Everything We Know is Wrong – Part I

Back in April, I gave a talk at the Decision Analysis Affinity Group (DAAG) Conference entitled, “Everything We Know Is Wrong.” One of the great things about DAAG is you can throw fairly provocative ideas out for everyone’s consideration without them thinking you’re crazy (well, maybe just a little crazy). I received a lot of good questions, feedback, and push-back, which was exactly what I wanted.

The thrust of the presentation was this: Many of the trends, objectives, and financial metrics which have served us all so well for more than a hundred years have become obsolete. Circumstances have changed. Up until the last few decades, the total human requirement for resources was small relative to the total availability of resources; this is simply not the case anymore. Most of our key measures of financial value – Net Present Value, Rate of Return, Capital Efficiency – have, at their core, some form of discounted cash flow calculation, which assumes that we would always rather have something this year than to have it next year. That may be true of money, but ultimately, the only thing money is good for is to purchase real things – food, steel, water, fuel, etc. Why would we want to consume as much as possible of these things as quickly as possible?

The concept of discounting capital goes back to the 19^th century, when vast stretches of continents – let alone the seabed – remained undeveloped and unexploited. Under those circumstances, humanity could consume (and waste) as much as we wanted without seriously damaging our short- and medium-term prospects for quality of life. A subtle assumption underlying the discounted cash flow approach is that there is always more stuff out there to produce, consume, and use. This is no longer the case.

There will undoubtedly be a cynical wail from many readers, decrying me as yet another Malthusian doomsayer. Many people point to the famous bet between Paul Ehrlich and Julian Simon in 1980 as proof that human innovation and technological improvements will result in ever-more-abundant, ever-cheaper resources. (The bet was whether a basket of five commodities would be more or less expensive in ten years’ time. Ehrlich, a biologist, bet that prices would rise as populations grew and resources became scarcer; Simon, an economist, bet that prices would fall as technology improved. Simon won; all five commodities were cheaper in 1990 than in 1980). What many people don’t realize, however, is that the bet is entirely dependent on timing. Had Ehrlich and Simon made the same bet in, say, 1985 – or any year from 1994 through 2000 – Ehrlich would have won. With the period of the bet set at ten years, price volatility seems to overwhelm any real trends.

In the long run, Malthus has to be right; it’s just a question of when. Humanity’s need for ever-increasing quantities of resources must bump up against the availability of those resources. The Easter Islanders, the Norse Greenlanders, the Anasazi – all of these societies grew and prospered to the point where their environment could no longer sustain their lifestyles (sometimes exacerbated by a climatic change – it became drier, colder, warmer, etc.). The problem was they would not or could not change their behavior, even when it became apparent that what they were doing was leading toward disaster. Western society has so far avoided this fate, but only because we have not been limited to a single island or area. When we use up the resources in one place, we simply go somewhere else and start consuming those resources. But there aren’t many unexploited areas on the globe anymore, and with more than seven billion of us – many whom are shifting toward a Western level of resource consumption – we are starting to feel the pinch.

So what are we going to do about it? I’m not a Malthusian doomsayer; I’m more of a Malthusian optimist (if such a thing is possible). I fully believe that we can develop robust strategies which are sustainable in a resource-constrained world, and that Western society is exceptionally well positioned to lead the way. But not if we insist on sticking to metrics and objectives which are only appropriate when resources are, effectively, unlimited. We need new metrics and objectives.

Tima Bansal of Western University in Ontario presented an interesting perspective on discounting cash flows into NPV: time is removed from the discussion. When things happen may be important, but if we collapse a cash flow time series into a single point, any information regarding timing is lost. We cannot make intelligent judgments regarding tradeoffs between two alternative strategies based on the timing of the costs and revenues. It is bluntly assumed that earlier is always better for revenues and worse for costs. So any strategy that involves significant investment or sacrifice now in order to achieve wonderful benefits for our grandchildren is hugely denigrated through the filter of NPV.

In fact, many people have pointed out that NPV effectively values our grandchildren at zero. Anything occurring two generations into the future gets discounted down to a tiny fraction of its value on the day. But as Jim Rogers, CEO of Duke Energy, pointed out in a keynote speech, the people who worked on the foundation and the walls of the Cathedral de Notre Dame in Paris never saw the spires of the final building. Construction took four generations. An NPV analysis would surely have indicated that all that effort and all those expensive materials should have been directed into something with a quicker return on investment. Likewise, thank God that Donald Trump hasn’t been able to buy Central Park in New York – it would be covered with (hugely NPV-positive) hotels and condominiums.

In short, we need wisdom. We need metrics and decision criteria which properly value very long-term investments and preservation of resources for future generations to use and enjoy. We should place a high value on activities and projects which improve the quality of life while keeping resource consumption and waste generation to a minimum. Leaving important choices to a mathematical function like NPV is an abdication of responsibility. We often tell our clients, “You cannot calculate a strategy.” In today’s resource constrained world, this is truer than ever.