Buffet on investing
The first question one must address when examining the theory of investing in common stocks is: What is the nature of the stock market? As is well-known, the fundamental assumption of modern finance theory is that the stock market is efficient. Munger asks whether the stock market is so efficient that people cannot 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.”83 Of course, the average result must be the average result; it is impossible for everyone to beat the market. In Munger’s view, “the answer is that [the market is] partly efficient and partly inefficient.”84 Or, in Buffett’s words, “observing correctly that the market was frequently efficient, [finance professors] went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.”85 The model preferred by Buffett and Munger – to simplify the reality of what actually occurs in the market for common stocks – is the pari-mutuel system at the race track. At first, this idea may sound bizarre, but “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.”
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As Munger explains, anyone 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.”87 Under these conditions, it is no longer clear which is statistically the best bet based on the mathematics of probability. That is, the prices change such that it becomes quite difficult to beat the system. Further, the racetrack then takes an additional 17 percent off the top. Therefore, a bettor not only has to outsmart all the other bettors – but he or she must outsmart them by such a wide margin that on average that bettor can afford to take 17 percent of his or her gross bets off the top and give it to the house. It is still possible, given those mathematics, for a few people to beat the odds.
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After all, mere intelligence gives an edge because many gamblers know nothing about horses and just bet lucky numbers and hunches. Therefore, a person who strictly thinks about horse performance and nothing else could indeed have a significant edge – at least if it were not for the “frictional cost” caused by the house’s take. Of course, it is quite rare that someone actually does earn a substantial income from betting on the races. However, the market is not perfectly efficient. “And if it weren’t for that big 17% handle, lots of people would regularly be beating lots of other people at the horse races,”
remarks Munger. “It’s efficient, yes. But it’s not perfectly efficient. And with enough shrewdness and fanaticism, some people will get better results than others.”88 Munger then draws a parallel to the stock market, noting that the dynamics are the same – except that the house handle is far lower. He argues that transaction costs (the spread between the bid and the offer plus the commissions) are fairly low – as long as one does not trade too actively. So “some of the shrewd people are going to get way better results than average in the nature of things. It is not a bit easy . . . . But some people will have an advantage.”89 Faced with this model, Buffett and Munger asked themselves years ago how one becomes a winner rather than a loser, in a relative sense. As Munger says, the pari-mutuel system provides the key: all the winning bettors bet very seldom. “It’s not given to human beings to have such talent that they can just know everything about everything all the time. ******But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one.”90 Moreover, the wisest people are those who bet heavily when the odds are in their favor – and the rest of the time they simply do not bet at all. *******
Very few investors actually operate in the manner described by Munger. But the managers at Berkshire Hathaway do operate that way. Their insight is that “you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced something or other.” Even Warren Buffett is not smart enough to find thousands of such opportunities in a lifetime. But when he does see one, he makes a very large commitment.
For example, Buffett observes that “Bill Gates will understand a lot of businesses that I don’t understand. Actually, I know something about his investments – and he invests in things that he understands. And more power to him. I just don’t happen to understand those businesses. So he will have a universe that’s different from my universe.” The essential message is this: As long as an investor can identify a handful of “mispriced bets” available in the stock market, that investor should come out well in the long run. Even if Buffett does not “understand” technology or does not have any special insights in that sphere, other “value investors” are in fact capable of “understanding” technology and having insights. And there is simply no reason why these investors should not prosper in a technology-driven environment.
The first question one must address when examining the theory of investing in common stocks is: What is the nature of the stock market? As is well-known, the fundamental assumption of modern finance theory is that the stock market is efficient. Munger asks whether the stock market is so efficient that people cannot 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.”83 Of course, the average result must be the average result; it is impossible for everyone to beat the market. In Munger’s view, “the answer is that [the market is] partly efficient and partly inefficient.”84 Or, in Buffett’s words, “observing correctly that the market was frequently efficient, [finance professors] went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.”85 The model preferred by Buffett and Munger – to simplify the reality of what actually occurs in the market for common stocks – is the pari-mutuel system at the race track. At first, this idea may sound bizarre, but “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.”
****
As Munger explains, anyone 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.”87 Under these conditions, it is no longer clear which is statistically the best bet based on the mathematics of probability. That is, the prices change such that it becomes quite difficult to beat the system. Further, the racetrack then takes an additional 17 percent off the top. Therefore, a bettor not only has to outsmart all the other bettors – but he or she must outsmart them by such a wide margin that on average that bettor can afford to take 17 percent of his or her gross bets off the top and give it to the house. It is still possible, given those mathematics, for a few people to beat the odds.
****
After all, mere intelligence gives an edge because many gamblers know nothing about horses and just bet lucky numbers and hunches. Therefore, a person who strictly thinks about horse performance and nothing else could indeed have a significant edge – at least if it were not for the “frictional cost” caused by the house’s take. Of course, it is quite rare that someone actually does earn a substantial income from betting on the races. However, the market is not perfectly efficient. “And if it weren’t for that big 17% handle, lots of people would regularly be beating lots of other people at the horse races,”
remarks Munger. “It’s efficient, yes. But it’s not perfectly efficient. And with enough shrewdness and fanaticism, some people will get better results than others.”88 Munger then draws a parallel to the stock market, noting that the dynamics are the same – except that the house handle is far lower. He argues that transaction costs (the spread between the bid and the offer plus the commissions) are fairly low – as long as one does not trade too actively. So “some of the shrewd people are going to get way better results than average in the nature of things. It is not a bit easy . . . . But some people will have an advantage.”89 Faced with this model, Buffett and Munger asked themselves years ago how one becomes a winner rather than a loser, in a relative sense. As Munger says, the pari-mutuel system provides the key: all the winning bettors bet very seldom. “It’s not given to human beings to have such talent that they can just know everything about everything all the time. ******But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one.”90 Moreover, the wisest people are those who bet heavily when the odds are in their favor – and the rest of the time they simply do not bet at all. *******
Very few investors actually operate in the manner described by Munger. But the managers at Berkshire Hathaway do operate that way. Their insight is that “you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced something or other.” Even Warren Buffett is not smart enough to find thousands of such opportunities in a lifetime. But when he does see one, he makes a very large commitment.
For example, Buffett observes that “Bill Gates will understand a lot of businesses that I don’t understand. Actually, I know something about his investments – and he invests in things that he understands. And more power to him. I just don’t happen to understand those businesses. So he will have a universe that’s different from my universe.” The essential message is this: As long as an investor can identify a handful of “mispriced bets” available in the stock market, that investor should come out well in the long run. Even if Buffett does not “understand” technology or does not have any special insights in that sphere, other “value investors” are in fact capable of “understanding” technology and having insights. And there is simply no reason why these investors should not prosper in a technology-driven environment.
