Investing Lessons From Unintended Consequences

During their latest episode of the VALUE: After Hours Podcast, Hoffstein, Taylor, and Carlisle discussed Investing Lessons From Unintended Consequences. Here’s an excerpt from the episode:

Jake: So, we are going to be talking about the SS Eastland. And I changed my background as a little foreshadowing. But everybody knows the story of the Titanic. And 1912, it hits an iceberg crossing the Atlantic, sinks to a watery grave, more than 1,500 people perish, about 700 of those were crew members. But there’s another sunken ship that actually killed even more passengers than the Titanic. And so, on the morning of July 24th, 1915, the passengers began boarding the SS Eastland on the south bank of the Chicago River, downtown Chicago.

It was a cargo ship that had been converted into a passenger ship, and it was shuttle people around the Great Lakes. The ship quickly reached its capacity of 2,500 plus people. Many of the passengers were standing around up on the upper deck. The ship began to list slightly to the port side, which is away from the wharf. The crew attempted to stabilize the ship by pumping water into the ballast tanks, but to little avail. And at 07:28 AM, the Eastland lurched sharply to port and then rolled completely onto the port side, and it came to rest on the river bottom, which is only 20ft 6 meters, for our non-US, below the surface. Barely, half of the vessel was even submerged. But many of the passengers had already moved below deck, and so hundreds were trapped inside by the water and the sudden rollover and some were crushed by heavy furniture or all kinds of stuff falling over.

The ship, even though it was only 20ft from the wharf, and there was a nearby vessel that responded quickly and people were able to jump off onto this other ship, 844 people and four crew members ended up dying, so which ended up being more passengers than the Titanic even. They’re related in a very instructive way. So, the Federal Siemens Act, hold your jokes, was passed in 1915 following the Titanic disaster that had happened three years earlier. And that law required the retrofitting of all ships to contain a complete set of lifeboats, which seems like, “Oh, yeah, that’s probably an obviously smart thing to do.” One of the boats that was retrofitted was the SS Eastland. The problem was that these additional lifeboats made an already top heavy boat even more prone to listing, and that extra weight topside contributed to the ship tipping over and killing more passengers than the Titanic.

So, investors, I think, often suffer from a similar fate here, where they get burned by something, or they’re like the general who was fighting the last war. It’s the cat that sits on the hot stove, and they swear off of it, but then they’ll also never sit on the cold stove again. It’s often that, otherwise, healthy risk appetite can be ruined, even for an generation of investors who get burned by this. So, let’s turn our attention a little bit now to what this bigger idea of this law of unintended consequences, because that’s really what we’re talking about here.

There are three kinds of unintended consequences. You have the unexpected drawback, which is a detriment that occurs in addition to the desired effect. You have a perverse result, which is actually an intended solution that makes the problem worse. In the SS Eastland case, the goal was saving lives and it ended up taking lives. By the way, if you want a Master’s course in negative unintended consequences, I would suggest reading Henry Hazlitt’s Economics in One Lesson. The first edition was published in 1946, and it’s still as relevant today as ever.

Then lastly, the third version of unintended consequences are positive unanticipated outcomes. So, this now brings us to Friedrich Hayek. Hayek, he wrote this 1945 landmark article called The Use of Knowledge in Society. He argues that a centrally planned economy can never match the efficiency of an open market because what is known by a single agent is only a small fraction of the sum total of knowledge that’s held by all the members of society. This knowledge is unevenly distributed. Therefore, decisions are best made by those with the local knowledge rather than by some central authority. A decentralized economy then complements this dispersed nature of information. Hayek was awarded a Nobel Prize in Economics largely for this insight.

The counterexample is always like the Soviets. When they tried to administer uncertainty out of existence through government fiat and planning, they ended up choking off social and economic progress. They were missing that spontaneous order that actually positive unintended consequence that comes out of a free market. Just as a kind of a fun side note, Jimmy Wales, who was the founder of Wikipedia, he cites The Use of Knowledge in Society, that article by Hayek, which he read as an undergraduate student, as one, is really central to his thinking about how he designed and managed Wikipedia. So, although no one plans it, there’s these positive expected outcomes that happen from free markets, from the Invisible hand.

So, that unfettered price change behavior is what creates the feedback loops that to me is actually a wonder of the world that actually works. I’m continually amazed by that. And Warren Buffett, I always try to tie it back to something Warren said, because he’s got a great quote for everything. In almost every single AGM, if you listen to it, anytime he’s talking about economics, or policies, anything, he says, “You always have to ask, and then what.” So, I would encourage, when you ask yourself, and then what think about both positive and negative unintended consequences. And perhaps, something as simple and as seemingly smart as requiring lifeboats to rescue people could end up with deadly unintended consequences.

Tobias: Do you think you get canceled for those free market views these days? Is YouTube going to shut us down for that? I, for one, welcome our new World Economic Forum overlords.

Jake: [laughs] Eat the bugs, Toby.

Tobias: [laughs]

Jake: I don’t know. If they do, then cancel me. That’s fine.

Corey: Can I ask some questions here, Jake? Because the Eastman’s a fascinating case of like, you talk about the local knowledge. You really have to wonder, was there someone locally who understood the implications of adding all those lifeboats to a top heavy boat? Or, whether it was the case of there was no one– Like, the captain wasn’t there saying, this is more unsafe and you needed the accident to occur as horrific as it is to recognize the issues with the regulation.

Jake: No. People knew about it, and they were arguing against the bill being passed for that exact reason, and then it went on to happen.

Corey: Okay, then.

Jake: Yeah. [laughs]

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