Special Situation Investing
Special Situation Investing
Wealth creation system (part 1)

Wealth creation system (part 1)

The first of a two-part series detailing the overarching steps in wealth creation and how a systematic approach can clarify your thinking

Welcome to Episode 72 of the show.

Have you ever been frustrated by the seemingly endless barrage of investment techniques available in the world and the lack of any system that connects them? Type wealth creation into any browser and you’ll instantly be flooded with advice on specific assets and tactics ranging from real estate, to stocks, to crypto. But how do you know which advice is best for you? In today’s episode we will discuss the system behind wealth creation and how that system can focus your efforts on the techniques that are best suited to your needs.

The idea behind this episode came to me while studying the unrelated field of Brazilian Jiu-Jitsu. I only recently took up the sport but as is always the case with me, or my co-host, we tend to go full steam ahead with anything that catches our interest, looking to achieve mastery of any new subject as quickly as possible. My deep dive into Jiu Jitsu quickly led me to John Danaher, a coach considered by most to be the best in the business.

John Danaher’s introduction to Jiu Jitsu took place in the mid 1990’s, when, as a graduate student in philosophy, he was moonlighting as a bouncer in a New York City nightclub. What impressed John so much about the sport is that it offered its practitioners a systematic approach to fighting. He observed that the system follows four simple steps which are first take the fight to the ground, second, pass the opponents guard, third, to pin your opponent and fourth and finally, to submit them. This meant that no matter where you were in a fight you knew what your next objective was. Other combat sports offered practitioners tools that could win a fight but they didn’t offer a system into which you could integrate the various tools into a holistic strategy.

Obsessed as we are on this show with all things investing, I immediately asked myself, what is the equivalent system for investing? What system could be applied to wealth creation that would allow for the organization and application of all of the tools available? I thought first of the various books I’d read on investing, but even the broadest of the books tended to focus on one or more particular wealth building techniques. One book, for example, focused on entrepreneurship and real estate while another tackled tax strategies and stock picking.

Even Buffet’s four filters approach, that screens for a company you can understand, with able and honest management, a large moat, and a reasonable price, was primarily an approach to buying businesses rather than a wealth creation strategy. Google searches and podcasts turned up the same tools and tactics over strategy and systems thinking that I’d experienced everywhere else.

This information vacuum led my co-host and I into several iterative brainstorming sessions on this topic. The result of those back and forth discussions was the four step process I’ll describe in this episode but before I do that its important to remember the following—all models are wrong but some models are useful. If anyone is smart enough to articulate a perfect wealth creation philosophy I can guarantee you they aren't writing content for this podcast. But on the other hand, I can also assure you that this framework, even though it wasn’t fully articulated at the time, provided a key road-map for my own wealth-creation journey.

So with those caveats behind us, here is the wealth creation system that we came up with. The four steps are: 1) identify your asymmetric advantage, 2) create surplus, 3) compound surplus, and 4) to repeat the process over again. Using this broad system a person should be able to feed in their unique situation and attributes and then identify where to apply the bulk of their efforts.

In order to understand the first step—identify your asymmetric advantage—we should begin with a definition. Your asymmetric advantage is the specific competency or circumstance, unique to you, that best leverages your efforts towards wealth creation. One person may have a great deal of time but no skills while another is highly skilled and highly paid but has little free time. The asymmetric advantage for each of the two people is very different and so too would be their path to wealth creation. One individual, for example, is ideally positioned for flipping houses while the other doesn’t have the time for such activities and might even see a reduction in their net worth if they pursued house flipping as a strategy.

You can see from the very first step this system does not treat wealth creation as a one-size-fits-all endeavor. Standard wealth creation advice offers would-be adherents specific tools instead of a framework with the trouble being that not all tools are right for all people.

Consider the following example: a recent high school graduate searches for podcasts on wealth creation and stumbles on a show about stock investing and tax strategies. If the sum total of the high school graduates net worth is $1,000 dollars earned from a summer job, is stock investing and tax optimization really what he should devote most of his effort to? The graduate could probably double his net worth in a month working an entry level job and be much further down the road toward wealth creation than had he spent his time on stock picking and tax optimization.

This first step in the system is so powerful because it acknowledges that we each have our own areas of advantage and disadvantage. Identifying your own advantages and capitalizing on them is a form of leverage that can accelerate your journey and prevent misallocation of your most important resource, which is time. We will dive much deeper into identifying your asymmetric advantage in part two of this episode, so for now let’s move forward with the remaining three steps of the process.

Step two of the process—create surplus—is an acknowledgment that regardless of the pathway you chose based on your own asymmetric advantage you have to create surplus in order to create wealth. We chose the word create rather than build because there are many different ways to create surplus. For many, the creation of surplus will necessitate increased earning through a raise, a second job, a side hustle, or some other entrepreneurial undertaking but for others savings and thrift might be the most effective means to create surplus.

Consider the example of a well paid surgeon who wants to follow step two of the system and create surplus. Increasing earning power may not be an option given the fact that one can only do so many surgeries at a time and even though the work pays well it does have a cap. For this individual, saving and thrift might be the best way forward. The surgeon could reduce his spending in a few key areas and create surplus without adding any new earning power. The savings that result from this choice could then feed into passive investments that don’t take time away from his primary and most lucrative occupation as a surgeon.

In contrast, a business owner is able to increase their earning power and is not limited to an hourly wage like the surgeon. The business owner can create surplus faster by increasing their sales and improving their cost structure than they can by simply reducing their spending and in this way can create the surplus required by step two.

The third step—compound surplus—is also key to any process of wealth accumulation. In step two we created surplus and now we must grow that surplus through the process of compounding. Exactly how you compound surplus, will again depend on the asymmetric advantage you identified in step one. If you’re the recently graduated high school student mentioned before then compounding surplus might mean additional earning through employment. (As a side note, I always encourage my own kids to work to learn rather than work to earn so that they will consistently grow their skillsets over time but the point remains that, for some, simply earning more may be the best way to compound their wealth early on.)

For others, however, additional time spent earning money may be a waste of effort. Consider Warren Buffet’s own journey through this process. As a teenager Warren sought to grow his wealth in the fastest way possible. In the early years, extra work and small side businesses were the fastest way for this budding genius to increase his net worth. Buffett famously subcontracted paper routes, worked in his uncles grocery store, and sold cokes at local sporting events all to grow his starting capital.

This was an effective strategy because young Warren could double his net worth with a months earnings from a paper route much more easily than he could by investing in stocks. For Buffett to take on a paper route in his 90s, however, would not only be silly but would be a colossal waste of time and skill. The earning power of an entry level job can no longer make a dent in his net worth and his skill-set has increased so much over the years that he can now get a much greater return by investing his attention and efforts on other things.

The last example illustrates why step four of the process, which is—repeat the process over again—is so important. Each time you go through the four steps you do so with slightly different skills, knowledge, and resources. This ever changing set of attributes causes you to identify different asymmetries that you can leverage. This continual revaluation, also changes the way in which you will create and compound surplus. The process continues in a never ending iterative cycle of growth over time.

Consider, once again, our high school graduate with his $1,000 dollars. The first time through the four step process he recognizes that earning more through employment is the fastest way to double his net worth. After three or four cycles through the system he has accumulated $2,500 dollars and grown his skill base. Perhaps he was employed with a landscape company and realizes that he can now do the work unsupervised and armed with this knowledge he purchases his own equipment and undercuts prices in the local market.

At this point our graduate transitions from an employee to an entrepreneur. Because of this change his means of creating surplus also shifts from simply working more hours to growing his business. How he compounds surplus will also change from a basic savings plan to more sophisticated considerations that go with business ownership. With each step, he will re-evaluate his circumstances and decide which next step best keeps him on the path of wealth creation.

Interestingly, the four step system can apply at multiple levels, from a macro view, that is your whole life, down to sub categories within particular investments. One example of this is your individual stock portfolio. Many investors have both a standard brokerage account and some form of IRA retirement account. The tax savings that come with an IRA account are a type of asymmetry that should influence your strategy within that account. The same can be said for an owner-occupied home which has tax benefits at the time of sale that other properties don’t. In each case, the investor has an asymmetric advantage for one investment and not another and those differences will influence how the system applies to you broadly as well as on a case-by-case basis.

Next week we will focus exclusively on step one of the four step process. This is likely the most important step because it directs you toward your unique advantages rather than showering you with unrelated tools and tactics devoid of an overarching framework. Just as a Jiu Jitsu practitioner knows which tool to apply in what situation because they fall within a broader system, so too should each investor understand where they are within a broader framework and which tool best fits their needs at any given time.

With that, we hope you gained as much insight from hearing this four step system as we did in creating it. Next week we will wrap up our two-part series with a closer look at how to identify your asymmetric advantage. If, after episode two, we’ve achieved what we set out to do, then you will be armed with a broad framework under which you can organize any particular wealth creation tools you come across. You will also be equipped to tailor your strategy to your own skills, knowledge and circumstances so that your efforts are spent in ways that guarantee the highest possible return on investment.

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Here are a few of our favorite podcast that we listened to over the last week. Enjoy!

  1. https://www.realvision.com/shows/the-essential-conversation/videos/winning-with-agriculture-investing-alan-boyce-R6rl?tab=details

  2. https://whatismoneypodcast.com/episodes/worldwide-debt-spiral-with-james-lavish-wim294

  3. https://www.whatbitcoindid.com/podcast/the-global-financial-crisis-2


Special Situation Investing
Special Situation Investing
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