Our modern financial system is relatively new. We don't have accumulated experience on it
- 401k came in 1978
- Roth IRA was born in 1998
- Since 1940, number of people above 25 having a college degree increased 5 times even though the fees increased 4 times. College loans became used more in this time
- Index funds are less than 50 and hedge funds are less than 25 years old
- Consumer debt - money became easy to borrow after WW2 GI bill
Yet here we are, with between 20 and 50 years of experience in the modern financial system, hoping to be perfectly acclimated. For a topic that is so influenced by emotion versus fact, this is a problem. And it helps explain why we don’t always do what we’re supposed to with money. We all do crazy stuff with money, because we’re all relatively new to this game and what looks crazy to you might make sense to me. But no one is crazy—we all make decisions based on our own unique experiences that seem to make sense to us in a given moment.
Nothing is as good or as bad as it seems.
Luck and risk are siblings. They are both the reality that every outcome in life is guided by forces other than individual effort.
If you give luck and risk their proper respect, you realize that when judging people’s financial success—both your own and others’—it’s never as good or as bad as it seems.
Eg. Bill Gates vs his best friend Kent Evans who died in an unlucky accident, Cornelius Vanderbilt's illegal railroads, Benjamin Graham's illogical lucky Geico investment, Rockefeller's flouting of law, Yahoo's refusal of buyout from Microsoft vs Facebook's refusal to Yahoo.
The line between “inspiringly bold” and “foolishly reckless” can be a millimeter thick and only visible with hindsight. Risk and luck are doppelgangers.
Tips to reduce difficulty in identifying luck vs risk in money matters:
- Be careful who you praise and admire. Be careful who you look down upon and wish to avoid becoming.
- Focus less on specific individuals and case studies and more on broad patterns.
The more extreme the outcome, the less likely you can apply its lessons to your own life, because the more likely the outcome was influenced by extreme ends of luck or risk.
You’ll get closer to actionable takeaways by looking for broad patterns of success and failure. The more common the pattern, the more applicable it might be to your life.
“Success is a lousy teacher. It seduces smart people into thinking they can’t lose.” - Bill Gates
As much as we recognize the role of luck in success, the role of risk means we should forgive ourselves and leave room for understanding when judging failures.
Eg. Rajat Gupta and Bernie Madoff - worth $100M+ and yet committed fraud.
There is no reason to risk what you have and need for what you don’t have and don’t need.
Things to remember:
- The hardest financial skill is getting the goalpost to stop moving.
- Modern capitalism is a pro at two things: generating wealth and generating envy. Perhaps they go hand in hand; wanting to surpass your peers can be the fuel of hard work. But life isn’t any fun without a sense of enough. Happiness, as it’s said, is just results minus expectations.
- Social comparison is the problem.
- “Enough” is not too little.
- There are many things never worth risking, no matter the potential gain.
- Reputation is invaluable. Freedom and independence are invaluable. Family and friends are invaluable. Being loved by those who you want to love you is invaluable. Happiness is invaluable. And your best shot at keeping these things is knowing when it’s time to stop taking risks that might harm them. Knowing when you have enough.
$81.5B of Buffett's $84.5B net worth came after his 65th birthday. Our minds are not built to handle such absurdities.
If something compounds—if a little growth serves as the fuel for future growth—a small starting base can lead to results so extraordinary they seem to defy logic. It can be so logic-defying that you underestimate what’s possible, where growth comes from, and what it can lead to. And so it is with money.
Good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off hits that can’t be repeated. It’s about earning pretty good returns that you can stick with and which can be repeated for the longest period of time. That’s when compounding runs wild.
“The first rule of compounding is to never interrupt it unnecessarily.” - Charlie Munger
Good investing is not necessarily about making good decisions. It's about consistently not screwing up.
Getting money and keeping money are two different skills.
- Getting money requires taking risks, being optimistic, and putting yourself out there.
- But keeping money requires the opposite of taking risk. It requires humility, and fear that what you’ve made can be taken away from you just as fast. It requires frugality and an acceptance that at least some of what you’ve made is attributable to luck, so past success can’t be relied upon to repeat indefinitely.
If I had to summarize money success in a single word it would be “survival.”
Not “growth” or “brains” or “insight" - the ability to stick around for a long time, without wiping out or being forced to give up, is what makes the biggest difference. This should be the cornerstone of your strategy, whether it’s in investing or your career or a business you own.
“Having an ‘edge’ and surviving are two different things: the first requires the second. You need to avoid ruin. At all costs.” - Nassim Taleb
Eg. Rick Guerin in the trio of Buffet, Munger and Guerin didn't make it even though he was equally smart, if not smarter. The only difference was that he got greedy and ended up losing everything because of over-leveraging.
Applying the survival mindset to the real world:
- 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 to stick around long enough for compounding to work wonders.
- Planning is important, but the most important part of every plan is to plan on the plan not going according to plan.
- Many bets fail not because they were wrong, but because they were mostly right in a situation that required things to be exactly right. Room for error—often called margin of safety—is one of the most underappreciated forces in finance.
- Margin of safety means raising the odds of success at a given level of risk by increasing your chances of survival. Its magic is that the higher your margin of safety, the smaller your edge needs to be to have a favorable outcome.
- A barbelled personality—optimistic about the future, but paranoid about what will prevent you from getting to the future—is vital.
- You can be optimistic that the long-term growth trajectory is up and to the right, but equally sure that the road between now and then is filled with landmines, and always will be.
- A mindset that can be paranoid and optimistic at the same time is hard to maintain, because seeing things as black or white takes less effort than accepting nuance. But you need short-term paranoia to keep you alive long enough to exploit long-term optimism.
Long tails—the farthest ends of a distribution of outcomes—have tremendous influence in finance, where a small number of events can account for the majority of outcomes. A lot of things in business and investing work this way.
It is not intuitive that an investor can be wrong half the time and still make a fortune. It means we underestimate how normal it is for a lot of things to fail. Which causes us to overreact when they do.
- Art collectors like Berggruen
- Disney's first big commercial success Snow White came after 400+ expensive cartoons.
- VC is a tail-driven industry. 65% ventures lose money, only 0.5% make 50x and drive the VC's returns.
- Similar tail-dominant trend can be seen even among public companies' stocks. A few star stocks drive returns of index funds and more than cover the duds.
- Amazon's growth is almost entirely because of Prime and AWS despite experimenting with 100s of products. Similarly iPhone -> Apple.
Over the course of your lifetime as an investor the decisions that you make today or tomorrow or next week will not matter nearly as much as what you do during the small number of days—likely 1% of the time or less—when everyone else around you is going crazy.
Your success as an investor will be determined by how you respond to punctuated moments of terror, not the years spent on cruise control.
A good definition of an investing genius is the man or woman who can do the average thing when all those around them are going crazy. Tails drive everything.
Controlling your time is the highest dividend money pays.
The highest form of wealth is the ability to wake up every morning and say, “I can do whatever I want today.”
Psychologist Angus Campbell's research - "Having a strong sense of controlling one’s life is a more dependable predictor of positive feelings of wellbeing than any of the other objective conditions of life eg. salary, wealth, prestige, material belongings, etc. "
Aligning money towards a life that lets you do what you want, when you want, with who you want, where you want, for as long as you want, has incredible return, and is the broadest lifestyle variable that makes people happy.
Today's knowledge workers in tech jobs never disconnect from work. They think about work even at home, causing them to feel like they don't have any control of their time, and hence feel unhappy.
Gerontologist Karl Pillemer's interviews of old people:
- "No one—not a single person out of a thousand—said that to be happy you should try to work as hard as you can to make money or to be as wealthy as your friends.
- What they did value were things like quality friendships, being part of something bigger than themselves, and spending quality, unstructured time with their children."
No one is impressed with your possessions as you are.
I can personally attest to this from my personal experiences.
“You might think you want an expensive car, a fancy watch, and a huge house. But I’m telling you, you don’t. What you want is respect and admiration from other people, and you think having expensive stuff will bring it. It almost never does—especially from the people you want to respect and admire you.”
People generally aspire to be respected and admired by others, and using money to buy fancy things may bring less of it than you imagine. If respect and admiration are your goal, be careful how you seek it. Humility, kindness, and empathy will bring you more respect than horsepower ever will.
Wealth is financial assets that haven’t yet been converted into the stuff you see.
Wealth is hidden. It’s income not spent. Wealth is an option not yet taken to buy something later. Its value lies in offering you options, flexibility, and growth to one day purchase more stuff than you could right now.
Exercise is like being rich. You think, “I did the work and I now deserve to treat myself to a big meal.” Wealth is turning down that treat meal and actually burning net calories. It’s hard, and requires self-control. But it creates a gap between what you could do and what you choose to do that accrues to you over time.
- The first idea—simple, but easy to overlook—is that building wealth has little to do with your income or investment returns, and lots to do with your savings rate.
Wealth is just the accumulated leftovers after you spend what you take in. And since you can build wealth without a high income, but have no chance of building wealth without a high savings rate, it’s clear which one matters more.
More importantly, the value of wealth is relative to what you need. Learning to be happy with less money creates a gap between what you have and what you want—similar to the gap you get from growing your paycheck, but easier and more in your control.
Past a certain level of income, what you need is just what sits below your ego.
One of the most powerful ways to increase your savings isn’t to raise your income. It’s to raise your humility.
- So people’s ability to save is more in their control than they might think.
- And you don’t need a specific reason to save.
Saving is a hedge against life’s inevitable ability to surprise the hell out of you at the worst possible moment.
- That flexibility and control over your time is an unseen return on wealth.
- And that hidden return is becoming more important.
In a world where intelligence is hyper-competitive and many previous technical skills have become automated, competitive advantages tilt toward nuanced and soft skills—like communication, empathy, and, perhaps most of all, flexibility. Eg. flexibility to wait for good opportunities, learn new skills or find your passion.
Aiming to be mostly reasonable works better than trying to be boldly rational.
Things that have never happened before happen all the time.
It is smart to have a deep appreciation for economic and investing history. History helps us calibrate our expectations, study where people tend to go wrong, and offers a rough guide of what tends to work. But it is not, in any way, a map of the future.
The cornerstone of economics is that things change over time, because the invisible hand hates anything staying too good or too bad indefinitely.
The correct lesson to learn from surprises is that the world is surprising (and difficult to anticipate). - Daniel Kahneman
Risks of relying heavily on investment history:
You’ll likely miss the outlier events that move the needle the most.
- "The thing that makes tail events easy to underappreciate is how easy it is to underestimate how things compound. How, for example, 9/11 prompted the Federal Reserve to cut interest rates, which helped drive the housing bubble, which led to the financial crisis, which led to a poor jobs market, which led tens of millions to seek a college education, which led to $1.6 trillion in student loans with a 10.8% default rate. It’s not intuitive to link 19 hijackers to the current weight of student loans, but that’s what happens in a world driven by a few outlier tail events."
- Past events like Great Depression or WW2 can't be used to guide worst case scenarios for future events.
- The most important economic events of the future—things that will move the needle the most—are things that history gives us little to no guide about. They will be unprecedented events, which means we won’t be prepared for them, which is part of what makes them so impactful. This is true for both scary events like recessions and wars, and great events like innovation.
History can be a misleading guide to the future of the economy and stock market because it doesn’t account for structural changes that are relevant to today’s world.
- Frequency of recessions has reduced over time
- Formulae in Benjamin Graham's The Intelligent Investor published in 1972 are no longer relevant
- VC firms and companies funded by them didn't exist 30 years ago
An interesting quirk of investing history is that the further back you look, the more likely you are to be examining a world that no longer applies to today.
That doesn’t mean we should ignore history when thinking about money. But there’s an important nuance: The further back in history you look, the more general your takeaways should be.
- Eg. people’s relationship to greed and fear, how they behave under stress, and how they respond to incentives.
The most important part of every plan is planning on your plan not going according to plan.
There is never a moment when you’re so right that you can bet every chip in front of you. The world isn’t that kind to anyone—not consistently, anyways. You have to give yourself room for error.
Instead of viewing the world as black and white, viewing it as a grey area—pursuing things where a range of potential outcomes are acceptable—is the smart way to proceed.
Room for error lets you endure a range of potential outcomes, 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.
Plan for the unexpected. Eg. In the battle of Stalingrad, only 20 out of 100+ tanks were operable because rats ate away electrical insulation.
“The best way to achieve felicity is to aim low" - Charlie Munger
Avoid single points of failure.
- A good rule of thumb for a lot of things in life is that everything that can break will eventually break. So if many things rely on one thing working, and that thing breaks, you are counting the days to catastrophe.
- The biggest single point of failure with money is a sole reliance on a paycheck to fund short-term spending needs, with no savings to create a gap between what you think your expenses are and what they might be in the future.
Very important to save for things you can’t possibly predict or even comprehend.
Long term planning is harder than it seems because people's goals and desires change over time.
An underpinning of psychology is that people are poor forecasters of their future selves.
- The End of History Illusion is what psychologists call the tendency for people to be keenly aware of how much they’ve changed in the past, but to underestimate how much their personalities, desires, and goals are likely to change in the future.
2 things to keep in mind when making long-term decisions:
- We should avoid the extreme ends of financial planning.
- Aiming, at every point in your working life, to have moderate annual savings, moderate free time, no more than a moderate commute, and at least moderate time with your family, increases the odds of being able to stick with a plan and avoid regret than if any one of those things fall to the extreme sides of the spectrum.
- We should also come to accept the reality of changing our minds.
- The trick is to accept the reality of change and move on as soon as possible.
- Sunk costs — anchoring decisions to past efforts that can’t be refunded—are a devil in a world where people change over time. They make our future selves prisoners to our past, different, selves. It’s the equivalent of a stranger making major life decisions for you.
Everything has a price, but not all prices appear on labels.
Most things are harder in practice than they are in theory. Sometimes this is because we’re overconfident. More often it’s because we’re not good at identifying what the price of success is, which prevents us from being able to pay it.
Hold stocks for the long term. Don't try to time the market. Price for long term compounded gains is short term volatility and uncertainty.
Thinking of market volatility as a fee rather than a fine is an important part of developing the kind of mindset that lets you stick around long enough for investing gains to work in your favor.
- The trick is convincing yourself that the market’s fee is worth it. That’s the only way to properly deal with volatility and uncertainty—not just putting up with it, but realizing that it’s an admission fee worth paying.
Beware taking financial cues from people playing a different game than you are.
- Bubbles form when the momentum of short-term returns attracts enough money that the makeup of investors shifts from mostly long term to mostly short term. That process feeds on itself. As traders push up short-term returns, they attract even more traders.
- Bubbles do their damage when long-term investors playing one game start taking their cues from those short-term traders playing another.
Many finance and investment decisions are rooted in watching what other people do and either copying them or betting against them. But when you don’t know why someone behaves like they do you won’t know how long they’ll continue acting that way or what will make them change their mind.
It’s hard to grasp that other investors have different goals than we do, because an anchor of psychology is not realizing that rational people can see the world through a different lens than your own.
Rising prices persuade all investors in ways the best marketers envy. They are a drug that can turn value-conscious investors into dewy-eyed optimists, detached from their own reality.
A takeaway here is that 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 than you are.
The main thing I can recommend is going out of your way to identify what game you’re playing.
- Write down your investing mission statement.
Optimism sounds like a sales pitch. Pessimism sounds like someone is trying to help you.
Optimism is the best bet for most people because the world tends to get better for most people most of the time. But pessimism is more common.
Reasons behind financial pessimism:
- Asymmetric aversion to loss is an evolutionary shield - Kahneman. Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.
- Money is ubiquitous, so something bad happening tends to affect everyone and captures everyone’s attention.
- Pessimists often extrapolate present trends without accounting for how markets adapt.
- There is an iron law in economics: extremely good and extremely bad circumstances rarely stay that way for long because supply and demand adapt in hard-to-predict ways.
- Eg. increase in oil production because of technical innovation.
- Progress happens too slowly to notice, but setbacks happen too quickly to ignore.
- Growth is driven by compounding, which always takes time. Destruction is driven by single points of failure, which can happen in seconds, and loss of confidence, which can happen in an instant.
- Eg. invention of human flight and advances in medicine vs market crashes and disasters.
The short sting of pessimism prevails while the powerful pull of optimism goes unnoticed. This underscores an important point made previously: In investing you must identify the price of success—volatility and loss amid the long backdrop of growth—and be willing to pay it.
Stories are, by far, the most powerful force in the economy. They are the fuel that can let the tangible parts of the economy work, or the brake that holds our capabilities back.
- Eg. In 2009, narrative damage was inflicted on US economy. Story about rising house prices broke down.
In a story-driven world, remember:
- The more you want something to be true, the more likely you are to believe a story that overestimates the odds of it being true.
- Beware of "appealing fictions". Always keep room for error - it should be as high as the stakes are.
- Everyone has an incomplete view of the world. But we form a complete narrative to fill in the gaps.
- We don't know what we don't know. So we try to explain the world through our limited mental models.
- We all want the complicated world we live in to make sense. So we tell ourselves stories to fill in the gaps of what are effectively blind spots.
Hindsight, the ability to explain the past, gives us the illusion that the world is understandable. It gives us the illusion that the world makes sense, even when it doesn’t make sense. - Daniel Kahneman
- Since big events come out of nowhere, forecasts may do more harm than good, giving the illusion of predictability in a world where unforeseen events control most outcomes.
- We are bad at market forecasts. Wanting to believe we are in control is an emotional itch that needs to be scratched, rather than an analytical problem to be calculated and solved. The illusion of control is more persuasive than the reality of uncertainty.
- Part of this has to do with confusing fields of precision with fields of uncertainty. Eg. astrophysics vs business, economics and investing - role of human behaviour and emotions.
Stories we tell ourselves because of Illusion of Control (Kahneman):
- When planning we focus on what we want to do and can do, neglecting the plans and skills of others whose decisions might affect our outcomes.
- Both in explaining the past and in predicting the future, we focus on the causal role of skill and neglect the role of luck.
- We focus on what we know and neglect what we do not know, which makes us overly confident in our beliefs.
- Eg. startup founders neglect their competitors' achievements and changes in market.
- Go out of your way to find humility when things are going right and forgiveness/compassion when they go wrong.
- The world is big and complex. Luck and risk are both real and hard to identify.
- Less ego, more wealth.
- Manage your money in a way that helps you sleep at night.
- If you want to do better as an investor, the single most powerful thing you can do is increase your time horizon.
- Become OK with a lot of things going wrong.
- You can be wrong half the time and still make a fortune, because a small minority of things account for the majority of outcomes.
- Use money to gain control over your time.
- Be nicer and less flashy.
- Save. Just save. You don’t need a specific reason to save.
- Define the cost of success and be ready to pay it.
- Uncertainty, doubt, and regret are common costs in the finance world. They’re often worth paying.
- Worship room for error.
- Avoid the extreme ends of financial decisions.
- Goals and desires change over time; the more extreme your past decisions were the more you may regret them as you evolve.
- You should like risk because it pays off over time. But avoid ruinous risk.
- Define the game you’re playing, and make sure your actions are not being influenced by people playing a different game.
- Respect the mess.
- Smart, informed, and reasonable people can disagree in finance, because people have vastly different goals and desires. There is no single right answer; just the answer that works for you.
Independence as the highest financial goal:
- Being able to wake up one morning and change what you’re doing, on your own terms, whenever you’re ready, seems like the grandmother of all financial goals.
- Independence, to me, doesn’t mean you’ll stop working. It means you only do the work you like with people you like at the times you want for as long as you want.
- Maintains a lifestyle established in 20s. Goalpost of lifestyle desires stopped moving at a young age.
- Maintains a high savings rate.
- Keeps a relatively high cash % - 20% of total assets outside the value of house.
- cash is the oxygen of independence.
- never want to be forced to sell the stocks we own.
- Only owns low-cost index funds instead of individual stocks.
- Outperforming the market averages is very hard.
- for most investors, dollar-cost averaging into a low-cost index fund will provide the highest odds of long-term success.
Effectively all of our net worth is a house, a checking account, and some Vanguard index funds.
There is little correlation between investment effort and investment results.
My investing strategy doesn’t rely on picking the right sector, or timing the next recession. It relies on a high savings rate, patience, and optimism that the global economy will create value over the next several decades.
Comfortably living below what you can afford, without much desire for more, removes a tremendous amount of social pressure.
Thanks for reading. I would love to hear your thoughts about this article. Connect with me on Twitter.