We laud athletes on a winning streak, startups with a skyrocketing valuation, hedge funds seeing record-breaking returns, and so on. But it’s easy to look good when everything goes according to plan and the circumstances are calm. Anyone can succeed for a while, even if it’s just out of pure luck. Doing well is no great feat if you’re not being challenged or tested.

***

Products and services are only as good as they are when they break, not when everything is functioning fine.

When a program stops working, do you face a baffling error message with no further guidance or clear instructions for how to get help? Is customer service quick and easy to access at any time or does it require you to jump through endless convoluted hoops? Even if you’ve had a positive view of a product or service for years, a problem that takes forever to fix or a hostile response when you ask for help will no doubt make you take your business elsewhere.

From a customer standpoint, companies are only as good as how they behave in a public relations crisis.

Do they shirk blame and try to pin it elsewhere or do they take responsibility? Do they try to cover up what happened or do they come forward with the full truth? Do they ignore any damages or do they promise to make things better for everyone affected—no matter the cost? Reputations are fragile. One incident of bad behavior will linger in the minds of customers for a long time.

From a financial standpoint, companies prove their worth when they show how they cope when something fundamental changes in the market or there’s a financial crisis.

Do they persist with the old business model under the illusion that what worked before should work again, or do they reimagine their approach? Do they fire staff to preserve CEO bonuses or do they play the long game to ensure they’ll be able to attract top talent in the future? Do they crumble when there’s a powerful new competitor or do they rise to the challenge? Like companies, investors might be able to perform well in ideal conditions due to luck. But when the market crashes and there’s blood in the streets, very few will know how to cope or be prepared. Only the smartest will know how to survive or even profit.

Leaders are only as good as how they lead during times of uncertainty and fear.

Do they hide away from public sight or do they serve as a reassuring, sympathetic presence that brings everyone together? Do they do what’s defensible or what’s best for everyone in the long run? Are they forced to react in the moment or were they already prepared? Ask anyone to name the finest leaders in the history of their country and they’re not likely to name those who were in power during calm, peaceful times. They’ll name those who were at the helm during wars, economic crises, pandemics, natural disasters, and so on—those who never wavered from a vision and whose consistent, empathetic appearances gave people a sense of hope.

***

As individuals, we tell people the most about who we are when everything goes wrong. These times are also when we stand to learn the most about ourselves.

Your kids might not remember how you behaved on a relaxed, sunny Saturday when work went well all week and you had little on your mind beyond playing with them. But they’re sure to remember how you behaved on the day when you’d lost your job due to a recession, you’d just had an argument with your partner, an unexpected bill arrived in the mail that morning, and then someone spilled spaghetti sauce on the couch. That’s the day when your behavior has the most to show them about what to model in the future.

Your partner might not remember how you treated them when you were lying on a beach on holiday together with all of your worries far away and a good book in hand. But they’re sure to remember how you treated them when you had your worst disagreement ever, over a problem that seemed insurmountable and involved complex emotions. That’s the moment when they might well make a decision about whether they’re in this for the long haul.

Your boss might not remember the work you did on an average week when everything went to plan. But they’re sure to remember the time when you stepped up, stretched the limits of your abilities, and delivered what seemed impossible at short notice while everything around you was on fire. That’s what they’ll recall when thinking about what you’re capable of.

***

You’re only as good as your worst day. Not because what you do for the rest of the time doesn’t matter. Not because you should be expected to be perfect under immense stress or to behave according to plan when everything goes awry. But because what you do on your worst day is impossible to fake. It’s honest signaling. There’s little time for posturing or stalling. On your worst day, you reveal whether you’ve been planning for the possibility of disaster or just coasting along, enjoying the good times.

Your plans and preparation (or lack thereof) show how much you care about the people who depend on you. You get to build and strengthen bonds in ways that will last a lifetime, or you risk destroying relationships in moments. You get to build trust and respect or you might break what you have irreparably.

Your worst day is a chance to prove it to yourself. Very few people plan or prepare for what they’ll do and how they’ll act during those times. Those who do might well turn their worst day into their best.

The post You’re Only As Good As Your Worst Day appeared first on Farnam Street.

***

“The whole secret of investment is to find places where it’s safe and wise to non-diversify. It’s just that simple.”

— Charlie Munger

Goal: An investment algorithm to lean on hard when it is available. Low-risk, long-duration, above-average returns.

There are many paths to investment heaven (and we’ve written on the topic before). The diversity of working approaches demonstrates that. However, fundamentally, any useful approach must do three things:

1. It must work in all conceivable financial environments.
2. It must be within the “circle of competence” and “circle of interestingness” of its user.
3. It must meet the moral criteria of its user.

I believe the system below satisfies the first criterion, and allows for all three.

A 7–Element Algorithm for Equity Investing

Everyone Wins
Successful businesses have indefinitely sustainable business systems: owners, employees, customers, suppliers, all content.

Ballast for the Storm
Look for a sustainable balance sheet, given the capricious nature of the world. Past bad events do not predict future bad events. Sometimes inefficient balance sheets allow companies to survive by positioning them for all environments, not just optimizing for one.

Different and Hard to Match
Candidates must occupy a structurally profitable, indefinitely sustainable business niche, allowing for the truism that all moats are subject to being crossed eventually. There must be an element of mystery.

Operational Soundness
Reliable execution of the “blocking and tackling” of operations is a must. Getting this wrong always costs big, and can ruin a good niche.

A Few Simple Variables
Allowing for the difficulty of predicting the future, candidates should have just a few reasonably predictable economic variables that will dominate their outcomes. In the words of Warren Buffett, “There are all kinds of businesses where we have no idea what they’ll earn this year, let alone any future year.” Look for boring investments, sexy is usually complicated and full of competition. Look for what’s staying the same.

Long Runway
You should be able to foresee an indefinite period of growth ahead, through some combination of market creation, market penetration, and pricing power.

Priced Attractively
Stock should be priced so that stock returns >= business returns, always including a margin for error in forward-looking estimates.

Seemingly missing is the concept of “good management,” but I consider this redundant in light of the first four elements. Any business meeting those criteria is being managed properly, and any investment going 7/7 has a very low probability of failure.

Notice that the word indefinite is used several times. This does not mean the same thing as infinite. There are no infinities in the business world. Indefinite means “as far out as can presently be seen.”

Caution: what psychologists call the “representativeness heuristic” puts us at risk of over-fitting to this or any algorithm. Always be on guard. In the words of Richard Feynman, “Never fool yourself, and remember that you are the easiest person to fool.”

The post An Investment Approach That Works appeared first on Farnam Street.

Those who understand compound interest can make it work for them and those that don’t understand it spend much of life trying to get out from its shackles. When we think of compounding we typically think of finance and positive returns, as in “good compounding.” But compounding just reinforces what’s already happening — good or bad.  There is no judgment. And compounding works outside of finance. So while we can compound money positively and negatively, we can compound ourselves as well.

The neutrality of compounding is what makes it interesting — as we can get it work for us. If we can replace a negatively compounding habit or mental discipline with one that’s neutral or positive, we instantly get better. And if we can accelerate positive compounding, we can really see the results.

Tiny, nearly imperceptible changes can make a huge difference when you factor in time.  As the graph above demonstrates, the difference in tiny changes is astonishing.

Clear writes:

Here’s how the math works out: if you can get 1 percent better each day for one year, you’ll end up thirty-seven times better by the time you’re done. Conversely, if you get 1 percent worse each day for one year, you’ll decline nearly down to zero. What starts as a small win or a minor setback accumulates into something much more.

Habits are the compound interest of self-improvement. The same way that money multiplies through compound interest, the effects of your habits multiply as you repeat them. They seem to make little difference on any given day and yet the impact they deliver over the months and years can be enormous. It is only when looking back two, five, or perhaps ten years later that the value of good habits and the cost of bad ones becomes strikingly apparent.

When we watch people make small choices, like order a salad at lunch instead of a burger, the difference of a few hundred calories doesn’t seem to matter much. In the moment that’s true. These small decisions don’t matter all that much. However, as days turn to weeks and weeks to months and months to years those tiny repeatable choices compound. Consider another example, saving a little money right now won’t make you a millionaire tomorrow. But starting to save today makes it more likely you will become a millionaire in the future.

Our brains have a hard time intuitively understanding time, compounding, and uncertainty. All of those things conspire to work against us when it comes to habits and mental disciplines. Why choose to save $20 today when I could buy a bottle of wine and have instant pleasure? Our minds do not easily realize that $20 saved today could be $100 in the future. And if we do save the money, there is no certainty that it will compound positively, it could, after all, compound negatively and I end up with $15. Now you can begin to see why it’s easier to just live in the moment and do whatever you want.

Clear writes:

But when we repeat 1 percent errors, day after day, by replicating poor decisions, duplicating tiny mistakes, and rationalizing little excuses, our small choices compound into toxic results.

As an entrepreneur, I’m always looking for opportunities. The opportunities that interest me the most offer superior returns, low risk, and a long duration. Just as investing in companies can give you the opportunity to find all three, so does properly investing in yourself. Habits and mental disciplines are controllable, offer enormous opportunity for returns, have extremely low risk, and you can use them for the rest of your life. More importantly, they allow you to diverge from the herd and advantageous divergence is the name of the game.

The post Why Small Habits Make a Big Difference appeared first on Farnam Street.

From Elon Musk’s advice on how to tell if people are lying to how to win an argument, the problem is so pervasive and so fundamental to succeeding in life that I keep a running file whenever people have a clever way to help quickly determine who knows. An unlikely book offered another technique called Racking the Shotgun and it comes from a professional gambler.

80/20 Sales and Marketing by Perry Marshall tells the story of John Paul Mendocha, a friend of Marshall’s. At age 17, Mendocha dropped out of high school, hitchhiked to Vegas, and became a professional gambler.

A teenager, however, needs some street smarts so he found himself someone who would take him under his wing for a split of the profits. Mendocha found Rob, a seasoned gambler.

“Son, the first lesson about gambling is, you have to play games you can win. You need to play people who are not as good at poker as you are. Those people are called marks.”

One time, Rob wanted to show John something so they got into the car and headed to the Cabaret. They walked in and sat down amongst the blaring music, dancing women, and copious amounts of alcohol. Rob had a sawed off shotgun in his coat.

He pulled the shotgun out, slipped it under the table. He pressed the lever, popping the chamber open as if to load it. But instead of inserting a shell, he loudly snapped it back shut, with that sharp, signature ratcheting sound shotguns are famous for— what enthusiasts call “racking the shotgun.”

A few heads in the crowd twisted around, trying to see where the racking sound had come from. Everyone else was oblivious, absorbed in their haze of nightclub revelry. Then Rob slipped the gun back into his jacket.

The owner of the club came over to their table and asked if everything was ok.

“Everything’s fine, Bill. Just teaching the lad a lesson,” Rob replied. Then he leaned over and said to John, “John, the people who turned around— those guys are NOT marks. Do not play poker with them. “John, your job is to play cards with everybody else.”

The post Racking The Shotgun: Quickly Sorting Those Who Know from Those Who Act Like They Know appeared first on Farnam Street.

One day you hear that stocks are risky and the next that they’re indispensable. Some days it seems like stocks only go up and sometimes that they only go down. Real estate used to seem like an automatic path to wealth, and then the housing crisis hit. For the uninitiated, it sometimes seems there are no central truths. And unlike certain fields, we all have to deal with money. We can’t “opt out” from financial concerns unless we plan to live in a monastery, and it is useful for all of us to understand the basic ideas.

Investing is not a science but a craft, and a craftsman needs tools. In the case of investing, the tools are mostly mental. If we accumulate a few simple mental tools, we can start evaluating the claims of experts, salesmen, or simply well-intentioned friends.

The Rules of the Road

(1) The value of an asset depends entirely on the net cash it will
generate from now to the hereafter.

This goes for a stock, an apartment house, a convenience store, a bakery, or an iPhone app startup. An asset only has value (in a financial sense) if it can generate net cash flow to its owner. The amount and timing of that cash determines the value of the business. The more cash to be expected and the sooner it’s expected to come, the more valuable the asset is today. This is the fundamental truth about investing. Nothing escapes the orbit of future cash flows.

The other determinant of value is interest rates: The average future interest that could have earned if you bought a “risk-free” asset is the opportunity cost of the asset you’re considering purchasing today. That risk-free interest rate determines the value of an asset’s future cash flows to you today. (Although we don’t recommend trying to compute the figure out to three decimal places.) If average risk-free interest rates are 6% over time and I offer you a chance to buy an apartment house that pays you 4% on cost, is that a good buy? You better feel confident that the 4% will grow over time, right? This basic form of reasoning can be applied to all types of cash-producing assets.

This is the thing you should be thinking about when you’re instead thinking about what the Fed will be doing or what Jim Cramer said on TV or what the hot industry is or what the CEO of some company had for breakfast. Do you have any idea what the business or property will earn over the next five, ten, or twenty years in relation to what it earns now? This Grand Unifying Theory of investing gets discussed surprisingly little.

It also generates some sub-conclusions that aren’t always recognized by lay investors and are frequently forgotten by professionals.

(A) What an asset has earned in the past does not determine its value. In stocks, looking at the last ten years of earnings is a useful exercise in trying to understand what type of business you’re dealing with, but while it’s a good guide, past earnings do not generate value. Future earnings do, and that goes for all types of assets. This means you must develop a view about the future, which we’ll address again in point (2) below.

(B) An asset that never earns any net profit after all expenses has no financial value. Please let that sink in. It is common for businesses to obscure this basic fact, and promote all sorts of alternative methodologies with which you’re supposed to see value. Book value, EBITDA, number of page views, number of users, brand recognition, and years of managerial experience do not, in and of themselves, tell you about the value of a business or an asset. The bare fact is that an asset must eventually generate net cash flows to its owner which are commensurate with the price paid in order for the investment to be worthwhile. Investing on another basis is, by definition, speculation.

(C) If you have no idea what an asset will earn in the future (at least in a general sense), then you have no idea what it’s worth. And if you do not know what the asset is worth, then you have no idea whether you are over-paying or under-paying for it, and as an intellectually honest person, you should consider both possibilities at least equally likely.

(D) Any future cash flows out of an asset must also be subtracted in determining today’s value. If a business is going to lose money for 10 years and only then start making it, it’s worth a hell of a lot less than one which will make the same amount of money starting this year. This is another idea which gets surprisingly little play in relation to its obvious importance.

***

(2) Buying a share of stock is a buying share of the underlying business.

Although we’re discussing general investment concepts, the stock market needs a bit more attention because of its seemingly abstract nature. No one gets confused as to what they’re buying when they invest in a local dry-cleaner. Most fixed income instruments are priced in a fairly straightforward manner. But when it comes to businesses traded on the public exchanges, which we call stocks, all sorts of weird theories abound.

Stocks, for all of their labels and all of the strange fears and speculations around them, are no more than a piece of an underlying business pie. When you buy stock in a business, you are buying the right to the net cash flows that its assets produce. Stocks do not escape the orbit of financial gravity no matter what the Fed is doing or what CNBC is saying. And buying into an index fund that owns many stocks means that you’re now part-owner in all of the underlying businesses; your return comes from the success of their business operations. If American business as a whole keeps on trucking, the index fund will reflect their success, assuming you paid a rational price. That’s why averaging into the indexes is such a common recommendation for non-professional investors. Buying individual businesses in the form of stocks carries a heavier burden of proof and much more specialized work.

One corollary to this idea is that stock prices tend to move around much more than intrinsic business values. If you were to take the ten year business record of any of a number of very stable corporations and then guess their high and low stock prices in the same period, you would almost certainly be surprised at the degree of variation. The reason for this can be found in point (3).

***

(3) Investing in any asset with uncertain cash flows requires an
element of speculation about the future.

Discerning an asset’s cash flows requires that we make intelligent guesses about a cloudy future. This idea has some deep corollaries:

(A) The more speculation needed to determine the value of the asset, the riskier it is all else equal, due to the higher probability of getting our estimates wrong. In the case of a 1-Year U.S. Treasury bill, we don’t have to offer any speculation beyond assuming that the U.S. government will be solvent and paying 12 months from now and that the U.S. dollar will continue to be accepted as legal tender. (If this ceases to be true, we’re all in big trouble.)

In the case of a biotechnology startup, on the other hand, our entire valuation is going to be based on speculation. In essence, the whole exercise of valuing such a start-up would be making difficult guesses about the future. The probability that we get all of our guesses correct approaches zero, although if we’re correct enough about one or two important factors we might still make money. But we’ll need great luck in doing so, whereas with the Treasury bill, we hardly need any luck at all.

(B) Investing in uncertain assets, including any kind of business-based investment like a farm or a technology stock, involves some difficult speculation, so it’s easy to predict that at times, investors will get caught up in their enthusiasms and mis-price assets. Charlie Munger has commented that stocks are valued partly like Treasury bonds, with obvious cash flows estimated and discounted at rational rates, and partly like art or collectibles, with speculation that the price will go higher or lower because of popularity, trend, or hope. The riskiest assets are the ones valued primarily on speculation because of our lack of ability to see into their economic future. That’s why a corporate bond tends to be less risky than a stock — you only need to establish that the corporation will be solvent for the bond to be a good investment, whereas with the stock, you must make much more complicated estimates.

(C) We know from watching horse-race betting, casino gambling, and lottery participation that people are frequently willing to speculate on odds-against bets that can only hurt them financially in the long-run. We observe the same behavior in the stock market and in other markets as well. (There was, for example, a speculative farming boom in the 1980s.) Financial markets cannot be perfectly efficient because of the speculative element. As with (B) above, more uncertain assets tend to have a greater speculative element attached.

(D) Assets with predictable cash flows tend to be inherently lower-risk than ones without predictable cash flows. Let’s use two different types of businesses to understand this point.

We can be essentially certain that over the next year, Visa and MasterCard will make a tremendous amount of money which is closely related to the amount they made last year — their cash flows are based on the number of transactions made on their cards and the amount of money they collect per transaction. Both elements tend to be extremely stable on a day to day and year to year basis, with a tendency towards growth as new cards make it into circulation. Unless hundreds of millions of people stop using their credit and debit cards or million of merchants find a way to pay a lot less to these intermediaries (who collect very little to start), the businesses will maintain a useful degree of economic predictability. The number of transactions you made on your card last month and the month before pretty closely predicts how much you’ll use it this month and the following one.

As we move out further to year 2, we can still be pretty sure that these characteristics will continue to hold, and thus we can predict with useful accuracy the kind of money Visa/Mastercard will make. The same goes for year 3. However, the longer we continue this exercise, the more our accuracy declines. Although things look pretty good this year, next year, and the year after, what about 30 years from now? By then, one can speculate on the possibility of certain changes to the financial system which might affect the economics of Visa/Mastercard. Our earnings estimate 30 years out is certain to be inaccurate even for a predictable business.

The opposite case is Twitter. Twitter has never shown a net profit to its shareholders and has not established a consistent business model which would allow it to do so. Thus, it would be very difficult to say what Twitter’s earnings might be in the next year, let alone 30 years from now. On this basis, investing in the common stock of Twitter contains a much larger speculative element than Visa/Mastercard. An investment in Visa/Mastercard at a fair price in relation to future earnings can be said to have far less risk than an investment in Twitter. Notice that we don’t come to this conclusion by saying that Visa/Mastercard are riskless, that we can predict their earnings forever, or that Twitter will never be a profitable investment. We are simply ranking potential investments on a sliding scale based on the predictability of their future cash flows. Any estimates will be necessarily imprecise, but they still have great value to us as investors.

***

(4) The price you pay determines the return you get.
Lower prices = higher returns.

You’ll often hear fables about how now is the time to invest because “The market has done really well over the past few years” or because “My friend has made a lot of money on this stock, I think it’s a good investment,” or some similar statement about other kinds of financial assets; real estate properties, oil royalties, McDonald’s franchises, etc.

Conversely, one frequently hears things like “That stock’s gone way down recently, it seems pretty risky” or “My friend bought a bunch of real estate that went way down, I think real estate is risky” and other notions to that effect.

These thoughts are 180 degrees wrong because they fail to understand the point that low prices create high future returns and that high prices create low future returns. (“High” and “low” being in relation to underlying value.) If a stock trades at 50% of its recent high price, then you are buying the same future cash flows for half the price. If a stock trades at 200% of a recent low price, then the opposite is true; you’re getting exactly half the value you would have before.

You should seek to buy assets with future cash earnings you can (roughly) estimate at prices that offer a fair return. The rest is almost always noise.

***

(5) Everyone has a unique circle of competence which allows them to
understand certain things best and other things not at all.

We discussed above in point (3) that certain investment situations are inherently speculative, as with the case of Twitter common stock. But even within the realm of knowable investment choices, each investor has his or her own unique circle of competence which they bring to the analysis. In the circle are the things that, through life experience and/or accumulated study, one can fairly evaluate and expect to end up in the right ballpark. Outside of the circle are things we don’t have the experience to understand.

Although this point seems simple to the point of banality, it is constantly violated even by smart and financially-savvy people. Many an expert in construction businesses or plumbing businesses or restaurant businesses have tried their hand at buying apartment houses or energy stocks only to find out that their expertise did not carry over. And it is thus for all of us: We are prisoners to our talents, and we’re wise to think long and hard about what we really know and don’t know.

For example, if you do not have the ability to read financial statements, understand microeconomics, and assess the future underlying cash flows of an individual business, are stocks truly in your circle of competence? If you don’t know cap rates from Captain America, is it wise for you to try to get rich buying real estate properties? Unless and until we learn to be honest with ourselves, we will make mistakes that we don’t need to make.

***

Investing does not have to be rocket science. Once you understand the central concepts and begin learning to apply them, all it takes is discipline and intellectual honesty. Anyone can be a successful investor, broadly defined, by sticking to their circle of competence and not straying outside of it, by not speculating when they think they’re investing, and by always looking to pay a fair price in relation to what they’re buying. These three central tenets, closely followed, can allow any intelligent person to operate safely in the financial world.

Still Interested? Read more about Warren Buffett and Charlie Munger, whose ideas on investing have influenced generations of wise and successful investors. The best books we know of on the topic are The Intelligent Investor, Poor Charlie’s Almanack, Berkshire Hathaway’s Letters to Shareholders, and John Bogle’s book The Little Book of Common Sense Investing to learn about indexing.

The post Investing: The Rules of the Road appeared first on Farnam Street.

Buffett was a student of Graham’s at Columbia and subsequently worked for him before breaking off on his own.

“Chapters 8 and 20 have been the bedrock of my investing activities for more than 60 years,” he says. “I suggest that all investors read those chapters and reread them every time the market has been especially strong or weak.”

So what’s the core of these two chapters?

The Investor and Market Fluctuations

Buffett explains in his 1987 letter to shareholders:

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.

… [A]n investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben’s Mr. Market concept firmly in mind.

Margin of Safety as the Central Concept of Investment

The core of this idea to know what a business is worth and pay less.

Again Buffett explains in his own words. At the 1997 annual meeting, Buffett explains this concept (quoted from Andrew Kilpatrick’s, Of Permanent Value: The Story of Warren Buffett)

If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.

When Mr. Market is happy he can materially erode the “margin of safety” that is the cornerstone of Buffett and Graham’s approach to investing.

Still curious? If you want to learn more about investing, there is no better education than the legendary investor himself. Read his shareholder letters online for free, in Kindle eBook, or book.

The post Warren Buffett — The Best Book On Investing And What It Can Teach You appeared first on Farnam Street.

…you don’t win by predicting the future; you win by getting the odds right. You can be right about the future and still not make any money. At the racetrack, for example, the favorite horse may be the one most likely to win, but since everyone wants to bet on the favorite, how likely is it that betting on the favorite will make you money? The horse to bet on is the one more likely to win than most people expect. That’s the one that gives you the best odds. That’s the bet that pays off over time.

And here is Charlie Munger speaking about the same topic:

The model I like to sort of simplify the notion of what goes o­n in a market for common stocks is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based o­n what’s bet. That’s what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so o­n and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it’s very hard to beat the system.

And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you’ve got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work.

The post May The Odds Be Ever in Your Favor appeared first on Farnam Street.

Simon compares successful scientific research with successful stock-market investing. What do they have in common?

Both scientists and investors are looking for mispriced bets.

[S]uccessful scientific research has much in common with successful stock-market investment. Information is only valuable if others do not have it or do not believe it strongly enough to act on it. The investor pits his knowledge, beliefs and guesses against the knowledge, beliefs and guesses of others.

In neither domain—science or the stock market—is the professional looking for a “fair bet.” On the contrary, he or she is looking for a situation where superior knowledge—knowledge not yet available to others—can be made, with some reasonable assurance, to pay off.

Sometimes that superior knowledge comes from persistence in acquiring more “chunks” than most others have. Sometimes it comes from the accidents that have already been mentioned. But whatever its source, it seldom completely eliminates the element of risk. Investors and scientists require a “contrarian” streak that gives them the confidence to pit their knowledge and judgment against the common wisdom of their colleagues.

If you want to learn more about Herbert Simon, I recommend reading Models of My Life.

The post The Hidden Link Between Scientific Research and Investing appeared first on Farnam Street.

In the early 1700s, Europeans discovered in the Pacific Ocean a large, unpopulated island with a temperate climate, rich in all nature’s bounty except coal, oil, and natural gas. Reflecting its lack of civilization, they named this island “Basicland.”

The Europeans rapidly repopulated Basicland, creating a new nation. They installed a system of government like that of the early United States. There was much encouragement of trade, and no internal tariff or other impediment to such trade. Property rights were greatly respected and strongly enforced. The banking system was simple. It adapted to a national ethos that sought to provide a sound currency, efficient trade, and ample loans for credit-worthy businesses while strongly discouraging loans to the incompetent or for ordinary daily purchases.

Moreover, almost no debt was used to purchase or carry securities or other investments, including real estate and tangible personal property. The one exception was the widespread presence of secured, high-down-payment, fully amortizing, fixed-rate loans on sound houses, other real estate, vehicles, and appliances, to be used by industrious persons who lived within their means. Speculation in Basicland’s security and commodity markets was always rigorously discouraged and remained small. There was no trading in options on securities or in derivatives other than “plain vanilla” commodity contracts cleared through responsible exchanges under laws that greatly limited use of financial leverage.

In its first 150 years, the government of Basicland spent no more than 7 percent of its gross domestic product in providing its citizens with essential services such as fire protection, water, sewage and garbage removal, some education, defense forces, courts, and immigration control. A strong family-oriented culture emphasizing duty to relatives, plus considerable private charity, provided the only social safety net.

The tax system was also simple. In the early years, governmental revenues came almost entirely from import duties, and taxes received matched government expenditures. There was never much debt outstanding in the form of government bonds.

As Adam Smith would have expected, GDP per person grew steadily. Indeed, in the modern area it grew in real terms at 3 percent per year, decade after decade, until Basicland led the world in GDP per person. As this happened, taxes on sales, income, property, and payrolls were introduced. Eventually total taxes, matched by total government expenditures, amounted to 35 percent of GDP. The revenue from increased taxes was spent on more government-run education and a substantial government-run social safety net, including medical care and pensions.

A regular increase in such tax-financed government spending, under systems hard to “game” by the unworthy, was considered a moral imperative—a sort of egality-promoting national dividend—so long as growth of such spending was kept well below the growth rate of the country’s GDP per person.
Basicland also sought to avoid trouble through a policy that kept imports and exports in near balance, with each amounting to about 25 percent of GDP. Some citizens were initially nervous because 60 percent of imports consisted of absolutely essential coal and oil. But, as the years rolled by with no terrible consequences from this dependency, such worry melted away.

Basicland was exceptionally creditworthy, with no significant deficit ever allowed. And the present value of large “off-book” promises to provide future medical care and pensions appeared unlikely to cause problems, given Basicland’s steady 3 percent growth in GDP per person and restraint in making unfunded promises. Basicland seemed to have a system that would long assure its felicity and long induce other nations to follow its example—thus improving the welfare of all humanity.

But even a country as cautious, sound, and generous as Basicland could come to ruin if it failed to address the dangers that can be caused by the ordinary accidents of life. These dangers were significant by 2012, when the extreme prosperity of Basicland had created a peculiar outcome: As their affluence and leisure time grew, Basicland’s citizens more and more whiled away their time in the excitement of casino gambling. Most casino revenue now came from bets on security prices under a system used in the 1920s in the United States and called “the bucket shop system.”

The winnings of the casinos eventually amounted to 25 percent of Basicland’s GDP, while 22 percent of all employee earnings in Basicland were paid to persons employed by the casinos (many of whom were engineers needed elsewhere). So much time was spent at casinos that it amounted to an average of five hours per day for every citizen of Basicland, including newborn babies and the comatose elderly. Many of the gamblers were highly talented engineers attracted partly by casino poker but mostly by bets available in the bucket shop systems, with the bets now called “financial derivatives.”

Many people, particularly foreigners with savings to invest, regarded this situation as disgraceful. After all, they reasoned, it was just common sense for lenders to avoid gambling addicts. As a result, almost all foreigners avoided holding Basicland’s currency or owning its bonds. They feared big trouble if the gambling-addicted citizens of Basicland were suddenly faced with hardship.

And then came the twin shocks. Hydrocarbon prices rose to new highs. And in Basicland’s export markets there was a dramatic increase in low-cost competition from developing countries. It was soon obvious that the same exports that had formerly amounted to 25 percent of Basicland’s GDP would now only amount to 10 percent. Meanwhile, hydrocarbon imports would amount to 30 percent of GDP, instead of 15 percent. Suddenly Basicland had to come up with 30 percent of its GDP every year, in foreign currency, to pay its creditors.

How was Basicland to adjust to this brutal new reality? This problem so stumped Basicland’s politicians that they asked for advice from Benfranklin Leekwanyou Vokker, an old man who was considered so virtuous and wise that he was often called the “Good Father.” Such consultations were rare. Politicians usually ignored the Good Father because he made no campaign contributions.

Among the suggestions of the Good Father were the following. First, he suggested that Basicland change its laws. It should strongly discourage casino gambling, partly through a complete ban on the trading in financial derivatives, and it should encourage former casino employees—and former casino patrons—to produce and sell items that foreigners were willing to buy. Second, as this change was sure to be painful, he suggested that Basicland’s citizens cheerfully embrace their fate. After all, he observed, a man diagnosed with lung cancer is willing to quit smoking and undergo surgery because it is likely to prolong his life.

The views of the Good Father drew some approval, mostly from people who admired the fiscal virtue of the Romans during the Punic Wars. But others, including many of Basicland’s prominent economists, had strong objections. These economists had intense faith that any outcome at all in a free market—even wild growth in casino gambling—is constructive. Indeed, these economists were so committed to their basic faith that they looked forward to the day when Basicland would expand real securities trading, as a percentage of securities outstanding, by a factor of 100, so that it could match the speculation level present in the United States just before onslaught of the Great Recession that began in 2008.

The strong faith of these Basicland economists in the beneficence of hypergambling in both securities and financial derivatives stemmed from their utter rejection of the ideas of the great and long-dead economist who had known the most about hyperspeculation, John Maynard Keynes. Keynes had famously said, “When the capital development of a country is the byproduct of the operations of a casino, the job is likely to be ill done.” It was easy for these economists to dismiss such a sentence because securities had been so long associated with respectable wealth, and financial derivatives seemed so similar to securities.

Basicland’s investment and commercial bankers were hostile to change. Like the objecting economists, the bankers wanted change exactly opposite to change wanted by the Good Father. Such bankers provided constructive services to Basicland. But they had only moderate earnings, which they deeply resented because Basicland’s casinos—which provided no such constructive services—reported immoderate earnings from their bucket-shop systems. Moreover, foreign investment bankers had also reported immoderate earnings after building their own bucket-shop systems—and carefully obscuring this fact with ingenious twaddle, including claims that rational risk-management systems were in place, supervised by perfect regulators. Naturally, the ambitious Basicland bankers desired to prosper like the foreign bankers. And so they came to believe that the Good Father lacked any understanding of important and eternal causes of human progress that the bankers were trying to serve by creating more bucket shops in Basicland.

Of course, the most effective political opposition to change came from the gambling casinos themselves. This was not surprising, as at least one casino was located in each legislative district. The casinos resented being compared with cancer when they saw themselves as part of a long-established industry that provided harmless pleasure while improving the thinking skills of its customers.

As it worked out, the politicians ignored the Good Father one more time, and the Basicland banks were allowed to open bucket shops and to finance the purchase and carry of real securities with extreme financial leverage. A couple of economic messes followed, during which every constituency tried to avoid hardship by deflecting it to others. Much counterproductive governmental action was taken, and the country’s credit was reduced to tatters. Basicland is now under new management, using a new governmental system. It also has a new nickname: Sorrowland.

The post Basically, It’s Over: A Parable About How One Nation Came To Financial Ruin appeared first on Farnam Street.

The great defect of scale, of course, which makes the game interesting—so that the big people don’t always win—is that as you get big, you get the bureaucracy. And with the bureaucracy comes the territoriality—which is again grounded in human nature.

And the incentives are perverse. For example, if you worked for AT&T in my day, it was a great bureaucracy. Who in the hell was really thinking about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-basket into somebody else’s in-basket. But, of course, it isn’t. It’s not done until AT&T delivers what it’s supposed to deliver. So you get big, fat, dumb, unmotivated bureaucracies.

They also tend to become somewhat corrupt. In other words, if I’ve got a department and you’ve got a department and we kind of share power running this thing, there’s sort of an unwritten rule: “If you won’t bother me, I won’t bother you and we’re both happy.” So you get layers of management and associated costs that nobody needs. Then, while people are justifying all these layers, it takes forever to get anything done. They’re too slow to make decisions and nimbler people run circles around them.

The constant curse of scale is that it leads to big, dumb bureaucracy—which, of course, reaches its highest and worst form in government where the incentives are really awful. That doesn’t mean we don’t need governments—because we do. But it’s a terrible problem to get big bureaucracies to behave.

So people go to stratagems. They create little decentralized units and fancy motivation and training programs. For example, for a big company, General Electric has fought bureaucracy with amazing skill. But that’s because they have a combination of a genius and a fanatic running it. And they put him in young enough so he gets a long run. Of course, that’s Jack Welch.

But bureaucracy is terrible …. And as things get very powerful and very big, you can get some really dysfunctional behavior. Look at Westinghouse. They blew billions of dollars on a bunch of dumb loans to real estate developers. They put some guy who’d come up by some career path—I don’t know exactly what it was, but it could have been refrigerators or something—and all of a sudden, he’s loaning money to real estate developers building hotels. It’s a very unequal contest. And in due time, they lost all those billions of dollars.

The core problem is simple: bureaucracies optimize for bureaucrats, not results.

When you have a department and I have a department, we settle into an unspoken agreement: don’t challenge my turf, I won’t challenge yours. This creates organizational sediment that accumulates over time, slowing everything down.

The greatest cost isn’t just slow decisions or wasted resources – it’s the human potential left unrealized. Every time someone’s initiative is crushed by process, or their creativity stifled by territorial politics, we all lose something valuable.

***

You can learn a lot from Warren Buffett and Charlie Munger. Reading the Berkshire Hathaway Letters to Shareholders was better than my MBA. I’m serious.

The post Charlie Munger Explains Why Bureaucracy is not Shareholder Friendly appeared first on Farnam Street.