Active versus Passive Investing
Charlie’s advice to other people on investing is very different depending on the nature of the investor.
“Our standard prescription for the know-nothing investor with a long-term time horizon is a no-load index fund.” http://www.myinvestmentforum.com/category/sgfunds-forum/interview-with-charlie-munger-t1655.html
What is a “know nothing” investor? The answer is simple for Charlie: a no-nothing investor is someone who does not understand the economics of the specific business in question. As was pointed out in the last blog post, to understand the value of an investment, you must understand the value of the underlying business since a share of stock is merely a proportional ownership interest in a business. If you are thinking about price of the stock and not the value of the business you are not an investor believes Munger. Occasionally some academic will claim that Munger and Buffett only know how to buy valuable companies at great prices. This is a moronic academic analysis of Munger and Buffett’s market outperformance (alpha) since that *is* investing.
Buffett makes it clear that being a know-nothing investor is nothing to be ashamed about. Know-nothing investors can know a lot about a lot. Sports, politics, science even some aspects of business can be the forte of a know-nothing investor.
“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.” http://berkshireruminations.blogspot.com/2007/12/thoughts-on-index-investing.html
“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” http://www.berkshirehathaway.com/letters/1996.html
Think about what this means. You can decide to become a long-term investor in the United States/global economy and not spend much time understanding the economics of specific businesses. You can spend that time engaged in things that interest you like skiing, sleeping or watching TV instead. Josh Brown lays it out cleanly here:
“… Prior to comparing your returns to this or that index and then tearing out your hair over them, ask yourself whether or not it should matter. If you are speculating for the sake of speculation, by all means, grade yourself. If you are running a fund, then you won’t need to grade yourself because you are already being judged as we speak. Only 39% of active managers beat their benchmarks in 2o12, which means more than half of the fund industry is under this microscope now and the light in their faces is a harsh one. Not a pleasant place to be.
And never mind comparing yourself to an index, it’s hard enough to keep up with this orange cat from London named ‘Orlando’ who took on a gaggle of supposed market-beating fund managers:
By the end of September the professionals had generated £497 of profit compared with £292 managed by Orlando. But an unexpected turnaround in the final quarter has resulted in the cat’s portfolio increasing by an average of 4.2% to end the year at £5,542.60, compared with the professionals’ £5,176.60.
This cat, a fucking ginger no less, threw a chew toy at the stock table pages of the Financial Times and beat guys with decades of experience and unlimited research at their fingertips.” http://www.thereformedbroker.com/2013/01/15/chasing-the-cat/
The most important thing people need to know in making this decision is their own limitations. As a previous post explained, Charlie believes that not making big mistakes is a huge determinant of whether you will have financial success in life. By understanding your limitations you will make fewer mistakes.
What Warren Buffett is talking about is the question of whether a person should be an “active” or a” passive” investor – concepts he learned from Benjamin Graham:
“The determining trait of the enterprising [active] investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades, an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort in the form of a better average return than that realized by the passive investor.” http://blogs.cfainstitute.org/investor/about-us/ben-graham/
Being an active investor and somehow outperforming the market after fees and expenses sounds good, but the catch is that being a successful active investor requires a massive amount of time and work. If you don’t enjoy it, why do it?
Even more importantly, if you are provably not good at it, why do it? If you keep track of your active investing results over the years and you are failing to match the indexes, what is that telling you? An active investor who does not keep written track of their results after fees and expenses and compares that to “being the market” instead is at big risk of fooling themselves. Charlie says that Richard Feynman was right that the easiest person to fool is yourself, and that especially applies to investing skill/results.
Munger agrees with Buffett that index funds make the most sense for almost all investors. Whether they know it or not most all investors should be passive investors. Some people try to escape from this trap by saying essentially: “I can be smart about picking other people who will outperform market via active investing.” Relying on a stock broker to be an active investor on your behalf is no solution says Charlie since “stock brokers, in toto, will do so poorly that the index fund will do better.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
If you are not a passive investor, you must beat the market after fees and expenses. As John Brown notes above, being an active investor and accomplishing that is nontrivially hard to do.
It is at this point that the debate about the so-called “efficient market hypothesis” (“EMH”) raises its ugly head. Munger’s view on EMH are clear:
“I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don’t think it’s totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It’s efficient enough, so it’s hard to have a great investment record. But it’s by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine.” http://www.myinvestmentforum.com/category/sgfunds-forum/interview-with-charlie-munger-t1655.html
The paradox facing the ordinary investor is that usually only the biggest investors (e.g., big pension funds, university endowments and the very wealthy) get access to the top three to four percent investment management. This problem for the ordinary investor is reflected in an old Groucho Marx joke: you don’t want to hire an investment manager that would take you for a client!
Why is the EMF theory so widely advocated? Academics love EMH because they can claim that they have mathematics-based formulas which can predict the future even though the underlying assumptions (borrowed from physics) are provably false. For a professor, the ability to create beautiful mathematics is important since it means that they are less likely to be teased by physicists in the faculty club. Life is infinitely more interesting for an academic if they can create beautiful mathematics in their papers.
“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.” http://ycombinator.com/munger.html
In future posts I will describe Munger’s his views on why behavioral economics invalidates key premises of EMH. They are numerous and detailing them will be more fun that the blog posts made to date by this author. Munger:
“The possibility that stock value in aggregate can become irrationally high is contrary to the hard-form “efficient market” theory that many of you once learned as gospel from your mistaken professors of yore. Your mistaken professors were too much influenced by “rational man” models of human behavior from economics and too little by “foolish man” models from psychology and real-world experience.” http://www.tilsonfunds.com/Mungerwritings2001.pdf#search=%22%20%22charlie%20Munger%22%20Outstanding%20investor%20digest%22
Munger likes to make fun of a few specific economists who have taken their academic theories into the real world and failed in spectacular fashion:
“Efficient market theory [is] a wonderful economic doctrine that had a long vogue in spite of the experience of Berkshire Hathaway. In fact one of the economists who won — he shared a Nobel Prize — and as he looked at Berkshire Hathaway year after year, which people would throw in his face as saying maybe the market isn’t quite as efficient as you think, he said, “Well, it’s a two-sigma event.” And then he said we were a three-sigma event. And then he said we were a four-sigma event. And he finally got up to six sigmas — better to add a sigma than change a theory, just because the evidence comes in differently. [Laughter] And, of course, when this share of a Nobel Prize went into money management himself, he sank like a stone.” http://www.loschmanagement.com/Berkshire%20Hathaway/Charlie%20munger/The%20Psychology%20of%20Human%20Misjudgement.htm
Charlie as similar feelings about other aspects of much of academically generated financial theory:
“Berkshire’s whole record has been achieved 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 to believe in the tooth fairy to believe that you could easily outperform the market by seven-percentage points per annum just by investing in high volatility stocks.” http://www.tilsonfunds.com/MungerUCSBspeech.pdf
The problems which arise due to people thinking that they can be successful active investors are huge and made worse due to one a dysfunctional heuristic in particular (more on this later) known simply as “overconfidence”:
“Most people who try [investing] don’t do well at it. But the trouble is that if even 90% are no good, everyone looks around and says, “I’m the 10%.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
The list of dysfunctional heuristics is a long and winding road.
One of the saddest cases in investing happens when someone thinks they are active investor but the reality is that they have invested in so many stocks that they have become “closet indexers.” Munger points out the ugliness simply:
“[With] closet indexing … you’re paying a manager a fortune and he has 85% of his assets invested parallel to the indexes. If you have such a system, you’re being played for a sucker.” http://www.tilsonfunds.com/wscmtg05notes.pdf
On this point, to understand Munger it is best to look again at his wonderful essay which compares investing to betting at a horse racing track:
“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. And yet, in investment management, practically nobody operates that way. We operate that way—I’m talking about Buffett and Munger. And we’re not alone in the world. But a huge majority of people have some other crazy construct in their heads. And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they’ll come to know everything about everything all the time. To me, that’s totally insane. The way to win is to work, work, work, work and hope to have a few insights.” http://ycombinator.com/munger.html
If you want to go deeper on the closet indexing issue I suggest you read Mauboussin as usual (when in doubt read Mauboussin is my rule of thumb): https://www.lmcm.com/905988.pdf More discussion can be found here: http://online.barrons.com/article/SB50001424052748703792204578221972943824046.html?mod=bol_share_tweet#articleTabs_article%3D2
Concentration is Key for the Active Investor
Munger is clearly a devotee of concentrating his investments since he is not a know-nothing investor.
“The idea of excessive diversification is madness.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
“Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.” http://investingcaffeine.com/2009/12/02/more-eggs-in-basket-may-crack-portfolio/
Seth Klarman believes: “The number of securities that should be owned to reduce portfolio risk is not great; as few as ten to fifteen holdings usually suffice.”
Jason Zweig adds:
“A conventional rule of thumb, supported by the results of Bloomfield, Leftwich, and Long 1977, is that a portfolio of 20 stocks attains a large fraction of the total benefits of diversification. … however, that the increase in idiosyncratic risk has increased the number of stocks needed to reduce excess standard deviation to any given level.” http://kuznets.fas.harvard.edu/~campbell/papers/clmx.pdf
“Even the great investment analyst Benjamin Graham urged “adequate though not excessive diversification,” which he defined as between 10 and about 30 securities.” http://online.wsj.com/article/SB10001424052748704533904574548003614347452.htm
Munger chimes in:
“The Berkshire-style investors tend to be less diversified than other people. The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn’t make you with a whip and a gun? http://www.myinvestmentforum.com/category/sgfunds-forum/interview-with-charlie-munger-t1655.html
Seth Klarman points out that it is better to know a lot about 10-15 companies that to know just a little about many stocks. When it comes to diversification vs. concentration Charlie feels like the Maytag repair man:
“I always like it when someone attractive to me agrees with me, so I have fond memories of Phil Fisher. The idea that it was hard to find good investments, so concentrate in a few, seems to me to be an obviously good idea. But 98% of the investment world doesn’t think this way. http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
The number of stocks a person can realistically follow and understand the economics of the specific business better than the market is significantly less than 20. The idea that a dentist working full time in his or her profession is going to pick technology stocks better than the market after fees and expenses is silly. A UPS driver is hoping to the same thing with a health care stock? Remember the task is not just to pick a quality company, but to find a mispriced bet.
The same principles apply to Angel investors who “spray and pray” investments at every start up they can find. Smart VCs and Angels investors make a lot of bets but in a relative sense they are still concentrated. A big VC fund may make 40 bets in a fund and the outcome for the funs may rest on two or three massive financial home runs, but each of the 40 bets must have optionality. To many companies VCs think they can just invest in 4o0 companies regardless of whether they have optionality.
You may recall from an economics class or reading that markets are “efficient.” This means markets take all the available information and create a price for the good or service. The market is often right about that price, but is not always right. It is possible, by finding an area in which you are particularly competent, to find an investment that is being offered to you for substantially less than it is worth. Not a little less than what it is worth mind you, but substantially less than it is worth. “How much is substantially less than it is worth?” you may ask. The price should be so good that it is screaming out at you to buy it. “How often is this likely to happen?” It may happen once or twice in a year or twice in a month and then not again for two or three years. As an example, the VC Fred Wilson is said to have made no investments at all in 2012. Sometimes that happens if you stick to your principles.
It is important to note that mispriced investments will happen more often that once or twice a year as a whole, but the only mispriced investment that is important to you is one that falls within an area in which you are very competent. The smaller the area in which you apply your time and effort to being competent, the more likely is that you will genuinely spot the opportunities. If you try to be competent in all areas and you will never be smart enough to find these investment opportunities.
“We don’t believe that markets are totally efficient and we don’t believe that widespread diversification will yield a good result. We believe almost all good investments will involve relatively low diversification. Maybe 2% of people will come into our corner of the tent and the rest of the 98% will believe what they’ve been told.” http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Warren%20Buffett/Berkshire%20Hathaway%20Annual%20Meeting%20Notes%202004.pdf
My next post will be: “Charlie Munger on the Importance of Consistently
not being Stupid.”