To end this story of my odyssey through science, mathematics, gambling, hedge funds, finance, and investing, I would like to share some of what I learned along the way.
Education has made all the difference for me. Mathematics taught me to reason logically and to understand numbers, tables, charts, and calculations as second nature. Physics, chemistry, astronomy, and biology revealed wonders of the world, and showed me how to build models and theories to describe and to predict. This paid off for me in both gambling and investing.
Education builds software for your brain. When you’re born, think of yourself as a computer with a basic operating system and not much else. Learning is like adding programs, big and small, to this computer, from drawing a face to riding a bicycle to reading to mastering calculus. You will use these programs to make your way in the world. Much of what I’ve learned came from schools and teachers. Even more valuable, I learned at an early age to teach myself. This paid off later on because there weren’t any courses in how to beat blackjack, build a computer for roulette, or launch a market-neutral hedge fund.
I found that most people don’t understand the probability calculations needed to figure out gambling games or to solve problems in everyday life. We didn’t need that skill to survive as a species in the forests and jungles. When a lion roared, you instinctively climbed the nearest tree and thought later about what to do next. Today we often have the time to think, calculate, and plan ahead, and here’s where math can help us make decisions. For instance, are seatbelts and air bags “worth it”? Suppose we upgrade a hundred million vehicles at a cost of $300 each, a total of $30 billion, and have five thousand fewer traffic deaths per year. If these vehicles with their added safety features are around for ten years, that’s fifty thousand lives saved at a cost of $30 billion, or $600,000 per life. Though many in the auto industry disagreed, we spent the money and saved the lives.
What about the pack-a-day smoker? Forty years of this will make his life on average seven years shorter. Each cigarette not only brings death twelve minutes closer, but adds health problems to spoil one’s remaining years. Then there are the costs to the rest of us, namely, higher medical costs in the final years, more sick days during the working years, and secondhand smoke damage. But these are averages. Some smokers do not die of smoking-related diseases, whereas others die at an early age. It’s like gambling at roulette. On average you lose 5 cents when you bet $1. But this is an average. Some gamblers are wiped out quickly and others may hold their own for quite a while.
One of the major public policy issues today is the trade-off between the costs and the benefits of certain procedures. Some choices are stark. Is it better to spend $500,000 to save the life of someone with super-drug-resistant tuberculosis or to use the same amount to save fifty lives by delivering fifty thousand doses of flu vaccine at $10 each to schoolchildren? Statistical thinking can help us with choices like these.
I believe that simple probability and statistics should be taught in grades kindergarten through twelve and that analyzing games of chance such as coin matching, dice, and roulette is one way we can learn enough to think through such issues. Understanding why casinos usually win might help us avoid gambling and teach us to limit our losses to their entertainment value. Gambling now is largely a socially corrosive tax on ignorance, draining money from those who cannot afford the losses.
Most of what I’ve learned from gambling also is true for investing. People mostly don’t understand risk, reward, and uncertainty. Their investment results could be much better if they did. For instance, years ago my homeowners’ association kept their cash reserves in thirty-day US Treasury bills for absolute safety. However, they spent only about a fifth of these reserves each year. I suggested that they put a fifth of their reserves into US Treasuries maturing in the coming year, another fifth to mature the year after, and so forth. This well-known strategy, called laddering, generally pays off because longer-term US bonds, with more price fluctuation before they mature, generally yield more. Five-year bonds have beaten thirty-day T-bills by about 1.8 percent annually over the last eighty-three years. The treasurer of the association, a professional accountant, opposed the idea at first but later agreed and used it profitably.
I would like to see basic finance taught in elementary and secondary schools. If more of our citizens knew how to balance their checkbooks and to create and understand income statements and balance sheets for themselves, they might do better at choosing homes they can afford. Properly managing investments would better prepare people for retirement and make them less dependent on society during their lifetimes.
One of my great pleasures from the study of investing, finance, and economics is the discovery of insights about people and society. The physical sciences have rules such as the law of gravitation that generally hold true in the world as we know it. But human beings and the way they interact aren’t covered by broad, unchanging theories and may never be. Instead I’ve come across more limited concepts that tie things together and serve as shortcuts to understanding.
One of these is a favorite of libertarians and free-market fans, introduced by Adam Smith back in 1776. Smith suggested that in an economy of many small buyers and sellers, each trying to increase his own profit, our collective benefit would be maximized as though guided by an “invisible hand.” The notion is of limited use, because most markets are not as Smith assumed. Take computer chips: 99.8 percent of them, worldwide, are made by just two US companies, and the smaller one is fighting to survive.
An opposite concept to the magic of the invisible hand is “the tragedy of the commons,” as explained in 1968 by Garrett Hardin. Imagine a natural resource that anyone can freely use, such as—once upon a time—catching fish in the ocean. In the eighteenth century, schools of cod were so vast that Benjamin Franklin was amazed when his ship plowed through them for days at a time. Now, after two centuries of overfishing, this population has collapsed. How has individual self-interest maximized social good? On a global scale we have the example of pollution. Individual humans have freely burned fossil fuels and greatly increased the amount of greenhouse gases such as CO2, leading to a continuing rise in the earth’s temperature over the last century. The tiny particles also emitted have caused lung diseases and deaths. But each polluter gains more individually from his own actions than he loses, so he has no direct pressure to change.
The solution for society illustrates another neat unifying concept, that of “externalities.” In the arcane jargon so beloved by the economic priesthood, an externality is a cost or benefit for society that results from private economic activity. The externality is negative in the case of air pollution. The “fair” solution then becomes obvious: Estimate the damage and tax it by that amount. Externalities also can be positive. If I fireproof my house it protects my neighbors, and tends to both reduce the costs of local fire services and increase profits for my insurer. Instead of being taxed, I may be rewarded by a drop in my insurance rates.
Berkshire Hathaway’s Charlie Munger presents his list of such thinking tools in the engaging Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger. This multidisciplinary collection of insights includes a favorite of mine for understanding deals and relationships, namely, “Look for the incentives,” which is closely related to finding “Cui bono?” or “Who gains?” Cui bono instantly explains why seven thousand US gun dealers, lining the border with Mexico from Tijuana to Corpus Christi, are allowed freely to provide nearly all the military-level arms used by the Mexican drug cartels. It explains why Congress mandated the wasteful folly of corn-based ethanol, the production of which causes almost as much pollution as it offsets and drives up food prices for everyone. If ethanol use were the goal, why was there, until the end of 2011, a 54-cent-per-gallon tariff to keep Brazilian ethanol out?
More insights come from a much bigger idea of fundamental importance for all investors, the recognition that the group I call the politically connected rich are the dominant economic and political power in the United States. This is a key concept for understanding what happens in our society and why it happens. They are the ones who buy politicians, using campaign contributions, career opportunities, investment profits, and more. As owners of wealth who also control power, they run the country and will continue to do so. We saw how they used the government to bail them out of the financial crisis of 2008–09.
Let me be clear. I don’t object to some people being richer, even much richer, than others. I object to gain of wealth through political connections rather than earning it by merit. If a basketball franchise pays my neighbor Kobe Bryant $20 million a year because it takes that much to get him, fine. But if hedge fund managers bribe politicians to put a clause in the laws cutting the tax rate on much of their income to a fraction of the percentage the average worker pays, I object.
Simplistically, there are two types of rich, those who use government to tilt the playing field in their favor and those who don’t. The former pay taxes at a rate well below the middle class and the latter pay at substantially higher rates. The blended rate of the two groups is similar to that paid by the upper middle class. But the politically connected rich typically point to the higher rates paid by their nonconnected rich fellows as a cover to demand still more tax breaks for themselves. The power in this group resides mostly in those who are in the upper 0.01 percent of wealth holders, currently worth $125 million or more.
Another theme for dealing with public policy issues is to simplify rules, regulations, and laws. Get government out of the business of micromanaging. For example, California and many other states have their own income tax code, which resembles the federal tax code but is different enough so that a resident must complete and file a state return that is as detailed and complex as his federal return. Here’s my solution. Let the state tax for individuals simply be a fraction of the federal tax, to be set by the legislature, and chosen to raise the same total revenue as the current tax. The return would fit on a postcard, saving hours for each taxpayer and freeing several thousand unproductive state employees for useful work in the private sector. Eliminating three thousand state of California employees at a cost of $100,000 each, including salaries, benefits, and overhead, would save the hard-pressed state $300 million a year, not to mention all the time and money saved by citizens. So we have a revenue-neutral proposal that is a net gain for the state.
Even greater benefits come when we apply this approach to the federal tax code. Tax rates are high because the loophole-riddled regulations allow many to pay less or even nothing. A revenue-neutral flat tax could make the tax code simple and fair, and would catch those who currently are getting a free ride from the rest of us. All income would be taxed equally, with an exemption set at, say, one and a half times the poverty level. Those below this cutoff would pay no tax. As this entire group has only a small part of national income, the impact of these exemptions would be minor. Because much currently untaxed income would be taxed, the estimated revenue-neutral rate would be 20 percent or so. Again, we could have an enormous benefit to society. Hundreds of thousands of government employees, tax lawyers, accountants, and tax preparers would be freed to make (hopefully) a productive contribution to society. The value-added tax is another proposal that recaptures those who have escaped taxation and cuts the top tax rate in half.
Having an idea that benefits society is the first step. The hardest part, more often than not, is passing laws to implement it. This has become harder, as the political clash between the parties in the United States has become extreme. Politics, once called the art of the possible, is becoming the art of the impossible. Gridlock between uncompromising factions was one cause of the fall of the Roman Empire.
History, arguably, has had just two great superpowers, the Roman Empire after the defeat of Carthage, and the United States after the fall of the Soviet Union. Of great importance for long-term investors is whether the US will be the dominant world power in the twenty-first century, or whether we have peaked, dissipating our strength in costly foreign wars, financial mismanagement, and domestic strife. The first scenario could lead to another century of equities returning 7 percent a year after inflation. The other outcome could be far less pleasant. I reassure the pessimists by noting that we’re still rich, still innovating, and besides, Rome wasn’t destroyed in a day. Nations that were once among the most powerful, such as Britain, France, Italy, Spain, the Netherlands, and Portugal, are still among the most developed and civilized of countries. To the optimists I mention the obvious: endless deficits, massive wastage of lives and wealth in wars, political subsidies (pork, bailouts, corporate welfare, paying the able-bodied not to work), and destructive partisanship in all three branches of government. Meanwhile, the rise of China is transforming the geopolitical and economic landscape.
One of the most ominous and underappreciated threats to our future is in education and technology. My own state of California is a leader in the race to the bottom. The anti-tax movement has starved the state of revenue, especially the educational system. The ten campuses of the University of California, once among the finest public systems of higher education in the world, raised tuition to $12,000 a year by 2015. When I was a student in 1949 it was $70, which is like $700 today, adjusting for inflation. A good education was available to any qualified student. The university’s graduates went on to lead the technological revolution; but by 2014 the state contributed only about 10 percent of the total cost of all campus operations.
If the UC system doubled tuition and fees it could drop state support altogether and go private! Since out-of-state and foreign students are charged three times the tuition paid by California residents, individual deans and administrators are raising more money by replacing the latter by the former. Meanwhile gifted foreign students, many of them Chinese, receive advanced degrees in the United States and return home, rather than struggle for postdoctoral funding and permission to become residents. Talented American-born scientists and engineers are joining them in a reverse brain drain. Economists have found that one factor has explained a nation’s future economic growth and prosperity more than any other: its output of scientists and engineers. To starve education is to eat our seed corn. No tax today, no technology tomorrow.