9/29/2017 investment: Heard of Cobra Effect?

Be careful what you ask for - The Economic Times

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Sanjay Bakshi
Managing Partner, ValueQuest Capital LLP

The author is a Managing Partner in ValueQuest Capital LLP, a Sebi Registered

Investment Adviser. He is also an Adjunct Professor at Management Development
Institute, Gurugram.

Heard of Cobra Effect? Be careful what you

ask for
ET CONTRIBUTORS | Updated: Sep 28, 2017, 12.24 PM IST

20
Comments Are you ready for Blockchain?

There is this funny story about the “Cobra Effect” based on

an anecdote from British colonial time in Delhi.

Apparently, the officials of the British government were

One of the key elements of a good
system design, therefore, is to avoid
creating incentives to game it as much
as possible. (In Pic: FM Arun Jaitley)
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A similar incident occurred in Hanoi under the French colonial rule. There were too many
rats, so the rulers introduced a bounty scheme for, of all things, rat tails. Pretty soon, Hanoi
was full of tail-less rats running around. The bounty hunters never killed them. Instead,
they just severed their tails, released them back into the sewers, so that they could SPOTLIGHT
continue to procreate and make more rats, which of course, increased the rat catchers’ Startups
income.

Why did both situations backfire? Because well-intentioned people who created the bounty
schemes didn’t think about second order effects. They didn’t pause, reflect and ask how
people will respond to their brilliant-sounding idea.
http://economictimes.indiatimes.com/markets/stocks/news/heard-of-cobra-effect-be-careful-what-you-ask-for/articleshow/60866402.cms 1/24
9/29/2017 investment: Heard of Cobra Effect? Be careful what you ask for - The Economic Times

Thinking about first-order effects is easy. Thinking about second or higher order effects is
hard.

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Charlie Munger complains that:
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Too little attention [is given] in economics to second order and even higher order effects. Now, buy a bike from Paytm Mall
This defect is quite understandable, because the consequences have consequences, and
the consequences of the consequences have consequences, and so on. It gets very
complicated.

It’s fascinating to observe how this problem keeps on repeating over and over again. One
variant is called “you get what you measure.” For instance, if hospitals are asked to publish
their mortality rate, the ones with the highest mortality rates are incentivised to turn away
terminally ill patients.

If someone is paid on a cost-plus basis (e.g. for generating electricity), you can be Looking for GST
confident that there will be plenty of gaming in the form of cost padding. Businesses which Consultant?
pay their managers to deliver strong near-term earnings also create incentives for those
SEARCH
managers to cut corners which increase near-term earnings (for example by cutting
expenditures on brand building, research and development, and employee training) but
destroy long-term value.

Another variant of this issue is something I learnt from the famous investor Jim Rogers
who, in one of his books wrote that you (i.e. a regulator) can either control the price of a
product or a service, or its supply, but you can't do both.

Back in the days of industrial licensing, the government wanted to fix both the maximum
production of Bajaj Auto BSE 2.07 % scooters in a year and their maximum price. It failed to
do both. Limiting production well below actual demand simply caused a black market to
emerge and lucky allottees would simply sell their allotment letters at several times the
maximum price allowed to be charged by the government.

The US government spends tens of billions of dollars every year to stop addictive drugs Most Read Most Shared Most Commented
from reaching its populace. Its prisons are full of drug dealers and drug addicts. All that
This value picker made 5,000% in Avanti; doubles
money spent does nothing but increase the price of drugs and profit margin for those folks,
wealth every 2 years
who have an incentive to smuggle it across the US border. No matter how risky the US
Market crashes on Army's firefight with Naga
government makes it for smugglers and drug dealers to do whatever they do, the addicts
insurgents alongside Myanmar border
can still buy the drugs. The more they try to stop it, the more they fail. In the meantime,
tens of billions of dollars spent every year could have been spent on finding a solution for Even if the market crash halts, these 300 stocks
may still fall
malaria. Also, in the meantime, in another country — the Netherlands — where drugs are
legal, crime rates are so low that the government is shutting down prisons. ICICI Lombard to debut on bourses today; will it see
listing day gains?

Back in India, they price of urea so low that it gets smuggled across the borders to Sri ICICI Lombard makes tepid debut, lists at 1.66%
discount to issue price
Lanka, Bangladesh and Nepal and sold at much higher prices.
More »

Recently, the Indian government put a cap on the price of stents used in heart surgery —
even for private, for-profit hospitals. Soon after the price controls were announced, some
manufacturers announced their intention to withdraw their stents from the market. So,
while the original intention (stop price gauging) was good, the outcome is not. Do we need
a black market in stents?
http://economictimes.indiatimes.com/markets/stocks/news/heard-of-cobra-effect-be-careful-what-you-ask-for/articleshow/60866402.cms 2/24
9/29/2017 investment: Heard of Cobra Effect? Be careful what you ask for - The Economic Times

In 1975, American economist Steven Peltzman studied the impact of seatbelt laws on
automobile death rate. What he found was quite revealing. While the use of seatbelts
made people safer inside the car, it also made people drive more rashly. As a result, there
were more accidents causing more fatalities outside the cars. The two effects cancelled
each other and there was no overall reduction in the number of automobile deaths.

This effect, called the Peltzman effect, has wider applications. Basically, the idea is that
whenever the government tries to regulate something, there will be an incentive for people Not to be Missed
to game the system. And gaming systems comes as naturally to some people as
Can GoI come out of a mess with a
breathing. We all remember what happened during the hours after our PM appeared on TV stimulus package?
on the night of November 8, 2016, don’t we?

One of the key elements of a good system design, therefore, is to avoid creating incentives Rs 1L cr needed to provide homes for
to game it as much as possible. People who design systems should always ask a critically poor in 2-3 yrs

important question: “And then what?” to make them think of ways in which people will
game them.
DGCA warns `indefinite wait' for delay
in take off
This particular idea — of asking “and then what?” applies not just to regulators. It applies
to everyone, including investors. As Warren Buffett writes:
The key thing in economics, whenever someone makes an assertion to you, is to always
Savings a/c with no min balance: Will it
ask, “And then what?” Actually, it’s not such a bad idea to ask it about everything but you suit you?
should always ask, “And then what?”

Indeed, some of the best investment ideas occur when a great business encounters a Freebies don't attract home buyers
problem which causes a temporary blip in its earnings growth but is perceived by the anymore

market as a significant-negative news. The loss of a customer which does not destroy the
business. A flood. A fire. A strike.
'Unlocked car no grounds to reject
insurance claim'
A few bad quarters caused by temporary factors — my current favourites are
demonitisation and GST — which have absolutely no bearing on the business’s bond with
the customer and its ability to deliver profitable growth over the long term. Indian internet firms bag $7.4 bn in just
3 quarters
The market is a pari-mutuel system wherein one is not betting against the house, but is
betting against other investors. In such a system, the behaviour of others changes the
odds. If temporary bad news causes stock prices to decline much more than they should, Fuelling the economy: Choice b/w
steroids and safety
smart investors see that as an opportunity.

Paradoxically, bad news for a business can be great news for an investor, because it gives
Juster's confirmation hearing for envoy
him a rare chance to buy at a fabulous price. Such an investor does not panic and run for next week
the exit at the first time of trouble. He pauses. He reflects while others panic and sell. He
quietens his mind so as to avoid jumping to hasty conclusions. He carefully studies the
“bad” news. He notes the drop in price. Govt crackdown on board directors
puts cos in a bind

And once in a while, his analysis shows that the market’s reaction is overdone and he buys
into a wonderful business at a bargain price.
Hot investment strategy can hurt
many; here's how
Thinking about first order effects is easy. Thinking about second or higher order effects is
hard. But just because it’s harder, doesn’t mean one shouldn’t do it. Indeed, the practice of
routinely thinking about second and higher order effects by asking “and then what?” should
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not be limited to chess players and regulators. It should be adopted by investors as well. sites cleared

(The author is a Managing Partner in ValueQuest Capital LLP, a SEBI Registered

Investment Adviser. He is also an Adjunct Professor at Management Development Twitter reveals Russia-backed ads
Institute, Gurugram.) ahead of US election

http://economictimes.indiatimes.com/markets/stocks/news/heard-of-cobra-effect-be-careful-what-you-ask-for/articleshow/60866402.cms 3/24