First Principles: What is Investing?

First Principles: What is Investing?

Everything In Life is Finite

Time, energy, attention, discipline, money, love. All of the resources we have are limited. What you are able to do with them is only limited based on the decisions that you make.

Investing is a skill to be able to manage those finite resources and effectively allocate them to create the best possible outcomes.

Time management, exercise, meditation, mutual funds, marriage. These are all activities or institutions we've created to help us best invest what limited resources we have. The goal of all of them is to generate a positive return.

Someone who is obsessed with productivity and efficiency is an investor of time. People who focus on exercise and healthy eating are investors of energy. Spending time identifying businesses, properties, and products to put money behind are investors of capital.

Most people think of investors as exclusively financial investors; people who invest money. Not all investors are focused on investing capital. But even among investors of capital, they are NOT just venture capital and private equity investors.

Someone who has worked their way up the corporate ladder and is now running a profitable carpet business in the midwest that you've never heard of? They're an investor. They have capital (the profits from the carpet business) and they have to make decisions about how to allocate that capital (do they modernize their machines? Increase their marketing? Buy a competitor?) And they'll be judged based on their ability to spend that money to create the optimal outcomes.

Start asking yourself: "how is this person allocating resources?" You'll realize that everyone is an investor. Broaden your horizons to understand the wide range of valuable insights from different investors that can benefit you personally and professionally.

Risk & Return

When you're evaluating any investment decision the key questions are around pros and cons. What could go right? And what could go wrong? The phrase "risk-adjusted returns" encompasses the calculation behind (1) How likely is this going to be a good outcome? (2) Just how good could that outcome be (e.g. is this a $1M idea or a $10B idea?), and (3) How likely is this going to be a bad outcome?

Then you ask yourself if the risk justifies the investment:

  • Should you love someone if they're not going to love you back?
  • Should you spend time doing something if it doesn't have a positive result?
  • Is something worth the energy required to do it?

When we find something we want to invest in, we often find ourselves easily picturing the best outcome, no matter how unlikely it is, and rarely predicting the worst outcome. Likely this comes down to a weakness in "risk literacy."

The ability to calculate risk correctly is based on understanding the likelihood of different outcomes. Some people summarize the role of an investor as "pattern recognition;" effectively identifying the frequency with which certain outcomes have occurred. All the work that professional investors do revolves around lowering the uncertainty with which they have to calculate those odds around any given outcome.

You have to live in a world where there are known and unknown variables. If I give you a math problem or a case study, you may know all of the important variables. But in the real world you're going to have to make countless decisions where all the variables aren't known.

Risk: Other Resources

Making Smart Decisions

In this video, Professor Gigerenzer makes a key point. We often thinks risks are calculable and we simply need to maximize the outcome based on a clear calculation. He illustrates the problem with pure calculation of risk in the real world.

When you ask a baseball player how they catch a fly ball, you never hear anyone say that they literally calculate the trajectory (see the formula below). Instead, they have a "heuristic" or rule of thumb that they can use to interact with the world around them and react as best they can.

image

As you evaluate all the opportunities you could pursue you will start to develop these types of heuristics and shorthands for what is interesting. Investing is the ability to understand what opportunities are available to you, what are the benefits and costs, and then evaluating your own psychology that might be impacting your decision making process. Don't lose sight of what your heuristics are and how they might be wrong.

💡

"It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent."

Forecasting

💡

"Investing is about making good forecasts. Too many investors subscribe to this clinical or expert-based judgement where 'if I know a lot about something I should be able to make good forecasts.' Philip Tetlock did this amazing study where he surveys thousands of experts over a 10 year period looking at some 30,000 forecasts and he finds that expertise in a given field does not improve forecast accuracy. All it does is increase your confidence in the accuracy of your forecasts. And if you think about investing there's nothing more dangerous than increasing your confidence that increasing your accuracy."

There is a difference between incremental information and differentiated insights. Most of the work we do (e.g. too much of the work we do) is just gathering information to make ourselves more confident. But if we could just find one piece of differentiated insight that would be more beneficial than hours of incremental work.

💡

"The only way to win is to work, work, work, work, and hope to have a few insights. And it makes sense to load up on the very few good insights you have instead of pretending to know everything about everything at all times."

The more you learn you start to get attracted to complexity. "You're learning this information for the first time, but this isn't the first time this thing has ever been learned." Don't just seek out more and more complex problems because it feels good.

💡

“Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”

Roger Lowenstein wrote, in his biography of Warren Buffett, "Buffett avoided trying to forecast the stock market, and most assuredly avoided buying or selling stocks based on people’s opinions of it. Rather, he tried to analyze the long-term business prospects of individual companies."

For more see:

Ownership

Another key fundamental of investing is ownership and accountability. If I did a lot of research 10 years ago and decided that Amazon was a good investment but then did nothing about it, all I can do is sit back and say "I told you so" without any real benefit. The benefit comes in committing to something once you've done the work.

A common way to think about the benefits of ownership is comparing paying rent to paying a mortgage. When you pay rent you get short-term use of a place to live but no long-term benefit. When you pay off a mortgage you slowly own more and more of a house which will hopefully increase in value over time, giving you a long-term benefit.

Robert Downey Jr. and Chris Evans co-starred in the movie Avengers: Endgame. They each made ~$15M - $20M salaries for the film. Ownership, though, is what put Robert Downey Jr. over the top. He negotiated to receive 8% of profits from the movie, which meant in all he made $75M.

Evaluate your investment decision as buying a whole business, not a stake in a business. Assume you're getting all the good and all the bad.

Compounding

It's easy to think about money and time going out, but how do you think about it coming back in? How does the things you invest in create more money, more time, more energy? In any kind of investing, you're not just considering what is my one resource outflow and what is my one resource inflow?

If you trade one outflow (cash) for a treat, you get temporary satisfaction (inflow). But real investments in relationships, skills, and quality businesses have long-term compounding benefits. Understand the compounding aspects of any investment you make.