Stock Stories | Case Studies and Mental Models for Individual Investors

Mental Model: Multiplying by Zero - Sometimes, One Thing Negates Everything

November 11, 2020 Alex Mason Episode 146
Stock Stories | Case Studies and Mental Models for Individual Investors
Mental Model: Multiplying by Zero - Sometimes, One Thing Negates Everything
Basic Definition
Explanation of the Concept
The Mental Model In An Investing Context
Stock Stories | Case Studies and Mental Models for Individual Investors
Mental Model: Multiplying by Zero - Sometimes, One Thing Negates Everything
Nov 11, 2020 Episode 146
Alex Mason

Multiplying anything by zero equals zero.  It's a numerical truth that we learn when we're young and in school.  Sadly, I think this concept gets applied to little more than math and people's homework when they're in formal education programs.  How can we apply this concept beyond the numerical and theoretical?

Today's episode explores what happens when we take the concept of multiplying by zero and apply it to life and investing.  We'll talk about:

  • The basic definition of Multiplying By Zero
  • An further explanation of the concept
  • Putting the mental model in the context of the investor

Come say hi with a direct message on Instagram: @stockstoryteller, or send me a note at [email protected]

Show Notes Transcript Chapter Markers

Multiplying anything by zero equals zero.  It's a numerical truth that we learn when we're young and in school.  Sadly, I think this concept gets applied to little more than math and people's homework when they're in formal education programs.  How can we apply this concept beyond the numerical and theoretical?

Today's episode explores what happens when we take the concept of multiplying by zero and apply it to life and investing.  We'll talk about:

  • The basic definition of Multiplying By Zero
  • An further explanation of the concept
  • Putting the mental model in the context of the investor

Come say hi with a direct message on Instagram: @stockstoryteller, or send me a note at [email protected]

Alex Mason: Hi, I'm Alex Mason, host of stock stories. This is the podcast where we decode investing principles by analyzing the business behind the stock, as well as learning about mental models in order to help you become a better investor. You ready? Let's go.

[00:00:42] Yeah. All right. All right. All right. All right. Welcome. Welcome to the show. Again, my name is Alex Mason. Thank you so much for joining me. This is the stock stories podcast and yeah, we study case studies and mental models here on the show to help you become a better investor. So, thanks again for joining me today is another week, another episode.

[00:01:08] And we've been going through a lot of different companies lately, but today I want to talk to you about a mental model if you're new to the show, usually about once a month or so, we will cover a mental model on the show. Now, what is that? If you never heard of that concept before? Well, mental models are basically thought experiments.

[00:01:26] They're ways that we can piece ideas together. So. We kind of marry these concepts with the actual case studies that we cover on most weeks of the show. To kind of combine this philosophical and practical side of investing. So that's what we're going to be doing here today. We're going to be talking about a mental model called multiplying by zero.

[00:01:48] So first we'll talk about the basic definition of what that mental model is. Then I'll go into a further explanation of the concepts. And then lastly, we'll kind of put it in context. Of investing. What does it actually mean when you apply the mental model as an investor? So that's going to be what we're talking about today.

[00:02:09] Now we're about to get into the content. Now, if you enjoy this show, the best way to show some love is to share this podcast with a friend who you think would benefit from it. So if you enjoy episodes like this and want to hear more of them sharing, it is the best way to help me make that happen. Also, you can head over to Apple podcasts and rate and review the show if you're pressed for time and you only have 30 seconds rating, it would be great.

[00:02:32] If you have two minutes, just leave that review. And that would be amazing. Thank you so much in advance. All right. On with the show.

[00:02:54] All right. So let's talk about the mental model of multiplying by zero. So first we'll start with the basic definition of this mental model. Essentially, it goes like this. If you multiply effort in any area of life by zero, then the effort is completely wasted. Pretty simple concept, right? If you multiply any effort by zero, then the effort is completely wasted.

[00:03:21] Let's talk about this a little bit more. So we know that for example, five times zero is zero. We also know that 584,235 times zero is still zero. We're taught this in school as simply a rule that we have to remember, and we go through life pretty much accepting this as a simple truth, but what do we really mean by this though?

[00:03:48] In a practical sense? So let's consider an example. For example, let's say you want to make something for dinner tonight. Let's say you want to create this grand meal this evening and you learn how to cook some new recipes. You buy books on grilling, baking, frying, and broiling. Your favorite dish or dishes, and then you might spend hours of the day studying the books with great interests.

[00:04:13] You might highlight some key ingredients, take notes, maybe even reread some of the most important parts to solidify your knowledge. Just really prepare for this and maybe even go a step further. And arrange the items that you need in your cupboard, and you take a careful count of all of the material that you'll need, including your cookware, your plating, your presentation, your, your actual food ingredients, all of those things.

[00:04:40] And then just before, you're about to get started on crafting the first course, your significant other comes home with a bag full of takeout food, and then you sit around and eat that. So I say this to say, 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.

[00:05:05] Well what was the point? All of your effort didn't matter, really, in the sense that your desired outcome of a home cooked meal, it was rendered useless because the takeout food. Was brought by your significant other. So it doesn't really matter how much effort you put into something. If it's just totally negated by something else.

[00:05:26] Right now, 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, then it doesn't matter how skilled they are or how high quality the block of ice is. It's going to melt and the sculpture will be ruined.

[00:05:45] The power of the hot sun is going to completely nullify what could have been accomplished by the artists. So just another example there of just trying to work against something that is just completely going against you. Is just a bad, bad move and it can nullify all this hard work and time that you put into something.

[00:06:07] So that's the basic idea of multiplying by zero. It doesn't just apply in a numerical sense when you're solving an equation, let's say, but it applies in real life when you're trying to do something or observe something and you see that there are forces that are completely wiping out every other characteristic or variable that's at play.

[00:06:29] All right now that we've got the basic concept down. Let's now talk about how that mental model applies in an investing context for you and I as individual investors. So first let's look at it from the company side. So to use an often quoted example, consider a horse and buggy manufacturer at the turn of the 20th century.

[00:06:50] Now 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. Right? I mean, if you were a horse and buggy manufacturer and you had this big business and you made the best ones in town, you had all these customers and you knew just how to make the wheels and the axles and all kinds of things.

[00:07:15] And people loved your craftsmanship and your salesmanship. Well, it didn't really matter when Henry Ford came to town, right? Because he was pumping out model Ts and they didn't need a horse. They didn't need maintenance of an actual animal to run. So it was a pretty astounding invention and one that completely wiped out that whole market.

[00:07:38] So unless the horse and buggy manufacturer quickly pivoted and maybe got into the car business very soon, they had no business. I mean, maybe you could apply that knowledge of making the buggy into working for someone like a Henry Ford and improving automobiles. Maybe some of the horse and buggy manufacturers did that.

[00:07:59] But if you didn't quickly pivot, if you didn't quickly apply your skills to a different area, that technological obsolescence completely wiped you out. Now I want to make a note that this didn't just affect the horse and buggy manufacturers. Think about all the adjacent industries and other people that were affected.

[00:08:18] I mean, think about the horse breeders. They probably had less work because less horses were needed for transportation of the raw materials used for manufacturing. The buggies needed to be purchased less. So. Think about the suppliers of those things. They had to find other customers as well. I mean, there's all these different.

[00:08:38] Underlying effects of a major shift due to technology. So this multiplying by zero effect came across when it came to these industries and these companies now combining the principle of multiplying by zero with the mental model of second order thinking, that's where we can lead our brains to conclusions like this, right?

[00:09:01] Where technological disruption impacts multiple layers of people and of companies. Now let's look at things from the investor's point of view. So let's say you invest in a company that's growing fast and it appears to have great prospects. But eventually it goes bankrupt, then it doesn't matter. It doesn't matter.

[00:09:22] And you lose all your money. I mean, there are many high profile examples that I could give and of course, many more lower profile examples. So think about companies like Enron, WorldCom. AIG or Washington mutual. I mean, these are all high profile failures or large companies that once had a lot of promise.

[00:09:45] People were investing real money and lots of money into these companies yet they ended up going bankrupt. Now, although most companies in your mind portfolio probably won't go bankrupt, especially if you choose them based on the concepts, we discuss a lot in this show. A few probably will over the course of your investing lifetime.

[00:10:06] I mean, your job as an investor is to try to figure out what factors could be that zero factor, right. That has the potential to wipe everything out. So you can avoid this by thinking about what that zero factor is. Now rapid changing technology is I think kind of the clearest example of this in this day and age, people love to flock to a lot of tech stocks, a lot of glamour stocks.

[00:10:31] I mean the most famous ones right now that people just seem to want to talk about every day are Amazon, Apple, Tesla, et cetera. Now, many people have made some small fortunes by investing in just these companies. And that's awesome because these are high profile examples. I think it can be easy to get lured into thinking that a lot, if not all of your investing dollars should be put into.

[00:10:56] Some high growth technology firms, but I would consider this. I studied some time ago is actually early this year I was studying this book called the future for investors by Dr. Jeremy Siegel, who comes from the Wharton school of business at U Penn. And in this classic book, he showed that only one third of a sector's performance.

[00:11:19] Can be explained by whether it's a growing or a contracting industry. So that means that if an industry is contracting, that doesn't necessarily mean you're going to have bad performance. And if an industry is expanding, that doesn't necessarily mean you're going to have good performance. So high growth doesn't necessarily mean high investment performance.

[00:11:39] Right? So that's something to think about, especially when it comes to tech stocks, right. And I kind of use that example because it's just so prevalent today for people to talk about the Fang stocks, like, you know, Facebook alphabet, Amazon, Netflix, Google, I guess Google is alphabet, but you get the idea, the big stocks that are often talked about today.

[00:12:03]Now it's very possible that those firms could. Be much bigger and stronger in the future, but there's also a unique set of risks. Wipe out risks that could effectively multiply these companies by zero, if they were somehow disrupted in a big way. So go ahead and do yourself a favor and check out what the biggest, most powerful companies were.

[00:12:28] Two decades ago. And a lot of them were indeed technology companies, but they were different technology companies than the technology companies that are on top today. So there's this constant shifting and shuffling of affirms and not all firms go bankrupt. Of course, maybe they don't get multiplied by zero, but maybe they get multiplied by 0.05 or something like that.

[00:12:50]Many of the firms that were powerful in the past are still in existence, but their glory days are basically over. So just be careful when you, when you see people clamoring over a glamorous stock, just because it's gone up in price a lot over the past 12 or 36 months And just be wary of that risk.

[00:13:12] Now, as far as risk, let's talk about that from another angle too. This doesn't just apply to technological disruption, consider a pharmaceutical company that derives all of its revenue from a single pill that becomes a blockbuster hit as a remedy for some disease. Now based on patent law. Now, typically companies can hold a patent for something like 20 years, and there are some legal ways to extend this a little bit even, but that's typically the norm 20 years.

[00:13:41] So after 20 years, what happens to the company? Well, if there's nothing in the pipeline, as a promising drug competitors will be ready and waiting to sell cheaply priced generics in order to gain market share and steal that market share from that company. So the firm's competitive advantage can disappear overnight.

[00:14:00] Because of how patent laws work. So that's another example of multiplying by zero. If you have this regulatory or legislative type of risk, that's lurking beneath the surface. If you don't understand that, then you could be toast and not even know it. So think about both of these things, not just technological risk and not just legislative or regulatory risk, but really risk in general.

[00:14:23] Like if there's some kind of massive events, like for example, a global pandemic, I mean the global pandemic Corona virus is shutting businesses down overnight and has been for months. And it's crippled many others and it's a terrible thing, but it's important. I think to recognize that during this time we're observing the fact that these kind of long tail probability scenarios, these very rare possibility scenarios can have an enormous impact.

[00:14:53] And that's actually one of the things that I think about sometimes is kind of like. Imagine a two by two matrix where on one side you have the probability of an occurrence. And on the other side, you have the severity of an occurrence. So imagine that this, this square is divided into four quadrants. And so.

[00:15:15] On on one corner, you have events that are low probability, but low impact, right? Those are things that could very well happen every day or any given day. But if they happen in your business or your investing, then it probably won't be that bad. Something like maybe The holiday season, wasn't that good for retail?

[00:15:35] Like, okay. Maybe they had a bad quarter, but they'll, you know, they'll come back next, next Christmas season or whatever it is, then you have events that have a high probability of occurring, but have a low severity. So. Something like, I'm trying to think of an example right now. Something like just walking down the street and like tripping on the sidewalk.

[00:15:59] Like maybe if you're a clumsy person, you have a high probability of that happening to you, but you're going to be okay. You're just tripping. Maybe your friends laugh at you, but you just move on with your day. So that's an example of that then think about things that are high. Probability of happening and a high severity.

[00:16:17] So those are the major, major risks that everybody knows about. For example, in the episode, the other day, we talked about Simon property group. We talked about Macerich. We talked about what we've been talking about. A lot of REITS lately, but specifically with the mall REITs, there's this huge existential risk that people will just not go to malls anymore and just sit in their homes and order stuff on Amazon, on their phones all day.

[00:16:40] And that's going to be it. I mean, I don't, I laid out in those episodes how I don't think that's going to happen, or at least not as dramatically as maybe some people paint it, but that's a real risk there and everybody knows it. So. That falls into that category. And then the fourth category is really the insidious one.

[00:16:58] And this is the one that I think links the best to this mental model of multiplying by zero. It's the events that have a low probability of actually occurring. So you don't often think about them as actually happening, but the potential severity, if they do happen is catastrophic. This is what Nassim Taleb calls, a black Swan event.

[00:17:20] So something that is. Not really, it doesn't have a high chance of actually happening, but if it does happen, man, the consequences are going to be bad. So think about something like an asteroid flying and colliding directly with earth and just wiping us all out, like scientifically and statistically that actually could happen.

[00:17:38] Like that's a very. Real possibility if it does happen, then, I mean, we better be on Mars or something. I don't know. But, but the chances of that happening in any given moment are really small. So it's not something that people tend to think about that much. At least I don't think they do. So those are the kinds of things as investors we need to be thinking about too how are we going to get multiplied?

[00:18:01] By zero in situations where we may not be considering the risk, because it seems like a small risk or a hidden risk or something. We kind of have to dig a little bit deeper into. But it doesn't come to top of mind right away. So those are the kinds of things that we need to be wary of as investors. So be careful of wipe out risks, whether it's technological risk, that's probably one of the easiest to spot, right?

[00:18:26] Because technology is just quickly changing all the time. And everyone kind of accepts this as a fact, but there are also other risks, like political risks, legislative risks, geographic risk on and on and on. And. In many ways as an investor, that's really our job. Our job is to identify and guard against risks, because if you're just buying stocks of a company, you know, because, you know, say you buy Netflix just because you like to watch Netflix every day.

[00:18:54] Like. That may be a great decision. I don't know, but it's an absolutely terrible way to make the decision because you're just basing it off of your use of the products. And actually I'll talk about that a little bit more in a future episode, but what I'm getting at is the process by which we make decisions as investors has to fundamentally, always come back to risk.

[00:19:18] And this mental model of multiplying by zero in many ways, uncovers those risks, particularly the existential ones, the ones that could wipe everything out. So think about that concept. I hope that this has helped you today. And I always love doing these mental model episodes. I hope you enjoy them as much as I do.

[00:19:37] And of course I love getting right into the nitty gritty of the companies as well. Which we will continue to do on the show. So thank you for listening to this episode of stock stories. Again, my name is Alex Mason, and I appreciate you listening. If you enjoyed the show again, if you are. If you want to help me in any way, sharing the show would be awesome.

[00:19:57] I really appreciate you for doing that. Thank you in advance. And if you're not already subscribed to the show and you're just happening across this episode, go ahead and click that subscribe button that lets the providers know that you value this content and you'll be getting it every week and I'll be showing up here for you every week.

[00:20:13] So I appreciate that and have a great one.

[00:20:39] Outro Music: The 

[00:20:39] Alex Mason: information presented on stock stories is for informational, educational and entertainment purposes only you and you alone are responsible for your investment and financial decisions please consult an appropriate tax legal or financial advisor that can analyze your specific situation in the context of your goals and circumstances.

Basic Definition
Explanation of the Concept
The Mental Model In An Investing Context