Munger on the Proper Discount Rate


Questioner: When you try to arrive at the valuation number using the discount rate…

Munger: Your opportunity cost is so great. Considering everything else, you should forget about it. Most people don’t pay enough attention to opportunity cost. Bridge players know about opportunity cost. Poker players know about opportunity cost. American faculty members and other important people, they hardly know their ass from a plate of hot squash.

We don’t use numeric formulas that way. We take into account a whole lot of factors. It’s a multifactor thing. There are tradeoffs between factors. It’s just like a bridge hand. You have to think of a lot of different things at once.

charlie-mungerThere’s never going to be a formula that will make you rich just by going through some little process. If that were true, every mathematical nerd that gets A’s in algebra would be rich.

Charlie Munger

Thanks to Farnam Street

Pension Fund Fantasy: Omaha’s 8% Return Projection


Omaha is not unique among municipalities across the country – deals cut with workers many years ago have left pension funds well short of money needed for retirement benefits. The shortage has cost Omaha it’s top municipal bond rating and has driven Chicago – the nation’s most egregious offender – to the brink of bankruptcy.

It’s time for the City of Omaha to level with unions and citizens and admit that it’s 8% return projection for the future is a mathematical impossibility.

Today’s World-Herald:

The city expects a return of about 8 percent each year. In 2014, the fire and police pension fund returned 4.9 percent and the civilian fund 5.5 percent, according to annual performance appraisal reports for the funds.


Let’s start out with how the pension fund managers performed over the past two years, because frankly, its hard to fathom. If you try to “back in” to the portfolio allocation, some weird numbers emerge:

First of all, let’s assume that the City of Omaha is smart enough to follow John Bogle’s advice and put its money in low-cost funds that track the indexes. If the City is paying anything more than 1% to have someone manage the portfolio, it is an outlandish fee and further detracts from the struggling performance. That’s an argument for another day. Let’s stick with the passive formula assumption for now…

In order to have generated a 16.2% return in 2013, the fund would have allocated roughly 33.7% of its money in bonds. Let’s say they went with the biggest option and chose the PIMCO total return bond fund. It was a bad year for Bill Gross and prompted his departure to Janus as the fund returned -1.92%. But don’t fret Omahans, the remaining 66.3% of the portfolio invested in the S&P 500 index would have returned 26.39% in 2013. Thus, for the year, the fund still generated an outstanding 16.2% return in 2013.

But if you apply the same asset allocation assumption to 2014’s numbers, the performance breaks down. PIMCO’s broad based bond fund bounced back and delivered a 4.69% return. Meanwhile, the S&P 500 continued its bull run and advanced by 12.39%. Based on the same allocation weighting at 34/66, the pension fund should have easily turned in a gain of 9.8%, not 5.5%. The only way this 5.5% performance could have occurred is if the managers shifted almost 90% to bonds or made the even-worse decision of holding straight cash in a large portion of the portfolio. The pension manager should be called on the carpet.

The questionable 2014 results notwithstanding, reaching an 8% return assumption will be a virtual impossibility going forward:

First, you have the problem of rolling bond maturities. Assuming the pension fund bought some 30 year treasuries back when rates were north of 10% means that as those bonds reach maturity, those funds have no place to go but lowly 2-4% yields.

Second, if bonds are 34% of the portfolio and a PIMCO-esque fund runs at a typical 100 basis points over treasuries, 3.5% is a good year. What would the 66% of the stocck portfolio have to generate to reach an overall return of 8%?


Nobel Laureate Robert Shiller has tracked stock market data from 1871 to the present and has shown an average return of about 8.2%.

Aswath Damoradan at NYU has a data series leading back to the late 1800’s showing that stocks have returned approximately 5.74% over the treasury bond. Based on these data points, one will do well to expect a stock return of more than 8% going forward with a Ten Year Treasury yield of 2.15%.

Using the same portfolio weighting noted above, the Omaha’s pension fund expected return should be adjusted to 7% (if not 6.5%!). Denial and compound interest don’t mix well.

If Omaha is looking for a dose of reality, it should look to California where unfunded liabilities are at 50%.  Calpers, the largest pension fund in the US, reduced it’s target rate to 7.5% in 2012. Its own actuary argued for 7.25%. 

WeWork: Venture Capitalists Take Real Estate to Ludicrous Heights


Do you like the idea of hanging out with people in a laid-back environment where you have free WiFi, beer, and ping pong? Hell yes. Do you want to work in this environment? Hallelujah.

WeWork sounds like a cool co-working concept where users pay fees for differing levels of access and services. But when I saw that venture capitalists have valued the company at $5 billion, I needed a beer of my own to wash down this slice of fantasy.

Source: Bloomberg

Here’s the founder quoted in Bloomberg’s article:

Adam Neumann, WeWork’s Israeli-born co-founder, has called the company a “physical social network,” and it makes every effort to lubricate connections. “We gave 90,000 glasses of beer last month,” he said in a recent onstage interview at TechCrunch Disrupt NY 2015, “which is a number we’re proud of.” 

I get the general concept, and it is appealing: there’s probably enough people in New York, LA, Chicago and San Francisco who would rather pay a la carte for office space. There’s a cool factor as well. These aren’t beige-carpeted Regus office centers with a Bunn coffee maker in the corner. Non-dairy creamer is probably disdained at WeWork.

But a $5 billion valuation is preposterous.

There are many flaws in the venture capitalists’ assumptions:

First, they make the old argument that X is a multi-billion dollar market, and if we can just capture Y, we’ve got a home run. In this case, they estimate the size of the office market as being $15 trillion, so their whole value is based on the idea that they can capture just a thimble-full of the market. Unfortunately, capturing a market of users does not necessarily translate into profits.

The doubts pile up quickly:

A. Sorry, there’s just not that many freelancers. I know we’ve all seen the hype around start ups, but most new tech businesses generate zero cash flow for many months or years and are purely boot strap operations that can’t stomach a posh rent in a highrise office space. There’s a reason why a lot of Silicon Valley success stories got started in garages.
B. So where do most small companies and freelancers work?Their homes. Why pay double rent?
C. Open floor plans suck if you need to complete tasks that require focused concentration. I’ve tried it. It’s hell.
D. There are already competitors (and will be more)…including building owners themselves.
E. There’s a little place called Starbucks that has free WiFi. I’ve heard they have some locations around.
F. WeWork has no assets and relies entirely on leased space. Leases are a contractual obligation akin to debt. They may not get capitalized on a balance sheet, but they should be. The company will immediately be an over-leveraged behemoth with tremendous fixed costs.
G. Ping pong and beer are amenities, they’re also distractions for the others who actually need to work. Go to a bar.
H. They will need to hire a staff to maintain the spaces.

Here’s my biggest gripe: The article references Uber as a comparable. The logic goes something like this: workers share spaces and more efficiently utilize a common area by making use of what would otherwise be spare capacity. But is WeWork really like Uber? In the case of Uber, individual drivers carry all the risk and Uber only acts as a technology infrastructure for sharing transportation. If there is no one to pick up, its the driver who doesn’t make any money. In this model, WeWork carries all the risk.

If I was going to create an “Office Uber” I can see a better market where companies with existing leased office space (an advertising firm or insurance company) post available cubes and conference rooms for rent when they are empty. You probably have offices that only run at 50-75% capacity on a daily basis (ie, Don Draper heads to California for a few weeks), so there’s a lot of spare space that can be posted. I’m sure someone has already thought of this concept.

On the positive side for WeWork, there’s probably a health club model here – sign up tons of people at $40 per month and know that they only show up a fraction of the time of what they thought.

But $5 billion is a bridge too far.

Kilroy Property Trust is one of the biggest office landlords in San Francisco (if not in the the entire US) and their market cap is $6 billion. Ping Pong and beer are probably not included in Kilroy’s market capitalization, however, so there’s tons of upside.

The Discipline to Say NO


You want to follow the herd. It’s natural. Do you remember the 1999 internet bubble? I got so frustrated hearing about my neighbors investing in Level 3 Communications, I thought I was the dumbest person on the block. I bought some Level 3. I made a little money, but I was too chicken to ride it out. I’m glad I didn’t.

Yes, some people escaped that bubble with fortunes intact, but most were swept away. The same can be said of house flippers and land developers in Las Vegas during the middle of the 2000’s. I remember feeling so envious of all these people making quick bucks left and right. What did I do? I went to Baltimore. I flipped a house and lost my ass. Thankfully I got out before the meltdown and I didn’t lose my entire net worth.

So, now, I look at my industry: apartments. Everybody loves apartments as an investment right now. The yield, the safety, the myth that people can’t afford houses anymore. I remember fretting about Omaha surpassing $1.00 per square foot rents in the late 2000’s. We’ve blown through that number.

Downtown is hot. Midtown is hot. But someone is going to be the last one in and they’re going to be late to the party. They will overpay for land, underestimate costs, and underestimate the depth of the market at an affluent level of rent.

It’s frustrating. You know people are making a lot of money right now. But you also have a sick feeling in your gut that everything is being propped up with artificially low interest rates. I went to a conference and heard they are paying 4.82% cap rates in Dallas.

Are we there? Is this Japan with a perpetual zero interest rate policy?

Everybody repeats the same cliche that real estate is about location, location, location. Here’s what they don’t say: real estate is also about price. You can have the best corner in the world, but if you pay too much for it you will dig yourself a hole that will take a generation to extricate yourself from.

We have to take risks as developers. You can’t make money without taking a risk. But you can’t follow the herd. Sheep get slaughtered as the saying goes. Lemmings head blindly over the cliff.

Farnam Street blog has an outstanding transcript of a television interview in India featuring Warren Buffett and Ajit Jain. Everyone needs to read it and watch the interview. It is pure gold.

Ajit: The discipline to say no, if you have that and you’re not willing to let people steamroll you into saying yes. If you have that discipline, that’s more than 50 percent of the battle.

Warren: Don’t do anything in life where, if somebody asks you the reason why you are doing it, the answer is “Everybody else is doing it.” I mean, if you cancel that as a rationale for doing an activity in life, you’ll live a better life whether it’s in the stock market or any place else.

I’ve seen more dumb things, and sometimes even illegal things, justified (rationalized) on the basis of “Everybody else is doing it.” You don’t need to do what everybody else is doing. It’s maddening, during the Internet craze when the bubble was going on.

You have to forget about all those things. You have to do what works, what you understand, and if you don’t understand it and somebody else is doing it, don’t get envious or anything of the sort. Just go on and wait until you find something you understand.”

Today’s Charles Munger Wisdom


“People chronically misappraise the limits of their own knowledge; that’s one of the most basic parts of human nature. Knowing the edge of your circle of competence is one of the most difficult things for a human being to do. Knowing what you don’t know is much more useful in life and business than being brilliant”

“It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.”
He says he sees nothing worth investing in right now and hasn’t bought an investment in his personal accounts in at least two years. He is waiting for an irresistible bargain.
From Saturday’s Wall Street Journal (9/13/14)

Never Mind the Bollocks: 34 Insights From Nassim Taleb


Nassim Taleb, the author of The Black Swan and Antifragile: Things That Gain from Disorder with 34 insights from his facebook account:

(Note: Thanks to Farnam Street Blog for this list. FSB is an outstanding site)

1. The artificial gives us hangovers, the natural inverse-hangovers.

2. The only problem with the last laugh is that the winner has to laugh alone.

3. Intelligence without imagination: a deadly combination.

4. There is no more unmistakable sign of failure than that of a middle-aged man boasting of his successes in college.

5. Never trust a journalist unless she’s your mother.

6. One of life’s machinations is to make some people both rich and unhappy, that is, jointly fragile and deprived of hope.

7. [If] someone is making an effort to ignore you he is not ignoring you.

8. The danger of reading financial and other news (or econobullshit) is that things that don’t make sense at all start making sense to you after progressive immersion.

9. It’s a sign of weakness to worry about showing signs of weakness.

10. Friends, I wonder if someone has computed how much would be saved if we shut down economics and political science departments in universities. Those who need to research these subjects can do so on their private time.

11. I trust those who trust me and distrust those who are suspicious of others.

12. A good man is warm and respectful towards the waiter or people of lower rank.

13. Journalists feel contempt for those who fear them and a deep resentment for those who don’t.

14. When someone starts a sentence with the first half containing “I”, “not”, and “but”, the “not” should be removed and the “but” replaced with “therefore.”

15. The only valid political system is one that can handle an imbecile in power without suffering from it.

16. Journalists cannot grasp that what is interesting is not necessarily important; most cannot even grasp that what is sensational is not necessarily interesting.

17. Never buy a product that the owner of the company that makes it doesn’t use, or, in the case of, say, medication, wouldn’t contingently use.

18. Just realized that to politely get rid of someone people in Brooklyn say “call me if you need anything.”

19. Injuries done to us by others tend to be acute; the self-inflicted ones tend to be chronic.

20. We often benefit from harm done to us by others; almost never from self-inflicted injuries.

21. You will never know if someone is an asshole until he becomes rich.

22. When someone writes “I dislike you but I agree with you”, I read “I dislike you because I agree with you.”

23. A great book eludes summaries. A great aphorism resists expansion. The rest is just communication.

24. For a free person, the optimal – most opportunistic – route between two points should never be the shortest one.

25. What counts is not *what* people say, it is *how much* energy they spend saying it.

26. Used skillfully, a compliment will be much more offensive than any disparagement.

27. I trust those who are greedy for money a thousand time more than those who are greedy for credentials.

28. Just as eating cow-meat doesn’t turn you into a cow, studying philosophy doesn’t make you wiser.

29. It is a great compliment for an honest person to be mistaken for a crook by a crook.

30. Many want to learn how to memorize things; few seek that rare ability to forget.

31. High Modernity: routine in place of physical effort, physical effort in place of mental expenditure, and mental expenditure in place of mental clarity.

32. The ultimate freedom lies in not having to explain “why” you did something.

33. A book that can be summarized should not be written as a book.

34. If you have something very important to say, whisper it.

Read more posts on Farnam Street on:
Nassim Taleb • Philosophy

A sure thing for $4 million. Or would you risk it?


“Loss aversion is certainly the most significant contribution of psychology to behavioral economics.”
-Daniel Kahnemann

Psychologist Daniel Kahnemann, with his partner Amos Tversky, earned the 2002 Nobel prize in economics for discoveries in the field of behavioral economics. His 2011 book Thinking Fast and Slow is a treasure for everyone seeking to understand the complicated and highly irrational nature of the economic brain.

Kahnemann’s biggest breakthrough came in the development of what is known as Prospect Theory.

In the 1730’s Daniel Bernoulli correctly showed that different levels of wealth have different levels of utility. Consider an increase in someone’s wealth by $1 million dollars: The person with zero dollars will have much greater utility for $1 million dollars than the man with $9 million who reaches the level of $10 million. The amount is the same, but the utility is much higher for the poor man.

Bernoulli’s Utility Theory found that the utility of wealth could be measured:
$ Millions = 1 2 3 4 5 6 7 8 9 10
Units of Utility: 10 30 48 60 70 78 84 90 96 100

So, if you were given this bet, the choice would be fairly simple:
A 50/50 chance to have either $1 million or $7 million, or a 100% chance to have $4 million.
$1 million x 50% is the utility unit of 10 x 50%
$7 million x 50% is the utility unit of 84 x 50%

(50% x 10) + (50% x 84) = 47 vs. 60 which is the100% certainty of $4 million.
You would choose the sure thing and take the $4 million.

Kahnemann and Tversky, building on the theories of Harry Markowitz, proved that Bernoulli’s theorem doesn’t take into account happiness resulting from a recent change.

Imagine that Jack and Jill each have $5 million today. According to Bernoulli, both Jack and Jill have an equal level of utility. Now assume that yesterday Jack had $1 million and Jill had $9 million. Obviously Jack is ecstatic and Jill is miserable.

Kahnemann’s two key points:

1.Utilities are attached to changes in wealth rather than to states of wealth.

2.Losses loom larger than corresponding gains for the economic mind.

What if you had to have surgery on your knee to repair damaged ligaments. Say the doctor informs you that there is a 5% chance that you could lose your leg. How would you feel if he informed you that there was a 10% chance of losing your leg? The percentage change is the same, but the level of risk is perceived to be much higher in the loss-averse mind.

What if the doctor said the same operation has a 95% success rate? What if he said it was 90% successful? What does that make you feel? Framing the question has a major influence on your perception of risk. The use of a negative outcome is far more influential.

Insurance salesmen have plenty of customers.