Charlie Munger: Stock market as a pari-mutuel betting system
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.—Charlie Munger, "Art of Stock Picking"
Although I don't share the same views on politics, I am probably closer to Charlie Munger than Warren Buffett when it comes to how we view the world. Warren Buffett is almost singly focused on business and investing, and is not very opinionated, indeed possibly not knowledgeable, in other areas. In contrast, I am closer to Charlie Munger in the sense that I have diverse interests—you can probably tell by the articles I link to or write about—and have an opinion on almost anything. There is one big difference though: I am not into the field of psychology quite like Munger.
So it may be surprising to see me rarely talk about Charlie Munger, given my suggestion that I'm somewhat similar to him. Partly it's because Munger doesn't give many interviews and rarely talks specifically about current market events, specific stocks, and so forth. Overall, though, I suspect I don't cover him much because I already share some of his thinking. As crazy as this may seem, I actually tend to cover dissenting views more than views identical to mine. For instance, I have been bearish on commodities for years and have no reason to cover commodity bulls. Yet, I often cover Jim Rogers. I also disagree with Jim Rogers' prescriptions for the economy based on Herbert Hoover's playbook but I still give space to Rogers.
When I do cover Munger, it is generally on very important topics with insightful thoughts. For instance, one of my recent posts dealing with Charlie Munger's suggestion of derivatives such as CDS swaps as being similar to bucket shop operations has radically altered my views. In a similar manner, I feel the subject matter I will cover in this post is very important. Even if you don't share my view or don't find what I am about to say interesting, do read some of the referenced works below. If you are a newbie, "Art of Stock Picking" by Charlie Munger is a must-read at some point in your life.
I'm sure what I will write will seem trivial to some, and the article is old, but it changed my thinking and hopefully some who started out investing recently will find my thoughts worthwhile.
Art of Stock Picking
I read "Art of Stock Picking", an undated speech by Charlie Munger, several years ago, and it completely changed my investment thinking. The speech is quite interesting, and in true Munger form, doesn't hold back any punches.
The section that was very influential—at least for me—was Munger's proposition that the stock market is a pari-mutuel betting system. It's a subtle notion and I never looked at the market like that, until I read his thoughts. I took some finance courses in university (it wasn't my major) and it's amazing to me, speaking in hindsight, that I never encountered anyone presenting the market quite like that.
Before I say go into detail, if you are interested in a brief overview of Munger's thoughts, you can also find them, starting on page 30, in The Evolution of the Idea of "Value Investing": From Benjamin Graham to Warren Buffett, by Robert Bierig (April 2000). This essay by Robert Bierig runs down value investing over the years.
Pari-Mutuel Betting System
I'm going to be quoting extensively since it is important to get the thoughts from the source. I hope this doesn't violate some fair-use law or something. (As is usually the case on this blog, all bolded or highlighted text within quotes are by me. I made some slight edits with spacing.)
What is a pari-mutuel betting system? It is a betting system that is used in horse racing, among other activities, which involves pay-offs based on the total pool. An important element of it—this is what I found important for the stock market—is that the odds change based on the bets. Here is Charlie Munger introducing the concept:
Everybody goes there [horse track using pari-mutuel betting system] 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.
Insight 1: Odds Constantly Change and Best Bet Never Obvious
The most important point to note is that the odds constantly change, just like the stock market. You can't go and invest in the company that appears best because the odds for that will be worse than a distressed company. As most stockpickers quickly find out, the divergent odds really makes a simple scenario very complex. I think value investors quickly understand this notion but many newbies, not to mention certain types of growth investors, really don't understand this.
Insight 2: House Takes A Cut—No Matter What Happens
Another important point is that the stock market, like the horse betting scenario, involves the house taking a cut off the top. The 17% in horse racing seems onerous but, fortunately, the commissions/fees/etc in common stock investing is usually in the 1% to 3% range. Nevertheless, if you want to beat the passive index, which is the goal of many (in addition to possibly posting absolutely positive returns), you need to overcome that. It is very difficult to beat the market by even 2% in the long run so one should attempt to minimize what the house takes from you.
It is also important to realize that, like horse racing, the house takes its cut even if you lose money. When you buy a stock, you pay a commission even if your investment turns out to be a dud; if you buy a mutual fund or an ETF, you pay an MER (management expense ratio) even if the fund lost money.
Characteristics of a Winner
Does anyone make money in horse racing? Munger mentions one person who made a living off it:
I used to play poker when I was young with a guy who made a substantial living doing nothing but bet harness races.... Now, harness racing is a relatively inefficient market. You don't have the depth of intelligence betting on harness races that you do on regular races. What my poker pal would do was to think about harness races as his main profession. And he would bet only occasionally when he saw some mispriced bet available. And by doing that, after paying the full handle to the house ‑ which I presume was around 17% ‑ he made a substantial living.
You have to say that's rare. However, the market was 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. It's efficient, yes. But it's not perfectly efficient. And with enough shrewdness and fanaticism, some people will get better results than others.
I bolded two elements that I feel are important to success in investing.
Winning Trait 1: Investing Should be Treated as a Profession
Firstly, like the guy who actually won at harness betting, you need to treat investing as a profession. This goes back to what Benjamin Graham said of enterprising investors—you have to be committed and work at it. This doesn't necessarily mean you need to work on it from 9 AM to 5 PM, but it does mean that you need to be committed—perhaps as your main "hobby".
Not everyone can turn investing into a profession due to various reasons—family, work, social life, etc—but I think this is a minimum condition. These people are making the right decision by staying away from investing. Even Benjamin Graham recognizes this fact and spends 1/3 to 1/2 of The Intelligent Investor on strategies for the 'defensive investor'. For most people, opportunity cost of trying to invest on their own is too high. For instance, if you have a good, professional, job, you can probably make more money climbing your career ladder than through investing. Similarly, if you were an entrepreneur, instead of spending time reading up on the stock market or individual stocks, you will probably make more money pursuing your entrepreneurial ideas. Some may also benefit far more from raising kids than spending time on investing and trying to make a bit more.
Some can probably perform above average by coattailing on superinvestors or selecting the right money managers, but they just won't be great investors (and I'm not sure what they will do when the superinvestors pass away or quit the business.) I actually think newbies, especially if you have a small portfolio, should stay away from blindly investing in the same things that superinvestors are buying. I see some bloggers, who are dedicated amateur investors, own basically what Edward Lampert or Warren Buffett or Mohnish Pabri own. Not just one or two positions but, like, 90% of their portfolio are from others. Nothing wrong with looking at the superinvestors but are they investing based on their own analysis or because someone else did the analysis? For example, I see many have high confidence in their estimates of intrinsic value of Coca-Cola. But are they getting their confidence from their own analysis or because Buffett owns it? How come I never see the same guys & gals ever saying anything about Pepsi or having high confidence in the estimate of its value?
Although some would disagree with me, I think the goal of amateurs who are starting out, especially if they have a small portfolio, should be to learn how to invest successfully, and not how to make money. (If you have a large portfolio, or are closer to retirement, then it is a different story.) One who blindly buys all of Warren Buffett's picks will probably outperform, at least for a decade, someone who buys only a few of Buffett's picks and tries to find others on his own. But I suspect the latter will probably be better off in the long run.
Winning Trait 2: Invest Infrequently
The winners bet infrequently. Munger reiterates this point:
And the one thing that all those winning betters in the whole history of people who've beaten the pari-mutuel system have is quite simple. They 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 be that they can occasionally find one.
And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple.
That is a very simple concept. And to me it's obviously right based on experience not only from the pari-mutuel system, but everywhere else....
So 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. And you're probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It's just that simple.
When Warren lectures at business schools, he says, "I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches ‑ representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all."
He says, "Under those rules, you'd really think carefully about what you did and you'd be forced to load up on what you'd really thought about. So you'd do so much better."
I basically became a concentrated investor after reading what Buffett said and Munger's comparison of investing to a pari-mutuel betting system. This basically changed my investing life. It doesn't mean it will lead to success; indeed, a concentrated bet on Ambac wiped out many years of profits. Besides, only a few people succeed and I might be the most incompetent investor in Toronto ;) But it does likely mean that if I sink, it will be while flying the flag of concentrated investing.
I think Buffett is right in saying that people will think differently if they only picked, say, 20 stocks in their life (this idea does not apply to special situation investing IMO.) Picking 20 stocks in your life is almost like picking one stock per year! I think most people will die of boredom if they did that—not to mention the fact that half the brokerages will end up declaring bankruptcy ;). I certainly think a lot more about a few ideas than I used to.
I think if you pursue concentrated investing, the most important element is the margin of safety. It is extremely critical for concentrated bets. Unfortunately, the difficulty, at least from my experience, is that newbies like me have a hard time valuing companies. This means that our estimate of margin of safety is not very solid.
To finish off, let me quote some more from Munger's speech:
All right, we've now recognized that the market is efficient as a pari-mutuel system is efficient with the favorite more likely than the long shot to do well in racing, but not necessarily give any betting advantage to those that bet on the favorite.
In the stock market, some railroad that's beset by better competitors and tough unions may be available at one-third of its book value. In contrast, IBM in its heyday might be selling at 6 times book value. So it's just like the pari-mutuel system. Any damn fool could plainly see that IBM had better business prospects than the railroad. But once you put the price into the formula, it wasn't so clear anymore what was going to work best for a buyer choosing between the stocks. So it's a lot like a pari-mutuel system. And, therefore, it gets very hard to beat.
As nicely put by Munger, the market is fairly efficient and generally prices things such that the long-shot is no worse than the expected winner.
The odds constantly change and the house always takes a small cut. If you invest, you better make sure that you can overcome the house's cut—commissions, fees, etc—and that your investment is actually worth investing in. The majority of the time the odds aren't attractive enough to invest. So it is best to make large bets on the few cases that you do find exceptionally attractive. Ideally, you should also treat investing as a profession and put in the work.