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The Deeper Message of Financial Markets’ Volatility

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The Dow swung 600 points (high to low) in two days this week—and the week’s not over.

Key stock market indices in Indonesia and South Korea lost over 6% of their total value yesterday alone. Seoul’s Kospi Index had its biggest point drop ever. 

Katie Couric leads the CBS evening news with tales of homeowners who can’t find lenders to refinance massively increasing adjustable rate mortgages they (stupidly) assumed.

What’s it all mean?

The short story is the same as the long story—but the long story is much more interesting.

The short story starts with a classic housing bubble. People start borrowing to buy real estate. It becomes musical chairs, flip the property, sell to the greater fool. And use leverage.  Better yet, OPM (other people’s money).  Best—use both.

Lenders, like good drug pushers anywhere, develop new products and pitches.  Finance the first mortgage with the second; “liar’s” loans, no proof of income required. Wall Street packages loans, slices and repackages them and resells them. No one is left holding the bag—-everyone is left holding the bag.

National Public Radio reports that you can purchase complete lies about your income and employment history at sites like verifyemployment.net  to help fuel the game.

The short story is that the world has become so connected financially that a housing bubble in the US can decimate the stock market in Djakarta.  Everything is linked to everything.  This isn’t like 1929, where wealthy people lost money in the crash and soon couldn’t pay their employees.  This is far more integrated, international, intertwined, interdependent—and fast.  Butterflies flapping wings and all that.

True enough. But the financial markets are just a piece of a bigger puzzle. 

In the long story, the growth in connectedness of all things  exceeds the wildest dreams of rabid conspiracy theorists from just a few decades ago.

Tom Friedman’s The World is Flat is, at root, about how the world has become interconnected.  Time and space are being obliterated by always-on, high-bandwidth,  voice, data and video connections.  Capital flows easily around the world. The internet’s inherent freedom runs roughshod over the desires of industries and nations alike to maintain boundaries.  Even labor becomes mobile—if not through immigration, then through outsourcing.

Six degrees of separation has for some time now begun to look like an overstatement.

The first level of business implications is clear.  Pick one thing and do it the best in the world; outsource everything else to whomever is doing those things the best in the world.

But even that is old paradigm stuff—competing in a global world and all that. Increasingly, that’s so five minutes ago.

The really, really big lesson is this.

The game of competition is over. It’s not about vertical corporations competing against each other anymore.  It’s about collaboration and connectivity—with everyone. He who can get along with everyone better than everyone else will succeed.

Not “win”—succeed.

In a massively connected world, corporate strategy is less relevant than customer strategy.  It’s your ability to cut agreements with customers and suppliers that helps you—not your ability to squeeze pennies out of them.

This is a huge shift for people raised in business in the last 50 years, weaned on concepts like sustainable competitive advantage and shareholder wealth creation.

The business-strategic value of trust was always high.  It’s about to get far, far higher.  Those stuck with mental models built on inter-corporate competition are going to get left behind those who "get" the simple idea of service to customers, employees, and partners.

The Dark Side of Trust? Not!

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This blog regularly sings the praises of trust. It greases the wheels of commerce, ennobles human interactions, and generally makes the world go round.

Could it possibly be that trust has a downside? Omigosh.

From the always-provocative Harvard Business School Working Knowledge series  comes another  case of good data, flawed interpretation. This time it’s about plumbers in Philadelphia.

The Dark Side of Trust  summarizes research by Harvard Business School professor Felix Oberholzer-Gee and Victor Calanog, a doctoral student at the Wharton School at the University of Pennsylvania, in "The Speed of New Ideas: Trust, Institutions and the Diffusion of New Products."

They researched the introduction of an innovative new product (a plumber’s product called TrapGuard) to 596 plumbers and plumbing firms in Philly.

Now, some of those plumbers had strong relationships of trust with their suppliers—who presumably hadn’t told their customers about TrapGuard.  As HBSWK puts it:

The basic question at hand: Would TrapGuard encounter significant barriers to entry from plumbers who enjoyed trusting relationships with their suppliers? In other words, would plumbers be less likely to consider new products, even though innovative, because they were content with their current suppliers?

It should surprise no one that, indeed, plumbers who strongly trusted their suppliers were less inclined to pursue a promotional brochure for TrapGuard when sent one in the mail.

Here’s Oberholzer-Gee:

I wanted to see whether there was a downside to building trusting relationships between buyers and suppliers. In some sense, the study reveals a dark side of trust.

Trust is a double-edged sword. In the short run, working with trusted suppliers reduces transaction costs and furthers the buyer’s competitive standing.

But trust can also make you blind because it can make it harder to see opportunities that arise outside established relationships. The managerial challenge is to build trusting relationships without losing sight of outside opportunities.

Oberholzer-Gee clearly sees the double-edged sword nature of trust.

But presenting this as some kind of  “fair and balanced” offset to the positives of trust is at least a blinding flash of the obvious, and more likely disingenuous.

For example:

• The dark side of trusting your spouse to be faithful is you might not notice him consorting with that hottie;

• The dark side of a child trusting his parents is they might be homicidal maniacs;

• The dark side of loving (as any oldies station will tell you) is a broken heart.

Trust without risk is not trust at all. But of course. Trust is human risk management, a response to uncertainty—but one wholly unlike the rational, risk-parsing quantitative techniques typically taught and used in academia.

And here’s where it gets insidious.  HBSWK summarizes:

trusting relationships can also have a negative side that managers must take into account

HBSWK, and HBS, and Every Business School preach the Gospel According to Analytics. According to this gospel, managers “must take into account” some analytic cognitive insight at pretty much every turn, every transaction.

Never mind that “must” reeks of arrogance.  Note simply that if you subject every micro instance of trust to a micro-consideration of its worth, you destroy trust at the macro level.

Want a philandering spouse? Let her know every day how much you fear her infidelity. Want a suspicious, self-serving supplier? Constantly check them for suspicious, self-serving behavior.  Want thieving employees?   Give them all monthly lie detector tests. 

You empower what you fear.

Trust is a macro-response to life’s micro-issues.  You’d better evaluate it from time to time, like you would a marriage.  But if you constantly subject trust to the cognitive microscope, you destroy its essence.

“Must” you see the dark side of trust?  Don’t look too hard, you’ll miss all the glory, and ruin it in the looking.

Does Your Customer Trust You? The Acid Test

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Most salespeople will agree—there is no stronger sales driver than a customer’s trust in the salesperson. And, I suggest, the best way to be trusted is to be trustworthy—worthy of trust. You can’t fake it.

Is it possible to know if your customer trusts you? Is there one predictor of customer trust? Is there a single factor that amounts to an acid test of trust in selling?

I think there is. It’s contained in one single question. A “yes” answer will strongly suggest your customers trust you. A “no” answer will virtually guarantee they don’t.

The question is this:

Have you ever recommended a competitor to one of your better customers?

If the answer is “yes”—subject to the caveats below—then you have demonstrably put your customer’s short-term interests ahead of your own. This indicates low self-orientation and a long-term perspective on your part (I’m assuming sincerity), and is a good indicator of trustworthiness.

If you have never, ever, recommended a competitor to a good customer, then either your product is always better than the competition for every customer in every situation (puh-leeze), or—far more likely—you always shade your answers to suit your own advantage. Which says you always put your interests ahead of your customers’. Which says, frankly, you can’t be trusted.

Here are the caveats: don’t count “yes” answers if:

a. The customer was trivially important to you
b. You were going to lose the customer anyway
c. You didn’t even offer a product in the category
d. You figured the competitive product was terrible and you’d deep-six them by recommending them.

The only fair “yes” answer is one in which you honestly felt that an important customer would be better served in an important case by going with a competitor’s offering.

If that describes what you did, and it is a fair reflection of how you think about customer relationships in general, then I suspect your customers trust you.

If not—well, then why should they? Would you?

Juries, Courtrooms and Linear Thinking

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Three years ago I filed a lawsuit. It was my first, and hopefully last, experience as a plaintiff.

I sued a professional—there’s no point in revealing the profession. I sued him for malpractice and negligence, with a specific damages calculation. He, of course, said it was my fault.

This week, after a four-day trial, it went to a jury.

I’m not a lawyer. Don’t even play one on TV, though I’ve done seminars and speeches for some.

So other than jury duty (always rejected), I hadn’t seen courts close up and personal before. Here’s what I learned—one data point, one person. For what it’s worth.

The treatment of jurors impressed me. The judge spoke seriously about gratitude for their civic responsibility. The parties rise and stand every time the jury enters and leaves (which is frequently).

But most of all, the judge admonished them, “If anyone approaches you about this case—call 911. Ask for the Sheriff, and have the Sheriff call me. Any time of day or night.”

The power of the judge scared and impressed me. He made an almost autocratic decision, unilaterally. Then he changed it the next day, calling himself out on his own potential fallibility—I was impressed. A powerful blend of brains, charm and the need to make more calls than an umpire; almost all very well done.

The rules of evidence are extreme, and powerful. Lots of very relevant material never made it in, because it didn’t pass several tests—hearsay, standing, expertise, etc. The intent is to limit the bases of decision to distilled-clean facts, precisely stated.

The presentation of data relied entirely on the cognitive skills of the jury. They listened to days of bland recitations of data, numbers and legal concepts, without physically seeing the documents being described. Data, abstraction, words, concepts. That’s what you’re fed as a juror.

The charges to the jury were complex; a tax-like form with “if yes to 2a, then go to 6; else, go to 3,” which covered several issues of liability, damages and mitigation.

Finally—to the jury. Both sides expected a decision in less than an hour. It went four hours, despite one juror postponing vacation, others their work.

The verdict? Breech of contract, not guilty—but malpractice, guilty. Was malpractice a proximate cause (not “the,” just “a”) of damages—no. Therefore no damages due.

Both sides found this a confusing, almost contradictory, verdict—at least,that is, from the point of view of the legal issues that had been so exquisitely, carefully crafted by the legal teams and the judge. And of course the jury doesn’t get the chance to share its thinking—just the results.

Yet I think there’s at least one explanation—an emotional, human, commonsense logic—that makes a lot of sense. It goes like this:

We’re not thrilled with any of you. We want our professionals to behave better. We’re also worried about excessively litigious behavior—and besides there’s blame enough to go around. Judge, lawyers and court system—we don’t like sitting for days on a case that should have settled; and we don’t like being fed abstractions.
So if your legal constructs don’t allow us to express these deeply held opinions, we will squeeze the constructs, not our opinions.

I have absolutely no way of knowing their thoughts, of course. Surely I could be wrong. But I could see myself thinking that way in their shoes, and I respect it.

It’s another arena of life where society wants us to be rational, cerebral people, solving life’s problems with our brains; while our human hearts drive us through to a clearly seen and desired end, ever-reminding us that we’re not just brains-in-bodies.

It was humbling—for both of us. But I now believe justice was served, and served well. It just wasn’t served on the same platter the system had provided.

Does Trust Drive the Dow?

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Over at Room 8 , Larry Littlefield suggests that the history of bear and bull markets in the US is the history of consumers’ trust in business. That is, market forces are, at a macro-level, governed by the public’s view of business.

Littlefield walks through eras in US history—the Robber Barons, the Progressives, corporate leadership in WWII, the Great Depression, Reaganism, the dot-com boom and crash—and points out the correlation with public confidence and trust in business.

Now there’s an audacious view for you. Wish I’d thought of it.

Is it true? As with any grand scope theory, the concept of “proof” is not really applicable. The point is to make you think.

With such a sweeping thesis, there are bound to be problems of definition, and problems of cause vs. correlation. What caused what? What what is “confidence” anyway, and how does that relate to trust? And so on.

Still. At a certain macro-level, he is most assuredly right. Markets do depend, at the end of the day, on confidence. Confidence about the prospects of the future relative to the present. Confidence about the economic good that business will bring forth. Or lack thereof.

Confidence at that level is wholly dependent on the belief that things will work out, that people and institutions can be depended on to play certain roles, that their motives will be socially acceptable, that the social fabric will continue to be intact.

You could certainly call that trust.

And from that vantage point, it surely is enough to move markets, both up and down.

Trust isn’t just the stuff of personal relationships and surveys; it has real economic consequences, to societies, economies, pension funds and people. Trust is money.

But its economic currency depends on all the rest. Economic value, for all we in business like to talk about “hard” things, really does depend on mutual trust—the “softest’ of things.

Wall Street and “tough” managers would do well to remember it.

 

Call for Submissions for the August Carnival of Trust

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Carnival of Trust Logo

The third Carnival of Trust is fast approaching and will go live on Monday August 6th. The deadline for entries is this coming Thursday, August 2nd. This edition will be hosted by the Editor of the Blawg Review. The mysterious Ed, as he’s known, was someone I asked for advice on how to set up a carnival, and I’m looking forward greatly to seeing his edition of the Carnival of Trust.

As I wrote when announcing the first Carnival of Trust my hope and ambition for the carnival is to begin establishing a home base, a center of gravity, for people who are interested in fostering greater trusted relationships in various realms of the world.

While my own material is primarily business-oriented, the Carnival of Trust will be explicitly more broad than business alone. Trust is heavily personal in nature, and I hope the submissions will reflect that—postings that deal with personal trust, business trust, and political trust are welcome, as well as pieces on the nature of trust.

I’ll be setting a hard limit of 10 postings per Carnival. The host will personally make the decisions about inclusion, in an inevitably subjective manner intended to push the thinking ahead in those broad areas of trust.

I invite, encourage and urge you to submit pieces for the Carnival. Send them to http://blogcarnival.com/bc/cprof_1693.html

The first and second carnivals of trust had some great articles I urge you to read if you haven’t already.

And I look forward to reading your articles in the August Carnival!

Transparency, News Media and the NBA

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What do news media and the NBA have in common?

If you guessed a trust problem, go to the head of the class.

So it’s interesting to see two pieces within a day of each other, suggesting the same solution to the respective industries’ woes.

Henry Abbott, in What the NBA Needs: Transparency offers a radical suggestion:

the crisis is if all those people who love watching the NBA find themselves in the position of not trusting the referees. That’s an indictment of the game itself…

The NBA keeps telling us how many ways they assess their referees. They insinuate that if we knew what they know, we’d trust those referees, too. Maybe that’s true. But telling us so isn’t going to convince anyone.

NBA, you’re going to have to show us.

… Let us go online after every single game and see video of every single call, all neatly sliced and diced by player, by time of game, by type of call, by referee, and by a bunch of other things I haven’t thought of yet.

Henry makes an important point about transparency—it’s hard to be partly transparent, because being partly transparent immediately suggests you’re hiding something. Call that a negative feedback loop. Don’t tell us—show us.

Alicia Shepard at the Chicago Tribune writes For News Media, Transparency Is a Matter of Trust, saying:

Poll after poll, year after year, the message is the same: Journalists are ranked down with used-car salesmen and snake-oil peddlers when it comes to credibility.

Is it because reporters lie? Is it because reporters make so many mistakes? Or because reporters are biased?

No. It’s because the public does not understand what journalists do or how the news gets put together, whether it’s for TV, print, radio or the Internet.

… The news industry should work harder at exhibiting the same transparency about how it operates that it demands from public corporations and all levels of government.

…. "Transparency is essential because it’s inextricably tied to credibility," said Susan Moeller, director of the International Center for Media and the Public Agenda. "Transparency doesn’t ensure accuracy. But it does ensure that when a news outlet makes a mistake … its audience can be assured that the news outlet is going to admit to it and correct it and will have policies in place for following it up."

Several other industries look at the same diagnosis—“the public does not understand us”—and conclude they have a PR problem, solvable by “getting the word out.”

NBA fans and media hounds know that won’t cut it. Transparency is not great spin—it’s a spin-free zone.

In our personal lives, the solution to mistrust is to “come clean,” “let it all hang out,” “just put it out there,” “tell the whole truth.” Be transparent.

At an industry level, the same dynamics are at play.

IQ, EQ and the Next Billion Banking Consumers

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The Boston Consulting Group might house the world’s highest concentrations of brainpower per square foot.  BCG is to consulting what Goldman Sachs and Cravath are to banking and law.

When it comes to intelligence, they are tops.

In terms of IQ, that is.

EQ?  Well, that’s not so much what they’re aiming for.

Case in point—the most recent article from BCG’s Industry Insight series, The Next Billion Banking Consumers. (The piece shares two authors and whole paragraphs verbatim with a more general piece from BCG’s Perspectives article series, titled The Next Billion).

BCG’s article series—particularly Perspectives—have been the source of breakthrough thinking for several decades now, including the experience curve and the barnyard portfolio theory, and the general concept of strategy as the pursuit of sustainable competitive advantatage.

The article opens big:

The problem of financial exclusion—individuals’ limited access to or use of formal banking services—looms large around the world. It both reflects and contributes to the stark socioeconomic divide that pervades many emerging markets…

By embracing innovative business models, however, banks can upend the economics of reaching consumers long considered impossible or unattractive to serve.

Great—energizing the banking sector to help accomplish what microfinance suggested might be possible. Cutting-edge capitalism, bringing the next billion—“just above the poorest of the poor and just below those who are currently targeted by most banks”—into the mainstream of the global economy.

Indeed, much of the article addresses the need for changes in product development, distribution, marketing and organization structure, listing some exciting innovative practices.

Then there appears this paragraph:

Unfortunately, regulations sometimes make it difficult—if not impossible—to offer products that suit the financial means of the next billion consumers. Our analysis shows, for example, that Indian banks would need to charge a 32 percent interest rate just to break even on the kind of small, short-term personal loan that the next billion consumers would want.  Yet national regulations prohibit banks from charging interest rates to priority sectors that exceed the prime lending rate, which currently stands at about 12 percent.  This problem underscores the need for regulatory reform that complements initiatives to reach the next billion consumers.  (italics mine)

The need for regulatory reform?  Let me get this straight.  A banking industry in a country with 5% inflation and 6% one-year t-bill rates needs 32% interest rates to break even in a new market, and the problem is—the presence of usury laws?

How about—oh, I don’t know—a banking industry that can make money on less-than-32% interest rates?

Unless I am seriously missing something—always a possibility—the inclusion of this paragraph, alongside discussion of radical product and distribution redesign, is socially and politically tone-deaf.  Narrow.  Myopic.

It feels like a hammer seeing an all-nail world.  If your constant goal is the pursuit of corporate competitive strategic advantage, then of course regulatory “reform” is inconsequentially different from product innovation—it all adds to competitive advantage, right?  (Except of course for the poor schmoe trying to make a buck with his feet in plus-32% debt cement shoes). 

In an increasingly connected world, the view of competition as the be-all and end-all of business—even just of strategy—is antiquated.  Out of sync. Competition without commerce just doesn’t add up to much.

The world is connecting more.  And it isn’t about just the connections, or the connected.  It’s about the synergy in the combination.

Kind of like IQ and EQ.

 

Negotiation and the Short Term Performance Trap

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Economists and psychologists love intellectual puzzles like The Prisoner’s Dilemma, a game that posits a 2-person bargaining or competition situation.

In The Prisoner’s Dilemma, one person goes free if he “rats out” the other prisoner and the other prisoner stays mum. Unfortunately, if both rat out each other, they each get life in prison.  If both stay mum, they each get off with just a year.

When the game is played with strangers—one time only—the most common result is the double-rat-out.  Oops.

The challenge to economists is to explain why people so frequently do not act “rationally.”

The answer shows up when you play it ten times in a row. With a friend. With eye contact.

But—especially—from playing it ten times in a row.

Then the players quickly learn to cooperate.  (Though sometimes they’ll turn vicious again the last round.  Or maybe not. Think reality TV shows.)

The point is: it’s smart to think collaboration, cooperation, medium to long term focus.  Not a one-time, zero-sum, confrontational me-vs.-you outcome.

The learning for managers, sales managers, brokers, etc. is clear: if you think you’ll never see this customer again, nor have to deal with this customer’s spouse, friend, or cousin, and you think no one will ever hear what you’re about to do, and you’ll gladly trade a good reputation for money—then go ahead, squeeze the customer, try to win the negotiation—treat it like a transaction.

All others: operate on the assumption of multiple transactions—which, for lack of a better term, let’s call relationships.

Assume you will have repeat customers; that your reputation matters, even in terms of simple self-interest; that what goes around comes around; that six degrees of separation in today’s world is a vast overstatement, and it’ll bite you if you don’t believe it.

It’s a simple enough answer. People in social situations routinely act as if they’re a member of an ongoing social group, even if they’re not. (See for example similar results regarding The Ultimatum Game).

That, however, is in social situations.  At the business level, particularly with customers, another belief system often gets in the way.  I hear it frequently.  It sounds like this:

You don’t understand, Charlie; around here, you get measured on short-term results. So there’s a lot of pressure. You have to be a lot tougher on customers—terms, pricing. Trust is nice and all that; but I’ve got a job and a bonus structure and I’ve got to make a living. Go tell it to my boss.

OK, let’s tell it to”your boss.”

Every time you treat a customer from a transactional point of view, you are hurting your long-term profitability. And the short term has a way of turning long-term very quickly. You run out of new customers to squeeze to get all you can in one deal.  And if you rat-out your customer, and your customer rats you out in return, you just bought yourself long-term low profit prison terms.

Put another way:

The best short-term performance does not come from short-term management—it comes from medium- and long-term management done well.

Management, that is, based on the presumption of a relationship, not a series of oppositional transactions. Management based on principles, not self-interest.  If you want to be in charge of your own long-term career, don’t let “your boss” ruin it with short-term management.  Your customers will remember your behavior, not your boss’s words.

Trust makes money.  Prisoners who rat each other out lose money.

Please tell “your boss.”

Trust, Conflicts of Interest and Death Bonds

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You trust your brother- in-law, and tell him you want to buy a used car. He says his cousin knows cars. You talk to his cousin, who recommends you buy a Saab. He finds you one; you buy it. All is good.

Then you learn the cousin is a used car dealer, and the car came from his inventory. Next, you learn your brother-in-law received a referral payment from his cousin for your business.

Now there are at least two people you trust a lot less. And the phrase “conflict of interest” becomes personal. But how, exactly, are the two related?

When I wrote (with Maister and Galford) The Trusted Advisor, we introduced the Trust Equation:

T = (C+R+I) / S, where
C=credibility, R=reliabilty, I=Intimacy, and S=self-orientation.

(To be precise, it’s a formula not for trust, but for trustworthiness of the one who would be trusted.)

The numerator factors are pretty clear. It’s the denominator that gets most readers’ interest, and rightly so—it’s the most powerful.
On a personal level, we trust someone if their focus and interest is about us: we do not trust them if their focus and interest is about themselves.

It’s why we’re sceptical of used-car dealers, telemarketers, and other stereotypes of sellers—people who clearly want our money, but less clearly have our interests at heart.

Conflicts of interest are fuel for the fire of self-orientation. How we choose as a society to deal with them says a lot about our view of government, and of humanity.

Arrayed in increasing order of social involvement:

Seven Responses to Conflicts of Interest: 

    by Level of Social Involvement

  1. Level one is caveat emptor. Society doesn’t have an interest compelling enough to create a solution beyond “deal with it.”
  2. Level two is ethical. Rely on collective shame heaped on used-car dealers to enforce behavior.
  3. A third is professional. The Association of Used Car Dealers should develop and enforce guidelines. (The Association for Brothers-in-Law is a less likely candidate for this approach).
  4. A fourth is enforcement. Vote for whatever district attorney will prosecute the hell out of the guilty parties using whatever laws are on the books.
  5. A fifth is required disclosure. As long as your brother in law and his cousin tell you their interests, the problem reverts to level 1.
  6. A sixth is regulatory. The National Used Car and Brother-in-Law Exchange Commission will do what the industry failed to do.
  7. Finally, there is structural reform. Separate the evil-doers so that they are not only free from temptation, but can never conspire to develop their nefarious schemes.

Society evolves. Big Tobacco went from level 1 to level 7 in mere decades. Sarbanes-Oxley was a level seven solution after many years at level three. Elliot Spitzer got elected governor of New York because of his activity at level four. Glass-Steagall’s repeal went from level seven back to levels five and lower.

Senator Herb Kohl of Wisconsin has been holding hearings about the pharmaceutical industry’s role in medical research; many researchers are funded by pharmaceutical industry money. The question is: what to do about it?

Kohl is inclined to recommend level five—disclosure. The Pharmaceutical Manufacturers Association says leave it at level three. Doubtless there are other views covering the others.

The July 30 2007 cover story in BusinessWeek is about Death Bonds—securitized life insurance policies, the same thing we’ve seen with mortgage-backed securities. The idea is individuals can cash in their life insurance policies to investors, and benefit. Along with the investors. The sooner the insured dies, the faster the investor makes money.

Right now, 26 states require professional licensing for "life settlement brokers"—level six.  Several investment banks have founded the Institutional Life Markets Association to lobby for appropriate regulation—level three. New York is prosecuting Coventry First—level four.  (Data from the BW article.)

What is the right role of society in mitigating conflicts of interest to foster greater trust?