By Chris at http://ift.tt/12YmHT5
Last week I discussed how humans are wired to pay attention to scary things. In financial speak: risk. Darwinism has chastised those who ignore risk by rewarding them with an early grave, and by process of elimination rewarded those who stay out of the cross hairs.
Thing is, we no longer live in a world where saber-toothed tigers threaten our existence. In today’s world far greater risk lies in the truly enormous and disproportionate emotional attitude to (and assessment of) risk.
This has nothing to do with Darwin but rather more to do with an educational system designed and built for the industrial age. Education today is an advertising agency which leads us to believe we need the society on which it relies upon for its existence.
Beginning with the schooling system and followed by “higher education”, the middle and upper middle class in developed societies are by and large serfs. And they’re serfs because they don’t understand risk.
The overwhelming majority look at risk incorrectly. They look at it two dimensionally: “The more risk I take the more ‘volatility’ I have.” The fact is, risk is actually subjective to your own personal situation. Mismanaging your own personal situation increases risk disproportionately.
Let me give you an example of how easily an otherwise intelligent person gets royally screwed by the system by routinely miscalculating risk.
Let’s take Harry, a fictional guy from a middle class family who’s just left high school. Harry really wants to get ahead and has set himself a goal of becoming a millionaire by the time he’s 25. He figures that by 35 he’ll be worth north of $10 million.
Truthfully, these figures don’t mean much to him but he’s had a small taste of the life and he knows it costs. There was that time he was trying to impress a brunette, and they dined at one of David Chang’s NY restaurants and he still remembers the almost palpable smell of money in the air as diners around him flashed Hublots, diamond necklaces and sophistication.
He remembers how the waiter unscrewed the cap of the water as though defusing a nuclear bomb. And although the beef he ordered was so thin that he had to lick it off the plate because it kept falling off the fork, his friends were really impressed and the girl so floored that she showed her appreciation by keeping him up all night.
The first thing poor Harry is told is to get an education. And so he does just that. Years of schooling have failed to developed in him critical thought. And so, though he has access to almost every resource one can think of, and at a cost approaching zero, he automatically associates education with a four-walled institution where people who like books theorize on how the real world operates, most never having experienced it first hand.
Here he spends 3 years getting into girls’ pants, drinking too much and associating with the same type of people as himself, which does little to develop his critical thought processes. Harry is rewarded with two pieces of paper. One represents his qualification and the other represents the six figure debt he now owes. Remember that the knowledge acquired between the drinking and sex is already free.
This is Harry’s first critical step in miscalculating risk. He exits university with a piece of paper and the world skills and street-smarts of a juvenile because his free time has been spent drinking and test driving anything in a skirt. Most importantly his future income is already tied up in debt repayments.
Fresh out of university Harry now has two doors ahead of him…
The Red Door
Choosing the red door takes Harry into a job. This promises a monthly revenue stream which appears to offer security and consistency. The lure is strong. After all the need to pay off his student debt lurks high on Harry’s list. He’s excited to put himself to test in the “real world” and believes that he can really target becoming wealthy once he’s got his student debt paid off and a few years under his belt.
The Green Door
Here Harry must take his skills learned and rapidly obtain an education. A real education. He will need to do this by becoming an entrepreneur and building his own outcome. This option offers no monthly revenue stream and no security or consistency. It also offers unlimited upside and a real, not imagined, shot at becoming wealthy.
Unfortunately, Harry has a distorted view of risk for two reasons:
- He has debt and must make debt payments. This distorts his view of real risk.
- He doesn’t have an education which shows him the real cost of risk.
The red door option appears far less risky than the green door option. After all, none of Harry’s friends are doing this and when he brought up the topic with his parents they nearly blew a gasket. “Don’t give up your future so early on,” they pleaded. Once again, poor Harry’s lack of critical thought gets the better of him and he takes the red door believing it to be less risky.
Fast forward a few years into cubicle hell and Harry is now earning $60,000 a year. His student debts are easily manageable and in an attempt to get ahead, Harry buys a house, reasoning that he needs somewhere to live and this is the first step towards fulfilling his goal of becoming wealthy.
He reasons that buying the house is a step in the right direction, but he hates his job more every day and it’s now dawned on him that it’s a long hard slog up the corporate ladder in order to earn the sort of money that can make him wealthy.
Once again, he’s faced with a dilemma. Does Harry risk kicking in the job and starting a business of his own, doing something that he really loves, or does he stay put?
And This Is How Harry Analyses The Risk
Scratching at his now receding hairline he thinks to himself, “I can’t take the risk of starting my own business because it may fail.”
The downside now is losing not only the $60,000 salary but defaulting on the payments now tied to this revenue stream. The risk is no longer $60,000. The risk now is in losing the ability to keep up student debt payments as well as mortgage payments.
Pretty soon he’ll fill that house he bought with “stuff” which will either come on hire purchase or simply be added to his mortgage. He lies to himself saying, “Hey, at least I’ve got the income, which I wouldn’t have had without the college education. And at least I’m on my way up because I now own an asset.”
Wrong! On So Many Levels…
Here is how Harry should analyse risk for something as simple as deciding whether to quit a $60,000 a year job or not in favour of having a crack at becoming wealthy.
Let’s look at the downside: if Harry has a job paying $60,000, chances are he’ll be able to pick up another paying $60,000.
Let’s say that those chances are 60%. So he has a 60% chance of getting back to where he is now if he screws up.
Let’s further say that there is a 20% chance he can only get another job paying $50,000, and another 20% chance he will only manage to get a position paying $40,000.
The worst case scenario is therefore a 20% chance of a $20,000 loss. This is his real risk. What then is the upside?
The upside is unlimited. Literally!
Even if Harry completely screws things up, a year running his own business will provide him with 10 years worth of “higher education” leaving him far more qualified than he’ll ever be if he stays in his job.
Why wouldn’t Harry risk a 20% chance of losing $20,000 for a potentially unlimited upside?
The reason Harry doesn’t make the trade is because he’s already tied his $60,000 revenue stream to a host of liabilities. Now I hear some of you saying, “Oh no, but he owns a house and that’s an asset”. No, it’s not!
Assets make you wealthy. They provide you with more, not less freedom. Is Harry’s house doing any of those things?
Harry has already fallen into a trap where he is no longer free to make rational choices. Freedom is wealth.
The financial infrastructure surrounding Harry and the education he’s received is DESIGNED to ensure that debt is never repaid, but only serviced.
If you, dear reader, and I can create a loan for a $1 million and collect an interest payment on it for eternity, all the while getting the poor sucker who’s taken the loan to sign up for even more loans on more liabilities, then that, my friend, is an awesome deal for us. This is what banks, insurance companies and credit agencies make a living out of.
80% of people routinely make the same decisions Harry does and then continue to do so throughout their life. Is it any wonder why despite having cars, boats, a house and all the trappings of the enslaved, they reach middle age, exhausted, unfulfilled, and forever trapped in these damn payments, with some far off absurd goal to pay off the loans upon retirement?
This brings me to that Italian mathematician I mentioned last week.
The Law Of The Vital Few
Vilfredo Pareto first observed the phenomenon that 80% of the land in Italy was owned by 20% of the people. Since then this phenomenon has been mathematically proved across literally every spectrum of society and business.
The principle states that, for many phenomena, 20% of invested input is responsible for 80% of the results obtained. Put another way, 80% of consequences stem from 20% of the causes.
What I discussed last week was how we’re hard wired to take notice of pain. This neurological fact is played upon by many industries where we are led to believe things which just ain’t so. We can see the results in wealth distribution, just as Vilfredo observed in the early 20th century.
Take early stage venture capital for example. If I had a brick for every person who’s told me that I’m taking massive risk by investing in early stage private companies, I’d have enough to rebuild the Berlin Wall.
Risk is not one dimensional. It’s a known fact that well over 50% of early stage deals go belly up. Risky? Sure, it is if viewed in isolation.
What is also a fact is that the mean return of early stage VC investments is north of 50% per annum. This is the mean and like anything else with a little bit (OK, a lot) of work, outperforming the average in anything is entirely achievable if you put effort into it.
Use proven laws to tilt the balance of probability massively in your favour. Turn off the TV. Travel. Educate yourself.
Unless you want to be part of Pareto’s 80%, then don’t invest in what 80% of the market are invested in. Look for asymmetry. Look for what lies in the 20%.
– Chris
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