Law of Averages,Regression to the Mean and the Walk down the Dalal Street!

 Sir Francis Galton, a British polymath, did pioneering work on Regression or Reversion to the Mean in Statistical Research in the late 19th Century. According to his analysis of human characteristics, he applied statistical methods to the study of human differences and inheritance of intelligence and pioneered the work on Eugenics. He also contributed to the field of psychology by founding psychometrics with personality mapping.

He was a versatile genius and being the half-cousin to Charles Darwin, his works in many ways drew sufficient inspiration from Darwin's studies. But his most outstanding contribution is Regression to the Mean in Statistical analysis. He is also considered to have developed a central limit theorem showing that with sufficient sample size the binomial distribution approximates a Normal Distribution and the practical demonstration of it is called Galton Board or Quincunx or Bean machine

Regression to the Mean is in simple terms that if there is volatility observed over the mean, over a while the values will show Regression to the Mean/Average and Francis Galton termed it as Regression to the Mediocrity in terms of inherited human characteristics. This led to modern statistical modeling based on linear regression analysis.

Regression to the Mean is also important to understand the stock market behaviour. Stock market behaviour is considered to be a Random walk and the financial world which considers a normal world will always look for stable returns. Jeremy Siegel said that "return to the mean" may show that returns may be unstable in the short term but stable in the long run. In such a situation the returns can be easily quantified and not a Random walk. But the stock market exhibits typical Random Walk characteristics. A Random Walk is one in which future steps or directions cannot be predicted based on past actions or performance. But Dalal street would hate to call its three-piece suit executives , who carry an air of super cat financial strategists,  as "Random Walkers"!!(link). The central hypothesis of Random walk is that one cannot consistently outperform the market averages. In other words, even the best of financial strategies would eventually start regressing to the mean.

The law of averages which is a law of large numbers gives false belief and therefore it is called "Gamblers' fallacy". It leads to the misconception that the probability of an outcome occurs with a small number of consecutive experiments so they will have to "average out" sooner rather than later. This is the fallacy that rules the mind of every gambler and that is why it is called "gambler's fallacy". Stock market ups and downs can also lead to this kind of fallacy in the short term.

Dalal Street is a minefield for the uninitiated and a good playground for those who have an appetite for a long walk or for those lethargists who buy indexed bonds, sleepover them and don't go for a walk!!

VUCA 2.0 and Board evaluation of Strategy.

VUCA 1.0 talked about Volatility, Uncertainty, Complexity and Ambiguity in the countries around the world and how this VUCA gets multiplied over the years with a purposeful push towards chaos.

The laws of thermodynamics are called into play to describe what was chaos yesterday which has moved into the chaos of today and which will move into the chaos of tomorrow, with entropy increase.

But to tackle VUCA 1.0 , I prescribed the following:

 In a VUCA WORLD

    -Volatile environment requires Vision to look beyond the immediate and prioritise

    -Uncertainty  needs calm Understanding of the situation to be purpose driven

     -Complexity  demands Capability of mind to look at locks & keys

     -Ambiguity  calls  for  Agility in the workplace to innovate, grow and excel.

In VUCA 2.0 Bill George in his HBS article gives out a solution model instead of a fearful premise.

 He elaborates that Vision, Understanding, Courage and Adaptability are the main constructs over which the Strategy can be raised.

When it comes to Adaptability, I am reminded of Charles Darwin, who famously said

that  "it is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is most adaptable to change."

If you want to swim against the tide and come out surviving, you will have to have the adaptability to change according to the demands of the circumstances.

A Board of Directors while looking at the Sustainability Goals of an Organisation will have to keep the above in mind while chalking out the Strategy. Whenever the Board faces a challenge in evaluating the goals vs the actual performance of the Co, they should remember the following as the compass for them to proceed.

“I can’t change the direction of the wind

but

I can adjust my sails to always reach my destination”

-Anonymous Sailor

Board diversity and "what if " strategy

The other day somebody told me that Abraham Lincoln after winning the elections , formed his first cabinet with three of the people who were his rivals for Republican nomination. Lincoln had a logic- Cabinet should represent diverse views and perspectives and also fiercely independent.

Should a Corporate Board reflect such diversity and independence? Every director in the Board brings with him or her wisdom for running the business and board diversity ensures that several new windows are opened and explored, new doors are found and hidden doors are unhinged.

One of the tasks for Boards is to form Committees like Audit Committee,NRC, Independent Directors' Committee etc. Now with rapid  and disrupting changes happening around you,the importance of forming Risk Management Committee, Technology Adaptation Committee, Business Strategy Committee etc. has gained quite a bit of traction. Invariably for effective functioning of these Committees, Boards must have requisite reservoir of expertise and experience.

In this respect it is worthwhile to consider what Elon Musk has said about adopting first principles of thinking. Usually first principles of thinking process involves breaking down a larger complex issue into its conceivable parts for a coherent, cogent and cohesive understanding. But Musk says getting rid of preconceived conceptions about what you are creating is first principle of thinking - new age thinking.

Technology with its long hands of IoT, AI, Robotics, ML, DL,Industry 4.0,3D printing etc. ,has occupied the pride of place in managing today's Companies be it Shopfloor or Boardroom.

The second most important part of decision-making in the Board room should be asking "What-if " questions to the Strategy development. Board members must not shy away or hesitate to ask "what if "questions on all problems they foresee and look for the impact of such scenario analysis on the expected results. They should not hesitate to seek the help of outside experts for a report on such objective views with back up sensitivity analysis,data mining etc.

As a corollary, Board must always look for fail safe mechanism and should have a Plan B, Plan C etc up their sleeves, if their strategy meets unexpected risks and Black Swan or Grey Rhino events.

Many a grand strategy flounder when "what if" questions are not asked by Board members before approving the Strategy.