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On ice ages, great expectations and the timelessness of investment returns

17 September 2021 Gareth Stokes

The path to financial happiness lies in balancing your income with your lifestyle expectations. This gem emerged during the 2021 Allan Gray Investment Summit, courtesy a presentation by US-based author and journalist, and partner at The Collaborative Fund, Morgan Housel. His main thesis was that economic and financial shocks could be better understood when viewed through a biology, psychology, sociology or political rather than financial lens.

Non-financial phenomena, financial outcomes

“Investment is not the study of finance; it is the study of how people behave with money,” said Housel, as he launched into a riveting 30-minute narrative that bounced between compounding, Harry Houdini, great expectations, snowballs, Stephen Hawking, risk, trees, Warren Buffet and wealth. His aim, consummately achieved, was to pair non-financial phenomena with financial outcomes. 

It is not that often that one finds trees used to explain complex investment constructs. We thought the old English adage about not seeing the forest for the trees might do the trick; but Housel was having none of it, preferring the ‘sapling into mature tree’ explainer. He pointed out that a sapling that grows over time, protected by surrounding trees, is more likely to reach maturity than a sapling planted on an open hilltop. The forest sapling grows into a strong, mature tree over decades whereas its fast-growing hilltop cousin may achieve a similar size in a handful of years. But the trade-off for fast growth is a soft, mushy wood that is more susceptible to rot and wind damage… Something similar happens to investors who try to grow their portfolios too fast, mused Housel. Yes, it can be a lot of fun; but they are more likely to make big mistakes and blow up by taking on too much risk. 

Lessons from global ice ages

Housel launched into three stories to illustrate the intersection of human behaviour and investment outcomes, starting with humankind’s understanding of the global ice ages that ravaged our planet millennia ago. “These stories have nothing to do with investing; but all of them lead to a clear takeaway insofar how advisers and investors can better interact with risk,” he said. An ice age, also referred to as ‘snowball Earth’ is not an overnight occurrence. We now know that previous ice ages were triggered by subtle shifts in the Earth’s axis that changed the planet’s orientation with the sun. It then took thousands of years for successive winters to win the seasonal tug of war in what Housel described as “the compounding effect of very subtle shifts in starting circumstances, leading to extraordinary results”. 

Compounding is one of the most important factors in building wealth; but the power of compounding is not intuitive. Our ice age example illustrates how a small event, in this case a shift in the Earth’s axis, can compound over 1000s of years to create a snowball Earth. The foundation is laid in the first cold winter, with each successive winter adding to that. In the investment world one of the best illustrations of compounding comes courtesy Warren Buffett, one of the world’s richest men and arguably the greatest investor of all time. Buffett did not turn US$5000 into US$120 billion overnight… He started at age 14 and grew and nurtured that initial sum over a period spanning more than seven decades. More importantly, 99% of his current wealth accrued after age 55. 

“Advisers and investors spend so much time trying to answer the question, how did Warren Buffett do it? We go into grand detail about how he thinks about business models and market cycles and moats … yet the answer to his net worth riddle is tied to the amount of time that he has been investing for,” said Housel. The impact of time on investment returns is underscored by US financial data going back to the 1870s, which confirms a 10 to 20-year holding period as the only way to guarantee positive equity market returns. Unfortunately, many investors still think of long-term as five to 10 years. The conclusion: “The central problem that investors fall for, is underestimating the amount of time that is needed to put the odds of success in their favour”. 

A theoretical physicist’s take on happiness

Housel’s second story focused on Stephen Hawking, a theoretical physicist who won worldwide acclaim for his ground-breaking theory of exploding black holes, among other works in the fields of relativity theory and quantum mechanics. Hawking suffered from motor neuron disease which left him wheelchair-bound from around age 21; but he did not allow his disability to weigh him down. In an interview with The New York Times, Hawking offered an amazing insight into personal happiness. He reportedly told the interviewer: “My expectations were reduced to zero when I was 21; everything since then has been a bonus”. 

It was not immediately clear how expectation and happiness could influence investment outcomes; but Housel wasted little time in getting to the point. He described how the average American citizen, when asked to identify the period of greatest prosperity in that country, always referred back to the so-called Golden Age that spanned from 1950-1960. Is this belief true? In 1955 the median household income was US$29000 compared to US$64000 in 2020; the average new home in the 1950s was 37% smaller than today; and food gobbled up 29% of an average household budget during the Golden Age versus just 13% nowadays. 

Housel pointed out that a doubling of income over the past 70 years was insufficient to offset a more than doubling in society’s expectations. And the reason Americans yearned for the 1950s was not that they were financially better off then; but because their expectations had shifted. “Wealth is a two-part equation,” he explained. “You need to grow your income and net worth as well as keeping that net worth in check relative to your expectations”. This was one of the most valuable lessons from the presentation, namely that if your expectations grow faster than your income, you will never be happy with the level of wealth you accumulate. The Bernie Madoff story supports this assertion. It turns out that the architect of one of the biggest Ponzi schemes of all time was earning US$30 million per year from legitimate business activities before he went off the proverbial rails. 

From great expectations to a great escape

The third and final story offered a lesson in investment risk couched in death of the greatest escape artist of all times, one Harry Houdini. Houdini died of a ruptured appendix, allegedly caused by an unexpected punch to the stomach on the previous day. Some context is needed here. One of Houdini’s stage tricks was to invite a member of the audience to punch him in the stomach, and his ability to absorb the toughest blows without flinching was the stuff of legend. But in the case of the aforementioned attack, Houdini had not had time to prepare. “How risky something is, depends on how surprising it is and whether you are prepared for it or not,” said Housel. 

The presenter marvelled at how US investment analysts had scanned the economic and political environments post the 2008-2009 Global Financial Crisis (GFC) in an attempt to identify the next serious economic risk. In the decade to 2020 they speculated about the risk in President Obama’s tax hikes; Ben Bernanke’s post-GFC money printing; and Donald Trump’s crazy and erratic policy making… “The irony is that the biggest risk to the economy was not from any of these individuals; but from a virus that nobody was talking about,” said Housel. “The biggest risk by far, and by an order of magnitude, was in what no one saw coming”. 

Housel’s concluding remarks focused on the different approaches necessary to accumulate wealth versus maintaining it. “Getting rich requires being an optimist, swinging for the fences, taking chances and taking risks; staying rich requires a degree of pessimism and paranoia … in either case, you must acknowledge that history is a continuous chain of setbacks, disappointments, recessions, bear markets and pandemics that you must financially survive in order for your long-term optimism to pay off”.

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