Latticework of Mental Models: Lindy Effect

“Many happy returns of the day Anshul!” One of my old friend wished me on WhatsApp. Dropping a message on WhatsApp is more convenient these days than calling up. It was still better than the standard birthday wishes you get on Facebook, which you know have come as a result of constant pestering from Facebook notifications – “Hey! It’s Anshul’s birthday today. Write something on his wall.”

“Thanks man. I am glad you remember.” I replied. I still didn’t believe that he actually remembered my birthday. May be Facebook sent him a customized birthday wish to be forwarded to me from WhatsApp. After all Facebook now owns WhatsApp.

“You know what? You just wasted another premium of your life insurance!” He joked.

“Well, that’s an interesting way to look at it. But I am glad that it was wasted. After all life is perishable and can end at any moment – insured or uninsured.” I told him with a smiley.

But that got me thinking about insurance (especially term insurance) and life. On one hand, every additional year I live on, the insurance premium seems to go waste. But on the other, as I grow older, since my life insurance premium remains fixed, I get more and more value for each rupee spent on insurance. How?

For anything that’s perishable, including human life, every additional day in its life translates into a shorter additional life expectancy. Isn’t it?

Well, isn’t everything perishable? Including humans, animals, plants and the planet earth itself? Even the sun will die one day. But let’s not get far too ahead into cosmic future. We are talking relatively here. Sun may perish one day but compared to human life, sun’s life is close to being infinite i.e. nonperishable. I mean what are the chances that any person who is alive today, outlives the sun?

Zilch! And how do we know that? Actuarial tables.

I’ll take help from Nassim Taleb, author of wildly popular books including Fooled By Randomness, to explain it. He writes –

Say I have for sole information about a gentleman that he is 40 years old and I want to predict how long he will live. I can look at actuarial tables and find his age-adjusted life expectancy as used by insurance companies. The table will predict that he has an extra 44 to go. Next year, when he turns 41 (or, equivalently, if applying the reasoning today to another person currently 41), he will have a little more than 43 years to go. So every year that elapses reduces his life expectancy by about a year (actually, a little less than a year, so if his life expectancy at birth is 80, his life expectancy at 80 will not be zero, but another decade or so).

The actuarial tables for the sun (as prepared by astronomers based on their decades of experience of stargazing) speculate that sun has been there for billions of years and the history of human life is barely few million years. However, when you see a young and an old human, you can be confident that the younger will survive the elder. But with something nonperishable, say a technology, that is not the case.

This brings us to a very interesting observation about predicting the future durability of things. Taleb calls it the Lindy Effect.

According to Lindy Effect, there are certain things, where every additional day may imply a longer life expectancy. Lindy Effect is applicable to anything that is non-perishable like a technology. The longer a technology lives, the longer it can be expected to live. A simple technology like spoon has been there, unchanged, for thousands of years. People have been using the spoons and forks for eating since Roman times.

Rolf Dobelli, in his book The Art of Thinking Clearly, writes –

You’re sitting in a chair, an invention from ancient Egypt. You wear pants developed about 5000 years ago and adapted by Germanic tribes around 750 B.C. The idea behind your leather shoes comes from the last ice age. Your bookshelves are made of wood, one of the oldest building materials in the world.

Lindy effect isn’t an iron law but it’s a good rule of thumb to use when you’re thinking about the prospects of a shiney killer app that claims to revolutionise the world. Think about it, email was used before SMS technology came in, and email is still there whereas SMS is almost at the brink of extinction.

Taleb argues that most of the technology that has existed for the past fifty years will serve us for another half century. And the recent technology will be passé in a few years’ time.

Think of these inventions as if they were species, writes Taleb, “Whatever has held its own throughout centuries of innovation will probably continue to do so in the future, too. Old technology has proven itself; it possesses an inherent logic even if we do not always understand it. If something has endured for epochs, it must be worth its salt.”

Because what survives must be good at serving some (mostly hidden) purpose that time can see but our eyes and logical faculties can’t capture. Apart from technologies you can extend this idea to think about objects like software, companies, business, books etc, where each one more year of survival helps in adding more years to lifespan and increases the survival strength.

Similarly, Lindy effect is a great mental model to decide what books to read. Taleb explains –

If a book has been in print for forty years, I can expect it to be in print for another forty years. But, and that is the main difference, if it survives another decade, then it will be expected to be in print another fifty years. This, simply, as a rule, tells you why things that have been around for a long time are not “aging” like persons, but “aging” in reverse. Every year that passes without extinction doubles the additional life expectancy.

…The best filtering heuristic, therefore, consists in taking into account the age of books and scientific papers. Books that are one year old are usually not worth reading (a very low probability of having the qualities for “surviving”), no matter the hype and how “earth-shattering” they may seem to be. So I follow the Lindy effect as a guide in selecting what to read: books that have been around for ten years will be around for ten more; books that have been around for two millennia should be around for quite a bit of time, and so forth.

The ROI on reading and understanding a concept from 500 years ago is highly likely to be exponentially greater in the long run than one presented only 5 years ago. Unfortunately if you were to look at a typical person’s reading list, the vast majority of books would be the recent bestsellers (low value) while fewer books would be the older classics (high-value).

Neomania Pitfall

According to Taleb, people who don’t understand Lindy effect and love change for its own sake, fall for neomania. These are the so-called early adopters, the breed of people who cannot survive without the latest iPhone. May be they are ahead of their time but chances are high that they suffer from neomania.

You might give counterexample of a technology that we currently see as inefficient and dying, like telephone lines, print newspapers, etc. But understand that Lindy effect doesn’t say that it’s true for everything. It talks about life expectancy which is simply a probabilistically derived average.

If I know that a forty-year-old has terminal pancreatic cancer, argues Taleb, “I will no longer estimate his life expectancy using unconditional insurance tables; it would be a mistake to think that he has forty-four more years to live, like others in his age group who are cancer-free. Likewise someone (a technology guru) interpreted my idea as suggesting that the World Wide Web, being currently less than about twenty years old, will only have another twenty to go—this is a noisy estimator that should work on average, not in every case. But in general, the older the technology, not only the longer it is expected to last, but the more certainty I can attach to such a statement.”

In Business and Investing

Unlike us humans where the probability of dying rises as we age, it’s mostly opposite in case of businesses. Of course, most businesses go through a cycle of birth, growth, maturity, decay, and death. In fact, while humans are experiencing increased life expectancy i.e., the gap between birth and death, a lot of businesses are experiencing a shortened lifecycle.

As you can see from the chart below, 44% of startups fail by the third year, and the mortality is across all industries, especially IT and communication where only 37% and 45% of startups cross the age of four.

On the other hand, there are businesses that last for decades and centuries. DuPont is 214 years old, JP Morgan is 60, Colgate is 210. In India, Dabur is 132 years old, Britannia is 124, Indian Hotels is 114, ITC is 106, and L&T is 78. For such businesses that cross a significant threshold in their lives, their life expectancy increases as they get older – the Lindy effect at work you see.

I am sure you may be smelling survivorship bias here because a lot of other companies that started 50-100 years ago are now resting in their graves, but that’s not the point here. The point here is that the longer a company has been around, the higher is the ‘probability’ that it will stay around for even longer. This is because companies that manage to survive the longest – by seeing through several business cycles and competitors – are the most robust and, hence, least likely to die. And this is one important aspect you should consider while going through your investment checklist – how long a business has been in operations and how well or badly it has done during these years.

Lindy effect, however, also comes with exceptions. When using this effect as a mental model, you will need to be on the lookout for disabling technological change. Kodak and Nokia did not. In India, managers at MTNL and HMT seemed to have been too impressed by the Lindy Effect to ignore the changes that sweeping by them. For businesses to keep living, first they must be built around simple products and services that do not go through a lot of technological disruptions or changes (IBM at 105 years is an exception here) and even then, they must keep evolving. Like Britannia or Dabur of today are highly evolved versions of their earlier years.

These are helpful checkpoints for you as an investor. Excluding investors who focus solely on micro caps or penny stocks or startups, for most of us considering a long past track record of the company is paramount. A company may remain small even after 50 years of operations – largely because the industry/market it serves is small, like tractor parts, speciality chemicals, local area banking etc. but such companies may also have the probability of keep on living and prospering for another 50 years. So a long track record of the business, and of the management is what you must look out for.

Lindy effect can help you filter out the latest overhyped management strategy from an author who is also a tenured professor at an international business school. Majority of those management theories aren’t going to survive beyond few years. In fact, odds are that the author himself will come up with another book touting his next discovery with a potential to transform the business practices all over the world.

Conclusion

So don’t get too excited about the latest revolutionary trading strategy. The odds are usually stacked against the brand new. Fifty years into future will not look like a scene from the latest sci-fi movie. We’ll still be sitting on chair, eating with spoons and using automobile (driverless or electric) for personal commute.

Things that have lasted a long time tend to last longer still.

One of the primary reasons for most people to lose money in stock market is their inability to make decisions independently. But there is class of people who have an advantage as investors because they can think independently and avoid psychological errors. Charlie Munger, the inimitable partner of Warren Buffett, heads that class.

He is one of the world’s most successful investors and known for having an interesting mind. What makes him interesting is not his success as an investor but the way he thinks and keeps his emotions under control. He thinks deeply about why things happen and works hard to learn from the experience.

Munger is a proponent of the idea of vicarious learning. According to him learning from the success and failure of others is the fastest way to get smarter and wiser without a lot of pain. He quips, “I observe what works and what doesn’t and why.”

So take care, keep observing and keep learning.