Charlie Munger: How the Stock Market Really Works

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Charlie Munger is commonly referred to as Warren Buffett's right-hand man, but he's actually a very clever, smart, successful investor in his own right. Back when he ran his investment partnership, he was able to generate 20% annual returns for a period of 13 years. But he's definitely an investor that likes to do things a little bit differently. He doesn't buy into the standard testosterone-fueled competitiveness that you see throughout Wall Street. In fact, Charlie Munger has openly criticized the locker room mentality that exists within Wall Street, and he actually says it causes enormous damage.

Wall Street attracts and rewards what I call a locker room culture. They'll let people who just have to win at football or soccer or something like that, and they're in nature, they're just so competitive that whatever A is doing, they have to be as good or better than A. And of course, Warren and I don't have those compulsions. I would rather live my way than theirs. They do enormous damage to the rest of us with their damn locker room culture that has to win and isn't very squeamish about what they have to do to win.

This is a deep-seated problem within Wall Street and always has been and always will be. It comes back down to how people end up in finance jobs. They start by studying economics or commerce or finance, whatever, and they get one of the lower pay, the lower tier jobs. It's like, you remember the scene in Wall Street where Leo gets talked down to, saying, "You know, you are lower than pond scum." However, the thing about these big fancy finance jobs or the corporate ladder that exists within finance is that there’s such a difference in pay between the low-paid people and the high-paid people.

So, in itself, creates this competitiveness, this competition where people are desperate to beat their peers just so they can rise to the top. Because at the end of the day, if you want to be successful in finance or investing, if you want to be a big money manager, then it just comes down to your results. If you can show you consistently pick winners, and you can generate returns year after year that consistently beat your peers, then you will get the top spot. If you can prove that you are making more money for the company than everyone else, then you're going to get paid the most, you're going to get that top job.

But the really interesting thing, and this is where a lot of the problems come in from this locker room mentality, is that Wall Street is judged quarter to quarter. For all of these asset managers that are basically competing against each other, what this means is that, first of all, you're basically going to stay always heavily invested in the market to try and continue to generate returns quarter after quarter. It also means that you want to avoid being that person that's left holding the bag.

While it makes sense you should just be focused on generating higher returns than the next person, one of the ways you can do that is by ensuring that you're not left behind when everyone else is making certain moves. What that means is that all of these money managers effectively are keeping most of their money in the market, but they're moving it around. They're kind of following each other, they're following the flow of money in and out of stocks.

Because if you know if everyone's getting into this stock, which is driving the price up, you don't want to be left behind on that, so you've got to get in as well and make your position as the price rises. On the flip side, you definitely don't want to be the money manager that's left holding the bag. If all the big money managers around you are starting to get out of this stock, then you better hurry up, and you better pull yourself out of that stock too. Otherwise, you are going to be the investor that's left holding the bag while they get their money out, and the share price falls. You're going to be stuck in there, and you're going to have a big unrealized loss.

At the end of the day, these big money managers more or less tend to follow each other in and out of these different positions. Because they're judged quarter to quarter, they're also keeping most of their money in the market at all times. Because say, you know, it doesn't really matter how overvalued the market is. Say the market is at, you know, 10 times its intrinsic value. Well, if Jimmy over there keeps all of his money in the market despite it being horribly overvalued and the market goes up by five percent in the quarter, then you know Jimmy will get a round of applause. He's made five percent in the quarter. Well done, Jimmy!

But if you say, "Whoa, whoa, this market is so expensive," and you take all your money and you keep it in cash, you keep it in gold, you keep it out of the stock market, but the stock market still goes up five percent, so even though you've done the right thing and you're protecting the capital, you haven't made any money. Whereas Jimmy over there just took a risk, kept all the money in there, and it just happened to go up another five percent.

Everyone's clapping Jimmy, and Jimmy's now coming for your job because his quarterly return was five percent. Yours was zero. So at the end of the day, they're all really competitive because they're vying for those top jobs. They're all keeping basically every single cent they've got in the market to try and generate returns so they can keep up with the people around them. At the end of the day, they're also watching what each other's doing and reacting to that so they're not left being that investor that's holding the bag.

The crazy thing to remember is that this is 80% of the stock market. This is literally 80% of the whole stock market that's doing this. This is why I think that sometimes the stock market is just the dumbest place ever. This is also the reason why I say, you know, when you are listening to big hedge fund managers yap and yap and yap on TV saying, "I'm buying this, I'm buying that," you should really not pay attention to any of it. Quite simply because they are caught in this competitive locker room mentality.

They are caught in this game that all these top dogs are playing, but they are playing a completely different game to what we as individual investors are playing. That's why I think that this locker room mentality frustrates Warren Buffett and Charlie Munger and all these types. Because Warren and Charlie, they play the game similarly to us. You know, they're not just staying in feeling the competition between everyone else. They are very much focused on the long term. They don't mind holding a lot of cash out of the market. You know, they're not too fast at people criticizing them, "Oh, you didn't make as much as this person over here this year."

They think much more like us. But for them, they've got billions and billions and billions of dollars that are sunk as long-term investments in the market. So obviously, all these big fund managers that are playing games with each other, they're causing quite drastic fluctuations in stock prices which I can imagine would frustrate people like Warren and Charlie quite a bit as their long-term investments fluctuate like crazy as well.

But one of the interesting things that Charlie didn't bring up in this interview clip is that it is this locker room mentality between all the top money managers in the world that are controlling 80% of the market that actually gives us as individual investors a really big advantage. It's actually hilarious at how big of an advantage we've got in the markets and most people out there, they don't even understand that this advantage is real and it does exist.

So what we're going to do now is we're going to head over into the computer, and I'm actually gonna show you how this advantage plays out in reality. So first up, what I want you to do is open up Yahoo Finance. Okay, once you've got that open, then just type in, let's type in a stock that has just seen its share price go up like crazy recently. So let's pick Tesla. And then once you get onto this screen, click full screen. That'll open up the interactive chart.

Now, this is just the share price line. As you can see, it's just gone up like absolutely crazy. It's actually cooled off recently but still up like crazy over the past 12 months or so. But what we're going to do is we're going to come over to the indicators tab and then we're just going to add in a MACD chart. Okay, now we can drag this up. Now firstly, I'm just going to zoom in here. This is the MACD chart or the MACD chart.

Now, I don't want you guys to pay too much attention to these lines up here. We're just going to look at the bars for the time being. Now, what the bars show us is whether the big money is trying to get their dollars into this stock or if they're trying to get their dollars out of this stock. Now, one thing to understand is because these guys are dealing with such large sums of money, they actually have to get their money in and out of the market quite slowly.

Because if they do it too quickly, they cause too much buying pressure. That's this area above the x-axis. If they put their money in too quickly, they cause too much buying pressure at once and then what that does is that increases the demand for the shares way too quickly. And that obviously supply-demand equation will drive the price up very quickly.

So as you can see here, if we go along and we kind of compare the MACD to the share price above, you know, in periods where we see that buying pressure above the x-axis, the share price generally goes up. And then as it comes back down, this is now selling pressure, and as you can see, the share price comes down a little bit and then back into buying pressure. This is just the big money moving in and out and in and then in again, and so on and so forth. As you can see, there's quite a bit of sustained, kind of bouncy buying pressure here.

But what I'm going to show you now is what happens when it gets stretched a little bit too far when they all try and get their money into the market too quickly. As we were saying before, if they get their money into the market too quickly, then they cause a massive spike in the share price. Now look at this, look at this back over here. Look at how small these curves are above and below the x-axis. But then with Tesla, obviously, the share price, we can see, is really starting to spike very quickly.

Now look at the difference in size between here, the buying pressure and the selling pressure. And then look over here, massive, massive buying pressure. And then as it dropped down, it came down from what effectively this is after the stock split, so this is effectively 180 down to 70 dollars. As you can see, look at how much selling pressure there is. And this is stuff that gets charted so you can literally log on to Yahoo Finance and watch this happen.

Then the share price comes back down all the way back down to 72, and then you can see that selling pressure starts to dissipate. Eventually, it turns back into buying pressure around about here, and as you can see after the buying pressure starts to really catch on, then it spikes the share price up heaps straight away. If we keep moving, there's a whole lot of nothing going on in the middle here, and the share price does a whole lot of nothing. And then all of a sudden, look back to here. Look at how small these bumps were, okay? Really not that much, and the share price doesn't do anything too crazy.

And then have a look at over here. We're seeing these massive, massive peaks and troughs, and that's causing the share price literally to go like 200 up to 300, up to what's this, four, almost 500. So that's an example where you can look at an instance where the money has been trying to flood into the market too quickly, and that's because they can't stop it because they've got to keep going because they're all following each other, right? So they cause this certain amount of buying pressure, which just spikes the share price up like crazy.

But then on the flip side, let's look up like Delta Airlines. This is a company that has had its share price crushed, like absolutely crushed. So what are we looking at? Last couple of years' worth, you can see share prices bumping around, bumping around, bumping around, and then bang, look at that! That just absolutely tanks. Now what we can see with the MACD again, if we ignore the lines and we just look at the bars, here we can see, you know, just small peaks and troughs, peaks and troughs, picks and troughs, they're just standard buying pressure and selling pressure.

But then, all the big money wanted to get out at once, and you can already see where this is starting to go. This is where the share price started tanking just horrifically. As you can see, look at the size here, a little bit of buying, a little bit of selling, a little buying, a little selling, little buying, a little selling, and then here, whoa dear oh dear, look at how much selling pressure there is on this! Absolutely unbelievable! And the share price tanked. So it was at 58, and then it dropped down to 21, which is pretty insane.

So this is the flip side of what we're seeing with the Tesla chart. This is obviously, you can see all that volume going up there; that's crazy. So there's just so much; all the big money is trying to get out of this stock, and as you can see, it absolutely takes the share price with it because this is just causing so much selling. So there’s much, much more supply for what there is demand, and that drives prices down.

So this is when they act too quickly, and then all of a sudden, the share price tanks way too far. Overall, there are going to be times like what we're seeing with Tesla where all the big money, they're chasing each other, and they've got to get their positions in, and that's going to help us out because that's going to just drag our share price up perfectly.

And then on the flip side, because they're all chasing each other on the way out as well, there are going to be these times where they're trying to all get out, but they try and get out way too quickly, and then that's going to cause the share price to tank. Now, I should say as well that if you're interested in learning more about this MACD chart, I've only really brushed over how it works very briefly in this video.

But if you'd like to learn more about how to look at the MACD chart and you'd also like to learn about the moving average and the stochastics, which is somewhere down here, then definitely check out Profitful: Stock Market Investing for Beginners. That's the course where we go through each of those three indicators and explain how they work and how you can watch them and see what's happening with the big money in the market.

But yeah, overall, really interesting to see that this is literally just watching big money going in and out and have a look at what impact it has on the share price, either going up as in Tesla's case or going down as in a case like Delta Airlines. So that's what Charlie Munger is talking about when he talks about this locker room mentality of Wall Street. It's ultra-competitive; they all want to be the best.

For that reason, they're all watching what everyone else is doing. They have to stay heavily invested in the market because they judge quarter to quarter. Every single quarter, they are focused on creating a certain percentage return. That means that they keep all their money in the market, but they also don't want to be that fund manager that's left holding the bag. So they are reacting, they are pulling their money out of these stocks, putting it into these stocks as everyone else is also doing the same thing.

However, I hope you now understand that that actually gives us as small-time investors a big advantage because we are nimble, because we are small. The other guys, they're not nimble because they're just so, so large. They've got so much money that they need to shift around, and they need to do it quite slowly.

So anyway, guys, that is it for this video. I hope you learned something out of this video. Leave a like on the video if you did enjoy it or if you found it useful. Leave a comment below. Do you follow this sort of stuff as well? Do you like having a look at the MACD charts, or are there other indicators that you like to follow, whether it be a stochastic or a moving average or something like that? I'd love to hear from you guys, so leave that stuff down in the comments section below.

But that'll do me for today. Thanks very much for watching, and I'll see you guys in the next video. [Music]