Before we move in to the second to last video of this series, of the billionaire investor
Charlie Munger and his mental models, let’s have a quick recap of the takeaways from the last video:
- Subjects within social science, such as economics
cannot easily be converted into Newtonian formulas
- Even if something is difficult to measure and quantify, it should probably be included
in your decision-making process, if you gauge that it is a determining variable for that decision
- In complex systems, an action will oftentimes have unexpected consequences
- Some investments have a great core, but seem terrible on a first glance
- Scale is a very common way for a large company to gain a competitive advantage …
… but trees to not grow to the sky.
Limits
People who expect perpetual growth in real wealth in a finite earth are either mad men or economists.
To consider the limits of any given system that you are trying to understand is really useful.
Let’s talk about some practical limits for the stock market investor.
First out is this one:
The stock market cannot grow faster than the economy does over a longer time-frame.
This statement must necessarily be true, as public companies are a part of the economy
(a fairly large part at that) and if they’d grew much faster than other companies over time
the stock market would become the economy eventually.
So – if you want to think about how fast the revenue or the profits of the stock market
could grow in the future, a really good metric to consider is the growth of GDP.
Secondly, we have a related one:
The stock market cannot return more than the aggregate
of the dividends of the underlying companies that it represents.
You might argue that appreciation in prices should be included,
but for investors as a group, they are not.
When I sell shares in company A another investor is paying me that same amount.
Buying and selling therefore represents just a transfer of value from one investor to another,
never enriching the group as a whole.
Meanwhile, dividends, is a transfer of value from a consumer to an investor,
and they actually make investors richer in aggregate.
If dividends is the only thing that is enriching investors as a group, it is interesting to see
that the S&P500 right now has a 1.3% dividend,
while a lot of hedge fund managers have more than 2% in fees.
Who is getting rich from this again?
Thirdly, Charlie Munger says that return on assets is an important limiter to how much
you can expect to return from a specific investment:
“Over the long term, it’s hard for a stock to earn a much better return
than the business which underlies it earns.
If the business earns six percent on capital over forty years and you hold it for that forty years,
you’re not going to make much different than a six percent return
– even if you originally buy it at a huge discount.”
Fourthly: Crypto currencies cannot grow to the moon.
To infinity and beyond!
Did I interpret that too literally?
Non-linearity
A bridge might be able to handle 5 tonnes with no problem, but at 5.5 tonnes, it collapses.
Brazil nuts contain selenium, which is an essential trace element, and is healthy in low doses,
but in higher doses it can kill you.
Smaller celestial bodies can be roughly any shape or form.
Once they hit around 1000 km in diameter,
their own gravity forces them to become round like planets.
If you increase their size even further, the celestial bodies will start to burn like a sun.
The top 1% richest people in the US control approximately $41 trillion,
which is 16 times more than the bottom 50%.
A lot of things in our world aren’t linear.
1 amount of input doesn’t always result in 1 amount of output.
We have breaking points, such as in the case with the bridge, where, if you’ll add
a few extra kilos, the result will be very different than if you did not.
There’s also the concept of critical mass, which is related to the example of the difference
in size between celestial bodies.
Then there’s just regular concavity and convexity.
The classical example of non-linearity from economics is that of marginal utility.
Eating two apples is not twice as satisfactory as eating just one, there’s often diminishing returns.
The same can be said about wealth.
For example, how much more useful is it to earn $50,000 per year vs $40,000?
I think this curve looks different for everyone, but we can probably agree about a few specific points.
The greatest utility money can give is shelter and food on the table for your loved ones.
After that, you still get a lot of improvement up until you can do whatever you want with
your spare time (this is the FU money state) but after that, the utility is arguably tapering off.
Another interesting example of non-linearity, for the stock market investor, is cyclicals.
Well, one advantage of buying these very cyclical businesses is a lot of people don’t like them.
And what difference does it make to us if the earnings average, say, 300 million a year,
if it comes in in a very lumpy fashion?
It’s kind of silly to expect that every business everywhere in the world
would have smooth and linear earnings.
New car models aren’t released once every year.
Innovative medicines aren’t discovered on a regular schedule.
And blockbuster games do not succumb to our yearly calendar.
Manage Expectations
The year I turned 26 as the head of my own brokerage firm,
I made $49 million, which really p***** me off
because it was three shy of a million a week.
Marcus Aurelius said that “Our life is what our thoughts make it”.
Charlie Munger argues that happiness is a result of your actual accomplishments
and your expectations, and that the easiest way to become happy therefore is to reduce
one’s expectations, rather than trying to accomplish the near-impossible.
I think that you can turn an exceptional life into a perceived failure if you have expectations
that are too off the mark.
In 2001 Munger told this little story about expectations in the stock market
which fascinates me, and I’ll paraphrase it here.
Years ago, a money management firm would tell their clients:
“We know how to make a 15 percent return per year in the stock market, year in and year out.”
At that point in time, most peoples’ response was:
“That’s impossible.”
Now, in this climate (Munger was discussing the pre-dot.com burst here), they say:
“So what?
Who’s interested in a lousy 15 percent return?”
Munger concludes from this story that, generally speaking, there’s more joy to be gained
from reducing one’s expectations than in any other way.
Also, there’s probably more to be gained financially too.
The person who thinks that 15% per year is a lousy return will be inclined to do some
very risky stuff to satisfy his needs, and oftentimes such endeavours
have disastrous consequences.
Now, I’m quite a competitive person myself and I believe that there’s power in believing
in that you can achieve great things if you try really hard to.
However, the iron rule of life is that only 1/5 of people can end up in the top 20%.
It would be a shame if only 20% of all people could be happy with themselves as a result.
And those whom I bump into seem to judge their progress in life as to whether or not
they’re keeping up with their age cohort at Goldman Sachs.
That appears to be the minimum standard by which progress of life is measured,
and this can’t possibly end well.
The Iron Prescription
Speaking about iron – here’s an inverted advice for you.
If you want to be successful in life you mustn’t feel sorry for yourself
or feel that the world is mistreating you.
Sure, in some circumstances that might actually be the case, you can be incredibly unlucky
in life and luck plays a huge role in creating successes and failures.
However, thinking that there’s something wrong with the world won’t help you.
Charlie Munger is a great example of having a strong character in this regard.
Even when Munger’s first-born son slowly passed away in incurable leukaemia
Munger said that “you should never, when facing some unbelievable tragedy,
let one tragedy increase to two or three through your failure of will”.
He had other struggles too – in his 50s after a failed eye cataract surgery,
Munger though he was going to become blind.
His reaction?
He bought books in braille, which is a system of dots that can be read with your fingertips,
and he started to take lessons in it.
Charlie Munger’s iron prescription for life is the following:
“Every time you think some person or some unfairness is ruining your life,
it is YOU who are ruining your life.”
The 5 Ws
I need your clothes, your boots and your motorcycle.
You forgot to say WHY?
We’re back at human psychology again, and this time let’s discuss how you can convince
someone to do something for you.
This is of course a useful tool for anyone – entrepreneur, worker, husband.
A neat little trick is to be very specific.
Always address the 5 Ws – who, what where, when and why.
Why is probably the most important one here.
The psychologist Ellen Langer from Harvard University illustrated the power of clearly
stating your WHY in a clever experiment with copy machines.
It went something like this.
A researcher would wait nearby a copy machine, waiting for someone to go there
and then approach them quickly with the intention of cutting the person in line.
One of three questions were used:
“Excuse me, I have 5 pages. May I use the Xerox machine?”
“Excuse me, I have 5 pages.
May I use the Xerox machine, because I'm in a rush?”
“Excuse me, I have 5 pages.
May I use the Xerox machine, because I have to make copies?”
You’ll notice that the third alternative contains a really silly WHY,
it should be fairly obvious that that was the intention even without stating it explicitly.
However, what were the results?
Using the first question, the researcher was allowed to skip in line 60% of the time.
Fairly high, I would say, perhaps the researcher sounded quite confident and dominant.
Using the second question, containing a real why, improved the odds a lot though,
the researcher was now allowed to skip the line in 94% of all cases.
But the most interesting result comes from the third question, using the “fake” why.
93% were allowed to skip the line just because they stated why they wanted to do so,
even though even though they used a really stupid why.
That’s more than 50% more often than when the why was excluded.
Think about this the next time you are trying to convince someone.
And with that, I have nothing more to add.
The last mental model should probably convince you that we humans are not always
as rational as we might think.
That’s the main topics of the last video in the series.
Also, you’ll finally learn about Charlie Munger’s famous Lollapalooza Effect.
Hope to see you for that one.
Cheers!