We make decisions based on our unique experiences that make sense to us in a given moment.
We all come from different generations, backgrounds and have our own unique experience with how the world works. What seems crazy to other people might make sense to you. For example:
- Stocks: If you were born in 1970, the S&P 500 increased almost 10-fold during your 20s. However, if you were born in 1950, the market had only about 0-2x returns in your 20s.
- Lottery tickets: The lowest income households in the US spend 4 more times of those in highest income group per year. If you’re not in the lowest income group, it seems crazy to you. However, they live paycheck to paycheck, can’t afford most things but are hopeful for a life-changing dream. To them, the definition of being wealthy is the life you’re taking for granted.
- Working condition of Foxconn: For American, it was long hours, small wage, poor working condition. For Chinese workers, it was an improvement as they would rather be “exploited” by an evil capitalist boss rather than having their bodies be exploited by several men for pennies (prostitution).
Risk and luck are doppelgangers.
Let’s talk about Bill Gates. He went to Lakeside, one of the only high schools in the world that had a computer. Additionally, most university graduate school did not have a computer as advanced as he had in 8th grade. Then, he and Paul Allen was obsessed with it, spent night and weekends hacking. They were smart, curious, hardworking, and ambitious. Now, Kent Evans was Bill’s best friend. He was smart, had business mind and endless ambition. He could be a founding partner with Gates and Allen but it would never happen because he died in a mountaineering accident. While Bill experienced one in a million luck by ending up at Lakeside, Kent experienced one in a million risk - the odd of being killed on a mountain in high school. Both are hard to measure, accept, that they often overlooked.
While luck actually plays a role in financial success, it’s hard to quantify it and rude to suggest people’s success is owed to it. On the other side, failure is equally overlooked. Say I buy a stock and 5 years later its' gone nowhere. Now, it’s possible that I made a good decision that has 80% chance of making money but I happen to end up on the unfortunate 20%. Just as with luck, failure is too complex to pick apart how much of an outcome is a conscious decision versus a risk. They are doppelgangers:
- Benjamin Graham’s investing success was due to owning an enormous chunk of GEICO stock which broke nearly every diversification rule that he laid out in his famous text.
- People praised Mark Zuckerberg for turning down Yahoo’s offer to buy his company but criticized Yahoo with as much passion for turning down Microsoft’s offer.
- “The customer is always right” and “customers don’t know what they want” are both accepted business wisdom.
- Not all success is due to hard work and not all failure is due to laziness.
When things are going well, it’s not as good as you think and vice versa. Nothing is as good or as bad as it seems.
There is no reason to risk what you have and need for what you don’t have and don’t need.
Rajat Gupta and Bernie Madoff had everything, wealth, prestige, power, freedom, before they committed crimes. Long-Term Capital Management took so much risk that they managed to lose everything. They threw it all away because they wanted more.
“Warren Buffett later put it: To make money they didn’t have and didn’t need, they risked what they did have and did need. And that’s foolish. It is just plain foolish. If you risk something that is important to you for something that is unimportant to you, it just does not make any sense.”
Now, at some point in your life, you will have a sum of money sufficient to cover every reasonable things you need and want, remember a few things:
- The hardest skill is getting the goalpost to stop moving. It gets dangerous when the taste of having more money, power, increases ambition faster than satisfaction.
- Social comparison is the problem. Top hedge fund mangers could look ahead to Warren Buffet while he could ahead to Jeff Bezos. It’s the battle that can never be won. The only way is not to fight in the first place and accept that you might have enough.
- Enough is realizing that the opposite will push you to the point of regret. For example, you can eat more than enough or until you’re sick. In business, it could mean burning out or risky investments you can’t maintain.
- There are things that never worth risking, such as reputation, freedom, family and friends, happiness.
Even with a small starting base, compounding can lead to extraordinary results.
“More than 2,000 books are dedicated to how Warren Buffett built his fortune. Many of them are wonderful. But few pay enough attention to the simplest fact: Buffett’s fortune isn’t due to just being a good investor, but being a good investor since he was literally a child.”
Buffet is the richest investor of all time, not the greatest when measured by average annual return. Jim Simons, has compounded money at 66% annually since 1988 while Buffet’s is at 22%. However, Jim’s net worth is not as big as Buffet because he’s had less than haft as many years to compound as Buffet. Buffet’s secret is compound interest with time as he’s been investing consistently for 3 quarters of a century. That said, it’s time in the market that builds returns, not market timing.
Compound isn’t always intuitive and we often ignore its potential. Plus, good investing isn’t necessarily about earning the highest return because the highest one tend to be one-off hits that can’t be repeated. It’s about earning a pretty good return which you can stick with for the longest period of time and let the compounding runs wild.
“The first rule of compounding: Never interrupt it unnecessarily." - Charlie Munger
Getting wealthy and staying wealthy are two different skills.
Getting wealthy requires taking risks and being optimistic while staying wealthy requires the opposite of taking risk:
- Fear: what you’ve made can be taken away just as fast.
- Frugality: accepting that at least some of your wealth is attributable to luck and past success can’t be repeat indefinitely.
“Michael Moritz, the billionaire head of Sequoia Capital, mentioned longevity, noting that some VC firms succeed for five or ten years, but Sequoia has prospered for four decades: I think we’ve always been afraid of going out of business. We assume that tomorrow won’t be like yesterday. We can’t afford to rest on our laurels. We can’t be complacent. We can’t assume that yesterday’s success translates into tomorrow’s good fortune.”
Survival mentality is the key with money for 2 reasons:
- Few gains are so great that they’re worth wiping yourself out over.
- Compounding only works if you can give an asset years to grow.
Applying the survival mentality comes down to 3 things:
- More than big returns, you want to be financially unbreakable so that you’ll able to stick around long enough for compounding returns. Good returns sustain uninterrupted for the longest period of time, especially in times of chaos and havoc.
- Have a plan that can survive reality, allowing room for errors. If there’s enough room for error in your saving rates that you can say: It’d be great if the market returns 8% a year over the next 30 years but if it only does 4%, I’ll still be OK.
- Be optimistic about the future, the long-term growth is up but equally be sure that the road between now and then is filled with misery, and over time things will balance out to a good outcome.
You can be wrong half the time and still make a fortune.
By 1990s and 2000, Heinz Berggruen became one of the most successful art dealers of all time by selling parts of his massive collection of Picassos, Braques, Klees,… to the German government. He bought everything he could, in portfolios not individual pieces he happened to like, waited for a few winner to emerge. 99% of the work turned out to be of little of value. However, 1% turned out to be the work of someone like Picasso. He could be wrong most of the time but still ended up right.
“It is not intuitive that an investor can be wrong half the time and still make a fortune. It means we underestimate how normal it is for a lot of things to fail. Which causes us to overreact when they do.”
Anything that is huge, profitable, influential is the result of a long-tail event. Take venture capital for example. A VC makes 50 investments, expects half to fail, 10 to make 10-20x return, 1-2 to make 50x or more. This is actually the same for large public companies as most of them are duds, a few do well, and a handful become extraordinary that account for the majority of the market’s return. It’s the tails that drive everything.
So what should you do right now? What stocks should you buy today? Well, it doesn’t matter. Over the course of your lifetime, your decision that you make today, tomorrow or next week will not matter as much as what you do during the small number of days when everyone around is going crazy. For example, if you invest $1 consistently from 1900 to 2019, whether it’s a recession or bear market, you could end up with the most money compared to whom invest only when a recession ends or sells when a recession begins. You can fail a lot of times but still end up making more since each stock’s return is not equal to each other. Warren Buffet owned 400-500 stocks but made most of his money on 10 of them.
“It’s not whether you’re right or wrong that’s important,” George Soros once said, “but how much money you make when you’re right and how much you lose when you’re wrong.” You can be wrong half the time and still make a fortune."
The highest form of wealth is freedom.
It’s the ability to wake up everyday and do whatever you want, when you want, with whom you want, for as long as you want.
The common denominator in happiness is that people want to control their lives. Money has the ability to give you that control. Building wealth means the ability to take a few days of work without breaking the bank, having shorter commute, dealing with a medical emergency without the added burden of worrying about how you’ll pay for it and eventually retiring when you want to.
Humility, kindness, empathy will bring you respect, not fancy things.
“People tend to want wealth to signal to others that they should be liked and admired. But in reality those other people often bypass admiring you, not because they don’t think wealth is admirable, but because they use your wealth as a benchmark for their own desire to be liked and admired.”
People generally aspire to be respected and admired by others. Using money to buy fancy things might bring less of it than you imagine. Instead, humility, kindness, and empathy will bring you more respect than any fast cars ever will.
Building wealth has little to do with your income or investment returns and lots to do with your saving rate.
Investment returns can make you rich but whether it will work and how long it will work for is always in doubt. Personal savings and frugality are more in your control. Also, the value of wealth is relative to what you need. Say you and I have the same net worth. You are a better investor since you earn 12% annual returns while I only earn 8%. However, I’m more efficient with my money since I need half as much to be happy while your lifestyle compounds as fast as your assets.
Less ego, more wealth.
Things that have never happened before happen all the time.
History offers a rough guide of what tends to work and what not. But it’s not a map of the future. Two dangerous things happen when you reply too heavily on investment history as a guide to what happen next:
- The most important events are not yet happened and they are what move the needle in the economy the most.
- History can be misleading because it might not be relevant in today’s world. VC barely existed 25 years ago. Thee S&P 500 did not include financial stock until 1976. Technology stock were nonexistent 50 years ago. The Intelligent Investor is one of the greatest books of all time even though most of its advices do not work in today’s time.
You can plan for every risk except ones that are too crazy to cross your mind. Those crazy things can do the most harm and they happen more frequently than you think.
Always leave room for errors.
“The wisdom in having room for error is acknowledging that uncertainty, randomness, and chance, “unknowns”, are an ever-present part of life. The only way to deal with them is by increasing the gap between what you think will happen and what can happen while still leaving you capable of fighting another day.”
Benjamin Graham calls it margin of safety, or room for errors. Instead of viewing the word as black or white, predictable or a crapshoot, view it as a gray area and pursue things where a range of potential outcomes are acceptable. It’s often misunderstood as a conservative move, used by those who don’t want to take much risk. However, when room for errors is used appropriately, it lets you endure a range of potential outcomes, and endurance lets you stick around long enough to let the odds of benefiting from a low-probability outcome fall in your favor. The biggest gains happen infrequently either because they don’t happen often or they take time to compound.
“Bill Gates understood this well. When Microsoft was a young company, he said he “came up with this incredibly conservative approach that I wanted to have enough money in the bank to pay a year’s worth of payroll even if we didn’t get any payments coming in.” Warren Buffett expressed a similar idea when he told Berkshire Hathaway shareholders in 2008: “I have pledged—to you, the rating agencies and myself—to always run Berkshire with more than ample cash … When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”
In short, you have to take risk to get ahead but no risk that can wipe you out is ever worth taking. Not only an event of wiping out leaves you broke, it also erases every opportunity to get back in the game at the moment opportunity is ripe. Manage your money in a way that helps you sleep at night.
People are poor forecasters of their future selves.
Imagine a goal is easy and fun. Imagine a goal in the context of life stresses is different. For example, a five-year-old boy wants to drive a tractor when he grows up but then realizes later that it isn’t the best career. He wants something more lucrative, like a lawyer. He then faces such long working hours that he rarely sees his family. He wants to take a lower-paying job with flexible hours. However, childcare is expensive so he becomes a stay-at-home father. At age 70, he realizes that he’s not prepared to afford retirement.
Things change as your goals and desires. It’s hard to make enduring long-term decisions when your view can shift. So then, how do you apply the compounding rule? How do you not interrupt your investment when what you want changes? How do we listen to Buffet to keep doing the same thing for decades and let the compounding runs wild then? There is no easy solution, but keep in mind these 2 things:
- When you consider your tendency to change over time, at every point of your life, avoid future regret and encourage endurance by avoiding the extreme ends. Aim to have moderate annual saving, moderate free time, moderate time with family and so on.
- Accept the reality of change and move on as soon as possible. Don’t let old decision make you prisoner to your past.
Every job looks easy when you’re not the one doing it.
The S&P 500 increased 119-fold in the 50 years ending 2018. All you had to do was sit back and let your money compound. But is it easy? Do you know how hard it is to maintain a long-term outlook when stocks are collapsing? It looks easy when you’re not the one doing it. Sometimes, this is because we’re overconfident. Most of the time, we’re not good at identifying the price of success, which prevents us from being able to pay it.
The price of successful investing is accepting volatility and upheaval. You can find an asset with less uncertainty and a lower payoff, or attempt to perform tricks to get the return without paying the price by selling before the next recession and buying before the boom. However, sometimes you get away with it, sometimes you get caught.
Why is it so hard? Because the price of successful investing is not immediately obvious. Market volatility feels like a fine that you should avoid. However, a trick is to view it like an entrance fee that you have to pay to enter. It’s worth paying in order to expect good returns.
Investors often innocently take cues from other investors who are playing a different game than they are.
How much should you pay for Google stock today? Are you looking to cash out within:
- 30 years: Analyze Google’s discounted cash flows over the next 30 years.
- 10 years: Analyze the tech industry over the next decade and whether Google can execute its vision.
- 1 year: Pay attention to Google’s current product sale cycles and whether we’ll have a bear market.
When investors have different goals and time horizon, prices that look crazy to one person can make sense to another. Take a look at Yahoo’s stock in the dotcom bubble 1999. To many short-term investors, it made sense for them to pay for a ridiculously high price. Bubbles form when the momentum of short-term returns attracts enough money that the makeup of investors shifts from mostly long term to mostly short term. In other words, bubbles are not about valuation rising but time horizon sinking as more short-term traders enter the field. They were not thinking about the next 20 years but the next days or months. They were not irrational or irresponsible at all. Matter of facts, they were really rational about chasing short-term gains. However, this created problem for long-term investors. The price was high, other people were buying it so they thought it was smart to go along. Unfortunately, it was too expensive to enter and hold for the long run.
Again, make sure you know what game you’re playing. Do not be persuaded by the actions and behaviours of people playing different games than you are.
Financial pessimism is easy, common, and more persuasive than optimism.
“If a smart person tells me they have a stock pick that’s going to rise 10-fold in the next year, I will immediately write them off as full of nonsense. If someone who’s full of nonsense tells me that a stock I own is about to collapse because it’s an accounting fraud, I will clear my calendar and listen to their every word. Say we’ll have a big recession and newspapers will call you. Say we’re headed for average growth and no one particularly cares. Say we’re nearing the next Great Depression and you’ll get on TV. But mention that good times are ahead, or markets have room to run, or that a company has huge potential, and a common reaction from commentators and spectators alike is that you are either a salesman or comically aloof of risks.”
There is a couple of reasons why financial pessimism is easy, common, and more persuasive than optimism:
- Money is ubiquitous as a recession could impact every single person.
- Assuming that something ugly will stay ugly is an easy forecast to make and persuasive because it doesn’t imagining the world changing and people adapting.
- Progress happens too slowly to notice (years long) while setbacks and failures happen to quickly to ignore (overnight).
Stories are the most powerful force in the economy.
The more you want something to be true, the more likely you are to believe a story that overestimates the odds of it being true. Especially, when you desperately need a solution and a good one isn’t known or readily available to you, you will believe anything. People listen to investment commentaries and financial advices that have little track record of success because they want to believe that 1% chance will come true and change their lives. In hindsight, Bernie Madoff’s Ponzi scheme was obvious. However, he told a good story and people wanted to believe it. If you want a certain stock to return 10x, you’re more likely to believe that’s true. So be aware. Make sure you leave room for errors.
Everyone has an incomplete view of the world but we form a complete narrative to fill in the gaps. The ability to explain the past/history gives us an illusion that the world is understandable, even when it doesn’t make sense. When a stock rises you might an explanation for it but that might not necessarily true. Your ability to predict recessions isn’t much better. However, there’s still tremendous demand for forecasts because we need to believe we live in a predicable world.