Mental models are sexy (for some people) but it can be challenging to apply them in our lives. It happens to me too and the clarity only come after some time – usually through certain situations whereby the mental models just clicked. My recent revelation was about Lindy Effect and stock picking.
Warren Buffett is the most revered investor ever. I am sure his name will live on even after his death, by Lindy Effect. And it is true for his teacher, Benjamin Graham plus his value investing methodology. His ideas have survived for almost a hundred years.
But that’s not the revelation I am talking about. Buffett and Munger have always stressed about long-term investing and lamented why most investors think and act too short term. What most people learn from these two investing greats are concepts revolving around economic moat, excellent capital allocators, circle of competence etc. These are good lessons but not the most crucial. Most importantly is to think Lindy which I think most Buffett followers missed totally.
First, let’s bring the concept of evolution into the picture. Imagine you are supposed to invest in a portfolio of species during the jurassic age. How would you pick your investments? Certain species may do well seasonally, expanding its produce, while others may go into decline and eventually go extinct. If you pick a Tyrannosaurus Rex then, you might see the value go to zero. If you have picked a cockroach, you will be a super winner today. Hence, investors can either buy and sell regularly to keep the portfolio alive, or to carefully select species that are likely to go extinct for a long time to come. The latter is what Buffett and Munger alluded to. Wait but why? Because compounding effect will give you the highest return you cannot even fathom – the compound interest calculator couldn’t give me an answer for compounding $1 at 1% per year for 300,000,000 years.
Fast forward to today. If you have a choice to invest in a specie, do you choose marbled crayfish (first appeared in the 90s) or the cockroach (lived more than 300m years ago)? Which do you think have a higher chance of surviving for decades to come? Lindy would say choose the cockroach.
This is why Buffett doesn’t really invest in technology stocks or the latest fads. He doesn’t know if they could last so long into the future.
McKinsey found that the average life-span of companies listed in S&P 500 was 61 years in 1958 and the lifespan has declined to less than 18 years currently. Many investors take it as the speed of disruption is here and it is ever more important to be nimble and switch stocks quickly. Long term investing is dead.
But if we invert it (another mental model), it just means that it is even more important to pick Lindy stocks, those that can really survive in a disruptive environment. Because more stocks are going extinct sooner than you think if you aren’t careful about it. Fads die faster too. This is true in nature as 99% of the known species have already gone extinct.
A rising rate of extinction is due to intense competition. Even picking Lindy stocks are much tougher now than when Buffett was younger. The amount of cash in Berkshire Hathaway is a testament to it.
The second evidence is that Buffett has left the instruction to invest majority of his money into S&P 500 ETF after his death. This is a Lindy bet too. The companies in the S&P 500 will change as some won’t survive. But the entire index will be there. He isn’t confident about his descendants having the ability to pick Lindy stocks so he suggested a Lindy fund.
Thus, the true lesson that Buffett is teaching us in investing is to think Lindy when we pick our stocks.