Wednesday, 22 February 2012

Stock Picking Philosophy from Charles Munger - Part 3

The following came from a 1994 article by Charles Munger, best known as one of the lead Berkshire Hathaway investors with Warren Buffett.

As a warning, its very long and talks about a lot of topics from role of math and psychology, business management, stock picking, etc but its very informative.

I've picked out a few more juicy paragraphs from it but if you have time, make sure to read it.  I've broken it up into several smaller chunks that I found interesting and will post them out over a few days.

Source: (Courtesy: The Big Picture)
Charles Munger, USC Business School, 1994
A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business

See Part 1 - Value Investing
See Part 2 - Fewer But Bigger Bets
See Part 3 - Efficient Market Hypothesis & Race Tracking Betting Model
See Part 4 - Advantages & Disadvantages of Scale
See Part 5 - Bureaucracy & Yes Men
See Part 6 - Efficiencies & Profitability Differences from Competition
See Part 7 - Negative Effects of Technology on Business Profits
See Part 8 - Focusing on Your Competitive Edge & Follies of Investment Management
See Part 9 - Sector Rotation & Yearly tax avoidance
  • Inefficiency of efficient market hypothesis
The first question is, “What is the nature of the stock market?” And that gets you directly to this efficient market theory that got to be the rage—a total rage—long after I graduated from law school.

And it’s rather interesting because one of the greatest economists of the world is a substantial shareholder in Berkshire Hathaway and has been for a long time. His textbook always taught that the stock market was perfectly efficient and that nobody could beat it. But his own money went into Berkshire and made him wealthy. So, like Pascal in his famous wager, he hedged his bet.

Is the stock market so efficient that people can’t beat it? Well, the efficient market theory is obviously roughly right—meaning that markets are quite efficient and it’s quite hard for anybody to beat the market  by significant margins as a stock picker by just being intelligent and working in a disciplined way.

Indeed, the average result has to be the average result. By definition, everybody can’t beat the market. As I always say, the iron rule of life is that only 20% of the people can be in the top fifth. That’s just the way it is. So the answer is that it’s partly efficient and partly inefficient.

  • Race track betting as a model for stock market
The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it’s very hard to beat the system.

And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you’ve got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work.
Given those mathematics, is it possible to beat the horses only using one’s intelligence? Intelligence should give some edge, because lots of people who don’t know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical could have a very considerable edge, in the absence of the frictional cost caused by the  house take.

Unfortunately, what a shrewd horseplayer’s edge does in most cases is to reduce his average loss over a season of betting from the 17% that he would lose if he got the average result to maybe 10%. However, there are actually a few people who can beat the game after paying the full 17%.

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