Episode #37 - Why look back when you can look forward?
The Math episode
Intro:
As we make our way through The Four Pillars of Investing, I hope you’re gaining new insights into the best way to presently prepare for your financial future. Chapter two tackles the traditionally hard to pin down conception of measuring the value of an investment. It contains some super history tidbits and I imagine this note would be more fully enjoyed if you bought the book here and read along. I don’t get a kick-back if you buy it.
I’m experimenting with different forms for these reviews/summaries/highlights and I appreciate any feedback, constructive or otherwise!
Content:
In what I would call one of the least shocking things of market history, there was a guy - super famous economist, advisor to presidents, the whole deal - who made a declaration in October 1929 that “Stock prices have reached what looks like a permanently high plateau.” His name was Irving Fisher, and weeks later the market shed 90% of its value in what kicked off the Great Depression.
Despite his “big miss” in '1929, you must learn Fisher’s most significant contribution to finance: the discounted dividend model (henceforth DDM, not DDR). The purpose of such a calculation is that it helps understand the value of an asset and its returns with far more accuracy than just a look to history. Why can’t we just use history? I think this saying attributed to Warren Buffet explains it: “if stock returns came from history books, then the wealthiest people would be librarians” (p. 72).
Before a full DDM explanation is shared (and really, you’d benefit by looking through the whole chapter to digest it), you must understand the three types of ways to spend money:
Purchase - buying something you want or need with no intention that it will appreciate in value and you’ll just use it.
Speculation - as Bernstein writes “The acquisition of a rare coin or fine painting for purely financial purposes is clearly a speculation: these assets produce no income, and your return is dependent on someone else paying yet a higher price for them later” (p. 44). This is also called the “greater fool” theory of investing, and I totally understand why it would be: the item does not create increased value on its own and to make money someone needs to buy it from you for more money.
Investment - this has a hard and fast definition: when something is an “income-producing” possession. Even if the company that you own stock in does not currently have earnings/dividends, the fact that it has a price in the market that is not zero means that people think it will have earning/dividends in the future. This category also includes real-estate and bonds.
I’ll slip in some editorial and audience participation: Based on the definitions above, do you think NFTs are investments or speculation?
Of course, money exchanges can sometimes be both an investment and a purchase (for example, a house), but it is important to be clear to yourself which one is the PRIMARY purpose of what you exchanged money for so you can best evaluate the success of the exchange.
Now for an explanation of DDM - written by Bernstein, translated for the page by me:
If you owned a gold mine with a first year yield of $2,000 and then each year after a yield minus $200 for ten years, how much would that be worth? Flip to page 45 for the chart, but simply put you’d think it totals $11,000 dollars. Of course, if investing was so simple, you wouldn’t be reading this to understand it, so I’ll continue to break it down.
Human beings are wired to believe that a dollar today is worth more than a dollar in a year from now, and further into the future, each dollar is valued less. With that in mind, Fisher discovered that we are required to “discount” the value of future income, even if you have an anticipated income number for how much you will net in 5 years from now. This reduction takes four things into account.
When will you get the benefit/how long is the deferral of income?
Inflation rate - with a HIGHER rate of inflation, the LESS value you will get when you receive the deferred income.
The value of present consumption according to society.
Risk. What are the chances that this income won’t happen? (In our mine example, what are the odds it goes belly-up or the gold disappears?)
Of course each case needs to come up with a formal number that represents these four items above you get a number for the percentage the value goes down every year - once you get that number you divide it by 100 and add it to one. For each year, you multiply the discount factor the number of years you are trying to discount. So if the discount rate is 8% you multiply the expected dividend in year 1 by 1.08. Then in year two you multiply it by the product of 1.08x1.08. This goes on all the way until the resources in the gold mine have depleted. Once you complete these equations you get the Discounted Income of the mine.
Ok, so this works pretty well for 10 years of a gold mine, but what about for all stocks?
I’m going to leave it to Bernstein’s full chapter for you to get the full dive. In short, though, you can see that there is a way to figure out value of something now that will only come into existence in the future.
Because of some limitations of DDM, we need to add in the Gordon Equation.
What the Gordon Equation brings to the table is that it gives us a way to calculate the market return:
Market Return = Dividend Yield + Dividend Growth
When applying this formula to the 20th century, the average dividend yield was about 4.5% and the compounded rate of dividend growth was also about 4.5%. When adding them together in the formula above, you get 9%. In reality, this was a 9.89% actual return. This is quite impressive.
The important thing to remember about all of these rules is that they typically function best over the LONG-TERM. You cannot get these numbers over a short time horizon (we’re talking 20 years at minimum).
Takeaway:
This is a super dense chapter, and I want to share that I’m totally still reviewing it to get all of the nuance. So, again, I recommend you doing some of the reading yourself. What we’re trying to understand here is how can we get as close as possible to evaluate the potential for consistent growth of assets that produce income over time. To bring into full relief, this isn’t covering doing this type of analysis on buying food or a car, nor is it purchasing art, rather trying to get the best evaluation.
My favorite quote from the chapter:
Human beings are quintessentially social creatures. In most of our endeavors, this serves us well. But in the investment arena, our social instincts are poison. (p. 66)
This makes us recall that the discount rate when global economics look great means you’re paying the price assuming that the future will be worse, but really the best time to invest in stocks are when things look bad this is when you get the lowest discount rate. The quote implies that often we get excited when everyone else does, usually that means you’re too late to the party.
Interact:
What sticks with you when thinking about the math behind evaluating income-producing assets? Any pieces that are still unclear to you? Drop a comment below or respond to the email and I’ll try to help clarify it for ya!
What did you think of this note?
Awesome - Good - Solid - Eh - Bad
Check out my tweets about #Winnings and more @StartupRabbi
Please remember, I’m not providing professional advice about personal finance. I’ve got a lot of friends who do that and you can totally hit me up for an intro if you’d like - I don’t get any commission - just the happiness that my readers are taking their financial health seriously.