SPP: First I really just wanted to start and ask you to give us a little background of what it is that you do? How it is you got to where you are? I know you’re a prominent author like a lot of your works, so I was just hoping you could tell us a little bit more about yourself.
Bill: Yes well I guess I had always wanted to be a writer I actually studied physics at MIT in college. But when I got out I went into basically editing, magazine editing, and I started doing articles and eventually I sold my first book and have been writing books every since. In describing the types of things I do I’ve certainly been all over the map, I’ve done a lot of things, but I think particular I think in recent years a lot of what I do sort of describes how little known scientific ideas have really had a very broad influence on people around us on society as a whole. So if that sort of makes sense I really like to take some idea that’s incredibly important but really no one out there knows about it and show how it really affects people in their everyday lives. So that’s what I’ve been trying to do.
SPP: I noticed from just the various books you’ve written and things like that you don’t really concentrate on one topic, but like you said you take kind of large topics and explain the intricacies of them. Is that how you would kind of explain it?
Bill: Yeah pretty much there’s like always one very strong connecting thread where everything sort of derives from something but the actual book can often create many different walks of life, many different types of characters, many different sorts of ideas. So that’s part of the fun of it I guess that you’re able to connect all these different things to one basically simple idea.
SPP: How do you use your background to cover these ideas? Do you use the background that you got at MIT or kind of how do you approach these things? Because I want to get into a couple of your books because they are fascinating, so before I do that I just want to see how you approach it using your experience.
Bill: Well I think it’s very important to have sort of this scientific world view where you come into it with a certain amount of skepticism. You really do want to look at the evidence and say “Is this really the way things are?” Because without that you really wouldn’t have a foundation for doing these types of books that I do. But basically it really comes down to curiosity I mean I’ve always enjoyed learning things. So each book it’s really a lot of fun to sort of start out in a whole new field in many cases and really learn about what’s going on there.
SPP: Bill I wanted to talk to you about one of your books “How Would You Move Mount Fuji?” where you talked about how Microsoft went about hiring their employees based on tests to see who was a creative thinker, you see stuff with Google and Google had that thing. When they went on a huge hiring spree and they had that math problem on the billboard, I don’t know if you’re familiar with that.
Bill: Yeah
SPP: Do you see that more companies are starting to do this now where they’re looking for people that can think critically as opposed to okay I got straight A’s in school, I did this, and I did that. I took standardized testing very well. Do you see that as a shift from how it used to be to how it is now? What is your thought on that?
Bill: Yeah it does seem to have been a long term trend and in a certain sense I think really the incredibly tough job market has if anything sort of caused it to spread even further, even to a lot of companies that before this really were not that selective. The way this whole book came about, maybe I should explain I’ve always kind of been known as a person who was good with logic puzzles.
A few years ago before I began that book I started getting emails from friends who said they’d been on a job interview and someone asked this crazy sort of logical puzzle question. They were basically writing me to see if they got the right answer because they wanted to compare their answer with mine. After I got a feel of these emails and started talking to some of these people I thought this would be a really fun book. I mean growing up I really admired Martin Gardeners Scientific American column, and all those wonderful books he wrote, many of which involved these sorts of logic puzzles, riddles and so forth.
It basically gave me an excuse to do that but it also when I looked into this; talked with people at Microsoft at Google and other companies like that I found that there is an incredible long history of this. I trace it back to the very earliest part of Silicon Valley where you had people actually having job interviews where they would quiz people and time them with a stopwatch to see, not only if you got the right answer but how fast you could get the right answer. I guess back then it just expressed this idea that it was incredibly important to find the smartest most creative people. I figured they’re engineers they have this analytical mind view, so they decided that would be the way they did it.
In recent years, I mean obviously we’ve moved away from intelligence tests, and a lot of people have also become kind of disenchanted with some of the formal education. Because everyone in Silicon Valley at least has had this experience where they hire someone who got straight A grades, went to Stanford or MIT or one of these really high power schools, and still they’re pretty hopeless when you actually hire them. They’re not necessarily good employees. It’s not that they aren’t smart but somehow they just don’t get along with people, they can’t apply what they know to a particular novel situation. They’re very good at regurgitating what they learned, but not in seeing connections between what they learned and this really novel type of situation.
I think that’s really one of the reasons they started doing this. As I say now even with this economy you’ve even got companies like Proctor & Gamble and Wal-Mart asking trickier questions than they used to, sort of emulating these companies like Microsoft and Google.
SPP: Now you brought up the fact that some of these employees that got straight As at Harvard didn’t end up being good employees, a lot of these CEOs of these tech companies dropped out of college. Do you see that there’s any type of correlation with that type of…?
Bill: Well kind of a self-made entrepreneur type. Yeah I think there is a big connection there actually. Bill Gates was very big on puzzles growing up and he figured you can learn more from that than you can from what you actually did in college. Because it’s always hard to tell who their professor was, how much the professor helped them, what else was going on there, whether they were really inventing something on their own or just sort of following this very brilliant professor.
So this is kind of an extra filter it’s another way of evaluating people. Places like Google and Microsoft they notice that you can’t tell everything from this that someone might have just heard these questions, they might have read my book and know some of the questions that are being asked. It’s just another way of getting information and they like to sift together all these different sources of information. So in that sense I think there is a pretty good rationale for it.
SPP: All right Bill I wanted to move on. It’s tough I could talk to you all day about the books you have out, because the things you cover are so interesting. But I wanted to move onto “Fortune’s Formula: The Untold Story of the Scientific Betting System that Beat the Casinos in Wall Street”. I guess numerous people are going to be unfamiliar with it but just by reading the subtitle they’re going to want to know what you discussed. First I want to talk a little bit about that book see if you could fill in our listeners, and then we’ll kind of dive in a little bit more.
Bill: Yeah that actually did come from my college experience. When I was at MIT Claude Shannon was still alive and he was a professor there. He’s of course the Founder of Information Theory that really is the basis of computers and the internet and the whole digital world today. But there was a funny thing about him no one ever saw him on campus. When you ask why that was you heard this story. It was said that he got the idea that he could use his information theory to make money in the stock market.
Apparently he did make a fortune with his investments and then he kind of used that wealth to drop out of the scientific world. It was said that he basically stayed home all the time and built kind of weird machines and robots in his basement workshop. There’re also stories that people who had seen his empty office at MIT said it contained large piles of uncashed checks because he couldn’t bother to come in and cash all these dividend checks or something.
So just remembering that it seemed like it would be interesting to investigate that, so I went to the Library of Congress and found these papers. And found quite a bit about this investing system he had which involved something known as the Kelly Criterion, which is really what the whole book “Fortune Formula” is about. It’s named after one of his colleagues at Bell Labs John Kelly, Jr. who otherwise is not that well known but he’s really a very brilliant and fascinating character.
But at any rate the Kelly Criterion is really this sort of all purpose betting formula that tells you when you’re in a situation where you have a wager that’s in your favor how much you should stake on that particular wager if you’re interested in making the most money possible in the long run. Now that sounds like it’s kind of very simple and a no brainer, but actually there’s some very subtle mathematical issues in there and Kelly was the first to really figure out the optimal way of betting.
So another plot in “Fortune’s Formula” is that a young mathematician by the name of Ed Thorpe that you probably know as the Founder of Card Counting and Blackjack once met Shannon and Shannon told him this Blackjack system is great but you ought to use this Kelly Criterion to decide how much you should be betting so even though you do have this advantage with card counting you got to make sure that you don’t go broke before you get rich.
That’s basically what this Kelly Formula tells you how to do. Thorpe used that in the casinos and he ended up starting an incredibly successful hedge fund where he used many of these same principles. I kind of weave all that together into this story and it is a very amusing sort of story, as well as telling you something about this very simple idea that’s become incredibly important in a lot of different walks of life.
SPP: Now do you think that because things like this have been public since, I mean obviously your book in 2005, do you think these are all factored into the market now and are no longer completely relevant? Or do you think it’s possible to use some of these strategies currently?
Bill: No it is very widely used by the really sophisticated hedge fund people and so forth, but basically everyone uses it because it’s basically a formula for telling you how to make the most out of any favorable opportunities that you find in the market. Now the actual things that hedge fund people are trading are constantly changing because you’ll find you can make some sort of arbitrage with the S & P 500 Index Funds, and so forth, and make a lot of money with that for awhile. Then someone else finds it and then that’s pretty much played out. Like a fishing ground that everyone is trying to fish.
You have to move onto something else, but whatever type of trade you’re using you do need to use something like the Kelly Formula to decide how much of a mistake, how you’re going to manage your risk. So in that sense, yeah it’s really the one thing in the hedge fund industry that really remains relevant. As much as things change and as much as all this high frequency trading is making everything happen much, much faster.
SPP: The other thing to go along with that is do you think that there are still opportunities to be exploited? And again this is talking specifically to I guess Wall Street, but investing in general, and also casinos. I mean like you mentioned there was the card counting thing and what you talk about in “Fortune’s Formula”. Do you think there are still things left or have we kind of reached the pinnacle of every edge we can find has been found and the house has the edge?
Bill: Well certainly card counting has gotten a lot more difficult. They’ve started using two decks and four decks, some places even more than that. But I do know that there are still people who count cards and seem to be making money off of it. You have to be very particular about where you go. Generally there’s a few casinos that decide that their market niche is that they’re going to appeal to card counters, so they may have a single deck setup there which is one reason why people will go there.
But yeah it’s true. And I think it’s always been true that anytime someone is basically giving away free money, even if unintentionally, people find out about it pretty quickly. But it’s funny the last time I talked to Thorpe he was telling me he found this new very interesting betting opportunity somewhere in the world, and he didn’t tell me what it was because he obviously wants to keep it under wraps, but where you could double your money very quickly. The people who run it don’t know about it, and he was working very actively on that and I imagine if he’s successful we will be hearing about it sooner or later.
SPP: All right great. I guess just moving along the list each subject keeps getting more and more interesting, but “Gaming the Vote: Why Elections Aren’t Fair and What We Can Do About It: I think that obviously you wrote this in 2008 is when it was published. We had been dealing with a lot of election issues I guess with Al Gore was running and things like that. It hasn’t been as public recently but I think it’s something that happens more often that we know gaming the vote.
Bill: Yeah.
SPP: Who knows if things are even counted or tallied correctly, but where do you stand on that and how that’s a problem we can fix? I mean given the technology we have these days should allow us to but it obviously still doesn’t.
Bill: Yeah. Well the problem isn’t even the technology it’s just the way that we cast and count votes. The way we vote normally where the person with the most votes win, and it is one man one vote, one person one vote, is known technically as the Polarity Vote because whoever has the most votes. There’s really a lot of problems with that mathematically and that’s been appreciated at least since the time of the enlightenment in the 1700s.
The problem is basically spoilers again with Al Gore and Bush and Ralph Nader, apparently Ralph Nader took away a lot of votes from Gore that kept him from wining. Of course we’re seeing that now in the opposite side of the political spectrum because they’ve got all these independent tea party candidates and even if one of these candidates takes just 1% of the vote away from the Republican that can lead to a Democrat winning. You can show that this really doesn’t make any sense. I mean if you explain it to people wherever they are on the political spectrum they’ll agree that it does make sense, but the problem is what do you replace it with?
Now there’s actually quite a few very sensible ways of voting that are considerable improvements on what we’ve got, but the thing is there’s almost too many. As I say in the book there’s been all this controversy among the various proponents of different voting systems. I think that really is one reason why we really haven’t made the change. If you could have everyone, every so called expert saying, “This is the way we should be voting” then I think maybe you could get people behind it. You could get politicians to say “We’ve got to reform our voting and this is important so let’s do it.” But instead you’ve got some people saying you want approval voting, some people saying you want instant runoff voting, some people you want arrange voting and then there’s many other options.
So it is so complicated that it’s really hard to know what you really should be doing. One of the fun things in writing this book was that I got to talk with a lot of the proponents of the different voting systems and I tried my best at any rate to give the pros and cons of each of these systems so that the reader can hopefully come to a conclusion.
SPP: I guess my overall question for this is going to be do you think that we will eventually be able to fix voting in the United States?
Bill: That’s a good question. If it does happen, and in some ways it is, actually instant run off voting has an organization behind it Fair Vote that is fairly well connected, it gets a certain amount of money. They have had IRV as it’s called, Instant Runoff Voting, being adopted by a number of local cities and municipalities. So there is a certain momentum behind that. Unfortunately if you talk to the mathematicians they’ll tell you that Instant Runoff Voting is a little better than what we’ve got now.
It’s probably like the least good of the ones that are taken seriously and other options like approval voting and range voting are actually better yet. As you say I mean I think that demonstrates a bit it is not an impossible goal to get people to change the way they vote it’s just a matter of doing the groundwork of educating people. And hopefully this book will be one way of trying to do that.
SPP: Can you explain for those that don’t know, and actually I’m not too familiar, but what instant runoff voting is?
Bill: Okay an instant runoff voting is instead of just saying I vote for Candidate A you have to rank your favorite candidate. Like this is my Number 1 choice, this is my Number 2 choice, this is my Number 3 choice and then they use that to decide who would win. So in other words, if your Number 1 choice is someone who has very few votes, like say Ralph Nader in 2000 your vote would then be cashed as your Number 2 choice. If that was Al Gore your vote would count towards Al Gore.
So in situations like that it’s actually a very good way of voting. It’s not so good though when you’ve got three or more types of very strong candidates. In those situations it can be kind of capricious as you can show in certain situations. The problem is that they’re really sort of unintended effects of almost any way of voting.
Our two party system is really an artifact of the way we vote, the plurality vote, because people know that it’s basically only one of the two frontrunners who’s going to win, so that’s why we have these two powerful parties. I think for that reason the parties feel maybe a little threatened by instant runoff voting, by approval voting and range voting, and these other options. Because no one really knows how that would change things for our political parties, for our candidates if we did adopt these new ways of voting. They certainly would make our democracy more responsive but it’s a little difficult to tell what they would actually mean for the political party system.
SPP: Have they, I mean I’m sure they have, but have they gone through and run simulations based on instant runoff voting, just to see what would occur with past elections or even a mock election?
Bill: Yes very definitely, in fat that’s a very active level of research. I do quite a bit of that in the book and show that there’s about eight presidential elections where you can make an argument that the wrong candidate won. In the sense that if you’d been able to transfer the third party candidate’s vote to their second choice or to the one that they approved of more, we would have had a different president. So it’s definitely not a theoretical thing. I mean it really does happen. You can calculate maybe in about 10% to 15% of elections. So it’s a pretty serious thing.
SPP: You talk a little bit in your book about what we can do about it? Have you determined or do you determine the best steps we can take going forward?
Bill: Well I’m not sure the best steps just in terms of like what you should do in terms of what politicians to talk to, what people to talk, whether they should be on the ballot. But there’s very good evidence in terms of these simulations that the best system of all is something called Range Building where you basically score each candidate like on a scale of 1 to 10 how much you like them. But there’s a certain argument to be made a simpler system called Approval Voting is probably for a lot of purposes almost as good. It does have the advantage of being simpler to explain to people and I think that’s a serious consideration as well.
There are organizations promoting both of those ways of voting, but they don’t have a whole lot of money. So if I would encourage people out there to do something I would say educate yourself on the various types of voting systems? Maybe think about volunteering or writing letters to congress people and so forth, maybe even sending a little money to some of these organizations.
SPP: Now I guess for the listeners that have made it this far I want to reward everybody, because your newest book titled “Priceless” which is about fair value and things like that. The subtitle and “The Myth of Fair Value and How to Take Advantage of It” is fascinating. I think something everybody’s going to be interested in because you really dive into kind of how things are priced and why we react to prices the way we do. I mean I know I found myself the other day searching on Amazon, I was looking for watches, and I was looking for the watch that they marked as the most expensive, yet it was priced down so much.
I found a watch that was initially marked at $1000 dollars priced down to $79 and without any caring about the watch I was like maybe I should buy that. And honestly that happened the other day and that’s why I was really excited to talk to you because I kind of wanted to get a look at why does this happen. I know you kind of go into the psychological aspect, which I’m really interested in kind of behavioral psychology, so it was another thing I really wanted to kind of dive into this with you.
Bill: Yeah. This was really a lot of fun to research because I think we all can relate to this every day, but they basically found that there are a set of rather simple psychological tricks that could really cause you to change your opinion about whether something’s a good price or a bad price or somewhere in between. And the one you just described where they have something like a $1200 dollar watch marked down to $79 dollars or some ridiculous discount is actually something that’s known as Advertised Reference Pricing. They’ve done actual experiments on that and found that it has an incredibly strong affect in motivating people to buy.
Now it’s not that people aren’t aware that this is some sort of come on. I mean if you ask them they’ll say they’re very skeptical that it was really worth $1200 dollars. They figure the price is good, maybe it’s not that good, but that’s what people say. The thing is in these studies you have to look at what people actually do. What they choose to do with their money? And even though everyone says they don’t pay attention to things like that, when you actually do the experiment you find that people do. I mean it does make a decision. It does motivate that decision to buy something. So that’s why you see it in an awful lot on Amazon and other retailers.
In fact with the whole online buying now it’s so easy to aggregate all this data and find out what sort of pitches work and what sort of pitches don’t. So in the book I go into a little about how they’re using that data now to really concoct the perfect price, the perfect pitch. It’s really something that we see all around us.
SPP: I’m not sure if anybody’s ever said this before, if you’ve said this before and if you have I apologize, but I’m starting to see that 99 cents might be the new penny. The reason why I say this is I was having a conversation with Chris earlier today. I was trying to convince him to buy an iPhone app that I really liked. And he’s like ah I’m not paying for it because it cost money I only get the free apps. And my response was its 99 cents. I don’t even blink an eye anymore. When I see an app that costs 99 cents I’m like, oh I’m downloading this.
SPP: I’m not that cheap it’s just you know.
Bill: Yeah there’s definitely a lot of truth to that. In fact the 99 cents price is kind of magical. There was a guy named Dave Gold who ran a liquor store in Los Angeles and he had these really cheap lines that weren’t selling. So he took all the really dog wines and put them on a shelf and put a big banner over it saying “Wines of the World, Anything you see here 99 Cents”. They sold out almost immediately, but the funny thing was some of the prices he had marked down from like a $1.29 to 99 cents, but others had actually been on sale for cheaper prices, like for 79 cents. And even the 79 cents wine sold better at 99 cents. So this was so amazing that he started joking to friends, I ought to open a whole store where everything’s 99 cents, and he did just that. And that really started this whole 99 cent store phenomenon.
He’s now got 250 stores in about half the country, and of course there’s all these other knockoff type stores also offering stuff for 99 cents. It is interesting though that there’s been a lot of debate about whether that price really does have this kind of mystic impact on people. For a long time economists thought no way. I mean people are smarter than that. They know that 99 cents is essentially a $1 dollar, so why not just say it’s a dollar and be done with it. But they started doing some actual experiments and found that, not only the 99 cents price but really any price ending in 9 or 99 really does have an amazing affect on people.
In one of the experiments I described some psychologist at MIT managed to convince one of the big catalog companies to printout separate versions of their catalog with different prices and send them to different subsets of their mailing lists. So they’d be selling the exact same thing product but in one catalog it would be selling for $34 dollars and in another it would be selling for $39 dollars. What they found was that it sold better at the $39 dollar price, even though it’s more expensive. So that really shows that it does have a strong motivating affect.
Now that experiment doesn’t necessarily explain why it has that effect, but the best guess is that we’ve all kind of been culturally conditioned to know that if something ends in 9 or 99 that kind of implies a discount. It kind of implies that there’s been competition that they’ve really tried to get the best possible price. Although everyone says they’re not influenced by these 99 cents prices, again when you look at the actual data they do make a big difference and they do cause people to buy stuff that they wouldn’t buy otherwise.
SPP: Do you think that it might be generationally my generation we’ve dealt with credit cards, debit cards, now PayPal, NFC, and we haven’t really had to deal with I guess that change currency for that long. So now when I see 99 cents I think oh that’s less than a $1 dollar, I might as well go ahead and buy it, because change has become a hassle for me. I don’t carry any change on my person I just have my credit cards or a PayPal account. Do you think that has anything to do with how we’ve kind of come in looking at those prices that are in store change?
Bill: Well what’s interesting is how I don’t think it actually has changed that much even as we’re moving to all electronic transactions. I mean in a few years we’re all going to be using our cell phones to make all these transactions, so really change is probably going to become obsolete. But you see these 99 cent prices on the web as much as anywhere else. Again I imagine it’s just this cultural memory and still does have this certain potency there. In fact, even the whole idea of which stores have 99 cents prices and which don’t is a big signifier.
Nordstrom’s makes a big deal of the fact that they do not use prices ending in 99 cents everything is in even $1 dollar. That’s sort of a way of saying we’re not a discount store. We have quality products here and we charge reasonable prices for them.
Wal-Mart on the other hand has sort of done the opposite. You’ll notice that most of their products end in 8, like they’re even cheaper than 99 cents they’ll end in 98 cents. And I guess that all ties in with their whole sales pitch there. So some stores actually use 99 cent prices if something is on sale or if it’s been discontinued, something like that. So it kind of sends a message there whether you’re consciously aware of that certain code or not.
SPP: Now I know as I mentioned you deal a lot in this book with psychology of purchasing, which in turn can be linked to psychology of how we make decisions on a daily basis. I know most people want to sit there and believe I’m not influenced by a price tag, and again 99 versus 98. Did you have any kind of ah-ha moments where you discovered that people are susceptible to pricing, or it doesn’t even have to do with pricing but anything in general, in terms of purchasing or decision making that you thought really stuck out in your research?
Bill: Well I think I had ah-ha moments almost continuously throughout the research and still do today. I remember I was choosing a cell phone plan and a lot of the different techniques they have there. There’s something called Flat Rate Bias where everyone really wants a flat rate. Because they don’t want to think that you’re charged for every text message, for every call after 5:00 pm, because who knows how much you would run up your bill.
But the reality is, and this has been well established both by the phone companies themselves and by psychologists, is that most people tend to greatly overestimate their usage of these various services. So you think figure oh yeah I definitely need unlimited text messages. But if you look at what you would pay and how many text messages you actually send there’s a pretty good chance that you would actually be better on the ala carte basis. And that’s true for really a lot of these services.
So that’s why they make sure that they do have these flat rates but they generally make their best profit with the flat rate because everyone just has this sort of inborn bias that causes them to overestimate how much they’re going to use. Again there’s various other tricks like that and as you read the book I mean really in every chapter you’re going to see yourself many times over.
SPP: Well Bill I know we went a little over the time we mentioned, but as I said find the books you write truly interesting and fascinating, so I appreciate you being on the show. I wanted to ask you where would you like to lead our listeners, whether it be a Web site or someplace they can find your works and things like that.
Bill: Yes I’ve got a Web site its www.home.williampoundstone.net.
SPP: Okay. And we’ll also have on our Web site www.smartpeoplepodcast.com we’ll have a link to your Web site and to your book so everybody can check him out. We highly recommend it. Again thank you so much for your time.
Bill: Well thank you so much it was fun. SPP: Thank you so much Bill.
Bill: Okay. Bye-bye.
SPP: Bye-bye.