One of the best investing speeches ever given was – A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business, by Charles Munger. In particular are Munger’s insights into investing in the stock market being a lot like betting at the race-track, which uses a system called pari-mutuel betting.
Pari-mutuel betting is a betting system in which all bets of a particular type are placed together in a pool; taxes and the “house-take” are removed, and payoff odds are calculated by sharing the pool among all winning bets. Munger says the same system can be used successfully in the stock market where the most successful investors bet heavily when mispriced opportunities present themselves.
Here’s an excerpt from that speech:
Odds on horses and stocks are set by the market.
The model I like—to sort of simplify the notion of what goes on in a market from 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 has been bet.
That is what happens in a 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 is not clear which is statistically the best bet using the mathematics of Fermet and Pascal. The prices have change in such a way that it is very heard to beat the system.
And then the track is taking 17% of the top. So not only do you have to outwit all the other betters, but you have 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.
Believe it or not, some people make money-betting horses….
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 is 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 is 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 is efficient, yes. But it is not perfectly efficient.
And with enough shrewdness and fanaticism, some people will get better results than others. It ain’t easy, but it is possible to outperform in stocks, too.
The stock market is the same way—except that the house hand 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 are 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.
What works betting horses also works for 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 are 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.
And the one thing that all those winning bettors in the whole history of people who have beaten the pari-mutuel system have is quite simple. They bet very seldom. Winners bet big when they have the odds—otherwise, never. It is 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 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 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 is just that simple.
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