Nothing Too Good or Too Bad Stays That Way For Long

Morgan Housel (0:06)

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Investing involves risks, including possible loss of principle. All right, welcome back.

What I want to talk about today, before I get into your questions, is a really important idea in finance, whether it's in business or for personal finances, which is the idea of being able to recognize when things are abnormally good and assuming that they will not last and taking actions that reflect the idea that they will not last. And I want to use a little idea from nature that usually does a better job than humans in these kind of social conditions of allocating resources. This little handsome fella that I'm showing right here is called a pika. This little mouse-like thing that lives up in the mountains. Cute little guy, right? And pikas have a very unique trait, which is unlike a lot of their fellow mammals that live up in the mountains, they do not hibernate. They're alive all winter in the freezing cold winter, and so they need food all winter, even when the winter is not growing the food that they eat. Grasses and grains and seeds and things like that. And so what does it do during the summer when there's food everywhere?

It collects it and it saves it. And as you can see here, it creates these giant piles of food that will last it all winter. Now, of course, if during the summer months it ate everything that it could find, it would be stuffed and full and have a grand old party during the summer and it would starve by December. And so it doesn't do that. It doesn't assume the good times last forever. It stocks a lot of it aside and it saves it. Now, that is so simple. The idea of saving for a rainy day, but it's astounding how often you don't see that behavior among humans that are much better at telling themselves a story that the good times will last forever. I saw the study a couple years ago. I just pulled it up when I was researching for this podcast. It was a study of small and medium-sized businesses, private businesses, not public companies, from the 1970s through the early 2010s. So a good 40-year period when it studied over 3,000 businesses that failed, that went bankrupt, and it looked through their tax returns. So it had a really good idea of how much profit and loss those businesses had every year. And what it showed is that the majority of businesses that failed, it wasn't necessarily that they weren't profitable enough. It was that during the profitable years that most of them had, they extracted all the profits out of the company. And then during the bad years, they had nothing left. And so, for example, just making this up, but this is the idea that it was presenting, you had a business that would earn $100,000 in profit during one year. And it took that profit and extracted it, and the owners went and had their nice life. And then the next year, they lost $30,000.

And because they lost it after they extracted all the money, there was nothing left and the business was bankrupt. It was not that the business was not profitable enough over time. It was. It was that they pretended, this is not a character flaw. I think this is a very common thing to do, but they assumed those good times, those good years would last forever, and they were completely unprepared for the bad years. The question that you want to ask is not how long these good times will last. The question you want to ask is, am I taking actions that require these good times to last forever? And that's not just mom and pop businesses. Some of the biggest companies run by what you would assume would be some of the smartest and most educated business managers in the world do this as well. I'll give you a very extreme example of this. Citigroup, the huge bank, which was, I think, one of the largest companies in the world about 15 or so years ago before the financial crisis. In the 10 years before the financial crisis, Citigroup repurchased $63 billion of its stock. Now, when you repurchase stock, that's basically giving the money back to shareholders, giving the money to the owners of the company. The company is saying, we earned a ton of profit that we don't need in the business. Hey, shareholders, this is for you now. They're giving it back to the shareholders. And then when the financial crisis came, they needed a $45 billion bailout from the government. That's what kept them alive during the financial crisis. And so you think about that.