Stock Market Is Not Efficient

Stock Market Is Not Efficient

The source combines remarks attributed to Munger with narrative conversations and accounts of his private thoughts. Those narrative passages frame the argument about markets; they should not be read as a verified transcript of the meetings described.

Charlie Munger: “I watched the same thing happen at the Jules Stein Eye Institute at UCLA. I asked, at one point, Why are you treating cataracts only with a totally obsolete cataract operation? And the man said to me, ‘Charlie, it’s such a wonderful operation to teach.’ When he stopped using this operation, it was because almost all the patients had voted with their feet. Again, appeal to interest and not to reason if you want to change conclusions.

“Well, Berkshire’s record has been archived without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to. I think you’d have easily outperformed the marked by seven percentage points per annum just by investing in high-volatility stocks.

“Yet, believe it or not, like Jules Stein’s doctor, people once believed this stuff. And the belief was rewarded. And it spread. And many people still believe it. But Berkshire never paid any attention to it. And now, I think the world is coming our way; the idea of perfection in all market outcomes is going the way of the dodo.

“It was always clear to me that stock markets couldn’t be perfectly efficient, because as a teenager, I’d been to the racetrack in Omaha, where they had the pari-mutuel system. It was quite obvious to me that the house take, the croupiers’ take, was 17 percent; some people consistently lost a lot less than 17 percent of all of their bets. And so, I didn’t accept the argument that the stock market was always perfectly efficient in creating rational prices. Indeed, there have been documented cases of people getting so good at understanding houses and odds that they actually are able to beat the house in off-track betting. There aren’t many people who can do that, but there are a few people in America who can lxxiv.”

Mr. Brown looked surprised. “If the efficient theory doesn’t work as you said before, what is the model you suggest? I just want to understand you better; isn’t that practical in total, sir? You are so honest and straightforward, and all of these wonderful credits and profit you have done with Buffett through the years. We couldn’t ignore it. I think the people have to be interested in ideas like that, to ask the right question from the right people. I consider anyone who isn’t interested in finding out the truth is just bonkers.

“Everybody is so selfish nowadays; everybody wants success in any way possible; it is a material necessity. People have no time to think for themselves; all they want is to have a lot of cash. Then they come to people like me and trust us with their money. But from time to time, I couldn’t trust myself. He, he.

“You are playing poker, Charlie. Is it helping you to know the rules and to play it accordingly? Tell me, what happens in stock markets, then? A shrewd horseplayer’s edge reduces the average loss. This is probably true. Again, that is not the point. This is not about humanity, Charlie. The folks need to live and eat today, don’t you think? Not tomorrow. I don’t have that time to wait. The point is in the following story. Have you read Darwin’s Voyage of the Beagle? You have done it. I know you like Darwin; I definitely know you have. I feel I must read this story once again, one of my favorites. I feel myself so familiar with it, and yes, it is applicable in our time, in our country, which, Charlie, you love as I do. This story’s moral is what right and wrong are just illusions of our mind. The book is right here with me; I will read it for you right now:

“I heard Mr. Law, a scaling-master intimate with the natives (Fuegians) of this country; give a curious account of a state of a party of one hundred and fifty natives on the West Coast who were very thin and in great distress…From the concurrent, but quite independent evidence of the boy taken by Mr. Law, and of Jeremy Button, it is certainly true, that when pressed in winter by hunger, they kill and devour their old women before they kill their dogs. The boy, being asked by Mr. Law why they did this, answered, “Doggies catch otters, old women no.” This boy described the manner in which they were killed by being held over smoke and thus choked, he imitated their screams as a joke, and described the parts of their bodies which were considered best to eat. Horrid as such a death by the hands of their friends and relatives must be, the fears of the old women, when hunger begins to press, are more painful to think of we, were told that they then ran away into the mountains, but that they are pursued by the men and brought back to the slaughter-house at their own firesides lxxv”!

After a short pause, Mr. Brown continued: “For me this is a simple, understandable concept, you know; there is no word fair or bonkers in the market. You got what you deserved, right? If this is the way that I earn this money. Moreover, it is legal; who could explain to me why I could not do it anymore? This case from Darwin shows that cannibalism is a normal process; there is not so much bad or unfair in that story. So I allow and consider myself as a hero of our time.” Mr. Brown smiled.

Charlie did not want to continue the discussion that evening. He gave Mr. Brown a friendly smile, and the evening ended.

After the dinner, Charlie reflected on fear, failure, and character. He wanted to avoid repeating mistakes while retaining his faith in humanity. He remembered the death of his son Teddy at nine and the end of his first marriage. These losses had been horrible, but he believed he had to continue without self-pity or resentment. His failing eyesight was another painful loss for someone who loved reading. Benjamin Franklin remained his model for continued learning and self-improvement. Franklin wrote, “For, even if I could conceive that I had completely overcome [my pride], I should probably be proud of my humility lxxvi.” Charlie was thinking the same: “In my whole life, nobody accused me of being humble. Although humility is a trait I much admire, I don’t think I got my full share lxxvii.” Learning from such models mattered beyond investing.

Pursuing money and power can displace the work of learning from people worth emulating. Good models can help us recognize familiar limitations: confirmation bias favors supporting evidence, cognitive miserliness discourages effort, and conformity draws our perceptions toward the group’s views.

Character should guide the pursuit of material success: act sincerely and justly, and speak accordingly.

Franklin, Jesus, and Socrates serve as models of character here. The criticism of Wall Street is severe: the pursuit of wealth becomes corrupt when it is seduced by financial power.

Richard Dawkins said, “In a universe of electrons and selfish genes, blind physical forces and genetic replication, some people are going to get hurt, other people are going to get lucky, and you won’t find any rhyme or reason in it, nor any justice. The universe that we observe has precisely the properties we should expect, at the bottom, no design, no purpose, no evil and no greed, nothing but pitiless indifference. As that unhappy poet A.E. Houseman put it: ‘For nature, heartless, witless nature, will neither care nor know’—DNA neither cares nor knows. DNA just is and we dance to its music.

“A universe with a God would look quite different from a universe without one. A physics, a biology where there is God is bound to look different so the most basic claims of religion are scientific lxxviii.”

Tired of thinking, Charlie wanted to speak with Warren on the phone and go to sleep. Back in his quiet hotel room, he fell asleep.

Charlie stayed a few more days in New York. Although he had reservations about the meetings with Mr. Brown and his friends, he was willing to meet again. He thought about Peter, the young man Mr. Brown planned to invite, and interpreted Peter’s criticism of capitalism as resentment about his own lack of money.

Charlie reminded himself of a speech from 1998: “To conclude, I will make one controversial prediction and one controversial argument. The controversial prediction is that, if some of you make your investment style more like Berkshire Hathaway’s, in a long-term retrospect, you will be unlikely to have cause for regret, even if you can’t get Warren Buffet to work for nothing. Instead, Berkshire will have cause for regret as it faces more intelligent investment competition. But Berkshire won’t actually regret any disadvantage from your enlightenment. We only want what success we can get despite encouraging others to share our general views about reality. My controversial argument is an additional consideration weighing against the complex high cost investment modalities becoming ever more popular at foundations. Even if, contrary to my suspicions, such modalities should turn out pretty well, most of the moneymaking activities would contain profoundly antisocial effects. This would be so because the activity would exacerbate the current, harmful trend in which ever more of the nation’s ethical young brainpower is attracted into lucrative money management and its attendant modern frictions, as distinguished from work providing much more value to others. Money management does not create the right examples. Early Charlie Munger is a horrible career model for the young because not enough was delivered from capitalism and other similar career models are even worse. Rather than encourage such models, a more constructive choice of foundations is long-term investment concentration in a few domestic corporations that are widely admired. Why not just imitate Ben Franklin? After all, old Ben was very effective in doing public good. And he was a pretty good investor too. Better his model, I think, then Bernie Cornfield’s. The choice is plainly yours to make lxxix.”

The narrative then contrasts its criticism of money management with examples of managers Munger respected. It describes a manager named Ted Combs meeting Charlie and then Warren, and receiving responsibility for Berkshire acquisitions. Another example is Munger’s longtime friend and investor Mohnish Pabrai 1. Like Buffett, Pabrai treats a stock as ownership of a business. In this account, he passes on a company that appears only 10 percent undervalued, waiting for an opportunity he considers obvious. The quality Charlie admires is patience.

Constant multitasking, email, and following the crowd can leave little room to understand a business. The alternative is patient work: keep learning, study the business, and allow a sound investment time to develop.