The Tail that Wags the Dog
January 25, 2021
Image used with permission: iStock/Wavetop
The Tail that Wags the Dog
We thank our friends at Northwood Family Office for having brought to our attention a fantastic book called, The Psychology of Money, written by former Wall Street Journal and Motley Fool journalist, Morgan Housel. We strongly recommend it!
In one of the most interesting chapters, Housel writes about “tails”. Not the canine kind, but the ones at the outer reaches of a probability distribution. The “dog” in our title is a metaphor for so many things in life, especially investing.
Most will remember probability theory from high school math. If you don’t, never fear, the idea is straight-forward. The most common probability distribution is the normal curve, where the high point on the curve is the mean, or average, of the possible outcomes of a certain event. The mean is the value with the highest probability of occurring. As you move away from the centre of the curve the probability of events gets lower and lower. You might recall that the mathematical measure of this is standard deviation. But that is not important here. What is important is that the outer reaches of the curve are the “tails” – the outcomes that are not very likely. Housel argues that the “tails” are critical, because so many things in life and investing depend on what happens in these “tails”.
It’s a fact of life that small probability events can account for a disproportionate outcome. As Housel writes, almost everything in life that “is huge, profitable, famous, or influential, is the result of a tail event – an outlying one-in-thousands or millions event.” (1) It’s normal for things to fail. An investor or business person can be wrong more than half the time and still make a fortune.
Before shifting to the investment world, Housel gives the example of Walt Disney. In the 1930s, Disney had made more than 400 cartoons. They were expensive, most lost a fortune, and Disney’s career seemed financially doomed. Then, in 1938, Disney produced an animated feature called Snow White and the Seven Dwarfs. It changed everything. Snow White was such an outrageous success it more than compensated for the economic disasters before it. Its profits overwhelmed the losses. The rest is history.
In the investment world, the idea of “tail” outcomes might be familiar to most in the context of venture capital. If a highly successful VC firm makes 50 investments, half or more are likely to fail. A good number of others will produce decent results. Only one or two will be fabulously successful and will drive virtually all of the returns of the successful firm.
This doesn’t seem surprising because we view the VC industry as “risky”. Most conservative investors stick to the public markets where returns seem more predictable and reliable. Except that they are not. Many public companies fail as well. A J.P. Morgan survey of the Russell 3,000 – the largest 3,000 companies in the U.S. – found that 40% of companies in the 1980 to 2014 period lost at least 70% of their value and never recovered. (2) All the index’s returns came from 7% of the companies. Failure is most common in industries like technology (57% failed), but no industry is immune. Even 13% of staid old utilities suffered catastrophic losses during this period.
Even within the companies that are themselves tail events in the market (the top 7%), there are tail events in their business. Apple has been wildly successful over the last decade, largely as a result of a tail event called the iPhone. But Apple has had many failures. Who remembers the Newton? The Lisa? Amazon is another successful company that has suffered more failures than we can ever know. Remember the disastrous Fire phone? CEO, Jeff Bezos, was quoted shortly after launch saying,” If you think that is a big failure, we’re working on much bigger failures right now. I am not kidding. Some of them are going to make the Fire phone seem like a tiny blip.” Sounds like a man who understands tail events.
Many of the greatest investors of our generation are well aware of the phenomenon of the tail. Peter Lynch, the legendary Fidelity manager, remarked that if you are terrific in the investing business you are right six times out of 10. At the 2013 Berkshire Hathaway annual meeting, Warren Buffett observed that he had invested in 400 or 500 stocks in his career. He made all his money on about 10 of them.
What’s the moral of the story? Failures, losses or setbacks can make us feel like we are doing something wrong. In fact, they are normal. Don’t be discouraged. Even people like Jeff Bezos and Steve Jobs made plenty of bad decisions. Second, accept that you don’t know when or where these tail events will occur. We’ve often said, “it’s time in the market, not timing the market.” If you are not invested, even when the outlook seems dire (think March 2020), you might miss out on the defining moment of an investing career.
Housel concludes the section on tail events with the following observation: “There are 100 billion planets in our galaxy, and only one, as far as we know, with intelligent life. The fact that you are reading this book is the result of the longest tail you can imagine.”
(1) This quote and other references in this blog all come from Chapter 6, “Tails, you win”, by Morgan Housel, The Psychology of Money, Harriman House, 2020.
(2) Quoted by Housel. “The Agony and the Ecstacy: The Risks and Rewards of a Concentrated Stock Position,” Eye on the Market, J.P. Morgan (2014).