Joys of Compounding - Part 2

This blog is a continuation of the previous one that I wrote inspired by one of the greatest treasures in my library, The Joys of Compounding by Gautam Baid, CFA. The book sheds light on different perspectives of life and how compounding is, has, and will always be the core of any activity that we undertake. In the previous blog, I highlighted seven lessons and will share eight more in this one. We Indians usually remember respective gods before we start a trip. This book is an adventurous trip in itself, and hence, remembering the gods of compounding before we start is a must. When Charlie was being interviewed by CNBC, he was asked how he liked the world would remember his. To which he replied, "A teacher and a learning machine. Most human beings die at the age of 25 and are buried at the age of 70. You might burry me, but I will always remain alive.". 

What he meant when he said that most humans die at the age of 25 and are buried at the age of 75 means that people stop learning after the age of 25, which is as good as dying. Hence, the key to a happy and successful life is to become a learning machine. With that, let's start your weekend with learning something new. 

1. The key to success is delayed gratification: 
     The ability to consciously delay our impulsive buy decisions and not succumb to our emotions is what the investment world calls delayed gratification. You all might be familiar with the marshmallow experiment. In the late 1960's, an American psychologist at Stanford University conducted a small test on a 5-year-old with a few marshmallows. The experiment was simple. The doctor placed a marshmallow in front of the kids and left the room. Before he left, he said that they can have the marshmallow, or they can have 2 marshmallows when he returns. Over the next forty years, the children were included in follow-up studies. It was found that the children who were willing to delay gratification and waited to receive the second marshmallow ended up having higher SAT scores. lower level of substance abuse, lower likelihood of obesity, better response to stress, better social skills, and obviously, more money. 

In other words, the experiment demonstrated the virtues of delayed gratification—doing what is hard now rather than doing what is easy. Over time, this builds up the muscle of discipline, strengthens one's skills and capabilities, and compounds into a much greater level of success and satisfaction than taking the easier path. Charlie also emphasized the importance of patience and being prepared to act at scale when great opportunities arise. Here's a short example. Munger used to read a magazine called the Barrons. In that, there was a page dedicated for stock tips. Throughout his life, Charlie never relied on tips until he came across a company called Tenneco. He was reading the magazine for almost 50 years, and in those 50 years, he invested in one stock, which turned his $15 million into $80 million. Later on, Charlie gave this money to a Chinese fund manager by the name of Li Lu, who turned that $80 million into $400 million. "It takes character to sit there with all that cash and do nothing. I Didn't get to where I am by going after mediocre opportunities", Charlie Munger. Delay gratification my friends. 

2. Build earnings through a business ownership mindset:

     "Investing is most intelligent when it is most businesslike," says Benjamin Graham. Trading securities for short-term, taking intraday bets, or taking index positions is all good. But the real money is made when you think and invest like a businessman and not a speculator. Throughout the history of the Indian stock markets, investing and trading have been looked down upon. People think that it is a place for gamblers, whereas the people who have actually made money in the markets always thought about it as a business. The sheer amount of brainpower that goes into understanding a business and trying to predict the future prospects is not what a gambler can endure. Similar to a businessman when he is about to start a business, an investor also thinks about the business economics, margins, expansion ideas, future prospects, competition, consistency of cash flow, etc. Businessmen never start a business from the viewpoint of selling it in a year or two. Rather, they never even think about selling a good business. 

Always remember that shares are part ownership in a company. An investor builds earnings power through a business ownership mindset. Investing in publicly listed companies is a great way to passively reap most of the major benefits of running one's own business without being exposed to the disproportionate risks emanating from the usual vagaries of directly running business.

 

3. Checklist in decision making:
     Investing in stocks is not as complex as doing a medical survey or flying an airplane, but checklists still play an important role. Charlie has been credited with popularizing the use of checklists in investing. In Poor Charlie's Almanack, Peter Kaufman summarized Munger's investing principles (risk, independence, preparation, intellectual humility, analytical rigor, allocation, patience, decisiveness, change, and focus) in a checklist form. By the way, Poor Charlie's Almanack is an MBA in itself. Once I complete reading that book, I am going to update my LinkedIn profile, mentioning having an MBA from Munger University. Anyway, back to the blog. 

It's not the answers that make you good in the investing business; it's the questions you ask. Ask the right questions; you will get valuable answers. Do the initial groundwork. A prudent investor never purchases ownership in a company without conducting the necessary due diligence. Learn about the company and its competitors from company websites, filings, and information on the internet. Read the past ten years' worth of annual reports, proxies, notes, and schedules to the financial statements and management discussion and analysis and observe the recent trends in insider shareholdings. If you think that's all you need, think about it again, my friend. And if you don't have time for doing these things, you can always call me. I make a good portfolio manager. 

 

4. Power of incentives: 
     "If you want to persuade, appeal to interest, not reason", said Ben Franklin. The iron rule of life is that you get what you reward for. People follow incentives the way ants follow sugar. Rewards as a valuable psychological tool have been part of the academic vocabulary since the mid-twentieth century, when behavioral psychologist B.F. Skinner articulated his philosophy of "positive reinforcement," a way to shape behavior through reward systems. Skinner's experiments in operant conditioning and behaviorisms are his biggest contributions to the field of psychology. If you haven't read my blog on behavioral biases, I suggest you grab your hands on it. 

https://economicsunbiased.blogspot.com/2023/11/behavioral-biases.html

Operant conditioning can be summarized as follows: a behavior is followed by a consequence, and the nature of the consequence modifies the organism's tendency to repeat the behavior in the future. It is imperative that we think deeply about the incentive systems we create, because ignoring the second or third-order effects of an incentive system often leads to unintended consequences. Often, the solution to a behavior problem is to simply align the incentives with the desired goal. I would suggest you read the story of Federal Express. 

5. Math, but avoid physics envy: 

"Investing in stocks is an art, not a science, and people who've been trained to rigidly qualify everything have a big disadvantage," says Peter Lynch. Math helps us evaluate when things make sense. And math is stable over time. It was true that two plus two equals four one million years ago, and it will be true one million years from today. When we quantify and translate something into numeric form, we can make relevant comparisons and sound judgment calls by heeding the wise words of John Mynard Keynes: "It is better to be roughly right than precisely wrong." As investors, we do not need to endlessly strive for precision. Just being approximately right while having a good margin of safety is sufficient to get the job done. Remember, you don't need a weighing scale to know that a four-hundred-pound man is fat. Don't obsess over whether the business will earn Rs 2 or Rs 2.05 in the next quarter. Focus instead on finding a big gap between the current share price and the value you have placed on long-term earning power using conservative estimates to create a large margin of safety, just in case your initial assessment is wrong. 

Don't overweigh what can be counted and underweigh what cannot. Be wary of clinging to false precision in a complex world. As Einstein once said, "Not everything that counts can be counted, and not everything that can be counted counts." The tendency to look for precision where none exists is a human bias and is referred to by Charlie as "physics envy." An epitome of this problem is the efficient market theory, which assumes all market participants to be homo economicus. This can get a little technical. This theory is the outcome of trying to impose the discipline of a hard science on economics, which actually is not a hard science. It is social science. Markets are all about human behavior, and while they are efficient at aggregating information and valuing data, they certainly are not rational. Emotional intelligence has a much bigger impact on the success or failure of investors than the college they attend or the complexity of their investment strategy. 

 

6. Three most important words in life - I love: 

Those three magical words are margins of safety. Poor you who thought I was about to say I love you. "A margin of safety is achieved when a security is purchased at a price sufficiently below its underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world." Seth Klarman. If you generate a 15% return per year for two years but lose 15% in year 3, your CAGR is only 4%. If you make 15% per year for the three years and lose 15% in the year 4, your CAGR is 6.6%. If you make 30% for 3 years and lose 30% in the fourth year, your CAGR is 11.4%. Buffett's adaptation of the margin of safety for the masses follows: 

Rule number 1: Never lose money. 
Rule number 2: Never forget rule Neumer 1
 
"Price is my due diligence" was the clearest articulation of Buffet's investment philosophy. He is extremely patient and disciplined and does not take a swing of the bat if any deal cuts too close with regards to the price paid versus the value received. His investment criteria are demanding. Buy great businesses at a reasonable price in order to maintain that margin of safety. 

 

7. Read more history and less forecast:
     "Be a business analyst, not a market, macroeconomy, or security analyst," says Charlie Munger. Buffet always says that market forecasts will always fill your ears and not your wallets. The supremely confident-looking authority figures in the media are not afflicted by the faintest of doubts, despite being wrong most of the time. The human urge to make predictions creates dopamine, which is famously called "the prediction addiction." Not only are our brains hardwired to believe that we can predict the future and make sense out of random acts, but it rewards us for doing so. Trying to predict the pessimism or the optimism of the markets will lead nowhere. Remember, the pessimists sound smart, but it is the optimists who make money. Commerce has been the backbone of civilization. When we invest in stocks, we participate in commerce and support its constant progress. Those who focus on the big picture prosper in the long run. Others who focus only on crises get jittery at the worst possible time and lose out on promising wealth-creation opportunities. Predict less, read more. 

 

8. Life is a series of opportunity cost: 
    Probably the most important yet most troublesome thing that I have ever read and thought about is the opportunity cost. As investors, we are in the business of intelligently allocating capital. With limited capital at our disposal and several alternatives, the critical concept of opportunity cost arises. An opportunity cost is defined as the value of the second-best opportunity, which we forgo when we make a choice. For everyone who believes in diversification, Munger has something to say. "If you expect to achieve a much higher level of return from one stock that you do not expect to achieve in the others, why should you continue to allocate capital to the rest of them? Capital is finite, and so is time. The beauty of investing lies in the fact that the concepts related to investments are not limited to the industry. Opportunity cost plays a dominant role in my daily life as well as yours. 

We make decisions every day about how we spend our time, money, brainpower, and energy, and for every decision we make, there is an alternative that we didn't choose. And it is the choice not taken that represents our opportunity cost. All rejected alternatives are paths to a possible future in which things could be better or worse than the path we chose. Opportunity cost also plays an important role when we are trying to figure out our friends, colleagues, girlfriends/boyfriends, spouses, or teammates. As Ben Franklin once said, "Be aware of little expenses; a small leak will sink a great ship." Time has an opportunity cost as well, so choose the right people to spend time with. Likewise, people we meet daily have opportunity costs as well. They have chosen to spend their time with us. Hence, it is our moral responsibility to make it worth remembering. I try to share as much value as possible through my blogs because I know that you are sparing 10-15 minutes of your daily lives for reading my blogs. I appreciate your support. 

Of all the constraints we face, the constraints of 24 hours in a day and a finite lifetime are ones we cannot escape. Getting the most out of life means using that precious time wisely. Using that time wisely means using and understanding opportunity cost. As Scrooge McDuck once said, "Nothing good is ever free.". 

    

Happy Investing.