Published on November 26, 2018 by Aditya Jaiswal
The Pope: ‘Tell me the secret of your genius. How have you created the statue of David, the masterpiece of all masterpieces?
Michelangelo: 'It’s simple. I removed everything that is not David.'
In this blog post, I am going to discuss three short cases: flash sales of smartphones, Coca-Cola’s universal appeal and the subprime mortgage crisis of 2007-08. Surprisingly, each case has some similarity with the other. I will also explain a few cognitive biases, as understanding these biases would help us grasp the lollapalooza effect. Finally, in the second part of this post, we will discuss how understanding the lollapalooza effect could help us identify new investment opportunities.
Flash sales of smartphones
Smartphone brands often use flash sales to quickly offload inventory and increase brand awareness.
Suppose you want to buy a newly launched smartphone, but you wonder whether or not to buy it at the current price. While you are struggling with this decision, the phone company announces that this particular model will be online exclusive and will be sold through flash sales.
In such circumstances, your decision could be affected by several psychological scenarios that come into play:
a) Scarcity error: Since the phones will be sold through flash sales, people may want to get it somehow; artificial scarcity inspires urgency
b) Social proof: If thousands are sitting in front of their computers battling for a slot in the flash sale, the product must be good.
c) Authority bias: Just before the launch of a product, smartphone companies often distribute a few samples to popular reviewers. These reviews often influence our reasoning.
d) Envy: Hari, a 15-year-old tech-savvy boy failed to buy the phone in the first flash sale, but his best friend managed to get one. What would Hari do? He will try harder in the next flash sale!
The result? Millions of smartphones sold in a few flash sales!
This case shows that when a couple of factors (in this case, cognitive biases) operate together in the same direction, the result could be extremely positive (or negative).
Defining the lollapalooza effect
The term was coined by Charlie Munger, vice chairman of Berkshire Hathaway, during a 1995 speech given at Harvard. It basically means an extreme outcome caused by a combination of factors moving in the same direction. When multiple forces are all operating in the same direction, the result is not linear but exponential. So, 2 + 2 won’t equal 4, but 22!
In 1996, Munger gave an impromptu speech titled "Practical Thought about Practical Thought", where he cited Coca-Cola's dominance in the global soft drinks market to illustrate the lollapalooza effect. Let's discuss Coca-Cola’s case to clarify our understanding.
Coca-Cola's universal appeal
The Coca-Cola Company is a global non-alcoholic beverage manufacturer. It has been operating since 1886, selling carbonated soft drinks. In 1988, it derived about 95% of its revenue from selling its original Coca-Cola soft drink. Today, its product portfolio consists of over 3,500 beverages sold across the world (except in North Korea and Cuba). It owns about 500 brands, 20 of which are billion-dollar ones. The USD180bn Coca-Cola brand has built at least three moats around its economic castle: strong brand value, a large-scale cost of production advantage, and a global network distribution advantage.
Have you ever wondered what the secret behind Coca-Cola’s universal appeal is?
What makes it so special? How did it manage to turn every factor we can think of to work in its favor?
Why has no other brand been able to catch up with Coke? If you were given USD180bn today, would you able to replicate its success?
Understanding the lollapalooza effect is the key to answering the above questions.
We learnt from the previous case that exponential results occur when multiple forces operate in the same direction.
So, which factors have worked in favor of Coke?
At least three factors have worked together to generate extraordinary results for Coca-Cola.
1) Pavlovian conditioning: Pavlovian conditioning theory implies learning a new behavior through the process of association.
Remember how the mere ringing of a bell caused Pavlov’s dog to salivate?
Similarly, the association of Coca-Cola consumption with events we attend and celebrities we admire (be they movie stars, sports stars, or supermodels) creates a Pavlovian conditioning. The more Coca-Cola spends on advertising and promotion, the more Pavlovian conditioning it creates.
2) Availability bias: We have a tendency to make decisions based on readily available information. When we are repeatedly exposed to a particular product or idea through interaction or advertising, it is stored in our minds, waiting to be recalled at a moment’s notice.
Why can't a new player imitate Coca-Cola's strategy by creating similar Pavlovian conditioning?
The answer lies in the easy availability of Coke. Coca-Cola's huge distribution network is an entry barrier for a new player.
"You will drink a helluva lot more Coke if it’s always available. I mean availability does change behavior and cognition" – Charlie Munger
Therefore, the easy availability of Coke reinforces the already established Pavlovian conditioning – a virtuous cycle!
3) Social proof: To understand this bias, let us take an excerpt from Rold Dobelli's book 'The Art of Thinking Clearly'.
"Suppose that 50,000 years ago, you were travelling around the Serengeti with your hunter-gatherer friends and suddenly, they all bolted. What would you have done? Would you have stayed put, scratching your head and weighing up whether what you were looking at was a lion or something that just looked like a lion but was in fact a harmless animal that could serve as a great protein source? No, you would have sprinted after your friends. Those who acted differently from the group exited the gene pool. We are the direct descendants of those who copied others’ behavior."
Therefore, social proof is basically herd instinct – the more individuals follow a certain idea/behavior, the better we consider the idea to be!
Similarly, imitative consumption of Coke triggered by the mere sight of consumption of Coke reinforces the “social proof” factor for Coke consumers.
Therefore, Pavlovian conditioning, availability bias, and social proof have worked in tandem to create a compounded effect that creates and maintains a competitive advantage for Coca-Cola – a lollapalooza effect.
Coca-Cola's success story reinforces what we learnt from the example of flash sales of smartphones: we have many cognitive biases that can sway our behavior one way or another. All these psychological tendencies work at a subconscious level. If these cognitive biases combine, the result could be a lollapalooza effect.
The subprime mortgage crisis of 2007-08
The subprime mortgage crisis of 2007-08 is a textbook example of the lollapalooza effect. Prior to the advent of securitization, lenders used to keep mortgages on their books; therefore, they were concerned about the creditworthiness of the borrower. However, when Wall Street came up with the concept of securitization, it created a massive lollapalooza effect. Securitization allowed lenders to sell their mortgages to the street, which would then bundle and sell them to investors around the globe.
The mortgage lending business was, therefore, transformed from a long-term affair to an assembly-line process, where lenders could clear all risks from their books and get paid faster and issue more loans. The entire system – from frontline real estate brokers to appraisers, mortgage lenders, banks and borrowers – was affected by a lethal dose of human misjudgment.
Frontline real estate agents were incentivized to sell more to earn more commission (incentive bias). They were keen to make more money, even if those sales weren't profitable or in worst cases, against the long-term interest of the organization. Borrowers were affected by herd instinct (social proof) as real estate prices rose; everybody was buying houses (bandwagon effect); even those who couldn't afford to took loans to support an unsustainable lifestyle; some become speculators, switching homes, trying to make a killing as real estate prices kept rising.
What was the result?
The lollapalooza effect brought the global economy to its knees!
In the next part of this blog post, we will discuss how understanding lollapalooza effect can help us identify great investment opportunities.
1) “The Psychology of Human Misjudgment” – Speech at Harvard Law School by Charles T. Munger, June 1995
2) INVESTEDUCO: Warren Buffett & Charlie Munger’s investment thesis in Coca-Cola that turned $1b into $10b, a 26% annualized return>
3) Simply Psychology: Classical Conditioning
4) Nasdaq: Practical Thought About Charlie Munger's "Practical Thought about Practical Thought"
5) T2 Partners LLC: An Overview of the Housing/Credit Crisis And Why There Is More Pain to Come
6) The Art of Thinking Clearly by Rolf Dobelli (Book)
7) Moats: The Competitive Advantages of Buffett and Munger Businesses by Bud Labitan (Book)
8) How India can become a $5 trillion economy (The Hindu)
9) Shut Chinese companies hit desi pharma players (TOI)
10) Pharma Sector: 80 per cent APIs via Chinese imports despite similar making costs (The Indian Express)
11) China’s evolving API industry and the impact of GMP regulations (CPhlonline)
12) India 2018, Overhauling The Rural Growth Engine (Phillip Capital)
What's your view?
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About the Author
Aditya Jaiswal has over 3 years of experience in equity research. Prior to joining Acuity Knowledge Partners, he worked at William O’Neil India and Stewart and Mackertich, a front-end wealth management firm. He is an alumnus of St. Xavier’s College, Kolkata, where he studied finance.
28-Nov-2018 09:19:39 am
Very nice. Well-explained.
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