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How to Think About the Stock Market

First things first. I had a wonderful workshop in New Delhi last Sunday. Here are the amazing tribe members who attended it…


My next Workshop is in Chennai on 15th March (this Sunday). If you are willing to attend, please click here to register now.

Anyways, coming back to the main topic of this post, I was recently having a conversation with a friend who owns an automobile components business. He mentioned how he was looking to invest Rs 2 crore to purchase a new piece of equipment for his manufacturing unit and why he thought this investment would pay fruits over the next 10 years.

During the conversation, it struck me that most investors don’t think the same way business owners do. It isn’t unusual for a business owner to buy a new machine, or upgrade the fixtures in his retail store with an eye on the long term.

Also, it isn’t unheard of for a business owner to invest large sums of his own money to expand a factory or spend money installing energy efficient lights to lower costs and increase profits. That is because the mindset of a business owner is on putting money out today in order to earn a return over time.

Many investors don’t think this way. Warren Buffett often says that he is a better investor because he is a business owner and a better business owner because he is an investor. It is valuable to think from both perspectives.

Anyways, that was about how to think from a business owner’s perspective while investing in the stock market.

But the first question is – How to think about the stock market and the entire art of picking stocks?

This is exactly what Charlie Munger explains in his speech “A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business” that he gave at the USC Business School in 1994.

Here is what Munger said about the nature of the stock market.

Read the following paragraphs extremely carefully (maybe twice or thrice) for these will define how you think about the stock market and subsequently how you behave yourself as an investor for the rest of your investing life…

The question…”What is the nature of the stock market?”…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 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.

And, by the way, I have a name for people who went to the extreme efficient market theory—which is “bonkers”. It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality.

Again, to the man with a hammer, every problem looks like a nail. If you’re good at manipulating higher mathematics in a consistent way, why not make an assumption which enables you to use your tool?

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%.

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.

The stock market is the same way—except that the house handle is so much lower. If you take transaction costs—the spread between the bid and the ask plus the commissions—and if you don’t trade too actively, you’re talking about fairly low transaction costs. So that with enough fanaticism and enough discipline, 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. And, of course, 50% will end up in the bottom half and 70% will end up in the bottom 70%. But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking.

How do you get to be one of those who is a winner—in a relative sense—instead of a loser?

Here again, look at the pari-mutuel system. I had dinner last night by absolute accident with the president of Santa Anita. He says that there are two or three betters who have a credit arrangement with them, now that they have off-track betting, who are actually beating the house. They’re sending money out net after the full handle—a lot of it to Las Vegas, by the way—to people who are actually winning slightly, net, after paying the full handle. They’re that shrewd about something with as much unpredictability as horse racing.

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 bet—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.

Way to Win in the Stock Market
“The way to win is to work, work, work, work and hope to have a few insights.” ~ Charlie Munger

Well, that’s exactly what Munger is trying to say in the above excerpt from his speech – Work hard, have few insights, search for mispriced bets, and bet seldom.

Now, the question is – how many insights do you need in your investing lifetime?

Not many, as Munger says…

…you don’t need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that’s with a very brilliant man—Warren’s a lot more able than I am and very disciplined—devoting his lifetime to it. I don’t mean to say that he’s only had ten insights. I’m just saying, that most of the money came from ten insights.

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.

Buffett’s 20 Punches
Warren Buffett is supposed to have said this at a business school…

I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty 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. 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.

The problem with most of us investors is that, too often, we scatter money around while saying to ourselves, “Okay, let me throw a little money in this stock and little in that stock and then see what happens. At least, one of the stocks will work!”

Now, that’s a sure shot road to a hell lot of risk – first you don’t know where you are scattering your money, and then you think you are investing while the reality is that you are speculating in the hope of hitting the “right” stock.

Buffett wrote this in his 1993 letter to shareholders…

Charlie and I decided long ago that in an investment lifetime it’s just too hard to make hundreds of smart decisions. That judgment became ever more compelling as Berkshire’s capital mushroomed and the universe of investments that could significantly affect our results shrank dramatically.

Therefore, we adopted a strategy that required our being smart – and not too smart at that – only a very few times. Indeed, we’ll now settle for one good idea a year. (Charlie says it’s my turn.)

Munger adds…

To me, it’s obvious that the winner has to bet very selectively. It’s been obvious to me since very early in life. I don’t know why it’s not obvious to very many other people.

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Epic Research says:

    I just can say that your blog is quite Wonderful, if anyone who want to invest in market he must read this article.

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