Entropy, Dodo Birds, and Reducing Complexity in Your Financial Life

Friday, November 16, 2012 at 10am
By John Friedman

We learn today that Hostess — maker of Twinkies and Hostess Cupcakes — is going to cease to exist. It will be no more.

Michael Pollan cheers. So do I (though, given the nasty labor vs. capital fight that is going on here, I limit my cheer to the part of the story pointing towards the possible permanent disappearance of a major vein of food-like substances).

But the little-me of 45 years ago — the one who absolutely delighted in eating frozen Twinkies — is having a little-sad.

It’s not clear that Twinkies et al. will also cease to exist — the brands could end up with Kellogg or someone else. But it’s also not clear that, a month from now let alone a year from now, you’ll be able to buy yourself a Ding Dong or a Ho Ho, as these food-like and rather-yummy-in-their-own-evil-way substances might be going the way of the dodo bird.

*  *  *

We live in a world which is hard-wired for comings and goings. Death ends life. Physical objects entropy their way towards decomposition and then into utter non-physicalness.

And businesses come and go.

Our world is one of creative destruction — of Schumpeter’s gale and Harrison’s Pisces Fish.

We are, therefore, always a least a little bit on death watch — some of us more than others, but each of us some of the time, especially when it’s looking like our own time or that of someone we love.

 *  *  *

Ahhh . . . but this is a blog about financial health, right? So let’s bring things back to the financial plane of our lives — shall we? — and leave behind the plane of physical comings-and-goings, even though it has a whole heck of a lot to do with our financial health.

Two related threads come to mind . . .

First, businesses really do come and go all the time, and some of us — especially back in the halcyon, pre-bubble (choose your bubble) days — can lose track of this coming-and-going fact.

Look at your local business district. Does it look like it did in 2006? No, right? It probably doesn’t even look like it did in 2011.

Here in Noe Valley, Esseff, CA (Noe is pronounced with two syllables, with the accent on the first, as in NO’ wee), the changeover is fast and the goings are brutal (all, except, the closed Real Foods storefront owned by Nutraceutical, a Bain Capital company and vitamin store roll-up play, which has lain abandoned and vacant for nearly a decade following Nutraceutical’s shutting of the business for purported business reasons but which the NLRB long ago found to be for illegal union-busting reasons . . . ).

Taking things bigger, right now it looks like Groupon, Zynga and Blackberry (a/k/a the badly named RIM), to name a few, are on the ropes. And a lot of folks will not be convinced that Facebook is heading towards long-term survivability until it pulls a Google, i.e., until it shows that it can transform all that attention it sucks up each moment of each day — all the eyeballs looking at its site — into a very real torrent of Google-like cashflow, as in gargantuan numbers of dollars flowing in every day and growing like all ever-lovin’-get-out.

And then there’s Mr. Softee. Given that I have no idea of how I would go about buying a Surface tablet if I wanted one, and given the hastening retreat of brain-extending machines away from sedentary boxes and towards the cloud, I am also now wondering for the first time whether Microsoft will long-term survive.

So businesses really do die.

*  *  *

Second, since businesses really do die, so, too, do they do something short of that. They wax and they wane, they ebb and they flow, they zenith and they nadir.

Directly investing in a single business is not, therefore, a set-it-and-forget-it sort of route to financial health, nor is investing in a large number of businesses, unless (a) you’re willing to watch all of that go on over the long-run, and (b) you’re lucky/prescient/smart enough to invest in companies that are Built to Last and actually do last, and/or you’re lucky/prescient/smart enough to dis-invest in companies for which the jig is at least temporarily up, and then you’re able to follow that up with yet another instance of you being lucky/prescient/smart enough to pick a replacement investment, and then, in a wash/rinse/repeat sort of way, you’re lucky/prescient/smart enough to keep on doing all of that all the live long day. Or at least, say, 55% of the time.

Years and years ago I invested in a company that was widely touted as having that Built-to-Last quality, including a big touting from Jim Collins, the instigator of the Built-to-Last label. That company was Motorola and it was not, as it turned out, built to last; it has ceased to exist in its old form, and a big chunk of its new form has been unceremoniously swallowed up by Google, which was buying it mostly for its patents — non-physical objects which, by definition, do not last.

*  *  *

All of this coming-and-going suggests the following approach to investing in companies:

  1. If you invest directly in companies (rather than investing in mutual funds which then turn around and invest your money directly in many, many companies), you need to attend to those investments on a fairly regular basis: you either have to do it yourself, or you have to hire a money manager to do it on your behalf. After all, one of those companies into which you’ve invested your hard-earned dollars might be swooning or even nadiring (and, gee, if it is, do you sell it because it’s a loser or do you buy more because it’s now on sale? Hmmm . . . ).

  2. If you invest in mutual funds, then you need to attend to the mutual funds on a regular basis, but you don’t need to attend — not much, anyway — to each of the investments in companies that the mutual fund owns on your behalf. Instead, you need to attend to things like how the mutual fund is performing, who is making the investing decisions within the mutual fund, whether the mutual fund is doing what it said it would do, etc.

Importantly, the “regular basis” on which you should attend to mutual funds you own is considerably less frequent than is the similar “regular basis” for stocks you own.

When you add all that up, one thing becomes exceedingly clear: being smartly attentive to stocks you own is a lot harder than being smartly attentive to mutual funds you own.

And this is especially true when the mutual funds you own are seeking to match a given chunk of the overall market, i.e., index-based mutual funds aka index funds. The amount of attention they require is close to nil.

*  *  *

I have yet to work with a client who wants to have a high-maintenance financial life. I’m sure such people exist, but as best I can tell they are as rare as, not the Dodo bird (which is 100% rare because the last dodo died in 1693 or so), but as hen’s teeth (which, because hens still walk the earth, still has a chance, though slight, of happening).

Instead, my experience is that, since pretty much everyone finds it difficult to regularly maintain their basic financial life — there’s that human nature thang at work again — it’s really not a good idea to add complexity to it.

And that’s why I recommend that most people — particularly people who are managing their investments on their own — *not* invest in single stocks, and that they instead invest in mutual funds. And that’s also why, if those same people allow me to do some ‘splainin’, I also recommend that a lot and, for some, most or even all, of their investing should be via index funds.

*  *  *

When you think about it, this, too, is about entropy. If you just let things happen in a stock-based portfolio, the portfolio will drift in various directions and, ultimately, will become something quite different from what it was; creative destruction will make something of your portfolio, though ahead of time we know not what.

But if you just let things happen in an index-fund based portfolio, the portfolio will in all likelihood continue to track whatever indexes you selected and very well might end up looking a lot like what it looked like when you first designed it.

In a way, then, index-based mutual fund investing is a good antidote to entropy — a good hedge against the unhappy situation in which you’re looking at a portfolio somewhere down the line and not recognizing it as one of your own, at which point you may ask yourself, how did I get here?

And, in that way, index-based mutual fund investing is a great method for reducing complexity in your life and, for many, an integral part of building a low-maintenance, long-run financial life. Yay.

And how will it perform, you might ask?

That is a question for a different day.

About 1500 words (about a fifteen-minute read sans linked-to content)

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