Picture a 5-Star Michelin restaurant. A chef whose face anyone would recognise, and his team of dedicated cooks. They’ve got the best kitchen and tools a culinary craftsman could ask for. Loyal to his notoriously high standards, the cook pours his soul into the cooking process, and his team execute his orders with masterful skill.
The food is finally served to an eager table of patrons. And it tastes… disappointing.
How could this possibly be?
Answer: The Law of Source and Derivation
We’ve all heard about the Law of Cause and Effect in one way or another. In school, we learned it as the third law of Newton’s Laws of Motion.
“For every action, there is an equal and opposite re-action”.
Isaac Newton
There is not a single physical entity in the universe that defies this law, and most of us have learned to respect and obey it. We stay out of the way of moving cars. We keep our backs straight when we lift heavy objects. If Mike Tyson throws a fist at us, we dodge (if we can).
However, there is another equally powerful law that is often overlooked and disobeyed by people, causing them endless stress, confusion and discontent. It is related to the Law of Cause and Effect but it is much subtler and easier to miss because it doesn’t operate on the physical plane and therefore can’t be seen.
This law is often the Achilles’ Heel of even some of the smartest people we know.
It’s called the Law of Source and Derivation. It states:
“A change in the source must result in change in the derivative. But a change in the derivative does not necessitate a change in the source”
I’ve taken the liberty of naming and defining this law, but I it can be easily understood through personal experiences and the examples below.
A derivative is simply a thing that comes from, or is made from, another thing, the source. It is different from the Law of Cause and Effect because the source does not actively cause the derivative to be made or happen.
i.e – a cup of orange juice (derivative) comes from oranges (source). But the oranges don’t cause the creation of orange juice.
To continue the illustration above, the reason that the food (derivative) produced by the best chefs in the world with the best tools in the world was disappointing is because the ingredients (source) were substandard. No matter the skill of the chef or the sophistication of the tools, the derivative cannot be disassociated from the source.
To change the food, the ingredients must change. But changing the food (by eating it) doesn’t change the ingredients that were used.
The mistake that people often make is that they will try to change the derivative without changing the source.
- Everyday, doctors prescribe pills and conduct surgeries to treat the symptom (derivative) without addressing the cause (perhaps a bad diet, or lack of exercise). If the source isn’t changed, the symptoms keep returning.
- Some middle-aged women try to achieve glowing skin (derivative) by applying the right cosmetics and gels, without addressing the natural source of glowing skin, which is youth and health (Youth can’t be changed, but health can). Artificially achieving glowing skin via cosmetics won’t affect your health, but improving your health will affect your skin.
- Some workers demand higher pay (derivative) without changing the amount of value that they contribute to the company (source). Raising someone’s salary doesn’t necessarily mean he or she will suddenly contribute more to the company, but increased contribution will naturally raise his salary over time.
Constantly trying to change the derivative while ignoring the source keeps people on a perpetual death-loop of frustration and confusion. Any result that they achieve will be temporary because the fundamental source of it remains unchanged.
So what should we do?
Follow the Chain of Derivation and Optimise for the Primary Source
There are always multiple layers to the source-derivative relationship. The source of the derivative is often a derivative itself and has its own source.
(Final Derivative) Z –> Y –> X –> W –> V (primary source)
To illustrate, we can use a simple exercise called “comes from“.
(Final Derivative) High salary ‘comes from‘ –> Increased contribution ‘comes from‘ –> Higher productivity ‘comes from‘ –> Increased skill ‘comes from‘ –> Personal development ‘comes from‘ –> Personal beliefs (Primary Source)
We could go further and further down the proverbial ‘rabbit hole’, but as you go further down the chain of causation the association between the source and the final derivative becomes weaker since every derivative can potentially have multiple sources. The time for the change in the source to reach the ultimate derivative also takes longer. Like ripples on the water, the outer ripples get weaker as it goes further out.
The ‘primary source’ is your ‘true north’. It is the optimal source that balances the level of association and effect toward the ‘final derivative’. In other words, if you change the primary source, you’re confident you’re going to get the change you want in the final derivative in the time frame that you want.
I used the above to illustrate, but often it’s not necessary to go so many levels deep. 2 or 3 levels will often suffice.
Here’s the important part – Once you find the ‘primary source’, optimise for that and ignore the derivative. The change might not be as quick as you want, but it will be more permanent. The Law of Source and Derivation will take care of the rest for you.
If you have any kind of problem in your personal life or business, it will be useful to do the ‘comes from’ exercise. I recently did this for myself, and discovered that no matter what the problem is, the ‘primary source’ of it usually came down to myself. This can be intimidating to think about, but it also gives you a lot of power since you are also the source of the solution to your problems.
Cash Flow is a False King. Discover the Your Real Estate True North
As discussed, it’s all about what you optimise for. If you optimise for the final derivative, you’ll be perpetually frustrated because the problem will keep returning. If you optimise for the primary source, you’ll eventually get a more permanent solution and enjoy the ‘ripple effect’ in other areas too.
I see many real estate investors and developers saying that “Cash flow is king”. This is an extension of the idea that real estate is a vehicle to reach ‘financial freedom’, where your passive income exceeds your expenses and you technically don’t need to work anymore.
The idea of financial freedom is very alluring, and I think we should all strive to achieve it. It allows people the freedom to do what they really want to do in life without being constantly constrained by the dollar bill.
But it also carries with it the risk of selling a false target. Financial freedom itself is great, but it’s a derivative in itself, and should not be the target of optimisation.
If you are purely optimised for ‘financial freedom’, you will be tempted to leverage your portfolio to the max, as long as your net cash flow is positive for each asset. Eventually you will have a large number of assets in your portfolio producing great cash flow and making you ‘financially free’.
Sounds great at first glance, but the fact remains that you still ‘own’ very little equity in your portfolio. The lenders essentially own your portfolio, and it could all fall like a house of cards if the market turns or, let’s say, a global pandemic happens (nervous laughter).
Alternatively, you could adopt a strategy where you ‘own’ nothing but still generate cash flow, such as rent-to-rent. With R2R, you rent properties at price X and rent it back out on a short-term or long-term basis at a higher price Y. Many people were living the dream of financial freedom based on this strategy, until they suddenly weren’t.
I believe that the key is to take a lesson from one of the great value investors, Warren Buffet, and look bigger and longer-term beyond simply ‘financial freedom’.
In 1996 Buffet wrote and distributed a document called “An Owner’s Manual”, in which he says:
Our long-term economic goal is to maximise Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis.
Warren Buffet
Roughly translated into property terms relevant to us, his long-term game plan is to maximise the acquisition of equity.
He has a number of other principles that go in tandem with this, but fundamentally speaking, ‘long term equity gain’ is his one primary source. He believes all of the other businesses successes comes from acquiring intrinsic value.
Cash flow is ultimately a derivative of equity. You could argue that it’s possible to generate cashflow without owning equity, but ultimately, the asset has to exist and hold intrinsic value for cash flow to come from it.
Cash flow without equity is like building a beautiful house on sand. It can stand for a while, but you never know when it will fall.
In other words, cash flow is not king. Equity is king, and cash flow is the prince.
At EPIC, we’ve adopted a similar approach toward long-term equity maximisation. This is our true north. This doesn’t mean that we disregard cash flow, but if we need to sacrifice cash flow in the short term in order to maximise equity in the long term, we’ll do it.
A simple example of this would be choosing between ‘interest-only’ loans vs the conventional ‘interest and principal’ loans. Although interest-only loans usually optimises greater cash flow in the short term, the latter optimises for longer-term equity gains.
Ironically, in the long-term, optimising for equity can also creates greater cash flow since you won’t have much interest on debt to pay. Optimise for the primary source, not the final derivative.
P.S: Going Down the Rabbit Hole and Seeing the Face of God
I previously mentioned the deep ‘rabbit hole’ you could go down if you continue with the “comes from” exercise.
Quite unrelated to the rest of the article, but as a fun exercise let’s begin with yourself as the ‘final derivative’ and go as deep as we possibly can down the hole. You are a derivative of your parents, and they are the derivative of their parents, and so on until the first human being in existence.
But what if you went even deeper?
Whether you believe in the Christian version of God or not is irrelevant (I personally don’t), the result is equally extraordinary.
If you are Christian, or a different kind of monotheist, you will follow the chain of derivation until you see the face of God (the ‘first source’).
If you are an atheist and believe in the Big Bang, you’ll follow the chain of derivation until you come to the conclusion that we are simply evolved heat, light and energy, since that’s all there was in the beginning.
Just some food for thought.
In conclusion, the Law of Source and Derivation would say:
If God (source) changed, the Universe (derivative) would change. If the Universe changed, God would not change.