Finance

The Truth About Crypto, A Practical, Easy-to-Understand Guide to Bitcoin, Blockchain, NFTs, and Other Digital Assets by Ric Edelman

Recommendation

In this guide to cryptocurrencies and blockchain, prominent financial adviser Ric Edelman pulls off an impressive balancing act. On the one hand, he comes across as an enthusiastic cheerleader for digital assets. On the other, he clearly and repeatedly tells readers not to put more than 1% of their portfolios into this new market. His cautious approach is a good thing, because the timing of this book was less than perfect: Its 2022 publication date coincided with a crypto crash. getAbstract never gives investment advice, but Edelman makes a strong case that cryptocurrencies aren’t going away and that investors would be wise to take them seriously.

Take-Aways

• Blockchain technology has the potential to transform economies.
• Bitcoin has gone mainstream.
• Yet bitcoin suffers from some fundamental flaws.
• Despite the doubters, cryptocurrency is real money.
• Some see bitcoin as a digital alternative to gold.
• An investor can take a position in digital assets in a number of ways.
• Bitcoin has generated truly eye-popping gains.
• Trepidation is typical – here’s how to overcome common objections to investing in bitcoin.

The Truth About Crypto Book Summary

Blockchain technology has the potential to transform economies.

The traditional economy is based on trust – a company or an individual can keep a record of deposits and withdrawals, for instance, but there’s no assurance that the ledger is accurate and complete. Blockchain, on the other hand, creates an “authentication economy.” Blockchain relies on distributed ledger technology, in which every transaction is recorded publicly, for all to see. This trait promises to transform previously complicated transactions. For example, with blockchain, there’s no need for a real estate transaction to be bogged down in weeks of mortgage approvals and title searches. The transaction can happen immediately. As a result, blockchain threatens to make title insurers and settlement attorneys obsolete.

“Blockchain technology will be so impactful because it revolutionizes business.”

It’s not just the real estate industry that will find itself disrupted by blockchain technology – blockchain can make stockbrokers, insurance agents and ticket resellers redundant. That’s because the blockchain is designed to be a foolproof way to authenticate large transactions. The blockchain is decentralized, which means no one person can commit fraud. It’s transparent – everyone can see every transaction. And this technology is permanent. Once a record has been entered on the blockchain, it can’t be removed, duplicated or changed.

Bitcoin has gone mainstream.

The bitcoin blockchain debuted in 2009, a moment when the global economy was in free fall. At the time, bitcoin was such a novel concept that few people attempted to solve the difficult math equations required to earn the new cryptocurrency. In 2009, the block reward for solving a problem was 50 bitcoins. As of 2020, after a series of halvings of block rewards, the compensation had fallen to 6.25 bitcoins. The competition has grown so fierce that bitcoin miners no longer use standard desktop computers. Instead, they buy $12,000 rigs, even stringing them together to boost their chances.

“All this publicity, supported by huge increases in the price of bitcoin and other digital assets, has created a seemingly unstoppable force.”

Bitcoin was always envisioned as an alternative to fiat currency. While the US government can create an endless supply of dollars, the supply of bitcoin will be limited to 21 million coins. As of 2022, about 18.5 million coins had been mined, and some 4 million had been lost. Some early miners didn’t bother to keep track of their bitcoins; others lost their passwords. Bitcoin billionaire Mircea Popescu drowned in Costa Rica in 2021, and no one knew his bitcoin password.

“We must always be careful when investing. It’s no different with digital assets.”

In recent years, bitcoin has gone mainstream. Some 200 million people own at least some bitcoins. Credit card issuers, retailers and even a mortgage company have acknowledged the trend by accepting bitcoins as payment. Transaction volume exceeds $1.5 trillion a year, more than twice PayPal’s annual activity.

Yet bitcoin suffers from some fundamental flaws.

The idea behind bitcoin was that it would replace government-backed currencies. However, that goal has been complicated by a few realities. One is that bitcoin is quite volatile, a characteristic that undermines its use as a currency. Another issue is that settling a transaction in bitcoin is slow – the bitcoin ledger takes seven seconds to approve a transaction. By contrast, Visa handles 1,700 purchases per second. Bitcoin’s shortcomings led to the creation of other cryptocurrencies, including Tether, Litecoin and Ether, many of which sought to address problems with the original virtual currency.

“The digital asset ecosystem is complex and ever-growing.”

Despite the growing popularity of bitcoin, skepticism remains. One line of criticism says that bitcoin can’t be money because it’s not underpinned by gold, silver or anything else of value. However, a similar argument could be made about US dollars – they’re not backed by anything tangible either. They have value because consumers place their trust in the government that issues the money.

Despite the doubters, cryptocurrency is real money.

Take a step back and analyze what makes a currency a currency. Those factors include scarcity, acceptability, uniformity and portability. Of course, bitcoin’s volatility undermines its status as currency. That’s why new flavors of cryptocurrency are positioned as stablecoins, or a cryptocurrency whose value is pegged to a fiat currency. A US stablecoin, for instance, is worth the same as a US dollar.

“This is why digital assets are here to stay: governments love ‘em.”

Across the world, governments are moving away from physical money. Hard currency presents problems. It’s untraceable, so criminals, cartels, terrorists and tax evaders favor cash. A number of nations are testing central bank digital currencies (CBDCs). The Bahamas has already introduced a CBDC, known as the sand dollar, and China, Russia and Japan are among the major countries testing virtual money.

Some see bitcoin as a digital alternative to gold.

Bitcoin enthusiasts aren’t the first group to question the primacy of fiat currency. Gold bugs have long pitched their favorite metal as a superior alternative to paper money. They point to a variety of reasons to prefer gold: The metal has served as a store of value for thousands of years, and it’s a hard asset. What’s more, they argue, gold provides its holders with hedges against political upheaval and inflation. In addition, the supply of gold is finite, and its value isn’t correlated with equities.

“The two asset classes have nothing in common, and the words bitcoin and gold should never appear in the same sentence.”

But the gold bugs overlook some obvious downsides of gold. Its bulk is an issue – $1 million of gold weighs 35 pounds, so it’s not the most portable of assets. What’s more, gold’s permanence means that its supply grows every year as more gold is mined. And gold isn’t guaranteed to provide a hedge against inflation – sometimes it works as a hedge, other times it doesn’t. But the salient point is that gold and bitcoin really have nothing to do with one another. Comparing them is pointless.

An investor can take a position in digital assets in a number of ways.

How can you make money from the revolution in digital assets? Here are a few strategies investors are using:

• Mine coins – If you have the technical expertise to mine coins and the cash to invest in mining rigs, solving math problems is one way to play the cryptocurrency market. If the coins you earn from mining are worth more than your expenses, this strategy will pay off.
• Invest in miners – As mining grows more difficult, the most successful miners are sophisticated companies. Riot Blockchain is one example: The publicly traded company said it spends about $15,000 to mine a single bitcoin – so as long as the price is above that mark, mining is profitable. A handful of other publicly traded miners let investors enter the market this way.
• Buy coins or tokens – You can directly buy bitcoin, Ether and other cryptocurrencies. Dozens of digital asset exchanges smooth this process, letting you set up accounts where you can buy and sell cryptocurrencies. Prominent exchanges include Binance, Coinbase, Gemini, Kraken and Robinhood.
• Farm for yield – You can lend or stake your coins to others and earn interest, a process known as “yield farming.” A word of caution: Yield farming is a risky endeavor.
• Invest in blockchain infrastructure – During the 19th-century California Gold Rush, Levi Strauss became a household name not by mining for gold but by selling supplies to miners. The picks-and-shovels strategy applies to digital assets, too.
• Buy derivatives – You could buy options, futures, forwards or swaps based on the future movements of digital assets. However, this is a risky approach. The leverage involved in these contracts magnifies gains and losses.
• Buy bitcoin futures ETFs – This type of ETF, or exchange-traded fund, doesn’t directly own bitcoins. Instead, the fund holds futures contracts on digital assets. For most investors, the consumer protections governing ETFs make this vehicle preferable to playing the futures market directly. Examples include the Global X Blockchain & Bitcoin Strategy ETF and the ProShares Bitcoin Strategy ETF.
• Invest in a venture capital fund or hedge fund – Once a growth company hits the stock market, all the big gains have already happened. But venture capitalists can score truly huge returns by taking stakes in early-stage companies. If this appeals to you, consider investing directly in a venture capital fund. But beware – the risks are no joke. Among the downsides: Your capital will be locked down for five to 10 years, you’ll get no dividends or interest, investment minimums can range as high as $10 million, and you’ll pay steep fees.

Bitcoin has generated truly eye-popping gains.

The first bitcoins traded in July 2010 for 7 cents apiece. As of October 2021, that price was $61,319. An investor who held bitcoins for the duration was sitting on a return of 87,598,471%. An investor who waited until October 2011 to buy bitcoin at $3.11 would have reaped a return of 1,971,572%. Even buying in October 2016 at $727 would have yielded a gain of 8,335%. Those sorts of outsized gains have encouraged many to try to market-time digital assets. This is a mistake, because it’s all too easy to miss the single-day gains. The recent history of bitcoin shows that most of the profits in any given year come in just 10 days of the year.

“Investing a lot is a mistake. But investing nothing is also a mistake.”

The smarter move is to use dollar-cost averaging, a strategy that lets you buy digital assets incrementally. You can set a schedule of weekly, monthly or quarterly investments. Dollar-cost averaging is less risky than investing a lump sum in digital assets. Say you bought bitcoin in December 2017, when the price was $13,379. By January 2019, the price had plunged 74%. But by October 2021, bitcoin had returned to late 2017 levels. Waiting nearly four years just to break even isn’t an exciting investment strategy. But if you had dollar-cost-averaged your purchases, your losses in the 2018 crash would have been smaller, and your break-even point would have come sooner.

Trepidation is typical – here’s how to overcome common objections to investing in bitcoin.

Cryptocurrency, blockchain and digital assets are strange new concepts, so reluctance is understandable. Those fears are logical, but they need not prevent you from investing in blockchain. Here are some common objections:

• “I’m nervous about investing in digital assets” – There’s no shame in feeling this way; you should be anxious about investing in an asset class you don’t understand. But the more you learn about blockchain, the more the case makes sense. What’s more, investing in digital assets can provide a variety of benefits, including diversification, higher returns and protection against inflation.
• “It’s a fad” – For investors, it’s crucial to distinguish between fads and trends. Bell-bottom jeans were a flash in the pan, but casual clothing is an enduring trend. Investors of a certain age remember the Beanie Babies fad. Digital assets are not another version of the Beanie Babies toys; this is a legitimate trend.
• “It’s a fraud” – Investors always need to be mindful of chicanery, but bitcoin itself isn’t a scam. Instead, you should recognize that every credible asset class – stocks, bonds, real estate, commodities – has been used as a tool by hucksters and fraudsters.
• “There’s no way to ascertain value” – In the blockchain space, prices are decentralized. No individual or authority sets the price. That’s actually an advantage of digital assets.
• “It’s too volatile” – Bitcoin crashes regularly. But so do other asset classes, including stocks and real estate. Savvy investors view volatility as an opportunity. Upside volatility is a reward for investors; downside volatility is an opportunity to buy at a discount.
• “It’s too risky” – Risk is involved in any new type of investment. You can mitigate the risk of digital assets by devoting no more than 1% of your portfolio to this class of assets.
• “I don’t need it in my portfolio” – Just as stocks, bonds and real estate provide you with diversification, digital assets can zig when the rest of the market zags.
• “It’s too late to buy” – It’s true that the price of bitcoin has soared, from $479 in 2012 to $50,000 or more in 2021. Some skeptics say this means the opportunity to buy has come and gone. In fact, the soaring price of bitcoin makes it a safer investment. Its price in 2012 reflected its novelty and its limited acceptance. Now, though, the use case for bitcoin has been well established.
• “I’ll wait for the next decline” – If you wait too long, the prices of digital assets will run away from you. So employ the magic of dollar-cost averaging. By buying in increments, you’ll benefit from the eventual rise of digital assets.
• “I don’t know how to begin” – Talk to a financial adviser. You can find good advisers at DACFP.com, the website of the Digital Assets Council of Financial Professionals.

About the Author

Ric Edelman was ranked the top independent financial adviser three times by Barron’s. He hosts a national radio show and podcast, and he is the author of 10 books about personal finance.

Video & Podcast

Winning the Loser’s Game, Timeless Strategies for Successful Investing, Eighth Edition by Charles D. Ellis

Recommendation

In this updated investing classic, market expert Charles D. Ellis offers a solid and unbiased analysis of how markets work today, and he explains why even the best professionals can no longer expect to sustain a winning streak. The savviest strategy for individual investors, he argues, is to invest in low-cost index funds where the objective is to replicate – not outperform – the broad market. While getAbstract never offers investment advice, it believes that anyone saving and investing to achieve a comfortable retirement and other goals will want this important reference book in their libraries.

Take-Aways

• It’s no longer possible to beat the market.
• Active investment is not a zero-sum game but a negative-sum game.
• Professional stock pickers try to find anomalies in share prices.
• Over the long haul, index investing produces better results than most actively managed funds and almost all individual investors.
• An investor loses simply by being out of the market.
• Diversification minimizes the risk of individual stocks and stock groups, but overall market risk comes with investing.
• Individual investors’ objectives, motivations and behavior differ from those of institutional investors.

Winning the Loser’s Game Book Summary

It’s no longer possible to beat the market.

The traditional notion of investment management holds that beating the market is possible and that superior management will do the job. In any given year, a couple of funds may do better than the averages, but sustained outperformance is rare indeed. In the dim past, experts with information and skills could beat the market. Nowadays, the market effectively consists of institutions with state-of-the-art technology. Nearly all trades in listed stocks are executed by institutional investors. The professionals trading for these institutions all have the same good technical capability and data. Their collective decisions establish the prices of stocks, so these professionals can’t beat themselves. In fact, when fees and expenses enter the calculation, most fund managers will underperform the broad market indexes. Individual investors, moreover, will underperform the professionals by a large margin.

“The reason investing has become a loser’s game even for dedicated professionals is that their efforts to beat the market are no longer the most important part of the solution; they are now the most important part of the problem.”

Take a lesson from tennis. Dr. Simon Ramo, an engineer, studied the game closely and found significant differences between a professional player’s game and that of most amateurs. Professionals excel at hitting the ball where they want it to go, forcing their opponent into a loss. Amateurs, however, make a lot of mistakes. In professional tennis, the winner determines the final score. In the amateur game, the loser’s errors determine the result. Institutional investing used to be a winner’s game. However, as professional investors with excellent information access and powerful computers have come to dominate the market, they now establish the consensus value.

Active investment is not a zero-sum game but a negative-sum game.

For the majority of investors, the hardest part of investing is sticking with the plan, no matter what happens in the markets and no matter what emotions arise. Professional investment advisers help clients set realistic and appropriate long-term objectives and policies. However, fees and expenses take a big bite out of whatever returns an active manager does generate, and those returns are not likely to match those of the market. A reasonable estimate of pretax operating costs for the typical mutual fund is 3.25%. So just to break even, an active manager has to recover that cost. With an estimated future rate of return for the market of about 7%, this means that the manager must return, before expenses, 10.25% just to match the market average. To outperform professional peers, it would be necessary to regularly find them making mistakes and to exploit those mistakes quicker than anyone else.

“For 9 out of 10 deciles of past performance, future performance is virtually random.”

The stock market is not what it used to be. Trading volume on the New York Stock Exchange has risen more than 2,000 times, with proportionately similar volume increases on other major exchanges. Today, derivatives trading is even greater than trading in the cash market.

The US Regulation Fair Disclosure, known as RegFD, requires public companies to make all information available to everyone simultaneously. Before RegFD, privileged access to information could give an active professional trader a big advantage. Now, that valuable edge is a mere commodity. Algorithmic and other forms of quantitative trading substantially influence the market. On top of that, the number of professional capital markets investors has multiplied from 5,000 to more than a million. None of them has an information advantage over the others; they all have 24-hour access through more than 345,000 Bloomberg terminals. Consequently, markets have become more efficient, and it is harder than ever for any investor to beat the market. In their advertisements, investment firms cherry-pick funds to highlight, selecting those that have turned in good returns over selective time periods. Some managers maintain hundreds of funds, so there will always be a few that look like winners.

Professional stock pickers try to find anomalies in share prices.

Price setting is a collective effort by all institutional investors with access to the same data. The only way to beat the market is to beat those professionals, and opportunities to get an advantage are rare. So, if it efficiently reflects real value, why does the market rise and fall? Understanding how other market participants think and anticipating their moves is part of an investor’s calculation of future value. Even small nuggets of information or misinformation can have huge market consequences. Long-term investors should steel themselves against the distractions from short-term market movements. Studying the history of markets to understand how they have acted in the past can provide insight into how they are likely to act in the future. Such insight can help you keep your head while others are losing theirs. Anomalies do happen and are part of the market’s normal behavior.

“All forms of active investing have one fundamental characteristic in common: They depend on the errors of others.”

By using an index fund, which replicates market performance, you can effectively assemble a team of the most knowledgeable and experienced professionals in the world and supplement their advice with research from the best analysts. Numerous investing experts, including Warren Buffett and Nobel laureates, recommend indexing for most individual investors. In addition to providing returns that most actively managed funds cannot equal, much less beat, index funds also bring less tax liability, and they charge lower fees. Index investors will see ups and downs, but they will not have to worry that their investment manager has made the wrong guess about timing the market.

Over the long haul, index investing produces better results than most actively managed funds and almost all individual investors.

The index investor can concentrate on developing a portfolio that reduces the probability of error and enhances the likelihood of achieving objectives. Investing has two risks: investment risk and investor risk. Numerous studies show that active investment costs more than it returns; no studies support the contrary. The formula for successful investing is to define the objectives, select an appropriate mix of assets and stay the course. Indexing makes this easier. The index investor need not worry about a company’s management problems or its acquisition by another firm, or about internal issues with a financial adviser. The strongest argument for indexing occurs in the major markets, such as those in the United States, the United Kingdom and Japan.

Diversification optimizes the risk-return trade-off. Therefore, the most prudent investors will choose a fund representing a total market. Individuals should avoid narrowly focused, specialized exchange-traded funds; professionals use these to tweak their risk management.

“Winning investors are not in competition with one another; they are in competition only with themselves.”

Only by holding on through thick and thin can the long-term investor realize the expected returns. This is why it is important to understand how capital markets work. Every investor has a “zone of competence” and a “zone of comfort,” and it is important to stay within both. Straying from the competence zone leads to expensive blunders; getting out of the comfort zone carries the risk of irrational, emotional decisions. Investment portfolios should be tailor-made for an investor’s age, assets, risk tolerance and other characteristics that differ from person to person. Only you as an investor can set your investment policy, whether or not you collaborate with a professional adviser. Neglecting such an assessment introduces the risk of managing long-term investments according to short-term developments.

An investor loses simply by being out of the market.

The greatest returns of the S&P 500 happened on less than 1% of the trading days in a 20-year period. Missing just the five best days in 72 years of trading would cut a portfolio’s returns in half. Although market timing does not work, time itself is a crucial consideration in investing. Time does not change the average expected return, but it can greatly affect fluctuations around the average. The longer the portfolio time horizon, the more probable it is that portfolio returns will approximate the average expected returns. The relative returns of stocks, bonds and cash differ significantly, according to the holding periods. The proportion of fixed income investments and equities is the most important consideration in your investment policy. Conventional recommendations of 60% equities and 40% debt may be reasonable for a five-year horizon but wrong for an investor with a 30- or 50-year horizon. Long-term investors know about regression to the mean and understand that both economic and market forces move eventually toward the average.

“If the market has been going up, investors, who curiously usually evaluate future prospects by looking into the rearview mirror, will assume some further upward momentum.”

Investment history shows that, on average, common stocks return more than bonds, which in turn return more than money market investments. Stock returns fluctuate more than bond returns, which similarly fluctuate more than money market returns, and the volatility of returns increases the shorter the investment time span.

Diversification minimizes the risk of individual stocks and stock groups, but overall market risk comes with investing.

Stocks of different companies may share similarities if they’re in the same industry or show the same pattern of growth, and they may exhibit similar risks. An investor who takes individual stock or stock group risk can only win if the expert consensus of the overall market is wrong about that investment’s value. Index funds provide the diversification that eliminates individual stock and stock group risk. The most important investment decisions are those that define the appropriate objectives and asset mix.

“Managing market risk to suit the investor is the primary tool of investment management.”

In the short run, a manager whose performance is significantly above or below the expected return is probably off mission. It is all too easy for the individual investor to mistake luck for skill. Some 90% of actively managed mutual funds that invest domestically have underperformed the benchmark index they were trying to beat. Only 11% managed to match the performance of their index over a 15-year time frame. The reality is even worse than these statistics indicate. Investment firms have several ways to give investors a falsely positive impression of their fund performance. They don’t, for example, report on funds they have closed, and more than 40% of domestic mutual funds close within 15 years.

Individual investors’ objectives, motivations and behavior differ from those of institutional investors.

Individual investors see money in a way that’s different from how institutional investors regard funds. For some people, the money they’ve amassed during their lives comes to symbolize what they’ve accomplished. Thus, money can take on emotional connotations, and those who are approaching or are in retirement might make financial decisions based on sentiment rather than economic rationality.

“Mortality is a dominant reality for all individual investors.”

For most people, investment begins with savings. Think of saving as something positive rather than as a form of self-denial. Specify savings goals, then plan a schedule to achieve those targets. Keep your focus on the idea that the purpose of saving is to achieve a better lifestyle. When you’re ready to invest what you’ve saved, minimize fees, taxes and expenses by indexing, and don’t forget to take inflationary expectations and their potential impacts on your portfolio into account.

“If you have successfully saved and invested enough to have ample funds for all your chosen responsibilities and obligations, you have truly won the money game. Bravo! This is an appropriately thrilling achievement.”

For an individual, the best long-term investment is in equities. Conventional wisdom says that older investors should have most of their money in bonds. However, that may not be so wise, especially in a low interest rate environment. The elderly may not have long personal time horizons, but their investment portfolios might. Children, grandchildren and other beneficiaries gain from the foresight of the investor who thinks about the future and invests in equity index funds.

About the Author

Charles D. Ellis founded Greenwich Associates, an international consulting firm, and he is a consultant to large institutional investors, government organizations and high-net-worth families.

Video & Podcast

Mastering the Market Cycle, Getting the Odds on Your Side by Howard Marks

Recommendation

Looking to improve your investment returns? Investing legend Howard Marks shows you how to recognize market cycles: the ups and downs of economic markets that repeat and reverberate throughout history. Deciphering market cycles provides a knowledge advantage. Calibrating your investment strategy to cycle movement enables you to be aggressive when the chance for success is high and defensive when it is not – which often puts you at odds with the rest of the investment community. Lean in to the human-driven phenomenon of market excess and correction to capitalize on opportunities for exceptional returns.

Take-Aways

• Calibrating your investment portfolio in response to changes in the market environment brings superior results.
• Learn to identify market cycle themes and patterns.
• Short-term economic activity fluctuates along the long-term trend without changing its trajectory.
• The free-market system enables the distribution of economic resources and promotes productivity.
• People’s emotional swings and resulting behaviors cause the highs and lows of market cycles.
• Assessing and managing risk are the greatest challenges to building a high-performing portfolio.
• Excessive risk aversion carries penalties: missed opportunities and depressed markets.
• The reactive, changeable credit cycle affects financial activity in many areas.
• The long development process differentiates the real estate cycle from others.
• Investor behavior causes market fluctuations beyond what company fundamentals might indicate.

Mastering the Market Cycle Book Summary

Calibrating your investment portfolio in response to changes in the market environment brings superior results.

Professional investors analyze industries, companies and securities to assess their intrinsic value and potential to grow or change in the short term. They compare the current market price with intrinsic value to establish worth. These investors often seek to build portfolios of assets with the highest cost-to-value relationship. Such portfolios perform equal to the average, but seldom above it. When every investor makes decisions from the same information, analyzed in the same way, no one can outperform the average. Calibrating an asset portfolio in response to changes in the investment environment brings superior results.

“Although it’s very easy to generate average investment performance, it’s quite hard to perform above average.”

Investors try to foresee tendencies and calculate the risk level inherent in different outcomes. Their predictions take the form of probability distributions informed by insights regarding the strength and likelihood of various tendencies. Learning to read market cycles provides investors with a knowledge advantage that allows them to be aggressive when the odds are in their favor and defensive when the odds are not.

Learn to identify market cycle themes and patterns.

Markets rise and fall or swing back and forth. Many factors – including human behavior – spur them into movement. The pattern of up and down remains consistent over time even though the length and causes of cycles vary. Fluctuations oscillate around a midpoint, known as the “secular trend, norm, mean or average.” Up or down movement in the cycle gains energy and momentum as one event gives rise to the next. The extremes of high – bubbles – and low – crashes – are deviations from the mean and forecast a correction or regression toward the mean.

“The events in the life of a cycle shouldn’t be viewed merely as each being followed by the next, but – much more importantly – as each causing the next.”

Circumstances rarely hover at normal on the way to the other high or low point. The market doesn’t move from overpriced, for example, to linger indefinitely at a fair price point.

Short-term economic activity fluctuates along the long-term trend without changing its trajectory.

An economy’s output is a measure of its overall productivity, determined, primarily, by the numbers of hours worked and population size. Birth rates, productivity speeds, and societal and environmental changes affect long-term economic growth; these take years or decades to play out. Economists concern themselves with gross domestic product (GDP): the market value of all the goods and services for sale that a nation produces within a given time frame.

“This underlying trend in growth clearly follows a long-term cycle, although the short-run ups and downs around it are more discernible and thus more readily discussed.”

The short-term economic cycle is the annual growth or constriction of an economy, and, generally, falls in the two to three percent range. Two negative quarters in a row signal the onset of a recession. Short-term cycles oscillate around a long-term upward or downward trend. Shorter movements in economic activity have little effect on the enduring trajectory.

The free-market system enables the distribution of economic resources and promotes productivity.

The term “free-market system” isn’t entirely accurate because government regulation and central bank activity temper the highs and lows of economic cycles. Central banks, such as the US Federal Reserve Bank, counteract inflation by restricting money supply, increasing interest rates and trading securities. They seek to boost employment with activities that support economic growth. These dual goals work against each other and require a counter-cyclical approach. Governments direct economic growth rates by increasing spending and cutting taxes during down times and doing the opposite when markets overheat.

“Since cycles produce ups and downs that can be excessive, the tools for dealing with them are counter-cyclical and applied with a cycle of their own – ideally inverse to the economic cycle itself.”

The economic cycle affects the sales and profits of some industries more than others. Corporate profit cycles echo the market cycle, but prove more variable than GDP because economics is not the only driver of sales. Price reductions, new product introductions and availability of financing, for example, all influence sales figures. An increase in revenues doesn’t always translate into larger profits due to differences in company operating costs and debt obligations.

People’s emotional swings and resulting behaviors cause the highs and lows of market cycles.

Human emotion drives the short-term ups and downs of the investment environment. People’s psychological reactions swing between the poles of “greed and fear,” “optimism and pessimism,” “risk tolerance and risk aversion,” “credulousness and skepticism,” and from “flawless to hopeless.” When times are good, and people feel positive, they become greedy and spend more on investments, inflating markets and increasing the value of assets. When their outlook is negative, they become fearful about losing money and sell, so asset values depreciate.

“Markets move upward when events are positive and psychology turns up, and they fall when events are negative, and psychology turns down.”

The tech stock market in 1999 serves as an apt example. When everyone bought, greed motivated investors to join the frenzy rather than stay on the sidelines while others became rich. When prices fell, fear replaced greed, and investors couldn’t dump their tech stocks fast enough. The lesson: remain objective and unemotional to protect yourself from making buying and selling decisions based on psychological excesses.

Assessing and managing risk are the greatest challenges to building a high-performing portfolio.

When investors become too risk averse or risk tolerant, their behavior causes swings and fluctuations that deviate from the capital market line – the risk/return continuum of rational markets. The shakiest investments often occur during the brightest and most robust economic times, due to unchecked optimism. 

“Risk is high when investors feel risk is low. And risk compensation is at a minimum, just when risk is at a maximum.”

A positive mind-set regarding the economic outlook triggers greed and the following pattern results:

• Optimism reduces investors’ caution and hightens their risk tolerance.
• Investors forego careful analysis and make unwarranted assumptions about an upside.
• Investors relinquish demands for risk premiums and accept lower margins of safety.
• More people purchase the risky assets, driving up prices and reducing returns.

The Financial Crisis of 2007-2008 exemplifies what happens when investors exercise an unjustified tolerance for risk. The steps leading up to the crisis included government promotion of home ownership, low interest rates, the creation of levered mortgage-backed securities and financial derivatives, and declining lending standards and practices. Media coverage was uniformly rosy and optimistic; the government relaxed necessary protections, such as the Glass-Steagall Act. High risk tolerance allowed unsound, unsafe financial behavior and led to the inevitable crash.

Excessive risk aversion carries penalties: missed opportunities and depressed markets.

Burned investors become overly cautious. Those hyper-focused on loss avoidance make negative assumptions, expose investments to unnecessary scrutiny and reject even the lowest margins of safety. In this market, savvy investors realize greater gains by taking on reasonable risk.

“The riskiest thing in the world is the belief that there’s no risk. By the same token, the safest (and most rewarding) time to buy usually comes when everyone is convinced there’s no hope.”

It pays to be a contrarian – to buy when others are cautious and to be conservative when others are aggressive.

The reactive, changeable credit cycle affects financial activity in many areas.

Even small fluctuations in the economy cause the credit window to open wider or slam shut. When the credit window opens, financing becomes readily available. When the window closes, financing becomes difficult to obtain. The availability of credit strongly affects companies’ ability to grow and refinance maturing debt. A tight credit market causes consumers and investors to curtail activity and retreat to their corners.

“The slammed-shut phase of the credit cycle probably does more to make bargains available than any other factor.”

Upward movement in the credit cycle occurs during economic prosperity. The positive economic environment creates a wide-open capital market; businesses and financial entities easily obtain financing at lower interest rates, and with fewer conditions. Economic activity increases, and asset prices rise; but, eventually, relaxed credit diligence leads to losses – the credit window begins to close. When the credit crunch occurs at the bottom of the cycle, shrewd investors find opportunities for low-risk, high-yield assets at rock-bottom prices.

The long development process differentiates the real estate cycle from others.

The real estate cycle follows the pattern of other market cycles with one glaring difference: The real estate development process can take years. During this time, market conditions may change drastically.

At the start of the real estate cycle, a suppressed economy keeps building activity low. As the economy improves, housing demand rises. Limited inventory inflates rents and housing prices, attracting developers who obtain easy financing. The first available building projects benefit from pent-up demand. Their rosy returns attract more builders to capitalize on the still unmet need. Inventory eventually outpaces demand, the economy slides downward from its peak, rents and housing prices fall, and last-in real estate developers lose out.

The factors unique to real estate that intensify its cycle are the long duration between a project’s beginning and completion, the high level of financial leverage and the inability of supply to adjust nimbly to demand. These realities create opportunities for astute investors to pick up incomplete projects at reduced prices when the cycle hits bottom.

Investor behavior causes market fluctuations beyond what company fundamentals might indicate.

Security prices vary more than current earnings and outlook for future earnings indicate. Investors tend to believe what they want to believe, follow the herd, bounce between risk tolerance and risk aversion, surrender to the fear of missing out and let emotion rule. Investing brings out people’s deepest insecurities and stokes their subconscious fears.

“The key to being able to behave in a way that’s appropriate given the market climate lies significantly in assessing the psychology and the behavior of others.”

To invest intelligently, ascertain what an asset is worth and buy it for slightly less. When emotions interrupt the relationship between price and value, you will lose money. Quantitative assessment of gauging valuations coupled with qualitative measures of evaluating investor behavior indicate the cycle position. When everyone is buying euphorically, hold back; when they panic, scoop up deals.

Consider these components to build a high-performing investment portfolio:

• “Cycle positioning” – Take on or avoid risk in response to market cycles.
• “Asset selection” – Choose investments based on safe and proven metrics.
• “Aggressiveness and Defensiveness” – Determine if market conditions warrant either stance.
• “Skill” – Make investment decisions on a range of reasonable probabilities.
• “Luck” – Random events and circumstances may break to your benefit.

About the Author

Co-founder of Oaktree Capital Management Howard Marks also wrote the bestseller The Most Important Thing.

Video & Podcast

Recommendation

Napoleon Hill, author of this 1930s classic, will remind you of an older, wiser, slightly wacky uncle who advises you about careers, life and love. This book is a wonderful collection of tips – many based on the ideas of Hill’s mentor Andrew Carnegie – that range from the practical (how to prepare a résumé) to surprisingly New Age-like mystical talk about the infinite powers of the universe. Of course, like an old uncle, Hill can get long-winded and repetitive at times, but since he packs so much wisdom into his slender book, you will want to re-read it over and over, repetitions and all. His classic compendium will interest anyone who is dangling from the career ladder and wondering how to prosper.

Take-Aways

• Your thoughts are a secret wealth generator.
• Desire, hopes and strategies increase wealth.
• Develop faith in your ability to succeed by telling yourself that you will triumph.
• You don’t need higher education to earn higher degrees of knowledge and wealth.
• Create vivid mental portraits of your success. Imagination is the “workshop of the mind.”
• To maximize your abilities, work with a great team. Make it your “master mind.”
• Don’t let short-term failure seduce you. Success often lurks in the shadows.
• Remain committed to your goals and your mission statement
• Nothing beats a mix of passion and discipline.
• You can mold and tap into your mind’s deepest chambers.

Think and Grow Rich Book Summary

Your thoughts are a secret wealth generator.

When author Napoleon Hill “was but a boy,” his mentor, Andrew Carnegie, the legendary corporate leader, shared his secret wealth-generating formula with him and challenged him to create a book that would explain this secret approach.

During Hill’s 20-year journey to fulfill that challenge, he studied the habits and philosophies of hundreds of corporate stars. This honor roll includes Theodore Roosevelt, John D. Rockefeller, F. W. Woolworth and many other household names who built large fortunes based on Carnegie’s wisdom. It begins with this simple idea: Your thoughts are real objects! With passion and purpose, your thoughts can evolve into wealth.

“One comes, finally, to believe whatever one repeats to one’s self, whether the statement be true or false…Every man is what he is because of the dominating thoughts which he permits to occupy his mind.”

Edwin C. Barnes demonstrates this principle. Barnes – an impoverished “nobody” – passionately wanted to launch a partnership with Thomas Edison, the great inventor. Barnes did not know Edison and could barely afford transportation to Edison’s office. At their initial encounter, Edison said Barnes looked like an “ordinary tramp.” But behind that rundown appearance, Edison detected a spark of promise and determination that prompted him to offer Barnes a low-paying job. Barnes seized this unexpected opportunity. Naysayers had rejected the “Edison Dictating Machine,” but Barnes had faith in it. He used it as a vehicle to launch his successful partnership with Edison. Barnes created material success from abstract thoughts, based on faith, determination and persistence.

Desire, hopes and strategies increase wealth.

If your goal is to become rich, don’t just wish for your dreams to come true. Desire is “the starting point of all achievement,” but to bring it to fruition, commit yourself to executing a plan to attain your objective. To create wealth from desire, follow this six-step plan:

1. Take a mental snapshot of the amount of money you seek. Name a number.
2. Name your price. What are you willing to do for the money?
3. Create a deadline. Fix a date by which you will achieve your goals.
4. Start a task sheet with a definite strategy. Start now.
5. Write a brief mission statement.
6. Make a declaration: Twice a day, read your mission statement aloud.

Dreams are not just thin air. Edison had far-fetched dreams of inventing an electrical lamp. He created thousands of failed prototypes before succeeding. While others stayed on the ground, the Wright brothers envisioned a flying machine.

“I believe in the power of desire backed by faith, because I have seen this power lift men from lowly beginnings to places of power and wealth.”

Other dreamers have overcome major obstacles. Beethoven composed music despite his deafness; Milton, the writer, was blind. Author Helen Keller was blind and deaf. But lit by the fire of desire, they worked on their goals and achieved epic greatness.

Develop faith in your ability to succeed by telling yourself that you will triumph.

Faith is the “visualization of and belief in the attainment of desire.” With the right tools, you can fill the fertile field of your mind with success or failure. Recite your mission statement daily to prepare your mind for success. This process, called “autosuggestion,” sows the seeds of mental success. It works because your mind will believe almost anything (true or not) that you tell yourself repeatedly. Dangerous thoughts also can take root in the mind-field. Doubt, fear and negative emotions can blight your success and uproot the fruits of your labor.

“Faith is the starting point of all accumulation of riches.”

Autosuggestion is a dose of self-talk delivered to your subconscious mind via your five senses, the roadways from your conscious mind to your unconsciousness. Be warned that this conduit does not work if you operate on automatic pilot. Feel the message. Jumping from printed words to passionate feelings is not easy. Make the leap by focusing on a fixed item. Close your eyes. Create a mental snapshot of the money you want to earn. View it daily.

To visualize your goals, use the six steps above in tandem with this three-stage program:

1. Retreat to a quiet location with freedom from distractions – Find a peaceful environment for daily renewal, review and recitation of your goals. Create mindful pictures of monetary success, possessions and achievement. Visualize your date with success. Be specific: On July 4, 2011, I will celebrate my financial independence.
2. Take a daily double dose of faith – Apply this program every morning and evening. Don’t stop until you achieve your financial goal.
3. Look at your mission statement twice daily – Seeing is believing. Read your mission statement first thing in the morning and last thing at night.

You don’t need higher education to earn higher degrees of knowledge and wealth.

Knowledge is just numbers, facts and insights. But through organization and planning, facts can assume great power. Harness that power to create wealth. So-called “formal knowledge” is not the last word in education. Many wealthy people spent little time in traditional classrooms, but had rich experiences. Edison went to school for only three months. Yet, through specialization, organization and networking, he gained the power of a well-educated mind.

“It takes more than a college degree to make one a person of education.”

Specialization is organized knowledge applied to a specific purpose. Gain this practical know-how from apprenticeships, night schools and other targeted training programs.

Create vivid mental portraits of your success. Imagination is the “workshop of the mind.”

Imagination operates on two playing fields. “Synthetic imagination” arranges existing ideas, concepts and strategies into novel formats. “Creative imagination” bridges the definitive mind of man and the borderless universe of “infinite intelligence,” the land of gut feelings and hunches. The top performers in business, music, art and literature operate in the domain of creative imagination, fueled by desire and faith. Your imagination is a muscle. Work it, develop it and create a written plan to convert airy dreams into concrete wealth. Constantly review your plan. Repetition works.

“Dreams are not born of indifference, laziness or lack of ambition.”

For a perfect demonstration of the fiscal power of the imagination, heed the legend of the “Enchanted Kettle.” Many decades ago, a country doctor drove his horse-drawn carriage to a small town. While in town, he debated the merits of his plain kettle with a young sales clerk. After a 60-minute discussion, the visionary young man gave the doctor his entire nest egg, $500, to buy the kettle and a secret formula the doctor wrote on a piece of paper. With that formula, a plan and imagination, sales clerk Asa Candler created Coca-Cola.

To maximize your abilities, work with a great team. Make it your “master mind.”

To develop your success, you need the right team. Do not skip this stage. Take these steps:

• Surround yourself with “master mind” allies. Cultivate a support team. Employ your talents and resources to help them and invite them to assist you.
• Fine-tune your plan with regular support group meetings.
• Establish harmony with each member of the group.

The mind has many layers. When a group works together, the energy of their combined individual thoughts, ideas and plans becomes a powerful driving force. Consider the humble battery. A single electric battery has power, but the electricity of several batteries easily overshadows its force. Multiply your brainpower by tapping into the infinite wisdom of the group mind, a master mind far greater than the mental powers of each individual.

Don’t let short-term failure seduce you. Success often lurks in the shadows.

Don’t accept failure. If your initial plan fails, adopt a new strategy and persist. Identify attractive opportunities. Study the field, the company and the individuals involved. Inventory your talents and skills. Write a detailed strategy for achieving the right job. Target the appropriate channels and people. Make your résumé concise, thoughtful, relevant and neat. Know your marketplace value.

“Success requires no explanation. Failure permits no alibis.”

Nurture success by avoiding the symptoms of failed leadership, which include: failure to structure details; inability to perform humble tasks; insecurity; absence of imagination; lack of discipline and trust; over-reliance on force and authority; selfishness; and insistence on titles and honor.

Remain committed to your goals and your mission.

Procrastination, a top cause of failure, is your enemy. Successful leaders make quick, meaningful decisions. Being decisive gives you “mastery over procrastination.” Consider the advice and insights of your support group. Avoid anyone who undercuts your drive. Dodge the trap of public opinion by revealing your plans only to your small circle of advisers. When you indiscriminately broadcast your strategies, ideas and goals, you lessen your chances of success. Keep quiet; keep the faith.

Sadly, many people surrender their dreams at the first hint of difficulty or failure. Don’t be a magnet for poverty. Avoid a “poor consciousness” in which negative feelings become self-fulfilling. End the cycle of poverty by creating and believing in a “wealth consciousness.” Everyone falls into doubt, disbelief and depression, but you can liberate yourself via perseverance, “the sustained effort necessary to induce faith.” Keep moving even if you must go slower. No one climbs great mountains without sliding off a few trails.

Nothing beats a mix of passion and discipline.

Sexual desire, when properly applied, is a powerful stimulant for success, wealth and creativity. You need passion to succeed in art, science or commerce. This passion enhances your sensitivity to the “infinite wisdom of the universe,” and the tiny whispers of insight from your gut. History is filled with people who were pushed to greatness by lust or love. Napoleon Bonaparte’s great campaigns were largely due to the inspiration of Josephine, his first wife. Sexual energy fueled William Shakespeare and Thomas Jefferson. But most men do not succeed before age 40 because it takes at least four decades to understand and harness the creative force of sexual energy. Through discipline, planning and willpower, sexual energy transcends the body, and generates success and creativity.

You can mold and tap into your mind’s deepest chambers.

Your subconscious is a “connecting link” that operates outside of your controlled thoughts. Use autosuggestion and planning to employ your subconscious mind. Repeat affirmations. Stay in the moment. Shun negative thoughts. Cultivate faith, desire, sex, love, energy, hope and romance. Avoid jealousy, fear, greed, revenge, anger and hatred. Remember the power of prayer.

Your brain is a unique “broadcasting and receiving station for thought,” like a radio station that transmits and receives signals. Learn to listen to the “intangible forces” in your life. These forces – gravity, electricity, thunder and other elements – surround you. Use faith to stimulate your mind and reach your goals. Believe in the power of thought and belief.

“Life is a checkerboard and the player opposite you is time. If you hesitate before moving, or neglect to move promptly, your men will be wiped off the board by time. You are playing against a partner who will not tolerate indecision.”

The sixth sense, “the door to the temple of wisdom,” is the direct connection between your subconscious mind and the infinite light of the universe. This link represents the home of your creative imagination, intuition and premonitions. Use this force to bring you wealth, success and creativity. Constantly repeat and review your goals; let the universe deliver insight to your subconscious mind.

Don’t be hampered by the “six basic fears”: fear of being poor, fear of reproach, fear of becoming sick, fear of being unloved, fear of getting old and fear of dying. Avoid fretting, dwelling on destructive thoughts and don’t let negativity sway you. The power of your thoughts gives you mastery and can give you money, as well.

About the Author

Napoleon Hill was born in 1883. A former newspaper reporter, he studied law and worked for Andrew Carnegie, whose ideas are reflected in Think and Grow Rich. Hill advised numerous prominent people, including Franklin D. Roosevelt, Mahatma Gandhi and Thomas Edison.

Video & Podcast

The Audit Society, Rituals of Verification by Michael Power

Recommendation

Why are individuals willing to live in an “audit society” where almost everything is checked? Perhaps they accept such monitoring because few folks would want to live under the opposite conditions, where nothing is checked. People want to know that their planes can fly, their banks won’t fail and their food is safe. Thus, auditing has become ubiquitous – but does it exist only for its own sake, or does it have intrinsic value? Does it help, hurt or control society? In this reprint of his original 1997 work, accounting lecturer Michael Power explains how auditing has come to permeate the social, political, corporate and economic worlds. His short text is often a hard, dense read, but he’ll broaden your understanding of auditing beyond the numbers in a ledger: Auditing, he teaches, underpins many facets of society and involves crucial questions of trust. getAbstract believes accountants, auditors and those who hire them will find this work particularly relevant, but those seeking deeper knowledge of professional practices and of how society works also will be intrigued.

Take-Aways

• Audits take place throughout society, not just in business.
• The different types of audits are numerous and extend far beyond just financial assessments. The practice overall has experienced an “audit explosion.”
• Auditors essentially render an informed opinion in an audit and ask people to trust it.
• The goal of auditing is “the production of comfort.” It can aid society in determining risk and examine possible risks to provide assurance.
• Financial auditing has four elements: “official knowledge, training and education, practice,” and “quality control.”
• Auditing to improve governance comes in three forms: “New public management, value for money” and “quality management.”
• Auditors must test representative samples and often call on teams of specialists.
• Auditing becomes ineffective if it falls prey to “decoupling” and becomes rote.
• Auditing also falters in the face of “colonization,” when it takes over the client it is screening, such as when testing teachers to make education more accountable.
• Auditing is different from “surveillance” and “inspection,” but can still compel change.

The Audit Society Book Summary

“The Audit Explosion”

You may not realize that you live in an “audit society,” but you do. For example, parents perform an audit every time they check to make sure their child’s safety belt is fastened. However, in the course of your daily life, you also exercise a certain amount of trust. If you lend money to a friend, you probably don’t demand assurance on paper that your pal will reimburse you.

“Could one imagine a society, or even a group of people, where nothing was trusted and where explicit checking and monitoring were more or less constant?”

Thus, though auditing is a fixture of a functioning society, people would not want to live in an environment without trust, an atmosphere that required constant checking. Since the late 1980s and early 1990s, auditing has become ubiquitous. This trend sparked an audit explosion, which continues still in fields such as business, education and medicine.

“Rather than providing a basis for informed dialogue and discussion, audits demand that their efficacy is trusted.”

Beyond vague statements that hint at auditing’s possibilities, experts do not agree on exactly how to describe it. They widely define financial auditing as the “independent examination of, and expression of opinion on, the financial statements of an enterprise.” Authorities do agree that an audit can occur only when auditors have independence from the body they are checking, experience collecting data, the ability to form opinions about their documentation along with “a clearly defined object of the audit process” – for example, a firm’s financial report.

“The production of official definitions of a practice like auditing…is an idealized, normative projection of the hopes invested in the practice, a statement of potential.”

The process of auditing becomes controversial when the organization under examination (the “auditee”) commits fraud, fails or goes out of business. Auditing used to occur without much fanfare, but recent high-profile corporate collapses pointed a new spotlight at the process and imbued it with a certain amount of tension, although the auditing process works on the assumption that people will trust it. In the end, this process produces a report where auditors render an opinion on the state of the organization they’ve audited. Auditors employ specific methods with the goal of becoming and remaining “systematically effective” and developing results that offer assurance.

Fraud Happens

Financial auditing is the oldest type of auditing. Even when members of the public do not understand auditing’s processes, they must have faith in its findings and in its independence from the organization it is checking. Auditing’s goal is to gather enough data to render a sufficient determination of whether a body is financially sound. Sufficiency requires “operational scope” – that is, the auditors’ determination of “how many transactions” to examine – and “operational depth” – that is, their decisions about the nature of the inspections they should conduct.

“Audit was a practice long before it was able to give an ‘account’ of itself in anything approaching a conceptual fashion.”

People generally assume that financial auditing sets out to find mistakes or lies. That said, the public now also tends to conclude that auditors who don’t find fraud have failed. Auditors must balance such expectations with reality, because when the public perceives that an audit has failed, the reaction can lead to more governmental regulation and control.

“The audit explosion reflects a distinctive response to the need to process risk.”

The financial auditing system has four elements:

1. “Official knowledge” – The rules and regulations governing auditing procedures.
2. “Training and education” – The skills auditors learn.
3. “Practice” – The actual methods auditors use.
4. “Quality control” – The “feedback mechanisms” of the peer review process.

“Auditing the Reinvention of Governance”

In addition to finance, auditing is important to the administration of an organization or firm. Companies must be careful over time that their methods and practices continue to serve their needs and their customers. That need helped generate the audit explosion. Companies use one of these three auditing practices:

1. “New public management” – This type of auditing checks the governance of public entities. It received a boost from the push for restraint in government spending. Auditors use this approach to encourage competence within slow bureaucracies.
2. “Value for money” – This kind of auditing checks economic resources to ensure that “regulated entities” observe the relevant rules. Auditors employ this method to examine firms’ “fiscal regularity” (how they manage income), “economy” (how responsibly they use supplies), “efficiency” (whether they achieve “maximum output”) and “effectiveness” (whether they produce what they say they will).
3. “Quality management” – This auditing method makes sure that organizations function at the highest possible level. These efforts usually lead organizations to institute internal performance measurements.

“A certain balance between the personal and the anonymous, the subjective and objective, the judgmental and technical, the concrete and the abstract is at the heart of professional expertise.”

When corporate scandals or fraudulent business practices come to public attention, the government usually reacts by regulating related firms more heavily. Aversion to increased regulation has, in turn, led companies to adopt more “internal control” structures.

“Samples, Specialists and Systems”

Auditors must determine “how much testing is necessary” and what subgroup constitutes a fair “representative sample.” Such sampling is not the same thing as a “block test,” where an auditor examines an organization’s activities during a certain time frame. Although auditors rely on scientific sampling methods, they must exercise their judgment to complete the audit process. When they find evidence, they must balance their conclusions with their other knowledge.

“Public sector auditing implicates questions about the distribution of authority and control in a way that financial auditing does not.”

The auditor and the auditee take a risk that legal liabilities may result if the auditor’s judgment is incorrect. Because no auditor can be an expert in every subject, auditors frequently join with teams of specialists to complete the audit process.

Auditors also must deal with the internal control systems of the organizations they audit. “Compliance structures” that exist at the ground floor and work their way up through the company should function well. However, some organizations may stumble at the difficulty of establishing internal controls, so their processes and results can vary greatly and become auditing issues. In that case, auditors face the task of “making things auditable,” a challenge they usually accomplish by conducting thorough representative sampling, calling in specialists as partners and using an organization’s existing systems for corroborating their findings.

“Auditees and the Auditable Performance”

The audit explosion has led to increasing “formalization” of audit procedures. The reason for this is because organizations expect audits to serve as mechanisms that encourage change (increased moneymaking abilities, better quality, and the like). Here, auditing can fall short in two ways:

1. “Decoupling” – Auditing loses its meaning if it becomes decoupled from its purpose. In such situations, the audit process becomes “ceremonial” and rote. This can happen when the entity undergoing auditing has internal control structures (like “audit committees, internal auditors, audit officers,” and the like) that ritualize and channel outside audits.
2. “Colonization” – Auditing can lose effectiveness if it “provides a dominant reference point” for the actions of an organization under audit, taking over or colonizing the body it is assessing. This can lead to auditing practices that fit the organizations’ ends, such as testing teachers to make educators more accountable or grading doctors to control the quality of health care. When colonization occurs, auditors and audited entities veer from their real goals. They end up measuring effectiveness, not fiscal solidity. Colonization can turn auditing from a useful exercise into a “fatal remedy” that “creates forms of dysfunction for the audit itself” instead of assessing a client’s financial controls.

“What makes auditing auditing is the legitimate requirement for one party to give an account of those actions relevant to its relation to another party.”

To avoid these pitfalls, auditors should “construct concepts of performance” that are true to auditing’s professional monitoring mission, and not deviate from that purpose.

Auditing has encountered new challenges in research, education and medicine. In the UK, auditors tried to use auditing to determine researchers’ eligibility for future funding, but they could not nail down the “auditability” of academic research. They considered compelling researchers to keep timesheets but abandoned the idea as intrusive.

“In the audit society the power to define and institutionalize auditable performance reduces evaluation to auditing.”

Still, the threat of audits that affect future funding has taught these scientists that they’re accountable to their “peers, patrons and publics.” Auditing in education has led universities to establish internal control systems to assess and cultivate high-quality teachers. The result: Auditing has become a tool for directing teachers rather than a mechanism to encourage better learning.

“The guarantee of quality in ‘inscrutable markets’ is somehow to have trust in people.”

The health care profession, by contrast, traditionally used a form of auditing to ensure quality and safety. Physicians have turned to case reviews, consultations and improved information to provide better diagnoses and health services. But medical auditing is undergoing a transformation: Funding agencies now predicate physicians’ financial reimbursements upon meeting certain quality standards, thus rendering medical audits more “programmatic.” Unsurprisingly, many doctors resent these audits as infringements on their independence, so “medical auditing remains a contested field.”

Trust, But Verify

Auditing exists because people need assurance that their systems and societies work. The “production of comfort” – the confidence that society has done all it can to avoid risk – is auditing’s central goal. However, societies should be wary of putting too much conviction in the auditing process and in allowing it to blind them to risk.

“Audit is a paradoxical and complex combination of surveillance and trust.”

To be fully aware, carefully examine the methods that auditors use. For example, auditors conduct financial audits according to the standards of Generally Accepted Accounting Practice (GAAP) – but an audit can’t keep a firm that doesn’t meet GAAP standards from conducting business. And a shortfall in that quality level generally does not become a subject of public discussion. When auditors present their findings, the audited organization essentially receives a “quality label.” If that label is negative, society must determine if the auditor’s report carries any real consequences.

“The risk of audit is not simply that it does not work and leads to fatal remedies…it is also impossible to know when it is justified and effective.”

Where creating consequences is important, using “surveillance” or “inspection” may be more appropriate than relying on an audit. Surveillance focuses on the actions of people in an observed organization. Because it can raise privacy and control issues, surveillance can be more “coercive” than an audit. Inspection is “an examination of what is happening” and usually results in some kind of certification or testimonial (such as in the case of food safety). More than auditing, inspection pays extra attention to how the examined organization acts. Surveillance and inspection are even more likely than audits to lead to increased regulation.

“The way societies call individuals and organizations to account says much about fundamental social and economic values.”

The rise in the use of audit, surveillance and inspection does not negate the continuing importance of trust. The social contract requires that auditors must be able to believe auditees, who must be able to trust auditors’ reports – as must society itself. The audit society, in short, “is not simply a distrusting society; rather, it reflects a tendency not to trust trust.”

One result of this reality is the constant presence of risk. Trust can mean that society is taking risks in, for example, medicine and manufacturing. Mistakes can occur in the operating room; substandard products can reach consumers. Auditing has become a primary vehicle for assessing those risks – “a style of risk processing,” even when circumstances call on auditors to verify “the unknowable.” Is auditing, then, the “tail…wagging the dog”? Is it the driver of results rather than the evaluator? After all, despite its limitations and inefficiencies, auditing remains the preeminent method for producing comfort and for gaining the “ability to demand accounts.”

About the Author

Former Coopers and Lybrand auditor Michael Power teaches accounting at the London School of Economics.

The Contemporary CFO, How Finance Leaders Can Drive Business Transformation, Performance and Growth in a Connected World By Michael Haupt

Recommendation

No longer just bean counters, chief financial officers are taking on more wide-ranging roles, Deloitte partner Michael Haupt writes in this practical guide to CFO responsibilities. In addition to preparing financial statements, top finance executives are now leading corporate digital transformations and overseeing sustainability initiatives. Haupt acknowledges that CFOs’ financial backgrounds don’t necessarily prepare them for these new challenges, so he offers advice based on his own work with high-level finance professionals. New occupants of the CFO’s office will find this a useful reference.

Take-Aways

• The roles and responsibilities of chief financial officers have expanded. 
• CFOs must embrace “design thinking” and assume a new digital toolkit.
• Data is a precious commodity for businesses, yet many rely on poor-quality numbers.
• Five main building blocks contribute to strategic performance.
• Networks and network effects are a major part of successful digital businesses.
• Digital business platforms succeed by leveraging networks.
• Digital business ecosystems are remaking the global economy.
• Sustainability is now within CFOs’ purview.

The Contemporary CFO Book Summary

The roles and responsibilities of chief financial officers have expanded.

Traditionally, CFOs were in charge of the finance function at their corporations. However, many companies have broadened that job description in recent years. Indeed, many CFOs’ duties have moved well beyond preparing financial statements. They’re tackling much larger challenges, most notably in leading digital transformations. Chief executives increasingly lean on their CFOs to take on wide-ranging tasks. CFOs have become “change agents” in many organizations, and firms are making these new demands while also holding CFOs to the highest standards of any executive in the organizational chart.

“The old stereotype of a mere ‘bookkeeper’ is long outdated.”

In this new job description, CFOs are expected to oversee their companies’ transformations. It’s a high-stakes assignment. Such corporate casualties as Blockbuster, Kodak, Polaroid and Borders illustrate the hazards of not keeping pace with technological change: Companies that don’t adapt in a way that prepares them to respond to constant change cease to exist. As one CFO of a Fortune 100 company notes, “We need to prepare ourselves to meet the demands for a business we haven’t even seen yet.” CFOs don’t necessarily need to become experts in specific technologies, but they do need to guide their organizations to “digital maturity.” It’s a state of technological transformation that means the company not only has met the technical demands of today but is prepared to evolve to meet the needs of tomorrow.

CFOs must embrace “design thinking” and assume a new digital toolkit.

As financial professionals, CFOs are accustomed to analyzing problems in a conventional way. That approach doesn’t necessarily work when it comes to digital transformation. These challenges demand creative and unconventional solutions, and that reality has led to the rise of design thinking. Design thinking involves engineering solutions that meet consumer needs in a way that’s elegant, easy to use and probably not what end users were expecting. As company founder Henry Ford famously quipped, if he had asked early 20th-century consumers about their transportation needs, they would have asked for faster horses.

“One of the key challenges of digital transformation is that both the problem and the expected outcome are often difficult to define upfront.”

Seven digital technologies that CFOs must add to their toolkits are:

• Cloud computing – This internet-based, remote storage method led to the rise of technology as a service.
• In-memory computing – Storing large volumes of data speeds processing and response times.
• Cognitive computing – This category, which includes artificial intelligence, allows technology to replicate human skills such as speaking and learning.
• Collaboration platforms – These networks allow communication across large groups of employees.
• Blockchain – Building blocks of digital assets verify transactions.
• Data visualization – These tools allow for the presentation and exploration of vast sets of numbers.
• Advanced analytics – New methods are emerging to analyze big data.

Data is a precious commodity for businesses, yet many rely on poor-quality numbers.

With storage and processing power seemingly unlimited, many organizations are amassing not just terabytes of data but also petabytes, zetabytes and even a huge sum of data known as a brontobyte. But the reams of data haven’t led directly to more knowledge and insight. Many organizations are awash in data, but the paradox is that none of it is good enough to drive meaningful business transformation. In fact, a Harvard Business Review study in 2016 placed the cost of low-quality data at more than $3 trillion a year.

“For all the impressive gains promised, only a few companies seem to have realized the expected benefits from their ‘big data’.”

Imposing best practices on data will help organizations tap into what should be a valuable source of insight. Some suggestions include:

• Look at data as a long-term investment – Cleaning up corporate information is an ongoing project, and it should be treated as such.
• Create a sensible strategy – In many organizations, data are fragmented and siloed. CFOs need to reposition data as a shared asset. And the data strategy should connect clearly to the company’s overall business objectives.
• Standardize data definitions – When data are dispersed across organizations, a hodgepodge of definitions and reporting practices follows. Effective data strategies start with consistent definitions of metrics, so that every individual in the organization is using information in a way that means the same thing to everyone else.
• Create strong guidelines for governance and ownership of data – Companies should establish frameworks for the safety of data and the ongoing improvement of data practices. Procter & Gamble offers an example of a company with a robust model of data quality and governance.
• Leverage cloud computing – Many organizations already are using the cloud to manage their data. This step promises both lower costs and access to greater resources.

Five main building blocks contribute to strategic performance.

The first leverage point the CFO must consider is the performance goal. One challenge of a company-wide performance goal is to persuade employees that it’s not just an arbitrary target but a shared motivation, one that drives growth and improvement across the organization. Performance goals also need to be clear and tangible. Former General Electric CEO Jack Welch hit the mark with this goal: “To become No. 1 or No. 2 in every market we serve, and to revolutionize the company to have the speed and agility of a small enterprise.” Performance goals set a direction and guide everyone to work in that direction. But in a rapidly evolving business landscape, the direction can change, along with external circumstances.

“The reality – whether we like it or not – is most companies are just muddling through.”

The second leverage point is the growth model: This part of strategic performance adds further detail to the performance goal. It helps company leaders develop a sustainable approach to driving and accelerating growth. The third component is accountability, which involves putting someone in charge of the performance objective and giving that person the responsibility to decide how to reach the goal. The details of the accountability model will vary by organization. One European streaming company, for instance, divides workers into small “squads” to tackle specific problems. In a different approach, a global manufacturing team sets up front-line teams that bring in expertise from important product groups.

“For a large company to work effectively and efficiently, the different parts of its organization must work well together toward a common performance goal.”

The fourth core part of strategic performance is the information management system. Because accountability models make individuals responsible for their own performance, the management information system should give clear and consistent feedback about how well contributors are performing. The fifth and final piece of the puzzle is risk management: Digital transformation is characterized by the automation of routine tasks and the freeing of front-line workers to act in ways that are more autonomous and creative. However, this new reality creates a risk that employees might make operational mistakes or commit ethical lapses. Risk management systems need to give clear guidance about what not to do, a form of boundary setting that reduces risk.

Networks and network effects are a major part of successful digital businesses.

The power of networks defines today’s tech world. Many CFOs have been trained to understand an economy dominated by the law of diminishing returns. In the business reality of yesteryear, Ford enjoyed hefty profits until competitors such as Dodge and Chrysler entered the market. The tech industry experiences a much different trajectory: Companies that already possess a strong market position grow even stronger and more profitable as markets mature. This is a result of the network effect, which allows companies to create markets and then solidify them through interlocking relationships with customers and communities.

“Networks are an essential ingredient in any complex adaptable system.”

One important characteristic of networks is that they gather momentum over time. The worldwide web started with just one website but then grew exponentially, thanks to network effects. Networks also benefit from the “rich-get-richer phenomenon”: Established networks tend to attract large numbers of new users, while less-established networks struggle. Operational excellence also matters. Google seemed a latecomer to the internet, but by offering a superior search engine, it quickly vanquished other networks and became a prime beneficiary of network effects. To succeed in a digital world, CFOs must understand and embrace networks’ importance.

Digital business platforms succeed by leveraging networks.

Back in the 1990s, Apple was struggling as a personal computer manufacturer. Then it pivoted to iTunes and the iPod, and Apple soon built a thriving platform. By 2005, Apple had sold 30 million iPods. Apple offers an early case study in the power of network effects in building successful platforms. More recently, ride-sharing platforms such as Uber and Lyft built platforms and then sought to create network effects. To achieve this goal, a ride-hailing platform must attract a balanced match of drivers and passengers: Too few drivers, and passengers will be forced to wait. Too few passengers, and drivers won’t have enough business.

“Traditional performance metrics are not appropriate for tracking and managing the complex, multi-directional value flows and dynamic network effects in digital platforms.”

From a business owner’s perspective, platforms offer many advantages. They can grow rapidly, thanks to the reality that digital goods can be transferred and replicated quickly. Platforms also don’t have the old-economy need for physical assets. Uber commands a fleet of drivers yet owns no vehicles, and Airbnb is a major lodging company that holds no buildings on its balance sheet. And once a platform is established, it can use artificial intelligence to keep growing and improving. All these realities distinguish digital platforms from an earlier generation of traditional businesses with physical goods and linear value chains. CFOs must understand that the financial accounting analysis that once applied to traditional companies isn’t relevant to the new breed of digital platforms.

Digital business ecosystems are remaking the global economy.

Digital ecosystems are becoming a major force, generating an estimated $60 trillion in global revenue by 2025, according to a study funded by the World Economic Forum. Unlike a digital network, a digital ecosystem consists of a group of independent entities that come together in pursuit of a common goal. Alibaba is one prominent example of a digital ecosystem. By harnessing the power of this model, the Chinese e-commerce platform became one of the world’s most valuable companies. Alibaba brings together sellers, marketers, service providers and manufacturers.

“The new generation of dynamic, digital business ecosystems is rapidly evolving and reshaping our connected economy, sometimes spanning traditionally disconnected industries.”

Apple’s iPhone offers another example of an ecosystem. While Steve Jobs at first was skeptical of opening the platform to third-party app developers, the wave of new apps from outsiders helped create a network effect. The ecosystem structure also helps companies achieve resilience. That’s how Microsoft’s Windows has remained the dominant operating system for decades. Building an ecosystem isn’t cheap – during its long road to profitability, Amazon reported cumulative losses of $3 billion in its first eight years of operation.

Sustainability is now within CFOs’ purview.

In the old days, a CFO might have sacrificed long-term value in pursuit of quarterly profits. In the newer iteration of the role, the CFO drives not just digital transformation but also sustainability initiatives. The reality is that most executives now see climate change as a grave threat. And some corporations are developing a new mind-set, one that sees companies pursuing performance goals that go beyond their financial statements. For instance, the Italian energy company Enel Group transformed itself from a traditional power producer into a leading generator of green energy.

“To meet quarterly earnings and short-term investor expectations, CFOs have consistently been forced to forego investment in long-term value creation and prosperity for the core business, for other stakeholders and for future generations.”

Paul Polman, the former head of Unilever, is another leader in the rethinking of the corporate role in society. Polman has called for a shift in attitude in corner offices. “We have to take responsibility, and that requires more long-term thinking about our business model,” Polman said in a 2014 interview. The Unilever Sustainable Living Plan drew a roadmap for the company to operate in a way that was less harmful to the environment. Both Enel Group and Unilever embraced a sustainability plan as a way to achieve significant value over the long term, an initiative largely driven by their CFOs.

About the Author

Michael Haupt is a partner at Deloitte Consulting in London. He’s a leader of Deloitte’s Finance, Performance Management and Technology practice in Europe and works closely with senior leaders of global companies.

The Unstoppable Startup, Mastering Israel’s Secret Rules of Chutzpah By Uri Adoni

Recommendation

Entrepreneurship isn’t for the weak-hearted. Tech startup entrepreneurs face challenges over funding and convincing investors their ideas work. Israel, a country of just under eight million people, leads the world in high-tech startups. Only the United States and China have more companies on the NASDAQ than Israel has. Venture capitalist Uri Adoni cites the cultural trait of chutzpah as the main reason for Israel’s startup success. A Yiddish word, “chutzpah” means having the nerve to speak your mind and to believe in yourself despite obstacles. Adoni portrays startups that could have failed without a touch of chutzpah and explains how you can develop yours and use it to succeed.

Take-Aways

• Startup entrepreneurs need a healthy dose of chutzpah.
• Startups hatch bright ideas or find new ways of doing something better.
• Follow six chutzpah rules.
• 1. Swim against the tide of conventional wisdom.
• 2. Make a dent in your market or create a new one.
• 3. There is always something new under the sun.
• 4. Earn your stripes by anticipating a need.
• 5. Rules are made to be broken.
• 6. Talk is cheap; show what you’ve got.
• Mission impossible? There’s no such thing.
• Most entrepreneurs encounter failure on the road to startup success.
• You need the right conditions to create a tech ecosystem.

The Unstoppable Startup Book Summary

Startup entrepreneurs need a healthy dose of chutzpah.

Many factors contribute to Israel’s leadership in high-tech entrepreneurship: A supportive government, an educated populace, compulsory military service and top educational institutions. Israelis have an abundance of chutzpah, a personality trait with positive and negative aspects, but a foundational quality of extraordinary organizations and entrepreneurs. However, Israelis haven’t cornered the market on chutzpah; you can develop and teach it.

For startup founders, chutzpah means ignoring conventional wisdom and long odds. For example, in 2015, Liran Tancman sold his cyber-security company, CyActive, to PayPal for between $60 million and $80 million. His revolutionary idea involved preventing cyberattacks from viruses that didn’t even exist yet. Tancman had the chutzpah to pursue his belief that computer viruses mimic biological viruses: as they spread, mutate and adapt, they maneuver around defensive barriers.

“Evolutionary algorithms have been around for years, but no one ever thought of applying them to computer viruses.”

CyActive applied algorithms to forecast thousands of methods hackers might utilize to bypass security measures and to predict a malware worm’s future strains. CyActive used a 2008 sample from the dangerous Poison Ivy Trojan malware and simulated five years of transformation. The algorithm accurately predicted several Poison Ivy variations that surfaced between 2012 and 2013.

Startups hatch bright ideas or find new ways of doing something better.

Tech startup investors aren’t necessarily looking for radical advancements. They might seek to create a new presence in the market or make something easier or cheaper. Investors consider a startup’s potential for going public, merging or being acquired. They want to sell their holdings at a profit.

“Not every innovative idea is a startup, but behind every good startup there’s an innovative idea.”

Successfully developing a product or a technology doesn’t guarantee success. Startups often crash because they can’t get into a market or fail to create a feasible business model. Generally, startups either succeed or they vanish.

Follow six chutzpah rules.

Entrepreneurs refuse to accept the status quo. They believe they can find better solutions. The two college guys who started Google, for example, had the chutzpah to believe their search engine was superior to any other. 

Traditional businesses use familiar, tested models, so proper execution usually ensures some measure of success. Startups have no such template and, therefore, take on more risk. Use the six rules of Chutzpah to navigate this fraught terrain: 

1. Swim against the tide of conventional wisdom.

Dr. Danny Gold, creator of Israel’s Iron Dome defense system, had the chutzpah to challenge conventional wisdom about missile defense. Before the Iron Dome, Israel faced danger from thousands of Qassam rockets fired from the Gaza Strip. In the summer of 2006, 44 civilians died after Hezbollah fired roughly 4,000 missiles into northern Israel from Lebanon. Each rocket sent a million Israelis scurrying to bomb shelters. Israel knew it needed to act, but the idea of missiles that could intercept other missiles in flight sounded like science fiction.

“The Iron Dome flew in the face of deeply held assumptions about what missile defense can and cannot do, about its costs and capabilities.”

In 2004, Israel formed a group to explore its missile defense alternatives. Gold thought about “intercepting and destroying” missiles, but worried about funding such a farfetched idea. Still, he refused to drop it. In 2005, he solicited proposals from the world’s top defense companies, but not one of the 14 he received proved sufficient. Gold’s group created their own design and sought private investors in case the government didn’t provide funding.

No one had ever attempted a defense system designed to protect a city with a six- to 10-mile radius. The system had to intercept, not just deflect, enemy missiles. To avoid wasting an intercepting missile, Iron Dome had to detect non-threatening missiles that were defective or headed to open areas.

“In 2012, Dr. Gold won The Israel Defense Prize for the same project he was criticized for three years before.”

Gold’s team worked on the project without government support. Funding finally came though two years later, though the US financial support Gold expected didn’t materialize after an American team questioned the project’s feasibility. In 2009, when the Iron Dome demonstrated its effectiveness, the American team came back, saw that the system worked and approved funding.

2. Make a dent in your market – or create a new market.

Startups must offer better solutions in an established market or create and lead a new one. In 2003, for example, Jerusalem Venture Partners (JVP) pinpointed an innovative opportunity in business intelligence (BI), a sector with two dominant firms. At the time, complex, time-eating BI studies analyzed raw corporate data to find more effective processes and reported only to top-level management.

“(Qliktech) had the chutzpah to believe that business intelligence projects should be simpler, cost less, and reach more people.”

Through its research, JVP discovered Qlik Technologies (Qliktech), a Swedish firm handling easier, cheaper and more accessible BI projects. After a visit, JVP invested in the company. In helping Qliktech grow from a small firm to a global force, JVP paired it with an American venture partner. Qliktech moved its headquarters to the United States and began an impressive upward scale.

3. There is always something new under the sun.

Startup entrepreneurs always seek new ways to disrupt the market. They see possibilities everywhere, but they aren’t foolhardy. They carefully assess each market to anticipate what might be in demand.

“Entrepreneurs are part futurists and part prophets; they are constantly foreseeing ‘new somethings under the sun’.”

Entrepreneurs go against the grain. When companies began storing data in the cloud, popular belief suggested big organizations would regard the cloud as insufficiently secure. The founders of Navajo, a cloud cybersecurity firm, disagreed, and they were right. Within a couple of years, big corporations embraced the cloud and demonstrated that Navajo offered workable, efficient security solutions. Salesforce eventually acquired Navajo; today’s multi-billion-dollar cloud cybersecurity market confirms its prescience regarding future demand.

4. Earn your stripes by anticipating a need.

Eyal Gura, a noted Israeli entrepreneur, exemplifies how you can disrupt an industry by creating a need and introducing a solution. He recognized the medical industry’s lack of sufficient radiologists in the face of growing global demand for imagining services. Gura co-founded Zebra Medical Imaging, which applies algorithms to show computers how to read images more accurately than humans can read them. These diagnoses help healthcare providers understand patient risks, identify and predict diseases, and manage preventative care.

“Large companies definitely do have the funds and the manpower to innovate on a large scale. But they rarely deploy them.”

In 2016, Zebra introduced new algorithms to help forecast and prevent heart attacks and other cardiovascular issues. The same year, Zebra and Israeli Clalit Health Services unveiled algorithms that detect osteoporosis by calculating bone density from CT scans used for other purposes. In 2018-2019, the US FDA granted three clearances for Zebra products. The company also signed a deal with India’s largest healthcare provider.

5. Rules are made to be broken.

A business typically doesn’t give its product away – unless a chutzpah-driven entrepreneur is in charge. Take Waze, for example. The popular traffic navigation app is an Israeli startup founded in 2008. Google acquired it five years later for $1.15 billion. When co-founder Ehud Shabtai conceived of adding Waze to a GPS, map companies objected, insisting that consumers pay for it, as they paid for GPS. Shabtai and co-founder Uri Levine realized that the solution – building their own map – required “tracking user actions.” They understood they had to offer their service for free to obtain data on the scale they required. Investors didn’t care for the concept, believing drivers wouldn’t share their locations due to privacy concerns. They didn’t understand Waze’s value and doubted people would download the app. But Levine and Shabtai had the chutzpah to press on.

“It took us a long time to raise funds. We went fundraising and investors disliked the idea, thought it was crazy.”

Chutzpah also drove three young Israeli engineers who decided six weeks before the December 31, 2010 application deadline to compete in Google’s $20 million Lunar X Prize contest to send a robotic spacecraft to the moon. Since they lacked the required $50,000 deposit or a spacecraft blueprint, their venture – SpaceIL – seemed unlikely to make the deadline. Working furiously, it collected needed funds, incorporated as a non-profit and wired its application in to Google on the final day.

“SpaceIL was committed to using the potential prize money to promote science and scientific education in Israel.”

Eight years and roughly $100 million later, SpaceIL launched its rocket on February 22, 2019 with an April 11 moon landing scheduled for TV broadcast. Problems occurred when the lander was roughly eight miles above the moon’s surface. Though the lander crashed, SpaceIL accomplished its goal of reaching the moon.

6. Talk is cheap; show what you’ve got.

It’s not enough for a startup entrepreneur to discuss grand plans and intentions of market or industry domination. You must demonstrate your novel product or service’s uniqueness and adaptability. TIPA, an Israeli manufacturer of biodegradable plastic packaging, for example, invited consumers into its lab to examine its packaging materials. To convince people to abandon conventional plastic wrap, TIPA emphasized how much cleaner the world would be if everyone used biodegradable products.

“TIPA needed to not just show the materials it invented, but also to prove the value its packaging brought to brands.”

Companies that demonstrate social responsibility and honesty are more likely to grow. A British company using TIPA products tripled its initial order as customers responded to TIPA’s mission. Supermarkets that initially rejected TIPA in favor of their conventional packaging eventually embraced TIPA.

Mission impossible? There’s no such thing.

Because military service is mandatory in Israel, its citizens understand the importance of completing a mission. Unexpected issues always arise. You must adjust and achieve your goal. Apply that attitude to your startup. For example, team members may have to work extra unpaid hours to accomplish their mission.

“There are results, and there are excuses. (Israel Defense Forces saying) ”

Chutzpah won’t help unless you plan properly. Startup leaders must define tasks and responsibilities as they form an operational strategy. Entrepreneurs must improvise, explore every option and persevere.

Most entrepreneurs encounter failure on the road to startup success.

Considering the grim statistics, it’s a wonder anyone takes the startup plunge. But passion – often irrational passion – drives entrepreneurs.Most startups fail. Fully 75% of “venture-backed startups” falter, according to a Harvard Business School study. 

“You really have to fall in love with the idea, and simply not listen to what people are telling you. ” (Waze entrepreneur Uri Levine)

The top 10 reasons startups fail are lack of market demand, lack of cash, a flawed team, tough rivals, expense or pricing problems, no user appeal, bad business model, weak promotion, faulty customer service or mistimed goods or services.

You need the right conditions to create a tech ecosystem.

Delegations from other countries regularly visit Israel to learn to duplicate its entrepreneurial ecosystem.

“Management by missions means that the organization is forced to define its priorities, objectives, and the means to achieve them.”

Reaching that level takes time and commitment, and requires these “pillars”:

• Talent – Even in tech, talented people don’t have to be engineers or scientists. They might have marketing or security backgrounds.
• “Cross stage funding” – Startups need a variety of funding sources to focus on innovation, customer acquisition and market share. You need money at every development stage.
• “Presence of large corporations and multinational enterprises” – Apple and Intel are among the some 300 international corporations in Israel. They seek access to talent and innovative firms.
• Government help – The government’s investment indicates its level of commitment to tech. Governments that will benefit from startups’ success should share their financial risks.

About the Author

Uri Adoni, a former partner at Jerusalem Venture Partners Media Labs, has more than 20 years experience in the high-tech industry.

Video & Podcast

Winning at the Acquisition Game, Tools, Templates, and Best Practices Across the M&A Process by Timothy J. Galpin

Recommendation

A blockbuster merger might seem like an executive’s easy path to profit and glory. In truth, the M&A field is fraught with pitfalls, strategist Timothy Galpin writes in this 10-step guide to mergers and acquisitions. The uncomfortable reality is that, despite the flowery press releases and breathless news coverage, most corporate marriages flop. But in this useful guide, Galpin tries to improve the odds by offering a methodical approach to everything from finding the right companies to acquire to making sure valued employees stick around after the deal is done.

Take-Aways

• The M&A process begins with formulating an acquisition strategy.
• Find acquisition targets that fall within your strategic parameters.
• Conduct due diligence to avoid any unpleasant surprises.
• When setting a valuation, beware of behavioral pitfalls.
• Negotiations can be a protracted search for weaknesses and compromise.
• Consummating the deal is an important – and treacherous – part of the M&A process.
• Integrating the combined companies sets the stage for future performance.
• Motivating the merged firms’ workers is a crucial part of a deal’s success.
• Innovating after the acquisition requires an intentional approach.
• Measuring the results of the merger is the final step in the process.

Winning at the Acquisition Game Book Summary

The M&A process begins with formulating an acquisition strategy.

Mergers are often an attractive way to grow, but the first step in winning at mergers and acquisitions is to understand their pitfalls. Ample research demonstrates the harsh reality of M&A outcomes: Overall, sellers win and buyers lose. A KPMG study concluded that more than 80% of M&A deals did nothing to boost the acquiring company’s fortunes, and other studies have shown similarly dismal results. While most acquisitive companies lose out, a minority of buyers do manage to boost their returns, mainly by applying a disciplined, systematic approach to M&A.

“Many companies are looking to change the way they conduct their business, alter their existing business model or scale their enterprise to meet the changes taking place within their industries.”

The companies that thrive in M&A zero in on potential acquisitions that offer one or more of the “10 Cs”:

• “Channels” – new modes of delivering products to customers.
• “Content” – novel offerings or services.
• “Capabilities” – enhancing an acquirer’s systems or people.
• “Customers” – entries into untapped markets.
• “Countries” – nations or regions where the acquirer isn’t a dominant player.
• “Capacity” – broader production output or supply chain abilities.
• “Consolidation” – savings reaped through cutting redundant business offerings.
• “Competition” – staving it off by buying current or future rivals.
• “Cash” – acquiring companies with good cash flows or reserves.
• “Creativity” – access to knowledge and innovation not possessed by the acquiring company.

Find acquisition targets that fall within your strategic parameters.

After you’ve settled on an acquisition strategy, the next mission is to locate suitable targets. There are three broad categories of acquisitions: “Opportunistic” deals fall outside the acquiring firm’s acquisition strategy but are nonetheless tempting. “Reactive” acquisitions are those in which the seller initiates the deal. And in a “proactive” transaction, the buyer launches a thorough search for acquisition partners. The more compatible the partners are, the more likely the transaction will prove profitable for the acquirer. On the other hand, mismatches in strategy or culture can doom a deal.

“Locating potential target companies that fit the firm’s M&A strategy is a key factor leading to successful transactions.”

Finding promising acquisitions is no easy task. Just 5% of companies are actively seeking buyers at any given moment, so aggressive acquirers invest considerable energy in discovering hidden deals. The pitch requires salesmanship: Persuading an acquisition target to consider an M&A offer requires demonstrating that the acquiring firm is a good fit and that the marriage brings benefits to the acquired company. In many cases, a target will rebuff the initial contact. However, the process takes time, and acquirers devote continuing efforts to building a relationship and trust with promising targets.

Conduct due diligence to avoid any unpleasant surprises.

Once you’ve found a viable and willing target, the next step is to do your homework. Because so many M&A deals go south, it’s crucial that the acquiring firm conduct a deep dive into the transaction before closing; after the deal is done, it’s too late. While the start of the acquisition process focuses on the broad contours of a deal, the due diligence phase is a thorough, detailed investigation of every pertinent factor. This includes a look at the finances, legal issues, technical topics, environmental concerns, and operational strengths and weaknesses of the target. The due diligence stage is the time for hard-nosed analysis and raw skepticism. The cost of believing a seller’s glowing words can be steep. Bayer learned this harsh lesson after its $63 billion acquisition of Monsanto: Following the deal, Monsanto’s legal fight over Roundup weed killer ended up erasing $28 billion of Bayer’s market value.

“Caveat emptor (buyer beware) is important advice to acquirers.”

While financial minefields such as pension liabilities are difficult enough to parse, the most challenging part of due diligence is assessing the cultural fit. Because ambiguity surrounds such issues as values, hiring practices, communication styles and training programs, it’s far too easy for the acquiring party to misread a cultural mismatch. The savviest acquirers conduct cultural due diligence on themselves, too – it’s the only way to determine a post-merger cultural fit.

When setting a valuation, beware of behavioral pitfalls.

Private equity legend Henry Kravis pithily summed up the reality of valuing an M&A deal. “Don’t congratulate us when we buy a company,” Kravis said. “Congratulate us when we sell it, because any fool can overpay.” While valuation might seem a straightforward exercise in filling in cells on a spreadsheet, the reality is far messier. Acquirers often overpay. Many factors can spur the mispricing of an M&A deal. Perhaps frothy markets have raised the bar on the prices paid by acquirers. Maybe herd behavior has created intense competition for a sparse field of targets. And because an acquisition is by definition an exercise in optimism, the “Pollyanna Principle” – the tendency to overplay the positive and downplay the negative – can drive up an M&A valuation.

“When valuing target companies, carefully scrutinizing the assumptions that go into creating valuation models is equally as important as, if not more important than, ‘crunching the numbers’.”

Misjudging a target’s value can be costly, as Procter & Gamble learned after taking a $3 billion write-down after its $12.5 billion purchase of cosmetics brand Coty. The good news for acquirers is that there are two sure clues that foretell overpayment: One is the acquirer paying mostly stock for the deal. Purchases funded with equity at a level of 88% or more of the price are risky – they have a 2.6 times greater chance of a subsequent impairment than do deals that rely more heavily on cash. Another warning sign is goodwill, an intangible asset that’s tricky to value. In deals in which goodwill accounts for more than two-thirds of the price tag, the odds of a future write-down are 81% higher than deals in which goodwill makes up 46% or less of the purchase price.

Negotiations can be a protracted search for weaknesses and compromise.

Even with a willing buyer and seller, negotiating a deal can take weeks or even months. The two sides must hash out a host of details – for instance, how the new organization will be structured, who will make which decisions, where the combined company will be located and how much the executives of the acquisition target will be paid. Negotiating strategies vary, too, with some organizations preferring an adversarial, winner-take-all approach and others leaning toward a more collaborative demeanor. There’s even scientific research about how much anger the parties should display during the process to gain concessions: Some is better than none or too much.

“The first rule of M&A negotiation is everything is negotiable.”

Talks typically begin with a letter of intent, or LOI, that spells out many of the terms of the deal. The LOI specifies the purchase price, along with such issues as promissory notes, debt assumption and severance expenses. The LOI also outlines the schedule for the deal, restrictions on the seller’s ability to talk to other suitors, and guidelines around how much access the acquirer gets to the seller’s books and records.

Consummating the deal is an important – and treacherous – part of the M&A process.

The negotiations are done, the deal has been signed and the press release has been disseminated. But that’s not the end of the M&A process. Depending on the transaction, the period between signing the M&A agreement and actually closing the deal can prove difficult. During this period, unfavorable actions from regulators and other third parties can sabotage a deal. And shareholders have a say, too.

“Whether you are a buyer or seller, engaging an experienced M&A attorney to assist with the transaction consummation is essential to avoid what can be very costly mistakes that can even undo a deal.”

Regulators might possess the most power over a deal during this time of uncertainty. Antitrust authorities in the United States, United Kingdom and European Union have broad leeway to investigate business combinations for consumer harm. The United States has a tradition of antitrust oversight stretching back to 1890, and the United Kingdom and European Union have their own regulatory schemes around merger approvals. In another potential deal killer, transactions typically allow the buyer to back out of the deal in the event of a material adverse change, a catchall category that could encompass any number of unforeseen turns in the economy, the markets or the target company’s business prospects. To navigate this fraught stage of the process, make sure to hire experienced M&A attorneys and advisers.

Integrating the combined companies sets the stage for future performance.

In truth, “postmerger integration” (PMI) is an ongoing process, one that starts well before a deal even enters the negotiating stages. Integration should be baked into the acquisition strategy from the start, but practical actions toward PMI begin in earnest after the deal has progressed. The early phase, known as “integration setup,” takes place during due diligence. During that stage, savvy acquirers are researching not only potential deal killers but also how the companies will fit together after the merger. The setup is the time for the acquiring company to establish a framework for PMI.

“Post-merger integration (PMI) is viewed by most dealmakers as the most important factor in creating M&A success.”

Next comes more specific planning for the marriage. During the period of “integration plan development,” a merger task force draws up a blueprint for combining staff, procedures and systems. This plan includes such topics as the numbers of employees assigned to various tasks, timelines for the combination and budgets. Finally, it’s time to execute. Managers of the merged company must monitor the integration plan as it goes into action. One reality of every integration is that it rarely follows the script, so adaptability is critical.

Motivating the combined companies’ workers is a crucial step in a deal’s success.

Keeping people engaged during and after a merger is a huge undertaking. While most executives and managers say the human aspect of M&A is important, they also admit that they don’t feel up to the task. An Oxford M&A Insights Project surveyed managers and found that fewer than 10% felt their firms were adept at communicating, managing and retaining workers and navigating cultural issues. But botching communications and other soft skills can be costly. A merger leaves the work force feeling uneasy – and anxious employees often focus on their fears to the detriment of quality, safety, customer service and other priorities.

“Once the talent is gone, it can’t be called back. And if enough talent leaves, there goes the value you spent so many millions of dollars on acquiring.”

Communication is the best antidote to uncertainty and anxiety. Executives should provide face-to-face communication as often as possible, making sure to not just talk but also to respond to questions. Executives won’t know all the answers to those questions, but managers should know that it’s OK to say that they don’t know. For these difficult conversations, smaller groups are more effective than larger ones.

Innovating after the acquisition requires an intentional approach.

Organizations can take specific steps after a merger to foster creativity and encourage innovation. One tactic is job rotation among the newly combined organizations. This allows managers and frontline workers to see alternative ways of working, with a goal of spurring fresh approaches. Integrating research and development also can help incite creativity among R&D employees at the postmerger entity. In another pro-innovation strategy, companies can delegate responsibility for innovation, a move that creates a sense of ownership among frontline workers.

“Transactions can help or hinder the combined company’s ability to innovate.”

To build momentum, managers can stress some rapid victories achieved by the combined companies’ innovation team. Premerger rivalries can survive the merger, so it’s up to the new company to work past any bad blood among employees who previously were competitors. Postmerger organizations also need to tread carefully around risk taking. Risk is part of innovation, and firms must avoid punishing people for taking risks and instead encourage staff to pursue considered risks. A merger spawns so much anxiety among employees that they can become fearful of putting forth ideas that might not prove successful.

Measuring the results of the merger is the final step in the process.

Effectively evaluating how the merger is progressing is another important part of the M&A cycle. This evaluation helps executives determine if the combined companies are meeting their goals – and if not, how they can change course to improve postmerger performance. The evaluation step also allows organizations to fairly compensate the individuals who contributed to performance outcomes.

“Effective M&A measurement should also support the agile nature of pre- and post-deal activities by prompting corrective and celebratory actions.”

Cost savings and revenue synergies are obvious metrics, but you should look at a variety of results. A merger scorecard should encompass not just financial statements but also factors such as the pace and effectiveness of the integration of departments like IT and HR. The analysis also should measure overall cultural cohesion after the merger. Employee retention, customer loyalty and knowledge transfer are among the metrics that should appear in a postmerger gradebook.

About the Author

Timothy Galpin is a senior lecturer in strategy and innovation at Saïd Business School, University of Oxford, and a consultant to boards and senior management.