A horse’s odds of winning : Charlie Munger

Found this article by Charlie Munger online. Another wise man. Interesting analogy.

“A lighter, sleeker, well-trained horse with a stellar record is very likely to outrun a heavy, out-of-shape pony with a poor track record. Even a novice can understand this. But if the damn odds are like this, the inferior horse’s odds of winning are 100:1, and the better horse may be around 3:2 odds of finishing first.

"So by using simple mathematics, it is anything but simple to comprehend which horse is a better vehicle for making some money. The same can be said for share prices and market volatility... so it’s also difficult to outsmart the stock market most of the time.”

To Munger, the so-called “odds” are the price of doing business.

"If you stop to think about it, the racetrack and the odds you face when you place a bet are, in fact, a market. If more people play the ponies, the more popular picks will see their odds go up accordingly. Just like a stock, the more people buy its shares, the higher its valuation climbs. This is the nature of share prices – the more they get bought, the hotter they get. Some call this “overheating.”

So before placing a bet – or buying a share – buyers must first take into account both the underlying fundamentals of the potential investment as well as the value of the target at the current price. If the price exceeds the value, then it should be avoided. At the racetrack, when people approach the counter single file and place their bets, the odds increase steadily for the more popular choices and reflect a more long-term position, if you will.

However, if everyone places their wager within a short period of time, the odds quickly go through the roof for the most sought-after fillies, just as when there is a surge in orders for a particular stock.

Munger observes that the successful long-term investor fully understands his stock’s (or mare’s) core capabilities and potential, and he or she also very likely has a fundamental understanding of both mathematical principles as well as having a good head on his or her shoulders. And his disciples will do well to remember that a horse with a 50% chance of winning any race will likely have odds of 3:1 given it.

This, of course, makes for a great deal of difficulty.Munger said: "Some 98% of the time that we are 'watching' the market, we are in fact just waiting for something to happen and have no idea which direction things are headed. Only when we deeply ponder the relative price and value of a particular counter at any given time can we begin to see advantages, and that is when opportunities suddenly land in our lap."