Munger on Why Bull Markets Mask Rising Costs

Charlie Munger’s November 2000 speech at the Philanthropy Roundtable touches upon the perils of excess: how rising stock prices create psychological illusions of wealth that encourage excessive spending, excessive risk-taking and poor decision-making. The speech questions a lot of the “wisdom” around how wealth is created and maintained. While it was directed at charitable foundations and institutional investors, the underlying lessons can be applied to investing at all levels. In this article, we pick up from last week, (where we discussed the wealth effect), and deconstruct Munger’s theory that bull markets make investors ignore costs.

What happens during bull runs

Munger states that several things occur in parallel during bull runs which makes investors forget about rising costs.

• The illusion of wealth: When stock prices rise rapidly, investors feel richer. Their portfolios grow in value, often without them having to do anything. That rising wealth can encourage greater spending, more risk-taking and a general sense that things are going well. Munger argues that this is where the problem begins. A rising portfolio can make investors less concerned about how efficiently that wealth is being generated and what fees they are incurring.  When returns are strong, a few percentage points spent on investment management or other costs may seem insignificant versus the gains being made.
• Costs are easily ignored: Munger's concept of "febezzle" captures this phenomenon. He describes a foundation that wastes 3% of its assets every year on unnecessary investment costs while its stock portfolio is rising strongly. Despite the waste, the foundation still feels richer because the value of its investments continues to increase. The costs haven't disappeared; they have simply become less visible. A bull market can make inefficient investing look successful.
• Strong performance fuels more activity: Munger says rising markets can also encourage investors to chase performance. A fund manager who has recently delivered strong returns attracts new money. Investors move assets away from managers who have lagged, towards those who appear to be winning. Moving money between managers and forcing portfolios to be liquidated and reallocated doesn’t guarantee returns, even in a bull market.
• Market corrections expose the flaws: The real test comes when the market corrects or falls. During a bull market, a portfolio can absorb considerable “waste” and still appear successful. But when returns fall, the costs don’t go away. Management fees still have to be paid, trading still creates friction, and those poorly-timed switches still destroy value. The investments made simply because they were performing well can suddenly look very different.

The enduring lesson…

Munger's argument can be understood as a chain reaction. When markets rise, investors feel wealthier, this makes them less sensitive to the costs involved in generating those returns, all while feeding more activity and greater risk-taking. As long as stock prices  continue to rise, those hidden wasteful costs remain hidden or are ignored.

Munger says, “If a foundation, or other investor, wastes three percent of assets per year in unnecessary, nonproductive investment costs in managing a strongly rising stock portfolio, it still feels richer, despite the waste, while the people getting the wasted three percent, ‘febezzlers’ though they are, think they are virtuously earning income.”

A bull market can make almost any investment process look like a smart move. But, when stock prices climb, high fees can be overlooked, frequent trading can appear productive and poor capital allocation can remain hidden behind rising valuations — and this is what leads, ultimately, to making money versus keeping money in the long run.