The Paradox of Choice Robert M. (“r0ml”) Lefkowitz VP, Research and Executive Education Optaros, Inc. Freely re-distributable with proper attribution • “Most of us would be better off with fewer options.” • “There is vastly too much choice in the modern world.” • “Anything that constrains choices is a benefit.” The Problems of Choice • Decisions require more effort. • Mistakes are more likely. • Blame is more severe. Theory and Reality • Asked if they would prefer to choose their treatment, 65% of the people who didn’t have cancer said “yes”. • Of the people who did have cancer, 88% said “no”. • We always say we want choice; we may not want it if we get it. Avoiding choice • Rules and Laws -- You are not allowed to choose. • Defaults and habits -- You decide not to choose. • Standards (in both senses) -- You restrict the set of choices. • Standard as in “living up to” or “meeting the minimum”. • Standard as in “industry” or “non-proprietary”. Standards Paradox • The purpose of an “industry standard” is to increase the choice of vendors by restricting the choice of features. • Competition lowers prices and a lack of competition (monopoly, duopoly) leads to higher prices. • More vendors: good; More features: bad. Open Source • The opposite of open standards. • A single product is not a monopoly, because multiple vendors can sell it. There is only one PERL. • Multiple products cause implementation and management complexity; fewer products are cheaper. • More products: bad; More vendors; good. • More features: good Open Source Paradox • The promise of open source is to eliminate the choice of products and increase the choice of vendors. • Example: Red Hat, CentOS, Lineox, Tao Linux, Progeny, SuSE, Mandrake, Conectiva, Ubuntu (Canonical), Xandros, Lycoris, Knoppix, Debian Enterprise Architecture • Developing strategy and “standards”. • Reducing the number of software and hardware vendors. • “We are planning on reducing the number of enterprise software applications from 800 to 300.” Optimize Bruce Rogow is the principal of Vivaldi Odyssey and Advisory. • “One-company, one-way” types: These companies have almost dictatorial adherence to common business processes and technologies. Their IT spend as a percentage of revenue is typically 40% to 60% of the industry average. • “Many companies, many ways” types: These companies have any number of versions of business process and technology. They're often the product of partially rationalized mergers or acquisitions... Their IT expenses are typically 180% or more of the industry average. Standards • The “standards” that Enterprise Architecture sets are often “product selections”. • Is the purpose of setting these standards to increase or decrease choice? Standards Paradox • Standards increase choice. • Standards decrease choice. One Throat to Choke • A commonly articulated failing of Open Source Software is that it doesn’t provide “one throat to choke”. SuSE Linux SAP Support Deal Gives 'One Throat to Choke' http://www.newsfactor.com/perl/story/21964.html • OTC = Good Vendor Lock-in • A commonly articulated benefit of Open Source Software is that it “prevents vendor lock-in” Vendor Lock-In Cited as Cost of Windows over Linux (http://www.eweek.com/article2/0,1759,1628647,00.asp) • VLI = Bad Paradox • The search for “one throat to choke” is the manufacture of “vendor lock-in”. • OTC means having only one vendor. • VLI means having only one vendor. • The “one throat” you are choking is the “vendor locking you in”. Paradox • Reducing choice saves money. Having no choice saves the most money. • Competition lowers costs. More competition lowers costs more. Money Risk One Tired Guy Finance • Thinking about Expected Return • Reflections on derivative instruments (options and futures) • Lessons from Portfolio Theory Prospect Theory One group was presented with this problem. 1. You have been given $1,000. You are now asked to choose between: A. A sure gain of $500 B. A coin flip to win $1,000 or nothing. 84% chose A Another group was presented with this problem. 2. You have been given $2,000. You are now asked to choose between: A. A sure loss of $500 B. A coin flip to lose $1,000 or nothing. 31% chose A The expected return of all four choices is the same. Source: Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision Making Under Risk," Econometrica, 1979. Expected Return • Given two envelopes to choose from, you are told that one contains twice as much money as the other. • You pick one. • It has $100 in it. • You are given the option to trade it in for the other envelope. Expected Return • There is a 50% chance the other envelope contains $200. • There is a 50% chance the other envelope contains $50. • Hence, the expected return is: (0.5 * $200) + (0.5 * $50) = $125 Paradox • Therefore, whichever choice you make, the other one would have been better. • Q.E.D. Software Valuation • What is software worth? Software valuation n λ + ∑µt t= 0 • The “standard” software license model is a licensing cost λ and a series of maintenance costs μt discounted by ωt. € n λ + ∑ωtµt t= 0 € Software valuation • Maintenance and support is typically 20% of the license fee. n • Hence, λ + ∑ωt 0.2λ t= 0 >>> 1+sum([0.2 * 0.9 ** (1+t) for t in range(5)]) 1.737118 € Thought Experiment • Pick the proprietary software product of your choice. • What would you pay for the same product if it came with a guarantee from the vendor that there would never be any security patches, fixes, enhancements, or new releases. Software valuation • The “up-front license” is really a license fee + a series of contingent claims φ (derivatives) on future maintenance. n λ = λ0 + ∑ϕt t= 0 € n n λ0 + ∑ϕt + ∑ωtµt t= 0 t= 0 • Is λ0 worth anything? • Futures? € • Forwards? • Options? • Warrants? • If your software isn’t a service, it’s a derivative. Open Source Definition • The key difference between open source and proprietary licenses is that the open source license allows you to create a derivative work. Derivatives • Financial derivatives are more complex, but give you more leverage. • Open Source software is/are more complex, but give/s you more leverage. • One can construct synthetic instruments to produce the desired return profile. • One can synthesize software “stacks” or “derivative works” to produce the desired functionality. There is no optionality • What about the option to • decline to pay for unwanted updates? • which includes the option to switch to a different update stream (to decline to pay for all future updates -- i.e. to switch to another product) • If you “don’t have the option”, it is because you didn’t buy it. Liquidity • Assumptions underlying the standard CAPM: the first assumption is that there are no transaction costs. • The second assumption behind the CAPM is that assets are infinitely divisible. • The third assumption is the absence of personal income tax. Liquidity • Markets are conversations. • Liquid markets have transactions. • Illiquid markets have relationships. Thought Experiment • What would it cost to convert from SuSE to Red Hat Linux (or vice versa)? • If Red Hat came in and offered to do it for “free”, would you? • If they offered to pay you, what would you ask? Skipping updates • Enterprises will skip updates or releases, because there is a cost associated with implementing the release (the transaction cost). • But they are paying for it anyway • Red Hat charges more for the version that has fewer updates (RHEL releases every 18 months, Fedora every 4-6) The size effect • Rolf Banz in 1981 published a study showing that excess returns would have been earned over the period 1936-1977 by holding small firms. The differential return from very small to very large was 19.8% per year. • One theory is that the small stock effect is a consequence of lack of liquidity. • In an environment where transaction costs are high, and earnings are similar, the returns must be larger to compensate for the transaction costs. Vendor lock-in • Vendor lock-in is a complaint about the lack of liquidity. • So the solution is to manufacture liquidity. • “An investment bank is in the business of manufacturing liquidity and selling it a profit.” -- Ross Miller Technology Portfolio • Just because one has multiple software products, it isn’t a portfolio. • You need fungible assets -- software that fills the same need -- to think of it like a portfolio. • Portfolio optimization is about adjusting relative weight (as β changes) -- not constantly replacing one asset class with another. Effect of diversification Expected Number of portfolio securities variance 1 46.619 • Portfolio 2 26.839 variance for the 4 16.948 NYSE 8 12.003 16 9.530 35 8.188 75 7.585 All 7.058 Back to Linux • The earlier question about “switching” implied an all-or-nothing before and after scenario. • Rather than a conversion, how about a “portfolio rebalancing” from 65-35% to 60-40% ? • How about including CentOS in the mix. 60-30-10% Active Portfolio • Enterprises have “one of everything”. • But the direction is towards eliminating choice -- diversity is a result of failure to converge. • Manage risk by actively diversifying the vendor mix while converging the technology. Bond Ladders • A bond ladder is a portfolio of bonds maturing at different times. • In the 80’s, we set up numerous subsidiaries to purchase mainframes. • Instead of a single three-year Enterprise License Agreement, consider an ELA expiring in 2006, another one expiring in 2007, and a third expiring in 2008. The Option to Switch • Say you want to switch from an expensive database to an open source (cheap) one in 3 years. • Or an expensive application server. • How much should you spend on that? The Option to Switch • Are you not buying a European call option for an asset 3 years hence? • So, for something which costs $10 today, but you want an option to buy it for $8 in 3 years ..