Morgan Housel’s book The Psychology of Money caught our attention on two fronts. The first in that it echoed in so many ways how we at Aroha think about investing and wealth and the second in some startling insights into the nature of wealth, its compounding and the role of luck in investing.
Extreme examples:
In chapter 2, Housel discusses Benjamin Graham’s investment in GEICO – a US based insurance company. In investing in GEICO, Benjamin Graham – the father of value investing, violated every rule of his own playbook. This included, not putting more than 5% into any single company (GEICO was 20% of his firm’s net worth at the point of investment), and not holding onto companies that no longer met the requirements of a value investment. Graham’s company (Graham-Newman Corp.) bought 50% of GEICO for $712,000 in 1948. By 1972, the value of this investment had grown to $400 million, a 562-fold increase. This one company was also what accounted for most of Graham’s financial success. In the postscript of the Intelligent Investor Graham writes: Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions. Are there morals to this story of value to the intelligent investor? … is that one lucky break, or one supremely shrewd decision — can we tell them apart? Benjamin Graham was a man of towering intellect. He had the humility to accept that he struggled to tell apart skill from luck. The lesson Housel draws is interesting. It is seductive to study extreme examples – of success and/or failure and draw inferences. However extreme examples are often the least applicable to our specific situation and are often influenced by the extreme ends of luck or risk. He continues - Focus less on specific individuals and case studies and more on broad patterns…There are more relevant lessons to takeaway from broad patterns than there are in studying the extreme characters that dominate the news.
Having Enough:
We have debated in many blogs on the search for investment return at the risk of ruin. On greed, Housel writes - The only way to know how much food you can eat is to eat until you are sick. Few try this because vomiting hurts more than any meal is good. For some reason the same logic doesn’t translate to business and investing, and many will only stop reaching for more when they break and are forced to. ..Enough is realizing that an insatiable appetite for more – will push you to a point of regret. There are no go zones where no matter how high the potential return, they are not justified for the loss they could entail. For example - the loss of Reputation and Independence. Recounting the consequences of Rajat Gupta’s insider trading crimes, Bernie Madoff’s ponzi investing scheme and Long-Term Capital Management’s extreme leverage provide insights into what can happen when there is never an “enough”. Warren Buffet’s quote on Long Term Capital Management’s debacle is apt - To make money they didn’t have and didn’t need, they risked what they did have and did need.
Compounding:
In a brilliant and insightful paragraph on compounding Housel writes – Warren Buffet’s net-worth is $84.5 billion. Of this $84.2 billion was accumulated after his 50th birthday. It is fascinating to realize that 99.65% of Warren Buffet’s wealth was generated after he turned 50!! A key aspect of Warren Buffet’s financial success is his longevity. Housel continues - His (Buffet’s) skill is investing, but his secret is time. The takeaway is that it is not the highest returns that define good investing. The highest returns invariably tend to be one-offs and unsustainable. It is good returns that you can stick with and which can be repeated for the longest period of time that makes compounding run wild.
Our blog Wisdom from an unlikely source : 31-Aug-19, refers to Ajith Doval’s (India’s National Security Adviser) interview where he refers to the concept of playing the game. That is, to stay the course of a game and not be in a position to be forced to give in before the game ends. In the same blog we refer to the Kelly criterion which explains how to size bets and resolve the tension between risking ruin and taking too little risk and consequently not growing at all. Here too in the book Housel writes - More than I want big returns, I want to be financially unbreakable. And if I’m unbreakable I actually think I’ll get the biggest returns, because I’ll be able stick around long enough for compounding to work wonders. This is another way of saying – play the long game and always ensure you are in the game. For compounding to work, one needs to be in the game. Never risk ruin. Housel continues - Compounding doesn’t rely on big returns. Merely good returns sustained uninterrupted for the longest period of time – especially in times of chaos and havoc – will always win.
Optimistic but paranoid:
With all the talk about risk of ruin, it is easy to be swayed and have a pessimistic view of the future. A pessimistic view of the future however pre-empts the very act of investing and results in very poor or negative real returns over the long run. It is akin to keeping cash under one’s pillow. Housel writes - A barbelled personality – optimistic about the future, but paranoid about what will prevent you from getting to the future - is vital. Without optimism, all investing for the future becomes futile. However, this optimism must be tempered with a paranoia about what can go dreadfully wrong. In our view this is very similar to our stand to embrace risk (optimism) where we wish and be close to risk free (paranoid) when we seek safety.
Getting it right or wrong:
In Russian Roullete a 6 round revolver with a single bullet, gives you a 5 in 6 chance of getting it right. However a 1 in 6 chance of being wrong can cost you your life. The upside of being right was just staying alive while the downside of being wrong is one’s life. It matters little how many times one was right (or) wrong. What matters more is that when you are right you have a significant up-side and when you are wrong you lose less. In George Soros’ words - You can be wrong most of the time. Its not about whether you are right or wrong that’s important, but how much money you make when you are right and how much you lose when you are wrong.
Wealthy versus Rich:
Housel has an interesting perspective on being rich. Rich he says is what you see. The flashy car, the big diamond ring and so forth. On the other hand, wealth is what you don’t see. The diamonds not bought, the nice cars not purchased, the clothes forgone. Wealth is financial assets that haven’t yet been converted into the stuff you see. Rich is current income. Wealth is income not spent. Its value lies in offering you options, flexibility and growth. The world is filled with people who look modest but are actually wealthy and people who look rich who live at the razor’s edge of insolvency. The highest form of wealth is the ability to wake up every morning and say “I can do whatever I want today” Controlling your time is the highest dividend money pays. The idea of wealth providing options rather than "things" is insightful and worth a serious consideration.
The only factor in our control:
It may be our earnest desire to generate the highest return on our money. However earnest our desire may be and however much effort we may put into such an endeavour, the reality is that we are competing in a real world for this superlative return. Is it really in our control? There is probably only one major factor that is in our control - how much we save. Compare the gains one makes by increasing the savings rate by a few percentage points versus trying to beat the markets by a few percentage points. Which one takes more effort? Which one is more sustainable? Which one is more predictable? Even if one is generating lower investment returns (than the highest possible), it can be compensated by a higher savings rate and longevity. To this we add one more item as what we believe is in our control - our behaviour or our response to external events. If we can structure our investments such that our response to market events allows us to act with equanimity and poise - we can allow compounding to work its magic with reasonable rates of return and long term investment horizons.
Extreme examples:
In chapter 2, Housel discusses Benjamin Graham’s investment in GEICO – a US based insurance company. In investing in GEICO, Benjamin Graham – the father of value investing, violated every rule of his own playbook. This included, not putting more than 5% into any single company (GEICO was 20% of his firm’s net worth at the point of investment), and not holding onto companies that no longer met the requirements of a value investment. Graham’s company (Graham-Newman Corp.) bought 50% of GEICO for $712,000 in 1948. By 1972, the value of this investment had grown to $400 million, a 562-fold increase. This one company was also what accounted for most of Graham’s financial success. In the postscript of the Intelligent Investor Graham writes: Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions. Are there morals to this story of value to the intelligent investor? … is that one lucky break, or one supremely shrewd decision — can we tell them apart? Benjamin Graham was a man of towering intellect. He had the humility to accept that he struggled to tell apart skill from luck. The lesson Housel draws is interesting. It is seductive to study extreme examples – of success and/or failure and draw inferences. However extreme examples are often the least applicable to our specific situation and are often influenced by the extreme ends of luck or risk. He continues - Focus less on specific individuals and case studies and more on broad patterns…There are more relevant lessons to takeaway from broad patterns than there are in studying the extreme characters that dominate the news.
Having Enough:
We have debated in many blogs on the search for investment return at the risk of ruin. On greed, Housel writes - The only way to know how much food you can eat is to eat until you are sick. Few try this because vomiting hurts more than any meal is good. For some reason the same logic doesn’t translate to business and investing, and many will only stop reaching for more when they break and are forced to. ..Enough is realizing that an insatiable appetite for more – will push you to a point of regret. There are no go zones where no matter how high the potential return, they are not justified for the loss they could entail. For example - the loss of Reputation and Independence. Recounting the consequences of Rajat Gupta’s insider trading crimes, Bernie Madoff’s ponzi investing scheme and Long-Term Capital Management’s extreme leverage provide insights into what can happen when there is never an “enough”. Warren Buffet’s quote on Long Term Capital Management’s debacle is apt - To make money they didn’t have and didn’t need, they risked what they did have and did need.
Compounding:
In a brilliant and insightful paragraph on compounding Housel writes – Warren Buffet’s net-worth is $84.5 billion. Of this $84.2 billion was accumulated after his 50th birthday. It is fascinating to realize that 99.65% of Warren Buffet’s wealth was generated after he turned 50!! A key aspect of Warren Buffet’s financial success is his longevity. Housel continues - His (Buffet’s) skill is investing, but his secret is time. The takeaway is that it is not the highest returns that define good investing. The highest returns invariably tend to be one-offs and unsustainable. It is good returns that you can stick with and which can be repeated for the longest period of time that makes compounding run wild.
Our blog Wisdom from an unlikely source : 31-Aug-19, refers to Ajith Doval’s (India’s National Security Adviser) interview where he refers to the concept of playing the game. That is, to stay the course of a game and not be in a position to be forced to give in before the game ends. In the same blog we refer to the Kelly criterion which explains how to size bets and resolve the tension between risking ruin and taking too little risk and consequently not growing at all. Here too in the book Housel writes - More than I want big returns, I want to be financially unbreakable. And if I’m unbreakable I actually think I’ll get the biggest returns, because I’ll be able stick around long enough for compounding to work wonders. This is another way of saying – play the long game and always ensure you are in the game. For compounding to work, one needs to be in the game. Never risk ruin. Housel continues - Compounding doesn’t rely on big returns. Merely good returns sustained uninterrupted for the longest period of time – especially in times of chaos and havoc – will always win.
Optimistic but paranoid:
With all the talk about risk of ruin, it is easy to be swayed and have a pessimistic view of the future. A pessimistic view of the future however pre-empts the very act of investing and results in very poor or negative real returns over the long run. It is akin to keeping cash under one’s pillow. Housel writes - A barbelled personality – optimistic about the future, but paranoid about what will prevent you from getting to the future - is vital. Without optimism, all investing for the future becomes futile. However, this optimism must be tempered with a paranoia about what can go dreadfully wrong. In our view this is very similar to our stand to embrace risk (optimism) where we wish and be close to risk free (paranoid) when we seek safety.
Getting it right or wrong:
In Russian Roullete a 6 round revolver with a single bullet, gives you a 5 in 6 chance of getting it right. However a 1 in 6 chance of being wrong can cost you your life. The upside of being right was just staying alive while the downside of being wrong is one’s life. It matters little how many times one was right (or) wrong. What matters more is that when you are right you have a significant up-side and when you are wrong you lose less. In George Soros’ words - You can be wrong most of the time. Its not about whether you are right or wrong that’s important, but how much money you make when you are right and how much you lose when you are wrong.
Wealthy versus Rich:
Housel has an interesting perspective on being rich. Rich he says is what you see. The flashy car, the big diamond ring and so forth. On the other hand, wealth is what you don’t see. The diamonds not bought, the nice cars not purchased, the clothes forgone. Wealth is financial assets that haven’t yet been converted into the stuff you see. Rich is current income. Wealth is income not spent. Its value lies in offering you options, flexibility and growth. The world is filled with people who look modest but are actually wealthy and people who look rich who live at the razor’s edge of insolvency. The highest form of wealth is the ability to wake up every morning and say “I can do whatever I want today” Controlling your time is the highest dividend money pays. The idea of wealth providing options rather than "things" is insightful and worth a serious consideration.
The only factor in our control:
It may be our earnest desire to generate the highest return on our money. However earnest our desire may be and however much effort we may put into such an endeavour, the reality is that we are competing in a real world for this superlative return. Is it really in our control? There is probably only one major factor that is in our control - how much we save. Compare the gains one makes by increasing the savings rate by a few percentage points versus trying to beat the markets by a few percentage points. Which one takes more effort? Which one is more sustainable? Which one is more predictable? Even if one is generating lower investment returns (than the highest possible), it can be compensated by a higher savings rate and longevity. To this we add one more item as what we believe is in our control - our behaviour or our response to external events. If we can structure our investments such that our response to market events allows us to act with equanimity and poise - we can allow compounding to work its magic with reasonable rates of return and long term investment horizons.