The Case for Balanced Skepticism

Social norms govern how individuals interact with each other and with society at large. Many norms have been incorporated into legal systems but most continue to be informal conventions. A significant percentage of the population will fail to adhere to established social norms despite the penalties that exist for those who fall out of line and are discovered. The worst offenders are those who, on the surface, appear to be exemplars of society but successfully flout our rules with impunity, often operating in subtle and nearly undetectable ways. Such serial offenders typically have charismatic attributes that mask underlying sociopathic tendencies.

Society cannot function at all in an environment where there is no trust, so we do not have the option of adopting a cynical attitude toward everyone and everything we encounter in day-to-day life. We cannot assume that everyone transacting with us is out to cheat us. We cannot form any meaningful relationships with others if we default to believing that they are acting disingenuously from the outset. At the same time, we have to take intelligent steps to avoid being the patsy at the poker table. We must find a way to willingly expose ourselves to a certain degree of vulnerability but, especially when the stakes are high, we would be ill advised to do depart very far from the concept of “trust, but verify”.

Letting Your Guard Down

Fortunately, life does not have to be so grim. Most of time, in day to day life, we can behave in a manner that gives everyone the benefit of the doubt whether the interaction is commercial or personal in nature. We benefit from the mental shortcuts that flow from acting in a manner that assumes that others are behaving in keeping with our society’s social mores. The downside of occasionally being taken advantage of in small matters is outweighed by the many positive interactions and ease of living with a positive and trusting attitude. Life is more pleasant when we are not constantly on guard.

The time to adopt an attitude of informed skepticism is when the stakes are high. It should go without saying that consumers are well served to be on guard when making transactions such as purchasing a vehicle or buying a home. In fact, any time there is a major asymmetry of information and experience, it pays to be very skeptical regarding the motives and strategy of the person on the other side of the table. Understanding how those with malign intent attempt to deceive us can be invaluable when it comes to defending against such attempts.

How to Lie with Statistics holds the strange distinction of being a book about … statistics that is nevertheless very amusing and informative for the general reader. Written by Darrell Huff in 1954, the book somehow avoids getting bogged down in math. Huff instead resorts to clever illustrations and cartoons to make his points regarding the myriad ways in which statistics can be used to deceive. The 1954 price and salary information he uses is unadjusted for inflation over the past sixty-five years, which only adds to the charm of the narrative.1 Huff is well aware that the techniques he discusses could become a “manual for swindlers” but notes that “the crooks already know these tricks; honest men must learn them in self-defense.” The tricks that Huff describes were fooling people back in the 1950s and the same techniques continue to work wonders today. It seems like little has changed in terms of lack of basic numeracy over the decades.

One of the most pernicious aspects of using statistics to mislead is that most people take mental shortcuts as soon as they see numerical figures in an article. When used in certain ways, statistics can serve as a sort of trump card for bad actors. Through manipulative choices, numbers can be developed to “prove” all sorts of disingenuous arguments.

Huff covers many of the straight forward fallacies that most of us are very familiar with, such as the confusion between the use of median and mean averages which can be particularly misleading when it comes to data sets that are not normally distributed, such as wealth in the United States. Of the methods described by Huff, two jump out as interesting enough to discuss at further length: The Semi-Attached Figure and The Gee-Whiz Graph.

“Compared to What?”

If you are selling something that has no proven benefits, or making an argument that has no intrinsic merit, not all is lost if you are willing to engage in a deceptive slight-of-hand that Huff refers to as the semi-attached figure:

If you can’t prove what you want to prove, demonstrate something else and pretend that they are the same thing. In the daze that follows the collision of statistics with the human mind, hardly anybody will notice the difference. The semi-attached figure is a device guaranteed to stand you in good stead. It always has.

How to Lie with Statistics, p. 76

Let’s say that you are the marketing manager responsible for coming up with an ad copy for a product that isn’t demonstrably better than its competitors. Huff uses the example of a juice extractor. The marketing manager cannot come up with any data to show that the juice extractor is more efficient or easier to use than competing products, but it would be easy to prove that the juicer is much better than using an old fashioned hand reamer. There would be no explicit lie in the statement that the device “extracts 26 percent more juice as proved by laboratory tests”. The deception rests in the act of omission: compared to what?

A similar trick is common within the investment management industry. An investment manager with a mediocre track record can easily present misleading data that is technically true. For example, let’s say that an investor made a public call that happened to “bottom tick” a particular stock, or catch the exact point at which the stock stopped falling and started to rise. The investor can say something like “after I called the bottom on Company XYZ and purchased shares, the stock went up over 2000 percent over the next two years!” This might technically be true. But it doesn’t mean that the investor had the foresight to hold that stock for that stellar gain. He could very well have sold it after it went up just five or ten or fifty percent!

Chart Crime!

Although Huff does not use the term “chart crime” in the book, he does have a full chapter dedicated to the “Gee Whiz Graph”. The reason charts and graphs are used so frequently in the media and in sales presentation is because most people are very visual and numbers naturally “come to life” when put into a drawing. However, a chart can be technically true but still provide grossly misleading impressions. For example, presenting only a portion of a chart can make changes look more dramatic than they really are. If you are showing data that ranges between 16 and 18, the variations will look much more dramatic if the y-axis ranges from 15 to 20 than if the y-axis ranges from 0 to 100. Of course, in some cases, small variations are meaningful. If the data from 16 to 18 represents the range of a company’s net margin over a decade, a tighter y-axis will show meaningful variations over time. The designer of the graph has the responsibility to present the data in a way that is not only accurate but meaningful.

“Map crime” is closely related to chart crime. It involves using a map to represent data to suit a particular agenda. For example, say that you want to represent the share of national income collected by the government in the form of taxes. Huff shows two ways in which this could be represented on a map of the United States:

How to Lie with Statistics, p. 105

Both the western and eastern style maps show an accurate representation of federal spending that is equal to the total incomes of the people living in the shaded states. The large area shaded in the western style map is due to the fact that, in 1954, the western states had vastly smaller aggregate income compared to eastern states. The eastern map merely demonstrates that a few eastern states had very high income. While both maps are accurate, someone who wanted to present a threatening picture of big government would opt for the western map while his political opponent favoring a larger state would choose the eastern map.

A similar effect exists when one looks at the results of a presidential election based on geography rather than population. For example, the map below shows the results of the 2016 election by county. If you wanted to present the impression that nearly everyone in the country voted Republican, you could use this map even though the reality is that the majority of the population actually voted for the Democratic candidate. Using land area rather than population density presents a misleading image.


As Jason Zweig wrote in his review of the book, Huff provides invaluable guidance for readers who are trying to figure out if they are being manipulated through the clever use of statistics. For those of us who took statistics in college, there isn’t much of anything that is new from a mathematical perspective. However, the book serves well as an introduction for those who are not familiar with the subject and is also a great refresher for the rest of us.

Robert Cialdini’s classic book Influence: The Psychology of Persuasion is one of Charlie Munger’s favorite books, and for many good reasons. Mr. Munger has long been focused on developing a better understanding of the psychology of human misjudgment. Human beings have developed many psychological tendencies over thousands of years and, normally, these tendencies serve as useful shortcuts that allow us to make quick and efficient decisions. However, in certain contexts, our instincts can lead us astray especially when we are being manipulated by experts. Just as Huff did not intend his book on statistics to serve as a roadmap for deceit, Cialdini wrote his book not to empower corrupt behavior but to warn the public against falling into avoidable traps. By publicizing the methods that “compliance professionals” utilize, Cialdini does the general public a service by highlighting situations in which we should exercise informed skepticism.

Over a decade ago, I wrote a brief article applying Cialdini’s ideas to Bernie Madoff’s Ponzi scheme.2 Madoff used the principles of social proof, authority, and scarcity to manipulate his clients for decades despite many warning signs. People who should have known better simply looked the other way. They were not sufficiently skeptical.

Uncomfortable Obligations

Reciprocity is one of the most powerful human tendencies and it has actually served us very well throughout human history. Without reciprocity, society would not function very well. Cialdini emphasizes the competitive advantages provided by the reciprocity rule:

Make no mistake, human societies derive a truly significant competitive advantage from the reciprocity rule, and consequently they make sure their members are trained to comply with and believe in it. Each of us has been taught to live up to the rule, and each of us knows about the social sanctions and derision applied to anyone who violates it. The labels we assign to such a person are loaded with negativity — moocher, ingrate, welsher. Because there is general distastes for those who take and make no effort to give in return, we will often go to great lengths to avoid being considered one of their number. It is to those lengths that we will often be taken and, in the process, be “taken” by individuals who stand to gain from our indebtedness.

Influence, p. 20

The almost universal instinct to reciprocate when someone does something that puts us in their debt allows compliance professionals to easily manipulate us. This can be fairly obvious, such as when we are presented with a “free gift” in a setting like a timeshare sales presentation, or when a local stock broker offers a “free lunch” to those who agree to listen to his presentation. The recipients naturally feel an obligation after receiving something of value. Many people will, in fact, reciprocate just to cancel out their obligation even if they do not want whatever is being sold.

Compliance professionals also exercise more subtle pressures that harness the reciprocation tendency. Cialdini points out that a concession in a negotiation normally creates a psychological need for the other party to also make a concession. This is why it is extremely dangerous to let anyone else control the terms of a negotiation. If a used car salesmen starts a negotiation from an inflated sticker price, he can make a fake initial “concession” that doesn’t come close to lowering the price to the car’s blue book value. The buyer can be manipulated into agreeing to pay more simply by the act of the salesman making a fake concession.

Skepticism, Not Cynicism

The risk we face when we learn about these psychological tendencies is to guard vigilantly against falling into traps even at the risk of flouting social conventions that are useful and bind people together in positive ways. When you are dealing with a used car salesman, informed skepticism and even cynicism might be warranted. It is probably a good idea to avoid accepting any “gift” from the salesman, even something as trivial as a free can of soda. Similarly, it is probably best to not allow a realtor to buy your lunch between visiting homes. That’s simply prudent.

But should you act with suspicion when you move into a new home and your neighbor brings over a casserole or a bottle of wine to welcome you to the neighborhood? It is true that by accepting you will likely feel a need to reciprocate in some way, but this is a healthy form of reciprocation. You’ll get to know your new neighbors as part of the process. It is possible that your neighbor may try to sell you life insurance the next time you see her, but it is more likely that she’s just being friendly. As Cialdini points out, we will always encounter people who are authentically generous. Refusing the kindness of all people, regardless of the context in which it occurs, will result in isolation.

Malcolm Gladwell’s latest book, Talking to Strangers, was all about the risk of miscommunication when we interact with people who we do not know well.3 We often make the mistake of thinking that other people are transparent when, in fact, we cannot really see into their minds. Giving people the benefit of the doubt and assuming benign intent is a good way to live our day to day lives, especially in cases where the stakes are low. However, when the stakes are high, defaulting to a skeptical outlook is only prudent. We must be vigilant regarding avoiding the traps that compliance professionals set out for us. At the same time, we should know when to let our guards down, even if only temporarily and in settings where a worst case outcome will not hurt us too badly.

  1. Federal Reserve Chairman Powell might consider low inflation to be “one of the major challenges of our time“, but the nearly ten-fold increase in the price level since 1954 leads one to believe this challenge is “solvable”. The reader can just add a zero to the 1954 prices to approximate the effects of inflation. []
  2. The article on Madoff in February 2009 was actually the sixth article to appear on The Rational Walk. []
  3. We reviewed Talking to Strangers in November. []

The Financial Illiteracy Epidemic

Money cannot guarantee happiness but grinding poverty can almost certainly guarantee misery. It is difficult to be happy when you know, in the back of your mind, that you are one small misfortune away from being unable to pay next month’s rent without resorting to payday lenders or the friendly neighborhood loan shark. Poverty is a complex topic and those of us who have never experienced it should not throw around simple platitudes regarding how to escape it. However, for a certain subset of those who find themselves in constant anxiety regarding money, the problem is almost certainly compounded by a lack of financial literacy.

Living on the Edge

According to a recent report, 66 million Americans have absolutely no savings available to cover a financial emergency.  This shocking figure is nearly one-third of the roughly 206 million Americans between the ages of 15 and 64 which makes up the age group most likely to lack a safety net to deal with emergencies.  A survey published by Standard & Poor’s revealed that only 57 percent of Americans are financially literate.  Although it isn’t a good idea to unfairly stereotype individuals in large groups, it seems very likely that the Americans lacking savings also have a general lack of understanding of basic personal finance.

Why is this the case and what can be done about it?

One of the problems is that human beings do not seem to naturally understand non-linear systems, and this deficiency prevents us from automatically understanding what is perhaps the most important topic in personal finance:  compound interest.

Here is one of the questions asked in the financial literacy survey:

Suppose you had $100 in a savings account and the bank adds 10% per year to the account. How much money would you have in the account after five years if you did not remove any money from the account: more than $150, exactly $150 or less than $150?

It is likely that most people would understand that 10 percent of $100 is $10 which represents the first year of interest.  The account will be open for five years, so many people will be tempted to simply multiply the $10 by 5 and come up with $50 in total interest which is added to the initial $100 balance for a total of $150.  However, this ignores the fact that you earn interest on interest which is the essence of compounding.  Assuming annual compounding, the balance of the account would look like this over the five year span:

A simple formula can be used to determine the ending result of a sum invested at a certain rate over a certain period of time:

Ending Balance = Starting Balance * (1 + Periodic Interest Rate) ^ Number of Periods

The formula can be applied to this example as follows:

$161.05 = $100 * (1 + 0.1) ^ 5

Compound interest is an example of an exponential equation and the results do not neatly fit our natural intuitions.  It is much more intuitive to think that the $100 deposit will earn $50 over five years than to figure out the actual result which is significantly more than $50.  However, it is important to realize that this particular exponential function is very simple and should be understandable to the vast majority of people if explained clearly as part of a basic education.

The Longer View

To make the effect of compound interest more clear, let’s extend the period of time that the $100 is kept on deposit at a rate of 10%.  Rather than assuming five years, let’s assume that the money is left alone for fifty years instead.  If we apply the same “gut instinct” (but incorrect) logic that would have led someone to believe that the $100 deposit would only earn $50 over five years to this longer example, the answer would be that the fifty year deposit should earn a total of $500, which is 50 years multiplied by $10 per year.

Let’s see what the correct result is:

Ending Balance = Starting Balance * (1 + Periodic Interest Rate) ^ Number of Periods

This formula can be applied to this example as follows:

$11,739.09= $100 * (1 + 0.1) ^ 50

Instead of earning the $500 that “gut instinct” might have led us to believe, the $100 deposit earns a shocking $11,639.09 in interest!

This unintuitive result is due to the exponential nature of compound interest, as we can see from the graph below:

We can see that progress is slow at first, which we already knew based on the first five years of the investment.  However, over time, earning interest on interest becomes the driving force behind the overall value of the account and we can really see the line start to explode upward over the second twenty-five year period.

What Applies to Savings Also Applies to Debt

How many people truly understand the horrible compounding effects of credit card debt?  Although paying 15 to 20 percent interest on a $1,000 sofa might seem like an annoyance over the first year, making minimum monthly payments while taking on additional debt will cause the problem to snowball over time in just the same way that savings multiplied like crazy in the previous example.  Actually, the snowball will be much worse. Compounding at 15 to 20 percent results in a much, much larger snowball than compounding at 10 percent.

Although credit card disclosure requirements have improved over the past several years and people are now clearly told how long it will take to retire debt based on minimum monthly payments, few people are going to pay much attention to the details on a credit card statement or stop using the credit card while paying it down.

Low Interest Rates Make Compounding Less Obvious

The example in the survey uses a rate of 10 percent for a savings account which is obviously unrealistic in today’s world of minuscule savings rates.  However, low interest rates are probably not going to be a permanent phenomenon over the long run.  The problem is that people have been trained to not appreciate the power of compound interest over the past several years because it is even less apparent than it otherwise would be.

Using a rate of 1 percent, which one would have been fortunate to get on a savings account over the past several years, the $100 deposit would have grown to only $105.10 over five years.  In this case, the “intuitive” answer of believing that the total interest would be only $5 is hardly different from the correct answer of $5.10.  In fact, it is so trivial that if we used the 1 percent rate in an example, people would laugh if we tried to claim that compound interest is actually important!

Multi-Disciplinary Education

Financial education is severely lacking in the United States and the fact that over half of Americans lack basic financial literacy is a national disgrace.  The place to remedy the problem has to be the public school system.  Ideally, parents would educate their children on personal finance but too many adults are financially illiterate themselves and we do not want to have a society where this perpetuates through multiple generations.

It should not be difficult to incorporate an appreciation for compound interest into the public school system.  Basic exponential functions are routinely taught at the middle school level and, if not, certainly as part of a high school curriculum.  Rather than using esoteric examples that students might not relate to, teachers could incorporate compound interest directly into basic math education covering exponential functions.

But is it the job of math teachers to cover personal finance?  The better question is why not?

There need not be a special course in personal finance (although such an offering has obvious merits as well).  Disciplines like mathematics should incorporate subject matter from other disciplines, particularly when doing so reinforces the math that is being taught.  All young people are concerned with having enough money to spend.  They might be too impulsive to care about long term growth of savings, but if they are at least aware of the potential of compound interest, that might prevent the accumulation of unwise debt in college or when starting out in the workforce.

Parents who are fully aware of the power of compound interest might try bypassing today’s low interest rate environment by setting up a family “bank” where their children can make “deposits” at rates that are far above market and possibly compound at a more frequent pace.  For example, parents could offer their children an “account” that compounds at a rate of 5 percent every quarter.  At that rate, a $100 deposit would grow to almost $150 over two years, well within the time frame that a teenager should appreciate.

Not a Panacea, But a Start

Even if every American left high school with a solid understanding of compound interest, we will still have people who fail to save because they lack self-control or fall into really hard times through no fault of their own.  However, it is hard to believe that wide dissemination of this very basic principle would not dramatically reduce human misery.  Not being able to cover the cost of a broken refrigerator, a tire blow-out, or a traffic ticket should be preventable for almost everyone.

There are enough truly difficult problems in life that do not lend themselves to simple solutions, so we should adopt simple ideas that have little or no downside such as teaching students about compound interest as part of their existing math programs.  It might be overly optimistic to hope that all Americans will automatically think in terms of exponential functions rather than using their linear intuitions in everyday life.  But when faced with major life decisions, the default should be to think in terms of compound interest when it comes to spending and saving money.

The Sage of Baltimore

“The real fortunes in this country have been made by the people who put their capital into a business that had a future, worked hard, invested more capital, and stayed with their investment throughout the years — depression and boom alike. Such names as Ford, DuPont, Rockefeller, Duke, Carnegie, Woolworth and many others that are well known to all. These names are legend. Fortunes are still being made this way and you and I can participate in their continued growth as their shares are available in the market.”

— Thomas Rowe Price, Jr, “What is a Share in a Business Worth?”, October 25, 1947

Many things in life are completely out of our control. Most fundamentally, the year of our birth is something that none of us had any control over, yet this biographical detail has an enormous impact on our lives. Those who enter the labor force in a robust economy do so with more ease. Even individuals with marginal skills and work ethic can find employment. Coming of age in a period of stagnation creates headwinds that only the determined will overcome. Just as importantly, the baseline psychology of an individual is drastically affected by the environment in which he or she is raised and gets started in life.

Warren Buffett often says that he won the “genetic lottery” of life in terms of being born in 1930 and brought up in a relatively affluent environment. Coming of age right as the post-World War II boom was getting underway clearly shaped his outlook and opportunity set. What if Mr. Buffett had been born thirty years earlier instead, right at the turn of the twentieth century? If he had been born around 1900, he would have come of age in the aftermath of World War I, experienced the roaring 20s as a young man, and then suffered through the subsequent crash and depression. One can argue that the generation of investors that came before Mr. Buffett had more headwinds to deal with and certainly lived through more challenging macroeconomic environments as they were getting started.

Most modern-day investors are familiar with Benjamin Graham and Phil Fisher, both of whom were born within a few years of the turn of the century. However, relatively few investors are familiar with the life of Thomas Rowe Price, Jr, who in his later years was recognized as one of the best investors of the century and known as the “Sage of Baltimore”. T. Rowe Price: The Man, The Company, and The Investment Philosophy by Cornelius Bond is the first-ever biography of Price and provides readers with a comprehensive understanding of the man and his investment approach. Bond worked directly under Price for nearly a decade during the 1960s, relatively late in Price’s career. From this vantage point, Bond provides his recollections and insights regarding Price coupled with the findings of research into Price’s earlier years. Although Bond shows a deep level of respect and admiration for Price, he manages to avoid veering into hagiography and presents a balanced and worthwhile view of Price’s life and his times.

Early Years Shape The Man

Benjamin Graham and T. Rowe Price were born within a few years of each other in the final years of the nineteenth century and both came of age around the same time, with the main difference being that Graham started on Wall Street in the midst of World War I while Price was still a student. Neither Graham nor Price chose to study business in college. Graham was such a gifted student at Columbia University that he was offered teaching positions in English, Philosophy, and Mathematics upon graduation. Price entered college intending to pursue a pre-med program but ended up earning a Chemistry degree from Swarthmore where he did not take a single class in business or economics.

While Graham turned down his academic job offers and opted to start a career on Wall Street, Price initially had no intention of pursuing a career in business. He initially obtained jobs in his field of study but soon became fascinated with finance while working for DuPont. Price found that he could pursue a career in a field that offered solid remuneration while also enjoying what he was doing. He entered the field of investing in 1921 at the age of 23 and witnessed the roaring 20s firsthand, albeit from the vantage point of Baltimore rather than Wall Street.

In 1925, Price joined Mackubin, Goodrich & Co, a small financial firm in Baltimore where he would spend the next twelve years of his career as market euphoria peaked in the late 1920s and then crashed in the 1930s. Unlike Graham, who lost most of his investments in the early Depression years, Price was at an earlier stage of his career and, fortunately, was not a partner in his firm.

In 1930, Mackubin, Goodrich & Co had significant cash flow issues that forced partners to liquidate securities to raise cash in order to keep the firm afloat. Price obviously observed this turmoil but was not forced to liquidate his investments. Price appears to have taken this as a lesson to avoid leverage based on a journal entry at the time:

“When once again we are in good times with rising prices and the public is clamoring for profits, BE SURE to point out the horror of a depression and BE SURE to state that the worst depressions come when least expected. If you are buying something which you cannot pay for in cash, you must be prepared to take losses.”

T. Rowe Price, p. 54

Although Price took losses on his holdings during the early 1930s, he does not appear to have fallen into financial distress to the same degree that many of his contemporaries suffered. He also was able to hone his own investment approach and came to the conclusion that starting his own firm was the only way to pursue his passion for research and providing investment council.

Price came out of the depression without a gloomy outlook. He remained an optimist and this was a key factor that allowed him to pursue his approach to growth stock investing. Benjamin Graham emerged from the Depression to establish the school of value investing with its focus on the balance sheet and downside protection. Both men ended up posting excellent investment track records in the post-World War II years, albeit with diametrically opposed approaches.

The Growth Stock Philosophy

Price developed his growth stock philosophy over a period of nearly a half century starting in 1934 when he created a model portfolio while still working for Mackubin, Goodrich & Co. The idea of investing for growth in the midst of the Great Depression was a novel one, to say the least. At the time, investors were more interested in the return of their principal rather than the return on their principal. Price refined his philosophy over the years and published the following summary in 1973:

“A growth stock is defined as a share in a business enterprise which has demonstrated long-term growth of earnings, reaching a new high level per share at the peak of each succeeding business cycle, and which gives indications of reaching new high earnings at the peaks of future business cycles. Earnings growth per share should be at a faster rate than the rise in the cost of living, to offset the expected erosion in the purchasing power of the dollar. The goal is a portfolio of companies that will double earnings over a 10-year period. It is believed that dividends and market value would do the same.”

T. Rowe Price, p. 97

The goal of holding a portfolio of companies that will double earnings every decade might seem rather modest to the modern reader but being able to compound at a rate of 7 percent is not a shabby result whatsoever. When combined with dividends, it is likely that such a portfolio would approach 10 percent annualized returns which is more than adequate for the success of any long-term investment program.

When one reads Bond’s chapter describing Price’s Growth Stock Philosophy, it is clear that elements of it closely parallel Phil Fisher’s approach. Price emphasized careful research including the type of “scuttlebutt” techniques that Fisher advocated. Price was a big believer in talking to management and making frequent visits to gain an appreciation for what makes a company and its leaders tick. He looked for managers who prioritized intelligent research that would foster a differentiated product strategy commanding higher than average margins. And although Price always kept his focus on growth, he did not ignore downside protection either. He insisted on strong finances that would allow a growth business to survive business downturns.

Once growth companies are found, Price believed in holding them for a very long period of time, often measured in multiple decades. Like all intelligent investors, Price did not view market fluctuations as “risk” but instead knew that the only risk that counts is permanent loss of capital which is usually driven by weak finances.

Price’s growth stock philosophy worked very well, allowing him to generate an enviable track record over a long period of time. From inception of the strategy in 1934 to the end of 1972, the growth stock strategy returned 2,600 percent, assuming reinvestment of dividends, compared to a 600 percent gain for the Dow Jones Industrial Average. The CPI rose 205 percent over this timeframe.

House Money?

When to sell is a dilemma facing all investors, but particularly those who focus on growth stocks. Many of the greatest growth stocks always appear to be “expensive” based on traditional metrics used by value investors such as the price-to-earnings ratio or price-to-book value. Price believed in holding his companies for decades but also had an interesting policy that recovered his cost basis in a company while letting his profits ride:

“Once a position is established, if a stock then moved to a significant premium over what it is deemed to be worth, he suggested that the stock be sold until the total cost of the stock position, plus capital gains taxes, is realized. The profit, he believed should be reinvested in long-term government bonds, or good-quality corporate bonds for safety and income. The profit represented by the shares left in the portfolio should be allowed to continue to grow in value until the company matures and is no longer considered to be a growth company. These shares effectively have no cost.”

T. Rowe Price, p. 106

On its face, this approach is not a rational one. If one deems a security to be overvalued, which implies that future returns will be sub-par and fail to approach returns achievable in other investments (or an index fund), one should logically sell the entire position. However, human beings have to grapple with our psychology and the fallibility of our analysis. We could be wrong about a company being overvalued. Many great growth companies are “overvalued” for their entire history by conventional metrics. A growth stock investor who adopts Price’s approach of getting their cost basis back might be able to psychologically handle leaving the remaining “house money” invested because it has “no cost”.

Of course, this type of mental accounting is not strictly rational. The remaining shares in the portfolio most certainly have an opportunity cost. They could be sold and reinvested. The market doesn’t “know” that you have retrieved your cost basis and are playing with house money. Yet, if this type of approach helps a growth stock investor to stay the course in promising companies through periods of transient overvaluation, perhaps that is a psychological trick that has some merit. Those of us who fall into the value investing camp are not likely to be comfortable with the house money concept but we should not easily dismiss its utility from a psychological perspective, especially for those with a focus on growth stocks.

A Different Era

It is impossible to read this biography without noting that Price and others during his lifetime operated by very different ethical standards compared to modern day Wall Street. The reason Price started his own firm in 1937 was primarily because he did not believe that the firm he was working for was focused entirely on providing investment council to clients but was instead always likely to view the world from a transactional perspective of a broker. Price wanted to forge long-term relationships with clients and had a higher sense of fiduciary duty.

The modest salaries taken by Price and others in his firm illustrate an ethos from an earlier time. In 1947, as his firm was regaining its footing after the war, Price paid himself an annual salary of just $12,000. According to the Bureau of Labor Statistics, this is equivalent to $134,000 in 2019 dollars. The other founding members of the firm earned just half of Price’s salary. By 1950, Price was earning nearly $23,000 in taxable income, or the equivalent of $241,000 in current dollars, a year that he referred to as “the most successful year in my business career from every angle.” At this point, Price was in his early 50s and at the start of an incredible run building his mutual fund business.

Until the early 1950s, T. Rowe Price & Associates was primarily focused on managing separate accounts for wealthy individuals and institutions. Several tailwinds in the 1950s, principally the fact that institutions started investing their pension funds in stocks, led to massive growth in the mutual fund industry. T. Rowe Price initially created its Growth Stock Fund as an ancillary service for existing clients and made it a no-load fund. Most funds at the time charged sales loads of five percent or more. Assets under management catapulted from $152 million in 1954 to over $1 billion by 1965 when Price began the process of selling his interest in the firm.

By modern standards, the $720,000 Price received for his interest in T. Rowe Price & Associates in 1966 seems microscopically tiny for a controlling interest in a successful asset management company. This amounts to only $5.6 million in 2019 dollars. Two years later, he sold his interest in Rowe Price Management, a firm that he established to manage portfolios of small growth stocks, for just $1.5 million, or $10.9 million in current dollars. Price earned significant wealth in his lifetime, but nothing like what modern executives in finance, many with no real skin in the game, earn in just a single year!

Lessons Learned

The life of Thomas Rowe Price, Jr. is well worth serious study and it is somewhat surprising that his first biography was written in 2019, 36 years after his death in 1983 at the age of 85. During his later years, he received the professional recognition that he always craved and was well known in the investment community as the Sage of Baltimore but in recent years his name is more likely to bring to mind the firm he founded rather than his growth stock philosophy and investment track record. That’s a shame because investors have much to learn from his life and approach to investing.

While none of us had any control over the outcome of the “genetic lottery” and, to a large degree, are products of our times, it is fascinating to read about how different people react to the same circumstances. Much of this, no doubt, has to do with temperament and personality. One gets the sense that Price was an eternal optimist. There is no doubt that this shaped his willingness to seek out investments with multi-decade time horizons even as the world was in the midst of depression and world war. Ben Graham lived through the same period and adopted a radically different, and much more skeptical approach. Yet both men did very well with their different approaches because they adopted styles congruent with their outlooks and personalities.

There are many ways to win in business and in life. Chances are that if you are reading this article, you are already a major winner in the lottery of life. There are truly unfortunate people in the world who have little opportunity based on the luck of the draw. Those of us fortunate enough to have built up capital to invest based on enterprise and hard work should bear in mind that we can pursue our activities through all sorts of economic vicissitudes knowing that following logically consistent and rational approaches will stand the test of time.

Disclosure: The Rational Walk LLC received a review copy of this book from the publisher.

The Aesthetic Tightrope

Dogs do not care what patterns are knitted into their sweaters. They may or may not appreciate the functional warmth provided by their sweaters but only their owners derive any benefit from details such as the color scheme, a Christmas pattern, or the overall quality of the stitching. Most dogs would probably be happier to wear nothing at all, even in the depths of winter.

Human beings are unique creatures in many ways, and probably viewed as somewhat odd by other animals, including our long suffering dogs forced to wear cashmere Christmas sweaters. Ever since the first cave paintings were created over 40,000 years ago, humans have expended time and energy to beautify our surroundings in ways that have little or nothing to do with functional elements of our lives. The quality of our homes and our clothing have been important ways to signal status for thousands of years and people have gone to great lengths to go well beyond functional utility due to the intangible value provided by aesthetics.

Other species may appear to take note of what we call aesthetics, but they do so for functional purposes, such as when a scavenging animal is repulsed by spoiled meat that would be poisonous to eat or when peacocks note the beauty of each other’s tail feathers during mating rituals. Being aware of the aesthetic qualities of food lowers the risk of poisoning and noting which potential mate displays the most impressive physical attributes is a necessary impulse for animals who seek to propagate their genes. In this sense, aesthetics in the non-human animal world have functional purposes. Only a peacock that is healthy, thriving, and likely to pass on strong genetic material will have the ability to dedicate scarce physical resources to growing beautiful tail feathers.

As human civilization progressed over the centuries and societies rose beyond the subsistence level, social stratification allowed a small number of people to dedicate their entire lives to pursuing their notions of aesthetic beauty. Often such artists were sponsored by royal courts that had tremendous resources to dedicate toward the aesthetic ideals prevailing at the time. Any tour through a great art museum leaves a modern visitor in awe of the works of art created by societies in which the vast majority of people were still focused on day-to-day survival.

The importance of aesthetic beauty is now pervasive in all segments of modern society and it would be rare to encounter anyone who has no desire to be near beautiful artwork or pleasing objects, however they choose to define it. At the same time, most of us go through our day-to-day lives with an intent focus on functional utility, whether we are commuting to work, reading the newspaper on our tablets, or preparing dinner at home. Ideally, we would like the functional objects in our lives to also provide aesthetic beauty.

The Intersection of Liberal Arts and Technology

In 1995, I decided to teach myself computer programming and I needed to purchase a computer. The problem was that as a new college graduate, I did not want to spend a lot of money on a pre-built system from a company like Dell or Hewlett-Packard. Fortunately, it was easy to go to Fry’s Electronics and purchase a tower case, a motherboard, CPU, memory, a hard drive, a power supply, and a few other components and plug them all together. Voila! I had a working system with Window 95 installed and I saved some money. The system had no aesthetic beauty. Few thought computers needed to at the time. With one notable exception.

”It is in Apple’s DNA that technology alone is not enough—it’s technology married with liberal arts, married with the humanities, that yields us the results that make our heart sing.” 

Steve Jobs introducing the iPad 2

Computers were thought of as functional objects for a long time. They were purely utilitarian and appearance did not resonate much with corporate or retail consumers, especially for desktop systems that spent their lives under a desk. However, Steve Jobs had long been obsessed with aesthetics. To Jobs, a computer or any other functional technology product had no soul if it did not have aesthetic virtues as well as technical prowess. Jobs famously also obsessed over what the inside of his products looked like even though customers would never see it. It was a matter of principle and pride of craftsmanship — attributes that great artists insist on.

Jobs was decades ahead of his time and suffered greatly for his obsession with the appearance of his products. And his competitors mercilessly ridiculed him for it as well. When Jobs, exiled from Apple in the 1980s, unveiled his first product launch for NeXT, he made the design and appearance of the computer a priority. Bill Gates dismissed not only the technology but the sleek, all black design stating: “If you want black, I’ll get you a can of paint.”1 Two decades later, Steve Ballmer laughed at what he considered the outrageous pricing of the first iPhone — after all, Microsoft had phones that could also “do email and internet”.

Importantly, Jobs was not a starry eyed romantic when it came to aesthetics. He realized that the beauty of the form had to be married to strong functionality to succeed in the marketplace. Additionally, he spotted areas where an aesthetic advance such as eliminating ugly physical phone keyboards could not only provide the same functionality but improve capabilities because virtual keyboards can be designed to adapt to changing contexts based on what the user is doing.

The Tension Between Form and Function

The best of both worlds occurs when an aesthetic advance, such as virtual keyboards on phones, also provides important functional advances. This is a clear win-win proposition. However, in many important design decisions, there is a tension between maximizing functionality and promoting physical beauty. This is true in many areas, but let us stick with technology for now and consider certain other design decisions made by Apple in recent years.

Apple has long been obsessed with making devices thinner and sleeker. Such attributes are prominently featured in all product launch events and the “wow” factor clearly impresses a large segment of consumers. In addition, highly visible changes to the physical appearance of a product, such as the iPhone or iPad, can be important to drive product upgrade cycles. Many customers will upgrade so they can be seen with the latest and greatest device. To drive this impulse that people have to signal status and wealth with technology, products must be visually differentiated from older versions.

The drive to produce thinner and sleeker products has required tighter and tighter construction of the components making up the device to the point where almost no consumer today would have the ability to service their product themselves. In many cases, devices cannot even be serviced by Apple itself. Additionally, the desire for thinner form factors has sometimes involved removing functionality. Such was the case when Apple discontinued a dedicated earphone outlet on new iPhones. Customers must now utilize the power port for wired headphones. And, of course, many have opted to purchase Bluetooth headphones like the AirPod.

The Price Paid for Beauty

The days of ordinary people tinkering with their consumer electronics is long past. When something goes wrong with a device, it typically must be returned to the manufacturer or taken to a third party repair shop for service. Often the cost of service, for devices past warranty periods, is too high to justify repair. The clearances within the device are simply too tight for people without training to replace broken parts or to diagnose problems.

I purchased a new MacBook Pro laptop in mid-2017 and it is both the most powerful and most beautiful computer I have ever owned. And it should be based on the $2,500 price tag! Unfortunately, Apple made a decision to introduce a new type of laptop keyboard using a “butterfly” mechanism in order to allow for a sleeker design. This design backfired:

In a weird way, Apple made a brilliant new laptop keyboard — it was thinner, sleeker, and felt fantastic to type with. Unfortunately, it only worked consistently in controlled environments and ruined one of the most important aspects of any computer.

What the hell is Apple’s butterfly keyboard?

The keyboard did feel fantastic to type with and it looked great as well. Win-win, right? Wrong. A little over two years of daily use resulted in several keys not working properly – either becoming non-responsive or repeating inappropriately. One faulty key was the period, which is probably the worst key to go bad for a user who works with spreadsheets frequently.

After some initial controversy and legal action, Apple did the right thing and created a program to replace all faulty keyboards free of charge. But customers are still being inconvenienced and losing access to their computers for several days while the problem is resolved. Additionally, due to the tight clearances and desire to make everything as compact as possible, Apple must replace not only the keyboard but the battery of affected laptops since both are within a single module that apparently must be replaced as a unit.

Balancing on the Aesthetic Tightrope

What is the right balance between form and function? Who had the “right” approach – Bill Gates or Steve Jobs? Looking at that specific question from the perspective of late 2019, we can note that both Microsoft and Apple have been resounding success stories and both companies now have market capitalizations in excess of $1 trillion.

Microsoft has never been known for the aesthetic beauty of its products, but hardware was not a focus for the company throughout most of its history. Apple, on the other hand, has always been known for the form and function of its products. Both have played to their strengths over the past decade with Apple continuing its innovations in product design while Microsoft made surprising headway in cloud services. There are many ways to win in business.

Apple without a focus on aesthetic beauty would be a company with no soul. It is clearly correct for Tim Cook to dedicate significant resources toward innovations that lead to thinner and sleeker devices that will cause people to line up for product releases. It is also probably correct for Apple to make a conscious decision to accept some functional constraints in the pursuit of aesthetic beauty, including taking risks that sometimes backfire as was the case with the butterfly keyboard issue.

In rare cases, advances in aesthetics and functionality go hand in hand and this is a clear win-win proposition. In most cases, however, there is a natural tension between form and function. Apple has generally managed to walk the aesthetic tightrope skillfully over the years even though the choices they make sometimes backfire and annoy their customers.

Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway which has a large holding of Apple common stock.

  1. See Loonshots, p. 122, which we reviewed in November. []

Holiday Book Recommendations for 2019

Reading a book can be deceptively expensive. The cost of a new hardcover book on Amazon is usually in the vicinity of twenty dollars, but the real cost of reading any book is the time you spend reading it. If you value your time at fifty dollars per hour and the typical book takes five hours to read, that is a $250 time commitment. And often that commitment is well worth it since you have the ability to absorb the knowledge a writer has poured out onto a page over hundreds or even thousands of hours of effort.

Books can represent a terrific value proposition provided that you avoid the ones that are not worth your time! In addition to hopefully conveying interesting information to readers, writing book reviews helps to synthesize the information and compliments the goal of active reading. Importantly, conveying this type of information does not carry with it the negative aspects of writing about investment ideas. As a result, book reviews have become a more common subject for articles on this website in recent years.

The book recommendations that appear in this article are mostly not related to finance and investing. Although these are all books that I read in 2019, most were not published this year. A similar list of recommendations appeared during the 2018 holiday season and a list specific to investing appeared several years ago. Hopefully these recommendations will provide an interesting starting point for your own holiday season reading or ideas for gifts.

Alexander Hamilton. Ron Chernow’s epic biography of Alexander Hamilton represents the authoritative modern account of the life of one of the most consequential founding fathers. Although often castigated as a monarchist by his rivals, Hamilton had anything but a privileged upbringing. He rose from a position of poverty and family dysfunction in the Caribbean to the heights of American political power in a very short period of time, gaining the trust of George Washington during the Revolution. He parlayed early success into positions of great influence in shaping the Constitution and establishing the foundational elements of American capitalism. Hamilton was a flawed man whose style sometimes led to more antagonism than necessary, but his importance to the success of the American experiment cannot be denied. Chernow has a way of bringing historical figures to life and Hamilton is no exception.

Dignity: Seeking Respect in Back Row America. Chris Arnade left his job as a trader on Wall Street in 2012 to focus on the plight of the poor in America. While still working as a trader, Arnade had a habit of taking long walks through New York City. His willingness to talk to the drug addicts, prostitutes, and homeless people he encountered formed the basis for a more in depth examination of what he calls “the back row” of American society – those left behind in our modern economy. Worse than being left behind, the back row is misunderstood and belittled by the “front row” elites, and this misunderstanding crosses racial, ethnic, political, and geographical lines. Although this isn’t a book about how Donald Trump came to power, it does help to get a sense for the dissatisfaction that makes people willing to make Hail Mary attempts to shake up the system.

The Bed of Procrustes. Nassim Nicholas Taleb is best known for his first book, Fooled by Randomness, which is part of a five volume set called The Incerto. The Bed of Procrustes is probably the least read of Taleb’s work and is also the shortest. As a book of aphorisms, the text is entirely comprised of short statements of a principle or opinion, such as “If you find any reason why you and someone are friends, you are not friends.” Chances are that if you appreciate Taleb’s work in general that you will also enjoy his often witty and profound takes on a variety of subjects from economics to philosophy to practical aspects of life. Taleb is often very polarizing on social media, something that he obviously views as a necessary aspect of his role as a “BS detector”, but the fact is that his insights have proven to be correct and his work extremely valuable even for those who are put off by his often acerbic online persona.

Night. No matter how many Holocaust museums one visits or how many first-hand accounts one reads, it is impossible to fully understand the horror of the crimes of Adolf Hitler’s Third Reich before and during the Second World War. Nevertheless, it is the responsibility of current generations to make an effort to remember what happened as the remaining individuals who witnessed it directly will be gone within the next couple of decades. Elie Wiesel experienced the horror firsthand as a teenager when he and his family were taken to the Auschwitz concentration camp in 1944. His account of the death of his family members and the suffering of countless others has deeply affected readers since the book’s publication over sixty years ago. Wiesel lived until 2016, clearly haunted by his experiences but determined to convey the horror so that such atrocities will not be permitted to happen again. Night can be paired with Dawn which is a story of the moral and ethical choices facing a Holocaust survivor-turned soldier during the war of Israeli Independence.

The Alchemist. Paulo Coelho published The Alchemist in 1988 at the age of 41. Published originally in Portuguese, the book attracted little attention at first and his original publisher cancelled his contract. However, the book went on to achieve great success and has sold over 50 million copies. Coelho did not give up. Like the story of the Andalusian shepherd boy in the book, Coelho had a laser-like focus on his “personal legend”: “It is what you have always wanted to accomplish. Everyone, when they are young, knows what their Personal Legend is.” The shepherd boy in the story had known ever since he was a small child that he wanted to travel in order to see and experience the world. His quest, set in an earlier time, led him from the comfortable pastures of Southern Spain that he had known all his life to the pyramids of Egypt. Along the way, he learned much about himself, human nature, his place in the world, and his ultimate destiny. A grand adventure sure to be appreciated by young and old alike.

Where Are the Customers’ Yachts? Fred Schwed wrote the first edition of this book in 1940 and revised it in 1955, yet far from stodgy and outdated, this book will seem like it was written about investor behavior this year. Contexts and examples change, but the underlying human condition and the follies we encounter never changes. On topics ranging from the investor’s passion for prophesy to inflation to chartists, to economists, to the inability of most people to simply sit and do nothing, Schwed will have you nodding in recognition of some of your own mistakes while bursting into spontaneous laughter. The book is full of gems such as: “When a statistician works up a sufficient reputation for profundity, he is graduated and becomes an economist”. As Jason Zweig notes in his introduction, many investment books can make you think, you can occasionally find something useful, but it is very rare to find an investing book that can make you laugh. Schwed’s classic is such a book.

Walk the Sky. The John Muir Trail in California’s Sierra Nevada mountain range is one of the most scenic pathways in the world. After writing an account of my walk this summer, I received several inquiries regarding the trip. It is difficult to convey the trail in words but, luckily, those with an interest in the scenery can read John Dittli’s Walk the Sky. The book is not a guide for the trail, but instead provides numerous excellent photos of the trail along with accompanying essays. Dittli knows the Sierra Nevada from his decades of exploration and has a unique talent for capturing scenery.

The Prado Guide. Madrid’s Prado Museum is one of the highlights of any trip to the city and is considered by many to be the greatest public collection of paintings in the world. You can easily spend an entire day wandering around the collection. This guide contains full color photos and could be of interest to anyone, but of course is of greatest interest to someone planning to visit the collection. My purpose for including it here is to point out that most people who visit museums either rent audio guides or rely on placards next to artwork. Neither provides a real understanding of what you are actually looking at. It is much more rewarding to invest a few dollars or euros in a proper guidebook and read about what you are looking at in more detail. By doing so, you will also escape the herds of tourists on tours who move from one piece to another with robotically timed precision. Unfortunately, this approach ends up being superficial – a mile wide and an inch deep. Consider investing in a book for your next visit to a great museum.

The Little Book of Valuation. One of the most consistently interesting investment blogs is Aswath Damodaran’s Musings on Markets. Over the past year, Damodaran has made a special effort to examine many of the highly publicized initial public offerings and attempt to provide valuations in cases where most investors would give up in frustration. Most IPOs are priced based on the strength of the narrative presented by the company whereas true investors, as opposed to speculators, care about estimating intrinsic value. Damodaran clearly lays out his assumptions regarding each company and presents valuations for each while fully acknowledging the hazards of doing so in cases where the variables are difficult to forecast. He also provides downloadable spreadsheets so readers can test variances based on their own judgment. The Little Book of Valuation is a 2011 book that lays out Damodaran’s approach to valuation in greater detail.

The Feynman Lectures on Physics. Like many who opted to study business in college, I viewed other subjects mainly as requirements to be met as efficiently as possible. I took science seriously, but only to the point where I needed to in order to secure an A. Information obtained in this superficial manner is usually not retained, and therefore cannot be called upon decades later. If we take Charlie Munger’s advice to learn as many mental models as possible, it is hard to ignore the hard sciences. The Feynman Lectures on Physics, which are also available free of charge, is an excellent way to begin to understand physics, and I have only made modest headway on the first volume this year. Often challenging but never boring, Feynman’s lecture notes are definitely worthwhile for the intellectually curious.

Disclosure:  The Rational Walk participates in the Amazon affiliate program and receives a small commission for all products purchased via links on this site.


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