SUMMARY OF THE POWER HABIT

Chapter 1: The Habit Loop: How Habits Work

In this very first chapter, Charles gets straight to the point and talks about how habits form an important part of our lives. This chapter begins with a story about Eugene Pauly who, through his sickness, helped scientists understand how we humans form habits. Although Eugene was operated because of a virus that had almost destroyed his brain, Eugene recovered easily. However, he began to have short-term memory problems after the surgery.

Then, a series of bizarre events occurred and though Eugene couldn’t even recollect where his kitchen was located, he could easily satisfy his hunger by walking into the kitchen, opening the drawer and fishing out a jar of nuts. He couldn’t remember where his house was, but he never asked for directions and walked back home safely after his walk every day. This made doctors understand that the importance of habits. The part of the brain that was responsible for remembering things were not controlling his habits and therefore, he could perform simple tasks easily.

Stig Brodersen  7:11  

I think it’s really profound how he talks about that your life is really habits. So you have to convince your brain what is a good habit and what is a bad habit for me. He’s saying that the whole idea is really the habits is that is a good thing. Clearly not bad habits, but the whole essence of having habits us a good thing. And I’m really thinking about Daniel Kahneman’s “Thinking Fast and Slow,” when I read this book, because habits relieve the brains from stress. Our brains are really just programmed to doing whatever’s easiest. If you have learned how to drive a car, if you have learned how to walk, you shouldn’t be thinking about how to do that. You should be thinking about other things. That’s why it’s so beneficial in the first place to have habits. 

But what he’s also talking about is how you should be aware of things that are not good for you. And he has a lot of different great examples later in the book. But in the very first chapter, he talks about how McDonald’s has actually been able to use the Power of Habit. He’s talking about how and McDonald’s is decorated, he was talking about what kind of food they’re serving, how fast the food triggers rewards in your brain, and how the whole experience of walking into McDonald’s should be as easy for the brain to do as possible because that way they have a chance of you of coming again. 

Just the awareness in the very first chapter of how you’re really controlled by habits. That’s really the takeaway from the first chapter because later in the book, he will go into more examples of how you can change your habits, but also how you can be exploited by other people, if they’re aware of how the brain works in terms of humoring the habit of how your brain works.

Preston Pysh  9:02  

Stig, I really like that you pointed this out. So the brain doesn’t know the difference between good habits and bad habits. I think a lot of people, they get so used to their life and they’re going through it and they’re doing these things daily that they don’t necessarily say, “Well, that’s a good habit versus a bad habit.” They just do it because it’s so ingrained into their mind that it almost becomes an unconscious kind of thing. Like say, you drink soda or something like that and maybe you want to cut back on it because it’s forcing you to have weight issues or whatever, I don’t know. But you’re doing this and you’re doing this habit, you don’t even realize it. It’s something that has been pushed so far into your unconscious mind that you’re just naturally going through the steps. 

So I think that the recognition that I got from reading this book was, well if there’s good habits and bad habits, I need to identify the good ones versus the bad ones. I need to cultivate the good ones and remove the bad ones and and effectively reprogram my life. So, if I go about this in a methodical manner, let me just pull out a piece of paper and let’s just start listing these things out, like, what are some of the good ones? I’d list them out. And then what was some of the bad ones? I’d list those out. And I say, “Okay, now that I know what the bad ones are, let me prioritize them so that I can focus on the really bad ones first and let’s try to remove those. Let me try to systematically go through this.” 

So before we go any further down that path, I want to talk about really kind of the three main things that he talks about in the book for identifying this. So there’s three things and I think this is really important for people to remember. Number one is the queue. Number two is the habit itself and number three is the reward. So those are the three things that encompass this loop, if you will, it’s almost like a programming loop. 

Let me just talk about one of mine. So one of the habits that I wanted to remove in the worst way was I am on my phone all the time. It’s ridiculous, like, any point in the day I’m pulling up my cell phone and I’m like checking email. I’m just searching the internet. I’m looking at stock tickers or just mindlessness. It’s just ridiculous. So it didn’t even occur to me, like, I knew this was kind of an issue. I knew it was almost like an addiction and there’s articles out there on this, that it’s like an addiction. So I didn’t know how big of an issue was until I implemented one of the things that I read from the book, which was, if you want to change the habit, all you have to do is you have to recognize the cue. 

First of all, if you recognize the cue, then it’s very easy for you to basically reprogram the habit. So for me, really, the cue is pretty obvious. I was pulling out my phone when I was bored. When I was just sitting there and I literally had nothing to do or like, let’s say there was people around me they’re having a conversation and it didn’t interest me in the least bit, I was bored. So I would pull out my phone. He talks about how in the book, sometimes it’s a time cue, like at 123:0 every day, that could be your cue. It could be a certain person that you run into is a cue, it could be something that you see. That’s for you to determine, and that can kind of be tricky at times. 

Sometimes it might take you weeks to really figure out what the cue is. But for me, with the cellphone thing, this was like such an obvious cue, I was just bored. So what you do is when you when you know the cue, and you can feel and you can sense that cue, you have to replace it with a habit. So this is what I did, and this is really vital, you have to write it down. You have to write it down. That is so important, because if you just think about this in your head, you’re never gonna do anything. But when you write it down, and you come up with a plan, and he talks about this in the book, and he gives lots of examples and it involves Starbucks and the training program that they have at Starbucks, but if you write it down, and more importantly, you come up with the plan of what you’re going to do in place of the old habit, you say, “When this happens, I’m going to do this,” and you write it down, you will do it. 

But when you don’t write it down and just think about it, it is going to fail. So maybe one of the first things you can do is go out and get a notebook because when you get a notebook that’s dedicated to just reprogramming your habits, I think you’re going to have probably, I don’t know what your success rate would be, but I would guess it would go through the roof of this actually working. 

So for this example, I wrote down any time I get bored, and I want to pull out my phone, instead of that habit, I’m going to kiss my son on the head and my daughter on the head, and I’m going to try to play or do something with them instead. That was what I replaced the habit with.

So, the reward, so then you talk about the reward. So before I replaced this habit, you know, I would check my phone and I guess I would get some kind of reward or feeling like I’m up to date or that I am current, and that I’m not falling behind with stuff that I need to be doing because I’m not responding to emails or whatever. But the reward for me was that I could… with a new reward from the habit was that I could see my my kids happy and like they could see me. You know them smile, me smile, and we are just having a good time. So that’s what how I replaced this habit loop. 

So I did this and in the first hour, I went over to my son and I was kissing him on the head like, he looked. You know, this is so funny. It’s a little sad and it’s funny at the same time, because I felt so bad like when I thought about it, because I was spending so much freakin time checking my phone. And so, the first couple times I went over, I kiss my son on the head and, and my wife had no idea that this is what was going on. And my son goes to me, he goes, “Daddy, where are you going?” And I said, “Buddy, I’m not going anywhere.” My son, he’s three and a half. And I said I’m not going anywhere. 

And so, it was just a couple minutes later and I get this urge of I’m bored, I need to check my phone. Like I’m feeling this urge, like it’s almost like a compulsion, you know? And I do what I wrote down, you know, as soon as you have the urge to go through the new habit, so I went over to my son again, I kissed him on the head, and I said, “I love you so much, little buddy.” And he looked back at me, he goes, “Dad, where are you going?” And I looked at my wife, and I said, “Why is he asking me where I’m going?” And she says, “Every time you do that, you go to work or you go do something or whatever. “And she said she had no idea that I’m like doing this whole habit thing. She goes, “That’s your habit.”

I died laughing I was like This is insane. This is crazy. This is absolutely crazy. That little experience, like for me was just so profound, like if I can just change something that quickly and see the impact that I guess I’m having, by doing this one thing that I’m not even thinking about, it’s totally unconscious. If I’m doing this, like what else in my life, am I doing unconsciously that I can reprogram or change for the better? This was such a insane experience for me.

Stig Brodersen  16:35  

But did your wife come up with a lot of suggestions for habits?

Preston Pysh  16:38  

No. I’m not telling her about this because if I tell her about this, she’ll start reprogramming everything, she’ll start telling me you need to do that. Nah, just joking. I know that there’s a ton more that I could work on, you know, like a ton more.

Stig Brodersen  16:54  

I think it was interesting what you said about how you had the cue of your phone. I think that’s probably something everyone in the 21st century can relate to. But also how your brain reacted, because I think he’s actually very specific about this in the book, when he talks about that the reward that you’re getting is the momentarily distraction. What’s interesting is that, just as if you’re a smoker, and you’re trying to quit, your brain anticipates nicotine, and it’s almost for the brain as you are already smoking when there is a pack of cigarettes. It’s the same thing for email, like your brain almost thinks that you’re actually checking email before we reach down in your pocket and get your phone. And that’s just how ingrained habits are. But I was thinking like, was it really that simple, Preston? Should I do the same?

Preston Pysh  17:46  

No, I think the reason mine was so much simpler than others is because these things, like you’re talking about nicotine, like that is highly addictive. Like it is really hard your mind has chemicals and stuff kind of going off firing because of that reward that’s associated with it. My reward with my phone was like really not that great of a reward. You know, it really wasn’t. It was just kind of a stupid reward. Like when I look at it now, I’m kind of cleaning up my email only a couple times a day and not, “Oh, I have no idea how many times I was doing it before.” And it’s actually I become more efficient because I’ve forced it into a couple spots during the day. 

What I’ve noticed is like, there’s really not much of a change, like there was nothing that was time sensitive at all with the stuff that I was doing on my phone. Not at all. So that’s what made mine so simple and easy to use, because the reward was kind of like a stupid reward. 

Now, when you get into some of these other ones like nicotine, alcohol, whatever, the reward is so much harder to replace. And I think that that’s going to be hard for some people, if they’re trying to replace those habits, but I think the hardest part of all is recognizing that it exists. And then I think the second hardest part about all of it is really developing the plan and writing it down because I don’t think people do that. It was amazing as soon as I wrote it down, and I thought, “Okay, well, what can I replace this habit with?”

If I didn’t try to write it down, I would have never taken that next step of trying to figure out what am I going to replace the habit with. I would have just thought about them like, “Oh, yeah, I’m sure that stuff works.” But as soon as I literally had a pen in my hand and a paper on the table, and I had to come up with the replacement habit. I mean, I just came up with that really fast. My family is so important to me. So it was like, “Okay, well, let’s, boom. Let’s try that one out. Let’s see what happens.”

Stig Brodersen  19:44  

I think it’s really interesting to realize how much it means to replace the cue with something else because I was changing a habit here, or to say, like six weeks ago or something like that. So in episode 92, or something we had Jesse Itzler on. Jessie Itzler is famous for founding Marquis Jet, which is later sold to Warren Buffett. 

But actually one of the most interesting things we talked about was how changing his diet, actually eating fruit until noon, was really, really one of the cornerstone habits of *inaudible today, even though you might be looking at him, he has an amazing financial success, but it was actually really what really sparked all this. And he kept talking about this book “Fit for Life” and so I got out and bought the book and it had… Like, Jesse, I want to say I’m not like a food scientist, but I was really captured by the whole idea of changing my diet like that. 

So I actually challenged myself to do that for one day first and later for a week, so only eat fruit until 12 o’clock. And just to return to the discussion about cues. What it’s really interesting is that I figured out that it was not always because I was hungry, that I ate breakfast, it was kind of a habit. It was not always because I wanted to have say eggs and bacon in the morning that I was actually doing that. That was also a habit. So what I did instead was every time I felt I should be doing what I used to do, call it eat bacon, I would go out and get a piece of fruit from a refrigerator. And what I realized was that it was actually a lot easier than I thought, because the reward for me was really to grab something to eat. It was not so much while I was eating. So I was like, “Hmm, this is really that simple.” 

And then the reward for that is, as Jesse said, you would actually feel a lot better. So in that sense, it was quite easy to to keep doing that. But the whole notion of having a cue what it used to one thing and then just stop and then do something else, even before I I read It could be scientifically proved that that’s the way to go, I just experienced it firsthand. That was really interesting and figuring out how easy it is to change your life like that. I think that was really an eye opener for me.

Preston Pysh  22:11  

Okay, so Stig kind of hinted at the idea of what we’re gonna move into next, and this is what he talks about in the book is this idea of keystone habits. So what this is, is think of a habit that you might have that has kind of a compounding impact on your life in multiple areas. That’s what a keystone habit is. It’s such a profound habit that it has this ability to really kind of a fall into other parts of your life. 

So he tells this story of a gentleman named Paul O’Neill, who was the CEO of a company called Alcoa which does a lot of metal work, and smelting, and all sorts of stuff like that. So this company before Paul O’Neill came in had a safety record and had a lot of accidents that occurred. The company was going through a very transformational time. They wanted to hire a new CEO. And so Paul didn’t work for Alcoa at this point, and Alcoa was looking for a new CEO. They wanted to bring in somebody new, somebody fresh, that was not part of the company. So they hire Paul and Paul came from this background in government service. He did have some private services, or he had worked in the private industry as well. 

So Paul comes in, and the company had already been running through some issues, their stock price was down, they had been having some rough quarters. Then, Paul comes in, and he gives the quarterly speech to the company. And everyone was expecting how we’re going to do this and that so our net income can be higher next quarter, we’re going to raise revenues. We’re going to do all this stuff and give basically the ordinary pep talk. 

But Paul comes in, and he does something that really freaked out a lot of people. He starts off his speech by saying, “Okay, so in the back of the room, there are two exits. And if there’s an emergency that occurs while I’m talking, proceed through those exits and make sure you exit the building to the right or whatever.” You know, just basically gives the safety briefing before he even starts talking, then he proceeds to go, “So our number one issue at Alcoa is we have a very poor safety standard. We are going to become the most safe organization in the whole United States. Alcoa is going to be the leader in safety. That is our number one priority. We’re not going to focus on anything other than safety.”

So what the author talks about in the book and this happened, this was in the 80s late 70s that that this event took place? 

Stig Brodersen  24:49  

Yeah. 

Preston Pysh  24:51  

So there’s stock analysts there in the meeting listening to this new CEO who has no track record at all comes in and the company is in shambles, and the only thing he’s talking about is safety. Then he talks about in the book how, you know, everyone’s just like, “Sell this company this guy’s cuckoo. He’s gonna destroy this place.”

But what they didn’t realize was that the thing that Paul O’Neill really understood was the power of habits and this idea of keystone habits. So Paul saw the critical variable of all this is if they could fix the safety and create a company that was centered around the safest habits of pouring these metals and working in what would determine a dangerous industry, if you can basically bulletproof that so that no one can get hurt. What you’re actually doing is you’re creating a more efficient process around the company that you have. And so what they found was in the long run, and it wasn’t evident at first and you had a lot of people thinking that this guy was going down the wrong path. But ultimately, you know, 5 or 10 years later, what happened was the company became extremely effective. And they were able to produce bigger numbers, they were able to do it at a lower cost, they were able to do it safely where nobody was getting hurt anymore. 

So by focusing on that keystone habit, it had a compounding impact across the entire organization. So in the book, one of the things that they say is a keystone habit through researches that people who work out and people that keep their body physically fit, that tends to be a keystone habit in a person’s life. And they provide other examples, but I found that discussion really insightful, and something that made me think, “Okay, so what are some of the keystone habits in my life?” And to be honest with you, I haven’t even really been able to figure it out yet. But it’s something that really has me thinking because that’s something I want to cultivate. That’s something that I want to work on.

Stig Brodersen  27:00  

Oh, I really love, Preston, you brought this up about exercise because one of the things he says in the book is that no one think it’s fun to begin exercising. He’s saying that most of the people that start exercise and do exercise today is because they had some sort of problem at some point of time in their life. It really takes a lot to start exercise because it’s so annoying for us as human beings. And the first thing I thought was like, laughable, like, “Oh, that can’t be true,” but I actually remember when I started exercising like eight years ago, it was because I was in a bad place personally. 

So for me, it was like, “That probably makes sense.” And what he’s saying is that whenever you exercise, or the reason why you can continue doing that is there’s a lot of chemicals released in your brain, you feel good about yourself, but it actually happens after some time. It doesn’t happen the first few times. The first few times, it’s just pain, and it’s really hard to get over that hump. So when he’s actually saying is if you want to exercise or if you want to really anything, remember to provide yourself with a reward. 

And you said that perhaps one of the best thing he would suggest is to give yourself like a one hour TV reward, and let your cue be coming back from work, because I just noticed so well for me, at least beforehand, that when I was coming home from work, whatever I do, I would just sit in my couch, and I would just never get up. So he was saying, “Yes, I totally get why you think it’s a pain to exercise. And I completely get that you don’t want to get started. But if you just have that as cue, go out immediately and then reward yourself. And I can tell you, whatever you watching that hour, it’s going to be a lot more fun, nstead of sitting on the couch and doing whatever.”

Preston Pysh  28:45  

Hey, so one of the things that I wanted to talk about that I really liked in this book, was this this discussion of Michael Phelps. So this was really profound for me because it really reinforced the idea of people that are peak performers, and that can just do things just without even really thinking about it, like Olympic athletes or anything like that. 

So the story of Michael Phelps… He talks about how Michael had such a rhythm and his habits were so strong that it was almost like he wasn’t even consciously thinking about his swimming and what he was doing. He was so trained to do what he did, that it was completely pushed into his subconscious, and he was just in a routine at this point. So he talks about… So it’s three hours before his butterfly race, he was at the cafe and he had the same meal that he had every single day for the last four years at that exact time before this race. He would finish that at two hours and 50 minutes before the start of the race. At that point in time, he would walk this many feet over to whatever. Then, he talking about literally by the minute, to like 15 minutes before the start of the race, he takes his headphones on. He puts on the same mixtape track that he had listened to for four years straight the exact same songs. You know, one minute prior he steps up he does his arm flaps the exact same way that he’s… It talks about this rhythm and this habit that he was in to do the race. 

And so the thing that was really interesting was he was saying that when a person is in this habit loop, and the first thing, let’s say he’s listening to the music and then the music ends of his mixtape track and it’s two minutes long. That in his mind is a win. He just won at that habit. So when you stack all these habits up, you know for the first three hours before he even dives into the pool, he has done all these things, call it 15 things in a row, and each one of them are done with a win at the end of it because it had gone exactly as planned and exactly had how he had done it in the past four years straight in a row. And so for him, he’s just on that path. He’s on that habit loop of now I’m going to jump in the pool, and I’m going to swim this certain time that I have done for the last four years.

He talks about on this particular race that he was referencing here, some water, whenever he dove into the pool, some water got into his goggles. Well, that was something that he had trained for. That was something that he had pushed into his habit loop that whenever that happens, I have to go into counting the number of strokes from one side of the pool to the other, so that I know exactly when I’m going to hit the wall since I can’t see. And so this was something that, even though he’s at the Olympics, he has done this so many times and he has done this habit so many times it is something… He’s not thinking about, “Oh my god, I’m not going to win. I’m not going to do whatever.” And it’s just completely out of his mind he isn’t. He’s in total robotic programmed response mode, because of the habits that he’s forced into his life. So then at the end of the race, he looks up, pulls the water-filled goggles off of his face. And right next to his name, it says world record. He had literally beat the world record on that race, even though his goggles were filled with water, because for him, it was just another day in the pool of something he had been doing over and over and over again.

Stig Brodersen  32:28  

I think he was even closing his eyes for the majority of the race because it didn’t matter. Like he knew exactly what to do. So why would he open his eyes? And there was some point of time when he said, “Yeah, now I had, like, need, like 20 flaps. It was not like, yeah, I’m probably half. No, it was 20. And then it was 19. And then 18.” I mean, he just knew that. 

There was another story and the thing was about the Buccaneers. So again, it’s about sports, and this is about how actually removing the human decision gives you better results. And I think they played close to the Super Bowl and eventually won the Super Bowl. But they had a few years where they really didn’t make it. And what they actually realized, after they were looking at the sports tapes and going through the tactics was that when it really mattered, the players had a tendency to think, “I probably know better than my habits.” And that was actually the situation where things went wrong. 

I can’t help myself guys, I need to relate this to stock investing, because the first thing I thought, whenever I heard this was, isn’t that the whole essence of quantum investing? Isn’t that the whole idea of always buying say stocks with the lowest PE and always buying with the lowest price to book or whatever your system is? But then when if there’s a financial crisis, you overwrite your own rules, which is actually where you really need to stick with the rules. And that’s really where things go wrong. 

I’m not saying you shouldn’t be thinking about how you invest or shouldn’t think about what you do in sports. I just think it’s really interesting that it’s actually when you’re really struggling with something is called information by the *inaudible sports that you need to stick most of the system because that’s actually where it needs to do what you’re really good at and not come up with a new solution. I just found a very applicable for both situations.

Preston Pysh  34:21  

You know, when you look at Warren Buffett and you wonder why he’s had so much success, you might be able to attribute it to the fact that he sticks to the same exact strategy, the same methodology, no matter what the circumstances are. And I think when you do that, from an investing standpoint, which where you went to stick with this is if you are consistent and you continue to make the decisions and almost like a habit loop, regardless of what circumstances are being served, you’re then able to identify if you are making a bad decision inside of that habit loop. 

But if you’re just smashing, you’re kind of changing like a meandering river here, it’s hard to for you to identify where maybe you’re making the wrong decision, because it’s constantly changing. You have to fix the system in place before you can identify where the failures are occurring. 

And so I think that’s really important and that, you know, all these guys that are super successful, they have a checklist, they use an investing checklist. I can’t stress that enough. Guys, we are just hitting it the tip of the iceberg with this book. I mean, there are stories and examples after examples. There’s fantastic advice on how you can do this. If you have some bad habits, this is a book you’ve got to read. I can’t tell you that strongly enough. 

So if you want to read this for free, go to our shownotes. There’ll be a link for audibles. You can click on Audibles. You can listen to this entire book for free, if you use our link. Your first book for Audibles is free. It’s all through Amazon. So that’s the nice thing about Audible is every book in the Amazon inventory is through Audibles, ad that’s why we use that service ourselves. 

The other thing if you want to get our executive summary of this book, sign up on our email list. We don’t send out any spam or garbage. It’s just the executive summaries and different market advice that we have. We usually send that out two times a month. To be honest with you, sometimes we send it out less than two times a month. So if you’re worried about us spamming your email, that’s not going to happen. In fact, we get lots of emails from people saying, “You’re not sending enough emails,” but that’s how we roll. We don’t like to bother people. So we send you something it’s because it’s something important or something that’s useful for yourself. 

Let’s go ahead and do a question from the audience. Okay, and so this question comes from Anna.

Anna  36:41  

Hi, Stig and Preston. This is Anna. I’m a Kiwi living in California. Thank you very much for all the amazing interviews and knowledge you share with The Investor’s  podcast and buffettbooks.com. I’m going through the lessons on buffettbooks.com and enjoy reading about Nancy’s ice cream stand as a way to understand investing terms. 

One question I keep asking myself is, as I learn about value investing, what does Warren Buffett think of value investing versus buying index funds? I learned about his $1 million bet with hedge fund managers recently. What does it say that Warren Buffett won by buying index funds? Shall I continue learning about value investing? Or should I just go out and buy some ETFs? Thanks again for all of your hard work.

Preston Pysh  37:26  

That is an awesome question and I love that. So here’s my opinion, and I could be completely wrong, because I’m basically theorizing on what Warren Buffett thinks. But from the stuff that I’ve studied, the meetings that I’ve attended, and all that kind of stuff, I think that Warren Buffett really likes index funds a lot. I think that whenever he looks at how things changed through his lifetime, when you know, when he started off investing, there was no such thing as an index fund. But now he’s seeing that it’s a good financial instrument because it distributes your risk across, you know, call it the S&P 500 index. You’re distributing your risk across 500 of the best companies in the whole United States versus just owning one company. So things have changed since he started off investing. 

Now, one of the main reasons Warren Buffett invests in individual companies is because he’s got an enormous amount of capital. And he’s able to kind of dig in there and really kind of make a good assessment because he has different access. He has all this kind of stuff. So I think that Warren Buffett would buy an index if it was valued better than an individual pick that he could find. And I think that goes for other people, too, if they want to invest in individual stock picks. 

The thing that I think Warren Buffett has found through the years is that most people, and when I say most, it’s probably like at the 99% level, have no idea how to assess the value of a company appropriately and assume and account for the risks that are associated with most companies. And so that’s why I think he has really kind of shifted in the last… He’s really seen it happen in the last 10 to 20 years where he’s really kind of starting to push people, really the last 10 years, towards ETFs and indexes. So that’s where he made this bet and I think what he is in? Year seven of the bet? I took a picture of it at the last meeting. So I’ll fire that off the Stig and we’ll get that added into the show notes so you can see the count. 

But what he did is he was at the top five managers that people selected, top five money managers or hedge fund managers were pulled together and their returns were average the top five, that people could select this when he made this bet. But his bet was that he’ll pick an S&P 500 index and it will outperform the top five hedge fund managers over a 10 year period. 

I would tell you unless you have a lot of experience investing in individual stocks, I really think that maybe an index is probably the best route. I think that it’s important for people to understand how to value an index, which is you take the inverse of the PE to get a percent. So if the Pe right now, and I like to use the Shiller PE in the States, let’s just call it a 25. You take one divided by 25, that gives you a 4% yield, if you would, that’s what you can expect, when you own the S&P 500 annually over the next 10 years.It would be about a 4% yield. That’s where it’s priced today.

Stig Brodersen  40:36  

You might be right, it was top five hedge funds. But I’m also thinking, it’s not just five guys picking great investments. These hedge funds., they’re extremely diversified. You might think, well, that’s fair enough. The S&P 500, that’s diversified. You have hedge funds on the other hand, they’re also diversified. 

Yeah, but as these huge hedge funds as they select a lot of different assets in a lot of different asset classes, it really comes down to how hedge fund is structured. It is more or less buying the market. And I think that’s that’s something I see with a lot of hedge funds, like it seems like they’re following a given strategy. And I can’t talk specifically about those five funds. But are they really just buy the market one way or the other, just with that a much more expensive structure? 

I think if you look at what Warren Buffett has made, it really comes down a lot of it to the cost structure and not so much to the performance. I think for the index that Buffett chose a thing was like 17 basis points or 21 basis points, which is not even the cheapest you can get for an ETF, but I think he took Vanguard because he put a lot of faith in them. But what was actually interesting, and I can see Preston here in the video, he has some data on the on the bat so go ahead. 

Preston Pysh  42:01  

Sorry to change your line of thought there, Stig. So here’s the numbers. So I snaped this at the Berkshire meeting in May. And he started this in 2008. And the cumulative yield for both of these is the following. So the hedge fund managers at this point are up 21.9% since 2008, and the S&P 500 index since that period of time is 65.7% up. And the way that these numbers are averaged is like in 2008, the S&P 500 was down 37%, the hedge fund was down 23.9%. So then the next year, it was up 20. The S&P was up 26, the hedge fund managers were up 15.9%. And so then he averages those over that period of time of what the results were annually. That’s how he got the 65.7% for the S&P 500 and the hedge fund managers were one third of that return over the last eight years.

Stig Brodersen  42:59  

I’ll assume that the numbers are highly correlated. So if Buffet had a good year, say 2010, then the hedge fund managers would show something similar and so on.

Preston Pysh  43:08  

Yes, exactly. So you do see the numbers are correlated as far as if Buffett has an up year the hedge fund managers have an up year or not Buffett, but the S&P 500 has an up year, then the hedge fund managers have an up here. So you’re exactly right with that.

Stig Brodersen  43:21  

I think is a great point, because one of the key arguments you hear from hedge funds is that they are market neutral. They can short when they’re thinking the markets overvalued and whatnot. And what you just see time and time again, is that it just appears to be a more expensive version of the market. And that’s what also I’ve talked to Raoul Pal about. You really had to know the ins and outs of the hedge funds before you would go and invest in it. 

If you think that’s the right thing to do with the markets or value, you read in the prospect that well you’ll probably make a profit and *inaudible a crash because they are not as vulnerable to that but as we saw during the last crash, that was not the case. 

But, Anna, really to also to answer your question you’re talking about what should you be doing and what Warren Buffett do, well, I think Warren Buffett, he actually made an index play in Korea a few decades ago, where he was saying, “I think that it’s hard for me to invest in the individual Korean company, but I can just see that there was something structurally wrong in terms of price and value.” So he would go in and buying, I think it was 20 or 25 different Korean companies, which turned out to be extremely profitable for him. 

So even someone asked him tell you and ask *inaudible Warren Buffett, he’s actually using an index approach one way or the other at least in this example. I think Preston is right and think Warren Buffett probably said something similar that for 99% of the people that might want to buy into indexes. But I also do want to say that if you’re really interested in seeing if you can create a return that’s higher than the market, but at the same time are not too crazy about going into the individual a company, you might want to find either an index or or perhaps an ETF that follows some of the rules in terms of value investing. I would be surprised if you do your due diligence, if that ETF or that index wouldn’t do slightly better than the market. You shouldn’t expect Warren Buffett kind of performance, but I would assume that it might yield a better return.

Preston Pysh  45:22  

I have a point that I think is really important for people to understand. You can still beat the market and use ETFs and use indexes. And the way that you do this really kind of gets at the heart of Tony Robbins. I know, I know, we didn’t like his book. But it really gets to the heart of what Tony Robbins was talking about in this book, it comes down to what assets are you allocating your portfolio into at the certain times in the market? 

So like right now Stig and I’s opinion is that the market is very expensive in the United States. Other parts of the world, it’s cheaper in other parts of the world, it’s even more expensive. Well, Denmark, to be honest with you is the most expensive market in the world right now. So Stig is smiling and nodding his head, you’re right, it is the most expensive in the world. 

So  when you look at that situation. So you don’t want to have your capital allocated to Denmark companies right now, you just don’t. So what you do is is you’re able to beat the market by taking your capital and putting it into other asset classes at those points in time, you transition them into less riskier asset classes or whenever the Denmark stock market has a correction, which will happen, okay, we don’t know when but it will happen. You’re not sitting in that asset class, you’re totally avoiding it. So you can still beat the market, which would, that’s when people say the market, they’re talking about the stock market, you can beat that by adjusting your asset allocation at different points in time based on the valuations. 

So that’s why I think like you’re going through the Buffett’s books courses, so that’s awesome. I think that that’s really important because that’s giving you a foundation in business, it’s giving you a foundation in asset valuation for an individual company. And when you understand that, then you can apply it to an index, you can apply it to different asset classes, and you can get more creative with it. But don’t be confused folks, tou can beat the market, if you are adjusting your asset allocation based on different points in time based on the valuations that you’re being offered. That is so important. 

All right, Anna, awesome question and because it was such a good question, Stig and I are going to be starting something a little bit new with we’re giving the people that leave responses. So Anna, you’re the first person to get two gifts for your question. The first gift is the Warren Buffett Accounting Book, we’re going to sign that and send it off to you for free. And then the second thing we’re going to give you is Stig developed an entire video course around the book, “The Intelligent Investor,” so you’re probably well aware that that’s one of Warren Buffett’s books that he attributes most of his knowledge and understanding to.

What Stig did is he made a chapter by chapter video of that entire book. And so he has outlined the whole thing made it easy to understand because the book is very difficult to understand. We actually sell this, this course on our website. So you’re going to get this course completely for free for sending in your question. So two gifts for you two gifts for anybody that asks a question and gets it played on our show, you get the video series that Stig made for “The Intelligent Investor” and also our book. So thank you so much, and I hope you enjoy it. 

So before we conclude this episode, there’s one quote, and this one is often misinterpreted, and a lot of people think that it’s Warren Buffett that came up with this quote, but it’s actually Samuel Johnson that came up with this quote, and the quote is this: “The chains of habit are too weak to be felt until they are too strong to be broken.”

Stig Brodersen  48:57  

Alright guys, that was all that we have for this episode. We will see each other next week.

Preston Pysh  49:02  

So one of the things that Stig and I are very strict about is not endorsing any kind of service or product that we don’t personally use ourselves. So with that said, we give our full endorsement of our sponsors’ content realvisionTV.com. Real Vision is a site that Stig and I personally use ourselves and it has had a profound impact on the way that we view the financial markets. 

One of the most important things a person can do is seek the knowledge of highly successful investors and business leaders and more importantly, understand their thought process and how they make decisions. And with Real Vision, you get exclusive and in-depth interviews and presentations from the world’s sharpest independent analysts, fund managers, geopolitical strategist, economists, and investors all in the same place. 

And right now, because you’re listening to this show, we have a special offer for everyone in the TIP community. If you go to realvisionTV.com and put in our special offer code, TIP, which stands for The Investor’s Podcast, you get 10% off your subscription in the Real Vision TV. If you’re not sure if you want to get a subscription to the site without seeing the videos and content first, we completely understand that. That’s why Real Vision is offering the TIP community a free week trial to see if you like their service.

So trust me, you cannot afford to ignore the value that Real Vision creates with these in-depth full length interviews from famous investors like Kyle Bass, Jim Rogers, Tim Ferriss, and many more. The people being interviewed often have a net worth far exceeding hundreds of millions of dollars. And watching Real Vision is like being able to sit in the corner of a room and listen to a conversation that you’re not supposed to have access to. So don’t pass up this amazing offer to tap into the world’s smartest investors all in one place. And go to realvisionTV.com. Don’t forget, use the discount code TIP for your free week and 10% discount today.

Extro  50:55  

Thanks for listening to The Investor’s Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www.theinvestorspodcast.com. Submit your questions or request a guest appearance to The Investor’s Podcast by going to www.asktheinvestors.com. If your question is answered during the show, you will receive a free autographed copy of The Warren Buffett Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP Network and must have written approval before commercial application.