Mental Model:

Multiplying By Zero

by Alex Mason | Nov 25, 2020 | Episodes, Mental Model | 0 comments

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Mental Details

Basic Definition

  • If you multiply effort in any area by zero, then the effort is completely wasted.

Explanation of the Concept

  • We know that five times zero is zero. We know that 584,235 times zero is also still zero. We’re taught this in school as simply “a rule” that we have to remember, and we go through life accepting this as a simple truth.
  • What is really meant by this though in the practical sense? Consider the example of you wanting to make something for dinner tonight. Let’s say you want to create a grand meal this evening and learn how to cook some new recipes. You buy books on grilling, baking, frying, and broiling your favorite foods.
  • You might then spend hours studying the books with great interest, highlighting key ingredients, taking notes, and re-reading the most important parts to solidify your knowledge.
  • Maybe you arrange the items you need in your cupboard and take a careful count of all of the material you’ll need, including cookware.
  • Then, just before you are about to get started on the crafting the first course, your significant other comes home with a bag full of take out food, which you then sit around and eat.
  • It doesn’t matter how hard you studied, how creative you were in your mind, how careful you were to prepare – because you ended up eating something pre-made and it was delivered to you, what was the point? All of your effort didn’t matter in the sense that your desired outcome (a home cooked meal) was rendered useless by the take out food that you were presented with.
  • For another example, let’s consider an ice sculptor carving a beautiful masterpiece out of a huge block of ice.
  • If they begin their work outside on a hot sunny day, it won’t matter how skilled they are or how high quality the block of ice is, it is going to melt and the sculpture will be ruined. The power of the hot sun completely nullifies what could have been accomplished.

The Mental Model in an Investing Context

  • Let’s now discuss how this applies to investing. First, we’ll look at it from the company’s side. To use an often quoted example, consider a horse and buggy manufacturer at the turn of the 20th century. It may have been a profitable business with lots of customers, but technological obsolescence and the rise of the automobile quickly took those profits away.
  • Unless the horse and buggy manufacturer quickly pivoted and got into the car business, very soon they had no business.
  • I want to make a note that this did not just affect the horse and buggy manufacturers. Think about the adjacent industries and people affected. The horse breeders had less work because less horses were needed for transportation. The raw materials used for manufacturing the buggies needed to be purchased less, so the suppliers of those things needed to find other customers. Combining the principle of multiplying by zero with second order thinking can lead to conclusions like these – where technological disruption impacts multiple layers of people and companies.
  • Now let’s look at things from the investor’s point of view. If you invest in a company that is growing fast and appears to have great prospects, but eventually goes bankrupt, then it doesn’t matter and you lose all your money.
  • Think about Enron, Worldcom, Pets.com, AIG, Washington Mutual – these were all high profile failures or large companies that once had a lot of promise.
  • Although most companies in our portfolios probably won’t go bankrupt (especially if you choose them based on the concepts we discuss in this show!) a few probably will over the course of your investing lifetime. Your job as an investor is to try to figure out what factors could be that “zero factor” that has the potential to wipe everything out, so that you can avoid it.
  • Rapidly changing technology is, I think, the clearest example of this. In this day and age, people love to flock to the famous technology stocks (Amazon, Apple, etc.) Many have made small fortunes by investing in just these companies.
  • Because these are high profile examples, it can be easy to get lured into thinking that many, if not all, of your investing dollars should be put in high growth technology firms.
  • Consider however, the research from Dr. Jeremy Siegel of Wharton. In his classic The Future For Investors, he showed that only 1/3rd of a sector’s performance can be explained by whether it grows or contracts. High growth doesn’t necessarily mean high investment performance.
  • Let’s also consider another angle. This “zero effect” can also be referred to as “wipeout risk”. There are many risks out there that can effectively make you “go back to zero” in your investing career if you’re not careful.
  • This doesn’t just apply to technological disruption. Consider a pharmaceutical firm that derives all of its revenue from a single pill that becomes a blockbuster hit as a remedy for some disease.
  • Based on patent law, typically companies can only hold a patent for twenty years. There are some legal ways to extend this a bit, but that’s typically the norm.
  • So after twenty years, what happens to the company? If there’s nothing in the pipeline, competitors will be ready to sell cheaply priced generics in order to gain market share. The firm’s competitive advantage can disappear overnight because of how patent laws work.

To wrap things up, be careful of wipeout risk in your investing process. It does no good to invest in an opportunity that many great characteristics yet contains one looming existential risk. Thinking about this can help improve how you and I approach other areas of life as well.

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