Saturday Serendipity
Quote, Mental Model, Interesting find.
Hi!
Reading time: About 4 minutes
Quote
“Nothing is more dangerous than an idea when it is the only one you have.”
―Emile Chartier Alain
Mental Model
Power Law
‘The average amount of money an MMA fighter in the UFC makes is $146,673.’ (wayofmartialarts.com)
Now if you look at this statistic you would say that UFC fighters are making decent amount of money. Well the reality is actually very sad. Connor Mcgregor earns about $40 million. Compare that to the average fighter. Now the biggest fighter is winning and getting the most money of the lot.
Most systems work like this. The money pooled in totally and the averages don’t tell the reality of the situation. Only a few winners comprise of most of the contribution.
This is how the power law looks like on a graph. The power law is a concept taken from algebra. I don’t want to go into it right now but what we will look at is how there are influences which comprise most of the contribution of a system.
Do you know the Pareto principle? The 80/20 rule? This law is basically an extension to that.
Nassim Taleb wrote this well,
“It [Pareto principle] is the common signature of a power law – actually it is how it all started, when Vilfredo Pareto made the observation that 80 percent of the land in Italy was owned by 20 percent of the people. Some use the rule to imply that 80 percent of the work is done by 20 percent of the people. Or that 80 percent worth of effort contributes to only to only 20 percent of results, and vice versa.
…The 80/20 rule is only metaphorical; it is not a rule, even less a rigid law. In the U.S. book business, the proportions are more like 97/20 (i.e., 97 percent of book sales are made by 20 percent of the authors)”
I think of it like this.
Let’s see the total amount of information that is collected in the field of investing. Most of the knowledge that I have been exposed to in value investing has come from Warren Buffett, Charlie Munger, Ben Graham, Phil Fisher and a few more. But the point is these investors comprise of probably 5% of the total investors that are out there that write books or content. But the knowledge is coming from only a select few (or at least the only ones that I am exposed to).
In Investing
When evaluating companies it is important to know that this law applies to industries and indexes as well. In India the Nifty 50 index comprises of 50 companies but there are few companies which have a very high weightage in the index. For example HDFC bank(post merger) and Reliance now comprise of close to 25% of the index.
In a similar way in industries as well, it works the same way. The biggest players of the industries take up most of the market share. This is a great thing to understand when evaluating industries.
When you make your portfolio as well some of your investments which go on to become multi baggers compensate for the other mediocre companies that you invest in. One great company offsets the other ones.
Same story in venture capital. Peter Theil wrote in zero to one,
“In venture capital, where investors try to profit from exponential growth in early-stage companies, a few companies attain exponentially greater value than all others. This is because venture returns don’t follow a normal distribution overall. Rather, they follow a power law: a small handful of companies radically outperform all others. If you focus on diversification instead of single-minded pursuit of the very few companies that can become overwhelmingly valuable, you’ll miss those rare companies in the first place.”
How to use this law to your advantage?
In my opinion simply, get into the positions where you can get the exponential growth to become the biggest contributor. Don’t get stagnated by being in a position where there are no growth opportunities.
Read Safal Niveshak’s blog on this .
Interesting find
Vantage Point: 8 Points of View For Evaluating a Stock
That’s it for this week!
Enjoy your weekend!