Week 7: The Power Law

Something true about business and life is the power law. If you think back to the various undertakings you’ve begun in life, you might find there were a lot of false starts and weak fizzles. Maybe that budget you were trying to stick to somehow didn’t survive the first three-day weekend that came along. Or perhaps that goal to start law school next year never really materialized.

These are things you didn’t do, but what about the things that you do execute on? Instead of law school, maybe you continue to be an above-average police officer. From that, you can safely infer that your past efforts around becoming good police are producing an outsized impact on your life – compared to say, those two months you studied for the LSAT.

Some call this the Pareto principle – the “80-20” rule – but statistics has a name for it too: the power law.

We intuitively grasp this concept when we name it the 80-20 rule, and the idea is basically the same. There are also enough naturally-occurring examples to give the power law a certain magistracy that hints at a deeper truth. But more immediately, isn’t it funny that so much of the advice we hear in business and investing contradict this straightforward thought?

It is a truth universally accepted that in investing you must diversify. Don’t keep all your eggs in one basket. Following that belief, you park some money in AT&T, some in Google, a bit more in Tesla, and maybe even a little in Phillip Morris International (though you probably don’t brag about that last one at cocktail parties).

The idea underlying all this is that if Google suddenly experiences some turn of fortune and tanks, you still have AT&T and the others humming along and making you money. Statistically though, this may give you only decent returns – sadly you’ll never retire off this milquetoast approach. If that is your goal, you need to seek grand slams, not singles and doubles.

For example, in 1998, would you rather invest $250K equally across the top ten biggest companies of the year (including General Motors, Ford, IBM, and Chrysler), or would you want to plow that into a nascent company called Google? Jeff Bezos decided to do the latter, and when Google went public in 2004, that $250K investment resulted in a return of over $280 million!

The power law has interesting repercussions for not only investing but for life in general. Maybe by forcing it to the front of our thoughts, we can harness what that means.

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3 thoughts on “Week 7: The Power Law

  1. Hi Nick,
    Do not put all your eggs in one basket. That has always been the best way and safest way to do business, 401k’s, retirement programs, and generally in life. If one thing fails then others will make up for it. BUT!!! As you pointed out if your are a risk taker and gambler and truly feel like you have a winner then dumping all investment money into that one item can either make you a fortune or keep you living in a small but nice home in your retirement.
    Do you feel lucky?
    Mary

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  2. Hi Nick,
    I believe it is better to diversity when investing. Bezos might not have made as much but I bet most people do not have 250K just sitting around to make that investment. Depending upon one’s risk tolerance it can be a little like gambling. Don’t invest what you can’t afford to lose. Look at all the people who invested with Madoff and lost millions. I bet they wished they had diversified.
    Cece

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  3. Nick,
    I also believe that mixing or have a diverse source of investment is the best option. With investing you can never play it too safe. But, at least if you try one thing and try another – you will have a better chance of receiving something.
    But, this always makes me nervous – I have a hard time picking cereal. lol

    Like

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