THE BLOG
08/13/2013 04:28 pm ET Updated Oct 13, 2013

Business Is a Book of Bets

Most of us hate chance and uncertainty. We make plans and construct narratives that imply we can control events. But history and science tell us we are on the wrong track, and there is a better mentality -- that of gambling.

Historians know that momentous events often hinge on something small, banal, and unexpected. In his fascinating book The Hinge Factor, Erik Durschmied gives many instances. Here are three of them. In the American civil war, General Robert E Lee, commander of the Confederate army, handed down a plan of attack to his next in command, General A P Hill. The latter wrapped the plan around a couple of cigars, and then mislaid them. They were found shortly afterwards in an abandoned Confederate camp by a sergeant from the opposing Union Army, and passed on to his supreme commander, General McClellan. As a result, the Union won a surprise victory at the battle of Antietam, which began to turn the tide in the war. Otherwise, the Confederate states would probably have won early and easily.

A similar trivial blunder sealed the fate of the world's fastest and most powerful battleship in the Second World War. Germany's Bismarck should have been able to block supplies from America to Britain. But in 1941, when rushing to leave Norway in order to attack the British battleship Hood, Admiral Gunther Lutjens forgot to fill the Bismarck up with fuel. The Hood was duly sunk, but during the battle slight damage was caused to two of the Bismarck's fuel tanks. That, combined with the failure to fill up in Norway, meant that the Bismarck's voyage to Occupied France was slower than normal. British warships were therefore able to catch and sink her, something that would normally be impossible.

Why did communism collapse in 1989? A crucial catalyst was an unscripted reply on television by the Communist party spokesman in East Germany, Gunther Schabowski. When, the interviewer asked, would East Germans be allowed to travel freely to the West? Schabowski, who was new in his job, immediately shot back petulantly, "They can go whenever they want, nobody will stop them." The audience was stunned, then bedlam followed. Thousands of East Germans poured over the border, and communism was dead.

Life is uncertain and risky. Past success gives no exemption. If outcomes are profoundly uncertain, the sensible thing to do is to take risks. Evolutionary psychology says that when we are comfortable, we take the fewest risks, despite being able to afford them. Because too few people take risks, the rewards from doing so, are, in aggregate, greater than they should be. In particular, rich and successful firms take too few risks. As long as you can avoid risks that might sink the company, take as many risks as you intelligently can.

Chaos, chance, and business

The concept of chaos is that the world largely comprises non-linear systems, which are hard to read. Yet there are patterns discernible within the irregularities. Disorder in the universe is constrained. Chaos and chance do not lend themselves to tracing simple, casual links. Yet here are six useful morals:

1. There is always some pattern and order in apparently random data

Patterns exist. The only question is whether we can detect them. All markets generate characteristic patterns of behaviour and response.

2. Analysis is probably not the best way of finding the hidden order

Analysis requires simple causal links. These will not exist if the system is complex and interdependent. Yet, the human brain has the flexibility and imagination to discover the pattern. To understand a market, immerse yourself in it, keep searching for the hidden pattern, and wait for inspiration to come.

3. Simple systems do complicated things

There may be three or four key things that, combined with chance -- which is often really sensitive dependence on initial conditions, as with weather patterns -- lead to incredibly complex behavior. Don't look for one main cause -- it's probably not there. Instead, look for three or four causes that interact with each other.

4. Complex systems can give rise to simple behavior

When you look at complex systems such as markets, customers, or rivals, look for typical patterns of simple behavior. For example, if a competitor always follows your price change, this is all you need to know. Always be alert to reliable patterns of simple behaviour, which are often there amidst all the confusing noise.

5. Come to terms with chance

Unexpected results can flow from genuine randomness or from complex systems that are sensitive to initial conditions. The unexpected happens much more than we expect, for no good reason or for reasons that we cannot anticipate or fathom. There are four corollaries:

• Don't expect to control everything. When the unexpected happens, take it in your stride.

• Build flexibility into your plans. If x happens, do y. If w happens, do z.

• When something goes wrong, don't beat yourself or colleagues up. It wastes time and energy, and, annoyingly, there may be no wrongdoers. Just get on with working out what to do next.

• When something goes right, thank your stars, not your consummate skill. Exploit the trend for all it's worth, but don't believe your own propaganda. The next sensitive dependence may suit a rival better.

6. Have multiple strategies

When you sense that an industry is about the change, but the direction is unclear, have more than one strategy. Eric Beinhocker gives a fascinating account of Microsoft's puzzling ambivalence at the 1988 computer industry trade show Comdex:

"While most booths focussed on a single blockbuster technology, Microsoft's resembled a Middle Eastern bazaar. In one corner, the company was previewing the second version of Windows. In another, it touted its latest release of DOS. Elsewhere, it was displaying OS/2, and new releases of Word, Excel, and SCO Unix...

In 1988 it wasn't obvious which operating system would win. In the face of this uncertainty, Microsoft followed the only robust strategy: betting on every horse to win."

Microsoft had strategies, not a strategy. As Beinhocker says, "A company should use most of its resources to build its current activities, but the resources devoted to riskier experiments further afield are critically important, since they contain the seeds of success in a currently unimaginable future."

If you can afford it, have a few side bets at long odds. And then when one exhibits surprising success, pile the investment on. If an experimental retail format suddenly and surprisingly works, open several more and establish your reputation and buying power before anyone else can. If the return on capital in a small product is extremely high, push the product or similar products as hard and far and wide as you can. If a manager demonstrates leadership or insight well above her pay grade, back her with far more capital.

Business is really just a book of bets, but one where it is possible to beat the house -- the required rate of capital return. By all means act soberly and try to assess the odds. But don't be afraid to show flair or to go against conventional wisdom. Respect what the market is saying, even if you don't completely understand it. Back what is working better than it "should." Deploy intuition and sheer brass neck. This is not just the way to make business more fun. It is also the way to win -- at least in the long run. Better to have several failures in your career and hit one jackpot -- in that order of course! Plugging away in the salt mines of mediocre returns, and working harder at what is not really viable, is the implied message in most inspirational advice. It's a pity that the authors of such advice have never understood history, chaos, or evolutionary psychology, and that they've never been professional gamblers. So ignore them. Follow my simple precepts and reap the rewards.