I was in fourth grade when I watched the Waco, Texas compound torch on live TV.
I didn't grasp the complexity of David Koresh and The Branch Davidians then, nor necessarily do I now. An anti-government religious cult, who during a 51-day standoff twisted with the minds of the media, the public, and FBI agents alike. Stocked to the gill with firearms and ammunition — women and innocent children inside — in communicating to the outside world before going up in flames, they draped a series of bedsheets out of a window with various statements.
One read: "Rodney King We Understand."
To a different tune, another read: "Let's Have A Beer When This Is All Over."
They preached vegetarianism, had teenage brides, and Koresh believed their war would bring about the end of days. The Brand Davidian story is first and foremost sad as hell, but it is also weird as hell.
Details of the events are still debated, but we know that on February 28, 1993, the FBI raid commenced. And it was horrendous, leading to casualties of both FBI agents and Branch Davidians. And then the building torched with bodies inside. And all of us, even fourth graders, could just watch it on live TV.
Look — it's not my intention to be cavalier, nor insult religions (popular or otherwise). Money and investing are many consequential steps removed from life, death, and religion. But there is a direct thread between cultish groups and many investors.
They grow too certain of the future, and hang around people who reinforce this certainty.
In the right environment, small (even fringe) ideas can turn into strong belief systems.
If you or I were part of David Koresh's community, would we have thought we were living a righteous cause? I think so. I'm not a Branch Davidian expert, and I know very little about their Seventh Day Adventist offshoot beliefs, but I know they believed them strongly. Context is everything to understand why people believe what they do. If our environment is being around people who believe something deeply, who talk about it religiously, who are being about it, who are living it and sacrificing for it — every single day for extended periods — then what was once foreign becomes familiar, what was never a part of us slowly diffuses into us, and then one day we can wake up and believe something entirely.
That's how being in a group works.
The same unknown-to-cult-fanaticism transformation occurs with thematic investment opportunities.
Nvidia, the AI darling company, is up 118,000% since it started trading in 1999.
That's compounding at 32% per year, which may not mean much to you — but it is an unfathomable number, and should be considered impossible to sustain.
Typically when investors highlight the fantastical outcomes of compounding, we underscore the outsized possibility over long periods of time: if you compound at "X" rate for "Y" number of years — you can be "THIS" rich.
But also important is the less-discussed, impossibility of compounding.
Nothing can compound forever at a rate greater than other things. Otherwise, eventually, everything else rounds down to zero.
An example: the U.S. economy currently generates about $25T (trillion) of economic activity, and historically grows at about 3% per year. The compounding possibility analysis starts with $25T and continually adds 3% for many years into the future. Eventually, you'll get a silly number when you get to years that are sillily in the future. Yet it is a reasonable extrapolation (it's been the actual growth rate), and we do expect the future itself to happen.
But our brains can't compound numbers very well, so our reaction upon hearing the answer will almost certainly be:
I can't believe the U.S. economy will be that big someday!
The compounding impossibility analysis says that anything growing more than 3% per year, over a long enough time horizon, will eventually be bigger than the entire U.S. economy.
And that's impossible.
Assume you make a $100,000 salary:
If you get 10% raises for 295 years, your salary will be bigger than the economy.
If you get 20% raises for 127 years, your salary will be bigger than the economy.
If you get 32% raises for 78 years, your salary will be bigger than the economy.
I know what you're thinking...
295 years is crazy. My great-grandkids will be dead, five times over.
127 years is crazy. My great-grandkids will be dead, two times over.
78 years is a lot. I would never work for 78 more years.
But 78 years isn't that crazy. Many people alive today will be alive then.
For the 78 years-example, it's the 32% salary raises that drive the wild outcome, whereas for the other examples it's 100+ years of time. Compounding at 32% gets to very high numbers, very quickly.
To contextualize why Nvidia can't compound at 32% ongoing, consider that its stock market value is currently ~ $2.25T, while the U.S. stock market value is ~ $51T (it is already 4% of the market!).
The stock market has averaged ~ 10%/year over the last 100 years, so if that continued while Nvidia averaged 32%....
In 10 years, Nvidia would be ~ 27% of the U.S. stock market.
In 15 years, Nvidia would be ~ 68% of the U.S. stock market.
In 25 years, Nvidia would be ~ 420% of the U.S. stock market.
But nothing can be more than 100% of something that it's a part of.
That's the impossibility (meaning if anything like this remotely occurred in reality, the entire market's return would of course be pulled higher than 10%, simply by Nvidia's weight and return).
But this is the rub. You cannot compound returns at high rates forever.
On an infinite timeline, anything compounding at a higher rate than something else will eventually completely subsume it.
Another example to illustrate:
Apple's current value: $2,600,000,000,000 (those are trillions).
El Pollo Loco's current value: $288,000,000 (those are millions).
Assume Apple stock compounds at 3%.
Assume El Pollo Loco stock compounds at 4%.
On a long enough timeline, Apple basically won't exist relative to El Pollo Loco (despite that today El Pollo Loco basically doesn't exist relative to Apple).
Compounding is a fascination for its possibilities, but let its impossibilities be the warning to investors: we don't know when assets will stop going up, but we know they can't go up at extremely high rates forever.
If you read some investment blogs or Reddit, watch investment TV, follow investment Twitter, etc...if these are part of your information diet, then you know the rabid fanbase that companies like Nvidia and Tesla, or cryptocurrencies like Bitcoin can foster.
There is nothing wrong with liking stocks or cryptocurrencies. But clinging to fringe dogmatism inside these groups will bring out the worst of our behavioral and emotional biases, and potentially lead investors to taking unconscionable risks, all while thinking they're reasonable and prudent.
These investors might believe that something that almost certainly won't happen, should happen. That's how cultish thinking works.
As any position in your portfolio grows at an extremely higher rate than others, it's relative portfolio weight increases, and your total outcome is then driven more by its individual outcome. Consider an inattentive investor with a relatively small sized Nvidia position decades ago, who wakes up to today to find Nvidia being an enormously outsized relative position today.
If we know that assets can't sustain extremely high growth rates, but having done so previously they now drive an increasingly larger portion of our investment outcomes, managing portfolio risks is critical.
Consider that from its IPO price, Peloton boomed +500% during Covid, and is now -84%.
Of course investors rue having held onto Peloton stock (while hoping they have held onto Nvidia). But I'm not even saying anyone should have sold all of Peloton. It had a bad outcome, but no one could have systematically forecasted its demise, in the same way we couldn't have systematically forecasted Nvidia's meteoric rise.
I'm just encouraging investors to eliminate the guessing game of what will be Pelotons and what will be Nvidias; have a plan to reduce the position sizes of outsized winners. It doesn't matter if it's Peloton, Nvidia, Bitcoin, gold, El Pollo Loco, whatever.
It will sometimes be frustrating because you will almost certainly never call the top. You may even owe taxes (manage accordingly!). The key is to not judge your decision by its outcome. Of course it may keep going up for a while even if we know it can't keep going up at an extremely high rate forever. Or it may whip back around like Peloton did.
Make diligent risk management your belief system. Listen to people who care about this. Consume their content.
If you do ever sell a stock because it has become such a large part of your portfolio, try not to care if it keeps going up. Your strong belief system can simply be to not own anything in a proportion that could crush you broadly if it gets crushed narrowly.
My colleague at Peltoma, Rachael Levine, has a simple way to communicate to clients the potential emotional toll of reducing an investment position and then watching it go even higher: accept ahead of time that you may regret it, or may be frustrated that we suggested to do so.
"That's an okay feeling to have," she tells them. Get comfortable with it. Because it's the right decision with the information we have, and what you're trying to accomplish.
We can't delineate future Pelotons from Nvidias ahead of time.
And for investors who don't pick stocks or don't own any outsized positions, may you take some relief that you haven't missed out on as much as people would have you believe. People mostly just talk about what's gone up.
And the laws of math tell us that jumping in now won't likely deliver you future returns that look like past returns.
Because they can't.
End.
Comments