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Prologue: Early Lessons

I learned some real good lessons in the barbershop.

Back in Lake Providence, Louisiana, where I grew up, my family would go to town on Saturday mornings so that Mama could run her errands and Dad could go to the barbershop for his weekly big lather shave. It was a small place with a few chairs and lots of mirrors, and a red-and-white barber pole out front. Dad would lie there in the reclining leather chair as the barber covered his face in hot towels before soaping him up and running a straight razor along a leather strop to sharpen it. While he lay there relaxing—this was a very relaxing way to spend the morning—Dad would talk with our neighbors from the cotton patch who also stopped by the barbershop on Saturday mornings. They would socialize, talk about the price of cotton, soybeans, and corn and about the weather, especially at high-water time. I’d sit there listening to them telling war stories and discussing crop methods and yields. Sometimes they’d debate whether to sell forward their crops just in case the price dropped before harvesttime in the fall.

It was at the barbershop in Lake Providence where I learned the fundamental concept of hedging.

The big dilemma for cotton planters like Dad was that they had to risk money in the spring to plant their cotton without any idea what the price would be after picking it in the fall. If prices went in their favor, they would make enough to get through the winter. If prices went against them, they would either have to convince the local banker to risk his depositors’ money to give them another year to try, or pack up and find another way to make a living. So what many farmers did was “sell forward,” meaning that they would negotiate a price with the cotton merchants in the spring for all or part of their crop in the fall. By passing the risk of dropping prices onto the merchants, the seller was losing the opportunity that, say, too much rain or not enough rain somewhere in the world would send prices climbing. But selling forward guaranteed there would be more revenue-in than costs-out. That is, as long as they physically brought the crop in; but, considering how they could get slammed by a Mississippi River flood or a plague of Mexican boll weevils, this was not always guaranteed.

One year, when all the barbershop talk was how, come fall, prices were going to rise, Dad felt particularly optimistic and decided to hold on to most of our crop rather than sell it forward. But it turned out to be an awful year and the losses we took were a big part of the reason we had to sell our white painted house with running water in town and move into an unpainted clapboard cabin with no running water or electricity out on the Island Plantation. The cash from the house sale helped pay down our debt on the land and, like Scarlet O’Hara in Gone with the Wind, we’d do anything to hold on to the land.

If we had hedged the entire crop, we never would have had to leave Lake Providence, because the hedge would have been like an insurance policy to reduce loss from the manic mood swing of the market. It was a lesson I never forgot.

When I was seven, Mama opened a savings account in my name, made the first deposit of a few dollars, and said that it was for my college education. I did not understand how only a few dollars could pay for college, so Mama explained that if I put money into the account on a regular basis, it would grow in two ways. One, by the sheer fact that I was saving it rather than spending it on Cokes and movies; and, two, because the bank would be paying me to keep my money there. I figured out for myself a third benefit: the more I put into the account, the more I’d get from the bank.

As I got older I poured everything in—the 75 cents an hour I earned working construction and the $1.35 an hour I made laying a pipeline in the oil fields—and even though I can’t recall Mama ever using the term “compound interest,” I knew what it was by watching my savings grow over the years.

Saving money and preserving interest earnings were fundamental principles that came home to me when I was in high school. I saw in my math book that if the Canarsee Indians who sold Manhattan Island to the Dutch for $24 had invested that money at 6 percent for 300 years, they would have $1.2 billion. If they’d left it invested, today it would be $145 billion.

When Albert Einstein attended a press conference after he won the Nobel Prize, a reporter asked him, “What is the strongest force in the universe?”

He smiled and replied, “Compound interest.”

All the journalists laughed.

But as every successful investor from neophyte to hedge fund manager knows, the greatest mind of the twentieth century was only half kidding.

Copyright © 2008 Sam Wyly