My views on compounding, a resource for investing frameworks and business models, how to beat the pandemic
When I read Reddit threads on investing and Twitter, people largely talk about how they want to hold stocks for the long-term. Over time, the number of new positions that they start (often on a daily/weekly basis) suggests that it's highly unlikely that they're truly long-term investors.
My views on the power of compounding and the discipline it requires have largely been driven by working at Constellation Many people are astounded by the growing cash flows generated by Constellation (over $355M in Q4) when the reality is that we're seeing the benefits of investments made ~3-4 years ago. It takes incredible discipline to stay true to your criteria during a down and upcycle. In fact, I'd argue it’s easier during a down cycle where you have the satisfaction of making a 'good deal.'
I also learned a great deal about compounding by reading Morgan Housel's book called Psychology of Money. I'd highly recommend it to everyone as I believe it compiles a number of painful lessons that would otherwise take years to experience.
Here's a couple of sections that I wanted to highlight today.
The End of History Illusion
This is what psychologists call the tendency for people to be keenly aware of how much they've changed in the past, but to underestimate how much their personalities, desires, and goals are likely to change in the future.
As Harvard Psychologist, Daniel Gilbert, says "All of us are walking around with an illusion - an illusion that history, our personal history, has just come to an end that we have just recently become the people that we were always meant to be and will be for the rest of our lives."
This is an important insight when it comes to enabling the power of compounding.
Charlie Munger's first rule of compounding is to never interrupt it unnecessarily.
This has definitely been true in my experience with investing. I can't count the number of times I have gotten in my own way of making outstanding returns.
Identifying great opportunities is only one part of the equation - holding them long enough to reap the rewards of the investment is the other part.
From this perspective, leverage is extremely dangerous. On one end, it can really accelerate your returns especially today where unsecured lines of credit can be had at ~1.5% interest.
However, it can also wipe you out during the times when you should double down. I experienced this first hand during the sudden drop back in March 2020.
The Price of Compounding
It's easy to talk about holding investments for the long-term. Very few people recognize how hard it is to actually do nothing but hold.
The fear of missing out on greater returns or suffering through greater losses often prevents us from holding during the extreme highs and lows of any market cycle.
When it comes to investing, we have a few options:
Pay today's price and accept volatility and upheaval
Find an asset with less uncertainty and a lower payoff
Try to get the return while avoiding the volatility that comes along with it
Most of us end up taking the last option. The irony is that by trying to avoid options 1 or 2, many investors end up paying double.
So why do people, who pay up for food, housing, clothes, don't want to pay the price of compounding returns?
It's largely because the price of compounding is generally unknown. It's important to think about volatility as a fee vs. a fine.
For investors who are entering today's market with expectations of making 20%+ returns, it's important to accept the possibility of 20%+ declines.
Once you start to accept that market volatility is the price of compounding, the next question you should ask yourself is which assets are worth paying the price of volatility.
This is probably one of the best documents I've seen on a wide variety of investing frameworks and business models. Here's a couple of sections that caught my attention:
The Seven Deadly Sins Are Actually The Seven Core Motivators
All successful consumer-facing companies appeal to one or more of the seven deadly sins. They are time-tested core motivators that incentivize people to do things (the fact that they have survived for all of time without any edits is proof of their power). There are no successful consumer companies that do not appeal to any of the seven deadly sins.
Different motivators can apply to different constituents within each company, even different behaviors from the same constituent.
Sloth: Uber, Amazon
Pride: Instagram, Tik Tok
Gluttony: DoorDash, Netflix
Lust: Tinder, OnlyFans
Greed: Bitcoin, Robinhood
A Specialized Tool Will Always Beat A Generalized Tool Over Time
A Swiss Army knife is very useful when you are space constrained. It is less useful when you need a dedicated screwdriver to assemble a room full of furniture. Similarly, products with a generalized value proposition will inevitably be cannibalized by more specialized competitors. Convenience is the only defense generalized tools have against erosion by specialized tools.
First Order Irrational, Second Order Rational
A very effective strategy to unlock potential energy in what may seem to be a calcified ecosystem is to do something that the existing, entrenched players deem to be completely irrational. The conceit in this strategy is that while the behavior may seem irrational at the first-order level, it is rational at the second-order level and often leads to a market-leading position if not a monopoly.
Distribution vs. Monetization
Platforms focus on offering the supply side of their ecosystem either distribution or monetization. Those that focus on a combination of both will be challenged by the specialized vs. generalized dynamic over time.
How to Beat the Pandemic by Summer
Living in Toronto, I'm incredibly pessimistic that we won't return to any state of normalcy until the end of the year. However, I found this post in the Atlantic to give a succinct view on how to solve the challenges of vaccine distribution.
The four main bottlenecks to accelerating vaccinations are:
Authorization: You can’t receive a vaccine that the FDA hasn’t authorized or approved.
Supply: Even with several vaccines authorized, you can’t get vaccinated if there’s a critical shortage of shots.
Distribution: Even with lots of vaccines available, we still need to distribute them to states, cities, hospitals, and clinics and create eligibility rules that people can understand.
Demand: Even if the public-health establishment does everything right, that won’t matter if Americans don’t want a vaccine.
My biggest fear is that we're constantly focused on the bottleneck of today (e.g. authorization/supply) that we don't spend enough time thinking about future bottlenecks (distribution/demand). This will inevitably lead to delays and wasted effort simply due to a lack of foresight.
Thanks again for reading this week’s newsletter. If you can just comment on what you think is interesting, what you find confusing, and what you think is boring or irrelevant, that would be really helpful.
Until next week,