What is magical thinking?
Economists have a term for hoping that the future will be different from the past – “magical thinking”. President-elect Trump’s infrastructure and tax plan is a great example of magical thinking. He has proposed spending up to $1,000,000,000,000 (yes, that’s $1 TRILLION) dollars on infrastructure repairs and upgrades. He has not proposed tax increases or other spending cuts to pay for this infrastructure spending. Rather, he is projecting that the infrastructure spending will increase US GDP growth from the current 2-2.5% to 4% per year, and the increased tax revenue created by higher growth will pay for the spending. Every single economist I’ve read says there’s no basis for this.
In short, Trump’s plan depends on hoping something will happen that’s never happened before. Hope is not a strategy.
Magical thinking in investing
Magical thinking also comes into play when analyzing potential investments. Let’s take Amazon as an example. Amazon has enormous sales yet is barely profitable. Despite being unable to prove that it can convert huge sales into even reasonable profits, Amazon is selling at ~175x earnings. Why?
Investors are hoping that at some point in the future something at Amazon will magically change.
Amazon has such enormous sales in large part because they have low prices. If Amazon believed they could raise prices and still have the same volume of sales, don’t you think they would have done it by now? The only logical conclusion is that Amazon believes the current pricing scheme maximizes profits and raising prices will decrease profits.
Some people will point out that Amazon is making more money on their “core” business of selling and shipping product and the numbers look worse because of their various R&D investments, their build out of distribution centers, etc. They claim that if you remove the “one time” costs Amazon’s numbers look better. The problem is that when “one time” costs happen year after year they cease to become one-time costs and start to become normal expenses. Amazon makes these continual R&D investments because they believe they need to do so to protect their current and future business.
Amazon does roughly $120B in sales per year and in 2015 had a profit margin of .56%. They already benefit from massive economy of scale and yet barely turn a profit. Why should we expect that to change in the future? If their sales double I don’t think it’s reasonable to expect their profits to go up by 10x. That would require magical thinking.
Magical thinking is what the entire dot-com bubble was built on. Somehow investors believed that money-losing Internet companies be able to turn “eyeballs” into profits. How? Nobody was quite sure, but they knew that profits were just around the corner.
South Park had a great example of this kind of thinking from their underpants gnome episode.
The underwear gnomes aren’t making money today, and they aren’t exactly sure how they will make money, but they are sure that if they just keep doing what they are doing then profits will somehow come eventually.
Or take Pets.com. They were losing money on every sale, but they hoped to become profitable by making more sales. It reminds me of this Saturday Night Live skit:
You just can’t analyze a company (or, by extension, an investment) if you can’t project future profits with some reasonable degree of certainty. And once your projections require something magical to happen you’ve crossed the line from investment to speculation.
I prefer to invest in companies where no magical thinking is required. Coca-Cola already makes money on every 12 oz can of soda they sell. Nothing needs to be different in the future for Coke to make money. Ditto with Visa or Nike – they make money every time somebody swipes a credit card or buys a workout shirt. Visa and Nike can just continue doing what they are doing on an ever larger scale to make ever larger profits. Nothing needs to magically change in the future.
Investing in a company and needing something magical to happen before profits appear is not a good strategy for building long-term wealth.