“The ultimate resource is people—especially skilled, spirited, and hopeful young people endowed with liberty—who will exert their wills and imaginations for their own benefits, and so inevitably they will benefit the rest of us as well. Human Ingenuity is the Ultimate Resource.”
– Julian Simon, Introduction for The State of Humanity
In last month’s article, we focused on “Not Being Surprised” as one of the great qualities to adopt for anyone who wants to become a great investor. This month we focus on a slightly different quality…Great Investors have Faith in the Future
Getting Paid for Uncertainty
A simple internet search for the definition of the word “invest” yields the following: To commit (money or capital) for future advantage or benefit.
In its basic form, the nature of all “investing” is the pursuit of some advantage or benefit which will accrue to us in the future. The act of investing capital is a conscious decision to defer the gratification we might experience from the current consumption of our financial capital, in hopes that that deferral might produce an even greater future utility for us. In order to invest our financial capital, we must have some belief that the future consumption of that capital will be better, more satisfying and “valuable” to us than the gratification we could derive from spending that capital now. Absent this belief, any rational human would instead opt to spend all of their capital now, in order to maximize their gratification.
Since the future is, by definition, uncertain and unpredictable, investing is really nothing more than an exercise in getting paid for taking on uncertainty about the future. If we are willing to subject our capital to the uncertainty of the future, we have an opportunity to create a future advantage from our capital. However, because of the reality of an uncertain future, this also means that we are exposing our resources to the possibility of being worth less in the future – and that the future consumption of that capital might be less “valuable” and gratifying to us than the current consumption would be.
If investing is about “getting paid” for taking on uncertainty, a related truth is that there is a direct correlation between the level of uncertainty we are willing to accept, and the amount by which we stand to “get paid”. The more uncertainty we are willing to accept, the greater our opportunity for future advantage. The less uncertainty we can take, the less we will be paid.
For example, an investor in short term Treasury Bills takes on almost no uncertainty. By making a short term loan to the US Government, the T-Bill investor can feel a high degree of confidence of being repaid their principal plus interest on time, with only a miniscule risk that the US Government will “default” on that loan. This investor also receives very little future advantage for their deferred gratification – the current one year return for T-Bills is just about 0.8%
At the other end of the spectrum, an investor in company stocks takes on a greater deal of uncertainty. By investing in equity, there is always a chance that the company could go bankrupt and their shares could go to $0. By investing in the overall stock market, there is always a chance that the market might experience a “Bear Market”, and decline by 30% to 50% in a year or so. However, investors have an opportunity to receive a much greater future advantage for their deferred gratification – the long term return for the S&P 500 has averaged just about 10% per year since World War II.
In order to maximize the potential return on invested capital, or promise of “future advantage”, an investor must also maximize their acceptance of uncertainty – which means to be a great investor, one must be comfortable with a certain degree of uncertainty, and in fact embrace it. The best way to do this is through a basic sense of Faith in the Future; a healthy “rational optimism” is the investor’s greatest secret weapon in the act of dealing with uncertainty about the future.
The art of “getting paid to take on uncertainty” becomes much easier when one is confident about the future. When one is optimistic, and has a healthy belief in a better future, uncertainty becomes much easier to accept. Our outlook shifts, and we become less concerned with the question of IF the economy and our investments will grow, the only uncertainty is the question of WHEN that growth will occur.
It is not possible to make a good investor out of a natural pessimist, and indeed lifetime investing success is always predicated on long term optimism, which is the “secret weapon” that makes all uncertainty seem trivial. We have written extensively in the past about the concept of “Rational Optimism” [The Glass is Always 100% Full] based on concepts in Matt Ridley’s incredible book: The Rational Optimist.
The Rational Optimist essentially makes the case that an educated and enlightened optimism is the only coherent outlook that is supported by the weight of history. This is not “optimism” in some sort of dreamy-eyed Polyanna way, but as an informed respect for economic and market history. The historical record in its entirety demonstrates that long term optimism is the only world view that squares with the facts. Likewise, this belief in a predictive past is not some lazy default extrapolation – “This is the way it’s always been, so this is the way it will always be”, with no supporting rationale. Rather, the economic trend of progress the optimist sees continuing is an essential expression of human nature, and the reasons for the clearly accelerating improvement in the quality of life around the globe. Examples of this abound, and are all around us, although we usually choose to ignore them or put a negative spin on them.
Rational Optimism is in fact based on the instinctive impulse of all humans, which is hard wired into all 7.5 billion people on earth. All humans have an irresistible urge to become more: to be, to do, and to own. The spirit of entrepreneurialism combined with human ingenuity and technology continue to arise and thrive in ever larger parts of the world. These are the forces of nature, which must triumph in the long run, as indeed they always have. Despite government, politics, financial crises, armed conflict, natural disasters, religious strife, and terrorist atrocities. And yes, no matter who is sitting in the Oval Office.
The Only Natural Resource: Human Ingenuity
As Julian Simon appropriately points out in the quote above, human ingenuity is the real driver of all progress. It is the combination of our human urge to become more, together with our natural intelligence, creativity, and mutual communication, which has driven the incredible explosion in quality of life that humans have experienced in the last 10,000 years. We can be comfortable investing in a future that is shaped by human ingenuity, because it is a resource that can never run out, and we have not even scratched the surface of what it can accomplish.
In the opening of this article, we explored the difference in historical return that T-Bill investors have achieved over time, compared to the returns that equity investors have achieved. Although the specific historical returns may be up for debate, depending upon the time frame chosen, what is clear is that stocks have historically produced returns which are multiples of the returns achieved with “conservative” investments like T-Bills. The reason for this is that equity ownership is one of the best ways to invest in human ingenuity.
This is a difficult truth for many investors to grasp. For some unknown reason, probably related to the financial media we constantly consume, most Americans cannot perceive the nature of stocks as shares of companies, which represent a direct ownership of the earnings, cash flow, and net assets of businesses which they themselves patronize. They don’t view the “stock market” as a portfolio of substantial businesses with real earnings and real dividends, but instead see stock prices as rootless, random, and inherently unstable. They see stocks not as investments, but as speculations, not as ownership of businesses but as casino chips. They understand the “stock market” as nothing more than a casino, where the odds are stacked against them. They believe media pundits who tout a “new normal” for market returns which is somehow inferior to hundreds of years of market history.
In our quest to become great investors, let us remind ourselves that stocks are actually shares of the profits, earnings, and assets of real companies, made up of real people, with real human ingenuity, creativity, intelligence, and communication. There is no upper bound for human ingenuity, just as there is no upper bound for the value of great companies.