Anyone who has followed Charlie Munger (Trades, Portfolio) for some time will know he is a great admirer of the work of 17th century mathematicians Pierre de Fermat and Blaise Pascal.
The two mathematicians have probably done more for investors than anyone else because they developed the original ideas behind modern-day probability.
Working on probability
As the story goes, in 1654, one of Pascal's friends approached the mathematician asking him why he consistently lost money when gambling. This man was no ordinary gambler. He was reportedly a highly intelligent individual who had an unusual gift for mathematics.
The problem intrigued Pascal, and throughout the summer of that year, he exchanged letters with Fermat, exploring the problem and trying to develop a solution. The correspondence between the two mathematicians became fundamental in the development of modern concepts of probability.
Munger has mentioned the work of Fermat and Pascal many times because he understands how important it is to think probabilistically.
Thinking probabilistically
In a 2008 speech titled "The Art of Stock Picking," Munger used the work of Fermat and Pascal to describe how inefficient the stock market is:
"The model I like to sort of simplify the notion of what goes on in a market for common stocks is the parimutuel system at the racetrack. If you stop to think about it, a parimutuel 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.
Any damn fool can see that a horse carrying a lightweight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it's very hard to beat the system."
The parimutuel system was a betting system introduced in France in 1870. It has since become one of the most popular methods of betting on horse racing. In the system, a bettor buys the tickets on the horse he wishes to back at the odds dictated by the operator. The winning payout is then made from the pool of all various bets made on the race after deducting commission and taxes. The benefits of the system is that it always gives the operator a profit and allows any number of players to win.
However, as Munger as went on to highlight in his speech, it is very difficult to beat the market consistently. Even without including frictional costs, assuming the bettor and betting shop both have access to the same information, it is unlikely either will be able to gain a consistent, substantial edge over the other. When you take out transaction costs such as commission, it is extremely likely the house will always win on average.
It is difficult to beat the market consistently, but there will always be the chance the bettor will be able to make one or two bets during their career, which will have a substantial payoff. That's precisely the strategy Munger and Warren Buffett (Trades, Portfolio) have pursued at Berkshire Hathaway for the past several decades:
"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. How many insights do you need? Well, I'd argue that you don't need many in a lifetime. If you look at Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) and all of its accumulated billions, the top 10 insights account for most of it. And that's with a very brilliant man. Warren's a lot more able than I am and very disciplined, devoting his lifetime to it. I don't mean to say that he's only had 10 insights. I'm just saying that most of the money came from 10 insights."
It is all about waiting for the perfect opportunity when the probability of success is high.
Disclosure: The author owns shares of Berkshire Hathaway.
Read more here:
- Howard Marks: Trying to Tilt the Odds in Our Favor
- Revisiting Ben Graham's Asset Allocation Policy
- Improving Your Investment Process With Shameless CloningÂ
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