the paradox of choice - immagic.com · the paradox of choice robert m. (Òr0mlÓ) lefkowitz vp ,...
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The Paradox of Choice
Robert M. (“r0ml”) LefkowitzVP, Research and Executive Education
Optaros, Inc.
Freely re-distributable with proper attribution
• “Most of us would be better off with fewer options.”
• “There is vastly too much choice in the modern world.”
• “Anything that constrains choices is a benefit.”
The Problems of Choice
• Decisions require more effort.
• Mistakes are more likely.
• Blame is more severe.
Theory and Reality
• Asked if they would prefer to choose their treatment, 65% of the people who didn’t have cancer said “yes”.
• Of the people who did have cancer, 88% said “no”.
• We always say we want choice; we may not want it if we get it.
Avoiding choice
• Rules and Laws -- You are not allowed to choose.
• Defaults and habits -- You decide not to choose.
• Standards (in both senses) -- You restrict the set of choices.
• Standard as in “living up to” or “meeting the minimum”.
• Standard as in “industry” or “non-proprietary”.
Standards Paradox
• The purpose of an “industry standard” is to increase the choice of vendors by restricting the choice of features.
• Competition lowers prices and a lack of competition (monopoly, duopoly) leads to higher prices.
• More vendors: good; More features: bad.
Open Source• The opposite of open standards.
• A single product is not a monopoly, because multiple vendors can sell it. There is only one PERL.
• Multiple products cause implementation and management complexity; fewer products are cheaper.
• More products: bad; More vendors; good.
• More features: good
Open Source Paradox
• The promise of open source is to eliminate the choice of products and increase the choice of vendors.
• Example: Red Hat, CentOS, Lineox, Tao Linux, Progeny, SuSE, Mandrake, Conectiva, Ubuntu (Canonical), Xandros, Lycoris, Knoppix, Debian
Enterprise Architecture
• Developing strategy and “standards”.
• Reducing the number of software and hardware vendors.
• “We are planning on reducing the number of enterprise software applications from 800 to 300.”
Optimize
• “One-company, one-way” types: These companies have almost dictatorial adherence to common business processes and technologies. Their IT spend as a percentage of revenue is typically 40% to 60% of the industry average.
• “Many companies, many ways” types: These companies have any number of versions of business process and technology. They're often the product of partially rationalized mergers or acquisitions... Their IT expenses are typically 180% or more of the industry average.
Bruce Rogow is the principal of Vivaldi Odyssey and Advisory.
Standards
• The “standards” that Enterprise Architecture sets are often “product selections”.
• Is the purpose of setting these standards to increase or decrease choice?
Standards Paradox
• Standards increase choice.
• Standards decrease choice.
One Throat to Choke
• A commonly articulated failing of Open Source Software is that it doesn’t provide “one throat to choke”.
SuSE Linux SAP Support Deal Gives 'One Throat to Choke'
http://www.newsfactor.com/perl/story/21964.html
• OTC = Good
Vendor Lock-in
• A commonly articulated benefit of Open Source Software is that it “prevents vendor lock-in”
Vendor Lock-In Cited as Cost of Windows over Linux (http://www.eweek.com/article2/0,1759,1628647,00.asp)
• VLI = Bad
Paradox
• The search for “one throat to choke” is the manufacture of “vendor lock-in”.
• OTC means having only one vendor.
• VLI means having only one vendor.
• The “one throat” you are choking is the “vendor locking you in”.
Paradox
• Reducing choice saves money. Having no choice saves the most money.
• Competition lowers costs. More competition lowers costs more.
Money
Risk
One Tired Guy
Finance
• Thinking about Expected Return
• Reflections on derivative instruments (options and futures)
• Lessons from Portfolio Theory
Prospect Theory
One group was presented with this problem. 1. You have been given $1,000. You are now asked to choose between: A. A sure gain of $500 B. A coin flip to win $1,000 or nothing.84% chose A
Another group was presented with this problem. 2. You have been given $2,000. You are now asked to choose between: A. A sure loss of $500 B. A coin flip to lose $1,000 or nothing.31% chose A
The expected return of all four choices is the same.
Source: Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision Making Under Risk," Econometrica, 1979.
Expected Return
• Given two envelopes to choose from, you are told that one contains twice as much money as the other.
• You pick one.
• It has $100 in it.
• You are given the option to trade it in for the other envelope.
Expected Return
• There is a 50% chance the other envelope contains $200.
• There is a 50% chance the other envelope contains $50.
• Hence, the expected return is:
(0.5 * $200) + (0.5 * $50) = $125
Paradox
• Therefore, whichever choice you make, the other one would have been better.
• Q.E.D.
Software Valuation
• What is software worth?
Software valuation
• The “standard” software license model is a licensing cost λ and a series of maintenance costs μt discounted by ωt.€
λ + µtt= 0
n
∑
€
λ + ωtµtt= 0
n
∑
Software valuation
• Maintenance and support is typically 20% of the license fee.
• Hence,
>>> 1+sum([0.2 * 0.9 ** (1+t) for t in range(5)])1.737118
€
λ + ωt 0.2λt= 0
n
∑
Thought Experiment
• Pick the proprietary software product of your choice.
• What would you pay for the same product if it came with a guarantee from the vendor that there would never be any security patches, fixes, enhancements, or new releases.
Software valuation
• The “up-front license” is really a license fee + a series of contingent claims φ (derivatives) on future maintenance.
€
λ = λ0 + ϕ tt= 0
n
∑
• Is λ0 worth anything?
• Futures?
• Forwards?
• Options?
• Warrants?
• If your software isn’t a service, it’s a derivative.
€
λ0 + ϕ tt= 0
n
∑ + ω tµtt= 0
n
∑
Open Source Definition
• The key difference between open source and proprietary licenses is that the open source license allows you to create a derivative work.
Derivatives• Financial derivatives are more complex,
but give you more leverage.
• Open Source software is/are more complex, but give/s you more leverage.
• One can construct synthetic instruments to produce the desired return profile.
• One can synthesize software “stacks” or “derivative works” to produce the desired functionality.
There is no optionality
• What about the option to
• decline to pay for unwanted updates?
• which includes the option to switch to a different update stream (to decline to pay for all future updates -- i.e. to switch to another product)
• If you “don’t have the option”, it is because you didn’t buy it.
Liquidity
• Assumptions underlying the standard CAPM: the first assumption is that there are no transaction costs.
• The second assumption behind the CAPM is that assets are infinitely divisible.
• The third assumption is the absence of personal income tax.
Liquidity
• Markets are conversations.
• Liquid markets have transactions.
• Illiquid markets have relationships.
Thought Experiment
• What would it cost to convert from SuSE to Red Hat Linux (or vice versa)?
• If Red Hat came in and offered to do it for “free”, would you?
• If they offered to pay you, what would you ask?
Skipping updates
• Enterprises will skip updates or releases, because there is a cost associated with implementing the release (the transaction cost).
• But they are paying for it anyway
• Red Hat charges more for the version that has fewer updates (RHEL releases every 18 months, Fedora every 4-6)
The size effect
• Rolf Banz in 1981 published a study showing that excess returns would have been earned over the period 1936-1977 by holding small firms. The differential return from very small to very large was 19.8% per year.
• One theory is that the small stock effect is a consequence of lack of liquidity.
• In an environment where transaction costs are high, and earnings are similar, the returns must be larger to compensate for the transaction costs.
Vendor lock-in
• Vendor lock-in is a complaint about the lack of liquidity.
• So the solution is to manufacture liquidity.
• “An investment bank is in the business of manufacturing liquidity and selling it a profit.” -- Ross Miller
Technology Portfolio
• Just because one has multiple software products, it isn’t a portfolio.
• You need fungible assets -- software that fills the same need -- to think of it like a portfolio.
• Portfolio optimization is about adjusting relative weight (as β changes) -- not constantly replacing one asset class with another.
Effect of diversification
• Portfolio variance for the NYSE
Number of securities
Expected portfolio variance
1 46.6192 26.8394 16.9488 12.00316 9.53035 8.18875 7.585All 7.058
Back to Linux
• The earlier question about “switching” implied an all-or-nothing before and after scenario.
• Rather than a conversion, how about a “portfolio rebalancing” from 65-35% to 60-40% ?
• How about including CentOS in the mix. 60-30-10%
Active Portfolio
• Enterprises have “one of everything”.
• But the direction is towards eliminating choice -- diversity is a result of failure to converge.
• Manage risk by actively diversifying the vendor mix while converging the technology.
Bond Ladders
• A bond ladder is a portfolio of bonds maturing at different times.
• In the 80’s, we set up numerous subsidiaries to purchase mainframes.
• Instead of a single three-year Enterprise License Agreement, consider an ELA expiring in 2006, another one expiring in 2007, and a third expiring in 2008.
The Option to Switch
• Say you want to switch from an expensive database to an open source (cheap) one in 3 years.
• Or an expensive application server.
• How much should you spend on that?
The Option to Switch
• Are you not buying a European call option for an asset 3 years hence?
• So, for something which costs $10 today, but you want an option to buy it for $8 in 3 years ...
Black Scholes
• 3 year option, 10% interest rate, $10 underlying, $8 strike, 30% volatility
• The implied volatility of the S&P 500 is about 20%, the NASDAQ about 30%
• That call option is worth about $4.40
Black Scholes
• 3 year option, 10% interest rate, $10 underlying, $5 strike, 30% volatility
• That call option is worth about $6.30
• $2 strike? $8.50
Complicated?
• It’s the price of choice.
• Optare. Latin. To Choose.