September 23, 2015

“For a security to be mispriced, someone else must be a damn fool.” – Charlie Munger

This idea is part of what I have called The 7 Noble Truths of investing. It’s such an important concept that it bears repeating often. There are two sides to this truth. The negative side is that there are securities out there that are significantly mispriced, and that’s bad for the investor who has bet the wrong way. Betting on a mispriced security is bad for one side of the transaction, and good for the other side.

For example, let’s say Apple is going through one of its phases where it’s unpopular with the crowd. This happens about every 3 or 4 years, so it’s nothing new. Eventually Apple gets to the point where the stock is so underpriced, that it becomes compellingly attractive. In other words, it becomes dirt cheap. If you are one of the unfortunates who decide to give up on the stock towards the end of this down cycle, you have just made a mistake. In Charlie’s words, you are a damn fool. But your damn foolishness is the buyer’s golden opportunity, because if it weren’t for your generous offer to sell the shares to her at a bargain basement price, she would have to find another sucker – er – seller who would probably charge a little more.

So, one investor’s foolishness is another investor’s fortune. But the thing is, these opportunities are extremely difficult to recognize in real time. Plus, the market has become so competitive and efficient, that true bargains from mispricing are a rare occurrence. The next time you find yourself thinking about giving up on a stock you’ve owned for a long time, and that has been “underwater” for a long time, consider the motivation of the buyer who is on the other side of your trade. Is she an amateur like you, or is she a professional? What does she know that you might not know? Which one of you is being a damn fool?

Howard Marks said “In order for one side of a transaction to turn out to be a major success, the other side has to have made a big mistake. Active management has to be seen as a search for mistakes.” This explains Warren Buffet’s observation that if you don’t see who the sucker is at the poker table, then the sucker is probably you. As Munger puts it, You have to look for a special area of competency and focus on that…. Go where there’s dumb competition.”

Other quotes that have to do with capitalizing on mistakes

“There’s no way that you can live an adequate life without many mistakes.”- Munger

“Of course, there’s going to be some failure in making the correct decisions. Nobody ‘bats a thousand.’” – Munger

“I don’t want you to think we have any way of learning or behaving so you won’t make mistakes.” – Munger

“I make plenty of mistakes and I’ll make plenty more mistakes, too. That’s part of the game. You’ve just got to make sure that the right things overcome the wrong.” – Warren Buffett

“There are three kinds of men. Some learn by reading. Some learn by observation. The rest of them must pee on the electric fence for themselves.” -Will Rogers

“I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.” – Munger

“A trick in life is to get so you can handle mistakes. Failure to handle psychological denial is a common way for people to go broke.” “Warren and I aren’t prodigies. We can’t play chess blindfolded or be concert pianists. But the results are prodigious, because we have a temperamental advantage that more than compensates for a lack of IQ points.” – Munger

About the author 

Erik Conley

Former head of equity trading, Northern Trust Bank, Chicago. Teacher, trainer, mentor, market historian, and perpetual student of all things related to the stock market and excellence in investing.

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