Bogle on "The Relentless Rules of Humble Arithmetic"

A follow up to this post:

"...it's been said (by my detractors) that all I have going for me is 'the uncanny ability to recognize the obvious.' The curious irony, however, is that most people either seem to have difficulty recognizing what lies in plain sight, right before their eyes, or, perhaps even more pervasively, refuse to recognize the reality because it flies in the face of their deep-seated beliefs, their biases, and their own self-interest. Paraphrasing Upton Sinclair: 'it's amazing how difficult it is for a man to understand something if he's paid a small fortune not to understand it.' But only by facing the obvious realities of investing will the intelligent investor succeed." - From John Bogle's remarks at NYU in 2007

Later in those same remarks Bogle added the following:

"The first of the two relentless rules of humble arithmetic I'll mention is a simple one: Gross return in the financial markets, minus the costs of financial intermediation, equals the net return that we investors share."

Bogle goes on to explain "the foolishness and counterproductivity of our vast and complex financial market system."

He does this by using his own version of a parable by Warren Buffett.*

Here is Bogle's version of the parable:

"Once upon a time...a wealthy family named the Gotrocks, grown over the generations to include thousand of brothers, sisters, aunts, uncles, and cousins, owned 100 percent of every stock in the United States. Each year, they reaped the rewards of investing: all the earnings growth that those thousands of corporations generated and all the dividends that they distributed. Each family member grew wealthier at the same pace, and all was harmonious. Their investment had compounded over the decades, creating enormous wealth, because the Gotrocks family was playing a winner's game.

But after a while, a few fast-talking Helpers arrive on the scene, and they persuade some 'smart' Gotrocks cousins that they can earn a larger share than the other relatives. These Helpers convince the cousins to sell some of their shares in the companies to other family members, and to buy some shares of others from them in return. The Helpers handle the transactions, and as brokers, they receive commissions for their services. The ownership is thus rearranged among the family members.

To their surprise, however, the family wealth begins to grow at a slower pace. Why? Because some of the return is now consumed by the Helpers, and the family's share of the generous pie that U.S. industry bakes each year—all those dividends paid, all those earnings reinvested in the business—100 percent at the outset, starts to decline, simply because some of the return is now consumed by the Helpers.

To make matters worse, while the family had always paid taxes on their dividends, some of the members are now also paying taxes on the capital gains they realize from their stock-swapping back and forth, further diminishing the family's total wealth.

The smart cousins quickly realize that their plan has actually diminished the rate of growth in the family's wealth. They recognize that their foray into stock-picking has been a failure and conclude that they need professional assistance, the better to pick the right stocks for themselves. So they hire stock-picking experts—more Helpers!—to gain an advantage. These money managers charge a fee for their services. So when the family appraises its wealth a year later, it finds that its share of the pie has diminished even further.

To make matters still worse, the new managers feel compelled to earn their keep by trading the family's stocks at frantic levels of activity, not only increasing the brokerage commissions paid to the first set of Helpers, but running up the tax bill as well. Now the family's earlier 100 percent share of the dividend and earnings pie is further diminished.

'Well, we failed to pick good stocks for ourselves, and when that didn't work, we also failed to pick managers who could do so,' the smart cousins say. 'What shall we do?' Undeterred by their two previous failures, they decide to hire still more Helpers. They retain the best investment consultants and financial planners they can find to advise them on how to select the right managers, who will then surely pick the right stocks. The consultants, of course, tell them they can do exactly that. 'Just pay us a fee for our services,' the new Helpers assure the cousins, 'and all will be well.'

Alarmed at last, the family sits down together and takes stock of the events that have transpired since some of them began to try to outsmart the others. 'How is it,' they ask, 'that our original 100 percent share of the pie—made up each year of all those dividends and earnings—has dwindled to just 60 percent?' Their wisest member, a sage old uncle, softly responds: 'All that money you've paid to those Helpers and all those unnecessary extra taxes you’re paying come directly out of our family's total earnings and dividends. Go back to square one and do so immediately. Get rid of all your brokers. Get rid of all your money managers. Get rid of all your consultants. Then our family will again reap 100 percent of however large a pie that corporate America bakes for us, year after year."

Market participants have a better alternative even if too many choose to ignore it. The emphasis should be on generating returns via increases to the intrinsic value of business instead of more cleverly trading price action than the next guy.

More from Bogle:

"That brings us to my second relentless rule of humble arithmetic. Successful investing is not about the stock market, but about owning all of America's businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation's—and, for that matter, our world's—corporations. For in the very long run, it is how businesses actually perform that determines the return on our invested capital."

This can be accomplished by owning an index fund bought well. It can also be accomplished, at least for those inclined and able to do so effectively, by owning a shares of good businesses, also understood and bought well.

In any case, it's buying only what one truly understands (an easy mistake to make is overestimating how well understood an investment truly is), knowing one's own limits, minimizing frictional costs, then allowing -- instead of clever trading -- the per share increase to intrinsic value to be the primary driver of future long run returns.

"By periodically investing in an index fund...the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you." - Warren Buffett in the 1993 Berkshire Hathaway (BRKa) Shareholder Letter

In both cases the emphasis is on not making the mistake that was made by the Gotrocks family.

This plainly makes a huge amount of sense but I suspect, since not many seem to have taken the advice of Buffett or Bogle before, they aren't likely to be inclined to do so now.

One of the reasons?

It's just too simple.

"...our model is too simple. Most people believe you can't be an expert if it's too simple." - Charlie Munger at the 2007 Wesco Meeting

"Stocks are simple. All you do is buy shares in a great business for less than the business is intrinsically worth, with managers of the highest integrity and ability. Then you own those shares forever." - Warren Buffett

"The business schools reward difficult complex behaviour more than simple behavior, but simple behavior is more effective." - Warren Buffett

Warren Buffett: What He Does Is "Simple But Not Easy"

And, as Bogle points out above, too obvious. Well, sometimes what's simple and obvious also happens to be wise.

"The statistical evidence proving that stock index funds outperform between 80% and 90% of actively managed equity funds is so overwhelming that it takes enormously expensive advertising campaigns to obscure the truth from investors." - From The Motley Fool

Some will continue to think they can pick the winning funds beforehand. Some actually will. Others will pay excessive fees thinking that the skill involved will more than offset it.

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value." - Jack Meyer, former President and CEO of the Harvard Management Company from 1990 to 2005, commenting on investment managers

An investment plan based upon picking the exception seems not a realistic plan at all.

The same is true for stocks. Many shouldn't be trying to pick individual stocks -- especially if their particular approach involves excessive amounts of trading -- but will continue to do it anyway despite the evidence that they're likely to underperform.

Investor overconfidence is a big part of the problem.

Bogle rightly emphasizes humble arithmetic. Yet, in what may seem but is not at all contradictory, Buffett and Munger say, when it comes to investing well, the numbers themselves matter less than some think.**

"If you need to use a computer or calculator to make the calculation, you shouldn't buy it." - Warren Buffett at the 2009 Berkshire Hathaway Shareholder Meeting

They're hardly implying that the numbers aren't relevant, it's just that there's no place for false precision in the investment process.

Too much of what matters isn't quantifiable.

Adam

Long position in BRKb established at much lower than recent market prices

* The parable can be found in the 2005 letter on pages 18-19. Buffett's version of this parable is also covered in the prior post. For those familiar with it, there'll be not much new here in Bogle's version. Still, I do happen to think it's the kind of thing worth revisiting from time to time. Others will likely see it, much like Bogle's detractors, as just more recognition of what is obvious. Well, considering the large proportion of participants who underperform the market as a whole, it sure seems that, too often, the obvious gets ignored by some otherwise very smart people.
** Charlie Munger in this speech at UC Santa Barbara: "You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically (1) everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Quotes of 2013 - Part II

Some additional quotes from 2013 as a quick follow up to this recent post.

Quotes of 2013

Munger and Buffett: High-Frequency Trading and the Flash Crash
"I think the long term investor is not too much affected by things like the flash crash. That said, I think it is very stupid to allow a system to evolve where half of the trading is a bunch of short term people trying to get information one millionth of a nanosecond ahead of somebody else." - Charlie Munger

"I think it is basically evil and I don't think it should have ever been allowed to reach the size that it did. Why should all of us pay a little group of people to engage in legalized front-running of our orders?" - Charlie Munger

"...it [HFT] is not contributing anything to capitalism." - Warren Buffett

"The flash crash didn't hurt any investor. I mean, you know— you're sitting there with— with a stock. And, you know, and the next day...it's gone past. The frictional cost in...investing for somebody that does it in a real investing manner are really peanuts. I mean, they're far less than the cost in real estate or farms or all kinds of things. So it's— unless you turn it to your disadvantage by trying to do a lot of trading or something of the sort, it's a very, very inexpensive market to operate in...and all that noise should not bother you at all. Forget it." - Warren Buffett

Efficient Markets
"Our current problems are very confusing. If you aren't confused, you don't understand them very well." - Charlie Munger

Market Freezes Up
"Plainly, physics has made a different kind of contribution to human society than economics has. Then, again, physics is an easier nut to crack than economics. Electrons don't have feelings, as they say.

Progress in science is cumulative; we stand on the shoulders of giants. But progress in finance is cyclical; in money and banking, especially, we seem to keep making the same mistakes." - From Page 17-18 in Grant's Interest Rate Observer, Volume 31 Summer Break, August 23rd, 2013

Deadly Sins of Investing
"What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding cost. It's a mathematical fact. There's no getting around it. The fact that we don't look at it, too bad for us." - John Bogle

John Bogle on "The Last Gatekeeper"
In this Morningstar interview, John Bogle points out that if you add together the money managed by the 25 largest firms in the mutual fund business, it represents something like 50% of the equity in America.

"A small handful of corporations, particularly the top five of them, control corporate America. And corporate America needs a lot of cleanup, a sweeping out. Executive compensation is a disgrace. Political contributions made by corporations are a disgrace..."

Bogle then later added...

"So when you look at the whole picture, really we're the last gatekeeper. Think about that for a minute; I have a chapter in the book about gatekeepers. We're the last gatekeeper. We, the mutual fund industry. The courts have failed us in terms of shareholder rights. The regulators have failed. The security analysts have failed. The money managers have failed. Right down, the press has in many respects failed with a few exceptions. The fund and corporate directors have both failed, and we're now down to the last line: the shareholders who own those companies. And if they don't speak, there's nobody left, and corporations should not be left to operate as private fiefdoms of their chief executives."

Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
"Economics is a very soft science but it has delusions of hardness or what has been called physics envy. One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed introduced rigor into economics, it unfortunately also brought mortis. Later in his career he felt that economics had lost sight of its job to be useful to society, having lost its way in a maze of econometric formulas, which placed elegance over accuracy.

At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not fi t the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).

We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the last 25 years at least four of the great investment bubbles in all of investment history." - Jeremy Grantham

"So, economics has been more or less threadbare for 50 years. Pity then the plight of the Bank of Sweden with all that money to give away in honor of Alfred Nobel and in envy, perhaps, of the harder sciences." - Jeremy Grantham

Happy New Year,

Adam

Quotes of 2012

Buffett: How to Minimize Investment Returns

At the beginning of the "How to Minimize Investment Returns" section found in the 2005 Berkshire Hathaway (BRKa) Shareholder Letter, Warren Buffett mentions that the Dow increased from 66 to 11,497 from 1899 to 1999.*

He then says:

"This huge rise came about for a simple reason: Over the century American businesses did extraordinarily well and investors rode the wave of their prosperity. Businesses continue to do well. But now shareholders, through a series of self-inflicted wounds, are in a major way cutting the returns they will realize from their investments."

The reason is straightforward enough as Buffett goes on to point out. He says the "fundamental truth" is that owners, in aggregate, can only earn what the businesses, in aggregate, earn over time. 

Naturally, individual participants attempt to gain advantage over other participants. 

Yet, it's not difficult to show how unwise this behavior generally ends up being.
(More on this below.)

I'd emphasize Buffett's point above that "businesses continue to do well."

Why?

Well, as long as a fair price is paid in the first place, how the businesses perform will be the long-term driver of future returns.

Buffett adds this later in the letter:

"For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.

Indeed, owners must earn less than their businesses earn because of 'frictional' costs. And that's my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.

To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We'll call them the Gotrocks."

In 2005, American corporations were earning roughly $ 700 billion each year and, as outright owners, this fictional family will spend obviously some of it. Yet that remaining large unspent portion is saved and compounds for these continuing long-term owners. More from Buffett:

"In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.

But let's now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family's annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.

After a while, most of the family members realize that they are not doing so well at this new 'beat-my-brother' game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he'll never outsmart the rest of the family. The suggested cure: 'Hire a manager – yes, us – and get the job done professionally.' These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.

The family's disappointment grows. Each of its members is now employing professionals. Yet overall, the group's finances have taken a turn for the worse. The solution? More help, of course.

It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we'll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. 'What,' the new Helpers ask, 'can you expect from such a bunch of zombies?'

The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.

The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.

And that's where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked).

A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks. Today, in fact, the family's frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one."

This 80% number might seem extreme. It's not. The reality that roughly 80% of returns is now going to "helpers" has been highlighted by John Bogle as well:

"Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return, and you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That is a financial system that is failing investors because of those costs of financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed."

Buffett closes the "How to Minimize Investment Returns" section of the letter with the quote about Sir Isaac Newton that's located in the upper right hand corner of this blog.

For lots of reasons, I've liked the story of Isaac Newton's speculative folly for quite a long time. It not only highlights that being very smart and investment success need not have much to do with each other; it also highlights, despite massive progress in other ways, the persistence of human nature and how unlikely it is to change. Similar mistakes are made under what seems to be not sufficiently different circumstances. The lessons are there for the taking but not applied. Buffett's quote about Newton provides another dimension: The folly of allowing market hyperactivity and frictional costs to enter the equation. It emphasizes how poorly lots of trading activity is going to work out for investors as a whole. Of course, that leads many to conclude they'll be on the right side of this gross returns minus frictional costs game. What Buffett calls the "'beat-my-brother' game." Well, for most market participants, the odds aren't good that this approach will fatten their portfolio. It would seem that Buffett's parable and all the other available evidence would make this pretty obvious but, well, history suggests it won't change behavior.**

Some will rightly conclude that there's no point to buying individual stocks. For many that's the right conclusion. The good news is there are many convenient, low frictional cost ways available to approach long-term investment this way. Still, for those inclined and able to judge the prospects of a business well, the same essential lesson applies: It makes little sense to allow all the frictional costs to creep into the process.
(Not to mention the chance for additional misjudgments. When an action is taken, how the move might improve results isn't the only consideration. In fact, it's the opposite outcome that just might deserve greater consideration.)

Buffett points out that the annual growth rate required to produce an increase from 66 to 11,497 over 100 years was 5.3%.

Compounding is a powerful force.

Keep in mind that, in addition to that not exactly modest increase, long-term investors would have received a not at all small quantity of aggregate dividends (which were, earlier in that century, a much larger part of total returns) over that time frame.

Investment results via marketable stocks -- in contrast to speculative results -- come primarily from the increase to per share intrinsic business value (driven by what the business earns, in aggregate, over time). Those that achieve (or claim to achieve) above average results via cleverly timed trades make for great stories and headlines. Some individuals will actually even succeed at this kind of approach but results, in total, will otherwise inevitably be gross returns minus frictional costs. It's one of "the relentless rules of humble arithmetic."

So sure there will be exceptions, but is it wise to engage in a strategy that's based upon being the exception?

At any point in time some market participant will be able to promote the brilliant trade they made. It might even get its fair share of coverage. The incentive to boast is surely there. I'm guessing the not so brilliant trades will get promoted just a bit less.

Best to trust only carefully audited results over very long time frames.

Otherwise, skepticism is very much warranted.

Investing well means not being impressed by -- and not being susceptible to -- the compelling "story". That's not only true when attempting to judge the actual capabilities and results of other market participants. That's true when judging the risk-adjusted prospects of a particular investment alternative.

Investing is about how price compares to value.

It's about how well value is truly understood (or can be understood).

It's not about how compelling the "story" sounds.

In any case, hyperactivity among market participants, combined with the willful payment of excessive fees, is a recipe for making the "helpers" rich and paying lots of taxes.

Those putting up the capital take essentially all the risk (well, at least beyond "career risk") and end up compensated insufficiently or worse.

Adam

Long position in BRKb established at much lower than recent market prices

* Pages 18-19 of the letter.
** If attractive long run results at the lowest possible risk is the objective, being realistic about not only one's own capabilities, but also what approach has a high likelihood of working over time, is a good chunk of the battle. Unfortunately, overconfidence in abilities and overestimating future prospects gets in the way and, naturally, isn't likely to end up being particularly lucrative. Of course, efficient market hypothesis doesn't allow for such an outcome -- less risk, more reward -- but that's another subject altogether.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Bogle & Buffett on Stocks

John Bogle and Warren Buffett and made some rather noteworthy comments about stocks last month.

More on their comments below. First, here's a quick look at the GMO 7-Year Annual Real Return Forecast for stocks:

U.S. Large: minus 2.0%
U.S. Small: minus 3.8%
U.S. High Quality: 3.3%
Intl Large: 1.9%
Intl Small: 1.6%
Emerging: 6.5%
(GMO also provides forecasts for other asset classes that I've not included here)

Now I don't usually find most forecasts to be all that useful but, at a minimum, this probably should give someone pause who has very high expectations of future equity market returns.

Keep in mind that GMO's forecast was made when the stock market was lower than it is now.

For some context, here's an article that summarizes how past GMO forecasts (going back to 1994) have looked against reality over the years.

"While there was clearly a pessimistic bias to the forecasts, the direction of their guesses was remarkably accurate..."

The reason I don't pay much attention to forecasts is simply because, in the long run, what the market as a whole does matters far less* than whether a specific investment's intrinsic value has be judged well, and whether a nice discount was paid to that estimated value.
(I've said before: A well-judged long-term investment that temporarily gets an even bigger discount due to market conditions shouldn't be a problem. It's just an opportunity to accumulate more while making buybacks, if they already made sense, even more effective.)

John Bogle recently offered his own slightly more optimistic and straightforward view.

He said that at "a 2% dividend yield, which is roughly where we are today, and possibly--maybe a little optimistically--5% earnings growth from here; that would be a 7% what I'll call investment return, a fundamental return--the real return, not real in the inflation sense, but the actual return earned by Corporate America. And that looks to be around 7%; it could be point or two more.

I don't look for speculative return, which is will that P/E go way up or way down. I can't imagine it going way up. I think it is unlikely it will go way down."

He continued by saying...

"7% is pretty good. You double your money in a decade. Think about this for a minute: That's not a very high real return. By the time this decade over, we'll probably be around a 2% inflation rate, if we are lucky. Maybe all hell is going to break lose, with all this purchasing by the Fed of the securities. But [assuming 2% inflation], that would be a 5% real return, and that's about a point lower than the long-term norm."

There's no getting around the fact that stocks are up quite a bit in a relatively short amount of time. Anytime prices start to move up quickly, there's an increasingly high probability that the margin of safety on many investments is beginning to disappear, has disappeared completely, or worse yet, is plainly overvalued.

To me, that's the time to start being more cautious unless a specific investment one happens to understand well has remained cheap.

This unattractive near-term environment might seem at odds with the following comment by Buffett in an interview last month on CNBC:

"The stock market compared to most assets, all of the big asset classes in my view, is the most attractive place to have your money over the next 20 years; whether it's over the next 20 days or 20 weeks I don't know but..we have our money in businesses. We own all of some businesses, we own parts of some businesses and we call those stocks -- and that's where we think value lies."

To me, it really is not at odds. Sometimes a fine business just happens to not fit in with whatever is hot at the moment; for whatever reason it just doesn't capture the speculative imagination.

Sometimes a fine business has near or intermediate term real, even serious, but fixable business challenges.

These can be opportunities for those who are more interested in long-term outcomes and less concerned with near term price action.

Even very good businesses run into difficulties from time to time. Well, market participants who chase the near-term price action are naturally not going to have patience for such things. They'll likely head for the exits at the first sign of real trouble.

In other words, they're mostly interested in profiting from price action and less focused on increases to long run per share intrinsic business value. For these participants, increases to per share intrinsic value are, at most, a secondary consideration. The idea of patiently waiting for challenges to be sorted out -- and, if they do, profiting much later -- just doesn't fit in with the ethos.

What stocks might do in the near term might be of interest to speculators, but Buffett and Bogle are talking strictly about changes to per share intrinsic business value over longer time frames.

Investment returns instead of speculative returns.

Share prices may fluctuate wildly near term but, in the long run, they're going to roughly reflect changes to per share intrinsic value.

Buffett doesn't think there currently is a bubble in stocks. When asked if stocks were at bubble levels he also added:

"...we could at some point, but no, stocks are not selling at bubble levels. What do you diversify in? Do you want to diversify into cash? I think it's a terrible investment compared to equities. Do you want to diversify into long-term bonds? I think it's a terrible investment compared to equities. So...I mean...you're going to have your assets in something, and I think that good businesses held for a long period of time are certain to deliver good results."

Certain individual securities may remain attractive, but that doesn't necessarily mean the market as a whole is particularly attractive.

It also doesn't mean it's in bubble territory even if certain stocks seem to surely be getting there.

In any case, the risks of buying whatever the hot money is chasing seem undeniable (even if the risks don't become obvious until much later). In fact, many individual stocks seem extremely overvalued. Okay, maybe not late 1990s overvalued**, but actually some individual high flyers aren't far from it.

Buying with a nice margin of safety is central to the investment process. With that in mind, the time to be buying was when huge discounts to per share intrinsic value existed. Several years ago -- during and coming out of the financial crisis -- was as good an example as any of an opportunity to do just that sort of thing.

That opportunity is mostly in the rear-view mirror. This probably seems obvious now, but investment success requires decisive action when it doesn't feel particularly good, and knowing what you want to own (with a high conviction level).

Buffett's emphasis is always on the long-term. That's not exactly news. It's just that investing is never about what the price action might be in the near term or even intermediate term. It's certainly not about market timing. Somehow, this sometimes still seems to get missed. It's a focus on how price compares to the per share intrinsic value of a business that's truly well understood (in contrast to an investor who overestimates how well something is understood). It's coming up with conservative estimates of value. It's ignoring short term market noise. It's being prepared to buy when uncertainty seems at its greatest (or very near to it).

Now, I'm certainly not always reluctant to buy stocks. Prior posts during what appeared to be more uncertain times over the past five years or so should make that pretty obvious. I say "appeared" because the world is always uncertain (it's just the perception of uncertainty that changes). Adverse and unpredictable events are inevitably always ahead. From a long-term equity investor point of view, the best times to buy are usually when the headlines are the most daunting.

That's when stocks are likely to be most attractive to invest in for the long-term.

That's when the margin of safety is generally largest even if buying doesn't feel good at the time. Temporary paper losses are almost a certainty. What's cheap becomes cheaper. Attempting to always buy something that's plainly undervalued without suffering temporary losses creates a very different risk: owning far fewer shares (or even none) compared to the quantity that was wanted of a well understood business. There's only so many investments one can know well. Missing the chance to own, for the long haul, a meaningful quantity of what one knows at an attractive price makes little sense.

Buffett's view might seem to contradict GMO's view greatly but really doesn't. That the market as a whole isn't likely to do particularly well in the coming years (as always I never have a view on the markets) doesn't mean shares of an individual business aren't selling at a nice discount to value.

The latest Berkshire Hathaway (BRKa) results revealed that Buffett did slightly more buying than selling of equities in the third quarter:***

Of course, you can't read too much into how much has been bought or sold in any given quarter.

Yet he seems inclined to be buying more so than selling if you look at the first nine months of this year (especially when the Heinz acquisition is included).

The same has been true, by and large, during and since the financial crisis began.

It's not timing the market. It's comparing price to per share intrinsic value and paying a nice discount for something that's understandable.

Even if, at times (like the late 1990s, for example), it becomes generally difficult to find attractively priced equities, the emphasis isn't on timing.

The emphasis is price versus value.

Adam

Long position in BRKb established at much lower than recent market prices

* Though those biased in favor of efficient markets surely won't agree.
** In contrast to now, Buffett was warning that many stocks were quite overvalued in the late 1990s.
*** Subtract purchases and sales of equity securities in the current (page 5) Consolidated Statement of Cash Flows from the prior purchases and sales of equity securities.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

John Bogle on "The Last Gatekeeper"

In this Morningstar interview, John Bogle points out that if you add together the money managed by the 25 largest firms in the mutual fund business, it represents something like 50% of the equity in America.

He goes on to say the following:

"A small handful of corporations, particularly the top five of them, control corporate America. And corporate America needs a lot of cleanup, a sweeping out. Executive compensation is a disgrace. Political contributions made by corporations are a disgrace..."

Bogle then later added...

"So when you look at the whole picture, really we're the last gatekeeper. Think about that for a minute; I have a chapter in the book* about gatekeepers. We're the last gatekeeper. We, the mutual fund industry. The courts have failed us in terms of shareholder rights. The regulators have failed. The security analysts have failed. The money managers have failed. Right down, the press has in many respects failed with a few exceptions. The fund and corporate directors have both failed, and we're now down to the last line: the shareholders who own those companies. And if they don't speak, there's nobody left, and corporations should not be left to operate as private fiefdoms of their chief executives."

Some tough talk by John Bogle but, to me, seems rather a fair assessment. It's not a small problem even if the damage done is sometimes less than intuitive and hard to measure. Quantifying how costly this is may not be easy but, even if difficult to know with precision, the current defects likely, over time, are harmful in a not insignificant way. How well the system functions eventually impacts - both positively or negatively depending on how well it's working -- wealth creation and living standards. So it may be a challenge to quantify the costs but they are very real.

Unfortunately, too many of those who are in the best position to influence sensible change in a meaningful way -- the gatekeepers -- mostly are not attempting to do so.

It's not all that hard to figure out why.

"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" - Upton Sinclair

Bogle has referred to and paraphrased that Sinclair quote on prior occasions. Making changes happen when it's so lucrative for those who operate within the existing framework is never going to be straightforward. That's especially true if those who prefer the status quo can afford to influence policy. It's not easy to make what might otherwise be considered sensible changes when, as a direct result of the changes, there's a real risk the game will become a whole lot less lucrative for those involved.

Fortunately, the current system still has many strengths to go along with the plain defects. We might get by okay with things remaining as they are, but not fixing at least some of the most obvious flaws is, well, dumb and costly. So it's not completely broken but rather just isn't serving the world nearly as well as it could be.

The compounded costs seem likely to be significant if, longer term, something close to the status quo remains in place.

There just aren't enough John Bogle's in the world. Wise changes would certainly come about more quickly if that were the case.

Adam

Related posts:
Munger on Corporate Finance and Psychology
Upton Sinclair
Bogle: History and the Classics

* John Bogle is referring to his book: The Clash of the Cultures: Investment vs. Speculation

Deadly Sins Of Investing

This Wall Street Journal article, The Seven Deadly Sins of Investing, covers some things that tend to get investors into trouble; things that lead to reduced returns, or worse, maybe even disastrous results.

Here's a quick summary of the first three "Deadly Sins":

1 Chasing Recent Performance

"People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them." - Warren Buffett in Fortune, December 2001

Chasing what has done well in the recent past just isn't likely to be a path to riches. During the tech bubble many market participants couldn't get enough of the high flyers -- stocks that went from already very overvalued to valuation extremes rarely seen -- while many bonds and other much less exciting marketable securities were rather more reasonably valued if not cheap.
(At least by comparison cheap if not absolutely cheap.)

"Recency bias" can be very expensive for investors.

That crazy time in the stock market wasn't solely caused by recency bias, of course, but the tendency played at least a supporting role.

2 Being Overconfident

It's easy to mistakenly believe more is known about something than is actually the case; to think that what will happen can be reliably predicted when, in reality, there is a rather wide range difficult to gauge future outcomes.

Outcomes that few if anybody can predict with consistent success.
(Though, no doubt, someone in the prediction business who correctly -- even if mostly through random good luck, less via skill -- predicts an outcome they will heavily tout the accomplishment for marketing purposes.)

"The illusion that we understand the past fosters overconfidence in our ability to predict the future." - Daniel Kahneman in his book Thinking Fast and Slow

In any case, for investors, thinking that future business prospects can be understood to a greater extent than is possible is no small pitfall.

As Warren Buffett has previously explained:

"If a business is complex or subject to constant change, we're not smart enough to predict future cash flows."

Buffett goes on to say that the best way to combat this reality is to 1) own simple, understandable (to oneself...that's necessarily unique to each investor), and stable businesses while 2) always buying with a margin of safety. An acute awareness of limits doesn't hurt. What matters is not how much the investor knows; it's rather how well they understand what they do not know.

That might make sense for someone who rightly concludes they can pick individual stocks. John Bogle would more than suggest too many kid themselves in this regard. 

Hard to argue with that.

Related: Fighting Investors' Greatest Enemy: Overconfidence

3 Overlooking Costs

Frictional costs of all kinds, if minimized, play a huge role in achieving satisfactory or better long-term returns.

As John Bogle said in this Frontline report earlier this year:

"What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding cost. It's a mathematical fact. There's no getting around it. The fact that we don't look at it, too bad for us." - John Bogle

Bogle: High Investment Costs Destroy 'Magic Of Compounding Returns'

2.5% in annual frictional costs means that way too much of investment returns does not go to who is putting the capital at risk. A large proportion of the long-term compounded returns is going to someone who isn't exposed to the risk of permanent capital loss.

Wait, isn't 2.5% too high? Mutual funds usually charge a whole lot less than that, right?

Well, explicitly yes, but...

According to John Bogle, if you include all the costs -- some explicitly visible, some less so -- it's more like 2.5% or so.*

Here's what Bogle had to say in this not at all recent but still very relevant PBS interview:

"...the financial system -- the mutual fund system in this case -- will take about two and a half percentage points out of that return, so you will have a gross return of 8 percent, a net return of 5.5 percent, and your $1,000 will grow to approximately $30,000. One hundred ten thousand dollars goes to the financial system and $30,000 to you, the investor. Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return, and you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That is a financial system that is failing investors because of those costs of financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed."

So what does Bogle say to those that think they can "beat the averages"?

"I say, don't kid yourself, pal."

He also said the following in this Forbes interview:

"I look at [the] investment system as being deeply troubled. Our system costs too much and does not provide enough value. The more you pay, the less you get net. If the market gives 8% return and it costs 2.5%, you get 5.5%. That's what is called 'the relentless rules of humble arithmetic.' There is too much cost in the system and not enough value.

There is too much speculation and not enough investment."

Absolutely true. Still, whether this is well enough understood or not, it seems likely that way too many investors will continue to incur these huge costs.

Unfortunate, but it's not like there isn't convenient ways to not incur these costs.

Three down, four to go.

More in a follow up.

Adam

* Anywhere from 2% to 2.5% has been used by John Bogle at various times from what I've read. Either way, it comes out to quite a material amount of money over the long haul.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Market Freezes Up

Those watching business news yesterday had to listen to talking heads acting like -- if not the end of the world -- that not being able to trade Nasdaq stocks for a few hours was yet another blow to market participant confidence.

Nasdaq market paralyzed by three hour shutdown

Well that may be the case but a marketable stock is, first and foremost, partial ownership of an operating business.

"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett

So, if the market system happens to malfunction from time to time -- as it seems almost certain to do, and maybe to a much greater extent than this most recent episode -- it doesn't change the per share intrinsic value of that underlying operating business. Those with an investment time horizon were fine; traders maybe less so.
(In the flash crash certain stocks temporarily were significantly impacted. That event similarly had no impact on underlying business value. An investor who did nothing, or maybe even bought shares they liked that became a bit cheaper, was just fine.)

Now, as Charlie Munger pointed out in a conversation at Harvard-Westlake back in early 2010, there is a real benefit to knowing one can sell, relatively easily, part or all of an investment that they've made; that those risking capital become more apt to invest if they feel certain they'll generally have, when the appropriate times comes along, a straightforward, low cost, way to sell.

As Munger says: "It's not like buying a restaurant in the wrong place."

That doesn't logically mean one must be able to sell their shares every second, minute, and hour of every trading day. The beneficial aspects of this ease of conversion -- from one investment to another -- exists as long as what should be an advantage isn't turned into a disadvantage by doing lots of unnecessary trading.

Actual investment (as opposed to trading price action) just doesn't require all that much buying and selling.*

Certainly not anywhere near the amount that our hyperactive modern market system allows participants to theoretically do.

In fact, in many ways, capital formation and investment is undoubtedly negatively impacted by this hyperactivity and other forms of short-termism.

Closing a market for five years may be extremely unlikely, but it's true that a few hours should matter little to the true investor.

It's what the business does over an investment horizon that matters.

Nasdaq Flash Freeze Called 'Inexcusable'

Nasdaq OMX connectivity disaster highlights stumbling markets

Words like "inexcusable" and "disaster" may apply in some ways but, if anything, the problem seems more that we have too many market participants focused on frenetically trading in and out of marketable stocks (not to mention their derivatives). Adding layers of activity and related costs with mostly no particular enduring value added (and, as we've seen from the financial crisis, some of it plainly destructive).

It's renting price action -- what is a zero-sum game before the frictional costs -- instead of owning pieces of businesses then benefiting from what they produce over the long haul.

Profiting from speculation on near-term price action depends upon cleverly timed trades to get good results.

In contrast, the primary drivers of investment returns come from changes to intrinsic value and the discipline to not overpay in the first place.**

An actual investment is definitely not zero sum; it depends not upon brilliant trading.

Considering the power of long run compounding effects, it seems foolish to no allow those forces to work for the investor. What initially seems like a minor tailwind becomes anything but with the benefit of longer time frames. Well, all this frenetic trading and resultant frictional costs can only, in aggregate, subtract from the magic of compounding returns.
(John Bogle calls this "the tyranny of compounding cost".)

There has certainly been lots of scientific and technological advancements that have enabled all this market hyperactivity.

James Grant once said that in science and engineering more generally (i.e. not just as it relates to finance and financial systems), progress tends to be cumulative.

Unfortunately, that's not really the case in finance.

"Progress is cumulative in science and engineering, but cyclical in finance." - James Grant in Money of the Mind

Grant put it the following way in his latest letter:

"Plainly, physics has made a different kind of contribution to human society than economics has. Then, again, physics is an easier nut to crack than economics. Electrons don't have feelings, as they say.

Progress in science is cumulative; we stand on the shoulders of giants. But progress in finance is cyclical; in money and banking, especially, we seem to keep making the same mistakes." - From Page 17-18 in Grant's Interest Rate Observer, Volume 31 Summer Break, August 23rd, 2013

Apparently, when scientific and technological progress meets financial progress, it is the latter's inherent cyclicality that wins.
(Cyclical in the sense that the same, or at least similar, mistakes seem to be repeated but the size of the financial sector as a percentage of U.S. GDP has been anything but cyclical -- especially since the 1940s.)

The systems have certainly become more sophisticated and technically complex. Whether, as a result, it's serving us better in most of the important ways seems debatable at best.

A market freeze up certainly matters for someone who has funds exposed to the market that are needed in the near term. Of course, funds needed in the near or even intermediate term shouldn't really be exposed to equities in the first place.
(Investment is ideally measured in decades, not years, but the appropriate time horizon is necessarily imprecise and unique to each situation. 2-3 years may seem long-term to some folks but, in my book, that kind of time horizon is simply not an investment horizon.)

A market disturbance like the one yesterday no doubt can pose real problems for the active trader. Yet Buffett and Munger explained back in May of this year why these sort of events should be of little concern to the long-term investor.

During such similar disturbances, the long-term investor who bought (via a marketable stock) part of a quality business at a reasonable valuation in the first place isn't hurt (again, even if the quoted price is temporarily an unpleasant one).

In fact, if it ended up being more than a short-term event, the reduced price should also not bother the long-term owner.

Why?

Well, it not only allows that owner to buy more shares cheap over time, it also allows the funds being allocated to share buybacks to go further. The highest quality businesses generally will throw off excess cash at a high return on capital. So a long-term investor focused on per share intrinsic business value should logically prefer lower stock prices in the near-term (and, for that matter, even the intermediate-term...the longer the low price persists the more powerful a buyback becomes when consistently executed below per share intrinsic value) while the business itself remains, at least, relatively sound.

Naturally an investor should want the earning power of a business to do well over the long haul but, as Warren Buffett has previously explained, a stock price that temporarily (or longer) lags is hardly a problem for the long-term investor.

Investment is about what the business itself produces over time.

Why Buffett Wants IBM's Shares "To Languish"

The intrinsic value of a productive asset (in this case a business that happens to be partially owned via a publicly traded marketable stock), especially one with durable advantages, just will not generally change nearly as much in underlying value as the daily quoted prices might otherwise suggest. There's inevitably lots of noise and, well, emotion in the short-term "votes" of a publicly traded company. A private business owner has no such noise and emotion to consider. With no daily quoted prices to distract, a long-term oriented private business owner can theoretically just focus on making sure the business is being run in a way that creates enduring value.
(Still, even with this longer term focus many businesses will do poorly or fail, of course.)

It need be no different for owners of a high quality business that happens to be publicly traded.

So these almost-certain-to-occur-from-time-to-time market disturbances matter a whole bunch for traders but not so much for investors. When justifiably confident in per share value, the investor focused on long-term effects is not going to mind if something bought at a discount temporarily gets an even bigger discount.

Highly volatile, unpredictable markets (whether due to self-inflicted instability/uncertainty -- market structure, poor system design -- or an external shock) can impact the real economy if severe enough to damage business and consumer confidence.

This can also keep investors who otherwise might participate in the capital markets from doing so.

That's quite a different but potentially very real problem.

Yesterday seemed pretty mild, but I don't doubt that the more serious versions of these kind of events adversely impacts confidence. Yet a more deeply embedded -- culturally and systemically -- longer term perspective among a greater proportion of participants just might mitigate this. Some education -- the development of an alternative trained response to market fluctuations -- and the right incentives can take us a long way toward material improvement in this regard.

So both a cultural shift and systemic changes will certainly be necessary. Well, I think it's fair to say that this kind of fundamental shift is unlikely to happen fast even in the best of circumstances.

In any case, for those with a longer investment horizon, the markets should be made as welcoming as possible.

For pure near-term speculation on price action, markets should be made a less welcoming place.

That'd make for a better balance than what's currently in place.

In the meantime, a long-term investor can still do just fine if they follow sound investment principles.

Buy only what is well understood.***

Focus on underlying business value.

Always have a margin of safety.

Ignore the near-term noise.

In fact, even better yet, is allowing the inevitable market fluctuations resulting from disturbances both small -- as in what happened yesterday -- and large -- as in the financial crisis -- to work for the investor.

The right temperament goes a long way in investing.

Adam

* Charlie Munger also points out -- using Alan Greenspan as an example but there are many others, of course -- some economists are in a camp that thinks "if you had a really free, liquid, wonderful market in securities, that would be wonderful, and the bigger and more wonderful it was, the better it was for the wider civilization." He also adds that some "presumably are looking forward to trillions" of shares being traded and then says:

"Our civilization is not going to work better if we have trillions of shares traded everyday. It's the most asinine idea you could ever have to extrapolate so vigorously..."

Munger states that Alan Greenspan's view of the world when he was leading the Federal Reserve was the the result of having "overdosed on Ayn Rand." Greenspan's views may have changed since (or, maybe, directly as a result of) the financial crisis but were a real factor at the time. At the very least he has seemingly been willing to modify his world view in light of what happened. Others appear less inclined to do so.
** It's buying shares of well understood businesses, with a margin of safety, and for the most part judging correctly -- within a range -- the core long-term economics. False precision in investing just leads to trouble. Act accordingly. It's recognizing what can't be reliably known or predicted. Margin of safety can be seen as just the humble acceptance of one's own limits; the understanding that an inevitably uncertain world exists. Overconfidence in one's own ability to forecast future outcomes will likely lead to more risks taken for less reward over the long haul. When an investor always strives to pay a price that requires nothing great to happen to get a good result, there should be few complaints if things go better than expected. This requires patience, discipline, and often a fair amount of work, but eventually the market usually offers an attractive price of something that is well understood. When it does decisive action is required. Easier said than done if not impossible. When an investor protects against permanent capital loss by employing sufficient margin of safety, the good news is it then also allows unforeseen (or unforeseeable) upside to remain a possibility.
*** Naturally, whether an investment can be understood well is necessarily unique to each investor. Those who make a particular investment because someone else thinks it has attractive long-term prospects (i.e. without having come to that conclusion via their own analysis) just aren't likely to have the conviction needed to hang in there -- or, well, to not hang in there if a mistake was made -- when the price action goes the wrong way. Stick with what you know.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Munger: "Cognitive Failure" In Economics

From this conversation with Charlie Munger at Harvard-Westlake:

"Alan Greenspan at the Federal Reserve overdosed on Ayn Rand. Basically he kind of thought anything that happened in the free market, even if it was an axe murder, had to be ok. He's a smart man and [a] good man, but he got it wrong. Generally, an over-belief in any one ideology is going to do you in if you extrapolate it too hard, and that's what happened in economics."

So, according to Munger, what caused this "cognitive failure" in economics?

"They reasoned correctly that a free market would be way more predictive than anything else, and they reasoned correctly that once you had a fairly advanced capitalist system – if the people that were putting up the capital could sell their pieces of ownership in the company to other people, they'd be more inclined to invest because it gave them an option to get out if they wanted to leave. It's not like buying a restaurant in the wrong place. Then they reasoned that if that was true, if you had a really free, liquid, wonderful market in securities, that would be wonderful, and the bigger and more wonderful it was, the better it was for the wider civilization."

Having a million shares trade in a day was a rare occurrence when Munger attended Harvard Law School. Now billions of shares trade each day. He guesses that those who think along these lines are probably looking forward to when trillions of shares will trade in a day. Munger then adds...

"Our civilization is not going to work better if we have trillions of shares traded everyday. It's the most asinine idea you could ever have to extrapolate so vigorously, and of course three or four billion shares is way too many. We have computer programs that are trading with other computer programs. We have many of the bright people who ought to be doing our engineering going to work at hedge funds and investment banks and algorithmic trading places and so on and so on."

Munger goes on to say "at any rate, these people got the idea [that] unlimited trading is a big plus for civilization."

Well, John Maynard Keynes certainly thought otherwise as Munger further explains:

"[Keynes] said a liquid market of securities is one of the most attractive gambling devices ever created. It has all the joy of gambling, plus it's respectable. Furthermore, instead of being a zero-sum game, where you are bound to lose the frictional cost, it's a game where you can pay the frictional cost and actually make a profit. This is one of the most seductive gambling devices ever invented by man, and some nut who took economics thinks that the bigger and better it gets, the better it is for wider civilization."

Now, consider that speaking to Forbes back in 1974, Warren Buffett described the business of investing in the following manner:

"I call investing the greatest business in the world...because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There's no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it."

Investing can certainly be a great business but all this hyperactivity is directly at odds with the reasons why.

Compared to all this rapid trading of price action, waiting patiently for something you understand to get cheap enough, then owning it for a very long time, is a completely different game.

Modern capital markets are an incredibly convenient way to buy part of a good business that's priced attractively with minimal frictional costs.

To me, it seems quite the shame to see something so incredibly useful and powerful converted into a casino; see it turned into something less than it otherwise might be.*

So more of something doesn't automatically make it better. There's often optimal amount -- at least within some range -- and, of course, diminishing returns or worse. Some short-term oriented speculative activity is necessary and even desirable. That doesn't logically mean that unlimited amounts of it is a good thing. 

The amount of speculation relative to investment matters and the former is currently swamping the latter. What John Bogle describes as The Triumph of Speculation over Investment.

There may not be a precisely knowable correct ratio of speculation to investment, but I think it's safe to say we are far from what makes sense. I've used the petrol engine as a simple -- even if a limited and imperfect one -- example of this. 

The petrol engine just doesn't function all that well if the air-fuel ratio strays too far from what's optimal (and, eventually, it won't function at all if there's too much of either substance).

As with most any system, even what is a comparably simple one, the proportion matters rather a lot.

If efficiently and effectively allocating capital and strong long-term business performance are the primary goals then, in their current hyperactive form, the equity markets seem likely to have far from the optimal ratio of speculation relative to investment.

Check out the entire conversation with Charlie Munger at Harvard-Westlake. 

Lots of useful thoughts and insights.

That 1974 Forbes article is a pretty worthwhile read too even if not exactly breaking news.

Adam

* Capital markets exist to move funds to where they're needed efficiently, to make sure owners of public companies have some reasonable visibility into how well what they own is being managed for the long haul so they can act accordingly, with frictional costs no higher than necessary. It's not a casino that exists to mostly serve the active participants themselves.

Charlie Munger at Harvard-Westlake