“History might not repeat itself, but it does rhyme.” –Mark Twain
You can learn a lot about the world just from studying its past. If you’ve ever watched or heard of the critically acclaimed PBS series, Cosmos, one of the most awe-inspiring thought experiments is actually how short humans have been in existence relative to the rest of the universe. For example, if the entire timeline of the universe were broken down into a single calendar year, all known human history–every king, civilization, major event, and person you know, have only been around for the last thirty seconds. Thinking about and reflecting on human history on a cosmic scale creates this incredibly humbling experience, because it proves just how little we really know about everything that came before us.
Ignorance of history isn’t a crime, but it’s a problem easily solved. Not only can historical education be enlightening, it can prove itself to be a valuable investment of your time. Intelligent investors know that future results aren’t based on past performance, but wise scholars of economics learn to recognize warning signs of impending doom. Thus, like a well salted and experienced sailor, the historically educated money manager learns from the mistakes of peers, as well her own mistakes, to navigate the economic seas, and weather any unforeseen storms.
Adam Smith’s Invisible Hand
Adam Smith was a Scottish moral, political, and economic philosopher. He’s regarded by many as the “Godfather” of modern economic theory. In 1776, the same year America declared independence from Great Britain, Adam Smith published The Wealth of Nations. The central thesis of the book explains that rather than hoarding wealth and restricting trade, it’s in the best interest of all parties to participate in a free market system, letting the “invisible hand” redistribute wealth at maximum efficiency. In other words, the outlines of modern capitalism.
As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.
How does this weave back in with value investing? One of the biggest lessons here is specialization. Rather than watering down one’s skills, Smith argues that specialization in combination with free trade, makes for a better society–as both the quality and quantity of goods increases, as prices drop. Specialization also happens to be a concept Warren Buffett is well acquainted with, as he is notoriously hands on with the allocation of his capital. Aside from a select few portfolio managers working for Berkshire Hathaway, Buffett doesn’t invest in funds-of-funds, mutual funds, venture capital funds, etc., because he knows that he’s really good at what he does: managing money.
Think of Warren Buffett as an Olympic champion of money managing. If he spots cheap capital, he wants to manage it. Thus, one of the biggest attractions of a company like, GEICO to a guy like Buffett is the “float” (premiums collected before claims are made). In the time between collecting and paying out insurance claims, Buffett actively invests this money, which comes to him interest free. This structure, which capitalizes on Buffett’s specialization of capital allocation is arguably one of the fundamental pillars of Berkshire Hathaway’s success.
Knowing your strengths and doubling down on them is something you can take away from Adam Smith. But in general, the more you understand about monetary policy, macroeconomics, and the real reasons goods and services are traded the way they are, the more likely you are to make smarter investing decisions over the long run. At the very least, studying economic history and theory can protect you from being exploited by those who know the inner workings of the system better than you.
Where Debt Actually Comes From
One of the most commonly perpetuated myths about money is in regards to its origins. There’ve been plenty of books written about money, which usually contain some story about the emergence of coins and paper currency, as a means of mutually accepted and tradable goods. While true that coins were used in early markets for trade, they weren’t created for the sake of trade; rather, money as we know it was created as a means to keep track of debt.
This discovery was the catalyst and thesis for David Graeber’s 2012 book, Debt: The First 5,000 Years. Graeber goes on to explain that debt as we understand it is more rooted as a moral obligation than a financial obligation. Debt is also a way to maintain ongoing relationships, as being slightly indebted to a friend or vice versa gives you an opportunity to engage with that person in the future. Thus, repaying one’s debts in full, as one does at the supermarket, is a sign that the relationship is over.
“In fact this is precisely the logic on which the Bank of England—the first successful modern central bank—was originally founded. In 1694, a consortium of English bankers made a loan of £1,200,000 to the king. In return they received a royal monopoly on the issuance of banknotes. What this meant in practice was they had the right to advance IOUs for a portion of the money the king now owed them to any inhabitant of the kingdom willing to borrow from them, or willing to deposit their own money in the bank—in effect, to circulate or “monetize” the newly created royal debt. This was a great deal for the bankers (they got to charge the king 8 percent annual interest for the original loan and simultaneously charge interest on the same money to the clients who borrowed it) , but it only worked as long as the original loan remained outstanding. To this day, this loan has never been paid back. It cannot be. If it ever were, the entire monetary system of Great Britain would cease to exist.”
On every balance sheet, you can be sure to find debt. But instead of looking at debt purely as just another number, it may be useful for the investor to investigate this debt further. Asking questions like, “To whom is this debt owed?” “At what rate of interest?” and “Why was this debt initially incurred?” are all excellent starting places for hedging against potential problems in the repayment of said debt. Reading Graeber’s historic and moral explanation of debt can further supplement your research and better equip the way you think about the balance sheet.
“All I want to know is where I’m going to die, so I’ll never go there.” – Charlie Munger
Mistakes and Bubbles
One of the best ways you learn is from mistakes. Think about the first time you ever burned yourself using a stove or oven. Maybe you didn’t know something was hot, or simply forgot; either way probably every person you’ve ever met has burned themselves cooking at some point in their life. The next time you’re about to make the same mistake, your brain instantly recalls the last time you burned yourself, sending warning signals flying through your brain. If you heed these warnings, you might save yourself from another painful experience.
The emotional pain experience by loss of capital is a very similar feeling to that of being burned by the oven. In that, the investor makes a mental note of that mistake and vows never to repeat such foolish activity again. Still, we see time after time, bubble after bubble, investors fall victim to overconfidence, and ignore the warning signs of doom.
Look through this list of economic bubbles. As far back as the 1600’s, investors were already speculating on ever rising prices for their assets. “Tulip Mania,” “The South Sea Bubble,” “Railway Mania,” etc., the list goes on and on, all the way up to modern day, where we see “The Real Estate Bubble”. In hindsight, it’s easy to spot the causes for these booms and busts. By studying these crisis, you can then compare current economic conditions to historic conditions. Take for example, this lesson from AVI’s Chuck De Lardemelle, on the latest crash:
It’s a very tough question because there is no precedent in financial history for what we’re going through today. In the 1800s in the U.S., you have a number of real, very severe deflationary busts that have been documented. 1814 was the first one but there are at least five during the 1800s where basically a number of banks went under, you had a massive contraction in money. And as a consequence, GDP falling 5%, 10%, 20% – very sharp drops followed by very sharp recoveries. And towards the 1800s actually, growth was very uneven but was strong. What happened in 1929 was that a bust of that nature happened when there was a tremendous amount of debt which was not the case in the 1800s. And as a consequence, there was a negative spiral that is well-documented and that Bernanke had studied, and we had something very similar happen in 2008, 2009. In hindsight, he reacted well with QE1 and trying to stabilize the whole system.
Learning from the mistakes of others is usually cheaper than learning your lessons the hard way. Fortunately, economic history is littered with “booms,” “bubbles,” and “manias” to study. Still, it’s on the investor to take the initiative to educate herself about these cyclical traps. One of the more popular ways to mitigate these avoidable errors is to use a checklist. Mohnish Pabrai, author of The Dhando Investor, and founder at Pabrai Funds, is one of the biggest advocates of checklists as applied to value investing. Every time he makes a new investing mistake, he writes it down on his checklist to avoid for next time. In a way, this is very similar to the way your brain makes a mental note to avoid touching a hot oven. When new investment opportunities present themselves, Mohnish simply runs them through his mistake minefield to see where he’s possibly exposed to risk.
In short, history should be the tool and old friend of the intelligent investor, rather than just the keeper of his mistakes. The past is like a goldmine of information, waiting to be excavated by curious prospectors. Those who ignore history, do so willingly. But those who take the time to dig just a little deeper, may find they’ve been sitting on gold the entire time.