The Psychology of Money Chapter 6: Tails, You Win

The Disney franchise, founded by Walt Disney and now worth hundreds of billions, was not always a financial success. Walt started his work in the early 1920s, and by the mid 1930s his first studio had gone bankrupt. By that time, he had made over 400 shows, which were very expensive to create and financed by debt at a high interest rate. On the whole people seemed to like them, but they were not bringing in enough money to make up for their high cost. Then, in 1937, Disney created Snow White and the Seven Dwarfs. In today’s dollars, it cost $22,500,000 to produce. Within the first 6 months, it had earned $180,000,000 – over 5x what it cost. This was the turning point financially for Disney. They paid off all their other debt and bought a state-of-the-art studio in Burbank, where it remains today.

It would be a stretch to call the first 400 shows failures, but on average financially, Disney’s productions were a failure. Then, one outlier changed their course and the rest is history. Collectively these outliers – occurrences that are far from the middle or average, are referred to as “tails” in statistics. Below is a bell curve, and the ends that taper off on either side are called “tails”, resembling the tail of an animal that slowly tapers off. Not all data points fall in line with the bell curve, but it’s an example of how data often presents itself. Nearly 70% of occurrences are in the middle (dark blue), 95% are within the lighter blue, etc. The more unique an occurrence either high or low, the further it is from the average and more it finds itself in the tail of the distributions.

Housel tells this and other stories to illustrate that “long tails—the farthest ends of a distribution of outcomes—have tremendous influence in finance, where a small number of events can account for the majority of outcomes.”

Snow White was a tail event for Walt Disney. To give an example in the financial markets, there is a stock-tracker (index) called the Russell 3000, that tracks the performance of the top 3,000 publicly traded companies in the U.S. Since 1980, nearly all the index returns have come from just 7% of the companies. Despite that, the index has multiplied 73x since 1980 — that’s an annual compound return rate of over 11%, largely produced from less than one-tenth of the companies. Most holdings were failures, but there were enough at the tail of the distribution that as a whole the index has been a major success. Similarly, Warren Buffett who we looked at in chapter 4, once said that although “he’s owned 400 to 500 stocks during his life [he] made most of his money on 10 of them.” 2% of the input accounting for the majority of the output. 

As we said in the introduction, this book is about helping us know how to behave as investors. So how does Snow White and other tail events help us behave? If Walt Disney and Warren Buffett couldn’t figure out in advance which 1% of their work were going to be the winners driving the majority of their results, we shouldn’t even try. Housel says, “The idea that a few things account for most results is not just true for companies in your investment portfolio. It’s also an important part of your own behavior as an investor.” If nobody knows which investments will fail, which will be average, and which will be a massive success, we should own a lot of them (otherwise known as diversifying, or diversification). Our clients' portfolios own stocks in large companies, mid-sized companies, small companies, companies in the U.S. and companies abroad, companies in developed countries and companies in emerging economies. (Sorry, this doesn’t mean putting 10% of your portfolio in your neighbor’s garage start-up. We’re talking about publicly traded companies.) And, beyond this, we should be okay when most of our investments are average, mediocre, just okay. By definition most will be average. Remember, we are trying to be “financially unbreakable”. If we increased our risk trying to get more positive tail events, we would also get more negative tail events. Snow White turned the corner for Disney, but it could just as well have put him out of business for good.

When I was little, my grandpa would flip a coin and say, “heads I win, tails you lose.” It took me a while to catch on, and here with investing, we should catch on to the fact that even if the majority of our individual holdings land on tails (a losing position in their own right), if we have a portfolio that can keep us investing for the long-run, we can still come out winners.

Until next time, happy reading!