Warren Buffett World

Warren Buffett’s long-time business partner Charlie Munger compares in his excellent book,Poor Charlie’s Almanack, success in the race track to success in the 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 race track. 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 damn 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 seventeen percent off the top. So not only do you have to outwit all the other bettors, but you’ve got to outwit them by such a big margin that on average, you can affort to take seventeen percent 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 using only 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 absense 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 seventeen percent that he would lose if he got the average results to maybe ten percent. However, there are actually few people who can beat the game after paying the full seventeen percent.

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 debt of intelligence betting on harness races that you do on regular races. What my poker pal would do was to think about harness as his main profession. And he would bet only occationally when he saw some mispriced bet available. And by doing that, after paying the full handle to the house - which I presume was around seventeen percent - 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 seventeen percent handle, lots of people would regularly be beating lots of other people at the horse races. It’s efficient, yea. 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 - except 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 fifty percent will end up in the bottom half, and seventy percent will end up in the bottom seventy percent. 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 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 bettors who have a credit arrangement with the track, now that they have off-track betting, who are actually beating the house. The track is 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 are that shrewd about something with as much unpredictability as horse racing.

It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it’s 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 wice 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.

The one thing all those winning bettors in the whole history of people who’ve beaten the pari-mutuel system have is quite simple: they bet very seldom.

And yet in investment management, practically nobody operates that way. We operate that way - I’m talking about Buffett and Munger.

This also reminds me what Warren Buffett wrote in his 1993 letter to Berkshire 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.)

You often hear that patience is one of the keys to Buffett’s success in investing. Earlier I thought that the patient is required after you have purchased the stock, when you are waiting for the market to discover the value, but these quotes show that the patience before you purchase a stock is maybe even more important.

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