part of the Axis of Evil (Iran). It is fair to say that each of these countries has portions of their populations or leadership more sympathetic to what the London bombers were trying to achieve versus the JPL scientists.

So what does all of this have to do with investing? More than one might think, including me up until recently. I originally planned to write an article in which I was going to review predictions I made in past writings and see where I was on and where I was off. These would have covered topics like housing, jobs, interest rates, the dollar, gold, oil, commodities, defense spending, etc. The track record has been reasonably good so I had an incentive to write the article. The one area I planned on avoiding was in regard to some of my post-9/11 writings about the Middle East and geopolitical events. It turns out that I should have focused there and ignored the other issues.

I recently read a fascinating book about Charlie Munger, Warren Buffett's incredibly brilliant partner in Berkshire Hathaway. The book is coffee table sized and is called Poor Charlie's Almanack and is modeled after Munger's hero Ben Franklin who wrote Poor Richard's Almanack. Included in the book are transcripts from ten Munger speeches. He tends to have a similar theme running through most of them, which is the exploration of the psychological traps that human beings fall into that leads to either poor decision-making or terrible human errors. And conversely, how to best put the odds in your favor to achieve success that is as much about not failing as it is winning.

Someone asked Munger what he thought was the key to his success and he said it was his rationality. I will not rehash my previous article that I wrote that framed the issues in the Middle East from the perspective of modern versus anti-modern societies. You can access it on the internet at http://cwscapital.com/pubs/ qupdates/020426/middle.html. Rather, it reinforces the importance of Munger's notion of rationality, of which one of the requirements for being rational is a willingness to be self-critical and to keep an open mind. Without this trait, then dogmatism and emotion can take over leading to sub-optimal decisions which can lead to cult-like behaviors (suicide bombers) or self-sabotage from an investment standpoint. Rationality is critical when evaluating investments and investment managers like CWS.

I once read that all pieces of paper with financial information are designed to separate investors from their money. While this is a pretty cynical attitude, it's still wise advice to keep in mind. The incentives for accessing capital are tremendous and never underestimate the power of incentives (Munger's first trap).

Irrationality is the death knell of investors and usually occurs when there is either a denial or misreading of reality. Each of these usually takes place because of psychological reasons or incentive-related bias. I spend an inordinate amount of my time trying to make sure that CWS manages based on what is as opposed to how we want the world to be. That is not to say that we cannot declare a powerful intention or set of goals and manage our business to achieve this future. To do this, however, still necessitates a sober evaluation of our operating environment and how we can best navigate through it and create the most value. I believe that I get paid to avoid land mines that will appear over the next year and to take advantage of opportunities occurring within the same time frame. To do this necessitates managing from reality and avoiding wishful thinking.

I am constantly questioning my assumptions about the world and trying to assimilate new data. Munger begs people to avoid man with a hammer syndrome in which to a man with a hammer every problem looks like a nail. To avoid this requires a multi-disciplinary approach to decision-making. As he says, "everything has to sit on a latticework of theory." These theories should be built on a foundation of the most powerful ideas from physics, biology, chemistry, psychology, and economics to develop multiple mental models so that one size does not fit all when it comes to solving problems. We must train ourselves to recognize patterns. It is not easy, but it can be done. One of the most important problemsolving tools, according to Munger, is to use algebraic thinking by looking forward and backwards and to concentrate mostly on what one wants to have happen or to avoid what one does not want to have happen. "Invert, always invert," said the famous algebraist Jacobi.

A perfect example of inversion is the lesson we learned about locking into fixed interest rates for long periods of time which made early repayment of these loans cost prohibitive in lower interest rate environments. I learned from this experience that I don't want to have that happen again so I study interest rates and loan structures very carefully to take this risk into much greater consideration.

After reading Munger's seminal speech entitled "The Psychology of Human Misjudgment," I was struck by the parallels between the psychology that leads to poor investment decisions and one adopting cult-like tendencies (think suicide bombers). Munger identifies 25 psychological traits that can lead to poor decision-making. Some of the ones that really caught my attention are listed below.

Liking/Loving Tendency "Makes the liker or lover tend (1) to ignore faults of, and comply with wishes of the object of his affection, (2) to favor people, products, and actions merely associated with the object of his affection, and (3) to distort other facts to facilitate love."

I would put this in the category of "you see what you want to see." This enables investors to be swayed by people and investments they like. For example, many of our investors had great success in manufactured housing investments and they would like to have more of these opportunities available. Nevertheless, the risks of the business for family communities have increased dramatically since we exited it and these investments should now be assessed very differently. This tendency should not get in the way of objectively assessing the risk/reward trade off. Adult communities remain very attractive but quite expensive to buy. This tendency also applies to those individuals susceptible to becoming suicide bombers as they can fall under the spell of influential people for whom they have affection.

Disliking/Hating Tendency "Makes the disliker/hater tend (1) to ignore virtues in the object of dislike, (2) dislike people, products, and actions merely associated with the object of his dislike, and (3) distort other facts to facilitate hatred."

You see what you want to see and this can result in investors passing on good opportunities for which they have negative past associations or experiences. We have faced very challenging circumstances in our Denver apartment investments. The dislike for Denver should not get in the way of objectively analyzing as to whether now is a good time to purchase additional assets there. This tendency is also particularly prevalent for suicide bombers who can completely overlook any positive attributes of those they want to destroy. For example, the 9/11 murderers took advantage of many of the freedoms and cultural attributes of an American life they so detested. Their complete disdain for Western culture enabled them to sacrifice their lives to help destroy something they found so contemptible. Even more shocking are the Iraqi suicide bombers (granted many are foreign born) who are willing to kill members of their own religion and society for an unattainable ideal promulgated by people who are most assuredly trying to stop something that will destroy them (free and pluralistic society and government) versus creating a society they truly believe in. Quite simply these pathetic individuals are pawns in a brutal game.

Doubt-Avoidance Tendency "The brain of man is programmed with a tendency to quickly remove doubt by reaching some decision...[I]t is logical to believe that at least some leaps of religious faith are greatly boosted by this tendency...[W]hat usually triggers Doubt-Avoidance Tendency is some combination of (1) puzzlement and (2) stress. And both of these factors naturally occur in facing religious issues. Thus, the natural state of most men is in some form of religion. And this is what we observe."

Confusion and stress create a desire for certainty, simplicity, and to be shown the way. This can lead to blind faith in investing and make people susceptible to religious fanaticism.

Inconsistency-Avoidance Tendency "The brain of man conserves programming space by being reluctant to change, which is a form of inconsistency avoidance...[P]ractically everyone has a great many bad habits he has long maintained despite their being known as bad...We all deal much with others whom we correctly diagnose as imprisoned in poor conclusions that are maintained by mental habits they formed early and will carry to their graves...And so, people tend to accumulate large mental holdings of fixed conclusions and attitudes that are not often reexamined or changed, even though there is plenty of good evidence that they are wrong."

Never let facts get in the way of what you want to believe. This is very dangerous for investing and can make the "true believer" incapable of seeing another point of view no matter how sound the logic and supporting evidence.

Curiosity Tendency "Curiosity, enhanced by the best of modern education, much helps man to prevent or reduce bad consequences arising from other psychological tendencies. The curious are also provided with much fun and wisdom long after formal education has ended."

To quote physicist Richard Feynman, "everything is interesting as long as you look deep enough." Those unwilling to explore things more deeply will be susceptible to surface-level manipulation.

Reciprocation Tendency "The automatic tendency of humans to reciprocate both favors and disfavors has long been noticed as extreme, as it is in apes, monkeys, dogs, and many less cognitively gifted animals. The tendency clearly facilitates group cooperation for the benefit of members...What both human and ant history suggest is (1) that nature has no general algorithm making intraspecies, turn-the-other-cheek behavior a boost of species survival, (2) that it is not clear that a country would have good prospects were it to abandon all reciprocate-disfavor tendency directed at outsiders, and (3) if turn-the-othercheek behavior is a good idea for a country as it deals with outsiders, man's culture is going to have to do a lot of heavy lifting because his genes won't be of much help."

Be cautious of nice acts from individuals who want something from you because you will probably feel better about that person and want to reciprocate. On a more Machiavellian level, however, the converse of this tendency, vicious behavior to those outside the group, is part of the genetic make up of many societies and we should not expect nice things from other countries even if we carry out selfless acts of kindness. Keep this in mind as we try to understand why a suicide bomber ends up doing such a destructive act. It could be as simple as we're outsiders and we need to be destroyed.

Simple, Pain-Avoiding Psychological Denial "The reality is too painful to bear, so one distorts the facts until they become bearable."

Denial is a dangerous tendency. It's another example of not dealing with what is and can lead to very destructive behavior. People are loath to sell poor investments when they have a paper loss even though their money may be better off in another investment. This is a form of denial.

Excessive Self-Regard Tendency "Some of the worst consequences in modern life come when dysfunctional groups of cliquish persons, dominated by Excessive Self-Regard Tendency, select as new members of their organizations persons who are very much like themselves...Therefore, some of the most useful members of our civilization are those who are willing to "clean house" when they find a mess under their ambit of control...Excesses of self-regard often cause bad hiring decisions because employers grossly over appraise the worth of their own conclusions that rely on impressions in face-to-face contact. The correct antidote to this sort of folly is to underweigh face-to-face impressions and overweigh the applicant's past record."

Investors may end up putting their money with people they like as opposed to those who offer the soundest advice. Future suicide bombers are very susceptible to manipulation from people they like.

Unfortunately I have barely scratched the surface of the power of Munger's speech or given it justice by excerpting so few of his psychological traps. Nevertheless, the denial of reality can lead to terrible consequences in all walks of life, with particular risk to one's financial health and to society at large. When these traps are combined with the power of technology the consequences can be devastating for individuals, businesses, and societies. Companies like Barings Bank and Kidder Peabody were brought down by rogue traders who covered up massive losses made possible by computerized trading and weak accounting. On a smaller scale, with the advent of online trading and low transaction costs individuals are very susceptible to falling into many of the same traps that these rogue traders experienced.

Perhaps most importantly, western civilization is at risk from lost souls exploited by sophisticated sociopaths seeking the destruction of anything that is progressive and well schooled in many of the psychological manipulation techniques described by Munger. Combine this with destructive technology and the consequences can be devastating to a free society exploited by those taking advantage of relatively unfettered movement of people, goods, services, and capital. I urge everyone interested in the War on Terror to do everything in your power to avoid viewing the enemies of the United States and Western civilization from our logical frame of mind. If you look through the prism of psychology you will have the ability to see things in a very different light... and you may not like what you see. Seeing the world in this light has left a Deep Impact on me as I hope it will you.

Gary Carmell
CWS Capital Partners LLC