And when these new businesses come in, there are huge advantages for the early birds. And when youâre an early bird, thereâs a model that I call âsurfingââwhen a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallowsâŚ.
But people get long runs when theyâre right on the edge of the waveâwhether itâs Microsoft or Intel or all kinds of people, including National Cash Register in the early days.
The cash register was one of the great contributions to civilization. Itâs a wonderful story. Patterson was a small retail merchant who didnât make any money. One day, somebody sold him a crude cash register which he put into his retail operation. And it instantly changed from losing money to earning a profit because it made it so much harder for the employees to stealâŚ.
But Patterson, having the kind of mind that he did, didnât think, âOh, good for my retail business.â He thought, âIâm going into the cash register business.â And, of course, he created National Cash Register.
And he âsurfedâ. He got the best distribution system, the biggest collection of patents and the best of everything. He was a fanatic about everything important as the technology developed. I have in my files an early National Cash Register Company report in which Patterson described his methods and objectives. And a well-educated orangutan could see that buying into partnership with Patterson in those early days, given his notions about the cash register business, was a total 100% cinch.
And, of course, thatâs exactly what an investor should be looking for. In a long life, you can expect to profit heavily from at least a few of those opportunities if you develop the wisdom and will to seize them. At any rate, âsurfingâ is a very powerful model.
However, Berkshire Hathaway , by and large, does not invest in these people that are âsurfingâ on complicated technology. After all, weâre cranky and idiosyncraticâas you may have noticed.
And Warren and I donât feel like we have any great advantage in the high-tech sector. In fact, we feel like weâre at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies.
Again, that is a very, very powerful idea. Every person is going to have a circle of competence. And itâs going to be very hard to advance that circle. If I had to make my living as a musicianâŚ. I canât even think of a level low enough to describe where I would be sorted out to if music were the measuring standard of the civilization.
So you have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you donât, youâre going to lose. And thatâs as close to certain as any prediction that you can make. You have to figure out where youâve got an edge. And youâve got to play within your own circle of competence.
If you want to be the best tennis player in the world, you may start out trying and soon find out that itâs hopelessâthat other people blow right by you. However, if you want to become the best plumbing contractor in Bemidji, that is probably doable by two-thirds of you. It takes a will. It takes the intelligence. But after a while, youâd gradually know all about the plumbing business in Bemidji and master the art. That is an attainable objective, given enough discipline. And people who could never win a chess tournament or stand in center court in a respectable tennis tournament can rise quite high in life by slowly developing a circle of competenceâwhich results partly from what they were born with and partly from what they slowly develop through work.
So some edges can be acquired. And the game of life to some extent for most of us is trying to be something like a good plumbing contractor in Bemidji. Very few of us are chosen to win the worldâs chess tournaments. Some of you may find opportunities âsurfingâ along in the new high-tech fieldsâthe Intels, the Microsofts and so on. The fact that we donât think weâre very good at it and have pretty well stayed out of it doesnât mean that itâs irrational for you to do it.
Well, so much for the basic microeconomics models, a little bit of psychology, a little bit of mathematics, helping create what I call the general substructure of worldly wisdom. Now, if you want to go on from carrots to dessert, Iâll turn to stock pickingâtrying to draw on this general worldly wisdom as we go.
I donât want to get into emerging markets, bond arbitrage and so forth. Iâm talking about nothing but plain vanilla stock picking. That, believe me, is complicated enough. And Iâm talking about common stock picking.
The first question is, âWhat is the nature of the stock market?â And that gets you directly to this efficient market theory that got to be the rageâa total rageâlong after I graduated from law school.
And itâs rather interesting because one of the greatest economists of the world is a substantial shareholder in Berkshire Hathaway and has been for a long time. His textbook always taught that the stock market was perfectly efficient and that nobody could beat it. But his own money went into Berkshire and made him wealthy. So, like Pascal in his famous wager, he hedged his bet.
Is the stock market so efficient that people canât beat it? Well, the efficient market theory is obviously roughly rightâmeaning that markets are quite efficient and itâs quite hard for anybody to beat the market by significant margins as a stock picker by just being intelligent and working in a disciplined way.
Indeed, the average result has to be the average result. By definition, everybody canât beat the market. As I always say, the iron rule of life is that only 20% of the people can be in the top fifth. Thatâs just the way it is. So the answer is that itâs partly efficient and partly inefficient.
And, by the way, I have a name for people who went to the extreme efficient market theoryâwhich is âbonkersâ. It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality.
Again, to the man with a hammer, every problem looks like a nail. If youâre good at manipulating higher mathematics in a consistent way, why not make an assumption which enables you to use your tool?
The model I likeâto sort of simplify the notion of what goes on in a market for common stocksâis the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on whatâs bet. Thatâs what happens in the stock market.
Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then itâs not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that itâs very hard to beat the system.
And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but youâve got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work.
Given those mathematics, is it possible to beat the horses only using oneâs intelligence? Intelligence should give some edge, because lots of people who donât know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical could have a very considerable edge, in the absence of the frictional cost caused by the house take.
Unfortunately, what a shrewd horseplayerâs edge does in most cases is to reduce his average loss over a season of betting from the 17% that he would lose if he got the average result to maybe 10%. However, there are actually a few people who can beat the game after paying the full 17%.