Nature Shows How This All Works

Two little stories from nature that teach us a few things about investing:

1. Extremes lead to extremes.

California has been devastated by wildfires for a decade. Back to back, year after year. Long-term droughts turned forests into dry tinder.

So everyone was elated when 2017 brought one of the wettest winters California had seen in recent memory. It was epic. Parts of Lake Tahoe received – I’m not making this up – more than 65 feet of snow in a few months. The six-year drought was declared over.

But the fires just got worse. The wettest year in memory was followed by “the deadliest and most destructive wildfire season on record.” And those two things were actually related.

Record rain in 2017 meant a surge of vegetation growth. It was called a super bloom, and it caused even desert towns to be covered in green.

That seemed great, but it had a hidden risk: A dry 2018 summer turned that record vegetation into a record amount of dry kindling to fuel new fires.

So record rain led to record fire.

That’s not intuitive, but there’s a long history of this verified by looking at tree rings, which inscribe both heavy rainfall and subsequent fire scars. The two go hand in hand. “A wet year reduces fires while increasing vegetation growth, but then the increased vegetation dries out in subsequent dry years, thereby increasing the fire fuel,” the NOAA writes.

The point is that extreme events in one direction increase the odds of extreme events in the other.

And isn’t it the same in the stock market? And in business?

The Japanese stock market is the most-cited example of when long-term investing doesn’t work. The Nikkei index traded lower today than it was in 1990. In 2012 it traded 70% lower than it was at 22 years before. Just a disaster.

There can be a lot of explanations for what happened, not least of which is Japan’s demographics. But the biggest cause is simple: Returns were so extreme from 1950 to 1990 that there was nothing left over for subsequent decades.

The Nikkei increased 400-fold from 1950 to 1990, an average annual return of more than 16%. I don’t think any other country, in any era, has a stock market that performed so well.

What’s happened over the last 30 years is the flip side of an extreme event in one direction leading to an extreme event in the other. Today we marvel at how terrible the Japanese stock market has performed, but the real shocker is how well it performed prior. Half a century of extraordinary performance in one direction might lead to half a century of flat in the other.

Record good leads to record bad – just like California’s fires.

Same in business, where extreme success increases the odds of becoming fat, happy, and in over your head. WeWork raising $12 billion from investors seemed like extraordinary success – every company gushes in a press release when it raises a huge round. But the more extreme the fundraising, the more distorted the business became. Raising record money led it to nearly run out of money. A similar thing happens all the time: Energy went from negative prices last year to global shortages today. NYC rents went from plunging to surging. Shortages lead to gluts, busts seed the next boom.

That’s nature’s first lesson: Extremes lead to extremes.

2. Small changes compounded for long periods of time are indistinguishable from magic.

The most astounding force in the universe is obvious. It’s evolution. The thing that guided single-cell organisms into a human who can read this article on a phone. The thing that’s responsible for 20/20 vision and flying birds and immune systems. Nothing else in science can blow your mind more than what evolution has accomplished.

Biologist Leslie Orgel used to say, “evolution is cleverer than you are” because whenever a critic says, “evolution could never do that” they usually just lacked imagination.

It’s also easy to underestimate because of basic math.

Evolution’s superpower is not just selecting favorable traits. That part is so tedious, and if it’s all you focus on you’ll be skeptical and confused. Most species’ change in any millennia is so trivial it’s unnoticeable.

The real magic of evolution is that it’s been selecting traits for 3.8 billion years.

The time, not the little changes, is what moves the needle. Take minuscule changes and compound them by 3.8 billion years and you get results that are indistinguishable from magic.

That’s the real lesson from evolution: If you have a big number in the exponent slot you do not need extraordinary change to deliver extraordinary results. It’s not intuitive, but it’s so powerful. “The greatest shortcoming of the human race is our inability to understand the exponential function,” physicist Albert Bartlett used to say.

And isn’t it the same in investing?

Howard Marks once talked about an investor whose annual results were never ranked in the top quartile, but over a 14-year period he was in the top 4% of all investors. If he keeps those mediocre returns up for another 10 years he may be in the top 1% of his peers – one of the greatest of his generation despite being unmentionable in any given year.

So much focus in investing is on what people can do right now, this year, maybe next year. “What are the best returns I can earn?” seems like such an intuitive question to ask.

But like evolution, that’s not where the magic happens.

If you understand the math behind compounding you realize the most important question is not “How can I earn the highest returns?” It’s, “What are the best returns I can sustain for the longest period of time?”

That’s not to say good returns don’t matter. Of course they do. Just that they matter less than how long your returns can be earned for. “Excellent for a few years” is not nearly as powerful as “pretty good for a long time.” And few things can beat, “average for a very long time.” Average returns for an above-average period of time leads to extreme returns.

“The only thing that matters is where you are in the long run,” Marks said.

That’s the second lesson: Less focus on change, more focus on the exponent.