What do horse racing and investing have in common? Charlie Munger (Trades, Portfolio) explained the difference between these two seemingly very different disciplines in his fantastic lecturem The Art of Stock Picking.
Ask most investors to explain the difference between investing and horse racing, and they might look at you blankly. After all, horse racing is widely considered to be gambling while investing is something else altogether. But the two do have a lot in common. As Charlie Munger (Trades, Portfolio) explained:
"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 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's bet. That's what happens in the stock market."
He went on to explain that in horse racing, the best horses are given the least attractive adds, while the most unattractive horses are offering the most attractive odds. The stock market works on a very similar model. The most attractive stocks tend to have the highest valuations while the lest attractive stocks are deeply discounted. In horse racing, the prices are adjusted so that it is tough to beat the house. With stocks, generally speaking, the market's most expensive equities tend to underperform over the long term. In both scenarios, "The prices have changed in such a way that it is very hard to beat the system," as Charlie Munger (Trades, Portfolio) described.
On top of the pricing problem, you have costs to pay:
"And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you've 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."
Munger went on to say that this 17% hurdle is what makes a game so difficult for most bettors. Without this tax on profits many more people would likely be making a substantial income from betting. Instead, the high hurdle rate reduces even the most intelligent, logical bettor's profits.
"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's efficient, yes. But it's not perfectly efficient. And with enough shrewdness and fanaticism, some people will get better results than others."
The stock market has a similar hurdle to overcome, although it is significantly less than the 17% paid to betting shops. If you include the bid/offer spread, commisions and management fees, the cost is only a few percentage points, and significantly less if you hold for many years.
This gives fanatical investors an edge:
"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, 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."
The big question is, how do you ensure that you end up on the right side of the market? The easy answer to this question is to work harder than everyone else, but in a market that is dominated by highly paid, highly intelligent skilled professionals, working harder is going to guarantee better results.
The solution, according to Charlie Munger (Trades, Portfolio), is quite simple. The best winners at both horse racing and investing make very few bets. They wait for the perfect opportunity and bet big when the odds are in their favor. "And the rest of the time, they don't. It's just that simple."
Disclosure: The author owns no share mentioned.
