The Paradox of Choice

Robert M. (“r0ml”) LefkowitzVP, Research and Executive Education

Optaros, Inc.

Freely re-distributable with proper attribution

• “Most of us would be better off with fewer options.”

• “There is vastly too much choice in the modern world.”

• “Anything that constrains choices is a benefit.”

The Problems of Choice

• Decisions require more effort.

• Mistakes are more likely.

• Blame is more severe.

Theory and Reality

• Asked if they would prefer to choose their treatment, 65% of the people who didn’t have cancer said “yes”.

• Of the people who did have cancer, 88% said “no”.

• We always say we want choice; we may not want it if we get it.

Avoiding choice

• Rules and Laws -- You are not allowed to choose.

• Defaults and habits -- You decide not to choose.

• Standards (in both senses) -- You restrict the set of choices.

• Standard as in “living up to” or “meeting the minimum”.

• Standard as in “industry” or “non-proprietary”.

Standards Paradox

• The purpose of an “industry standard” is to increase the choice of vendors by restricting the choice of features.

• Competition lowers prices and a lack of competition (monopoly, duopoly) leads to higher prices.

• More vendors: good; More features: bad.

Open Source• The opposite of open standards.

• A single product is not a monopoly, because multiple vendors can sell it. There is only one PERL.

• Multiple products cause implementation and management complexity; fewer products are cheaper.

• More products: bad; More vendors; good.

• More features: good

Open Source Paradox

• The promise of open source is to eliminate the choice of products and increase the choice of vendors.

• Example: Red Hat, CentOS, Lineox, Tao Linux, Progeny, SuSE, Mandrake, Conectiva, Ubuntu (Canonical), Xandros, Lycoris, Knoppix, Debian

Enterprise Architecture

• Developing strategy and “standards”.

• Reducing the number of software and hardware vendors.

• “We are planning on reducing the number of enterprise software applications from 800 to 300.”

Optimize

• “One-company, one-way” types: These companies have almost dictatorial adherence to common business processes and technologies. Their IT spend as a percentage of revenue is typically 40% to 60% of the industry average.

• “Many companies, many ways” types: These companies have any number of versions of business process and technology. They're often the product of partially rationalized mergers or acquisitions... Their IT expenses are typically 180% or more of the industry average.

Bruce Rogow is the principal of Vivaldi Odyssey and Advisory.

Standards

• The “standards” that Enterprise Architecture sets are often “product selections”.

• Is the purpose of setting these standards to increase or decrease choice?

Standards Paradox

• Standards increase choice.

• Standards decrease choice.

One Throat to Choke

• A commonly articulated failing of Open Source Software is that it doesn’t provide “one throat to choke”.

SuSE Linux SAP Support Deal Gives 'One Throat to Choke'

http://www.newsfactor.com/perl/story/21964.html

• OTC = Good

Vendor Lock-in

• A commonly articulated benefit of Open Source Software is that it “prevents vendor lock-in”

Vendor Lock-In Cited as Cost of Windows over Linux (http://www.eweek.com/article2/0,1759,1628647,00.asp)

• VLI = Bad

Paradox

• The search for “one throat to choke” is the manufacture of “vendor lock-in”.

• OTC means having only one vendor.

• VLI means having only one vendor.

• The “one throat” you are choking is the “vendor locking you in”.

Paradox

• Reducing choice saves money. Having no choice saves the most money.

• Competition lowers costs. More competition lowers costs more.

Money

Risk

One Tired Guy

Finance

• Thinking about Expected Return

• Reflections on derivative instruments (options and futures)

• Lessons from Portfolio Theory

Prospect Theory

One group was presented with this problem. 1. You have been given $1,000. You are now asked to choose between: A. A sure gain of $500 B. A coin flip to win $1,000 or nothing.84% chose A

Another group was presented with this problem. 2. You have been given $2,000. You are now asked to choose between: A. A sure loss of $500 B. A coin flip to lose $1,000 or nothing.31% chose A

The expected return of all four choices is the same.

Source: Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision Making Under Risk," Econometrica, 1979.

Expected Return

• Given two envelopes to choose from, you are told that one contains twice as much money as the other.

• You pick one.

• It has $100 in it.

• You are given the option to trade it in for the other envelope.

Expected Return

• There is a 50% chance the other envelope contains $200.

• There is a 50% chance the other envelope contains $50.

• Hence, the expected return is:

(0.5 * $200) + (0.5 * $50) = $125

Paradox

• Therefore, whichever choice you make, the other one would have been better.

• Q.E.D.

Software Valuation

• What is software worth?

Software valuation

• The “standard” software license model is a licensing cost λ and a series of maintenance costs μt discounted by ωt.€

λ + µtt= 0

n

∑

€

λ + ωtµtt= 0

n

∑

Software valuation

• Maintenance and support is typically 20% of the license fee.

• Hence,

>>> 1+sum([0.2 * 0.9 ** (1+t) for t in range(5)])1.737118

€

λ + ωt 0.2λt= 0

n

∑

Thought Experiment

• Pick the proprietary software product of your choice.

• What would you pay for the same product if it came with a guarantee from the vendor that there would never be any security patches, fixes, enhancements, or new releases.

Software valuation

• The “up-front license” is really a license fee + a series of contingent claims φ (derivatives) on future maintenance.

€

λ = λ0 + ϕ tt= 0

n

∑

• Is λ0 worth anything?

• Futures?

• Forwards?

• Options?

• Warrants?

• If your software isn’t a service, it’s a derivative.

€

λ0 + ϕ tt= 0

n

∑ + ω tµtt= 0

n

∑

Open Source Definition

• The key difference between open source and proprietary licenses is that the open source license allows you to create a derivative work.

Derivatives• Financial derivatives are more complex,

but give you more leverage.

• Open Source software is/are more complex, but give/s you more leverage.

• One can construct synthetic instruments to produce the desired return profile.

• One can synthesize software “stacks” or “derivative works” to produce the desired functionality.

There is no optionality

• What about the option to

• decline to pay for unwanted updates?

• which includes the option to switch to a different update stream (to decline to pay for all future updates -- i.e. to switch to another product)

• If you “don’t have the option”, it is because you didn’t buy it.

Liquidity

• Assumptions underlying the standard CAPM: the first assumption is that there are no transaction costs.

• The second assumption behind the CAPM is that assets are infinitely divisible.

• The third assumption is the absence of personal income tax.

Liquidity

• Markets are conversations.

• Liquid markets have transactions.

• Illiquid markets have relationships.

Thought Experiment

• What would it cost to convert from SuSE to Red Hat Linux (or vice versa)?

• If Red Hat came in and offered to do it for “free”, would you?

• If they offered to pay you, what would you ask?

Skipping updates

• Enterprises will skip updates or releases, because there is a cost associated with implementing the release (the transaction cost).

• But they are paying for it anyway

• Red Hat charges more for the version that has fewer updates (RHEL releases every 18 months, Fedora every 4-6)

The size effect

• Rolf Banz in 1981 published a study showing that excess returns would have been earned over the period 1936-1977 by holding small firms. The differential return from very small to very large was 19.8% per year.

• One theory is that the small stock effect is a consequence of lack of liquidity.

• In an environment where transaction costs are high, and earnings are similar, the returns must be larger to compensate for the transaction costs.

Vendor lock-in

• Vendor lock-in is a complaint about the lack of liquidity.

• So the solution is to manufacture liquidity.

• “An investment bank is in the business of manufacturing liquidity and selling it a profit.” -- Ross Miller

Technology Portfolio

• Just because one has multiple software products, it isn’t a portfolio.

• You need fungible assets -- software that fills the same need -- to think of it like a portfolio.

• Portfolio optimization is about adjusting relative weight (as β changes) -- not constantly replacing one asset class with another.

Effect of diversification

• Portfolio variance for the NYSE

Number of securities

Expected portfolio variance

1 46.6192 26.8394 16.9488 12.00316 9.53035 8.18875 7.585All 7.058

Back to Linux

• The earlier question about “switching” implied an all-or-nothing before and after scenario.

• Rather than a conversion, how about a “portfolio rebalancing” from 65-35% to 60-40% ?

• How about including CentOS in the mix. 60-30-10%

Active Portfolio

• Enterprises have “one of everything”.

• But the direction is towards eliminating choice -- diversity is a result of failure to converge.

• Manage risk by actively diversifying the vendor mix while converging the technology.

Bond Ladders

• A bond ladder is a portfolio of bonds maturing at different times.

• In the 80’s, we set up numerous subsidiaries to purchase mainframes.

• Instead of a single three-year Enterprise License Agreement, consider an ELA expiring in 2006, another one expiring in 2007, and a third expiring in 2008.

The Option to Switch

• Say you want to switch from an expensive database to an open source (cheap) one in 3 years.

• Or an expensive application server.

• How much should you spend on that?

The Option to Switch

• Are you not buying a European call option for an asset 3 years hence?

• So, for something which costs $10 today, but you want an option to buy it for $8 in 3 years ...

Black Scholes

• 3 year option, 10% interest rate, $10 underlying, $8 strike, 30% volatility

• The implied volatility of the S&P 500 is about 20%, the NASDAQ about 30%

• That call option is worth about $4.40

Black Scholes

• 3 year option, 10% interest rate, $10 underlying, $5 strike, 30% volatility

• That call option is worth about $6.30

• $2 strike? $8.50

Complicated?

• It’s the price of choice.

• Optare. Latin. To Choose.