The Principle of Cumulative Advantage

“The snowball just happens if you’re in the right kind of snow, and that’s what happened with me. I don’t just mean compounding money either. It’s in terms of understanding the world and what kind of friends you accumulate. You get to select over time, and you’ve got to be the kind of person that the snow wants to attach itself to. You’ve got to be your own wet snow, in effect. You’d better be picking up snow as you go along, because you’re not going to be getting back up to the top of the hill again. That’s the way life works.”

I was re-reading Alice Schroeder’s “The Snowball” (Official Buffett biography) and this paragraph really stood out to me as the principle that Buffett has based his life around. It is a sociological idea called cumulative advantage, also known as “The Matthew Effect”, so named from this passage taken from the Gospel of Matthew

‘For unto every one that have shall be given, and he shall have abundance; but him that have not shall be taken, even that which he have.’ Matthew 25: 29

In layman’s terms, this is oft quoted as the rich get richer and the poor get poorer or that having an advantage tends to lead to an even bigger advantage.

Business

Ceteris Paribus, large companies with economies of scale have an advantage over small ones, leading to lower fixed costs of production per unit volume. This means that they can also lower their prices while still maintaining decent return on capital and profit margins, while also taking market share from companies who cannot afford to compete at those rates or costs of production. However, this may not be the only advantage gained – large companies may be able to borrow at lower interest rates. Even more money flows down to the bottom line, and maybe they spend this extra money on advertising to gain even more customers. I’m not saying all large companies are superior to smaller ones, only that there are situations where a company can acquire a cumulative advantage in this manner.

Businessmen and investors like Warren Buffett have had the advantage of their reputation, track record and wealth to be offered deals that nobody else gets, and have access to connections that could tilt the scales in their favour. While Buffett has been the gold standard for CEOs while running Berkshire, others could exploit this advantage to line their own pockets or gain power merely to satisfy their own ego.

Investing and Wealth Creation

What is compounding if not cumulative advantage? Everyone who is introduced to compounding is shown graphs that illustrate how starting earlier leads to a larger retirement corpus. Money is inherently prolific – the more you have, the more you can invest to earn even more money. Again, Buffett is a prime example of this – he started early and was able to build wealth over a lifetime of compounding, the bulk of his fortune being achieved towards the latter half of his life.

Warren Buffett Net Worth by Age

That’s not all: while an average person has to work for money, a wealthy individual can generate the same income off his assets. Take Person A with a corpus of 1 million. If person A were to generate 10% returns on those funds, he would have added 100,000 to his net worth in a single year, and be able to make 110,000 the next year with the same rate of return assuming he reinvested it. A similar person B who did not have those assets would have to work to generate an equivalent income. Meanwhile Person A could work, operate a business, write a book, travel or spend his time however he saw fit, a luxury that Person B does not have. It is quite likely that this gap would only widen over time hence the tendency for the rich to get richer and wealth inequality to widen.

Education and Learning

Educational Psychologist Keith Stanovich’s research describes a phenomenon in which early success in reading skills usually leads to later successes in reading as the learner grows, while failing to learn to read before the third or fourth year of schooling may be indicative of lifelong problems in learning new skills. Human beings naturally tend to shy from things that they are not good at, thus those who fall behind in reading read less, increasing the gap between them and their peers. Later, when students need to “read to learn” (where before they were learning to read), their reading difficulty creates difficulty in most other subjects, causing a much higher drop out rate.

Matthew effect in reading

Taking this idea one step further is Charlie Munger’s idea of being a learning machine and applying multidisciplinary thinking. Not only does this enhance problem solving ability, avoid errors due to the Dunning Kruger effect and improve general awareness, but will also lead to the person being better at chosen vocation or something like investing (leading to more money), and likely spur further interest in reading and learning. It is a positive feedback loop at its best.

Conclusion

In a world with limited resources, competition is inevitable and Darwin’s laws apply. Every agent, from individuals to nations are seeking an edge which will give them an advantage. We should understand that advantages tend to stack and the gap between someone with cumulative advantage on their side and someone without is likely to be exponential, not linear, i.e a lollapalooza. It is up to us then, to build our own personal snowball – by developing our human capital as well as our investment capital. We only get to stand on the top of the hill once.

Advertisements

One thought on “The Principle of Cumulative Advantage

Please share your valuable thoughts

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s