Nostradoofus

New touring bicycles cost thousands of dollars, but we live in an era of industrial plenty — perfectly good used bicycles are available at an 80% to 90% discount from new. Here are some things to know.

1980s-vintage lugged “chromoly” steel frames are an incredible bargain. Also known as chromium-molybdenum alloy, or CrMo for short, these were state of the art during the bicycle fad of the late 1980s. Used chromoly bikes are cheap, light, indestructible, and last forever. Best of all, they flex in a way that provides remarkable comfort on high pressure tires. My 1987 chromoly Trek 520 runs 95psi tires, yet is more comfortable over uneven surfaces than my 2006 Bianchi Milano, which has big soft tires but a rigid TIG-welded aluminum frame.

In my experience, many vintage bikes are actually more durable than newer ones of similar configuration, because the components are mechanically simpler. For example, my 1987 Trek has gone 100 times as many miles as my wife’s 1997 Trek 2100, yet her Shimano shifters have already failed. Mine can’t fail, because there is nothing to break — they are simple downtube index shifters.

Cheap used 1980s chromoly bikes of interest include Trek, Nishiki, and even high-end Schwinn. You can purchase whole bikes for under $100 at garage sales, and they often need nothing more than new brake cables ($20), handlebar tape ($10) and a modern seat ($50) to approach modern standards of performance, and to exceed modern standards of durability.

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Bicycling across America

Several years ago I bicycled solo from Newport Beach, California to St. Augustine, Florida, pedaling roughly 2,500 miles in 40 days.

Conclusions:

• Anyone can do it. It’s a test of mind, not body. You build strength
  (both kinds) as you go.

• Solitude is rare and valuable. Reflection, like family, is one of the
  basic sources of meaning.

• Gulf Coast motorists throw beer bottles at bicyclists.

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You can exploit inefficiency in non-equity markets, of course. Here is a way to get screaming bargains on used kayaks from craigslist.

I wrote this Ruby port of Jeremy Zawodny’s similar Perl script. It runs every 20 minutes, notifying me by email of new postings likely to interest me.

The result is effective, but potentially creepy: you post an item on Craigslist, and your phone rings 5 minutes later with my offer to buy. This freaks a few people out.

Using this method, I bought a nearly new $1500 sea kayak for $600, and a well-maintained $1200 Stairmaster for $200. Beneficial deflation in action.

(You could do this with an RSS reader, as craigslist can publish your search as a feed. But I always forget to check RSS. By contrast, nothing shakes you by the lapels like an incoming email saying, “bargain here.”)

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Google’s effort to index governmental websites may hasten the end of your privacy, but won’t change the outcome. Personal privacy is dead, and only obscurity remains.

The concept of personal privacy began very recently, with the Industrial Revolution and consequent transition to urban living. Before that, most people lived in small towns, where there were no secrets.

The advent of privacy brought with it sociological advantages (one could be unusual without facing close-minded social pressure) and disadvantages (dangerous weirdos can operate unchecked).

For better or worse (I won’t argue for either one), this recent concept of privacy is now declining as the cost of information transmission, storage and search fall to zero. This brings good and bad, but is a technological inevitability.

Google is just a messenger of change. The trend will happen regardless. As Sun founder Scott McNealy said years ago, privacy is dead — deal with it. Anyone can find out anything
about you for under $50, and legislating against that is like shouting at the wind.

In short, then, it’s time to get very comfortable with who you are and what you do, because it might be on the front page of Slashdot tomorrow. Everyone will have access to that info.

Luckily, keep in mind that most people won’t care. We tend to overestimate our own importance (for example, by writing blogs), but in truth, the odds are low that anyone will find out your embarrassing secret, whatever it may be.

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“What is the value per hour of what I’m doing at this moment?”

“Value” doesn’t necessarily mean money. The point is that, beyond financial planning, return on investment is an organizing principle.

When you are able to answer the above question accurately at any time during your workday, you understand time management deeply. You know which parts of your day generate most of the value — often ten, a hundred, even a thousand times the value of your least valuable moments.

I said “accurately,” not “precisely.” Precision doesn’t matter. Nor do the units on your yardstick: they can be dollars, fun, self-improvement — whatever is important.

Armed with this knowledge, changes automatically suggest themselves. If, at that point, you are still busy, it’s generally by choice.

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What happens when every MBA has read Porter? or when every general has read Clausewitz and Sun Tzu? What happens to strategy when everyone knows about it?

What’s left is the exploitation of tactical asymmetry — usually in the form of a competitor’s inflexibility.

To see why, try a thought experiment: what if a natural monopoly opportunity is revealed simultaneously to two companies of equivalent resources and competitive position?

If firms were rational agents with equivalent information, then each would invest one half of the present value of the monopoly over its lifetime, and NPV across that entire industry would be near zero, no matter who won.

But real-world agents are not rational, and the bias is toward overinvestment. In particular, individuals within firms have personal incentives to overestimate market size and odds of success, and to abandon failed efforts only reluctantly. As a result, in the thought experiment, we would tend to get negative NPV in real-world cases.

This negative NPV results from the symmetry of the two positions: even though the industry may be a highly profitable natural monopoly in the steady state, no firm can reach a dominant position. Yet it continues to invest as if it can.

Historical examples abound. English canals and American railroads, obviously natural monopolies, yielded many investment failures in part because of such overinvestment.

The symmetry is the problem. So, to have a reasonable expectation of positive NPV in chasing a monopoly, you must begin with a significant tactical asymmetry over competitors — resources (money, incumbency), information (insight, access, surprise), or preferably all of the above.

For a venture capitalist, this would be the second half of an investment evaluation. The first half would be “is the market likely to be a monopoly (i.e., to yield supernormal profits to the winners) at all?” If so, then to have fair odds of success, there must be an tactical advantage that may be exploited as a strategy.

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MSN Search (or Live Search, or whatever they call it this month) now accounts for under 6% of my search engine traffic. In fact, even this is overstated, because it includes all links from “unknown search engines.

Google accounts for 68% to 91% of my search engine traffic, depending upon the site.

My sites are all #1-ranked for their primary search phrases. My site content is highly diversified (video games, Palm image software, and investment newsletters). The implication is that my results are representative of search traffic generally. It implies strongly that Microsoft’s share of search traffic has fallen dramatically (more than half) in the past year.

This may explain their desperation to attract advertisers.

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Mr. Bogle, don’t take this the wrong way. Index funds are a great invention: they are simple, tax efficient, perform well, and push down investment management fees generally. All of these things benefit individual investors.

“Parasite” refers only to the fact that index funds benefit from market efficiency, while providing none.

Index funds track an overall market index by maintaining an appropriately weighted portfolio that mirrors the index. This performs well by riding the rising tide of the general stock market at very low cost.

But imagine if all equity capital were invested through index funds. Then index funds would comprise the entire market. No mechanism would exist for buying stocks below intrinsic value, and selling above intrinsic value. Markets would not be efficient, and stocks would follow a path that bore no relationship to value.

That imaginary situation cannot occur, because in the real world, “value arbitrageurs” always step in to restore market efficiency. But the fact is that index funds are nonmarket entities. Realistically, as index funds take an ever larger fraction of total market capitalization, a market distortion might begin to appear in the form of increased volatility.

Investors extrapolate. Thus, when markets have gone up recently, they pile into index funds, which then automatically buy stocks without regard to price. If this is done in sufficient volume, stock prices generally will rise to historically unusual price/earnings ratios. This creates a self-reinforcing state: rising stocks cause rising index investments, which cause rising stocks.

But individual investors also fear loss more than they desire gain. Thus, when a general market decline begins, redemptions accelerate. If index funds accounted for a large percentage of all stocks, and if price-earnings ratios were at historically high levels, then such a decline/redemption cycle could also be self-reinforcing. “Self-reinforcing decline/redemption cycle” is a very polite way of describing a market crash.

But that can’t happen, the efficient market theorist might argue, because the remaining non-index investors will simply arbitrage all that out, restoring efficient pricing. OK, let’s assume the theorist is right there. In that situation, who makes all the money? Hint: it’s not the index fund investor. Suddenly, they are on the wrong side of the efficiency equation. The arbitrageur makes the money by betting against the blind money going into or out of the market.

Thus it seems two things are true. First, index funds cannot grow past a certain point without ceasing to perform as they have. The change seems likely to emerge not as lower total returns, but rather as much higher volatility.

Second, for index funds to work, a mechanism of market efficiency must exist in the form of managed investments. That role might be small — perhaps only 10% of total market capitalization — but it must exist. And the larger the fraction of total capital under index fund management, the greater and more likely the distortion, and thus the higher the potential returns to traditional managed investments would become.

Thus, in the long run, index funds may actually benefit the few that remain as traditional investment managers.
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Computer-driven stock selection began in the late 1960s, most notably with Ed Thorp’s firm, Convertible Hedge Associates. Thorp applied information theory principles to portfolio allocation, and sought simple convergence plays, e.g. warrants underpriced relative to underlying stock.

The 1970s were a heyday for such strategies. Small but systematic market inefficiencies lurked everywhere. Computers were not widely available, so the few who had access and capability were at an advantage.

By the mid-1990s, most such opportunities had been competed away as understanding became widespread. But the democratization of data and computation was not finished.

By 2000, a small fund could afford fundamental and other data from specialized services like Compustat ($12,000/yr).

By 2002, an individual could obtain reasonably accurate U.S. company and stock data from free services like MSN Money. One could also filter the data set for free, to find all companies fitting a particular profile.

In 2006, these capabilities were spreading to worldwide markets, beginning with London.

It’s reasonable to assume that, very soon, investment managers will have no information advantage in terms of data and screening capability. It will all be instant and free, for everyone.

What’s left? Plenty. As always, strategy — defined as the profit that remains when your competitors execute perfectly — provides the direction.

Financial industry structure always forces a short-term bias. Because clients can pull their money out any time, there is irresistible pressure for investment managers to focus on short-term gain. This is a competitive inflexibility shared by almost the entire investment management industry. As a result, long-term strategies are likely to retain a larger advantage, for longer, than any other strategy.

Short-term bias forces non-fundamental strategies. When a fund manager is under pressure to hang onto clients by delivering an extra 100 basis points this month, he has no time to wait for intrinsic value to be recognized. That can take months or years, and he’ll be fired or out of business by then. So his effort inevitably goes to strategies that attempt non-fundamental strategies, those that try to guess short-term price movements. Individual investors tend to do the same, simply due to impatience. Thus intrinsic value strategies are less competitively exposed.

Index funds are a non-fundamental strategy. Index funds simply buy everything — they do not have the flexibility to stay out. Again, intrinsic value strategies are less competitively exposed.

Non-fundamental strategies are destabilizing in aggregate. Relative-price investment schemes — those that buy or sell based on a stock’s price relative to other stocks — are popular, yet distorting and destabilizing in the aggregate. This definition emphatically does include index funds. Since such “investors” are simply reacting to one another, trends are amplified. This is the reason stock prices are not normally distributed (the “fat tails” distribution problem). It is the source of bubbles and panics, and will always create opportunity for the investor that makes decisions only based on price relative to intrinsic value.

In summary, what’s left is intrinsic value, always intrinsic value. If it says to stay out of the market altogether, then so be it. But that won’t always be true.

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A popular theme of science fiction writers is a sort of high-tech cargo cult, in which ignorant descendants of an advanced culture live, dependent and uncomprehending, on the towering technical achievements of their forefathers. This idea turns up in everything from Heinlein (”Orphans of the Sky”) to Star Trek (#38, “The Apple” #63, “For the World Is Hollow and I Have Touched the Sky” — thanks to Eric for the correction).

There is historical precedent. Radiocarbon dating of the Egyptian pyramids yielded an archaeological surprise: the biggest and most advanced ones came first. Thereafter, they became progressively more primitive, as successive generations essentially made imperfect, poorly understood copies of the original.

One might argue the Enlightenment was similar: a new reasoning methodology fomented by Descartes, Galileo and Bacon triggered a blinding flash of collective insight, fading ever since, even as we discover ever more.

A more immediate example appears to be Windows Vista and, more generally, Microsoft product development. Here are some forgotten technologies of the Forefathers of Microsoft

Compatiblity engineering. This is the primary complaint about both Vista and AdCenter. These two products are arguably the top two strategic priorities for the company, so if both suffer the same failing, the problem is systemic to the company.

Sustained initiatives. Traditionally, companies feared Microsoft in part because it could sustain a strategic focus for years at a time, chipping away at a market until it took over. This characterized Excel in the 80s, Windows in the 90s, and XBox in the 00s. This seems less true today. What looks like sustained focus today is merely a group of insular departments just doing what they did last year, over and over again.

Speed. Say what you want about MSFT, but in the 80s and 90s, by and large, they wrote fast code. They were early commercial adopters of C/C++, they knew downcoding, they knew about designing data structures for speed, etc. It’s hard to see those strengths in the newer products. Adcenter is slow compared to lightning-quick alternatives (Google). Vista is slow compared to alternatives (Intel Macs). In both cases, no advantage is offered in return for this slowness.

The overall impression is that Microsoft is now a pilotless, decaying spaceship, carrying the childlike descendants of its brilliant forebears to a distant, forgotten destination.

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