Sunday Reads #111: How would you discount your life?
The eternal Explore vs. Exploit question.
Hope you and yours are keeping safe (and sane).
If you’re new here, don’t forget to check out the compilation of my best essays: The best of Jitha.me. I’m sure you’ll find something you like.
And here’s my newsletter from last week, in case you missed it: Sunday Reads #110: Probabilities, Vaccines, and Failed Fat Startup Experiments.
This week, we apply a Finance 101 concept to our life and careers. Most of us understand the concept of “time value of money”. But it teaches us about far more than just valuing financial investments.
Intrigued? Let’s dive in.
[PS. If you like what you see, do forward to your friends. They can sign up with the button below.]
How would you discount your life?
Most of us have learnt about "time value of money". Many would call it Finance 101. (In fact, it was Lesson #1 among the 10 things I learnt from Business School).
Well, it turns out you can apply the concept of "time value" to much more than financial investments.
But first, a quick primer.
I will not share a full intro to time value of money (Investopedia is a good resource). But suffice to say that it's a way of valuing future cash flows in terms of today's dollars.
How much is $10000 in one year worth to you today?
Keeping things simple, it's the amount of money you could put in a bank account today, that will return $10000 in one year.
If the bank pays 5% interest per year, then $9524 invested today will yield $10000 in one year.
That's what “time value of money” means - that $10000 one year from now, is worth $9524 today.
Any cash flow in the future will be worth less today. And the interest rate by which you discount it (5% in my example above) is the discount rate. This is, in a sense, the opportunity cost. What return you could have earned on the cash, if you got it today.
Now let's do something a little more complex.
Assume you're getting a series of cash flows every year, growing at 5%. The chart below shows the proportion of the total value in today's dollars, that you get every year.
How do you read this graph?
Look at the curve for 6% discount (orange line). By year 10 (see X-axis), you've only received ~10% (Y-axis) of the total value of the cash flows.
But with a 20% discount rate (light blue line), you receive 75% of the total value (Y-axis) by year 10 (X-axis).
Now look at the 10% discount line. By Year 20 (last value on X-axis), you've received ~63% of the total value of the cash flows. What does that mean? It means that 37% of the total value accrues from cash flows beyond 20 years!
Three insights from the graph:
Insight #1: A dollar tomorrow is worth less than a dollar today.
That's why the value doesn't go up and to the right in a straight line; it curves slightly downwards.
Insight #2: A majority of the value comes after Year 5.
Even with a 20% discount rate (which is exorbitantly high), 50% of the value comes after Year 5.
This notion - that the majority of the value of any investment comes several years in the future - is not a new one.
As Peter Thiel said in his book Zero to One in 2014,
In March 2001, PayPal had yet to make a profit but our revenues were growing 100% year-over-year. When I projected our future cash flows, I found that 75% of the company’s present value would come from profits generated in 2011 and beyond—hard to believe for a company that had been in business for only 27 months.
But even that turned out to be an underestimation. Today, PayPal continues to grow at about 15% annually, and the discount rate is lower than a decade ago. It now appears that most of the company’s value will come from 2020 and beyond.
LinkedIn is another good example of a company whose value exists in the far future. As of early 2014, its market capitalization was $24.5 billion—very high for a company with less than $1 billion in revenue and only $21.6 million in net income for 2012. You might look at these numbers and conclude that investors have gone insane. But this valuation makes sense when you consider LinkedIn’s projected future cash flows.
Insight 3: The higher the discount rate, the more important the short-term is vs. the long-term.
In the graph above, as we increase the discount rate, the more the initial years matter.
The converse is also true.
The more importance you explicitly place on the short term, the higher the implicit discount you're applying on the long-term.
Hold that thought. We’ll come back to it in a minute.
Should I explore, or should I exploit?
There is an important class of problems in mathematics, called "explore vs. exploit problems". A simplistic example:
Let's say you love gambling and you've just entered a casino. You see an array of slot machines in front of you.
You know they all have different odds of payoff. But you don't know which ones pay well, and which ones don't.
How do you find out? You try different machines. But at what point do you stop trying different machines, and stick with the best one you've found so far?
This is the "explore vs. exploit" conundrum.
"Explore vs. Exploit" applies to life and business too.
As Brian Christian and Tom Griffiths says in Algorithms to Live By:
Our intuitions about rationality are too often informed by exploitation rather than exploration. When we talk about decision-making, we usually focus just on the immediate payoff of a single decision—and if you treat every decision as if it were your last, then indeed only exploitation makes sense.
But over a lifetime, you’re going to make a lot of decisions. And it’s actually rational to emphasize exploration—the new rather than the best, the exciting rather than the safe, the random rather than the considered—for many of those choices, particularly earlier in life.
As the authors say, don't explore new places on your last night in town. Discovering an enchanting café on your last night in town doesn’t give you the opportunity to return.
But if you've just finished one week in a new city, then don't stick with the best restaurant you've found in 7 days. Explore!
It's all about the time horizon.
The longer the time horizon you're looking at, the more exploration is valuable.
The shorter the time horizon, the more exploitation makes sense.
Putting the two concepts together.
Discounting the future at a low rate → Long time horizon → The future matters a LOT. Focus on exploration. Search for golden eggs.
Discounting the future at a high rate → Short time horizon → The future matters less. Focus on exploiting. Kill the Golden Goose.
The time horizon makes the strategy.
And here's the thing: By observing the strategy, we can also infer the time horizon.
Here's Algorithms to Live By again, on Hollywood.
Among the ten highest-grossing movies of 1981, only two were sequels. In 1991, it was three. In 2001, it was five. And in 2011, eight of the top ten highest-grossing films were sequels. In fact, 2011 set a record for the greatest percentage of sequels among major studio releases.
Then 2012 immediately broke that record; the next year would break it again.
From a studio’s perspective, a sequel is a movie with a guaranteed fan base: a cash cow, a sure thing, an exploit.
And an overload of sure things signals a short-termist approach.
By entering an almost purely exploit-focused phase, the film industry was signaling a belief that it was near the end of its time horizon.
And for what it's worth, they were right! Streaming video has taken over, and fewer people are going to theaters (a trend which COVID has irreversibly accelerated).
We see such time discounting in business.
This is often what happens when a private equity firm takes over a profitable luxury / niche consumer brand.
Immediately add on a ton of debt. It makes perfect sense. Given the short-term outlook (i.e., high rate of discount), debt at low interest rates looks cheap.
Monetize as much as possible. When a private equity firm took over Marvel in the early 90s, they immediately pushed to monetize. Lots of “exclusive bumper issues”, which cost more than 3x a regular comic. Lots of crossovers between different comic universes, to capture fans of distinct franchises, and so on. And true to their short-term outlook, revenue grew for a while. And then nose-dived, as fans tired of the mercenary approach.
When you see a brand suddenly monetizing like crazy (operative word being “suddenly”), you can be sure one of two things is true:
A major investor is looking to exit, and wants to raise the valuation.
Or the opposite - a corporate raider wants to buy the company. And so the company is trying to become too expensive to buy.
There are many more examples of short-termism in business - five year plans, quarterly reporting, retirement ages, etc. All of these issues focus people on the short term, implicitly discounting the future.
This applies to society as a whole, as well.
Implicit discounting of the future is why inequality always tends to increase, in a non-welfare state.
Paraphrasing from Filters against Folly, a great book on how society evolves over time:
Inequality always increases, in a situation where different people discount the future differently.
Poorer people always think more short-term, which means they are less likely to find value in long-term goods. This increases inequality, because the rich discount the future less heavily vs. the poor.
The rich buy more goods that are valuable in the long-term, and therefore get richer over time. While the poor focus on the short term, and don’t build long-term assets. Thus, the gap widens.
And last, this applies to careers as well.
If you’re planning your career over two year horizons (or even five years!), you're discounting the future at a high rate (remember my chart above? Only a very small percentage of total value accrues in the first 5 years). You’re way too short-term focused.
In the same vein, complacency is cancer. If you're happy in a dead-end job, then you're implicitly assuming that your career will end soon. It’s OK to focus on “exploiting” in the last year of your career, but not when you have 20 years left.
So when you’re mulling your next career move, don’t think about just the next 1-2 years or even the next 5 years. See how the new role fits in your 30 year working life. How does it help your skills, your expertise, your effectiveness compound?
Whenever you catch yourself saying "Let me try this for a year, and we'll see after that", ask yourself, how am I discounting the future? How am I discounting my life?
I’ll end with this tweet, which I return to quite frequently.
Some Link Love.
Last week, I wrote about the COVID vaccine, and whether I would take it (answer is yes).
Here's a great podcast with an update on the situation with vaccine development.
As Paul Offit says in the podcast, "Developing a vaccine typically takes 20 years and a billion dollars." WOW!
In a way, various governments around the world have cut out all the risk, by ordering hundreds of millions of doses in advance. And that has helped speed up development.
Operation Warp Speed is working, even if we don't necessarily like everyone involved.
For those worried about side effects, here’s some info about the side effects of the Moderna vaccine, and how it compares to other vaccines in use today.
And putting it in context of everything else happening in 2020, maybe the Roaring '20s are here?
That's it for this week! Hope you liked the articles. Drop me a line (just hit reply or leave a comment through the button below) and let me know what you think.
See you next week!