Stagnation

"For the first time since the Great Depression, middle-class families have been losing ground for more than a decade."

David Leonhardt goes on to make many more impactful points in his post today on the Economix blog of The New York Times. I’ve written about this topic before and will continue to do so not only because I believe it is the most pressing issue of our time but also because I believe we in Silicon Valley can do something about it. 

For now, I’ll just leave you with this chart. 

Generosity of strangers

Michael Moritz of Sequoia Capital is donating $115 million to Oxford University exclusively to fund scholarships for students from low income families. 

“I wouldn’t be here today if not for the generosity of strangers…it is all too easy not to remember,” he said while announcing the donation. 

Oxford announced the donation on Wednesday of last week. On Friday, President Obama made a campaign speech in Roanoke, Virginia, in which he made the following remarks:

There are a lot of wealthy, successful Americans who…want to give something back. They know they didn’t get there on [their] own….I’m always struck by people who think, well, it must be because I was just so smart. There are a lot of smart people out there. It must be because I worked harder than everybody else. Let me tell you something—there are a whole bunch of hardworking people out there.

If you were successful, somebody along the line gave you some help.  There was a great teacher somewhere in your life. Somebody helped to create this unbelievable American system that we have that allowed you to thrive. Somebody invested in roads and bridges. If you’ve got a business—you didn’t build that. Somebody else made that happen. The internet didn’t get invented on its own. Government research created the internet so that all the companies could make money off the internet.

The point is, is that when we succeed, we succeed because of our individual initiative, but also because we do things together.

So we say to ourselves, ever since the founding of this country, you know what, there are some things we do better together. That’s how we funded the GI Bill. That’s how we created the middle class. That’s how we built the Golden Gate Bridge or the Hoover Dam. That’s how we invented the internet. That’s how we sent a man to the moon. We rise or fall together as one nation and as one people, and that’s the reason I’m running for President—because I still believe in that idea. You’re not on your own, we’re in this together.  

So all these issues go back to that first campaign that I talked about, because everything has to do with how do we help middle-class families, working people, strivers, doers—how do we help them succeed? How do we make sure that their hard work pays off? That’s what I’ve been thinking about the entire time I’ve been President.

The timing of the donation and speech was impeccable because, yes, we do all need to realize that. The best CEOs acknowledge the impact their team, their investors, the market, and even sheer luck had in their success. There’s research that shows how much the success of “star performers” is, in fact, attributable to the environment in which they worked.

It’s important to note that President Obama didn’t discount the important of personal factors: “The point is…that when we succeed, we succeed because of our individual initiative, but also because we do things together.” He just placed it in the context of our environment.

This is important because we’re living in an era when the middle class, the heart of this country that holds it together, is struggling. Real middle class income has decoupled from economic growth for three decades now:

(Source: Lane Kenworthy)

Unemployment is not only high and declining very slowly…

…but, worse, the average unemployed individual is unemployed longer than at any time in recent history:

This situation can’t last. Markets aren’t built on theoretical consumers. People have to be able to buy. And if the reckoning doesn’t come in time to harm the wealth prospects of those creating products today, it will come in the next generation.

Government has become a bad word, and I believe it’s largely an outcome of Republican marketing efforts: make government seem evil so that people don’t support spending programs, allowing for lower tax rates on the wealthy with less of an obvious effect on the country’s budget. 

I try to think of better, more charitable explanations, but I can’t. It seems like nothing more than, at best, misguided self-interest because, again, wealth creation is tied to a healthy society. And the above charts don’t paint a picture of a society moving in the right direction.

So in my mind, there’s no way around it: we live in a society together, and all of our welfare is tied together. Government is the means through which we invest in our society for the long-term. If you believe government is broken, fix it. But if you starve it, you’re only harming yourself.

Even beyond enlighted self-interest, those of us who have done well have a responsibility to not be the extractors that destroy the system that allowed us to do well. 

The disruptors' playbook

"A classic is something everybody wants to have read, but nobody wants to read." —Mark Twain.

I suspect Clayton Christensen’s book The Innovator’s Dilemma could be described this way. Evidence enough is the way most people misuse the term “disruptive innovation.”

And yet, it’s a book with incredible value to anyone running or starting a business. It’s apparently the one business book Steve Jobs read, and Andy Grove credits Christensen’s ideas for Intel’s launch of Celeron.

Christensen has a deep respect for people, and in trying to explain why, so often, successful companies ran into trouble, he wasn’t satisfied with an explanation that said managers simply did stupid things. This respect is key to his outlook on life and among the reasons he was able to keep pushing until he came up with the disruptive innovation framework.

The timelessness of the principles of disruptive innovation lies in the fundamental behavior of humans and organizations. The key findings of Christensen’s research are as follows. 

1. Disruptive innovations are not interesting to the currently attractive customers

This is where the key distinction comes in between classifying innovations as sustaining/disruptive or radical/incremental. Most people misuse the term disruptive innovation when they mean to say radical innovation (i.e., significant, difficult, etc.).

Christensen describes a sustaining innovation, which can be radical or incremental, as follows:

A sustaining innovation is an innovation that improves the performance of established products along the dimensions of performance that mainstream customers in major markets have historically valued. 

A key finding from Christensen’s exhaustive research is that most innovations are sustaining in nature and “rarely have even the most radically difficult sustaining technologies precipitated the failure of leading firms.”

In contrast, a disruptive innovation is one that “brings to a market a radically different value proposition than had been available previously.” The products underperform along key dimensions that matter to the most important, largest, most profitable customers, but they appeal to fringe (and generally new) customers. They’re typically cheaper, simpler, and more convenient to use. 

This is the key dynamic: a disruptive innovation is not one that gets existing, large, profitable, mainstream customers excited because it allows them to do something they already to better, faster, or cheaper, offering some absolute benefit. The characteristics of the product and the market to whom they appeal are the key factors. 

2. Technology improves faster than market needs

Companies engage in predictable behavior in trying to charge higher prices, outmaneuver competition, and earn higher margins: they add more and more features. In doing so, they “overshoot” their market. Customer needs advance relatively slowly compared to the pace of innovation.

The dramatic implication of these two behaviors is that companies end up offering bloated, high-priced, complicated products to even their highest end customers (think Microsoft Office) and certainly to their low end customers that care for very basic features. These low end customers are the ones that are most vulnerable. It’s to them that a disruptive innovation that underperforms on many characteristics important to the high end customer may be just perfect.

But here’s the most mind-blowing part: even the disruptive innovation, once it finds a foothold with those low end customers, will start improving in functionality, likely at a similar (if not faster) pace than the existing offerings. It will soon overserve the low end customers and meet the needs of the high end customers. But by then, it will also be simpler, cheaper, and more convenient than the existing offering. And then it’s game over for the incumbent because it’s too late to respond with their own offering. 

3. Incumbents can’t create disruptive products even if they wanted to

The third element in Christensen’s framework essentially says that you could send a letter to the CEO of an incumbent firm letting him know what was coming—that a disruptive technology had emerged that would, in a few years, make his company’s offering extinct—and he still wouldn’t be able to do anything about it. 

Firms that meet with great success end up creating processes and cultures that lead to an institutionalized process of creating and improving products for their largest, most profitable customers. Yet, disruptive technologies are simpler and cheaper, offering lower margins, not greater profits. They’re a fit for comparatively less attractive customers in emerging or insignificant markets. The mainstream, largest, most profitable customers of a company don’t want the products, and in many cases, can’t even use them if they wanted to. 

Meaning: “companies with a practiced discipline of listening to their best customers and identifying new products that promise greater profitability and growth are rarely able to build a case for investing in disruptive technologies until it is too late.”

Translated: you can do everything right and drive right off a cliff.

That’s the bang-your-head-on-a-desk dilemma that CEOs of successful companies face. It’s why Christensen’s book is so incredible. It’s why there will always be opportunities for smart startups. And it’s why it blows my mind more people don’t read and re-read this book until they’ve absorbed the ideas and can convince others to make significant decisions based on it.

So…create (or be early to) new markets no one else cares about

The most powerful part of the book for me was when Christensen summarized his research on the disk drive industry in a table. 

(A lot of Christensen’s initial research was based on the disk drive industry in the years between 1976 and 1993, though Christensen went on to confirm the findings in markets ranging from excavators to steel to motorcycles.) 

Between 1976 and 1993, eighty-three firms entered the disk drive industry. He categorizes them by technology strategy (vertical axis), with firms at the bottom using only proven technology strategies and firms at the top using one or more new components. He also categorizes them by market strategy, with firms on the left having entered existing disk drive markets (what he calls existing “value networks”) and those on the right having entered new markets, defined as those less than two years old.

He defined a successful company as one that generated $100 million or more in revenue in at least one year, even if it subsequently failed. (His table, Table 6.1, shows more detail, including type of firm and more detail on types of outcomes. I’ve included here only the percent he qualified as successful, which gets to his same point.)

He goes on to show the total revenue dollars logged by the firm in each category as well as that total divided by the number of firms in that category (whether successful or not). 

Bottom line: firms that entered new markets had a dramatically higher rate of success, 38 percent versus 7 percent, and had dramatically bigger success, $1.9 billion in cumulative revenue per firm versus $78 million.

Please read this book. Christensen writes largely from the perspective of large companies that are facing this dilemma. If you’re an entrepreneur, those dilemmas are your opportunity. This is your playbook of how to create companies that have a dramatically higher likelihood of success. 

Thinking about thinking

There’s no way around it: if you think you and others behave rationally all, or even most, of the time, you’re wrong.

If you think you make major decisions rationally, you’re wrong.

The sooner we all understand this, the sooner the world will improve—through better decisions and, through better understanding of how people make decisions, better messages. The effect can be incredible: more sales, better outcomes, bold action on seemingly intractable problems.

It might be hard to believe that such dramatic change is possible, but when I started digging into this topic, I was amazed at how immense its implications are and yet how few people think about it. I’ve been addicted to this topic ever since reading the psychologist Robert Cialdini’s bestselling book Influence: The Psychology of Persuasion about a year ago. I couldn’t believe what I read so I read it again. 

Fundamental Human Nature

What amazed me about the book was Cialdini’s explanation that, although there are thousands of different persuasion tactics employed by what he calls “compliance practitioners,” the majority fall in six categories, each of which “is governed by a fundamental psychological principle that directs human behavior and, in so doing, gives the tactics their power.” 

The tactics are:

• Consistency
• Reciprocation
• Social proof
• Authority
• Liking
• Scarcity

Thinking fast and slow

But that book was only getting things started because shortly after I read it, the psychologist Daniel Kahneman, who won the Nobel Prize in economics, released his book Thinking Fast and Slow. 

The book is tremendously well-written. I’ve developed this funny intuition (which Kahneman actually explains) about what I’m reading: I’ll often know when there is much more depth to something than I’m actually getting. In Kahneman’s case, as I read each page of incredible insights about our brain, I knew that I was just scratching the surface. It’s dismaying because it makes you realize just how poorly our brains functions. Reading it, I realized just how many massive errors in the world could be explained by shortcomings of our thinking process. 

Kahneman is so respectful about the nature of the human mind that he structures his book accordingly. He admits that even he, having dedicated his life to studying the errors of the human brain, falls prey to the errors he describes all the time. So he doesn’t position the book as a self-help book. He knows we can’t fix these parts of ourselves. Rather, he aims to create a framework with which to assess the decisions of others. Knowing that social pressures are among the most potent drivers of change, his aim is that once we generally begin to assess decisions through these lenses, only then will people start to change.

The fundamental idea in the book is that we have two modes of thinking and often switch between them without realizing. One is fast—System 1. The other is slow—System 2. He describes them very simply as follows

System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control.

System 2 allocates attention to the effortful mental activities that demand it, including complex computations. The operations of System 2 are often associated with the subjective experience of agency, choice, and concentration.

When we think of ourselves, we identify with System 2, the conscious, reasoning self that has beliefs, makes choices, and decides what to think about and what to do. Although System 2 believes itself to be where the action is, the automatic System 1 is the hero of the book. I describe System 1 as effortlessly originating impressions and feelings that are the main sources of the explicit beliefs and deliberate choices of System 2. The automatic operations of System 1 generate surprisingly complex patterns of ideas, but only the slower System 2 can construct thoughts in an orderly series of steps. I also describe circumstances in which System 2 takes over, overruling the freewheeling impulses and associations of System 1. You will be invited to think of the two systems as agents with their individual abilities, limitations, and functions.

It sounds so simple and obvious, but I can’t stress how important this all is. It has obvious implications for explicit decisions, most obviously how we investors make decisions. But it has broader implications as well. Kahneman goes on to explain how System 1 can be trained, and how it can lead to incredibly intuitive leaps, explaining the miraculous judgments of experts. I think this explains the origins of groundbreaking entrepreneurial ideas—the ones that are truly visionary in nature.

I’m going to write about that and other implications of Kahneman’s framework in future posts. I’m also going to start cataloguing the heuristics Cialdini, Kahneman, and others write about. (Heuristics is a fancy word for mental shortcuts.)

Learning Curve

I learned a lot from Robert Rubin’s book In An Uncertain World, which I wrote about first here. 

Among Rubin’s strengths was the humility to admit what he didn’t know. He didn’t just play to his strengths. He adapted to the environment and asked himself what he needed to do to succeed. 

Asking the right questions

Rubin wrote about his first day as the head of the newly-created National Economic Council, his first day working in government having just left Goldman Sachs after 26 years:

As I had done at Goldman Sachs, when I showed up for my first day of work not knowing what an arbitrageur did, I started writing down questions. How had other Presidents coordinated economic policy? What had worked and what hadn’t? What would make this new body succeed or fail? How could we get cabinet members and senior White House staff to buy into the NEC process? What should my substantive role be? I had other questions about how to function in Washington. How could I be seen to have authority without behaving in an authoritarian manner? How could I follow my inclination to maintain a low profile but deal effectively with the media? How should I allocate my time? How could I do my job and still have time to think?

Legal pad in hand I made the rounds and interviewed people. A few, such as Bob Strauss, I already knew well. Others, such as Brent Scowcroft, who had been national security advisor to Ronald Reagan and George Bush, I didn’t know at all. What they had in common was knowing a lot about life and work in the White House. While some of the advice didn’t work for me, my semi-legible notes from those conversations make an interesting primer on the ways of Washington. As much as I would learn from my own mistakes in subsequent years, I’m lucky to have been able to begin by learning from other people’s.

A lesson in politics and media

Rubin continues later in the book:

My modesty about my skills in this world was frequently reinforced. In May 1993, as we were struggling to get our economic plan through Congress, I appeared on The MacNeil//Lehrer NewsHour opposite Pete Domenici, the ranking Republican on the Senate Budget Committee. I spent considerable time preparing with Gene [Sperling, Deputy Director of the National Economic Council]. My opening comment was that our deficit reduction plan was real and serious.

"Frankly, it is predominantly a tax plan," Domenici replied.

I responded by talking about the “trust fund” we had proposed so that monies set aside for deficit reduction would go to deficit reduction.

"If the American people think there’s too much taxes and not enough spending cuts in the plan, please don’t think that calling the taxes a trust fund changes it," Domenici said.

I responded that Leon Panetta and Alice Rivlin felt very strongly that the numbers in our plan were real.

Domenici responded that the defeat of our “tax plan” would be the best thing that could happen to the country.

I fired back with more specifics. The numbers produced by the non-partisan Congressional Budget Office were close to those produced by OMB. Both agreed that the ratio of tax increases to spending cuts in our plan was approximately 1 to 1.

Domenici responded that our tax plan would hurt the economy.

I thought I’d done pretty well and was very pleased to say so to Gene after the broadcast. They had asked me various questions, and I had come back with good, detailed answers. Domenici had just kept repeating the shibboleth that our plan was a tax increase. Gene had a different take. He said that people who saw the program would think that “you seemed like a nice, smart man who wanted to raise their taxes.” Domenici’s performance demonstrated both how effective a simple message could be on television and how effectively our plan could be attacked. My response demonstrated the difficulty of crafting an effective, simple defense of our substantively complicated strategy.

Rubin admits, “Of course, part of the problem simply may have been me,” and went on to work with a media coach.