Chapter IV

Chapter IV: The Great Way Is Simple

16 min · 12 ideas

"The true teaching fits in a single sentence; the false fills ten thousand books."

Investing is about earning the money that time makes, and what gives time its power is compounding. If you want to put compounding to work in stocks, and build an investing method that is steady, repeatable and sustainable, you first have to use "first principles" to see clearly what compounding and the stock market really are.

Wall Street encourages speculation, because speculation is good for Wall Street. The more complicated something is, and the further it strays from the truth, the more often it gets dressed up and sold. The ideas that truly work are usually simple enough to say in a sentence or two.

1. First Principles

The term "first principles" became famous because Elon Musk talks about it all the time. Its meaning is plain: don't do something just because "everyone does it." First ask, "What are the most basic facts here?" Then think the whole thing through again from there.

The example people use most often is the electric-car battery. Back then, everyone said batteries were too expensive for electric cars ever to work. Musk broke a battery down into its raw materials and worked out, item by item, what those materials were actually worth. He found that what made batteries expensive wasn't the materials themselves but the way they were made. So he went after the manufacturing process and the supply chain, and drove the cost down.

I borrow this way of thinking for investing. There's no end to what people say about the market. Rather than chase every claim one by one, it's better to go back to the very bottom and ask just two questions: How does money grow? How does the stock market work? Once you've thought those two through, you can tune out most of the noise.

Four Levels of Understanding

Psychology has a model called the "four stages of competence." Here it is in my own words, applied to investing:

1. You don't know what you don't know: you make a little money and think you've figured it all out.
2. You know what you don't know: you've been burned, you start to treat the market with respect, and you're willing to learn from the beginning.
3. You know what you know: you understand the patterns, and you have a method.
4. You do it without thinking: discipline has become habit. However noisy the market gets, you keep doing the right thing.

Most people who lose money in the stock market are stuck at the first level.

2. The Law of Compounding

Compounding is interest earning interest: money making money, returns on returns. You reinvest your gains, add them to your principal and keep building, which produces still more gains.

Principal × (1 + rate of return) ^ time = principal plus earnings

I break it down into four ingredients:

1. Principal: Don't lose money. Once your principal takes a big loss, compounding loses its foundation.
2. Multiplier: your growth factor each year (that is, 1 + the rate of return). The higher the multiplier, the faster the snowball rolls; and the cheaper the price you buy at, the higher the multiplier the same asset can give you.
3. Time: Hold for the long run, without interruption. Most of the effect of compounding shows up in the later years.
4. Stable, unchanging conditions: What you invest in has to keep existing and keep growing for a long time. If it disappears partway, years of compounding can be wiped out in an instant.

For an ordinary family, nothing meets all four ingredients at once as well as a broad-market index ETF: the index it tracks won't go bankrupt and vanish the way a single company can (principal and stability); it shares in the long-term growth of the whole economy (multiplier); and all you have to do is hold it for the long run without interrupting it (time).

The line "compound interest is the eighth wonder of the world" is often said to be Einstein's. In fact, it first appeared in advertising by American financial companies in the 1910s and 1920s, and Einstein's name was attached to it only after he died. Still, the idea behind it is right.

Stories of Compounding

NT$1 million a day, or NT$1 on the first day and double it every day after?

Suppose a wealthy person offers to give you money and lets you choose between two options:

• A: NT$1 million a day, every day for 31 days;
• B: NT$1 on the first day, NT$2 on the second, NT$4 on the third... doubling every day for 31 days.

Choose A, and you'll get NT$31 million. Choose B, and the last day alone brings you about NT$1.07 billion; over all 31 days, the total comes to about NT$2.15 billion.

The King and the Wheat on the Chessboard

This story has been told for a very long time. A king wanted to reward a wise man who played chess, and the wise man asked only for wheat: 1 grain on the first square of the chessboard, double that, 2 grains, on the next square, 4 grains on the one after, and so on, doubling all the way until all 64 squares were filled. The king laughed at how little he was asking for and agreed on the spot. Only when they actually started counting did he discover that emptying every granary in the kingdom would not be enough.

Filling all 64 squares takes about 18.45 quintillion grains of wheat. At 30 to 50 grams per thousand grains of ordinary wheat, that comes to roughly 550 billion to 920 billion tonnes, or 650 to 1,200 years of the entire world's wheat harvest.

Both stories teach the same lesson: when it comes to building wealth, time matters more than money. Many people say, "I'll start investing once I've saved up a decent sum." In truth, when you start is what matters most.

Time Is a Multimillionaire Maker

Suppose that from the day a baby is born, the parents put away NT$2,000 a month for the child in an asset with a long-term return of 8%. After 80 years, it will have grown to about NT$146 million. Put away NT$5,000 a month instead, and after 65 years it comes to about NT$115 million.

There's nothing mysterious about this; it's just that few people ever make a point of telling you. One caution: these are nominal amounts. Inflation will eat away at the buying power of that NT$115 million 65 years from now; at 2% inflation a year, it's worth only about NT$32 million in today's money. Even so, small investments started at birth can still give a person a lifetime free of money worries. That is the power of time. (In Chapter V, the section "Long-Term Holding" reruns these numbers using actual historical returns from the US and Taiwan.)

3. The Stock Market

The spirit of the Tao Te Ching is often summed up in a four-character phrase meaning "the great Way is simple" (though the phrase itself never appears in the original text): the principles, patterns and methods behind how things change are usually remarkably simple.

The stock market is the same: most of the information is noise. The most basic facts about the stock market come down to just two:

1. The market rises over the long run: as long as humanity keeps progressing and companies keep making money, the stock market will grow over time.
2. The market moves in cycles: booms and crashes are partners that can't be separated. As André Kostolany put it, "This is an eternal law: every crash and collapse in the stock market is preceded by a boom, and every boom ends in a crash." (Translated from the Chinese edition.)

The point of understanding cycles is not to guess the top and sell at the peak — historical data show that doing so actually costs you over the long run — but to keep from being afraid in a crash, and even to find the courage to add more.

1. Market Cycles

Kostolany's egg theory is a good way to explain the cycle. Stand an egg on end and trace a path around its shell, and you have one complete cycle. Starting from point Y at the very bottom and moving up, trading is quiet at first and few people own stocks. The higher you go, the more people come in and the busier trading gets. At point X, the very top, volume peaks and nearly everyone owns stocks. Then, moving down the other side, more and more people sell, all the way back to point Y, where the fewest people own stocks and volume picks up again — that's the last group of holdouts giving up and selling at a loss. Kostolany's advice is simple: buy at the tail end of a decline, when everyone is most in despair.

If you swap each stretch of the shell for a human mood, it looks roughly like this:

On the three stretches going up, the mood moves from doubt to optimism to euphoria. At first, people are still shaken by the last fall. No one dares touch stocks, and as prices quietly creep up, nobody pays attention. Then the economy improves and companies make money; more and more people come back to the market, and the rise speeds up. In the end, even friends and relatives who never touch stocks are swapping hot stock tips, the fear of missing out (FOMO) overrides everything, and prices have long since run far beyond what the companies are really worth.

On the three stretches going down, the mood moves from disappointment to pessimism to despair. When prices first start to fall, the news still isn't bad; people treat it as a pullback and buy more as prices drop. Then the bad news surfaces, the index falls more than 20% from its peak, a bear market officially begins, and everyone scrambles to get out. At last, with one piece of bad news after another, people lose heart and stop looking at the market altogether — and it's often right then, when nobody is paying attention, that the bear market is coming to an end.

Splitting bull and bear markets into three stages each is an old idea from Dow theory, and John Templeton captured the moods of a bull market in a famous line: "Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria." A word of caution: these stages are clear only in hindsight. When you're living through them, every stage feels like "this time is different." So I don't use this to guess turning points. I use it only to remind myself: when everyone is most in despair, remember to buy a little more.

Peter Lynch's cocktail-party theory takes the market's temperature from the mood at parties. He said that when he told people at a party he was a fund manager, their reactions fell into four kinds:

1. No one is interested; they'd rather talk to the dentist about their toothaches — the market is probably near the bottom.
2. A few people chat with him for a minute and grumble about how bad the market is — the market may be about to recover.
3. A crowd gathers around him, asking which stock to buy — the market has already risen a long way.
4. Now it's the other way around: people tell him which stock he should buy — the market may be overheated.

To put it in today's terms: when someone in your LINE group chat starts posting hot stock tips every day, it's time to cool down.

2. The Pendulum of Emotion

In The Most Important Thing, Howard Marks compares market sentiment to a pendulum. The middle of its arc is the "reasonable" position, but the pendulum almost never stays there. It is always swinging from greed to fear, and from fear back to greed; however high it swings, it eventually swings back.

Jason Zweig, who wrote the commentary for The Intelligent Investor, uses the same image: the market is forever swinging between too much optimism and too much pessimism, and the clear-headed investor is the one who doesn't join in the buying when others are too optimistic, and is willing to step in when others are too pessimistic.

For a family that buys only broad-market ETFs, the pendulum works in one direction only: when it swings to the fear end, that's a chance to buy more; when it swings to the greed end, it's a reminder not to borrow along with everyone else and not to raise your bets. Just keep investing a fixed amount on your usual schedule.

3. Bubbles

What is a bubble? In one sentence: prices overshoot, climbing so high that nothing the asset could ever earn in the future would justify them. When the bubble bursts, everyone rushes to sell, and prices often overshoot on the way down too, falling below what the asset is really worth.

How do bubbles form? Looking back, you'll find that almost every bubble starts from something real: tulips really are beautiful, the internet really did change the world, electric cars really are the future. Precisely because these things are new, no one knows what they should be worth, so there's no limit to what people imagine. Good news follows good news, and the mood moves from half-doubting to hopeful to more and more optimistic, all the way to mania. Then it bursts.

What are people in a bubble thinking? There are many popular lists of these weaknesses of human nature, and the names vary. In my own words, here are a few that show up most often in bubbles:

• Everyone around them is doing it, so their own judgment drowns in the emotions of the crowd (herding and amplification);
• They buy every day and win every day, until they believe the winning will never stop (conditioned response);
• Prices stay high for so long that people come to take high prices for granted (anchoring);
• They know it's too expensive but buy anyway, believing someone else will come along and pay even more (the greater fool theory);
• They hear only what they want to hear and dismiss warnings as noise (cognitive dissonance).

Don't think these are just other people's problems. Once you're caught up in it, anyone can fall for them.

Bubbles in history: the Dutch tulip mania of the 17th century; Britain's South Sea Company and France's Mississippi Company in the 18th century; US stocks in 1929; Japan's stock market in 1989; the dot-com bubble of 2000; the 2008 global financial crisis...

Even someone as brilliant as Isaac Newton lost a fortune in the South Sea Bubble of 1720. Afterward, he is said to have lamented, "I can calculate the motions of the heavenly bodies, but not the madness of people." (This line has been passed down secondhand; there is no firsthand record of Newton himself saying it.)

How bubbles burst: Jeremy Grantham, an investor who specializes in studying bubbles, says that when a "superbubble" bursts, the usual script goes like this: first prices balloon into a bubble, then comes the first leg down; next, a rebound makes people think the bull market is back; and finally, when the fundamentals really do get worse, prices fall all the way to the bottom.

But I have to be honest with you: even an expert like Grantham gets it wrong in real time. In August 2022 he publicly declared that US stocks were partway through a superbubble bursting, and that they would fall further after the bear-market rally. Instead, US stocks were rising again in 2023 and went on to set new highs. I, too, judged in 2024, using the indicators in this book, that Taiwan's stock market bubble was about to burst. Looking back, I was wrong. (Chapter V, in the section "Why I No Longer Sell at the Highs," tells the whole story.)

4. Taiwan's Big Crashes

(Most highs and lows are intraday figures. Figures from 1999 on come from the historical data of the Taiwan Stock Exchange (TWSE); earlier ones come from media reports.)

Every crash felt like the end of the world at the time. Yet so far, Taiwan's stock market has returned to new highs every time: in February 2024 it broke above its 2022 peak, and in October 2026 it rose above 49,000 points. But Japan's stock market took 34 years to get back to its 1989 high; no one can guarantee that every market will recover this quickly.

5. Why Individual Investors Keep Getting Fleeced

Put plainly, individual investors get hurt again and again because they hand the steering wheel to their emotions: they chase prices in excitement when the market rises, and flee in fear when it falls. And the media and all kinds of tips and news are experts at pouring fuel on the fire — when the market is good, rosy visions are everywhere; when it's bad, predictions of doom are everywhere.

Declines rarely happen all at once, either. They usually come in stages, up and down: a bounce lures people in to pick up bargains; another leg down scares them back out. After a few rounds of this, the money has drained away in all the getting in and getting out.

What I do: step back and be a spectator. If you don't play this game of chasing back and forth, it can't fleece you. I don't guess where prices are going; I invest a fixed amount every month with discipline and add more in crashes. That's enough.

6. Two Lessons You Often Hear

The two stories below have circulated online. I can't verify every detail, but the same thing happens all over again after every crash:

• One investor had been a highly paid engineer. When he retired early, he had nearly NT$10 million in stocks and retirement money. Then the 2008 financial crisis struck. Because he had borrowed heavily on margin, his stocks were sold off in a margin call; then he lost his house, and his family broke apart. At seventy, he was getting by on odd jobs and a government old-age allowance, and he kept defaulting on paying for his stock trades.
• Another, an office worker, made more than NT$6 million day trading in 2020, so he quit his well-paid job to day-trade full-time. Within two years he had lost more than NT$10 million and even had to sell his car.

The two have only three things in common: borrowed money, leverage and short-term trading. The market doesn't care one bit how much you once made.

Key Takeaways

1. Look at investing from first principles: compounding = principal, multiplier, time, and stable, unchanging conditions.
2. Broad-market index ETFs meet all four ingredients of compounding at once better than anything else.
3. Time matters more than money: the earlier you start, the better.
4. The stock market rises over the long run, and it also moves in cycles. Understanding the cycles is about not being afraid in a crash and daring to add more, not about guessing the top and selling.
5. Bubbles keep happening, but even experts get it wrong in real time. Don't borrow, don't use leverage, don't trade short-term.