Poor Charlie's
Almanack: The Wit and Wisdom of Charles T. Munger
About Author:
Charles Thomas Munger (born January 1, 1924) is an American
investor, businessman, former real estate attorney, and philanthropist. He is
vice chairman of Berkshire Hathaway, the conglomerate controlled by Warren
Buffett; Buffett has described Munger as his partner. Munger served as chairman
of Wesco Financial Corporation from 1984 through 2011. He is also chairman of
the Daily Journal Corporation, based in Los Angeles, California, and a director
of Costco Wholesale Corporation.
Summary of Book:
People in general, think that the individual investor
doesn't stand a chance against the professionals. Pointing to high-frequency
trading and the complexity of the financial instruments that Wall Street has
become renowned for, many argue that this must be true. And besides, why would
the professional analysts have such high salaries otherwise?
In this book Burton Malkiel argues that this couldn't be
further from the truth! He shows that even a blindfolded monkey throwing darts
at stock listings would outperform their professionals. Fees, taxes, human
psychology, and most of all that markets behave like a random walk, are stated
to be reasons for this. This is an extremely controversial topic, as you
probably can tell already. And the stakes are high. Banker's bonuses all over
the world are threatened.
Fasten your seat belt, for the following takeaways won't be
any less provocative!
Takeaway #1:
Fundamental analysis doesn't outperform the market:
In beating the market, professionals tend to rely on one of
two strategies: The fundamental approach or the technical approach. The
investors who use fundamental analysis as their vehicle for earning money in
the market, believe in the so-called "firm
foundation theory" This theory argues that the price of an investment
is anchored is something called "intrinsic value", and that the price
of an asset typically over or underestimates this value.
The task of the fundamentalist is therefore to buy assets
that have an intrinsic value higher than the current price of the asset, and
sell if the opposite is true. The intrinsic value can be determined by
discounting all the future cash flows of an investment. Discounting is the
process of turning future earnings into today's value.
Remember that a dollar today is worth more than a dollar
tomorrow! To calculate the correct intrinsic value of a stock, a fundamentalist
must assess the following 4:
1.
Earnings
growth rate. The most important part of the calculation revolves around the
estimation of future growth rates of earnings.
2.
The
expected dividend payout. The higher the dividend payout, the greater the
value of the stock, everything else equal.
3.
The
degree of risk. Everyone prefers an investment with a lower risk of losing
money over an investment with a higher risk of losing money, even though the
expected returns are the same.
4. Future market interest rates. I stated earlier that a Swedish crown today, is worth more than a Swedish crown tomorrow. But I didn't state how much more. The so-called "risk-free rate of return", which is decided by the interest rate of the three-month US Treasury bill for US investors is used as a baseline for this. The higher the risk free rate of return, the higher the return should be expected from any other investment
Perhaps you already see some of the problems ...
1.
Faulty
information. The information given by the company you are interested in
acquiring could be misleading. This has been common, especially during times of
mass optimism, such as during the dot-com bubble. In these situations CEO could
mean "chief embezzlement officer", and you can't be sure where the
CFO is a "corporate fraud officer" or not. Also the EBITDA in the
income statement might be an acronym for "earnings before I tricked the
dump auditor". All kidding aside, there are many cases where reported
earnings, assets and the likes are misleading, which makes it very hard for the
fundamentalist to predict the future. Any computer scientist knows that garbage
in means garbage outs.
2.
Errors
and wrong conclusions in the analysis. Even if the information given to the
fundamentalist is trustworthy, he's still faced with the daunting task: He must
make predictions about the future without the benefit of divine inspiration. He
must use the information available without conducting errors or drawing the
wrong conclusions.
3.
Influence
of unexpected events. The fundamentalist might use all the current
information available to assess a perfect analysis of the stock, only to find
out later that the company's primary production plant was hit by an earthquake.
Or that the CEO, and the founder of the company, dies of a sudden heart attack.
Approximately 90% of the analysts on Wall Street are fundamentalists.
Takeaway number 2:
Technical analysis doesn't outperform the market either:
Technicians, as the people believing in a technical analysis
are called, trust in the "castle-in-the-air theory". As opposed to
the fundamentalist view, this theory argues that intrinsic value is of less
importance. Instead, what's most important is the behavior of the investment
community. Crowds do not act rational, and they are susceptible to building
castles in the air in the hopes of acquiring wealth. A successful investor's
primary task is therefore to estimate which investments that are most prone to
castle building. A sucker is born every minutes and the technicians task is to
buy investments that later can be sold to these people. If someone else is
willing to buy higher, the price you pay matters not! Dutch tulip bulbs during
the mid-1600s, conglomerate's in the late 1960s and Internet stocks in the
early 2000s, are great examples of castles in the air. The technician will use
charts of stock prices and trading volume to determine future prospects of
castle building. There are 3 primary reasons as to why technical analysis is
stated to work according to Malkiel:
1.
Price
increases are self-perpetuating Increases in price tend to cause additional
increases. People can't stand waiting on the side-lines when others are
making money. Therefore, demand increases with every price increase which
causes prices to go even higher, creating a dangerous upward spiral.
2.
Unequal
access to information. Insider's are the first to know about changes in a
company. Then comes the friends the families of these people, then the
professionals and their institutional capital and finally, poor people like you
and me. Charts are supposed to give information about when either insiders or
professional are buying, so that you can make your move before the rest of the
market does.
3.
Investors
underreact to new information. The stock market will react to new
information gradually, which results in longer periods of sustained momentum.
Malkiel, and other advocates of the random walk counter argues with: 1: Sharp reversals Uptrends can
happen drastically, which may cause the technician to miss the boat. When an
uptrend is signaled, it may already be too late. 2: Profit maximization. Let's say that company A's stock is at
$20.
One day, it develops a new product that increases the value
of the company to $30. Before releasing this information, wouldn't it make
sense for the insiders to buy the stock until $30 has been reached? Every
dollar they invest before $30 is an instant profit! 3: The techniques are self-defeating. Once people know about the
techniques that are supposed to efficient, the technicians will compete each
other out.
Other traders will try to anticipate certain signals that
they know that everyone else is buying or selling to. Approximately 10% of the
analysts of Wall Street are technicians.
Takeaway number 3:
Human psychology makes it even more difficult to beat the market:
As if the aforementioned reasons weren't enough, there are 4
factors that professionals and individual investors alike face when they are
trying to beat the market, which further reduces their chance of doing so.
Overconfidence:
This bias causes mortals like us to be over optimistic about assessments of the
future, and to overestimate our own abilities. Thereby, we conduct sloppier
analysis and take higher risks than otherwise would have been the case.
Biased judgments:
Humans tend to think that they have some control in situations, even though the
situation is completely random. Technicians are argued to be especially
vulnerable to this as they think that they can predict future prices by looking
at past ones.
Herd Mentality:
This might be the most obvious one. Herd mentality is the primary reason for
many of the stock market's greatest bubbles and following meltdowns. When your
friends all brag about their latest stock profits and the news of predicting
economic "golden ages", it's hard if not impossible, to stand idle on
the side-lines.
One great example of this is group thinking. Individuals can
influence each other into believing that an incorrect point of view is, in
fact, the right one Loss Aversion.
Lastly, loss aversion
is another psychological factor that makes it difficult to us to stay rational
in the market. Losses are considered far more undesirable than equivalent gains
are desirable. Consider the classic game of a coin flip. Heads, you lose $100,
and tails, you win $100. Do you want to play? Most people don't. Studies have
shown that the positive payout had to be 250 dollars before people were ready
to take this gamble. You can only imagine the consequences that this results in
for us in the stock market.
Takeaway number 4:
The random walk and efficient market hypothesis:
Now, if neither fundamentalists nor technicians can predict
the market, who can? According to the author, no one can! Why? Because the
development of the market is a random walk. A random walk is one where future
steps or direction cannot be predicted by history. Based on this concept of the
random walk, three versions of the so-called "Efficient Market
Hypothesis" have been developed.
Weak EMH: The
market is efficient in the way that it is reflecting all currently available
price information. If there are obvious opportunities for returns, people will
flock to exploit them until they disappear. The weak theory suggests that
technical analysis can't be used for beating the market, but that fundamental
analysis might be able to.
Semi-strong EMH:
The market is efficient in the way that it is reflecting all publicly available
information. This would mean that an investor cannot beat the market by either
technical or fundamental analysis. The only way to stay ahead of the curve
according to its advocates is by using insider information.
Strong EMH: The
market is efficient in that it is always mirroring the true value of an asset.
In this case even insider information wouldn't help you trading stocks and
earning above market returns. People often joke about supporters of the
efficient market hypothesis by telling this story: A professor and his students
was walking down a road when the student suddenly spots a $100 bill. He stops
to pick it up, but is interrupted by his professor. "Ah, don't bother
picking it up boy. If it truly was 100 dollar bill, it wouldn't be laying
there." The author of this book is not a believer in this strongest form
of the efficient market hypothesis. But rather he would answer his pupils
something along these lines: "Hurry up and pick it up boy. If it's truly a
hundred dollar bill, it won't be laying around for long."
Takeaway number 5:
How you can beat Wall Street:
Because of the flaws of the two primary strategies of investing
and because of human psychology, Wall Street professionals have been unable to
beat the market historically. This can be proven by making a very simple point:
An investor who puts $10,000 in the
S&P; 500 market index at the beginning of 1969 would have $736,000 in 2014,
compared to an investor who puts his money in the average actively managed
fund, who would end up with "only" $501,000. When it comes to
investing, you get what you don't pay for! Herein also lays the solution on how
to beat Wall Street: Invest for the long run, and in cheap index funds
primarily.
There are other asset classes to consider as well, to
increase diversification and decrease your risk. Here's a lifecycle-guide on
how to invest to beat "The Street". Mid-20s, Late 30s, Mid-50s, Late
60s, and beyond. This might sound too simple to be true, and it actually is.
You must also consider these 5 core principles for asset allocation:
1. Risk and
reward are related Anyone would pick $100 guaranteed before a $200 coin
flip. Risk in the stock market is defined as the volatility of the individual
investment. Volatility is measured by how much the return typically differs
from its expected value. A higher volatility means a higher risk that you might
be forced to sell with a loss at a later stage and may imply that your
investment has a higher risk of defaulting
2.
Length of
holding time decreases risk. The longer you hold on to a position, the more
likely that it will perform according to its expected value. In other words,
the longer you can hold on to an investment before you need that specific
money, the less risk you take! This is best illustrated by the following graph
which shows how much yearly return different holding periods in stocks resulted
in during 1950 to 2013. Notice that when holding stocks for at least 15 years,
there wasn't a single period of negative returns. Trust in time in the market,
rather than timing the market!
3.
Use
dollar cost averaging. Dollar cost averaging means investing the same fixed
amount at regular intervals. For instance, put 10% of your salary in an index
fund every month. By doing this you will benefit from the up- and downswings in
the market. Your average price per share will actually be lower than the
average price at which you bought them. Why? Because you'll buy more shares
when the market is cheap and depressed and less of them when it's expensive and
over-optimistic.
4.
Decide
your tolerance for risk. How much risk you can tolerate depends on your
financial situation, your age and your psychology. If losing your investment
money, means that you will have to drastically change your lifestyle, as in the
case of a retiree living from his or her investment income, you might want to
downsize risk. Similarly, if your sleep is affected by the volatility in your
stock portfolio, you might want to "sell down to the sleeping point"
as JP Morgan once suggested to a friend.
5.
Rebalancing
can reduce risk and possibly increase returns. Let's say that you're a 25
year old. You are then suggested to keep 70% of your assets in index funds, and
15% in bonds, according to the examples presented before. If stocks have been over
performing lately, you might end up with 80% index bonds and 5 percent bonds.
Here's a quick recap: Takeaway number 1 is that fundamental
analysis has a tough time beating the market and the 2nd takeaway is that
technical analysis doesn't seem to be a winning strategy either. Number 3 is that
beating the market is made even more difficult due to human psychology. 4 is
that future market development is essentially a random walk and therefore it
cannot be predicted. The final takeaway is a hopeful one for the individual
investor, as it suggests that he can easily beat the average analyst on Wall
Street, by simply buying and holding the market index. This was only a fraction
of what the more than 420 pages of "A Random Walk Down Wall Street"
has to offer.
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