Capitalism’s success is built on a belief – a story – that, given the right incentives, people can work together to solve problems. It’s worked magnificently. It’s the greatest story ever told.
But to wrap our heads around its potential, we have to dig into how stories are told, why we believe them, and how our ability to tell stories has changed in the last decade, as social media has turned everyone into a storyteller.
Imagine an alien from another planet whose job is to keep tabs on Earth’s economy.
He does this from his spaceship, checking out the action below. He circles above New York City, trying to size up how its economy changed between January 1st 2007 and January 1st 2009. This is what he sees in Times Square on New Year’s eve, 2007:
There was one change the alien couldn’t see between 2007 and 2009: The stories we told ourselves about the economy.
In 2007, we told a story about the stability of housing prices, the prudence of bankers, and the ability of financial markets to accurately price risk. In 2009 we stopped believing that story. That’s all that changed. But it made all the difference in the world. Once the narrative that home prices will keep rising broke, mortgage defaults rose, then banks lost money, then they reduced lending to other businesses, which led to layoffs, which led to less spending, which led to more layoffs, and on and on. Other than clinging to a new narrative, we had an identical -- if not greater -- capacity for wealth and growth in 2009 as we did in 2007. Yet the economy suffered its worst hit in 80 years. This is different from, say, Germany in 1945, whose manufacturing base had been obliterated. Or Japan in the 2000s, whose working-age population was shrinking. That’s tangible economic damage. In 2009 we inflicted narrative damage on ourselves, and it was vicious. It’s one of the most potent economic forces that exists. Capitalism’s success rests on a belief that, given the right incentives, people can work together to solve problems. It’s the greatest story ever told. But to wrap our heads around its potential, we have to dig into how stories are told, why we believe them, and how our ability to tell stories has changed in the last decade, as social media has turned everyone into a storyteller.
Part 1: This is not a story about something happening; something is happening because there’s a story.
The growth of anything -- an economy, a company, a market, a career -- has two parts:
A technical ability that can solve problems and add value.
People’s propensity to believe in that value.
It is intuitive to believe that most of what drives success is the first point. Real skills add real value. But the second point -- the stories we tell ourselves about those skills and values -- can play the deciding role. Stories can influence the production of real skills themselves, effectively becoming the pilot of our economy. It comes down to this: Stories drive price, and price drives fundamentals.
Think about bitcoin in 2017.
We have seen an explosion in investment activity, not just in currencies but in exchanges, mining networks, energy infrastructure, and companies looking at blockchain as a component of their future. Bitcoin infrastructure now consumes more energy than Denmark.
What is driving this boom? Not actual problems being solved. Few currencies to date actually solve people’s problems. The boom is being driven by a booming belief in the boom.
Investor Charlie Bilello polled the investment community several times in 2017, asking whether bitcoin was a bubble.
He found something amazing: The higher bitcoin’s price goes, the less people think it’s a bubble. A four-fold price increase caused a 12 percentage point drop in those who believed it was a bubble, and a doubling of those who found it undervalued:
People have heard -- and increasingly believe -- a story about what bitcoin will become. Maybe that story is flagrantly speculative, like, “The price will go up more.” Maybe it’s more fundamental, like, “Bitcoin will become the world’s reserve currency.”
It doesn’t matter.
The price is being driven by a story -- a belief. And if crypto goes on to solve real problems in the world, it will owe its success to its current story. Belief attracts capital and infrastructure. It allows the technology to be taken seriously by businesses, regulators, and investors who have the potential to turn it into something meaningful and useful.
Crypto is an amazing example of this in action, because its current technology solves so few problems. Yet it is being taken so seriously by so many people that doors are opening up, red carpet rolled out, for it to eventually solve problems, which increases its odds of success in ways that just looking at the technology today wouldn’t let you comprehend. The same was true for energy last decade. We believed a story that the world was running out of oil, and whether it was true or not, my God, we believed it. Oil prices rose from $30 in 2003 to $140 in 2008.
The point is that if you’re trying to figure out where something is going next, you have to understand more than its technical possibilities. You have to understand the stories we tell ourselves about those possibilities, recognizing that stories aren’t just the observer, but can be the actual pilot of their subjects.
Stories create their own kind of truth. Lyndon Johnson built a political career off his storytelling ability. Many of his tales were clearly farfetched. Doris Kearns Goodwin wrote in Johnson’s biography about a question people often asked after hearing a Johnson story: “Was it true? The question had little meaning. What mattered was the story itself.” Now, let’s talk about the stories we tell ourselves.
I can’t explain it because I can’t describe it
This is true for the most fact-based of subjects. Take history. It’s just the recounting of stuff that already happened. It should be clear. But as B.H. Liddell Hart writes in the book Why Don’t We Learn From History?:
[History] cannot be interpreted without the aid of imagination and intuition. The sheer quantity of evidence is so overwhelming that selection is inevitable. Where there is selection there is art. Those who read history tend to look for what proves them right and confirms their personal opinions. They defend loyalties. They read with a purpose to affirm or to attack. They resist inconvenient truth since everyone wants to be on the side of the angels. Just as we start wars to end all wars. I once interviewed Daniel Kahneman.
We got to talking about the stories people tell themselves to make sense of the past. Kahneman remarked:
“Stories that protect your ego.” These are probably the most common of all stories. Few things are harder than looking in the mirror and saying “I’m not good at this.” People do it, of course. But coming up with a story about why you’ve been good, are good, are going to be good, or should be good at whatever you’re doing is the path of least resistance. Here’s the thing: We judge others based solely on their actions, but when judging ourselves we have an internal dialogue that justifies our mistakes and bad decisions.
The two of these mix together in a potentially toxic way. More data is always preferable to less. But it has a downside: Big data takes cherry-picking and data mining to a cosmic scale. You can “prove,” with reliable statistics, virtually anything you want these days. And the rise of social media gives everyone a platform to disseminate that “proof ” to a huge and attentive audience. Twitter has 310 million active users. In my experience it attracts two groups of people like magnets: Those who want their views confirmed, and those who are easily persuaded with vague and outsourced ideas. In other words, the two groups that are most interested in stories over statistics. And social media is perhaps the most dubious source of storytelling. According to the Wall Street Journal: “About 19% of the messages viewed by Twitter users during the last month of the presidential campaign were generated by bots.” We have, in short, taken our storytelling ability to a new level, exponentially higher than just a few decades ago. For most of history, stories were limited by their ability to spread, with a few powerful voices controlling the microphone. That is no longer the case. A viral tweet can give a relative nobody an audience of tens of millions within hours. The cult of data often underestimates that stories are more powerful than statistics. While Big Data has grown, Big Anecdotes have exploded. Statistics are useful to the extent that we find their insights more persuasive than stories. But we often don’t. Data takes effort to contextualize. Stories offer instant gratification. Statistically, a company should want some of its new projects to fail. Realistically, a story about failure burns so badly that many companies never try new stuff.
By the end of the study, pigeons were pecking a food lever up to five times per second “for as long as fifteen hours without pausing longer than fifteen or twenty seconds during the whole period.” B.F. Skinner made a pigeon lose its mind.
Skinner, a Harvard psychologist, studied the science of incentives. He did this by giving thousands of animals different incentives to be rewarded with food. Sometimes the animal just had to hit a lever, and a food pellet popped out every time. Sometimes it had to learn a pattern – two lever taps, or a long tap, or a tap and a delay and another tap. Pigeons and rats are remarkably good at figuring this stuff out.
Part of Skinner’s research was determining what incentives are so powerful that they can’t be ignored, causing animals to become obsessed beyond the need for food pellets. What kind of incentives make a pigeon lose its mind?
He basically found three types of incentives:
Fixed. One tap gives one food pellet. Same result every time. Animals figure this out quickly but don’t get excited about it. “This is how I get food. OK. Move on.”
Changing. Today you get food with one tap. Tomorrow it will take two taps. The next day, a tap pattern. This gets animals excited. It’s a stimulating puzzle. “Oh! Let’s figure out how to get food today!”
Variable interval. Tap the lever and you will get food on average every hour, but that might mean five pellets in the next hour and then nothing for the next five hours. Animals will get the same amount of food over the course of a day, but at random and unpredictable times. This turns them into addicts. They lose their minds. “I know food will come so I’m going to keep tapping but AHHHH MAN WHEN IT IS COMING THE SUSPENSE IS KILLING ME JUST KEEP HITTING THE DAMN LEVER.”
The science behind this is how much dopamine you get for different rewards.
Fixed rewards are too easy to get excited about. Changing rewards offer enough buzz to want to figure out tomorrow’s puzzle. Variable interval rewards flood your brain with dopamine because that high is evolutionary necessary to survive the hellish world of hunting and famine.
The dopamine rush of obtaining something important that you knew would eventually come but didn’t know when is what keeps you hunting for more.
The pigeons in Skinner’s study got so much buzz from variable interval feedings that they became compulsive, completely out of control.
“You can move from the pigeon to the human case,” Skinner once said. “[Variable interval] is at the heart of all gambling devices. It has the same effect. A pigeon can become a pathological gambler just as a person can.”
Variable interval rewards are why we compulsively check email. Some messages are really important, but you don’t know when the important ones will come, so you keep checking and checking.
Same with checking Twitter and Facebook, watching cable news, or even waiting for a boring meeting to end.
Find something that captures people’s attention and turns them into crazed animals and you will likely find a variable interval reward.
Skinner’s research caused a stir, particularly when he compared pigeon behavior to human tendencies. But “science is a willingness to accept facts even when they are opposed to wishes”
How we respond to rewards can be more embarrassing than any of us want to admit, but admitting it is how we get better.
Something that should be more obvious than it is is that the gap between a great product and a great business can be ten miles wide. Oftentimes that gap is correlated: The reason some products become popular is because users aren’t paying a sustainable price for them. They’re getting investor-subsidized services, and of course they like that.
Just separating those out as two different things is important, because while every great business is backed by a great product, not every great product turns into a great business.
Making a business work requires mastering a series of steps, each one harder than the one before it. I call it the hierarchy of profit😀
In January 2004, when Facebook was a days-old dorm room project, Mark Zuckerberg was asked by a friend whether he...
Albert Einstein spent a lot of his career arguing against quantum theory. It seemed contradictory to everything we thought about physics.
“One cannot make a theory out of a lot of ‘maybes’” he once told a group of physicists. “Deep down it is wrong, even if it is empirically and logically right.” -Albert Einstein
“Einstein, I’m ashamed of you,” said physicist Paul Ehrenfest, according to Isaacson’s biography. Fellow physicists said he was being as stubborn as others had been when disputing his theory of relativity.
Einstein eventually came around. He nominated the two physicists who devised quantum theory for the Nobel Prize in 1933. He wrote in his nomination: “I am convinced that this theory undoubtedly contains a part of the ultimate truth.” You could, in fact, make a theory out of maybes.The development of quantum physics next to Newtonian physics shows how hard it is to grasp that some things can be measured and are in our control, and some things can’t, and aren’t. It’s especially hard to grasp when those things are in the same field.
The same dissonance affects investors.
Accepting that investing is made up of both precise facts and theories of maybes is the hardest thing for investors to grasp. Theories of maybes can often be distilled into probabilities. But this doesn’t solve the problem, because we can’t calculate the probabilities of things we don’t know. The history of markets is, and will always be, the story of things that were unprecedented until they happened. That’s hard to accept if you have a Newtonian physics mind. And many investors do
.Getting comfortable may require two things: Humility, and room for error. Humility that there’s a lot of stuff we can’t know, and room for error to offer the only protection against that uncertainty. It’s the only way to survive in an industry where some of the most important variables can’t be calculated, measured, or fully understood.
Newton, interestingly, figured this out. After allegedly losing a fortune investing, he said he could “calculate the motion of heavenly bodies, but not the madness of people.”
Why did Amazon start with books? Jeff Bezos once explained:
You have to go back in time to 1994, and there’s something very unusual about the book category. There are more items in the book category than there are items in any other product category. One of the things that was obvious you could do with an online store is have a much more complete selection.
E-commerce was insanely hard in the 1990s. It was slow, and people didn’t trust it. If your pitch was “this is more convenient than going to the store,” you were toast, because it wasn’t. If, like Amazon, your pitch was “We have more stuff than your local store,” you had a real value prop. A value prop that stuck with customers during the dot-com shakeout of the early 2000s. It’s a base few paid attention to, but explains a lot of Amazon’s current success.
Most brands are like that. Brands are fueled by their consistency. Consumers value quality products, but not as much as they value the confidence of knowing exactly what they’ll be getting before they buy. This requires years of delivering a predictable experience. Apple has a strong brand, not just because it builds good products, but because it’s consistently been building good products since the 1980s. Deep roots, strong base.
Michael Batnick once explained it. If I ask you to calculate 8+8+8+8+8+8+8+8+8 in your head, you can do it in a few seconds (it’s 72). If I ask you to calculate 8x8x8x8x8x8x8x8x8, your head will explode (it’s 134,217,728).
It is so easy to overlook how powerful it can be to take something small and hammer away at it, year after year, without stopping. Because it’s easy to overlook, we miss the key ingredients of what caused big things to get big.
Physicist Albert Bartlett put it: “The greatest shortcoming of the human race is our inability to understand the exponential function.”
How To Make The Economy Grow
Make more stuff with less productivity. That’s how the economy grows. Workers figure out new tricks, machines get faster, and the resulting efficiency means people who used to make steel can now make apps and lithium batteries.
Everything about growth revolves around productivity. Economists are rightly obsessed with it, promoting investment and innovation. But there’s a distinction here that makes me more optimistic about our productive potential than most economists would suggest.
There are two types of productivity:
Discover new tricks to make something more efficient, like creating or planning a social event
Reduce old hindrances that slow things down, like social biases that affect hiring, pointless meetings, and work that serves no purpose other than impressing your boss.
Additive vs. subtraction. Think of the economy like a racehorse. Its owner can invest in a new training regimen and diet, which may make the horse faster. Or it can get rid of the overweight jockey, which may do just as good. My point is that too many businesses, and the economists who size them up, focus on inventing new training routines with little attention paid to the fat jockey. There is so much productive potential within reach that doesn’t require new inventions.
The point is that the world is full of low-hanging productivity fruit that doesn’t rely on our ability to invent new ideas. There are smart economists who are pessimistic about our future potential, based on the idea that things like electricity, air conditioning, cars, and what seems to be the most important is money. - A wise man once said “For the love of money is the root of all evil” ~Jesus
Another wise “man” once said - “We have proposed a system for electronic transactions without relying on trust. We started with the usual framework of coins made from digital signatures, which provides strong control of ownership, but is incomplete without a way to prevent double-spending. To solve this, we proposed a peer-to-peer network using proof-of-work to record a public history of transactions that quickly becomes computationally impractical for an attacker to change if honest nodes control a majority of CPU power. The network is robust in its unstructured simplicity. Nodes work all at once with little coordination. They do not need to be identified, since messages are not routed to any particular place and only need to be delivered on a best effort basis. Nodes can leave and rejoin the network at will, accepting the proof-of-work chain as proof of what happened while they were gone. They vote with their CPU power, expressing their acceptance of valid blocks by working on extending them and rejecting invalid blocks by refusing to work on them. Any needed rules and incentives can be enforced with this consensus mechanism”. - Satoshi Nakamato
Diving into multipliers that drove 20th Century productivity – were so powerful that we shouldn’t expect their boost to be repeated. I bought that. But we underestimate our potential when we only view productivity through the lens of creating new inventions, ignoring how much unnecessary productivity-sapping social nonsense we put up with, but shouldn’t.
Gathering statistics is a skill. Finding facts is a behavior. The former is a set of numbers; the latter is a complete set of numbers calibrated with enough context to provide a model of how the world actually works.
Identifying smart people is a skill. Managing smart people is a behavior. The latter requires sussing out what motivates people and dealing with difficult personalities.
Being good at your job is a skill. Working well with others is a behavior. The latter generally dictates the duration of the former.
Successfully managing money during calm times is a skill. Successfully managing money during a recession is a behavior.Recessions require all the skills of managing money during expansions, but with an added worry about career risk, whether your past success was due to luck, and whether good times will return.
Interpreting data is a skill. Understanding your tendency toward confirmation bias is a behavior. Charlie Munger on Charles Darwin: “He trained himself to consider any evidence tending to dis-confirm any hypothesis of his, especially if he thought his hypothesis was a particularly good one.”
Make middlemen irrelevant. Someone told me most economic growth is just “the elimination of one middleman at a time.” Directionally true. Narrowing the gap between production and purchase, without sacrificing quality or distribution, will almost always be a winning formula. This is especially true when middlemen are gatekeepers of data. Empower customers to make better decisions and you’re indispensable.
Make things disappear. More value has been created taking stuff away from consumers than has by offering them more. That stuff includes: The need to farm, standalone cameras, cassette tapes, cable TV subscriptions, physical books, physical newspapers, filing cabinets, fax machines, mail, malls, a second car, and maybe soon, any car. All of these were replaced by something as good or better, but so invisible that you barely know it exists. Which can make customers happier than getting something new.
Expiring knowledge catches more attention than it should, for two reasons.
One, there’s a lot of it, eager to buzz our short attention spans.
Two, we chase it down, anxious to squeeze out insight before it loses relevance.
Long-term knowledge is harder to notice because it’s buried in books rather than blasted in headlines. But its benefit is huge. It’s not just that long-term knowledge rarely expires, letting you accumulate it over time. It’s that compounds over time. Expiring knowledge tells you what happened; long-term knowledge tells you why something happened and is likely to happen again. That “why” can translate and interact with stuff you know about other topics, which is where the compounding comes in.
Consider a company’s performance—its sales, margins, and cash flow.
These are important pieces of information. But they expire. No one cares anymore about Microsoft’s Q2 2004 revenue growth. They care that Microsoft generates lots of cash over time because it has a moat. Understanding moats – why they exist, how they are defended, etc. – is long-term knowledge. When you view it this way you realize that the revenue and cash flow information is a short-term reflection of the moat. Which means the expiring information can’t be put into proper context without the permanent stuff. And once you spend enough time studying moats you start to see them (and the lack of them) in other industries – which is something Microsoft’s Q2 2004 revenue number won’t do for you.
If your job is to dig a ditch, or sew a shirt, there is a clear distinction between working and not working. But if your job is creating a marketing campaign, or managing a project, or writing software code, the line between work and not work blurs. You’re working with your mind, which is harder to shut off than your arms or your legs.
As the economy shifts from manual labor to “thought” jobs, work increasingly becomes something that people can’t turn off. You may be just as engaged in work making dinner in the evening as you are during a mid-day meeting.
Add to it that many thought jobs require, more than anything else, time to think. Quiet time to let creativity grow, and to think a problem through. But we’re still stuck in the old world where productive work was only what took place when you were doing something, like swinging a hammer.
Since we still equate action with productivity, people spend a big part of their day uselessly engaged in looking busy: endless meetings, creating deliverables, and generating the appearance of work without making much headway.
If your job requires you to think, but you spend your work day trying to look busy, then your job inevitably comes home with you, since the only quiet time you have to think about work is during what’s supposed to be your after-work leisure time.
Here again, busy but not productive. Just as Sevareid warned.
Knowing what to expect. That’s the essence of a brand
Branding is more powerful than ever today, because consumer options have proliferated. There used to be three news channels. Now there are millions of blogs. The grocery store used to stock five types of toothpaste. Now Amazon offers 87,268.
Staying relevant in this world requires building a strong brand. But we often mistake a brand for two of its cousins: marketing and design. The most important thing about a brand is that you can’t create one. You can create a marketing campaign. You can create a slick design. Both are tremendously important. But brand has to be earned through repetition, convincing people that what they experienced yesterday is what they can expect to experience tomorrow. It’s hard, and it can take a long time. But it’s sensationally powerful.
When you realize how much of a brand is just a tight distribution of outcomes, you see that powerful brands can be built on top of subpar products. Julia Child once asked her host to take her to the local McDonald’s. The host was horrified. Child explained: “I like McDonald’s. It’s always consistent.” Motel 6 is a powerful brand. You know exactly what you’ll get: A pitifully no-frills room, identical in every city. Same with Domino’s. It is not the best pizza in the world. But it’s pretty good every time, from Baltimore to Tokyo. That’s enough to make it the best-selling pizza in the world.
The big insight on brands is that consumers hate surprises more than they enjoy the chance at perfection. Truly amazing companies combine perfection with consistency. Apple is a good example. But it is an exception, and consistency still drives the bulk of its brand. Motorola and Blackberry made some amazing phones. But they sold them in a lineup that included some awful phones. The distribution of outcomes widened. The brands diminished.
History is full of parallels. Sometimes I wonder what the modern equivalent of Underwood’s Deviled Ham is. What’s the new frontier of making your product known that we’ll look back on 150 years from now as shockingly obvious?
Perhaps we’ll recognize that the pursuit of two things – speed and scale – tainted many brands. Maybe we’ll realize that slowing down to focus on quality and consistency is the new way to win over more customers.
The biggest branding challenge 150 years ago was signaling to customers that you could promise consistency – selling in. Today the biggest challenge is keeping that promise in a market where it’s easy to grow big quickly by sacrificing consistency – selling out.
Quality falling with quantity is visible in almost every industry. Health care satisfaction falling as hospital networks combine. Banks lost focus as they merged into behemoths. Blogs posting garbage as they seek clicks and volume. It seems to have picked up over the last decade, as technology makes scaling easier than ever.
This report will argue that:
Stories can be more powerful than tangible things.
Stories are often wildly disconnected from our productive capacity.
We confidently convince ourselves of absurd stories.
We’re in a new era of storytelling, which changes how all of us need to think about investing.
You can download it here, or click on the image below.
Rich man in the car paradox.
When you see someone driving a nice car, you rarely think, “Wow, the guy driving that car is cool.” Instead, you think, “Wow, if I had that car people would think I’m cool.” Subconscious or not, this is how people think.
The paradox of wealth is that people tend to want it to signal to others that they should be liked and admired. But in reality those other people bypass admiring you, not because they don’t think wealth is admirable, but because they use your wealth solely as a benchmark for their own desire to be liked and admired.
This stuff isn’t subtle. It is prevalent at every income and wealth level. There is a growing business of people renting private jets on the tarmac for 10 minutes to take a selfie inside the jet for Instagram. The people taking these selfies think they’re going to be loved without realizing that they probably don’t care about the person who actually owns the jet beyond the fact that they provided a jet to be photographed in.
The point isn’t to abandon the pursuit of wealth, of course. Or even fancy cars – I like both. It’s recognizing that people generally aspire to be respected by others, and humility, graciousness, intelligence, and empathy tend to generate more respect than fast cars.
The finance industry talks too much about what to do, and not enough about what happens in your head when you try to do it.
People’s lives are a reflection of the experiences they’ve had and the people they’ve met, a lot of which are driven by luck, accident, and chance. The line between bold and reckless is thinner than people think, and you cannot believe in risk without believing in luck, because they are two sides of the same coin. They are both the simple idea that sometimes things happen that influence outcomes more than effort alone can achieve.
Every money reward has a price beyond the financial fee you can see and count. Accepting that is critical. Scott Adams once wrote: “One of the best pieces of advice I’ve ever heard goes something like this: If you want success, figure out the price, then pay it. It sounds trivial and obvious, but if you unpack the idea it has extraordinary power.” Wonderful money advice.
Anchored-to-your-own-history bias: Your personal experiences make up maybe 0.00000001% of what’s happened in the world but maybe 80% of how you think the world works.
Since no amount of studying or open-mindedness can genuinely recreate the power of fear and uncertainty, people go through life with totally different views on how the economy works, what it’s capable of doing, how much we should protect other people, and what should and shouldn’t be valued.
The problem is that everyone needs a clear explanation of how the world works to keep their sanity. It’s hard to be optimistic if you wake up in the morning and say, “I don’t know why most people think the way they do,” because people like the feeling of predictability and clean narratives. So they use the lessons of their own life experiences to create models of how they think the world should work – particularly for things like luck, risk, effort, and values.
And that’s a problem. When everyone has experienced a fraction of what’s out there but uses those experiences to explain everything they expect to happen, a lot of people eventually become disappointed, confused, or dumbfounded at others’ decisions.
A team of economists once crunched the data on a century’s worth of people’s investing habits and concluded: “Current [investment] beliefs depend on the realizations experienced in the past.”
Keep that quote in mind when debating people’s investing views. Or when you’re confused about their desire to hoard or blow money, their fear or greed in certain situations, or whenever else you can’t understand why people do what they do with money. Things will make more sense.
Historians are Prophets fallacy: Not seeing the irony that history is the study of surprises and changes while using it as a guide to the future. An over-reliance on past data as a signal to future conditions in a field where innovation and change is the lifeblood of progress.
Geologists can look at a billion years of historical data and form models of how the earth behaves. So can meteorologists. And doctors – kidneys operate the same way in 2018 as they did in 1018.
The idea that the past offers concrete directions about the future is tantalizing. It promotes the idea that the path of the future is buried within the data. Historians – or anyone analyzing the past as a way to indicate the future – are some of the most important members of many fields.
I don’t think finance is one of them. At least not as much as we’d like to think.
The cornerstone of economics is that things change over time, because the invisible hand hates anything staying too good or too bad indefinitely. Bill Bonner once described how Mr. Market works: “He’s got a ‘Capitalism at Work’ T-shirt on and a sledgehammer in his hand.” Few things stay the same for very long, which makes historians something far less useful than prophets.
Consider a few big ones.
The 401(K) is 39 years old – barely old enough to run for president. The Roth IRA isn’t old enough to drink. So personal financial advice and analysis about how Americans save for retirement today is not directly comparable to what made sense just a generation ago. Things changed.
The venture capital industry barely existed 25 years ago. There are single funds today that are larger than the entire industry was a generation ago. Phil Knight wrote about his early days after starting Nike: “There was no such thing as venture capital. An aspiring young entrepreneur had very few places to turn, and those places were all guarded by risk-averse gatekeepers with zero imagination. In other words, bankers.” So our knowledge of backing entrepreneurs, investment cycles, and failure rates, is not something we have a deep base of history to learn from. Things changed.
Or take public markets. The S&P 500 did not include financial stocks until 1976; today, financials make up 16% of the index. Technology stocks were virtually nonexistent 50 years ago. Today, they’re more than a fifth of the index. Accounting rules have changed over time. So have disclosures, auditing, and market liquidity. Things changed.
The most important driver of anything tied to money is the stories people tell themselves and the preferences they have for goods and services. Those things don’t tend to sit still. They change with culture and generation. And they’ll keep changing.
The mental trick we play on ourselves here is an over-admiration of people who have been there, done that, when it comes to money. Experiencing specific events does not necessarily qualify you to know what will happen next. In fact it rarely does, because experience leads to more overconfidence than prophetic ability.
"Money is meant to be used as a tool to build each other up and transfer energy into one another." -anonymous
7. The seduction of pessimism in a world where optimism is the most reasonable stance.
Historian Deirdre McCloskey says, “For reasons I have never understood, people like to hear that the world is going to hell.”
This isn’t new. John Stuart Mill wrote in the 1840s: “I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.”
Part of this is natural. We’ve evolved to treat threats as more urgent than opportunities. Buffett says, “In order to succeed, you must first survive.”
But pessimism about money takes a different level of allure. Say there’s going to be a recession and you will get retweeted. Say we’ll have a big recession and newspapers will call you. 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.
A few things are going on here.One is that money is ubiquitous, so something bad happening tends to affect everyone, albeit in different ways. That isn’t true of, say, weather. A hurricane barreling down on Florida poses no direct risk to 92% of Americans. But a recession barreling down on the economy could impact every single person – including you, so pay attention. This goes for something as specific as the stock market: More than half of all households directly own stocks.
Another is that pessimism requires action – Move! Get out! Run! Sell! Hide! “Optimism” is mostly a call to stay the course and enjoy the ride. So it’s not nearly as urgent.
A third is that there is a lot of money to be made in the finance industry, which – despite regulations – has attracted armies of scammers, hucksters, and truth-benders promising the moon. A big enough bonus can convince even honest, law-abiding finance workers selling garbage products that they’re doing good for their customers. Enough people have been bamboozled by the finance industry that a sense of, “If it sounds too good to be true, it probably is” has enveloped even rational promotions of optimism.
Most promotions of optimism, by the way, are rational. Not all, of course. But we need to understand what optimism is. Real optimists don’t believe that everything will be great. That’s complacency. Optimism is a belief that the odds of a good outcome are in your favor over time, even when there will be setbacks along the way. The simple idea that most people wake up in the morning trying to make things a little better and more productive than waking up looking to cause trouble is the foundation of optimism. It’s not complicated. It’s not guaranteed, either. It’s just the most reasonable bet for most people. The late statistician Hans Rosling put it differently: “I am not an optimist. I am a very serious possibility.”
8. Underappreciating the power of compounding, driven by the tendency to intuitively think about exponential growth in linear terms.
IBM made a 3.5 megabyte hard drive in the 1950s. By the 1960s things were moving into a few dozen megabytes. By the 1970s, IBM’s Winchester drive held 70 megabytes. Then drives got exponentially smaller in size with more storage. A typical PC in the early 1990s held 200-500 megabytes.
And then … wham. Things exploded.
1999 – Apple’s iMac comes with a 6 gigabyte hard drive.
2003 – 120 gigs on the Power Mac.
2006 – 250 gigs on the new iMac.
2011 – first 4 terabyte hard drive.
2017 – 60 terabyte hard drives.
Now put it together. From 1950 to 1990 we gained 296 megabytes. From 1990 through today we gained 60 million megabytes.
The punchline of compounding is never that it’s just big. It’s always – no matter how many times you study it – so big that you can barely wrap your head around it. In 2004 Bill Gates criticized the new Gmail, wondering why anyone would need a gig of storage. Author Steven Levy wrote, “Despite his currency with cutting-edge technologies, his mentality was anchored in the old paradigm of storage being a commodity that must be conserved.” You never get accustomed to how quickly things can grow.
I have heard many people say the first time they saw a compound interest table – or one of those stories about how much more you’d have for retirement if you began saving in your 20s vs. your 30s – changed their life. But it probably didn’t. What it likely did was surprise them, because the results intuitively didn’t seem right. Linear thinking is so much more intuitive than exponential thinking. Michael Batnick once explained it. If I ask you to calculate 8+8+8+8+8+8+8+8+8 in your head, you can do it in a few seconds (it’s 72). If I ask you to calculate 8x8x8x8x8x8x8x8x8, your head will explode (it’s 134,217,728).
The danger here is that when compounding isn’t intuitive, we often ignore its potential and focus on solving problems through other means. Not because we’re overthinking, but because we rarely stop to consider compounding potential.
There are over 2,000 books picking apart how Warren Buffett built his fortune. But none are called “This Guy Has Been Investing Consistently for Three-Quarters of a Century.” But we know that’s the key to the majority of his success; it’s just hard to wrap your head around that math because it’s not intuitive. There are books on economic cycles, trading strategies, and sector bets. But the most powerful and important book should be called “Shut Up And Wait.” It’s just one page with a long-term chart of economic growth. Physicist Albert Bartlett put it: “The greatest shortcoming of the human race is our inability to understand the exponential function.”
The counter intuitiveness of compounding is responsible for the majority of disappointing trades, bad strategies, and successful investing attempts. Good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off hits that kill your confidence when they end. It’s about earning pretty good returns that you can stick with for a long period of time. That’s when compounding runs wild.
9. Attachment to social proof in a field that demands contrarian thinking to achieve above-average results.
The Berkshire Hathaway annual meeting in Omaha attracts 40,000 people, all of whom consider themselves contrarians. People show up at 4 am to wait in line with thousands of other people to tell each other about their lifelong commitment to not following the crowd. Few see the irony.
Anything worthwhile with money has high stakes. High stakes entail risks of being wrong and losing money. Losing money is emotional. And the desire to avoid being wrong is best countered by surrounding yourself with people who agree with you. Social proof is powerful. Someone else agreeing with you is like evidence of being right that doesn’t have to prove itself with facts. Most people’s views have holes and gaps in them, if only subconsciously. Crowds and social proof help fill those gaps, reducing doubt that you could be wrong.
The problem with viewing crowds as evidence of accuracy when dealing with money is that opportunity is almost always inversely correlated with popularity. What really drives outsizes returns over time is an increase in valuation multiples, and increasing valuation multiples relies on an investment getting more popular in the future – something that is always anchored by current popularity.
Here’s the thing: Most attempts at contrarianism are just irrational cynicism in disguise – and cynicism can be popular and draw crowds. Real contrarianism is when your views are so uncomfortable and belittled that they cause you to second guess whether they’re right. Very few people can do that. But of course that’s the case. Most people can’t be contrarian, by definition. Embrace with both hands that, statistically, you are one of those people.
10. An appeal to academia in a field that is governed not by clean rules but loose and unpredictable trends.
Harry Markowitz won the Nobel Prize in economics for creating formulas that tell you exactly how much of your portfolio should be in stocks vs. bonds depending on your ideal level of risk. A few years ago the Wall Street Journal asked him how, given his work, he invests his own money. He replied:
I visualized my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.
There are many things in academic finance that are technically right but fail to describe how people actually act in the real world. Plenty of academic finance work is useful and has pushed the industry in the right direction. But its main purpose is often intellectual stimulation and to impress other academics. I don’t blame them for this or look down upon them for it. We should just recognize it for what it is.
One study I remember showed that young investors should use 2x leverage in the stock market, because – statistically – even if you get wiped out you’re still likely to earn superior returns over time, as long as you dust yourself off and keep investing after a wipeout. Which, in the real world, no one would actually do. They’d swear off investing for life. What works on a spreadsheet and what works at the kitchen table are ten miles apart.
The disconnect here is that academics typically desire very precise rules and formulas. But real-world people use it as a crutch to try to make sense of a messy and confusing world that, by its nature, eschews precision. Those are opposite things. You cannot explain randomness and emotion with precision and reason.
People are also attracted to the titles and degrees of academics because finance is not a credential-sanctioned field like, say, medicine is. So the appearance of a Phd stands out. And that creates an intense appeal to academia when making arguments and justifying beliefs – “According to this Harvard study …” or “As Nobel Prize winner so and so showed …” It carries so much weight when other people cite, “Some guy on CNBC from an eponymous firm with a tie and a smile.” A hard reality is that what often matters most in finance will never win a Nobel Prize: Humility and room for error.
11. The social utility of money coming at the direct expense of growing money; wealth is what you don’t see.
I used to park cars at a hotel. This was in the mid-2000s in Los Angeles, when real estate money flowed. I assumed that a customer driving a Ferrari was rich. Many were. But as I got to know some of these people, I realized they weren’t that successful. At least not nearly what I assumed. Many were mediocre successes who spent most of their money on a car.
If you see someone driving a $200,000 car, the only data point you have about their wealth is that they have $200,000 less than they did before they bought the car. Or they’re leasing the car, which truly offers no indication of wealth.
We tend to judge wealth by what we see. We can’t see people’s bank accounts or brokerage statements. So we rely on outward appearances to gauge financial success. Cars. Homes. Vacations. Instagram photos.
But this is America, and one of our cherished industries is helping people fake it until they make it.
Wealth, in fact, is what you don’t see. It’s the cars not purchased. The diamonds were not bought. The renovations were postponed, the clothes forgotten and the first-class upgrade declined. It’s assets in the bank that haven’t yet been converted into the stuff you see.
But that’s not how we think about wealth, because you can’t contextualize what you can’t see.
Singer Rihanna nearly went broke after overspending and sued her financial advisor. The advisor responded: “Was it really necessary to tell her that if you spend money on things, you will end up with the things and not the money?”
You can laugh. But the truth is, yes, people need to be told that. When most people say they want to be a millionaire, what they really mean is “I want to spend a million dollars,” which is literally the opposite of being a millionaire. This is especially true for young people.
A key use of wealth is using it to control your time and provide you with options. Financial assets on a balance sheet offer that. But they come at the direct expense of showing people how much wealth you have with material stuff.
12. A tendency toward action in a field where the first rule of compounding is to never interrupt it unnecessarily.
If your sink breaks, you grab a wrench and fix it. If your arm breaks, you put it in a cast.
What do you do when your financial plan breaks?
The first question – and this goes for personal finance, business finance, and investing plans
How do you know when it’s broken?
A broken sink is obvious. But a broken investment plan is open to interpretation. Maybe it’s just temporarily out of favor? Maybe you’re experiencing normal volatility? Maybe you had a bunch of one-off expenses this quarter but your savings rate is still adequate? It’s hard to know.
When it’s hard to distinguish broken from temporarily out of favor, the tendency is to default to the former, and spring into action. You start fiddling with the knobs to find a fix. This seems like the responsible thing to do, because when virtually everything else in your life is broken, the correct action is to fix it.
There are times when money plans need to be fixed. Oh, are there ever. But there is also no such thing as a long-term money plan that isn’t susceptible to volatility. Occasional upheaval is usually part of a standard plan.
When volatility is guaranteed and normal, but is often treated as something that needs to be fixed, people take actions that ultimately just interrupt the execution of a good plan. “Don’t do anything,” are the most powerful words in finance. But they are both hard for individuals to accept and hard for professionals to charge a fee for. So, we fiddle. Far too much.
13. Underestimating the need for room for error, not just financially but mentally and physically.
Ben Graham once said, “The purpose of the margin of safety is to render the forecast unnecessary.”
There is so much wisdom in this quote. But the most common response, even if subconsciously, is, “Thanks Ben. But I’m good at forecasting.”
People underestimate the need for room for error in almost everything they do that involves money. Two things cause this: One is the idea that your view of the future is right, driven by the uncomfortable feeling that comes from admitting the opposite. The second is that you’re therefore doing yourself economic harm by not taking actions that exploit your view of the future coming true.
But room for error is underappreciated and misunderstood. It’s often viewed as a conservative hedge, used by those who don’t want to take much risk or aren’t confident in their views. But when used appropriately it’s the opposite. Room for error lets you endure, 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 occur infrequently, either because they don’t happen often or because they take time to compound. So the person with-enough room for error in part of their strategy to let them endure hardship in the other part of their strategy has an edge over the person who gets wiped out, game over, insert more tokens, when they’re wrong.
There are also multiple sides to room for error. Can you survive your assets declining by 30%? On a spreadsheet, maybe yes – in terms of actually paying your bills and staying cash-flow positive. But what about mentally? It is easy to underestimate what a 30% decline does to your psyche. Your confidence may become shot at the very moment opportunity is at its highest. You – or your spouse – may decide it’s time for a new plan, or new career. I know several investors who quit after losses because they were exhausted. Physically exhausted. Spreadsheets can model the historic frequency of big declines. But they cannot model the feeling of coming home, looking at your kids, and wondering if you’ve made a huge mistake that will impact their lives.
14. A tendency to be influenced by the actions of other people who are playing a different financial game than you are.
Cisco stock went up three-fold in 1999. Why? Probably not because people actually thought the company was worth $600 billion. Burton Malkiel once pointed out that Cisco’s implied growth rate at that valuation meant it would become larger than the entire U.S. economy within 20 years.
Its stock price was going up because short-term traders thought it would keep going up. And they were right, for a long time. That was the game they were playing – “this stock is trading for $60 and I think it’ll be worth $65 before tomorrow.”
But if you were a long-term investor in 1999, $60 was the only price available to buy. So you may have looked around and said to yourself, “Wow, maybe others know something I don’t.” And you went along with it. You even felt smart about it. But then the traders stopped playing their game, and you – and your game – was annihilated.
What you don’t realize is that the traders moving the marginal price are playing a totally different game than you are. And if you start taking cues from people playing a different game than you are, you are bound to be fooled and eventually become lost, since different games have different rules and different goals.
Few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviors of people playing different games.
This goes beyond investing. How you save, how you spend, what your business strategy is, how you think about money, when you retire, and how you think about risk may all be influenced by the actions and behaviors of people who are playing different games than you are.
Personal finance is deeply personal, and one of the hardest parts is learning from others while realizing that their goals and actions might be miles removed from what’s relevant to your own life.
15. An attachment to financial entertainment due to the fact that money is emotional, and emotions are revved up by argument, extreme views, flashing lights, and threats to your wellbeing.
If the average American’s blood pressure went up by 3%, my guess is a few newspapers would cover it on page 16, nothing would change, and we’d move on. But if the stock market falls 3%, well, no need to guess how we might respond. This is from 2015: “President Barack Obama has been briefed on Monday’s choppy global market movement.”
Why does financial news of seemingly low importance overwhelm news that is objectively more important?
Because finance is entertaining in a way other things – orthodontics, gardening, marine biology – are not. Money has competition, rules, upsets, wins, losses, heroes, villains, teams, and fans that makes it tantalizingly close to a sporting event. But it’s even an addiction level up from that, because money is like a sporting event where you’re both the fan and the player, with outcomes affecting you both emotionally and directly, which is dangerous.
It helps, I’ve found, when making money decisions to constantly remind yourself that the purpose of investing is to maximize returns, not minimize boredom. Boring is perfectly fine. Boring is good. If you want to frame this as a strategy, remind yourself: opportunity lives where others aren’t, and others tend to stay away from what’s boring.
16. Optimism bias in risk-taking, or “Russian Roulette should statistically work” syndrome: An over attachment to favorable odds when the downside is unacceptable in any circumstance.
Nassim Taleb says, “You can be risk loving and yet completely averse to ruin.”
The idea is that you have to take risks to get ahead, but no risk that could wipe you out is ever worth taking. The odds are in your favor when playing Russian Roulette. But the downside is never worth the potential upside.
The odds of something can be in your favor – real estate prices go up most years, and most years you’ll get a paycheck every other week – but if something has 95% odds of being right, then 5% odds of being wrong means you will almost certainly experience the downside at some point in your life. And if the cost of the downside is ruin, the upside the other 95% of the time likely isn’t worth the risk, no matter how appealing it looks.
Leverage is the devil here. It pushes routine risks into something capable of producing ruin. The danger is that rational optimism most of the time masks the odds of ruining some of the time in a way that lets us systematically underestimate risk. Housing prices fell 30% last decade. A few companies defaulted on their debt. This is capitalism – it happens. But those with leverage had a double wipe-out: Not only were they left broken, but being wiped out erased every opportunity to get back in the game at the very moment the opportunity was ripe. A homeowner wiped out in 2009 had no chance of taking advantage of cheap mortgage rates in 2010. Lehman Brothers had no chance of investing in cheap debt in 2009.
My own money is bar-belled. I take risks with one portion and am a terrified turtle with the other. This is not inconsistent, but the psychology of money would lead you to believe that it is. I just want to ensure I can remain standing long enough for my risks to pay off. Again, you have to survive to succeed.
A key point here is that few things in money are as valuable as options. The ability to do what you want, when you want, with who you want, and why you want, has infinite ROI.
17. A preference for skills in a field where skills don’t matter if they aren’t matched with the right behavior.
This is where Grace and Richard come back in. There is a hierarchy of investor needs, and each topic here has to be mastered before the one above it matters😀
18. Denial of inconsistencies between how you think the world should work and how the world actually works, driven by a desire to form a clean narrative of cause and effect despite the inherent complexities of everything involving money.
Someone once described Donald Trump as “Unable to distinguish between what happened and what he thinks should have happened.” Politics aside, I think everyone does this.
There are three parts to this:
You see a lot of information in the world.
You can’t process all of it. So you have to filter.
You only filter in the information that meshes with the way you think the world should work.
Since everyone wants to explain what they see and how the world works with clean narratives, inconsistencies between what we think should happen and what actually happens are buried.
An example. Higher taxes should slow economic growth – that’s a common sense narrative. But the correlation between tax rates and growth rates is hard to spot. So, if you hold onto the narrative between taxes and growth, you say there must be something wrong with the data. And you may be right! But if you come across someone else pushing aside data to back up their narrative – say, arguing that hedge funds have to generate alpha, otherwise no one would invest in them – you spot what you consider a bias. There are a thousand other examples. Everyone just believes what they want to believe, even when the evidence shows something else. Stories over statistics.
Accepting that everything involving money is driven by illogical emotions and has more moving parts than anyone can grasp is a good start to remembering that history is the study of things happening that people didn’t think would or could happen. This is especially true with money.
19. Political beliefs driving financial decisions, influenced by economics being a misbehaved cousin of politics.
I once attended a conference where a well known investor began his talk by saying, “You know when President Obama talks about clinging to guns and bibles? That is me, folks. And I’m going to tell you today about how his reckless policies are impacting the economy.”
I don’t care what your politics are, there is no possible way you can make rational investment decisions with that kind of thinking.
But it’s fairly common. Look at what happens in 2016 on this chart. The rate of GDP growth, jobs growth, stock market growth, interest rates – go down the list – did not materially change. Only the president did:
Years ago I published a bunch of economic performance numbers by president. And it drove people crazy, because the data often didn’t mesh with how they thought it should based on their political beliefs. Soon after a journalist asked me to comment on a story detailing how, statistically, Democrats preside over stronger economies than Republicans. I said you couldn’t make that argument because the sample size is way too small. But he pushed and pushed, and wrote a piece that made readers either cheer or sweat, depending on their beliefs.
The point is not that politics don’t influence the economy. But the reason this is such a sensitive topic is because the data often surprises the heck out of people, which itself is a reason to realize that the correlation between politics and economics isn’t as clear as you’d like to think it is.
20. The three-month bubble: Extrapolating the recent past into the near future, and then overestimating the extent to which whatever you anticipate will happen in the near future will impact your future.
News headlines in the month after 9/11 are interesting. Few entertain the idea that the attack was a one-off; the next massive terrorist attack was certain to be around the corner. “Another catastrophic terrorist attack is inevitable and only a matter of time,” one defense analyst said in 2002. “A top counter-terrorism official says it’s ‘a question of when, not if,” wrote another headline. Beyond the anticipation that another attack was imminent was a belief that it would affect people the same way. The Today Show ran a segment pitching parachutes for office workers to keep under their desks in case they needed to jump out of a skyscraper.
Believing that what just happened will keep happening shows up constantly in psychology. We like patterns and have short memories. The added feeling that a repeat of what just happened will keep affecting you the same way is an offshoot. And when you’re dealing with money it can be a torment.
Every big financial win or loss is followed by mass expectations of more wins and losses. With it comes a level of obsession over the effects of those events repeating that can be wildly disconnected from your long-term goals. Example: The stock market falling 40% in 2008 was followed, uninterrupted for years, with forecasts of another impending plunge. Expecting what just happened to happen soon again is one thing, and an error in itself. But not realizing that your long-term investing goals could remain intact, unharmed, even if we have another big plunge, is the dangerous byproduct of recency bias. “Markets tend to recover over time and make new highs” was not a popular takeaway from the financial crisis; “Markets can crash and crashes suck,” was, despite the former being so much more practical than the latter.
Most of the time, something big happening doesn’t increase the odds of it happening again. It’s the opposite, as mean reversion is a merciless law of finance. But even when something does happen again, most of the time it doesn’t – or shouldn’t – impact your actions in the way you’re tempted to think, because most extrapolations are short term while most goals are long term. A stable strategy designed to endure change is almost always superior to one that attempts to guard against whatever just happened happening again.
If there’s a common denominator in these, it’s a preference for humility, adaptability, long time horizons, and skepticism of popularity around anything involving money. Which can be summed up as: Be prepared to roll with the punches.
Jiddu Krishnamurti spent years giving spiritual talks. He became more candid as he got older. In one famous talk, he asked the audience if they’d like to know his secret.
He whispered, “You see, I don’t mind what happens.”
That might be the best trick when dealing with the psychology of money.
Ryan
