Tuesday, December 29, 2015

Munger on Efficient Markets, Indexing, & Stock Pickers

Charlie Munger said the following at the 2015 Daily Journal (DJCO) shareholder meeting:*

If all you had to do was figure out which companies were better than others, an idiot could make a lot of money. But they keep raising the prices to where the odds change.

I always knew that. They were teaching my colleagues that the stock market was so efficient that nobody could beat it....I knew it was bull. When I was young I never went near a business school so I didn't get polluted by the craziness.

[laughter]

I never believed it. I never believed there was a talking snake in the Garden of Eden. I had a gift for recognizing twaddle, and there's nothing remarkable about it. I don't have any wonderful insights that other people don't have. I just avoided idiocy slightly more consistently than others.

Other people are trying to be smart; all I'm trying to be is non-idiotic. I've found that's all you have to do to get ahead in life, be non-idiotic and live a long time. It's harder to be non-idiotic than most people think.

Later at the same meeting, he also had the following to say about indexing and stock pickers...

In the world as it is, indexing has gained a lot. It probably should have gained a lot, because it's quite rational. It's bad for a lot of people who would otherwise be earning money as stock pickers. It probably should have been bad for those people.

Money earned alongside investors isn't the problem. It's when, all too often, the money manager does well mostly from fees collected over time whether or not the average investor in a particular fund does well. Naturally, a money manager will do even better when the fund they manage performs well. So the incentives would seem aligned. Yet the range of outcomes for the investor putting money at risk, in most cases, is far different than that of a money manager. An equity investor generally has plenty of downside risk. With most fee arrangements that's just not the case for a money manager. Exceptions no doubt exist but the range of outcomes of a typical money manager -- often without the need to put their own capital at risk --  is usually good or better.

If you stop to think about it, civilized man has always had soothsayers, shamans, faith healers, and God knows what all. The stock picking industry is four or five percent super rational, disciplined people, and the rest of them are like faith healers or shamans.

And that's just the way it is, I'm afraid. It’s nice that they keep an image of being constructive, sensible people when they're really would-be faith healers. It keeps their self respect up.

Worse yet, it turns out many market participants don't even gauge their own performance objectively.

In fact, a study of investors showed that they overestimated "their returns by more than 11 percentage points per year. The average investor painfully lags an index fund and thinks he's Warren Buffett, basically."

Surprising? I certainly think so. That's why it likely deserves careful consideration:

"The thing that doesn't fit is the thing that's the most interesting, the part that doesn't go according to what you expected." - From The Pleasure of Finding Things Out by Nobel Prize winning physicist Richard Feynman

In other words, this particular bias -- like most -- may not be just someone else's problem.** So it's probably, at a minimum, not a bad idea to at least keep in mind. Simply being aware of the tendency is insufficient but it's a start. Deliberately taking steps to counteract such a bias can't hurt even if becoming completely immune may be difficult at best.

How's the portfolio objectively doing? Is all the extra complexity and effort actually yielding a clear benefit in terms of risk and reward? Am I ignoring certain things in order to feel better about all the effort that went into subpar results?

Choosing to avoid these kind of questions might prove costly in the long run.

Historically, the likelihood of doing well compared to index funds over the long run just hasn't been all that great. Some might think that's somehow going to change going forward but, at the very least, some skepticism seems warranted. The fact is too many who choose to pick individual stocks end up being overly optimistic about their abilities/prospects and, as a result, spend a lot of energy and time to little avail or worse.

Lots of unnecessary extra work.

Zero or even negative incremental reward.

The compounded long-term impact of frictional costs will always be a significant factor.

Reduce them wherever possible.

Adam

No position in DJCO

* From some excellent notes taken at the meeting earlier this year. Not a transcript.
** This has been covered, at least to some extent, in some earlier posts.
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