The Tail that Wags the Dog

Q1 | January 2021

Topic: Investments

John C.A. Stevenson CFA

January 25, 2021

Image used with permission: iStock/Wavetop


Print & Share

Print

The Tail that Wags the Dog

Q1 | January 2021

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 fact, reading this book inspired us to recruit Morgan for a virtual event in February, hosted by Nexus’s Tom Wilson.

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.”

If you are interested in watching a replay of Talking Risk: A Virtual Event Featuring Morgan Housel, please contact your Nexus relationship manager.

(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).

More Like This...

See another CRM2 blog post that may be of interest to you.

CRM2: The Nexus Approach to our CRM2 Reports

Topic:
CRM2
Excerpt:
With changing securities regulations coming into effect, investment firms are now required to provide individual investors with specific additional in

More Like This...

See another Foundations & Endowments blog post that may be of interest to you.

Charitable Giving Made Easier

Topic:
Foundations & Endowments
Excerpt:
Giving to charities and supporting our community are important to us at Nexus. We donate a portion of our management fees back to the charities and

More Like This...

See another Human Interest blog post that may be of interest to you.

The Case for Openness – An Open and Shut Case?

Topic:
Human Interest
Excerpt:
From time immemorial, mankind has been open. Open to new ideas, open to trade, and open to migration – the three critical ingredients for progress.

More Like This...

See another Inside Nexus blog post that may be of interest to you.

Embracing the Golden Years: A Journey of Reflection and Wisdom

Topic:
Human Interest, Inside Nexus
Excerpt:
It was an otherwise slow mid-afternoon trading session on the “old” floor of the Toronto Stock Exchange at 234 Bay St. The dog days of summer had

More Like This...

See another Investments blog post that may be of interest to you.

From Vineyards to Portfolios: Cultivating Long-Term Wealth

Topic:
Investments
Excerpt:
My wife and I have been stymied so far this summer in getting to the Niagara region for our annual weekend of cycling through the vineyards and

More Like This...

See another Pearls of Wisdom blog post that may be of interest to you.

“Work, Work, Work, Work, Work, Work”

Topic:
Pearls of Wisdom
Excerpt:
This has been a busy year. I’ve had lots happening on the home front (a wedding!) and lots going on at the office (too long to list!) Managing work

More Like This...

See another Tax Planning blog post that may be of interest to you.

Saving in my Professional Corporation – It’s a Great Idea!

Topic:
Tax Planning
Excerpt:
The ability for professionals in Canada to incorporate their practice has existed for some time. Doctors, dentists, lawyers, accountants, and other

More Like This...

See another Wealth Planning blog post that may be of interest to you.

Dentists Get Their Financial Check-Up: Nexus attends the 2022 Ontario Dental Conference

Topic:
Wealth Planning
Excerpt:
In early May, we had the opportunity to attend the Ontario Dental Association’s (ODA) Annual Spring Meeting (ASM) in Toronto. Now in its 157th year,

On a Side Note…

See another CRM2 Nexus Notes Quarterly article that may be of interest to you.

No posts found.

On a Side Note…

See another Foundations & Endowments Nexus Notes Quarterly article that may be of interest to you.

Charitable Giving Made Easier

Topic:
Foundations & Endowments
Excerpt:
Giving to charities and supporting our community are important to us at Nexus. We donate a portion of our management fees back to the charities and

On a Side Note…

See another Human Interest Nexus Notes Quarterly article that may be of interest to you.

Worth 1,000 Words

Topic:
Human Interest
Excerpt:
A little humour makes the world a better place.

On a Side Note…

See another Inside Nexus Nexus Notes Quarterly article that may be of interest to you.

Where Have All the Boutiques Gone?

Topic:
Inside Nexus
Excerpt:
Many small, once independently managed, firms have fallen into the clutches of larger organizations such as banks, institutional money managers and

On a Side Note…

See another Investments Nexus Notes Quarterly article that may be of interest to you.

Don’t Worry, Be Happy

Topic:
Investments
Excerpt:
A recent article by David Brooks in The Atlantic magazine argues that, despite the heavy shroud of pessimism that envelopes most of our current

On a Side Note…

See another Pearls of Wisdom Nexus Notes Quarterly article that may be of interest to you.

Pearls of Wisdom

Topic:
Pearls of Wisdom
Excerpt:
Reading is one of the principal occupations in our profession. As we digest a wide range of material, interesting ideas and surprising facts – some

On a Side Note…

See another Tax Planning Nexus Notes Quarterly article that may be of interest to you.

A Nexus Feature on: First Home Savings Accounts (FHSA)

Topic:
Tax Planning
Excerpt:
The FHSA is a registered plan to help Canadians save for their first home and could play a role in either your or your adult child’s overall wealth

On a Side Note…

See another Wealth Planning Nexus Notes Quarterly article that may be of interest to you.

From The Editor: Planning for Long-Term Care

Topic:
Wealth Planning, Living to 100
Excerpt:
As part of our Living to 100 series, Nexus hosted a client event in June featuring guest speaker Karen Henderson, an expert in long-term care planning