top of page
  • Writer's pictureNicholas Pihl

Searching for the next Is it a bad idea?

Updated: Apr 25, 2022

TLDR: Yeah. It is.

Investors spend a lot of time speculating (read: daydreaming) about what it would be like to have bought Amazon stock 20 years ago. The stock has returned about 30% a year, turning $10,000 into $2,187,931 over that time. In other words, $10,000 invested in the perfect stock would have produced enough of a gain for most people to retire on.

But there are a couple problems with this. One, is that everything looks obvious in hindsight. We ignore the many ways things could have gone wrong, and focus only on the version of events that we can see. The problem with this is that the future is a lot less certain than the past. This is also a classic case of survivorship bias. We forget all the other investments that might also have looked attractive at the time, but that produced nowhere near the gains that Amazon's stock did. Most of these underperformed the index, and many went all the way to zero

The problem with focusing on extreme successes is that the dispersion can be equally extreme on the downside. Howard Marks has this nifty risk-reward graph, showing the range of outcomes associated with targeting a particular level of return.

That narrow range on the left is a small, positive return, with low probability of downside. It also has a low probability of achieving a higher upside.

Over on the right, you have a risky asset, which has higher returns on average. Each individual investment has the potential to produce a big positive return, or a very low return. A portfolio of such investments might be expected to have a return around the midpoint of that range.

Do you see the bow-shaped graph to the left of those vertical lines? That's a probability distribution, meaning more investments will have returns in the fat part of the curve, with relatively few lying on the outer extremes.

But the creator of this graph, Howard Marks, is a bond-investor, and these ranges are tiny compared with the dispersion of returns you see in equities. Here's my artist's impression of what those would look like.

Notice how ugly this graph is, and not just because of my limited drawing abilities. The A, B, C, and D ranges are miniscule in comparison to the range on the right, which closely approximates the distribution of returns for a basket of high-risk equities, the likes of which could become the next

That the fat part of this curve centers around a 0% return isn't an accident, that's reality. Most individual stock investments, at least those in the category capable of producing Amazon-like results, are dead money.

Then you have everything below that horizontal line. Those are money-losing investments. Pay special attention to that weird, flat part at the bottom. That represents the huge number of investments that go completely to zero. This too, is typical of this sort of investment.

Think about what it takes to grow a company from 0 to $1.5 trillion in just 25 years. Is that a "slow, steady, play-it-safe" type of company? Or is it a, "do-or-die, fire-ready-aim" type of company? It's great when the hyper-aggressive approach works, but there are about a million ways for it to blow up along the way.

A big part of my philosophy is focusing on high quality businesses that can grow for many, many years. I want companies like Amazon in my portfolio. But I also don't want to be an idiot about it.

There's a Motley Fool ad, you've probably seen it, where they talk about buying Amazon in 2002 and how much money they made. Which is cool. It's just that most years aren't 2002. That year was unique because it included the post-9/11 recession and the aftermath of the tech bubble. High-growth tech companies (like Amazon) were totally bombed out, and trading at huge discounts to their long term value.

Moreover, these hard times separated the wheat from the chaff. Of the companies that were going to fail, most already had done so. The survivors were more robust, with proven business models and free cash flow. Too, the fact that many of their competitors were eliminated only made them stronger.

In short, it was an ideal environment for investing in companies like Amazon. But not all years are like that. For every 2002, you have a 1995, 1996, 1997, 1998, 1999, 2000, and 2001. A good investment process should be able to put money to work productively, regardless of whether you have a once-in-a-lifetime opportunity to invest in future 100-baggers.

Let's look at what has to happen consistently (not just in exceptional years) to reap the rewards of investing in "The Next Amazon." Then, you can judge whether that's something you want to sign up for.

Fundamentally, you need to make sure that your winners can grow big enough to make up for the losers in your portfolio. You also need to make sure that you can hold them long enough for them to grow big.

This is far easier to do in hindsight than it is in real time. To illustrate this point, here's a table I made in excel, approximating what a portfolio of "This could be the next Amazon" stocks might look like over time. This shows what would happen if you had a portfolio of 10 stocks, with one stock returning 50% a year, and the other 9 losing 50% a year. It's not a perfect approximation, but I don't think it's too far off from reality, given the distributions of returns you tend to see for venture capital and other speculative investment methods.

Sure, if you look ahead 11 years, those 20% annualized returns look pretty juicy. But look at what happens in years 1-5. In year one, you lose 40% of your money. And while that year looks like a blip on the graph, those 12 months will feel like a long time. It's gets worse.

If you thought 12 months felt like a long time, then 60 months will feel like an eternity. Even after 5 years, this hypothetical portfolio hasn't grown. In fact, you've waited 5 years to turn a dollar into 80 cents. Woof. Which also means you've massively underperformed the market. Double Woof. So while your friends are talking about how their $300,000 portfolio got turned into $500,000, you're feeling like Charlie Brown on Halloween.

I can't over-emphasize this point enough. If you don't think you'll get discouraged during those five years, you're crazy. If you don't think you'll lose faith, and start doubting the process, again, you're crazy. If you don't think you'll want to fire your advisor or change your process, you're crazy.

Evidence backs this up. The average investment committee tends to fire underperforming managers after about 3 years of poor performance.

In year one, they say, "hey this is a long term thing, let's be patient."

In year two, they stop looking at it, determined to wait it out.

In year three, they go, "why are we even in this thing? Nothing has gone like we thought it would. Maybe it never will." And they bail.

Even then, you still have 2 long years to sit through, waiting for those winners to grow enough to start carrying all the dead weight in the portfolio. Just to get to that point in year 5 where the portfolio is down 20%, but the winners are starting to reveal themselves.

This is why venture capital funds usually require a 7-10 year lockup. Because for those first few years your money is gone, spent trying to grow companies that will ultimately fail. Any "performance report," will look a lot like that table above. One small winner, with lots of big losers. No LP (limited parter, aka investor in the fund) wants that.

The lockup period makes it so clients can't take their money out of the fund, and have to sit it out until years 7-10 when positive results finally show up. In a sense, it's for their own good. It's also a testament to how difficult it is to adhere to this strategy.

Where do we go from here? Well, I guess my main point is that it may sound great to invest in the next Amazon, but you'd better know what you're signing up for, even if things go really, really well. Most people are so mesmerized by the potential upside that they fail to prepare for the utterly brutal path to getting there. Failure to prepare, is just preparing to fail.

Here are a few other notes to help you prepare. Please accept that this isn't specific investment advice for you. Nor is it advice that will maximize your chances of success. These are just a few things to minimize your odds of soul-crushing, divorce-causing failure. Pay attention: "Minimize" does not mean the same thing as "eliminate." If you wanted to jump off a bridge, I'd tell you to make sure you know how deep the water is, try to land feet first with your legs and back straight, and to try to exhale as you hit the surface. This would minimize, but not eliminate your likelihood of drowning.

Here's some similar advice.

First, you'd better diversify across many potential Amazons, because most of your investments will fail. The rule of thumb is that 90/100 will fail or flounder, while the remaining 10 will dominate your portfolio. This has two implications. One is that you need to cast a net wide enough that you have decent odds of catching an Amazon. Investing in 10 stocks does not remotely guarantee that one of them will be a winner. Two, even if you manage to get roughly 1 winner out of 10, you don't want your whole financial future tied up in just one stock. There are so many reasons for this that it needs to be its own article, but my rule of thumb is that you don't want more than 10% of your assets invested in any one stock. 10 winners would be better than 1 winner.

Second, you'd better be prepared to feel really dumb for a really long time. And you'd better not be using money you'll need anytime soon. Like, any time in the next decade.

Third, there's no guarantee that this will work out well for you. You might lose a lot of money. You might underperform the market to such a large extent that you have to postpone your retirement, or sacrifice your lifestyle make ends meet. You'd be better off covering your basic retirement needs with a more conventional approach, and using a separate pool of "extra" for this approach.

Fourth, all equity investments can be really volatile, and you'll likely see your biggest position lose half or more of its value, even on the road to victory. It's hard to know in the moment whether you're still on that road or have veered into a ditch.

Fifth, there's a temptation to double down on your losers. That's usually not a good idea.

Sixth, life happens, and you might need to access this money sooner than you think. This might lead you to sell at a bad time. Or, fear of that scenario may also cause you to sell at a bad time. You don't want to be that guy at the bar with no money telling everyone how you would've been rich if you could have just held on to your investments. Make sure you have good liquidity.

Seventh, even if this works out really well, and you have a big winner in your portfolio (and hopefully you have more than one), you might do something that looks stupid in hindsight. Market wisdom says both "ride your winners" and "diversify your portfolio." When you have a big winner in your portfolio, those two pieces of advice are working at cross purposes to one another. The right thing to do is probably somewhat dependent on your situation. Good luck not torturing yourself.

Eighth, I hope you appreciate that this is a very high risk approach. It maximizes return at the cost of anything approaching a reasonable risk profile.

Finally, you have taxes. These will probably be about 30-40% of the gains you make. On one hand, this actually could help you hold on to your investment, since you'll want to avoid unnecessary taxes. On the other hand, you only get to keep about 70% of your money.

At this point in the article, there should be three kinds of people left. One who says, "screw that, it's not worth it." And another who says, "as much as I might like to go hunting for the next Amazon, it is beyond my personal means to create the situation where I can accomplish that without jeopardizing my financial future." A third person, maybe less wisely than the other two, might say, "I think I understand what it takes, and I'm going to put a plan together so that I have a chance at achieving this goal, while limiting my risk of working until I'm 85."

To that third person, I'd just say, be really, really sure you know what you're signing up for. Don't just check off the boxes and hope it works out. Really think through what it will mean for your life and your finances to choose this path, and understand that you'll have to recommit to this path at least a couple times a year for 15 years. Which means you'll have to make 30 independent decisions to stay the course, and you'll have to make those decisions correctly every time regardless of what's happening in your life, or the markets.

Finally, be sure you factor in some of the curveballs life can throw at you, which will make this path harder to adhere to, such as: losing your job, getting sick and being unable to work, getting a divorce, having kids, your partner losing their job, or realizing that either of you hate your jobs and want to take some time for a career change. This is a non-exhaustive list, and I encourage you to add to it from the list of things that keep you up at night.

In other words, don't do it. There are better things to do with your life and your money. The price is high and the reward is anything but certain.

Recent Posts

See All

Notes on Long Term Care Notes: "But to throw out one more statistic, more than half of all Americans over age 65 will need some level

Not-so-Dumb-Guy Stock Market Math

The concept I'm sharing here is technically wrong, but I think it actually yields a better way to think about saving and investing in the stock market. The basic problem most of us have with investing


bottom of page