Morgan Housel

Partner, The Collaborative Fund.

[morganhousel]

Financial Advice for My Son

My son is a year old. Just after he was born, I wrote a list of financial advice for The Motley Fool that I hope he’ll read some day. Some of the highlights: 

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.

When you see someone driving a nice car, you probably don't think, "Wow, that person is cool." Instead, you think, "Wow, if I had that car people would think I'm cool." Do you see the irony? No one cares about the guy in the car. Have fun; buy some nice stuff. But realize that what people are really after is respect, and humility will ultimately gain you more of it than vanity.

It's normal to assume that all financial success and failure is earned. It mostly is, but only up to a point -- and a lower point than many think.

People's lives are a reflection of the experiences they've had and the people they've met, a lot of which are driven by luck, accident, and chance. Some people are born into families that encourage education; others are against it. Some are born into flourishing economies encouraging of entrepreneurship; others are born into war and destitution. I want you to be successful, and I want you to earn it. But realize that not all success is due to hard work, and not all poverty is due to laziness. Keep this in mind when judging people, including yourself.

This may sound harsh, but I hope you're poor at some point. Not struggling, and not unhappy, of course. But there's no way to learn the value of money without feeling the power of its scarcity. It teaches you the difference between necessary and desirable. It'll force you to budget. It'll make you learn to enjoy what you have, fix what's broken, and shop for a bargain. These are essential survival skills. Learn to be poor with dignity and you'll handle the inevitable ups and downs of financial life with ease.

The best thing money buys is control over your time. It gives you options and frees you from relying on someone else's priorities. One day you'll realize this freedom is one of the things that makes you truly happy.

Your savings rate has a little to do with how much you earn, and a lot to do with how much you spend. I know a dentist who lives paycheck to paycheck, always on the sliver's edge of financial ruin. I know another who never earned more than $50,000 and saved a fortune. The difference is entirely due to their spending.

How much you make doesn't determine how much you have. And how much you have doesn't determine how much you need.

Don't become a money hoarder or a miser. But realize that learning to live with less is the easiest and most efficient way to gain control of your financial future.

[morganhousel]

The Most Complicated Simple Problems

“Investing isn’t complicated. You just buy stocks when they sell for less than they’re worth.”

“How do you know what they’re worth?”

“That’s complicated.”

Einstein said everything should be made as simple as possible, but no simpler. I’ve learned the latter part the hard way, realizing that it’s often hard to tell the difference between two simple but opposite views.

For example …

It’s hard to know the difference between “I was wrong” and “The odds were in my favor but it just didn’t work out.” You can’t learn from a mistake unless you can accurate identify a mistake. But doing so is easier said than done. An investment that soured could have been a mistake, or it could have had a 90% chance of success with great return prospects, but unfortunately stumbled upon the 10% chance of things going wrong. The problem is we rarely know the exact odds of success of our decisions; we can only make educated guesses, and those guesses are influenced by how we want the event to turn out. This creates two challenges: Sometimes we make terrible bets and think we just got unlucky, and sometimes we make excellent bets whose unfortunate outcomes discourage us from pursuing them again.

It’s hard to know the difference between “Be patient” and “Change your mind when the facts change.” All worthwhile investments are cyclical, so capturing long-term returns requires patience through difficult times. Then again: Ninety-six percent of companies go outof business within 10 years, and even about 40% of established public companies at some point lose most of their value and never recover. Blindly saying “Be patient” isn’t safe in a world where most stuff eventually breaks for good. You should change your mind when the facts change. But by the time we can tell whether something is a changed fact or just a cyclical downturn, it’s often too late. The same people who are lauded for holding firm on Amazon during its dark days could be criticized for being patient with General Motors during its fall. The solution is diversification and an acceptance of some degree of loss, but along the way you’ll constantly question whether you’re dealing with a normal cycle or the beginning of the end.

It’s hard to know the difference between contrarian and cynical. Getting ahead can mean doing things different than the masses. But the masses aren’t always wrong. They’re often right. The idea that you should always bet against what’s popular is not contrarianism; it’s cynicism. The trick is realizing the rate occasion when the masses delude themselves into believing something that isn’t true. This is easier said than done, because for every unsustainable bubble there are at least ten instances of things legitimately being different this time. I suspect many people, in an attempt to become wisely contrarian, accidentally stumble into cynicism. And that’s often more dangerous than going along with the crowd.

It’s hard to know the difference between your viewpoint and the complete viewpoint. Someone once described Donald Trump’s personality as, “Unable to distinguish between what happened and what he thinks should have happened.” I think all of us suffer from this to some degree. Everyone needs to tell themselves a story about how the world works, and the path of least resistance is to tell yourself a simple, logical story based on what you’ve personally experienced in life. But since all of us have only seen a tiny fraction of the world, we fill in the gaps of what’s unfamiliar with what we know. “The recession occurred because [this specific thing I’m familiar with].” “The company failed because [this specific interaction I had].” Trying to accurately explain 100% of something you’ve only experienced 0.0001% of is as difficult as it is prevalent.

It’s hard to know the difference between incentives and motivations. Here’s the simple difference: Mark Zuckerberg in the early days of Facebook was motivated. The Wells Fargo employees who opened fake accounts to meet their targets were incentivized. Both worked on a system of, “If I do X, I’ll be rewarded with Y.” But one wanted to earn the reward – it was like an emotional mission for a cause larger than himself – while the other only wanted (or needed) to get the reward. Without hindsight it can be hard to tell which is which.

It’s hard to know the difference between data and data mining. I want my decisions to be driven by data, not my gut. But if my gut can’t logically explain why the data says what it does, maybe the data is wrong, incomplete, biased, or I’ve found a spurious correlation. Following data without asking, “Is this really true? Am I missing something” is dangerous. But once you let yourself start questioning data, you open up the door to seeing what you want to see and explaining things how you want them explained. This is why equally smart people can look at the same data and persuasively draw opposite conclusions. And it’s why we have more data than ever before but are still highly susceptible to making terrible decisions.

[morganhousel]

The Long Run is Just a Collection of Short Runs

Every great idea can be taken too far. Take the notion that investors should ignore the short run.

I argued on a radio show last week that venture capital, like all successful forms of investing, is a long-term game.

“That’s surprising,” the host said. “All we hear about venture capital from companies is how short-term oriented they are, focusing on this month and next month.”

“Those points aren’t mutually exclusive,” I said.

If a company only has enough cash in the bank to cover six months of operations, the short term is absolutely imperative. You have to watch monthly, weekly, even daily expenses like a hawk, questioning everything.

But value is ultimately created in the long run. That’s where scale takes off and compounding works its magic – over years and decades, not months and weeks.

The key is recognizing that the long run is just a collection of short runs, and capturing long-term growth means managing the short run effectively enough to ensure you can stick around for a long time.

Everyone has heard of the marshmallow test, the famous study where kids who had the willpower to forgo eating one marshmallow right away in exchange for two marshmallows 10 minutes later went on to do better in life. The study is interpreted as proof that those who look ahead make better decisions than those who focus on the short run.

But the most important part of the study is often overlooked.

The kids who held out for the second marshmallow didn’t just sit there patiently. Have you met a kid before? They can’t do that.

They were able to wait 10 minutes because they distracted themselves. They sang a song, or played with their shoes, or told the researchers a story. One kid hid under a desk. Another did jumping jacks.

The only reason they made it to the long run is because they effectively managed the short run, in this case by diverting their attention from something that was otherwise too tempting to resist.

And that, I think you’ll see, is the key to long-term thinking.

I hold a lot of my personal assets in cash – more than 25%, which few financial advisors would say is appropriate for someone with three decades in front of them before retirement.

People ask: Have I calculated how much long-term return I’m giving up by holding so much money in cash? I respond: Yes. But I’ve also calculated how much I’d lose if I were forced to sell stocks during a downturn for any reason, like covering bills in an emergency. That could be far costlier than the return I’m giving up on my cash. Earning a long-term return on my stocks means ensuring I can actually hold them for the long term. Which means I’m actually obsessed with the short run – not for its returns, but as a treacherous path to the long run that needs to be treated with respect.

Companies do this too. In his early days as CEO of Microsoft, Bill Gates said:

I came up with this incredibly conservative approach that I wanted to have enough money in the bank to pay a year’s worth of payroll even if we didn’t get any payments coming in. I’ve been almost true to that the whole time.

Microsoft could focus on the next 10 years not in spite of, but specifically because it managed its short-term finances so conservatively. A recession or a huge mistake wouldn’t be a fatal blow, and wouldn’t require selling strategic assets just to stay alive. Google, Facebook, Cisco, and Apple are similar. They hold hundreds of billions of dollars in cash that earns virtually no return. But by doing so they have the flexibility and endurance to earn much higher long-term returns on other assets, without the risk of having to firesell strategic assets in a pinch. The only reason the long term works is because the short term is so protected. There is a graveyard of investors and companies who were fully invested in the honorable name of long-term thinking but learned the hard way that their I’m-not-focused-on-the-short-run attitude has its costs.

Economist Tyler Cowen recently wrote:

Plenty of companies have made big mistakes from thinking too big and too long-term; for instance, a lot of mergers were based on notions of long-run synergies that never materialized. In reality, short-term improvements are often the best way to get to a good long-run plan.

Long-term thinking is often viewed as what’s left over when you ignore the short term. But it’s not. It’s what’s left over when you’ve nursed the short term so well that the rewards compound into something great – after a long time.

[morganhousel]

Today’s Innovations Are Tomorrow’s Baseline

Tony Hawk was the best skateboarder of all time. He is the Michael Jordan or Tiger Woods of his sport. Not just the best, but iconically so.

Hawk won 73 of the 103 pro contests he entered. His video games sold 30 million copies and grossed $1.7 billion. Six Flags named a rollercoaster after him.

I was never into skateboarding. But like millions of others I remember Tony Hawk for one thing: Landing a 900 at the 1999 X Games.

The 900 – two and half spins – was to skateboarding what the four-minute mile was to track: A goal so ambitious many thought it could never be done.

But after 10 failed attempts at the 1999 X Games, Hawk landed a 900.

It’s hard to describe how big a deal this was. ESPN recently remembered it as “arguably the most famous moment in action sports history.” Skateboarding in 1999 was viewed as the degenerate punk’s sport, yet the New York Times devoted an entire article to this one trick. It wrote :

Tonight at Pier 30 on his 11th try, [Hawk] seemed to defy gravity, launching himself high above the halfpipe. Spiraling with gymnastic skill, a twirling mass somersaulting two and a half rotations, he landed nearly perfectly on his waiting skateboard, his feet seemingly glued to it. He lightly touched the ground with his right hand, then rose up, riding the trick out clean. There was a wild ovation from the capacity crowd of 8,000 on the pier. The other skaters jumped to the bottom of the halfpipe and lifted Hawk until he seemed to soar above them.

But what happened next is even more amazing.

This is a 10-year-old amateur kid landing a 900 last year.

Hawk was also the first person to land a 720 (two spins) – a feat recently accomplished by a second-grader.

This isn’t to discount Hawk’s achievement. It’s an example of something vital to progress in virtually every field: Innovation works like compound interest. Today’s group uses yesterday’s hard work and discovery as a starting point to build off of, rather than a finish line.

It took an eternity for one person to master the 900 because there was no one else to watch or mimic. Hawk was alone, like a tinkerer. Today’s skateboarders have a set of directions. They can watch videos of Hawk and say, “Look how he did it. Look how he bent his knees and tipped his shoulder.” Not to mention the motivation of, “If he can do it, I can too.” It’s a roadmap of how to do something, versus the black hole of doubt Hawk faced when trying something no one had before.

We see this in so many fields. Today’s innovations become tomorrow’s baseline, which means people, as a group, get better over time.

Nassim Taleb writes, “According to the medieval science historian Guy Beaujouan, before the thirteenth century no more than five persons in the whole of Europe knew how to perform a division.” Modern algebra didn’t exist until the 1600s. Today both are taught standard by age 15. An average pre-teen today can perform calculations the world’s top mathematicians couldn’t fathom 500 years ago. Which means we now start from a high baseline of what’s achievable, and can easily go on to do amazing things with math – like, say, engineer software. Coding itself is being taught younger and younger, and as a standard subject, thanks to people like Bill Gates and Mark Zuckerberg – the Tony Hawks of their field – who showed the world what’s possible.

Until the 1940s people doubted whether humans could ever run a mile in less than four minutes. Then Roger Bannister did it in 1954. “Nowadays, college kids do that every year,” author David Epstein says. “On rare occasions, a high school kid does it. As of the end of last year, 1,314 men had run under four minutes in the mile.” Same for the 100-meter dash. Today’s U.S. high schoolrecord (10.0 seconds) would have been a world record as recently as 1960. Just qualifying for the Boston Marathon requires a time that, 100 years ago, would put you within nine minutes of a world record. Part of this is thanks to advances in training, equipment, and track material. But part is the motivation of, “If they can do it, so can I.” Anyone who runs knows you have more stamina in a group race than you do running by yourself. Why? Because motivation feeds off watching other people do things you would otherwise justify quitting, or never trying. The result is that, in almost every field, people are constantly trying to one-up the competition, even when the competition does things that were previously thought impossible.

Humans have been practicing the art of throwing their bodies around for tens of thousands of years. But it’s almost comical how far gymnastics has come in just the last 60 years.

In investing, John Burr Williams made a bold statement in 1938 when he argued the proper way to value a stock was by discounting its future dividend payments. It was a big deal at the time, and right after Benjamin Graham and David Dodd’s bookSecurity Analysis taught, for virtually the first time, how to value stocks as companies, rather than faddish pieces of paper. Today these concepts are mastered by first-year analysts right out of college. It’s not an exaggeration to say a 22-year-old analyst today has more information and conceptual investment knowledge than most Ivy League finance professors did a century ago.

In all of these cases, growth follows the same exponential road of compound interest. One person sticks their neck out and does X. The next generation starts with X and says “I can do X + 1.” The next starts with X+1 and shoots for X+1+1, and so on. These are often tiny improvements. But, as compound interest teaches us, tiny improvements built upon a base that’s generations in the making can add up to something remarkable.

This all may seem obvious. But a lot of pessimism about the future comes from being incredulous that today’s generation is producing, say, another Bill Gates, Henry Ford, or Tony Hawk. This misses a critical point: We now get to use all of those people’s discoveries as a starting point, a foundation to build off of. Never underestimate the power of someone armed with the accumulated trial and error of every genius who came before them.

A few years ago a twelve-year-old skateboarder named Tom Schaar landed a 1080 – three full spins.

Asked what he thought of the achievement, Hawk replied: “It represents everything I love about skateboarding: constant evolution.”

Which is a statement you can apply to just about any field.

[morganhousel]

The Hierarchy of Earning Profit

The joke has been around for years:

Business is so much fun when you dream this way. But the reality, as Elon Musk eloquently put it, is that running a company “is like eating glass and staring into the abyss of death.”

How businesses go from sales to profit is taught through the income statement – start with revenue, subtract all costs and taxes, and finish with a bottom line of profit.

This is great for accounting, but it just shows whether a company went from Step 1 to Step 3, not what it took to get there – the glass-eating of Step 2.

No matter the business, there is a hierarchy of steps necessary to earning a profit. It’s like a qualitative income statement.

Here’s how I think of it. All of these steps have to be completed before sustainable profit becomes reality:

These steps have to be checked off sequentially – each box doesn’t matter until the one above it is completed. If your product isn’t priced competitively, it doesn’t matter how cool your office is or how much free food you offer employees. A cheap product with no competition that checks all the regulatory boxes doesn’t matter if it’s not solving a legitimate problem that customers can’t solve themselves. And no business plan is worth the paper it’s written on without a willingness to constantly adapt.

People – especially really smart people – have a tendency to attempt solving big problems (like earning a profit) without first solving more basic ones (like how you’ll get there). This is why the “Step 1, Step 3” joke resonates. And it’s why understanding the hierarchy of earning profit is so important.

More from the Collaborative Fund:

What a time to be alive

When you change the world and no one notices

Simple rules of capitalism

[morganhousel]

What A Time To Be Alive

John D. Rockefeller was the richest man the world had ever seen.

But for most of his adult life he didn’t have electric lights, air conditioning, or sunglasses. And he never had penicillin, sunscreen, or Advil. This is not ancient history: One in twenty Americans were born before Rockefeller died.

The majority of Americans think the next generation of adults will be worse off than their parents.

I think of two things when I hear this.

One, the pessimists are probably wrong, extrapolating a bad decade into infinity. Two, progress is like compound interest – you don’t even notice it in the short run, but it’s mindblowing when you zoom out and see what can be accomplished over long periods.

There are so many things still wrong with the world, and the future will always be hard. But when confronted with pessimism, Warren Buffett reminds us that normal Americans “live better than John D. Rockefeller did.”

Here are some examples of how right he is.

Life expectancy in America has increased from 47 years in 1900 to 78 years in 2011. That’s great. Here’s what’s better: The majority of that gain has come from declines in infant and childhood mortality. One in 15 babies born in 1900 didn’t see their first birthday; a fifth didn’t make it to age five. In America! Today fewer than seven in a thousand die before age five. The decline means 700,000 fewer kids die each year who would have died 115 years ago. That’s like adding a city the size of Seattle every year.

To put that stat a different way: Being born in America in 1900 gave you a 79% chance of living for five years. Today, the five-year survival rate for non-Hodgkin’s lymphoma is 82%. So just being a kid 1900 was riskier than having lymphoma is today.

Penicillin has saved between 80 and 200 million lives since first used in 1942, depending on whose estimates you use. Put that in context of deaths from World War I (~17 million) and World War II (~60 million), and it’s possible that Alexander Fleming’s accidental discovery saved more lives than both world wars took.

Auto fatalities per capita have declined so much in the last 80 years that every hour of every day, 5.6 people who would have died in car crashes in the 1930s are still alive today. Put another way: Without the improvement in auto fatalities, 487,500 more people would have died in car accidents in the last decade than actually did. That’s equal to the population of Sacramento.

The frequency of U.S. recessions has plunged. From 1860 to 1900 we were in recession 48% of the time, according to the National Bureau of Economic Research. From 1900 to 1940, 43% of the time. From 1940 to 1980, 15%. Since 1980, just over 12%.

New homes today are, on average, more than1,000 square feet larger than they were in 1973, according to the Census Bureau. For perspective, the average house in 1900 was roughly 1,000 square feet total. So in 43 years we have added what people had in 1900.

Microsoft sold a computer mouse in 1985 for $179, or $401 adjusted for inflation. Today $401 can buy you a Chromebook, a Kindle tablet, and an iPhone 5, with enough money left over for lunch.

The percentage of American adults who smoke daily declined from 45% in 1965 to 18% in 2012,according to OECD. Which is to say: 65.5 million Americans who would have smoked daily 50 years ago don’t today.

The number of cigarettes sold in America declined from 640 billion in 1981 to 360 billion in 2007, according to the Tobacco Situation and Outlook Report. Put another way: Americans smoke 8,878 fewer cigarettes per second than they did 35 years ago.

Median household income during the boom year of 1929 was about $16,000 adjusted for inflation, according to Census Bureau data. It’s more than $53,000 today. What was average back then is now considered deep poverty, and what’s average today would put you in the top decile back then.

According to the World Health Organization, “Measles vaccination has saved an estimated 17.1 million lives since 2000.” If those 17.1 million people were their own country it would be 65th largest in the world, sitting between Ecuador and Netherlands.

“In the late 1940s to the early 1950s … polio crippled an average of more than 35,000 people in the United States each year,” writes the CDC. Today it’s wiped out.

According to the Bureau of Labor Statistics,there were 1.75 million children age 10-15 working in America in 1900. That made up 6% of the labor force. Today, employment under age 16 is effectively banned.

Nationwide murders declined from 23,326 in 1994 to 14,196 in 2014, according to the FBI. The difference – 9,130 per year – means one person per hour, every hour, is alive today who would have been murdered 20 years ago (more if you adjust for population growth). Similarly, robbery declined from 618,949 incidents in 1994 to 345,031 in 2014, a drop of 44%. Aggravated assault fell 35%.

A December 2015 flight from Miami to Los Angeles was delayed and took 20 hours, which one passenger told CNN was “a nightmare that you can’t believe.” As recently as 1929 that 20-hour travel time would have been a world record.

The percentage of women with bachelor’s degrees at age 18-33 nearly doubled from the Baby Boom to the Millennial generation, from 14% to 27%.

“Hip fractures have been dropping by 15-20 per cent a decade for 30 years,” writes the Financial Times. One theory: We’re better at providing daily mobility assistance for those who need it.

Rates of dementia for Americans over age 60 have declined by more than a third in the last 30 years. Some think better control of blood pressure led to a decline in ministrokes, which then reduced the prevalence of dementia.

The DailyMail writes, “In 1900 a typical male was 5ft 6in tall, but by 2000 that had gone up to 5ft 10in … Researchers put the growth spurt mostly down to pregnant mothers eating better food which meant their babies grew up to be stronger and healthier.”

In 1933 there were 37 workplace fatalities per 100,000 workers, according to OSHA. In 2009 there were 3.6 per 100,000. With 144 million U.S. workers, the decline means 48,100 fewer workers die each year who would have 80 years ago. Every 14 months we avoid as many workplace deaths compared to 1933 as U.S. soldiers died in the Vietnam War.

The average expense ratio for equity mutual/index funds has declined 34% since 1996, according to the Investment Company Institute. The drop, from 1.04% a year to 0.68% a year, on a $100,000 portfolio growing 6% a year will save you $37,000 in fees over 25 years. Put another way: The decline in financial fees has added an extra year of retirement income to the average saver’s nest egg.

Historian Deirdre McCloskey recently wrote , “A billion or so people on the planet drag along on the equivalent of $3 a day or less. But as recently as 1800, almost everybody did.” (Adjusted for inflation).

The global fertility rate has declined from 5.1 babies per women in 1964 to 2.5 today, according to the Census Bureau International Database. This is wonderful: Fertility declines as countries become richer and infant mortality falls. In the 18th century Adam Smith wrote, “It is not uncommon in the highlands of Scotland for a mother who has borne 20 children not to have 2 alive.”

The percentage of the world living on less than $2 a day (adjusted for inflation) has been cut in half over the last 40 years, according to the World Bank.

Americans over age 100 are the fastest growing age group, by far. In 1980 there were about 15,000 Americans over age 100. Today there are 78,000. By 2030, an estimated 138,000, according to the Census Bureau. That means the centenarian share of the population will more than quintuple, from 0.0007% in 1980 to 0.04% by 2030.

In 1930 Americans spent more than 8% of their disposable income on energy, according to the Bureau of Economic Analysis. During the 1980s oil spike it peaked at more than 9%. Today it’s less than 4%, an all-time low. The decline in energy spending as a share of income since 1950 means the average household can spend $1,728 on other stuff each year that used to go toward energy.

A BMW plant in South Carolina gets part of its power from methane siphoned off a nearby landfill. People don’t think of this kind of stuff when making peak-energy forecasts.

Twenty people have received face transplants since 2005, according to Johns Hopkins Hospital. This was unfathomable 30 years ago.

The percentage of an average household’s budget devoted to food fell from 46.4% in 1901 to 13% in 2011, according to the Bureau of Labor Statistics. If that percentage had not declined the average household today would spend more than $2,100 a month on food.

Real median wages have been stagnant for a while. But real median compensation – which includes things like health insurance subsidies and 401(k) matches – is up more than 40% since 1980. People are getting a raise, it’s just coming in the form of subsidies on ever-rising insurance premiums.

We have a retirement funding crisis, which would sound like the most peculiar thing in the world to people 100 years ago, most of whom had no concept of retirement and worked until they died. In 1900 65.4% of men over age 65 were still working, according to the Census Bureau. And nearly all jobs were physically demanding. By the 1990s it was down to 17%.

In 1900 the median age at death was 59. Today it’s 80, according to the Social Security Administration. So the average person today lives almost an entire generation longer than their great-grandparents.

In 1900 it took four days to travel from New York to Los Angeles. Today it takes 19 hours to travel from New York to Singapore.

The age-adjusted death rate per capita from heart disease has declined more than 70% since 1965, according to the National Institute of Health. The New York Times says this was “spurred by better control of cholesterol and blood pressure, reduced smoking rates, improved medical treatments — and faster care of people in the throes of a heart attack.”

Health insurance prices are rising fast. But consider that anything resembling modern medical insurance didn’t even exist until the 1920s, when a group of Texas teachers began prepaying for hospital expenses. Health insurance wasn’t needed before the 1930s because medical care wasn’t that expensive, and it wasn’t that expensive because we didn’t know that much about medicine and couldn’t do a whole lot for sick people.

People uploaded 657 billion pictures in 2014,according to Mary Meeker’s Internet Trends Report. “Another way to think about it: Every two minutes, humans take more photos than ever existed in total 150 years ago,” writes The Atlantic.

A 1996 computer catalog has an average list price of $3,412, or more than $5,200 adjusted for inflation. A Chromebook today can bepurchased for $101 and is, on every level, an order of magnitude or greater more advanced.

Bank failures in the early 1930s wiped out deposits equal to 2.2% of GDP, according to the FDIC. That’s the equivalent of $396 billion today. Thousands of people lined up at banks, some for days on end, wondering if their money was gone. With FDIC insurance, no one with less than $250,000 in the bank has anything to worry about anymore. That’s amazing: What was once one of life’s biggest financial stresses isn’t even a thing anymore.

“The United States uses less than half as much energy for every unit of GDP as it did in the 1970s,” writes energy analyst Daniel Yergin. This rise in efficiency cuts the effective energy price in half.

“A new car in the 1970s might have averaged 13.5 miles to every gallon. Today, on a fleet average basis, a new car is required to get 30.2 miles per gallon,” writes Yergin. Here again, the effective price of gas is cut in half without even knowing it.

“Between 1995 and 2005, Dow Chemical reduced its energy use on a worldwide basis, per pound of product, by 25 percent. Those savings are a big number; the same amount of energy would have been more than enough to supply electricity to all of California’s residents for a year,” Yergin writes.

The gold medal winning time for the men’s 100-meter Olympic sprint improved by 21% from 1896 to 2012, from 12.2 seconds to 9.63 seconds. This is astounding when you consider we’ve been running for as long as we’ve been human. Our ability to keep improving at things you’d think we should have mastered tens of thousands of years ago is a good reason for optimism.

The high-school graduation rate was 6.4% in 1900, 50.8% in 1940, 77.1% in 1970, a record-high 80% in 2012, according to the Department of Education.

Here’s a short list of common conveniences that did not exist in 1940: Tylenol, Velcro, airbags, credit cards, ATM machines, nonstick pans, Tupperware, and calculators.

Fatal airlines accidents have declined from more than 40 per year in 1970s to fewer than 10 per year in the last decade.

Tom Goodwin writes , “The world’s largest taxi firm, Uber, owns no cars. The world’s most popular media company, Facebook, creates no content. The world’s most valuable retailer, Alibaba, carries no stock. And the world’s largest accommodation provider, Airbnb, owns no property.”

What a time to be alive.

[morganhousel]

When You Change The World And No One Notices

Do you know what’s happening in this picture? Literally one of the most important events in human history.

But here’s the most amazing part of the story: Hardly anyone paid attention at the time.

Wilbur and Orville Wright conquered flight on December 17th, 1903. Few inventions were as transformational over the next century. It took four days to travel from New York to Los Angeles in 1900, by train. By the 1930s it could be done in 17 hours, by air. By 1950, six hours.

Unlike, say, mapping the genome, a lay person could instantly grasp the marvel of human flight. A guy sat in a box and turned into a bird.

But days, months, even years after the Wright’s first flight, hardly anyone noticed.

Here’s the front page of The New York Times the day after the first flight. Not a word about the Wrights:

Two days after. Again, nothing:

Three days later, when the Wrights were on their fourth flight, one of which lasted nearly a minute. Nothing:

his goes on. Four days. Five days, six days, six weeks, six months … no mention of the men who conquered the sky for the first time in human history.

The Library of Congress, where I found these papers, reveals two amazing details. One, the first passing mention of the Wrights inThe New York Times came in 1906, three years after their first flight. Two, in 1904, the Times asked a hot-air-balloon tycoon whether humans may fly someday. He answered:

That was a year after the Wright’s first flight.

In his 1952 book on American history, Frederick Lewis Allen wrote:

Several years went by before the public grasped what the Wrights were doing; people were so convinced that flying was impossible that most of those who saw them flying about Dayton [Ohio] in 1905 decided that what they had seen must be some trick without significance — somewhat as most people today would regard a demonstration of, say, telepathy. It was not until May, 1908 — nearly four and a half years after the Wright’s first flight — that experienced reporters were sent to observe what they were doing, experienced editors gave full credence to these reporters’ excited dispatches, and the world at last woke up to the fact that human flight had been successfully accomplished.

The Wrights’ story shows something more common than we realize: There’s often a big gap between changing the world and convincing people that you changed the world.

Jeff Bezos once said:

Invention requires a long-term willingness to be misunderstood. You do something that you genuinely believe in, that you have conviction about, but for a long period of time, well-meaning people may criticize that effort … if you really have conviction that they’re not right, you need to have that long-term willingness to be misunderstood. It’s a key part of invention.

It’s such an important message. Things that are instantly adored are usually just slight variations over existing products. We love them because they’re familiar. The most innovative products — the ones that truly change the world — are almost never understood at first, even by really smart people.

It happened with the telephone. Alexander Graham Bell tried to sell his invention to Western Union, which quickly replied:

This `telephone’ has too many shortcomings to be seriously considered as a practical form of communication. The device is inherently of no value to us. What use could this company make of an electrical toy?

It happened with the car. Twenty years before Henry Ford convinced the world he was onto something, Congress published a memo, warning:

Horseless carriages propelled by gasoline might attain speeds of 14 or even 20 miles per hour. The menace to our people of vehicles of this type hurtling through our streets and along our roads and poisoning the atmosphere would call for prompt legislative action. The cost of producing gasoline is far beyond the financial capacity of private industry… In addition the development of this new power may displace the use of horses, which would wreck our agriculture.

It happened with the index fund — easily the most important financial innovation of the last half-century. John Bogle launched the first index fund in 1975. No one paid much attention to for next two decades. It started to gain popularity, an inch at a time, in the 1990s. Then, three decades after inception, the idea spread like wildfire.

It’s happening now, too. 3D printing has taken off over the last five years. But it’s hardly a new invention. Check out this interview with the CEO of 3D Systems in … 1989. 3D printing, like so many innovations, had a multi-decade lag between invention and adoption. Solar is similar. Photovoltaics were discovered in 1876. They were commercially available by the 1950s, and Jimmy Carter put solar panels on the White House in the 1970s. But they didn’t take off — really take off — until the late 2000s.

Big breakthroughs typically follow a seven-step path:

First, no one’s heard of you.

Then they’ve heard of you but think you’re nuts.

Then they understand your product, but think it has no opportunity.

Then they view your product as a toy.

Then they see it as an amazing toy.

Then they start using it.

Then they couldn’t imagine life without it.

This process can take decades. It rarely takes less than several years.

Three points arise from this.

It takes a brilliance to change the world. It takes something else entirely to wait patiently for people to notice. “Zen-like patience” isn’t a typical trait associated with entrepreneurs. But it’s often required, especially for the most transformative products.

When innovation is measured generationally, results shouldn’t be measured quarterly. History is the true story of how long, messy, and chaotic change can be. The stock market is the hilarious story of millions of people expecting current companies to perform quickly, orderly, and cleanly. The gap between reality and expectations explains untold frustration.

Invention is only the first step of innovation. Stanford professor Paul Saffo put it this way:

It takes 30 years for a new idea to seep into the culture. Technology does not drive change. It is our collective response to the options and opportunities presented by technology that drives change.

More at collab0rativefund.com/blog

[morganhousel]

Things I’m Pretty Sure About

Recessions and bear markets are very easy to predict, except for the timing, cause, magnitude, duration, location, and policy response.

Jeff Bezos once said "Your profit margin is my opportunity," which is basically all of economics summarized in six words.

Bubbles occur because confidence rises as fast as asset prices. People don't just get excited about making money; they feel brilliant, and intellectually justified to play harder in the next round.

Look at today's five largest companies in the world. Fifteen years ago, one of them didn't exist, one was a tiny start-up, one was a belittled relic of the dot-com bust, another was fighting to stay relevant after flirting with bankruptcy a few years before. I suspect the next 15 years will be even more extreme.

Good ideas rarely come in meetings. They come in the shower, in the car, or while going for a walk. Companies should recognize this and give employees more time to think idly.

If you tell people what they want to hear, you can be wrong indefinitely without penalty. This explains the careers of many pundits.

Individual investors roughly break out into three groups. Ten percent of investors don't need help – they get it naturally. Ten percent of investors can't be helped – they're compulsive gamblers. Eighty percent both want and need good advice.

Almost without exception, the best coworkers aren't the smartest or the most experienced, but the nicest. One pound of intelligence is easily overwhelmed by one ounce of jerkiness.

Many rich people will always have money problems, because expenses increase just as fast as wealth. This probably true for countries as well.

Successful investing is found at the intersection of being respectful of the past, indifferent to the present, optimistic about the future and skeptical of salespeople.

It's almost impossible to hide anymore. Social media has lifted the veil on dishonest businesses and lack of competition. Stuff you could get away with 10 years ago is now impossible, which is a great thing.

A lot of things that look unsustainable are new breakthroughs that don't apply to past trends. Tech, demographics, culture, globalization have been changing old rules for centuries. It's always different this time, but we're so addicted to patterns that we'll never believe it and always think something is in the middle of a bubble.

No one will ever "solve" investing for the same reason we can't eliminate the flu virus: Everything adapts and changes itself into something unrecognizable to solutions that worked in the past.  

The same traits needed for huge success are the same traits that increase the odds of failure. We should be careful blindly praising winners or criticizing failures because they often made similar decisions with different degrees of luck.

A lot of people are pessimistic with their words but optimistic with their actions. Many of the same people who talk about how terrible things will get probably buy stocks every month in their 401(k) and try to do a little better at work each day.

Most new technologies look stupid at first, then like toys, then expensive luxuries, then fun gadgets, and finally, necessities. This process often takes 20 or 30 years, and rarely less than 10.

We underestimate our ability to adapt. The root of most pessimism is the failure to recognize that people, business, and economies acclimate and move on from even the toughest setbacks.

Everything I've learned about investing points to the idea that simplicity almost to the point of abdication is the way to success for most people.

For more:

Why does pessimism sound so smart?

Why we're terrified of typical

Is today's market more volatile than the past?

The evolution of good investing ideas

[morganhousel]

The Double-Edge Sword of Incentives

Two things never fail me in investing. One is the constant reminder that what works is counterintuitive. The other is that I rarely go a day without reading something that utterly shocks me.

Take this, from yesterday's Wall Street Journal:

$100 invested in the 20% of companies with the highest-paid CEOs would have grown to $265 over 10 years. The same amount invested in the companies with the lowest-paid CEOs would have grown to $367.

Amazing.

My first thought was that this makes sense, because the highest-paid CEOs tend to come from the largest companies, and large companies in general have lagged small-cap stocks over the last decade. But the study's authors removed the largest companies from the sample and found similar results. Higher CEO pay, on average, is correlated with lower returns. Ten years isn't a long time — I'd love to see a study spanning 30 or 50 years — but it's still a staggering statistic.

Here's one, totally unscientific, explanation for what's going on.

Incentives are one of the most powerful concepts in psychology. Charlie Munger once said, "Never think about something else when you should be thinking about the power of incentives."

But incentives can be taken too far.

Psychologist Dan Ariely writes in his book The Upside of Irrationality:

Incentives can be a double-edged sword. Up to a certain point, they motivate us to learn and perform well. But beyond that point, motivational pressure can be so high that it actually distracts an individual from concentrating on and carrying out a task — an undesirable outcome for anyone.

Ariely showed what he means with a study he performed in India. He offered a group of students cash rewards for solving a set of puzzles and brainteasers. The puzzles weren't easy, but were achievable at the students' level, designed to be solvable only if they really focused. Students were paid a small amount in one round, and progressively larger amounts until the prize for right answers was literally the equivalent of five months' pay. The difficulty of the questions remained the same. All that changed was the incentive.

Here's what happened, according to Ariely (emphasis mine):

Those who stood to earn the most demonstrated the lowest level of performance. Relative to those in the low- or medium-bonus conditions, they achieved good or very good performance less than a third of the time. The experience was so stressful to those in the very-large-bonus condition that they choked under the pressure.

With lower incentives, players could focus on the task at hand. When five months' pay was on the line, all they could think about was, "FIVE MONTHS' PAY. DON'T SCREW THIS UP. FIVE MONTHS' PAY! IT WILL CHANGE YOUR FAMILY'S LIFE." The incentive backfired.

I suspect something similar happens with CEOs, some of whom earn dynastic pay for hitting annual numbers.

This is generalizing, but I often see two types of CEOs:

Those who focus relentlessly on customers and product.

Those who focus relentlessly on business outcomes.

Some do both, of course. But many CEOs sit distinctly in one of these two groups. And what you'll often find is that CEOs in the second bucket tend to be both highly compensated and prone to blowing themselves up.

Lehman Brothers is a good example. Former CEO Dick Fuld was a billionaire thanks to pay packages that, near the peak of the bubble, inched near half a million dollars a day. Few people in business had more incentive than he did. Indeed, the whole Lehman Brothers culture centered on outsized pay, primarily with stock. Lehman's annual report said the company has a single goal: "maximizing shareholder value." It promised: "We are deeply committed to building the value of the Firm ... in everything we do, we are constantly identifying and evaluating ways to add value." In one 2007 conference call Fuld reminded analysts how he planned on raising the stock price, then repeated: "Our goal is simple; that's to create value for our shareholders." Bankrupt one year later.

When someone like Fuld stands to earn as much money as he was, the focus shifts from building a great company to meeting the numbers and earning your enormous pay at all costs. The carrot is too big to think about anything else. Focus on product or long-term goals gets sidetracked.

Then think about CEOs like Elon Musk, Mark Zuckerberg, and Jeff Bezos. They have a common denominator: They focus relentlessly on customers and product, rather than business, and their annual compensation rounds to zero. They have incentives of course, as each holds billions of dollars of stock. But these incentives don't skew toward meeting annual numbers to earn an annual reward, as most high CEO pay packages do. They incentivize the long run. The business. Customers.

These examples are admittedly cherry-picked, and this topic admittedly complicated. But incentives, like everything else, can be taken too far and are more complex than they might seem. I imagine this is relevant for a lot of money managers, particularly hedge fund managers where incentives can be stratospheric.

For more:

Explaining investing in ways that make sense

Why does pessimism sound so smart?

Things I'm pretty sure about

Hard truths for investors to wrap their heads around

Simple Financial Advice for New Grads

[morganhousel]

1945-2016: Here’s Basically What Happened

History is infinitely complicated. Too much stuff has happened for anyone to chronicle, so historians are forced to pick and choose. And wherever there's picking and choosing, there's the delicate art of interpretation.

Sometimes the best approach to complication is to strip things down to the broadest points. It's how you get a decent sense of what happened without getting lost in the details.

When I think about the U.S. economy over the last 70 years, here's basically what happened.

World War II ends. Twelve million U.S. soldiers are demobilized and sent back to an economy that's only a few years out of the Great Depression.

This looks dangerous. Many smart economists think we'll slip back into the depression. Two recessions hit within three years of the war ending as wartime spending falls.

So, we did something. Interest rates are kept low, access to household credit is expanded, and the GI bill provides education to millions.

It works. America is the only major power whose industrial base isn't bombed out by the war, which limits competition. Post-war currency agreements and businesses that learned new operating efficiency during the war sparks an economic boom. It's driven in part by pent-up consumer demand after years of wartime retooling that halted production of things like cars and toasters. Consumer spending rises from 56% of GDP in 1950 to 65% by 1970 to 70% by 2000.

Class evens out. There are huge skews by race, but wage growth and employment within races is pretty good and evenly distributed, party due to unionization and perhaps a wartime ethos of cooperation toward a common goal. Real income for the bottom 20% of wage-earners grew by a nearly identical amount as the top 5% from 1950 to 1980. Economic classes within races narrow dramatically. The laborforce participation rate for women jumps from 32% in 1948 to 58% by 1990, adding more fuel to growth.

Things work pretty well for about three decades. There are recessions, busts, and race wars. But the 1950s-1970s create prosperity and opportunity that, within social groups, fosters a sense of fairness and togetherness. The rich clearly had more money, but lived lives not drastically different from the masses. Normal people drove Chevys; Rich people drove Cadillacs. Hard work paid off and provided a lifestyle that, measured against almost all your peers, you could be proud of.

Growth continues, but spreads unevenly. The economy booms in the 1980s and 1990s, but real wages for the bottom 10% of workers fall 5% from 1980 to 2013, while wages for the top 5% of workers rise 41%.

Technology and globalization pushes this further. A more connected world – which takes off after the collapse of the Soviet Union – brings huge rewards for business winners (thanks to more customers) while suppressing wages in the developed world (thanks to competition from global workers).

This causes a cultural consumption problem. Rising income inequality sparks up the Keeping Up With The Joneses effect as the lifestyle of a small group of legitimately rich people increases the aspirations of everyone else. More of your peers become wealthier and start living in bigger homes, driving nicer cars, and sending their kids to private schools. Everyone else feels entitled to not fall behind them, because they're used to the 1950-1980 culture of equality and togetherness.

To compensate, more households turn to debt. Household debt surged as soon as income inequality took off – that was how the masses kept up with the Joneses as their income fell behind. Household debt to disposable income was flat from 1960 to 1980, at about 60%. The ratio jumped to 80% by 1988, 90% by 1996, and 125% by 2007.

Instability rises. Insatiable appetite for debt, huge savings among the richest sliver of society, and loose Fed policy increases the prevalence of bubbles.

It reaches a tipping point, then collapses. The 2007 financial crisis was the culmination of two decades of Americans using debt to fund a lifestyle they couldn't afford, inspired by a sliver of society who could.

Policies necessary to combat the financial crisis kept the trend going. Almost everyone would be worse off without quantitative easing, but no one gained more than the richest group of Americans who own the most stocks and bonds.

The result is a three-front storm. After wages stagnate for two decades, the financial crisis takes away the last of what many Americans held onto – the stuff they bought with debt. What remains is a new economy that offers even less employment, income, and stability, and more inequality.

The Tea Party, Occupy Wall Street, Brexit, and the rise of Donald Trump are ideologically different, but each represents a group of people shouting, "Stop the ride, I want off." And they're shouting for the same reason: An economy that set a precedent of working for them in the three decades after World War II doesn't anymore, and they're tired of it.

Almost none of this was intentional. It's just what happened, unplanned and unforeseen. "On damn thing after another," a historian once said of his field.

For more:

Explaining investing in ways that make sense

Why does pessimism sound so smart?

Things I'm pretty sure about

Hard truths for investors to wrap their heads around

Simple Financial Advice for New Grads  

[morganhousel]

What I Learned Buying a House

My wife and I bought a house last week. It's our first.

Buying a house is a big deal for everyone. It's especially big for us because I've spent years writing about the downside of home ownership. I've never been against home ownership, but I've always believed its financial rewards are overstated. "A large liability masquerading as a safe asset" I once wrote.

But with an eight-month old son and a better idea of where we want to settle, it was time to buy.

We did this purely for social and stability reasons. We love the home, the neighborhood, and a sense of settling down. Twenty years on I suspect it will look like a mediocre financial decision, especially when the opportunity cost of money sunk into the house is factored in. A good rule of thumb is that nothing in need of constant repair and requiring a half-dozen commissioned middlemen will yield superior investing results.

But here we are.

Mark Twain said, "A man who carries a cat by the tail learns something he can learn in no other way." Something similar applies to buying a house. As much as I've studied home ownership, nothing could prepare me for the actual process of finding, bidding, and buying a home.

Here are a few things I learned.

1. A home is emotional. It's silly to pretend otherwise.

My wife and I pride ourselves on making unemotional financial decisions. But the first time when pulled into the driveway to tour new house she gasped and said, "Wow, I love it." I did the same.

And that was it. Emotion was involved and there was nothing we could do about it.

In theory, buying a home should be a calm decision made on a spreadsheet. In reality, you walk through the house and picture where furniture will go, imagine Christmas morning with your kids, and barbecues with your friends.

The night before our bid was accepted I asked my wife how she'd feel if we lost the house. "I'd be devastated" she said. I would have been too. I know this is the worst possible way to think about the biggest financial decision of your life, but it was the reality of what we were doing. It's the reality of what everyone does. No one thinks about a home in the same way they think about a lawnmower.

We bought a house we love for a price well within our debt-averse budget. In that sense, we stuck to calm, unemotional decision-making. But we did a few things I never thought we would. We didn't look at every option on the market; We fell in love at first sight. We didn't want to do any remodeling; Now we're going to blow up half the house. We promised ourselves we wouldn't get into a bidding war. But we did.

And I don't regret any of it. I understand it was the reality of getting a house we love, and I shouldn't pretend otherwise.

Jason Zweig of The Wall Street Journal once wrote:

"I have no emotional attachment to the house; I never liked it physically," Mom told us. "But everything important that ever happened in our life as a family is here, and I can't just leave all that behind."

Accepting that a house is inherently emotional reiterated the point that buying a home is not something you do to maximize your return on investment. It's something you do to provide stability and quality of life for your family. In that sense, it's far more like picking a spouse than picking a stock.

2. Technology has shaken up how people find homes, but it's barely touched fees

We found the house on Zillow ourselves. Almost everyone I know in my generation does something similar. Technology has upended how people find homes, from the days when realtors held all the information to putting consumers in the driver's seat.

But we still needed a realtor to help us draft the offer, fill out all the paperwork, and answer our questions. Not doing this would set us up for screwing something up and putting us in a legal mess.

Between our agent and the seller's agent, the commission was many percentage points of the sales price. Pretty standard.

My dad and I talked about how high realtor fees are. I said it's not a problem in my situation because the seller pays the commission.

"No, Morgan, you are," he said. "You're the only one in this transaction writing a check. Believe me, you're paying it. You're paying everything. It's built into the price."

I couldn't argue.

When I think about it, other than the home itself, the realtor commission is the largest single expense I've ever paid in my life, by far. And we found the house ourselves.

I'm surprised that in the world of the 0.04% fee index fund, the average real estate commission is still more than 5%.

And those fees have barely budged over the years, even as information increased with online portals like Zillow and Redfin. The average brokerage commission was 5.94% in 1993, and 5.02% in 2005, according to the Department of Justice – which dryly notes that "consumers are not enjoying all of the possible benefits of competition in the real estate brokerage industry."

3. I was shocked at how complicated it was. I understand why people get swindled.

I had heard of closing costs and prepaids, but I had no idea how fast they piled up.

I had never heard of property transfer taxes. I didn't know there were various levels of title insurance, some of which are optional. I had no clue how escrow for property taxes worked. I always wondered why people paid their property taxes each month to their mortgage company rather than paying them directly to the county twice a year, keeping more cash in their hands. Now I get it: Skip that option and you'll pay a higher mortgage rate.

I consider myself reasonably astute in personal finance, because it's so much of what I write about for a living. But I can't count how many times I had to stop, realize something confused me, and spend an hour of research to understand what I was about to sign. Even with a realtor, homebuyers need to be amateur lawyers to fully understand what they're doing. I can't imagine what it's like for people for whom finance is already a daunting topic. And that's most people.

This probably explains why housing transaction fees are still so high. When you combine emotion with legalese, the path of least resistance is to just sign your name without much consideration of what you're doing. I had a few moments of, "They wouldn't be offering me this if it wasn't in my best interest" only to stop, want to slap myself, and dig into more research.

Now the remodeling begins. That'll be another story.

[morganhousel]

Tyranny of the Calendar

About 4.6 billion years ago, a cloud of hydrogen and dust collapsed and gave birth to our Sun. Then, 4.5 billion years ago, some comet debris coalesced and formed planet Earth. The laws of physics mean the gravitational pull of the former pulls the latter around its orbit every 365.25 days.

Somewhere along the way we decided that this orbit -- one year -- is the perfect amount of time to measure a money manager's performance against.

Daniel Kahneman is one of the smartest scientists to ever live. But I never agreed with an assessment he made about the performance of money managers.

Kahneman took the performance data of 25 professional investors, and calculated the correlation of one year's performance with the next. He wanted to separate skill from luck. If a money manager was skilled, he should beat the market every year, the logic went. If he only beat it some years, he was just lucky. Kahneman wrote:

I computed the correlations between the rankings of advisors in different years, comparing Year 1 with Year 2, Year 1 with Year 3 and so on up through Year 7 with Year 8. That yielded 28 correlations, one for each pair of years. While I was prepared to find little year-to-year consistency, I was still surprised to find that the average of the 28 correlations was .01. In other words, zero. The stability that would indicate differences in skill was not to be found. The results resembled what you would expect from a dice-rolling contest, not a game of skill.

But why one-year returns? Why not 13 months, or two-and-a-half years? Or 5.21 years?

You should expect year-to-year stability in investing returns if there is something special about a year. But there's not. A money manager is looking for exploitable opportunities, not all of which will fit neatly into a time period governed by the gravitational pull of a celestial ball of gas. Anyone using astrology to measure future returns is considered a lunatic, but almost everyone uses it to measure past returns.

Take the 50-year record of Warren Buffett, whose success virtually everyone agrees comes from more than luck.

Buffett has outperformed the S&P 500 by more than a million percentage points since he took over in 1964. But he underperformed the market in a third of all years -- better than a coin toss but not much. In years when Berkshire Hathaway generated its highest returns, beating the market by more than 10 percentage points, it was almost as likely (39.5% of the time) to underperform the market the following year as it was to beat it at all.

If you measure Buffett based on the stability of year-to-year returns, he hardly looks better than a coin flipper. It's not until you view five-, 10-, and 15-year periods that he's delivered consistent outperformance:

YEARLY DATA SINCE 1965. MONTHLY, QUARTERLY, AND DAILY DATA SINCE 1985. S&P CAPITAL IQ. INCLUDES DIVIDENDS.

Buffett's partner, Charlie Munger, is about the same. Munger ran a hedge fund from 1962 to 1975 that beat the market by more than tenfold during its lifetime. But he underperformed the market in more than a third of all years, including four of his last six.

Kahneman's main point is that most money managers trail the market, which is true no matter how you slice the numbers.

But an obsession with stable year-to-year performance makes investors look worse than they are. In March,The New York Times reported that out of 2,862 equity mutual funds, not a single one beat the market in each of the last five years. But if you look at an entire five-year period, rather than individual years, you'll see that about one in five equity funds did outperform its benchmark. That's still abysmally low, but "beating the market every year for five years" gives a different answer than "beating the market over the lastfive years." And the latter is clearly more important.

To me, the problem is that an obsession with the calendar pushes investors to focus on beating the market each year, which is a perfectly insane, unattainable goal. No one can do it. But managers feel like they have to do it because it's the standard measure of performance. Many managers will be fired by investors after a bad year. Their only hope is a desperate, rarely successful attempt to fit outperformance within the time frame of Earth's orbit. Does anyone see how crazy this is? People use one-year returns to show how hard it is to beat the market, but I wonder if the biggest challenge to beating the market is the pressure to do it in one-year intervals.

Part of me gets it. Performance has to be measured, and measures need a yardstick, however arbitrary. We might have a different list of baseball greats if players were allowed two strikes instead of three and a different list of Super Bowl champions if a quarter lasted 16 minutes rather than 15. But the line has to be cut somewhere.

Investing, though, is personal. All that matters is performance between today and your end goal, not the individual years in between.

"Better three hours too soon than a minute too late," Shakespeare said. I imagine that's the tyrannical mind-set of so many investors fighting to outperform by Dec. 31. I don't ever want to go there.

[morganhousel]

The Hierarchy of Investor Needs

One summer in college I interned at an investment bank. It was the worst job I ever had.

A co-worker and I survived our days by bonding over a mutual interest in the stock market.

My co-worker was brilliant. Scary brilliant. The kind of guy you feel bad hanging out with because he makes you realize how dumb you are. He could dissect a company's balance sheet and analyze business strategies like no one else I knew or have known since. He was the smartest investor I ever met.

He went to an Ivy League school, and after college he landed a high-paying gig at an investment firm. He went on to produce some of the worst investment results you can imagine, with an uncanny ability to pile into whatever asset was about to lose half its value.  

This guy is a genius on paper. But he didn't have the disposition to be a successful investor. He had a gambling mentality and couldn't grasp that his book intelligence didn't translate into investing intelligence, which made him wildly overconfident. His textbook investing brilliance didn't matter. His emotional faults led him to be a terrible investor.

He's a great example of a powerful investing truth: You can be brilliant on one hand but still fail miserably because of what you lack on the other.

There is a hierarchy of investor needs, in other words. Some investing skills have to be mastered before any other skills matter at all.

Here's a pyramid I made to show what I mean. The most important investing topic is at the bottom. Each topic has to be mastered before the one above it matters:

Every one of these topics is incredibly important. None should be belittled.

But you can be the best stock-picker in the world, yet if you buy high and sell low – the epitome of bad investing behavior – none of it will matter. You will fail as an investor.

You can be a great stock-picker, but if you only have 20% of your assets in stocks – a poor asset allocation for most investors – you're not going to move the needle.

You can be a super-tax-efficient investor. But if your stock selection is poor, you're not going to have many capital gains to pay taxes on in the first place. And if you're paying too much for advice, tax savings can be irrelevant.

A common problem for any investor to stumble on is the temptation to solve one problem without first mastering a more fundamental one. It can drive you crazy, because if you've gotten the hang of an advanced topic, you might think that you're on the road to success, but something more basic like investor behavior or asset allocation could still put you on a road to ruin. Just like my old co-worker.

For more:

The blind forecaster

The world's smartest investors have failed

What's wrong with finance

Markets change. So should you.

[morganhousel]

Short Investing Philosophies

The Spartans were fans of brevity.

In his book The Warrior Ethos, Steven Pressfield tells the story of a Spartan general who captured a city. "His dispatch home said, 'City taken.' The magistrates fined him for being verbose. 'Taken,' they said, would have sufficed."

People are persuaded by complexity. It gives the impression of brilliance. But if you can't explain something simply you probably don't understand it at all.

Years ago, journalist Jason Zweig was asked if he could summarize his investment philosophy in 10 words or less. At first he laughed and said no.

With some more thought, he came up with, "Anything is possible, and the unexpected is inevitable. Proceed accordingly." He went on to ask investors to do the same and they came up with some amazing responses.

I love this exercise. My own would be: "Worry only when you think you have it figured out."

I asked my investing friends to sum up their investment philosophy in 10 words. Here's what I got.

Tom Gardner, Motley Fool: "Find remarkable leaders on a lifelong mission -- buy and add."

Bill Mann, Motley Fool Asset Management: "Seek to invest alongside great managers. Then, be patient."

Josh Brown, CNBC, The Reformed Broker: "Roses are red, violets are blue. I don't know what will happen and neither do you."

Barry Ritholtz, Bloomberg: "Keep it simple, do less, and manage your stupidity."

Robert Brokamp, Motley Fool: "Diversification reduces risk, increases predictability, and boosts returns."

Michael Batnick, Ritholtz Wealth Management: "Avoiding catastrophic mistakes matters more than constructing the 'perfect portfolio.'"

Tim Hanson, Motley Fool: "Buy the awesome at prices that don't reflect their awesomeness."

Cullen Roche, Pragmatic Capitalism: "Low-fee, tax-efficient, index-based global-macro asset allocation."

Rich Greifner, Motley Fool: "Think long term, stay patient, and seek asymmetric returns."

Eddy Elfenbein, blogger, Crossing Wall Street: "Be patient and ignore fads. Focus on value. Never panic."

Michael Kitces, financial adviser: "Invest long term, don't speculate. But don't ignore market valuations."

Ben Carlson, author of A Wealth of Common Sense: "Less is more. Process over outcomes. Behavior is the key."

James Early, Motley Fool: "Exploit the cognitive weaknesses of others."

Harold Pollack, University of Chicago: "Save 15-20%. Low-fee Indexes. Pay off plastic. Maximize 401(k)."

Ron Gross, Motley Fool: "Buy solid companies with a margin of safety and hold."

Tren Griffin, blogger, 25iq: "Rationally purchase assets at prices creating a margin of safety."

Jeff Fischer, Motley Fool: "Own stocks to compound. Use options for income. Short failures."

Bryan Hinmon, Motley Fool Asset Management: "Own compounders. Buy smart. Be patient."

Justin Wolfers, economist, University of Michigan: "Save money. Avoid costly advice. Diversify widely."

David Gardner, Motley Fool: "Use my six Rule Breaker traits. Buy to hold."

Matt Koppenheffer, Motley Fool Germany: "Seek differentiated, well-managed, customer-oriented businesses. Buy when undervalued. Own long term."

Seth Jayson, Motley Fool: "Be safe, keep your costs low, and don't overthink."

Craig Shapiro, venture capitalist: "Aligning self interest with broader interest will generate exponential returns."

Patrick O'Shaughnessy, OSAM: "Find pessimistic outlooks. Dig deeper. Put wax in your ears."

For more:

One Sentence Financial Rules

122 things everyone should know about investing

99% of investing is doing nothing. The other 1% will change your life

[morganhousel]

Why It Feels Like We’re Falling Behind

Wilbur and Orville Wright's airplane flew for the first time in December 1903. It was one of the most important innovations of human history, changing the world in every imaginable way.

To celebrate their accomplishment, the press offered a yawn and a shoulder shrug.

Only a few newspapers reported the Wright's first flight at Kitty Hawk, N.C. All of them butchered the facts. Later flights in Dayton, Ohio, the brothers' home, still drew little attention.

David McCullough explains in his book The Wright Brothers:

"Have you heard what they're up to out there?" people in town would say. "Oh, yes," would be the usual answer, and the conversation would move on. Few took any interest in the matter or in the two brothers who were to become Dayton's greatest heroes ever.

An exception was Luther Beard, managing editor of the Dayton Journal ... "I used to chat with them in a friendly way and was always polite to them," Beard would recall, "because I sort of felt sorry for them. They seemed like well-meaning, decent enough young men. Yet there they were, neglecting their business to waste their time day after day on that ridiculous flying machine."

It wasn't until 1908 -- five years after the first flight and two years after the brothers patented their flying machine -- that the press paid serious attention and the world realized how amazing the Wrights' invention was. Not until World War II, three decades later, did the significance of the airplane become appreciated.

It's a good lesson to remember today, because there's a growing gripe about our economy. Take these headlines:

"Innovation in America is somewhere between dire straits and dead."

"Innovation Is Dead."

"We were promised flying cars. Instead we got 140 characters."

The story goes like this: American innovation has declined, and what innovation we have left isn't meaningful.

Cancer? Not cured. Biofuel? An expensive niche. Smartphones? Just small computers. Tablets? Just big smartphones.

I think the pessimists are wrong. It might take 20 years, but we'll look back in awe of how innovative we are today.

Just like with the Wright brothers, most important innovations are only obvious in hindsight. There is a long history of world-changing technologies being written off as irrelevant toys even years after they were developed.

Take the car. It was one of the most important inventions of the 20th century. Yet it was initially disregarded as something rich people bought just to show how deep their pockets were. Frederick Lewis Allen wrote in his book The Big Change:

The automobile had been a high-hung, noisy vehicle which couldn't quite make up its mind that it was not an obstreperous variety of carriage.

In the year 1906 Woodrow Wilson, who was then president of Princeton University, said, "Nothing has spread socialistic feeling in this country more than the automobile," and added that it offered "a picture of the arrogance of wealth."

Or consider medicine. Alexander Fleming discovered the antibiotic effects of the mold penicillium in 1928. It was one of the most important discoveries of all time. But a decade later, penicillin was still a laboratory toy. John Mailer and Barbara Mason of Northern Illinois University wrote:

Ten years after Fleming's discovery, penicillin's chemical structure was still unknown, and the substance was not available in sufficient amounts for medical research. In fact, few scientists thought it had much of a future.

It wasn't until World War II, almost 20 years later, that penicillin was used in mass scale.

Or take this amazing 1985 New York Times article dismissing the laptop computer:

People don't want to lug a computer with them to the beach or on a train to while away hours they would rather spend reading the sports or business section of the newspaper. Somehow, the microcomputer industry has assumed that everyone would love to have a keyboard grafted on as an extension of their fingers. It just is not so ...

Yes, there are a lot of people who would like to be able to work on a computer at home. But would they really want to carry one back from the office with them? It would be much simpler to take home a few floppy disks tucked into an attache case.

Or the laser. Matt Ridley wrote in the book The Rational Optimist:

When Charles Townes invented the laser in the 1950s, it was dismissed as 'an invention looking for a job'. Well, it has now found an astonishing range of jobs nobody could have imagined, from sending telephone messages down fiberglass wires to reading music off discs to printing documents, to curing short sight.

Here's Newsweek dismissing the Internet as a fad in 1995:

The truth [is] no online database will replace your daily newspaper, no CD-ROM can take the place of a competent teacher and no computer network will change the way government works.

How about electronic publishing? Try reading a book on a computer. At best, it's an unpleasant chore: the myopic glow of a clunky computer replaces the friendly pages of a book. And you can't tote that laptop to the beach.

Yet Nicholas Negroponte, director of the MIT Media Lab, predicts that we'll soon buy books and newspapers straight over the Internet.

Uh, sure.

You can go on and on. Rare is the innovation that is instantly recognized for its potential. Some of the most meaningful inventions took decades for people to notice.

The typical path of how people respond to life-changing inventions is something like this:

I've never heard of it.

I've heard of it but don't understand it.

I understand it, but I don't see how it's useful.

I see how it could be fun for rich people, but not me.

I use it, but it's just a toy.

It's becoming more useful for me.

I use it all the time.

I could not imagine life without it.

Seriously, people lived without it?

This process can take years, or decades. It always looks like we haven't innovated in 10 or 20 years because it takes 10 or 20 years to notice an innovation.

Part of the problem is that we never look for innovation in the right spot.

Big corporations get the most media attention, but innovation doesn't come from big corporations. It comes from the 19-year-old MIT kid tinkering in his parents' basement. If you look at big companies and ask, "What have you done for the world lately?" you're looking in the wrong spot. Of course they haven't done anything for the world lately. Their sole mission is to repurchase stock and keep management consultants employed.

Someone, somewhere, right now is inventing or discovering something that will utterly change the future. But you're probably not going to know about it for years. That's always how it works. Just like Wilbur and Orville.

For more on this topic:

Everything is amazing and no one is happy

50 reasons we're living through the greatest period in world history

Why I'm an optimist

[morganhousel]

What Good Is History?

Do you read history? Believe almost all of it? Use it as a guide to the future?

Me too. But let's consider something. Take these two statements:

"11 million jobs have been created since 2009. The stock market has tripled. The unemployment rate nearly cut in half.  The U.S. economy has enjoyed a strong recovery under President Obama."

"The recovery since 2009 has been one of the weakest on record. The national debt has ballooned. Wages are stagnant. Millions of Americans have given up looking for work. The economy has been a disappointment under President Obama.

Both of these statements are true. They are both history. Which one is right?

It's a weird question, because history is supposed to be objective. There's only supposed to be one "right."

But that's almost never the case, especially when an emotional topic like your opinion of the president is included. Everyone chooses the version of history that fits what they want to believe, which tends to be a reflection of how they were raised, which is different for everybody. We do this with the economy, the stock market, politics -- everything.

It can make history dangerous. What starts as an honest attempt to objectively study the past quickly becomes a field day of confirming your existing beliefs. This is like steroids for inflating your confidence and puts you on a path to misguided, regrettable decisions. (Misguided and regrettable decisions being the one thing everyone agrees history is filled with).

In his book Why Don't We Learn From History?, B.H. Liddell Hart wrote:

[History] cannot be interpreted without the aid of imagination and intuition. The sheer quantity of evidence is so overwhelming that selection is inevitable. Where there is selection there is art.

Those who read history tend to look for what proves them right and confirms their personal opinions. They defend loyalties. They read with a purpose to affirm or to attack. They resist inconvenient truth since everyone wants to be on the side of the angels. Just as we start wars to end all wars.

I see this all the time in investing. The amount of investing data is incomprehensible and growing by the day. Anyone can think up a narrative, then sift through mountains of historical data to find examples backing it up.

Think stocks are expensive? History agrees. Think stocks are cheap? History agrees. Think tax cuts spur economic growth? History agrees. Think tax cuts don't spur economic growth? History agrees. History shows that raising interest rates is both good and bad for stocks. It proves that buy-and-hold investing is the best and the worst strategy. In the age of big data, no idea is so absurd that a good spreadsheet can't make it look right.

And a lot of the historical events investors try to study -- recessions, bear markets, bouts of hyperinflation -- are rare enough that we don't have many episodes to draw conclusions from.

To know a lot about recessions, for example, you'd ideally want hundreds of examples to study. But there have only been 33 recessions in the last 150 years. And the data we have on most of them is dubious. Estimates on how much the economy contracted during the 1920 recession range from 2.4% to 6.9%, which is the difference between a moderate recession and a near-depression. In the last 50 years, when data is more reliable, there have been just seven U.S. recessions. So how are we supposed to take seriously any historical statistic about the average recession? How long the average recession lasts? How frequently they occur? How high unemployment goes? We're talking about something that has occurred just seven times in the last half-century.

So, what good does looking at history do us?

A lot, in fact. You just can't take it too far.

People get history wrong when they look back at specific events and expect them to repeat in the future. It's so easy to underestimate how much past events were caused by trivia and accident rather than trends that should repeat in some clean way. Investors who have unshakable faith in markets reverting back to specific historical averages have some of the worst track records you can imagine. This goes into overdrive when you acknowledge the subjectiveness of historical recordkeeping. "I have written too much history to believe in it," historian Henry Adams once said.

But history can be great at teaching broad, unspecific lessons. Here are five.

Something usually occurs to keep good news and bad news from going on forever. Recessions end because excess gets washed away; booms end because everything gets priced in. Most people wake up every morning wanting to make the world a better place, but psychopaths, idiots, charlatans, and quacks are persuasive enough to occasionally shake things up.

Unsustainable things last longer than you think. Every war was supposed to be over in a month, every boom was surely going to pop any day, and every round of Federal Reserve money printing meant high inflation right around the corner. In reality, things that look unsustainable can last for years or decades longer than seems reasonable. "I was right, just early," are famous last words, and indistinguishable from "wrong".

Normal things change faster than you expect. "History doesn't crawl," Nassim Taleb writes, "it leaps." Things "go from fracture to fracture, with a few vibrations in between. Yet we like to believe in the predictable, small incremental progression."

Irrationality spreads at the worst possible times. Most people can keep their heads straight when things are calm. It's when things get exciting -- bull markets, bear markets, wars, recessions, panics -- that emotions take over. Importantly, decisions during made during those crazy moments are the most important decisions you make over the long run.

Nothing is stronger than self-interest. When someone in charge of lots of people gains the most by promoting their own interests, you get inefficiencies at best, disaster more often. What everyone knows is the truth or the right thing to do is ignored because a few people can get ahead doing something else. This describes most organizations.

For more on this topic:

Histories of things that never happened

Why I'm an optimist

50 reasons we're living through the greatest period in world history

[morganhousel]

Maybe Yes, Maybe No

Statistician Nate Silver correctly predicted the outcome of every state in the 2012 presidential election. It instantly shot him to fame in a field most people associate with the most boring class they ever took. He's been on The Daily Show twice. He has more than a million Twitter followers.

But the most important part of Silver's analysis is that he's not really making predictions. Not in the way most people think of predictions, at least.

You will never hear Silver say, "He is going to win the election." You might hear him say, "He has a 60% chance of winning," or "The odds are in her favor." Pundits make predictions. Nate Silver calculates probabilities.

All probabilities of less than 100% admit a chance of more than one outcome. Silver put a 60% chance of Obama winning Florida in the 2012 election, which, of course, implied a 40% chance that he wouldn't win. Silver's pre-election probability map gave Obama the edge. But, had Mitt Romney won the state, it wouldn't necessarily have meant Silver was wrong. In his book The Signal and the Noise, Silver wrote:

Political partisans may misinterpret the role of uncertainty in a forecast; they will think of it as hedging your bets and building in an excuse for yourself in case you get the prediction wrong. That is not really the idea. If you forecast that a particular incumbent congressman will win his race 90 percent of the time, you're also forecasting that he should lose it 10 percent of the time. The signature of a good forecast is that each of these probabilities turns out to be about right over the long run ... We can perhaps never know the truth with 100 percent certainty, but making correct predictions is the way to tell if we're getting closer.

What set Silver apart is that he thinks of the world in probabilities, while the punditry crowd of coin-flipping charlatans thinks in black-and-white certainties. His mind is open to a range of potential outcomes before, during, and -- most important -- after he's made his forecast. Things might go this way, or they might go that way. He adjusts the odds of certain outcomes when new information arrives. It's the most effective way to think about the future.

Why don't more people think like Nate Silver?

Twenty years ago, Berkshire Hathaway vice chairman Charlie Munger gave a talk called The Psychology of Human Misjudgment. He listed 25 biases that lead to bad decisions. One is the "Doubt-Avoidance Tendency," which he described:

The brain of man is programmed with a tendency to quickly remove doubt by reaching some decision.

It is easy to see how evolution would make animals, over the eons, drift toward such quick elimination of doubt. After all, the one thing that is surely counterproductive for a prey animal that is threatened by a predator is to take a long time in deciding what to do.

In other words, most of us don't think in probabilities. It's natural to quickly seek one answer and commit to it.

If you watch financial TV, or read investing news, you will almost never hear someone say there's a 55% chance of a recession this year. They say there is going to be a recession this year. Rarely does an analyst say there's a 60% chance of a bear market this year. They say there is going to be a bear market this year. There's no room for error. There are no probabilities. People want exact answers, and pundits are happy to oblige.

Consumers of financial news are part of the problem. Not knowing what the future holds is scary. But you don't gain much confidence hearing someone say there's a 60% chance of one outcome and a 40% chance of another. We are more likely to listen to a forecaster who uses unwavering confidence to insist they know the future. It's like warm milk for our fears.

But thinking in certainties is usually a reflection of how you want the world to work, rather than how it actually works. Silver writes:

Acknowledging the real-world uncertainty in [pundits'] forecasts would require them to acknowledge to the imperfections in their theories about how the world was supposed to behave — the last thing that an ideologue wants to do.

If you have a view of the world that says raising taxes will slow the economy, no amount of information will change your mind. You won't tolerate a claim of an 80% chance a tax cut could slow the economy, because it leaves open the possibility that your entire world view about tax cuts could be wrong.

One of the top reasons investors make mistakes is that the world works in probabilities, but people want to think in certainties. It's why bear markets surprise people, banks use too much leverage, budget forecasts are always wrong, and most pundits make themselves look like idiots.

As soon as you start thinking probabilities, all kinds of things change. You'll prepare for risks you disregarded before. You'll listen to people you disagreed with before. You won't be surprised when a recession or a bear market that no one predicted occurs. All of this makes you better at handling and navigating the future -- which is the point of forecasting in the first place.

Here's Silver again:

The more eagerly we commit to scrutinizing and testing our theories, the more readily we accept that our knowledge of the world is uncertain, the more willingly we acknowledge that perfect prediction is impossible, the less we will live in fear of our failures, and the more liberty we will have to let our minds flow freely. By knowing more about what we don't know, we may get a few more predictions right.

For more on this topic:

Admit it: No one has any idea what's going on

The blind forecaster

You would have never believed it