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Success and Leverage (Oddball Stocks blog)


Liberty
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http://www.oddballstocks.com/2015/03/leverage-and-success.html

 

Food for thought by Nate.

 

What does all of this have to do with success?  As I've looked at successful people a theme has become clear, all have leverage in their life.  Some have achieved success through financial leverage, others through operational leverage, but always leverage. […]

 

Leverage doesn't always need to be obtained through financing or outside investment either.  It's possible to create a business with sweat equity where operational leverage is created through hard work.  If possible this is the best type of leverage to look for.

 

While there isn't a formula for success one thing is clear.  Abnormal success doesn't occur without some sort of leverage.  The trick is finding how to best incorporate leverage as well as manage the risk.

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A good quote from Buffett comes to my mind when I read this:

 

Buffett: "Most people fail because of leverage and liquor."  ;)

 

That's true. But the question here is about success, not failure.

 

If you read Nate's post, you'll see that he isn't talking about just financial leverage, but also operational, and what I would call "putting yourself in situations where success is scalable". Leverage is kind of an ambiguous word for that.

 

Buffett himself has done quite well with leverage, as have many of the companies in which he's invested.

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Most people benefit from a normal job as starting your business and "leveraging your potential" entails a lot more risk than most would estimate.

 

Success in scalable jobs and businesses is quite rare. It's a system of the winner(s) take(s) all, meaning very few winners and a lot of losers. So those failing people and businesses that took on leverage (in any way) are silent evidence (see Taleb's Black Swan) that people don't take into the equation.

And how are you sure that (some of) the successful entrepreneurs didn't take equally excessive risks than those that failed but just turned out to be the lucky ones? You can't just assume that those that were succesful were able to effectively manage their risk.

 

Luckily for them, wage slaves get paid regardless of what the business they work for does. 99.9% of people should stay clear of excessive leverage (be it through a scalable job or business, an enormous mortage, margin debt for portfolios, ... ) as most wouldn't even be able to handle the additional stress, let alone the possible financial despair when things go south.

 

Also, I would argue that success in business is a lot like getting a good track record in investing. Generally markets are rather efficient and it's very hard to get ahead of the crowd by pure skill. You could look at options, portfolio concentration*, ... as the leverage in investing versus debt, scalability/fixed costs, ... for businesses. You can take on that leverage and have a small chance at becoming very succesful or you can blow up or at least perform subpar. But just like in investing you can become successful in business by exploiting market inefficiencies, there is no denying that.

Anyway, over the longer term you need the skill but the luck is definitely a big boost. Even for The Outsiders (see the book) I would argue that it is hard to determine how much of it was skill and how much was luck. Gladwell also had a good example on Buffett's life in his book Outliers.

 

 

But I'm confident that Nate will agree with me on most things here. Just some ramblings.  ;)

 

 

*Before all outperformers start replying: Do you hold 500 companies in your portfolio like your benchmark?

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Tom,

 

Good points.  I've had a few comments related to survivorship bias and here are my thoughts on it.  This thing is riddled with survivorship bias, but that's what we want to look at, the survivors.  Not everyone who tries to start a business succeeds, but everyone who succeeds has some leverage.  Is it luck that caused success? I don't know, I'd say for any venture luck plays a larger part than anyone would admit to.

 

Most people want the safe path in life.  But I'd argue that working a job for a company is actually the riskiest path.  Say you have a business mowing lawns.  You mow 100 lawns a week to make ends meet.  On a given Friday you're in a bad mood and mess things up, maybe you lose 3-5 customers.  It's not the end of the world, your client base is diversified.  Working for an employer is like diversifying your entire portfolio into a single stock.  The problem is how well you work or how hard you work doesn't always matter.  A friend told me recently the best person in his department was fired because a new manager was hired and their personalities didn't match.  That best worker didn't have a choice in who was hired, and it wasn't like they could change their or the new boss' personality.  They were 100% concentrated in a stock and ended up on unemployment, yet they were the best.

 

Where people kill themselves with leverage is by financing depreciating things or not looking for margins of safety.  That sounds too platitudish, but I think it's true. 

 

There are a LOT of simple scalable things someone could do on the side.  Look at self publishing on Amazon, or even just writing a blog about something that interests them.

 

Maybe this idea is similar in nature to the Graham & Doddsville thing.  Was it value investing that caused all of those investors to do well?  Maybe it was something psychological.  The fact remained that all of those investors all learned under Graham, and Graham was this common thread.  I'd argue success and leverage are the same.  Is it the leverage itself?  Maybe it's how risk is managed when leverage is present.  I don't know, but I can't get away from the thought that when I read and look at success stories both individual and in business leverage (or some aspect of scalability) is involved.  Is it a cause or effect? 

 

Someone with zero leverage would be a worker who saves for retirement in a 100% cash account.  Investing in a 401k or on the side introduces a small amount of leverage that through 20-30 years of investing grows large. 

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A little aside on something that's been bugging me:

 

Mention survivorship bias, and a lot of people's brains turn off. "Oh, of course, they're successful, but survivorship bias, so it doesn't mean anything."

 

This bias doesn't mean that these people haven't done anything except be lucky to be successful. In a coinflip contest, sure, that's what it is. But in other areas of life, there's still things to be learn from studying winners even if they aren't representative of the average person that tried to do what they did.

 

Evolution by natural selection shows you the results of a contest between adaptations. Sometimes it can be luck that made certain genes succeed, but many times there's a reason why these genes were passed on. The same can be true for studying successes and failures, unless you think you're just a feather on the wind, with no control on your life.

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Hi Nate,

 

To be clear, I completely agree on your premise that real success is extremely unlikely to happen without leverage. You made a good analogy with the G&Dville thing. You're right that not all usage of leverage by average folks is risky when done wisely and it's an important distinction to make. It's somewhat easier to determine skill from luck in those smaller and less complex activities that many people can undertake versus the complex world of business and investing.

 

Thank you for expanding on your thoughts, I'll be thinking them over tonight.

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A little aside on something that's been bugging me:

 

Mention survivorship bias, and a lot of people's brains turn off. "Oh, of course, they're successful, but survivorship bias, so it doesn't mean anything."

 

This bias doesn't mean that these people haven't done anything except be lucky to be successful. In a coinflip contest, sure, that's what it is. But in other areas of life, there's still things to be learn from studying winners even if they aren't representative of the average person that tried to do what they did.

 

Evolution by natural selection shows you the results of a contest between adaptations. Sometimes it can be luck that made certain genes succeed, but many times there's a reason why these genes were passed on. The same can be true for studying successes and failures, unless you think you're just a feather on the wind, with no control on your life.

 

I'm not sure if you posted this because I started about luck but I obviously agree. ;) As I said, the skills are needed. They are an entry pass to roll the dices of luck over the longer term. You could objectively be the best investor in the world and not come even close to others because you happen to lack some luck in some departments of life. No biggie, you'll do fine regardless.

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Operating leverage is vital.  To go back to Nate's comments on the lawn mowing business.  No matter how good you are there is little scalability.  You probably can't charge much of a premium for doing a better job.  A barber or beautician is in a similar situation.  The person who gains wealth looks for scalable businesses with fat margins.  Asset management, software, franchising, royalties, etc.  I often hear people say I should start x business and it almost always is a business with little upside beyond a regular job.  Most of the time it is much worse - more time consuming, no benefits, and less pay.  No matter how hard they work it is marginally profitable. 

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A little aside on something that's been bugging me:

 

Mention survivorship bias, and a lot of people's brains turn off. "Oh, of course, they're successful, but survivorship bias, so it doesn't mean anything."

 

This bias doesn't mean that these people haven't done anything except be lucky to be successful. In a coinflip contest, sure, that's what it is. But in other areas of life, there's still things to be learn from studying winners even if they aren't representative of the average person that tried to do what they did.

 

Evolution by natural selection shows you the results of a contest between adaptations. Sometimes it can be luck that made certain genes succeed, but many times there's a reason why these genes were passed on. The same can be true for studying successes and failures, unless you think you're just a feather on the wind, with no control on your life.

 

I'm not sure if you posted this because I started about luck but I obviously agree. ;) As I said, the skills are needed. They are an entry pass to roll the dices of luck over the longer term. You could objectively be the best investor in the world and not come even close to others because you happen to lack some luck in some departments of life. No biggie, you'll do fine regardless.

 

I didn't mean to imply that that's what you believed. I saw survivorship bias mentioned a few times lately on twitter and elsewhere, and this reminded me of this.

 

Another interesting aside, cached thoughts: http://lesswrong.com/lw/k5/cached_thoughts/

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Not all forms of leverage are bad.  Some are good some are bad.  And the risks involved also depend on the amount of leverage. Leverage if used wisely can enhance return significantly. Those who tell everyone to avoid all forms of leverage is trying to keep people ignorant.  Maybe they are right because many people are not intelligent enough to use leverage. 

 

If we look at leverage in investing, it always amaze me when some people are contemplating borrowing at 4% and getting a 7% return from the stock market thinking this is smart move because they are earning a spread of 3%. and they are borrowing for the long term. Well, there's not much of margin of safety here.

I like to hold short  term debt not long term debt. I prefer LOC/margin over mortgage. I only borrow when the expected return is around  10 times to 20+ times of interest cost and the leveraged investment's expected return can be realized within short period of time, months to 1 year. This is only possible in information age because the market is so efficient at reflecting information. Mr. Market is very emotional in the short term about what he hears. and he likes to predict what the next EPS and gets really upset if it's off by only a few cents. The more percentage the quality stock moves relative to its future value, the bigger the opportunity.  If it doesn't go anywhere for more than 1 year, I consider I made a mistake.Worst case is I break even or at a small loss.  I think it's very risky to do a leveraged lump-sum investment.  Leveraged investment should always involves multiple entry points depending on the price movement..e.g. -10%,-20%,-30%.,-40%.. etc. i am not suggesting averaging down on a value trap! The most important factor in investing to me is quality. Price is secondary. When quality and low price both exist, it's golden.    The risk is different at different price so I can have different positions for the same stock with different risk/return ratio.  Overall, the returns are being averaged out and the final result mostly turned out okay. Being a small investor is a huge advantage compared to institutional investors.  The bigger the portfolio, the harder it is to do leverage safely and respond to situations quickly.

 

 

Here's a relevant article about leveraged investing: http://www.moneysense.ca/magazine-archive/leverage-investing-borrow-big-retire-rich

 

 

 

 

 

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Working for an employer is like diversifying your entire portfolio into a single stock.  The problem is how well you work or how hard you work doesn't always matter.  A friend told me recently the best person in his department was fired because a new manager was hired and their personalities didn't match.  That best worker didn't have a choice in who was hired, and it wasn't like they could change their or the new boss' personality.  They were 100% concentrated in a stock and ended up on unemployment, yet they were the best.

 

I agree with your other points, but you are really misrepresenting the situation there.

 

I'll flip your argument completely: if you are the best worker, it does not matter that you are fired, you can find another job easily, possibly even better one with better pay.

 

Your example only makes sense if employee is in bad business field (e.g. even if they are best street sweeper, they could be fired and be unemployed for long time). But that's because they chose bad business and not because they chose to work for employer. A person choosing to be entrepreneur in bad business will suffer similarly.

 

A lot of people in the world can do quite well by working for employers. They can do above average if they choose profession well. (It is tough to choose profession well if you lack skills/training/education, etc., but that's also tough position to be in if you want entrepreneur.)

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Nate's blog is accumulating a bunch of non-stock-related, insightful posts.  We his readers are benefiting from his self-described slacker mentality during his high school and college years.  I for one am glad he wasn't an academic stand-out, where he would have been indoctrinated in the ho-hum conventional ideas.  Looks to me like he is a self-educated late-bloomer, thus the oddball, off-beat perspectives, not to mention leveraging this independence with his various start-ups.

 

Nate's latest post could be a kind of counterpoint, on the macro-, country level, to James Grant's history of American finance, Money of the Mind (which I just read twice this past month).  Grant candidly admits his book was like an account of the interstate highway system written from the point of view of the accidents.  An opposite case could be made that the system of American finance, in which credit was expanded to the masses, and risks were increasingly socialized, played a large part is the success of the American economy.  But along with all the financial leverage, we Americans also have more laissez-faire entrepreneurialism, better bankruptcy laws, a system of government, and rule of law.  And, taking off from Jared Diamond's Guns Germs and Steel, a lucky geography.  All of which we have leveraged into what is the most successful society ever.  A lallapalooza, as per Munger.

 

If QE turns out to be successful for the U.S., and unsuccessful in Japan and Europe, it may partly be because in those other places, QE alone is not enough.  They lack many of the fiscal and structural advantages of the U.S.  Of course, it's a whole different debate whether we have the appropriate amount of debt and stimulus, and whether we are in the sweet-spot with regard to the non-leverage factors.  Regardless, some level of leverage seems essential.

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A little aside on something that's been bugging me:

 

Mention survivorship bias, and a lot of people's brains turn off. "Oh, of course, they're successful, but survivorship bias, so it doesn't mean anything."

 

This bias doesn't mean that these people haven't done anything except be lucky to be successful. In a coinflip contest, sure, that's what it is. But in other areas of life, there's still things to be learn from studying winners even if they aren't representative of the average person that tried to do what they did.

 

Evolution by natural selection shows you the results of a contest between adaptations. Sometimes it can be luck that made certain genes succeed, but many times there's a reason why these genes were passed on. The same can be true for studying successes and failures, unless you think you're just a feather on the wind, with no control on your life.

 

I'm not sure if you posted this because I started about luck but I obviously agree. ;) As I said, the skills are needed. They are an entry pass to roll the dices of luck over the longer term. You could objectively be the best investor in the world and not come even close to others because you happen to lack some luck in some departments of life. No biggie, you'll do fine regardless.

 

I didn't mean to imply that that's what you believed. I saw survivorship bias mentioned a few times lately on twitter and elsewhere, and this reminded me of this.

 

Another interesting aside, cached thoughts: http://lesswrong.com/lw/k5/cached_thoughts/

 

Thanks for the article Liberty. I have been thinking about this a lot but had a hard time formulating my thoughts for myself. Luckily I found this article so next time I can rehash these cached thoughts. Or shouldn't I? :D I don't think we would want to know the disappointing level of unique, personal contribution we add when formulating "our" thoughts.

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OT

 

Another interesting aside, cached thoughts: http://lesswrong.com/lw/k5/cached_thoughts/

 

I did not like this article. It touched important topic(s), but I thought that it was too simplistic and I'm pretty sure "caching" model is not a good shortcut to describe how brain works. Artificial neural nets would be a better model, but possibly tougher to explain to non-computer-scientists. It also might be better model to explain why "recomputing" is not as easy as author might imply.

 

It seems that the author took "caching" and shoehorned heuristics and a bunch of cognitive biases into this model. I found his examples strange, since I personally would not complete any of them the way he did. This is not to say that I don't have (false) heuristics, biases, etc.

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I absolutely agree with the post's core insight. I think the principle can be applied in a lot of small ways, too. If you work for others, you could try to do projects that have a wider impact on the business and that are more visible, so that the recognition benefits of your work scale better. Or if you spend a lot of time writing a tutorial or instruction for a few people for a private class you teach, you could put that up on YouTube.

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Operating leverage is vital.  To go back to Nate's comments on the lawn mowing business.  No matter how good you are there is little scalability.  You probably can't charge much of a premium for doing a better job.  A barber or beautician is in a similar situation.  The person who gains wealth looks for scalable businesses with fat margins.  Asset management, software, franchising, royalties, etc.  I often hear people say I should start x business and it almost always is a business with little upside beyond a regular job.  Most of the time it is much worse - more time consuming, no benefits, and less pay.  No matter how hard they work it is marginally profitable.

 

I agree. You need scalability, otherwise why bother - the upside will be relatively limited. What you really want is not leverage as that usually cuts both ways, instead you want asymmetric pay-offs like call options. Putting effort into a scalable business is asymmetric: your down side is limited to the opportunity cost of your time while your upside is huge. A serial entrepreneur trying to make a bunch of very asymmetric situations successful should eventually get a very large pay-off.

 

I have a good friend/business partner. He isn't rich, but don't talk to him about something that can make a million or two, he doesn't get out of bed to make a million, his head space is always "Ok, my minimum goal is $100 million by xx date, can this get me there". He is very risk averse yet very focussed on this huge upside goal. He wants big scale with no to limited downside. That's basically all he thinks about.

 

 

 

 

 

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"I have a good friend/business partner. He isn't rich, but don't talk to him about something that can make a million or two, he doesn't get out of bed to make a million, his head space is always "Ok, my minimum goal is $100 million by xx date, can this get me there". He is very risk averse yet very focussed on this huge upside goal. He wants big scale with no to limited downside. That's basically all he thinks about."

 

original mungerville

I like the high expectations, thinking big and the focus of your friend.  :)

Did he have success or does his life feel terrible because of too high expectations?

 

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"I have a good friend/business partner. He isn't rich, but don't talk to him about something that can make a million or two, he doesn't get out of bed to make a million, his head space is always "Ok, my minimum goal is $100 million by xx date, can this get me there". He is very risk averse yet very focussed on this huge upside goal. He wants big scale with no to limited downside. That's basically all he thinks about."

 

original mungerville

I like the high expectations, thinking big and the focus of your friend.  :)

Did he have success or does his life feel terrible because of too high expectations?

 

He's interesting, he talks a lot and thinks a lot but does almost nothing which concerns me a bit. He's sitting in India on land he bought 7 years ago which is looking like its going to be worth a few million (was on the boarder of the city in the direction of development as we reasoned there was only one direction for the city to expand; now its dead center of one of the largest IT/BPO parks being developed in the city). For Indian cost of living, that's pretty good - translated to North America, that might be 10 million in buying power. Now, after a long vacation (a few years), he has seen every temple/monk/restaurant/ read every classic book he had on his list, etc etc and is looking like he is onto Phase 2.

 

We'll see where Phase 2 brings him, but so far, he is surprisingly on track despite his philosophical sloth like behaviour. He is the smartest guy I know by far however and very very personable. He is off the charts in terms of intelligence.

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I found his examples strange, since I personally would not complete any of them the way he did.

 

You've just found out you are not like most random people off the street. Congrats. This can be good or bad.

 

Thanks.  8)

 

I knew it already. I'm not even like most random people on CoBF.  8) This is good and bad.  ::)

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