Save like a pessimist, Invest like an optimist

Jan 09, 2022

Have you ever been extremely optimistic about a situation, when pessimism stares you in the face? If that be the case, then you must get hold of the book I am currently reading - James Stockdale’s Courage Under Fire, which I plan to follow up with In Love and War.

Admiral James Stockdale was at the mercy of his brutal captors during his 8-year imprisonment in Vietnam. He was tortured, lived out the war without any prisoner’s rights, no set release date, and no certainty as to whether he would even survive to see his family again.

Jim Collins, in Good to Great, shares a discussion he had with him (I reproduced only relevant sentences).

Stockdale: I never lost faith in the end of the story. I never doubted not only that I would get out, but also that I would prevail in the end and turn the experience into the defining event of my life.

Jim: Who didn’t make it out?

Stockdale: The optimists. They were the ones who said, ‘We’re going to be out by Christmas.’ And Christmas would come, and Christmas would go. Then they’d say, ‘We’re going to be out by Easter.’ And Easter would come, and Easter would go. And then Thanksgiving, and then it would be Christmas again. And they died of a broken heart.

This is a very important lesson. You must never confuse faith that you will prevail in the end with the discipline to confront the most brutal facts of your current reality, whatever they might be.

(This powerful psychological duality of stoically accepting the brutal facts of reality, and yet maintaining an unwavering faith to prevail with a good outcome, came to be known as the Stockdale Paradox.)

How does this apply to investing?

I have to thank Morgan Housel for this, as he had drawn a parallel when talking about a realistic portfolio. Here are his thoughts, collated from his writings and book, The Psychology of Money.

  • The best financial plan has the ingredients of pessimism of and optimism.

Embrace that the short run is a continuous chain of setbacks and disappointments, problems and embarrassments, breakages, recessions, depressions, bear markets, pandemics, and errors. But none of those prevent the long run from being able to compound into something glorious.

It’s intuitive to think you should either be an optimist or a pessimist. It’s hard to realize there’s a time and a place for both, and that the two can – and should – coexist. But it’s what you see in almost every successful long-term endeavor.

The business that takes huge risks with new products, like an optimist, but is terrified of short-term debt and always wants a big chunk of safety-net cash, like a pessimist.

The worker who turns down a lucrative opportunity because it might come at the expense of their reputation, which over the long run is exponentially more valuable.

Check out the caution in Bill Gates’ answer, when Charlie Rose asked him if APPLE will survive: I think it is within their power to continue to be very successful. Like all technology companies, they don’t have a guaranteed future. Microsoft doesn’t. Intel doesn’t. We all have to use that customer feedback loop, our research, and try and stay on top of things.

This was in 1996, when Bill Gates was already a billionaire, and the richest man in America, and Microsoft was the world’s largest software company.

In another interview with Ellen DeGeneres: I would always have to be careful that we wouldn’t hire too many people. I was always worried because people who worked for me were older than me and had kids, and I always thought, ‘What if we don’t get paid, will I be able to meet the payroll?’ So I was always very conservative about the finances.

These are the reasons why Bill Gates insisted on Microsoft always having enough cash in the bank to keep the company alive for 12 months with no revenue coming in.

Optimism and pessimism can coexist. If you look hard enough, you’ll see them next to each other in virtually every successful company and successful career. They seem like opposites, but they work together to keep everything in balance.

  • You can only be an optimist in the long run if you’re pessimistic enough to survive the short run.

Optimism doesn’t mean that one is oblivious to risk. Pessimism is not to be confused with defeatism. The trick is being able to survive the short-run problems to enjoy the long-term growth.

An important lesson from history is that the long run is usually pretty good and the short run is usually pretty bad. It takes effort to reconcile those two, and learn how to manage them with what seem like conflicting skills. Those who can’t usually end up either bitter pessimists or bankrupt optimists.

All good investing comes down to surviving an inevitable chain of short-term setbacks and disappointments in order to enjoy long-term progress and compounding. Growth is driven by compounding which always takes time. Destruction is driven by single points of failure, which can happen in an instance.

More than I want big returns, I want to be financially unbreakable. And if I’m unbreakable I think I’ll get the biggest returns, because I’ll be able to stick around long enough for compounding to work wonders.

  • Save like a pessimist.

Acknowledge the cold statistics of how common bad news is. It’s common at the global, national, local, business, and personal level. A zillion different things can go wrong, so at least one of them is likely to be causing havoc in any given moment.

Save heavily, knowing with certainty that you’ll need a cushion to deal with the next banana peel. Be a little bit paranoid, knowing the assumptions you hold today could break tomorrow, and you’ll need enough room for error to make it to the next round.

  • Invest like an optimist.

Since progress is cumulative (we don’t forget past innovations) but setbacks are temporary (we rebuild), the long-term odds tilt towards growth. The long-term odds are in an economy’s favour. And that’s virtually always the case because the screw-ups – the declines, the recessions, and panics, the wars – fuel the problem solving.

Once the odds are in your favour, compounding takes hold. Once the odds are in your favour and you can keep them in your favour for a long time, you should be a full-blown, giddy optimistic.

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