Four Timeless Graphs for Investment and Life

1. Compounding

"Compound interest is the most powerful force in nature"

-Unknown

The most interesting tale about the power of compounding is about the Indian inventor of the chess. The legend is that a king was so impressed by his invention, he asked for any reward he wants. The inventor asked for one grain of rice for first square of the chess board, two grains for the second square, four grains of rice for the third square and so on till the 64th square. It turned out the 64th square corresponding to more than 9 billion billion grains of rice, more than all grains in the entire world!

While all of us have heard this story, we still think it applies only to interest or other parts of financial domains. We miss that compounding is pervasive and applies to many fields of life.

To understand compounding in our daily life, we need to ask ourselves: what results in compounding? Very simply if the interest earned itself earns more interest in future, that results in compounding. In the same way, if whatever you have acquired so far aids to further growth in future, it results in compounding. As Warren Buffett famously said, knowledge compounds just like interest. Every piece of knowledge you acquire, makes you understand other sources of knowledge better. Your network of contacts compounds. The more people you know, the easier it is for you to get to know more people in future. Customer base of a company compounds (at least till a certain size if you have a good product). The more customers you have, the more they they are going to talk about your product and the more customers they will bring in. Businesses with network effect (think e-commerce) also compound. A big part of my job as an investor is to try and understand whether the business of the company has a good compounding effect or not and how long that effect is going to last. Similarly some jobs have a compounding effect, where the skills and/or visibility acquired opens more gates for you, and some do not. I think we all would be more efficient over a long term if we focus our efforts on things that compound. The results will be fantastic over long term, though you will hardly notice the difference in first few years.

2. Optionality

"All I want to know is where I am going to die, so I won't go there."

--Charlie Munger

I think people with analytical bent can be broadly divided into two broad categories. The first category believes that it is possible to assign probabilities to various outcomes and the decisions you take can be optimized based on it. The second category believes that it is possible to assign rough probabilities to some outcomes (mostly over a longer term) but completely unforeseen things always tend to happen. (Of course there are people who believe they know perfectly what is going to happen and those who believe nothing can be known about the future, but let's drop those cases from discussion for sake of simplicity).

When we talk about complex systems like financial market, economy or life, I believe the truth is closer to what the second category believes in. In financial markets, economy and in life there are several things closely interrelated. The randomness in the system is too much because the nature of interrelationships between various elements keep on changing. Also new factors, which we have never seen before, keep cropping up every now and then. In such situations, trying to predict even the range of possible outcomes, leave apart precise outcome is a fool's job.

What we can instead do is to make sure that whenever we take a decision, we try to ensure that in case things don't go our way we don't lose much, but if things go our way then we win big. That is essentially what a call option looks like. As Mohnish Pabrai said "Heads I win, tails I don't lose much". This seems counterintuitive given the mainstream thoughts that 'there are no free lunches' and 'more risk you take the more return you will get'. However, ingenuity sometime does lead to counterintuitive results.

If you buy stocks of good companies at low price, not only your risk of downside is lower, the chances of upside are higher. Health insurance not only covers your large expenses in case you fall ill, it also arguably increases the upside for you by freeing the amount of money you can invest in profitable ventures (which would otherwise be locked away for a 'rainy day'). Regular exercise has outcomes similar to a call option which not only prevents from illness but also provides more energy for the day. Just a little bit of thought behind every decision can create these call options. And if you ensure optionality in enough number of decisions, just as in case of compounding, the results over a long term can be fantastic. The positive outcomes of incidences during that time will multiply together to give a very large number, while the negative events will multiply together to produce 1. The end result will be identical to the effect that compounding produces.

3. Leaking Bucket

Just like compounding leads to outsized returns over a long term, leaking bucket leads to ruin over a long term. Leaking bucket is any small, often imperceptible, negative change that keeps on happening constantly over a long period of time. It mostly relates to habits, organizational or individual. Example of such leaking buckets for an individual will be to keep upgrading lifestyle in small bits or wasting time on social media in small chunks. While the effect may be imperceptible in short term, over a longer term the risks brought about by such leaking buckets are enormous. For organization, leaking bucket may relate slow deterioration of culture, building of 'flab', gradual shift of focus from product & customer to 'organizational matters' and so on.

4. Resonance

When I refer to resonance, I am talking about several small forces combining together to create a very large force (I have dropped the term 'periodic' from the scientific definition). Charlie Munger refers to it as "Lollapalooza effect".

Cults are a powerful example of what resonance can achieve. Several people telling you the same thing can lead you to believe that world is coming to an end and suicide is the only way out. Similarly working in a particular direction, developing hobbies related to your direction and keeping company of people who promote your progress can lead people to achieve supernormal results. On one hand small negative forces can join together to create a huge negative force, on the other hand small positive forces can also add together to result in a huge positive force. That is why great results are often achieved by aligning several elements towards a single direction.