Charlie Munger on Why Most Investors Can’t Outperform the Market

And by the way, my definition of being properly educated is being right when the professor is wrong. Anybody can spit back what the professor tells you. The trick is to know when he's right and when he's wrong. That's the properly educated person.

In the investment world, people involve an enormous amount of high IQ individuals trying to be more skillful than normal. You can hardly imagine another activity that gets so much attention, and weird things have happened. Years ago, one of our local investment counseling shops, a very big one, were looking for a way to gain an advantage over other investment counseling shops. They reasoned as follows: we've got all these brilliant young people from Horton and Harvard and so forth, and they work so hard trying to understand business and market trends and everything else.

If we just ask each one of our most brilliant men for their single best idea, then created a formula with this collection of best ideas, we would outperform averages by a big amount. That seemed plausible to them because they were ill-educated. That's what happens when you go to Harvard and Horton. They tried it out, and of course, it failed utterly. So they tried it again, and it failed utterly, and they tried the third time, and it also failed.

What they were looking for is the equivalent of the alchemists of centuries ago, who wanted to turn lead into gold. They thought if you could just buy a lot of lead and wait for a magic wand to turn it into gold, that would be a good way to make money. So this counseling shop was looking for the equivalent of turning lead into gold, and of course, it didn't work. I could have told them, but they didn't ask me.

The interesting thing about this situation is that this is a very intelligent group of people that come from all over the world. You've got a lot of bright people from China, where people tend to average out a little smarter. The issue is very simple: the simple question is, why did that plausible idea fail? Just think about it for a minute. You've all been to fancy educational institutions. I bet you there's hardly one in the audience who knows why that thing failed.

That's a pretty ridiculous demonstration I'm making. How can you not know that? It's where the main activity of America is an obvious and important failure. Surely we can explain it. You have to have stayed awake in your freshman college courses to answer that question. But if you ask that question at the department of finance at a leading place, the professors wouldn't answer it.

Right now, I'm going to leave you that question because I want you perplexed, and I will go on to another issue. But that's one you should be able to answer, and it shows how hard it is to be rational about something very simple. How hard it is! How many kinds of crazy ideas people have, and they don't work. You don't even know why they don't work, even though it's perfectly obvious if you've been properly educated.

And by the way, my definition of being properly educated is being right when the professor is wrong. Anybody can spit back what the professor tells you. The trick is to know when he's right and when he's wrong. That's the properly educated person. And of course, they're frequently wrong, particularly in the soft sciences. In fact, if you look at a modern elite institution, it's fair to say that a lot of the faculty are a little crazy. It's so left-wing now in the humanities, and it's very peculiar.

That's another thing: why should 90% of the college professors in the humanities be very left-wing? I leave that question for you too, but it happens. Another issue, of course, that's happened in the world of stock picking, where all this money and effort goes into trying to be rational, is that we've had a really horrible thing happen to the investment counseling class. These index funds have come along, and they basically beat everybody.

Not only that, the amount by which they beat everybody is roughly the amount of cost of running the operation and making the changes in investments. So you have a whole profession that's basically being paid for accomplishing practically nothing. This is very peculiar. This is not the case with bowel surgery or even the criminal defense bar or the law or something. They have a whole profession where the chosen activity they've selected, they can't do anything.

Now, in the old days, the people in the profession always had some of this problem, and they rationalized as follows: we are saving our clients from the insurance salesman and the stock broker. The standard stock broker serves the active trader, and they were saving people from the life insurance salesman and the hustling stock broker who liked active trading.

I suppose in the sense that the investing class is still saving those people from an even worse fate, but it's very peculiar when a whole profession that works so hard and is so admirable, and the members of which we are delighted when they marry into our families, just can't do what the profession is really trying to do, which is get better than average results. How is that profession handling this terrible situation as index investing gets more and more popular, including by a lot of fancy places?

Well, I guess the very simple answer is they're handling it with denial. They have a horrible problem they can't fix, so they just treat it as non-existent. This is a very stupid way to handle a problem. Now, it may be good when you're thinking about your own death, which you can't fix, and just denial all the way to the end.

But in all the practical fields of life, this problem, thoroughly understood, is half solved or better coped with. So it's wrong to have all these people in just a state of denial and doing what they've always done year after year and hoping that the world will keep paying them for it, even though an unmanaged index is virtually certain to do better. It's a very serious problem.

Think of how much New York City needs a flow of money from finance. Think what happened to Manhattan if there weren't any fees for investment management or trading spreads, and so on. It's a weird situation, and of course, it's unpleasant. Big investment counseling shops, some of them shrink, and some go out of business.

The value investors, of course, who many of I know because we came from that tradition—the value investors who are honorable are quitting. Boom, boom, boom! What worked for them for years stopped working. They’re honorable people; they just quit, and they're also rich, so it makes it easy. But those who aren't rich have a hell of a problem.

It costs about fifty thousand dollars to stay in Manhattan to send your kid to preschool, non-deductible. And that's just the start of an endless recession of years of vast expense. So if your game is money management, you have a serious problem. I don't have any solution for this problem.

I do think that index investing, if everybody did it, won't work, but for another considerable period, index investing is going to work better than active stock picking where you try and know a lot.