Political Economics Prof

Tag: Investment Strategy

  • The 10 Minute MBA – Almost Everything You Need to Know to Manage Organizations, People, and Yourself

    The 10 Minute MBA – Almost Everything You Need to Know to Manage Organizations, People, and Yourself



    Positive Externality


    You need to know three things about management and corporate finance:





    80/20 Rule

    Opportunity Cost

    Compound Growth


    80/20 Rule (Also called Pareto’s Law)


    This idea says that a relatively small percent of actions account for a relatively large percent of outcomes. Find and concentrate your efforts on the important influences on your business (and life).


    20% of your customers account for 80% of your sales.


    20% of your product line accounts for 80% of your sales and profits.


    Often, companies with a large product line with many variations find that 50% of their products account for over 90% of sales. An even smaller percent usually account for most of the profits.


    20% of your SKUs account for 80% of your stockouts (and lost sales).


    20% of your programmers account for 80% of the bugs in new programs.


    The percentages aren’t always 80/20. Some examples:


    McDonald’s accidentally learned that 10% of its customers accounted for 60% of its daytime sales. And it was an identifiable group that they had never aimed its massive advertising at.



    A landmark study by Arizona State University found that over the past century, just 4% of stocks have accounted for the entire net gain of the US stock market The other 96% were either flat, down, or so volatile they gave back everything they made.


    The possibilities are almost endless.


    The 80/20 rule implies:


    “Less is more” … reminds us that much of what we do, when closely analyzed, has negative value. Many activities, customers, products and suppliers actually subtract value, which helps to explain why their very positive counterparts produce such a high proportion of net value.


    Richard Koch, The Natural Laws of Business(182-3)


    Eliminate losing products, customers and functions. This is probably happening because a competitor is more innovative or new companies have entered your markets.


    Look at divisions, regions or product lines that consistently have low sales growth rates and make below the minimum cost of capital. Reduce or eliminate these businesses. This frees up capital and resources to find and fund growth opportunities. Loser operations have a potentially high opportunity cost (see below).


    Look at positions or functions in the corporate structure that don’t add value to the company. Eliminate or outsource. This is a major strategy many companies are now pursuing, which is why a high percent of job losses over the last three decades occurred because the position or function was eliminated.


    Better yet, avoid complexity in the first place. Concentrate on what you’re good at. Pound away at it. No complacency. Continuously innovate. And, with Andy Grove, be paranoid; your actual or potential competitors want to eat your company. (His successors at Intel obviously didn’t read his book. They became complacent. A beast named Nvidia is devouring them.)    


    Growth through mergers and acquisitions is a high-risk strategy with a high failure rate (loss or discounted return below the cost of the acquisition). The seller knows where they bad stuff is hidden; you don’t. (If you missed this in B-school, it’s called “asymmetric information.”) 


    If you get into a bidding war with another company, walk away. The odds of “buyer’s remorse” is high. 


    Opportunity Cost


    After you’ve identified the critical opportunities and problems, opportunity cost is a good guide to deciding what to do about them. It reminds you that time and assets are limited and valuable. Time and assets you spend on one problem or function might be more profitably spent managing something else. For example, if you have a small customer who takes up a lot of your time, either raise prices, reduce service or stop supplying her. The opportunity cost is too high.


    Opportunity cost is a guide for better decision-making. Good managers think in terms of possible alternatives, not simple yes or no decisions on isolated proposals.


    What are the realistic options and alternatives (not a list from a management textbook)? Is there a less expensive (more profitable) way to do something? Lease or rent rather than own? Outsource some of your production?


    What is the net benefit (profit) over time of each alternative?

    Include risk as part of cost. If your company depended on inputs from China, as soon as President Obama (and successors) focused on China as America’s number one geopolitical threat, it was time to diversify your sources to other countries.


    In the extreme, some corporations have learned they are in the wrong business. They could have used their time and assets more profitably doing something else.


    A word about accounting systems. Accounting systems are not set up to tell you which products or services are profitable. They are also poor indicators of return on capital or assets. Asset values should be adjusted from depreciated historical cost to present opportunity cost (often market value if sold or leased). The classic example is that Coca-Cola for decades carried the value of their brand name at $1 on their balance sheet. Really?



    Compound Growth (also known as exponential growth). 


    After you’ve freed up people and resources by applying the ideas of the 80/20 rule and opportunity cost, start looking for growth opportunities. By this time you will have a good idea what are the critical factors for your company’s success, the knowledge and resources that give you a competitive advantage. Develop opportunities that have a good chance for  sustained  high growth rates. Know the difference between unit sales growth rates and dollar amount of sales growth. 


    In the beginning, new ventures often have low sales compared to the size of the company but high compound growth rates. If there are high growth rates, these ventures can become large contributors to sales and profits in the future. Other good things can happen such as continuing reductions in unit costs.


    One application is personal investment. Compound growth rates are the first thing you need to know about finance, particularly personal investing. Earn income. Start saving early, save steadily over a long period of time, invest in high-quality bonds and dividend-paying stocks, and reinvest interest and dividends. Let compound interest (interest on principal and past interest) do its thing. Same advice for investing in stocks generally – start early, invest in index funds. Starting early is important because there will be periods when stock prices go down or stagnate. Spend all the time you save not analyzing or worrying about investments doing more pleasant and productive things (see opportunity cost).


    These three tools work together.


    These ideas applied to starting a new business:


    Opportunity cost is a part of start-up costs.

    Loss of income from the job you quit.

    Loss of income from the saved money you invest.

    What are the critical factors for success?

    Look for sources of exponential growth and exponential reductions in unit costs as volume grows.



    These ideas applied to personal life:


    Eliminate activities and people with high opportunity cost.

    Avoid high-maintenance (high opportunity cost) people (selfish, self-centered, demanding, whiny, long-winded). Life is too short.

    Concentrate on a small number of important people and activities who add meaning to your life.

    Remember the learning curve when starting something new.

    Persevere; learning something new is slow going at first but accelerates. (Again, concentrate on what’s important; 30% of the assigned reading in a textbook will account for 80% of the questions on the tests.)



    ALMOST EVERYTHING YOU NEED TO KNOW ON HOW TO MANAGE AN ORGANIZATION


    BEST BOOK ON HOW LARGE ORGANIZATIONS REALLY FUNCTION


    Joseph Heller, Catch 22.


    BEST BUSINESS MANAGEMENT BOOK


    Andy Grove, Only the Paranoid Survive. Andy Grove grew up in communist Hungary, escaped during the Hungarian Revolution, got his Ph.D. in solid-state physics at 22, and was CEO of Intel during its critical period developing and mass producing the integrated circuit (aka the microchip).


    BEST ADVICE ON STRATEGIC MANAGEMENT FOR A SMALL, DISRUPTIVE COMPANY


    “Hit ‘em where they ain’t.”

    “Wee Willie” Keeler


    One of the greatest hitters in baseball. Only one of 22 men ever to hit over .400 in a season. Also one of the smallest ever to play in the major leagues. Innovative. See biography in Wikipedia.


    “Get there the firstest with the mostest.”

    Nathan Bedford Forrest


    Surprisingly successful Confederate general in the Civil War. Consistently defeated larger Union armies. Not size but speed, surprise and force at the point of attack leads to victory. Same strategy used by Stonewall Jackson and Erwin Rommel against larger forces. Reason for success of guerilla warfare.


    Good general advice but especially relevant if you are going up against a larger competitor with more resources. Hit them hard where they are weak. Toyota almost destroyed the huge and powerful General Motors by first attacking GM at its weakest point (compact cars).



    ALMOST EVERYTHING YOU NEED TO KNOW ON HOW TO MANAGE PEOPLE


    Be consistent.

    Subordinates will then know how to act and what to expect.

    If you are consistently nasty, expect to change jobs every two or three years.


    Business educators, consultants and commentators love sports analogies. But be careful. My favorite.


    Football (American) analogy. Be a pulling guard. You’re a pulling guard, not the quarterback (COO) or coach (CEO). Run interference for your people so they can concentrate on high value-added work.

    Hire good people (independent, flexible, adaptable, cooperative) and have confidence in them. Trust them.


    Never hire a graduate of Harvard Business School or anyone who has only been a consultant. They think they are qualified to run the business. Before they understand it.


    If your company’s management is hiring a lot of management consultants to tell everyone how to run their operations, you should probably update your resume and think about working for a better company. One that has confidence in its employees.



    MANAGING UNDER UNCERTAINTY


    “Nell,” the Constable continued, “the difference between ignorant and educated people is that the latter know more facts. But that has nothing to do with whether they are stupid or intelligent. The difference between stupid and intelligent people – and this is true whether or not they are well-educated – is that intelligent people can handle subtlety. They are not baffled by ambiguous or even contradictory situations – in fact, they expect them and are apt to become suspicious when things seem overly straightforward.


    Neal Stephenson, The Diamond Age, 256.


    This is a key to success in the information age. Your phone can contain more facts than you can learn in a lifetime. It can analyze more data in seconds than you can in a year. But algorithms hate ambiguity. Well, so far.


    Good managers are not afraid to make decisions in uncertain environments. I’ve worked for corporate and divisional managers who talked a good game but were scared to make decisions quickly because they were afraid they would be blamed or fired for a bad outcome. Afraid of the annual review. Stressed by the tyranny of the quarterly report. This is management by fear or blame. This is how Jack Welch and his picked successor ran General Electric into the ground. (BTW, read Greek tragedies. It’s a good way to spot arrogant people who will be destroyed by their own hubris.)


    When the CEO is like this, the company is doomed to mediocrity. Or worse. Update your resume.


    Some decisions fail – lose money, not meet corporate cost of capital, not achieve a tactical or strategic goal. But good managers cut losses and change strategies quickly as they realize their assumptions were wrong or the actual outcome turned out to be different than expected. This takes courage. And humility. 


    A company’s managers don’t have to be right all the time – just more often than the competition. And adapt quicker to changing circumstances.


    George Washington lost every major battle he fought before 1781. But because of his failures, he changed his assumptions about the war and changed his strategy. He inspired his officers and men under terrible conditions. He persevered; he refused to accept defeat. His reward – he won his last battle (Yorktown) and won the war.



    LEADERS AND MANAGERS – KNOW THYSELF


    Are you a leader or a manager? 


    A leader has strategic vision.

    A manager has functional expertise.


    A leader looks outward.

    A manager looks inward.


    A leader thinks abstractly.

    A manager thinks concretely.


    A leader anticipates.

    A manager reacts.


    A leader is able to make decisions in an uncertain environment.

    A manager attempts to reduce uncertainty to routines.


    A leader thinks and worries about the future.

    A manager thinks and worries about the present.


    A leader indicates a general direction for the company.

    A manager wants specific instructions to carry out a function.


    A leader is paranoid and insecure.

    A manager seeks security and certainty.


    A leader thinks in terms of trade-offs and possible scenarios.

    A manager wants to find the one best way to optimize performance.


    A leader is not guided by financial data and short-term financial objectives.

    A manager is directed by her budget.


    A leader thinks strategically in a hostile, competitive environment.

    A manager is concerned with operational efficiency.


    A leader can make decisions in an environment of accelerating change and
          discontinuities.

    A manager can’t.


    A leader sees potential opportunities in an age of radical change.

    A manager sees problems to be dealt with.


    A leader persuades.

    A manager commands.


    A leader adapts, improvises, overcomes obstacles.  (From Heartbreak Ridge)

    A manager waits for explicit instructions.


    A leader looks for talent.

    A manager looks for skills and experience.


    A leader trusts other people.

    A manager controls other people.


    A leader discovers, nurtures and promotes potential leaders inside the company.

    A manager doesn’t.


    A leader reads books and articles about history, the global economy, other cultures and values, new ideas like complexity theory and tipping points, biotech, and science fiction.

    A manager reads books and articles about management and her functional
           specialty.


    A leader reads The Economist.

    A manager reads The Harvard Business Review.


    If you see yourself as a manager, join a large organization. But be warned; you are in danger of having your position eliminated by AI.

    If you see yourself as a leader, think seriously about starting your own company.

    Published 1/23/2019.

    Last updated 8/17/2025.

    There are posts on American History, American Economic History, demographics, and much more. Some essays on information, innovation, and how markets work. Even some essays on business, finance and economics.

  • Stock Market Investment Primer

    Stock Market Investment Primer

    This primer is aimed at the long-term investor. But this does not mean that you should necessarily hold all of the stocks and funds in your portfolio for a long time.

    WHY STOCK PRICES GO UP

    The movement of a stock index such as the S&P 500 or an individual stock depends on two things:

    Earning per share (EPS) and changes in EPS.

    Stock price/earnings per share ratio (PE ratio) and changes in the PE ratio.

    If the PE ratio stays the same, an increase in EPS often leads to an increase in the stock price. The same is true of a stock index. Rising EPS combined with a rising PE ratio is often the reason why a stock goes up more than the average stock.

    Since 2009, the beginning of the stock market recovery from the last recession, most of the increase in stock prices has been due to the increase in earnings per share (EPS).

    Well, that was easy. Well, not really.

    The stock market is “forward-looking,” that is, it tries to anticipate change, especially change in EPS and the PE ratio. There is a great amount of forecasting. But since the forecasted changes are in the future, they are inherently uncertain. The forecasts of some companies’ EPS are more uncertain than others. Some are very uncertain. For example, the future sales and earnings of a small biotech company may depend on the success of a clinial trial and FDA approval. If one or both fail, the company could go bankrupt. 

    The EPS of a stock can go up for a number of reasons:

    The economy is expanding. This has been the usual situation in the United States and also for the global economy for decades. So there is an upward trend in the economy leading to an upward trend in income and spending. Most companies can usually expect expanding sales and profits (earnings). This is the main reason why you can expect to make money in the long run; it is also one of the reasons why you should buy a stock index fund, either as a mutual fund or an ETF.

    Corporate earnings and EPS are more volatile (bigger percent changes) than the economy’s GDP changes or a company’s changes in sales. Part of the reason is that for most companies, their EPS is leveraged by debt (see below). So, for example, a 5% increase in nominal GDP might lead to a 10% increase in a company’s sales and a 20% rise in earnings per share. The same relationship works in reverse when an economy goes into recession.

    A company’s stock price does not entirely depend on economic expansion or other influences external to the company. Some factors are internal. It may have a successful new technology, successful new products or become more efficient. 

    If you find yourself buying new products or services, you might want to look at the company as a potential investment. The first time you or your tax accountant used Turbo Tax, when you had your teeth fixed with Invisalign, when you bought your first iPhone, when you started looking for “organic” foods, when you go on your first space flight, you might investigate the company behind these new products or services as potential investments.

    A company’s PE ratio depends on the market’s consensus on the rate of increase in the company’s EPS. A company with a higher than average expected EPS growth rate will generally have a higher than average PE ratio. Both the market’s PE ratio and a stock’s PE ratio can change if there is a change in expectations of the future growth rate. A company’s PE ratio and stock price may go down even if its EPS grows but at a slower rate than expected. This is one reason why higher potential reward (percent gain) comes with higher risk.

    Generally, PE ratios rise over a business cycle. Earnings have been growing for a long time and investors expect earnings to continue growing at least as fast as over the cycle. But a large and sudden increase in the market’s PE ratio may indicate that the market has developed a speculative bubble. This increaes the chances of large downturn.   

    OTHER REASONS STOCK PRICES GO UP

    If you are a long-term investor, you might consider investments based on a long-term

    demographic or social change. The aging of the national and global population presents opportunities for certain categories of companies, the most obvious being health care. Some leisure activities, such as cruise lines, should do well. Another trend is that most of the increases in income and wealth is going to high-income households. Companies that sell luxury products to this income group have done well.

      

    Whether or not a company pays a dividend and changes in the dividend influence the price of a stock. Not all companies pay dividends. On the other hand, some companies have a history of increasing dividends over time. A good strategy if you own such a company is to reinvest the dividend. The company will then pay rising compound interest, which over time can be an important part of the total return of owning the stock. Check to see if the company has rising earnings to cover the rising dividend. There are also ETFs and funds that only contain these types of companies.

    Another way you can make money in the long run is corporate acquisitions. The acquiring company has to pay a premium over the acquired company’s stock price to obtain all the shares. Premiums are usually between 30% and 50%. Certain types of companies tend to get bought out – specialty food producers, local and regional banks, small biotechs with a FDA approved drug or good clinical results. Small tech companies tend to get bought out while still private.

    Companies can influence their stock price through financial planning. One strategy, noted above, is to increase the dividend. A company can also buy back some of its outstanding stock, raising EPS by reducing the number of shares outstanding. Or a company can fund its expansion through taking on more debt. The two can be combined; much of the cost of share buybacks over the last 10 years has been financed by new debt.

    Earning per share is leveraged by debt. Interest rate expense on the debt is fixed. Imagine two companies both making $1,000,000 a year from operations and do not pay income taxes. One has 1,000,000 shares, so its EPS is $1.00/share. The other company has more debt and only 500,000 shares. Its EPS is $2.00/share. Well, not quite. It has to pay interest on the debt, which is subtracted from the $1 million in operating earnings. But typically its EPS is still higher than $1.00/share. And its share price is probably higher. Also, its EPS growth rate will be higher for a given amount of increase in earnings.

    In a period of low interest rates, corporations will tend to take on more debt and buy back shares. This increases EPS. If done over time, this combination of financial strategies might increase the growth rate of EPS and the PE ratio.

    Your long-term rate of return on buying a stock or an index will depend on when you buy the stock or the index. It you bought the stock at the end of a business cycle or bull market and then the stock’s price went down, your rate of return for years might be low or even zero. At the extreme, if you bought a group of stocks like the Dow Jones Industry 30 in 1929 you would have waited until 1953 to get even. On the other hand, if you buy stock at or near the bottom of a market downturn, it is likely that your rate of return for the next 3-7 years will be substantially higher than the long-run average rate of return.

    A word about market downturns. There are two general types – with and without recession. A market downturn not caused by a recession tends to reverse quickly. A market downturn caused by a recession tends to be deeper and takes longer to recover. 

    WHAT SHOULD YOU BUY? AND WHY.

    Should you buy an index fund or ETF, a managed fund or ETF, or individual stocks? The three are not mutually exclusive. You might start with an index fund or ETF; the most popular is an index fund that mirrors the S&P 500 (the 500 stocks with the largest market value). Then you might like a particular industry or a set of similar stocks. It may be difficult for an outside investor to pick potential winners and avoid hyped probable losers. Choose a managed fund. You are paying for their research and their keeping up with changes. But be careful; many managed funds are very similar to index funds. Also, do not chase funds with outstanding recent results. Research indicates that the funds with the best results over three years are likely to exhibit below average returns over the next three years. 

    Index funds and managed funds are good for ignorant investors. Index funds beat most managed funds over the long run, mostly because their costs are lower. If you buy a lot of individual stocks or a lot of specialized funds, you may have a disguised index fund. At a higher cost.

    A few words about index funds. An index fund contains many stocks but they are not equal. The greater the total market value of a stock – “market cap” (capitalization) – the greater the weight of the stock in the index. So right now monster tech companies are the five largest companies in the S&P 500; the ten largest companies account for about 23% of the total market value of the index. To some extent, these and other really big corporations have become very large and very profitable because of innovation and high growth in the past. You are betting they will have higher than average growth in the future. This is a poor bet. If you look at the tech companies that dominated the indexes 20 years ago (or 10 years ago, or 30 years ago), they have been poor investments since then, although a few tech companies have made a recent comeback by getting into new businesses. 

    The indexes contain companies that are losing money and many companies whose sales and earnings growth depend mostly on overall economic growth. If you believe that the U.S. economy is in for a period of low growth, then the rate of return on an index fund will probably be below the historic rate of return. In addition, many of the companies in a market index will be hurt or destroyed by technological change and innovation from new companies.

    The index fund becomes “the market.” You would not buy a managed fund or an individual stock unless you expected your total return (capital gains plus dividends) was going to be greater than the total return of the index fund. This tends to rule out older, mature companies whose sales and earnings depend mostly on the total income growth of the entire economy; the change in their stock prices tend to closely followed the change in the market index.

    Which gets us to the idea of risk. Research indicates that on average 60-70% of a stock price’s movement is correlated with the movement of the market. When you buy an individual stock, you are buying the other 30-40%. The question is:  Why do you think this stock will have higher EPS growth than the market? Or in the words of Dirty Harry, “Do you feel lucky?”

    What kinds of stocks have a chance to outperform the market? One group is sometimes called “disruptor” companies. These are innovative companies that are creating new demand or disrupting existing industries or markets. For example, my beloved local electric utility, whose main service seems to be service interruptions and blackouts, is installing “smart” meters. Who makes the meters? My dentist raves about this new digital imaging system that replaced X-rays and gummy impressions. Who makes the digital imaging system? Again, avoid the stock of companies that are getting hurt (losing sales and market share) by new competitors with new technology or new products and services.

    If you are thinking of buying individual stocks, the warning here is that a good company – a company that you admire – may not be a good stock. I once worked for a very well-run company. But it produces a commodity in a competitive, price-sensitive market. Its earnings vary widely and are unpredictable. Its stock has underperformed the market for decades. It is financial performance that counts.

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    But first, you have to learn how to make enough income to start saving and investing. See my The 10 Minute MBA – Almost Everything You Need to Know to Manage Organizations, People and Yourself.

    A good place to learn the basics and mechanics of investing in the stock market and other financial markets is the Investopedia website.

    For an analysis of the stock market crash of 1929 and the start of the Great Depression, see my The Stock Market Crash of 1929 and the Beginning of the Great Depression. This essay questions the conventional wisdom that the stock market crash of 1929 “caused” or “triggered” the Great Depression.

    Go back to the Guide for Pages and Posts.

  • You, Your Brain and Credit Cards


    A basic assumption in economics and business finance is that individuals are rational in the sense that they compare the cost and benefits of a decision. Generally, this means comparing the cost of investing or consuming today to the expected benefits in the future. Cost is usually the price of the product or investment; expected benefits are harder to figure. The rule is simple; if the expected benefits are greater than the cost, buy it. If not, don’t.

    Even if the cost is spread out into the future – a car paid for with a cash down payment and a car loan – it is relatively easy in theory to discount future costs along with expected benefits back to “present value” (today’s dollars) and do the comparison.

    One question that economics and finance doesn’t ask is: Does how you make a purchase or investment affect the buying decision? Does it matter if you pay cash or use a credit card? Theoretically, the answer is no. But recent neuroscience research indicates that the answer is yes. Whether or not you buy something may be influenced by how you pay for it.

    Paying with plastic fundamentally changes the way we spend money, altering the calculus of our financial decisions. When you buy something with cash, the purchase involves an actual loss… Credit cards, however, make the transaction abstract, so that you don’t really feel the downside of spending money. Brain-imaging experiments suggest that paying with credit cards actually reduces activity in the insula, a brain region associated with negative feelings. As George Loewenstein, a neuroeconomist at Carnegie Mellon, says, “The nature of credit cards ensures that your brain is anesthetized against the pain of payment.” Spending money doesn’t feel bad, so you spend more money. Jonah Lehrer, How We Decide, p.86.

    In another experiment, a group (MIT students) was asked to bid for Boston Celtics tickets. Half the group was told they would pay with cash, the other half with a credit card. The average credit card bid was twice as high as the average cash bid. (Drazen Prelec and Duncan Simester, “Always Leave Home Without It,” Marketing Letters, 12 (2001), 5-12.)

    This example is one of many experiments that indicate our brain tends to highly value immediate gain or pleasure and has difficulty computing future cost. The brain is not very good at “discounting” the future or understanding abstract concepts like interest rates on credit balances. The price we pay for impulsive purchases is an interest rate on credit cards that would make a loan shark blush.

    This type of behavior is reinforced by other types of “irrational” behavior that leads to bad decision making. The limits to human rationality is a major reason why managers find it difficult to make strategic decision involving future events. (See a summary of the brilliant work on the limits of “rational” decision-making by Nobel Prize-winning Daniel Kahneman, Thinking Fast and Slow.)



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