While some academic economists continue to cling to the notion that the stock market is highly efficient, the long history of manias, booms and busts, cult stocks and behavioral anomalies speak to the contrary.
Just because the market can often behave irrationally, however, doesn't mean it is not prone to taking a somewhat rational course under normal conditions. Even Charlie Munger (Trades, Portfolio), Warren Buffett (Trades, Portfolio)’s longtime business partner at Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), acknowledges the market behaves fairly rationally most of the time.
Munger on market efficiency
According to Munger, the market is fairly efficient overall, though far from completely so:
"I think it's roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don't think it's totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It's efficient enough, so it's hard to have a great investment record. But it's by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine."
The broad efficiency of the market is, in Munger’s estimation, a major reason why few investors can achieve market-beating returns. However, it is hardly impossible, as Munger’s own track record shows.
Only move when you have an advantage
Market inefficiencies arise without clear pattern and can vary widely in scope, from all-consuming market panics to industry-spanning irrationality to company-specific mispricing. According to Munger, the key to beating a broadly efficient market is to act only during these occasional bouts of irrationality:
"Move only when you have an advantage. It's very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor. We just keep our heads down and handle the headwinds and tailwinds as best we can, and take the result after a period of years."
Success requires embracing the virtue of psychological grit, especially patience and fortitude. Standing apart from the crowd, refusing to follow fads and diligently pursuing possible inefficiencies to exploit can take a toll on investors. Being contrarian is not easy, but tends to pay off handsomely for those with the fortitude to wait for the right moment to make a move.
Apply rigorous analysis to every potential opportunity
While psychological grit is a necessary quality in an investor hoping to beat an efficient market, it is not sufficient by itself. The ability to remain patient and go against the grain can only pay off if that psychological individualism is paired with an analytical mind. According to Munger, investors cannot beat an efficient market by adopting a cookie-cutter approach to securities analysis. Instead, investors must develop the flexibility to approach opportunities from multiple angles through the adoption of carefully selected mental models:
"You need a different checklist and different mental models for different companies. I can never make it easy by saying, 'Here are three things.' You have to derive it yourself to ingrain it in your head for the rest of your life."
While grit is what keeps an investor in check when opportunities are scarce, cleared-eyed analysis is what directs decision-making when an opportunity arises.
Play devil’s advocate with every opportunity
Since every company – and every opportunity – is rife with idiosyncratic factors, investors must become comfortable with developing bespoke analytical strategies. However, Munger does admit that there is at least one lens that is useful for any and every analysis:
"Invert, always invert: Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don't we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead. Tell me where I'm going to die, that is, so I don't go there."
By examining every potential opportunity from multiple angles, and through multiple lenses, an investor can act with maximum confidence.
Verdict
Munger has proven over a lifetime of value investing success that it is possible to beat an efficient market over the long run, provided one embraces the necessary psychological and analytical attributes with rigor and vigor.
Grit allows investors to be in the room when opportunities arise. Clear-eyed thinking and analysis allow investors to seize those opportunities. Both are essential to the successful value investor.
Disclosure: No positions.
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