“The real measure of your wealth is how much you’d be worth if you lost all your money.”
“In my short time in Washington I’ve seen firsthand how the system is broken. A small group of failed voices who think they know everything and understand everyone want to tell everybody else how to live and what to do and how to think. But you aren’t going to let other people tell you what you believe, especially when you know that you’re right.”
– Donald Trump
I love capitalism. I think capitalism has done wonders for society and for humanity. There hasn’t been any other tool that is capable of lifting people in such quantities out of poverty and improving the living standards and upward mobility of so many people. But the older I get, the more I start to feel like there are some mistakes in what we think of as capitalism. Things that seem like they make sense but then when you see it play out in reality they really don’t.
One of the tenants of capitalism is that people behave rationally in their purchases and investments. That they consider and weigh the pros and cons of most of their investment decisions which creates an efficient market with prices that reflect overall supply and demand. People thinking carefully about their decision to pay a certain price for a good or service creates an efficient market. If the price is too high, nobody buys it and the price falls; if the price is too low, lots of people buy it and then the business sees they could make more profit and the price goes up.
But people are emotional creatures and most of the time we buy some item it’s because we like it or love it. People buy things that are bad for them all the time and I think that most investing and purchasing decisions are actually done emotionally, not rationally. Almost to the extent that I would say most investments and purchases are in fact not being rational. When a person buys a house, which for most people is their biggest asset, most of the time I’d say they aren’t weighing up the future equity growth or market dynamics. They just fell in love with the house, that’s why they bought it.
I think that phenomenon actually translates to investing without realising. Where we buy or invest in assets emotionally. Except I think this isn’t the minority, it’s actually the majority of people. But if a market is made of people and most purchasing or investing is done emotionally, then a market is therefore not rational. Any pretence that a market is made up of rational actors is just wrong. So the concept of a rational efficient market by definition can’t be rational or efficient if it’s made up of a bunch of emotional people making emotional decisions.
But since our understanding of underlying value and of prices is the equilibrium formed by rational actors. If there are no rational actors, does that mean all prices and values of everything is basically just emotional guesses? It basically means everything we think of as assets and markets and an efficient market price is at it’s core a bunch of emotional people making giant guesses and then putting all their money into these emotional guesses. Which causes the prices to go up and down accordingly.
But so much of the world is just markets. Which makes this sobering thing to think about and makes me feel akin to thinking that the whole concept of a market is an emperor that is wearing no clothes. My whole life in economics I was taught that market participants are rational actors and then I got older and realised that in fact, nobody in the market was rational and it was all just made up to begin with.
Compound Annual Growth Rate
The way you measure returns in an asset like shares or property is with the Compound Annual Growth Rate (CAGR). Basically it’s just the average of the growth per year divided by the amount of time you’ve owned it for. So for example, you could say a house or share of a business grows at a CAGR of 5%. That means that on average if you own this house or share, it’ll give you a 5% return per year. Which is very reasonable. Things like the S&P500 stock market index returns an average of 8% – 10% per year.
This intuitively gives the impression that the growth looks something like a linear straight line up and is therefore reasonably predictable. But that’s not actually the case. Because when you actually dive deeper and investigate exactly what the year to year returns are sometimes it looks completely out of whack. A property with a CAGR of 5% over 10 years may actually return 0% per year for 9 years and then 50% in year 10. That equals a CAGR of 5%. But then if you actually buy the thing and hold it for 9 years, you’re getting nothing, then all of a sudden you get all the returns in the 10th year.
A lot of things perform like this. Long flat periods followed by short and sharp growth before being followed by more long flat periods. The S&P 500 index itself sometimes swings by as much as a 30% loss or profit per year. Real estate is famous as an asset for being flat for 5 years, then grows a lot in 1 year, then being flat for another 5 years. That’s the problem with it. In this example, how likely is a person owning the asset to really hold it for 5 years or 10 years to get the CAGR of 5%?Most of the time someone is going to buy it, get no growth for many years and then give up and sell, achieving a bad return of basically nothing. It’s even worse if you account for inflation.
CAGR doesn’t factor in the reality of human behaviour. People like to see numbers going up consistently per year. They don’t like flat periods then sudden upswings, even if the average growth per year ends up being the same. Because long flat periods make you feel like you’ve made a mistake and have done something wrong that needs to be fixed. So the property in the above example that produces a CAGR of 5%, I would say 90% of the people who are owning that property are going to end up with no growth and only 10% are going to hold onto it long enough to pick up that 50% jump in year 10.
The key insight to this is that growth is never linear. Even if it looks linear, it usually isn’t. And the holding periods to make the growth seem linear are so long that few people ever materially realise the gains. Tons of people buy the S&P 500 expecting safe 10% per year returns only for it to swing down and they lose 20% that year and they get scared and sell. They don’t realise that to get the 10% consistent CAGR returns, they may only get the bulk of that growth in the 5th year they’re holding it for.
But the CAGR of an index is usually the benchmark by which you measure your own returns when making investments. Are you beating the index or not? Because if you’re not then the investment is probably not a good idea because you could just put your money into the S&P 500 index and get the average return of 10% per year, right? Wrong, because that year the index might have lost 20% of it’s money and if your investment makes you even 2% that year, it was better than the index.
Even though if you looked at an investment that yielded a 2% return, you probably wouldn’t do it because you’d think you could get 10% in the index. And just end up losing lots of money that year. This is something that I think happens to a lot of people when they invest money. A lot of very good but mediocre returning investments in the 1%-5% range are overlooked because of CAGR number benchmarks that never eventuate in the year they’re talking about.
I think this is because to get those consistent CAGR return numbers, the holding period basically has to be forever. But for most people with most things your time horizon isn’t forever. You need money at different points in life. So almost the whole idea of a benchmark is wrong and sets people up for unrealistic expectations. So people constantly think they’re doing worse than they are. You can only benchmark against a return in the same year it happens, not a generalised average return over a long period of time. If you own a stock and you lose 10% on it, that’s actually a good return if the index loses 20% that same year.
People’s behaviours is determined by price signals. When something is expensive, people buy less of it and when something is cheap, people buy more of it. That seems to make sense right? Except that one of the fastest growing largest companies in the world is LVMH, the maker of high end fashion and luxury goods. This is a company that owns brands like Luis Vuitton and Tiffany’s, where they sell a Tshirt for $1,000. And if the growth of the business tells us anything, people are lining up in droves to pay $1,000 for clothes and items they can get for 1/1000th the cost elsewhere. For practically the same item but without the brand name.
There was a great talk I heard once where the CEO of a big company was asked how he sets the price of his products. His answer was as much as he thought the market could bear, then add 10%. The audience laughed at this answer but it made me realise that what he’s talking about is literally trying to make something as expensive as possible. The CEO is absolutely not worried about competition or people not buying his product because it’s too expensive. In fact he thinks that the more expensive his product is, the more it will sell. Which completely flies in the face of conventional economics.
I think that what happens in reality is that price signals only send signals to people who can’t afford something. It isn’t so much as a signal as a hurdle. Are you above this hurdle? Then you can buy this product. If you’re not above the hurdle then you can’t. And the hurdle is basically a type of pseudo club that you become part of if you’re over the hurdle. Such that you buy the product because the brand says to other people that you’re rich enough to be over the hurdle. That’s actually what a price signal is.
That brand then sends informal social cues to everyone who sees it that you are of high status. The purchaser is not trying to buy value, they are trying to buy social status. But social status is not something that is measured in value and price graphs. It’s intrinsically not something that can be measured. Because everyone’s social circles are different. Which means there is a whole immeasurable shadow at work behind the concept of a price of a product. The status of the peer group of the person purchasing.
Innovation Doesn’t Matter
One of the things you realise is that almost everything that exists in the world is made by a company or business. Everything you see or touch or go to in the world, some business somewhere is making that thing and earning a profit from it. They have employees that help them make that thing and customers that buy it. The world of work is so massive, it is truly hard to comprehend just how big it is. And that’s just products, the services world are just as large, if not bigger.
That’s when you realise in the vast world of business, marketing is more important than product. Competition between businesses often aren’t based on product improvements. They’re based on improving operational efficiencies and better marketing. When fast food or grocery or big oil companies compete, they’re competing on marketing not on product. Their products are all similar. It’s the same thing with most services. When multiple plumbers are competing with each other for work, they both basically do exactly the same thing. The plumber with the better marketing will usually win.
That is to say, most items in the world aren’t revolutionary leaps in innovation. They’re just a slightly better thing than what was previously being used. Or a slightly better service than was previously used. This isn’t to say the incentives aren’t there to create new products that will sell. But most products or services in the world aren’t new. They are just a small improvement on already existing things. In fact, totally new things often challenge peoples perceptions to the point they usually don’t want to use it. Because they’re too new, people’s behaviour hasn’t caught up.
Most entrepreneurs I meet have this fear that if they aren’t first to release a product then their company won’t succeed. But then when you look at all the big successful companies, most of what they make is the same thing everyone else makes. I’m of course not talking about the mega corporations that continuously research and make new products like big drug or tech companies. I’m talking about just your average giant company.
Most billion dollar companies in the world don’t actually seem that innovative. They just take things people want and get it to them easily for a fair price. They don’t invent anything or produce anything new. But there is a lingering view that to succeed you have to be at the brink of innovation, riding waves of failure, until you create some brand new thing everybody flocks to. But that isn’t the case. Incremental product improvements with incrementally better marketing is how success really happens. Not innovative revolutionary new things.
Monopolies Are Bad
In university economics you’re taught that monopolies are bad for society. That it leads to big companies that act badly and have no incentive to produce newer and better products or lower prices. That very large companies start to mistreat their customers and workers when they are a monopoly because customers have no alternative. The monopoly then extracts too much value out of the market hurting other suppliers and industries.
That may have been the case many decades ago in the age of monopolistic railroad barons and the proletariat overthrowing the bourgeoisie. Where the owners of the capital and means of production took advantage of the labour that produced it. But today I think a lot of the monopolies in the world are nice monopolies. They’re firms like Google (search) and Facebook (social) and so on which actually make a lot of useful things for free that they give away.
Because they have their core products making vast profits. Instead of extracting value from the market to the detriment of others, they have an essentially unlimited money tap that there is no risk of being turned off. Because of that it gives them the freedom to back global moonshots and invest capital in projects that have no hope of generating returns. The monopoly profits essentially subsidise all variety of hugely capital intensive research and development.
Google because it makes monopoly profits from Search is able to release global world class products like Maps and Gmail and Chrome absolutely free with no expectation of making money from those products. Because they make their money from the unlimited money tap of their monopoly product. In this way, the idea of a monopoly being bad for society has suddenly shifted to some monopolies being good for society.
In an increasingly globalised winner take all world. If all monopolies were like Google, then we’d have an unlimited supply of truly incredible new products with zero expectation of any meaningful return from the product maker. This would be a very beneficial thing for society. You almost want there to be a lot more monopolies in the world that are like Google. So monopolies aren’t always bad.
Large Companies Crush Competition
Large companies try to crush their competitors by using their size and network to employ unfair business strategies. My favourite story of this is Apple computers when they were releasing the iphone bought all the touch screen compatible glass in the world. This basically gave them a multi year headstart before their competitors could even acquire the glass they needed to release their own touch screen phones. In retail another example is using volume sales to strong arm a supplier to give you a better price that might be unprofitable or unsustainable for them to do so.
We get an intuitive sense from this that that large company by using shrewd business practices will therefore be around for a long time. But that isn’t the case. In fact none of the 50 largest companies 50 years ago are the 50 largest companies today. That’s a line you have to read again. It plays out over and over again in history. The largest companies never stay the largest. They always get beaten by the new businesses that come along and eat their lunch.
That means it isn’t that large companies crush competitors, it’s the competitors that almost always come and crush the large companies. The top companies around today, Apple, Microsoft, Google. You can almost guarantee that in 50 years they won’t be the top companies in the world. They will get disrupted by new businesses who will someday become the new Apple , Google or Microsoft.
It’s because we collectively underestimate how fast things change and how fast things can grow. Even the largest companies are killed almost overnight sometimes by changing technology or consumer preferences. So what happens is actually it isn’t the large company that does the killing. It’s the business that gets killed.
Diversification is Required
One of the most attractive concepts in investing is diversification and you’re taught how important it is at the start. Because what it seems to mean is that you can get most of your gains while reducing the risk of losses. That it saves you from potential losses and making bad decisions. But what isn’t exactly clear in that is you also remove most of your upside gains when you do this.
Why? Because the world works with a built in power law distribution. Most of the upside in a given industry go to the winner. Most of the returns in the stock market are only in a handful of companies. When you concentrate an asset portfolio you also concentrate the upside and downside returns you get. It is very much live by the sword, die by the sword.
But if you look at the portfolios of the most successful investors or company builders. They’re rarely diversified. In fact most of the time their fortunes are built on just a handful of ideas or businesses, usually even just one or two. This is because they intuitively understand the compounding nature of the performance of the best thing. If you own the best thing, you’re not doing 10X better, sometimes you’re doing 10,000X better.
I think rich people and athletes and anyone succeeding improbably intuitively understand this because they’ve experienced it. Most of the rich people I know have more than 50% of their net worth in just one thing, a business or home. They don’t bother with diversification at all. This seems to track, you don’t get really rich by diversifying.
Why? Because it’s a defensive strategy. It limits your downside but also your upside. But making money is all about balancing risk and reward. To get more reward you have to take more risk. When you take less risk, you get less reward. Diversifying therefore limits your upside in the name of safety. But I think most people who do this don’t realise that’s what it does.
Some of the greatest investors in history openly don’t believe that diversification is something an investor should even do. That it should be avoided at all costs if you can help it. Diversifying into other ideas is akin to putting money into your 5th and 6th best idea instead of putting more money into your 1st and 2nd best ideas.
I think diversification as a concept started with good intentions. That it tried to minimise people’s losses. I think it meant to mean, don’t put so much of your net worth in something that if it goes badly and you lose it all you’ll end up on the street. But I think as the idea got parsed through business schools it morphed into something else entirely. A strategy for achieving low upside with low downside. Which is a strategy for getting to first base not hitting a home run.
Competition Competing Down Prices
Competition is supposed to decrease the price of something. But you have only to go to a housing auction to see that sometimes competition actually raises prices. The argument there would be because they’re competing for 1 item. But that’s not always the case. Sometimes competition en masse for something that is a commodity also raises prices.
What happens in a world full of software companies where the supply is basically infinite? You would think that they compete prices down to zero. But that doesn’t happen. Almost every software company in the world that charges money has another software company that offers the same product for free. But what happens? They both usually grow. Millions of people in the world are paying for Microsoft Word and Excel even though Libreoffice also exists, is free and does the same thing.
Free alternatives in that scenario don’t compete the price down to zero. In fact having a free alternative does almost nothing. I don’t think Libreoffice even meaningfully effected the growth of Word and Excel and in that time I think the price of buying the software actually grew. It used to be a one time purchase, now it’s a yearly subscription. So actually perfect competition sometimes does nothing to prices.
I think a lot of the economics theory was created in a world of physical goods and isn’t ready for a world of digital goods. With low to zero unit economics sometimes and infinite worldwide digital distribution. But we still use this theory because we haven’t got a good replacement economic theory that explains what’s happening in a way that makes sense
For example it used to be that companies were profit extracting machines whose goal of operating a business was profits. They earned revenue and made a profit on that revenue. That made sense. A generation of investors were then taught to value companies using Earnings. But almost all of the growing top tech companies are unprofitable and have no hope in sight to earn any, something I think older economic theory couldn’t even comprehend that there would be so vast an appetite among investors for loss making businesses.
So market indicators like Price to Earnings ratios suddenly become worthless. What’s the point of measuring a Price to Earnings ratio for a business that doesn’t have any profits and therefore doesn’t have any earnings and doesn’t plan to have any? Earnings itself aren’t a priority, nowadays many companies don’t care about profits and invest everything in growth. Businesses can run for decades without turning a profit and the market is completely happy with that even though it makes no sense.