How to Maximize Investment Returns – By Warren Buffett

Let’s talk about maximizing returns instead of minimizing now. In Warren Buffett’s Gotrocks story, he explains how involving too many fee-charging people and trading commissions in your investments can only reduce the overall return for everybody. One way to maximize investment returns is then to invest in low-cost, passively managed index funds. Indeed, he has stated it bluntly – “A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.” However, this doesn’t actually mean that Warren Buffett believes that there is no skill involved in investing. The whole reason we listen to what he has to say is due to the fact that he is one of the few people to outperform the S&P 500 for decades (and thus insanely rich!). He simply states that costs matter a lot – no matter what type of investing you do.

Coincidentally, a reader recently sent me this interesting article, The Superinvestors of Graham-and-Doddsville, written by Buffett in 1984. In it, he directly questions the Efficient Market Hypothesis which has suggested that individuals like himself are simply random (lucky) outliers on a bell curve. Although I highly recommend reading the whole thing, here is an excerpt:

Before we begin this examination, I would like you to imagine a national coin-flipping contest. Let’s assume we get 225 million Americans up tomorrow morning and we ask them all to wager a dollar. They go out in the morning at sunrise, and they all call the flip of a coin. If they call correctly, they win a dollar from those who called wrong. Each day the losers drop out, and on the subsequent day the stakes build as all previous winnings are put on the line. After ten flips on ten mornings, there will be approximately 220,000 people in the United States who have correctly called ten flips in a row. They each will have won a little over $1,000.

Now this group will probably start getting a little puffed up about this, human nature being what it is. They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.


Assuming that the winners are getting the appropriate rewards from the losers, in another ten days we will have 215 people who have successfully called their coin flips 20 times in a row and who, by this exercise, each have turned one dollar into a little over $1 million. $225 million would have been lost, $225 million would have been won.

By then, this group will really lose their heads. They will probably write books on “How I turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning.” Worse yet, they’ll probably start jetting around the country attending seminars on efficient coin-flipping and tackling skeptical professors with, ” If it can’t be done, why are there 215 of us?”

By then some business school professor will probably be rude enough to bring up the fact that if 225 million orangutans had engaged in a similar exercise, the results would be much the same – 215 egotistical orangutans with 20 straight winning flips.

I would argue, however, that there are some important differences in the examples I am going to present. For one thing, if (a) you had taken 225 million orangutans distributed roughly as the U.S. population is; if (b) 215 winners were left after 20 days; and if (c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were on to something. So you would probably go out and ask the zookeeper about what he’s feeding them, whether they had special exercises, what books they read, and who knows what else. That is, if you found any really extraordinary concentrations of success, you might want to see if you could identify concentrations of unusual characteristics that might be causal factors.

He goes on to point out that many investors with great tracks record all happen to be disciples of Benjamin Graham, author and co-author of two famous books – The Intelligent Investor and Security Analysis.

Does that mean that the markets really aren’t efficient? Mostly efficient? Kinda efficient? I don’t know…. but I do have some opinions:

- This article was written in 1984. Since then, many studies have discovered a certain amount of “value premium” in stocks that have certain characteristics like low price-to-book ratios. This is true in both international and domestic stocks, and even from large-cap to small-cap stocks. These days, many portfolios designed under Modern Portfolio Theory include allocations to value stocks. (Mine does.) While this doesn’t account for all of the performance by Mr. B, it is something that wasn’t around back then. 25 years from now, I’m sure we’ll still be learning something new.

- Warren Buffett is either being very modest, or he simply underestimates his innate talents (or both). If beating the market was as easy as reading a book, there would be a lot more “super-investors” out there. Can you name 10 other such managers in the entire world? I mean, look at how often he is mentioned in the media.

- Personally, I do think there is room for skill in picking stocks. However, I think the bar is a lot higher than just being “better than average”. Due to the higher expenses and tax consequences that go along with more active trading, as well as the many psychological barriers, you have to be significantly above average. It’s like saying that either you can (a) take $1,000 and walk away, or (b) take $1,000 but be forced to spend it entering a professional poker tournament where only the top 5% will win money. Is that a risk worth taking?

- For me, it might be a risk worth taking if it’s a small portion of my portfolio. And I wouldn’t want to pick a manager, I’d want to do it myself. Mainly, I see it as a fun intellectual exercise with an added profit motive.

Comments

  1. Luck has a lot to do with everything and he’s probably more of an outlier than he would like to think. That doesn’t necessarily mean that he displays no skill, merely that only a small percentage of people as skilled as him would be similarly successful.

  2. I think it’s also good to remember that Warren has a Ph.D.! He is a very, very smart guy, unlike most of us, including myself, who are not.

  3. I would agree that it is the psychological barriers that keep many people from doing better in the markets. I disagree with you estimation that there are not more “super-investors” out there. Warren is most definitely a wildly successful outlier and a “household name”, but there are plenty of other people who’ve done really well over the long haul. David Dreman, Bill Miller, Peter Lynch, Lou Simpson, David Swensen, etc. While not quite as successful as Warren they most certainly beat the S&P handily over many, many years.

    While studying Graham can provide some insight into value investing, overcoming the psychological barriers is the real challenge.

    “All man’s miseries derive from not being able to sit quietly in a room alone.” –Blaise Pascal

  4. You know if there were 3 or 5 Warren Buffetts, I would be more convinced of the “more-than-luck” argument. I’m guessing that there are a few more people just like Mr. Buffett, that we just haven’t heard much from, either b/c they quit after a while or didn’t want to share their secrets.

    Due to the higher expenses and tax consequences that go along with more active trading, as well as the many psychological barriers, you have to be significantly above average.

    This is in fact the reason that I do believe that there is more than just luck involved. It’s an insanely difficult game, but with so many people playing it quite poorly, there has to be money to be made. I’ve consistently met smart people (engineers, computer nerds, a millionaire) who say the dumbest things about the markets. Things that simply illustrate how little they know about what’s going on.

    But it’s b/c of the difficulty of the skills involved that I feel there’s a lot of leeway for beating the odds. You have to be capable at math in a very holistic sense, you have to be able to read bullshit and call it bullshit, you must be able to lose money and accept your losses and your psychological failings. How many people do any of us even know that we would trust with that level of honesty and capacity?

  5. Gates VP: “You know if there were 3 or 5 Warren Buffetts…”

    FYI, I think I dropped about 5 names in my comment alone and that doesn’t even scratch the surface. They’ve all enjoyed streaks of better than average returns. They may not be as rich as Warren, but when someone can beat the market for more that 10 years in a row, I tend to chalk it up to more than luck. As I mentioned before, Warren is absolutely a freak of nature when it comes to investing, but that shouldn’t change the definition of “successful investing”, which I consider to be the ability to consistently beat the market indexes over the long-term.

  6. There’s a lot of skill involved, as Buffett was a Golden Child when young (dedicated and thorough student of investing) and received attention from the big insiders.

    He then chose the value strategy (which was overlooked in his day but is now so popular that it’s rather worrysome to me) and got big support from big money. It’s kind of like being at Goldman Sachs–when you have enough power to *create* the financial markets you can find a way to gain an edge over retail investors.

    Finally, Buffett has often had enough money to buy a controlling interest in businesses and/or provide $$$ to help them avoid failure. This alone reduced his losses (and hence improves his record).

    In the end Buffett is a talented business *manager* given an inside track rather than an average My Money Blog reader/investor with a day job.

    p.s. My bet is that value stocks will lag growth for the next few years…too many Buffett wannabes and dividend investors have moved to value stocks…too many hedge funds manipulate small stocks…and drove up the prices…

  7. Actually, the Buffett speech, given at Columbia’s graduation in the 1980s, does list 8 or 9 disciples of Graham and Dodd, and their returns over a 15-30 year period.

  8. Gates VP, studies have shown that it only takes a small group of “bullshit callers” to make a market efficient.

    MyMoneyBlog, isn’t it possible you’ll never know if your success or failure is due to chance or skill? Stick with the small amount and consider it your poker money…

  9. I just can’t buy the Effecient Market theory. People are too emotional and too much like sheep with the dow as their shepherd. Even if all of the information is completely available and even if CNN said “Hey, the Dow dropped 1000 points, but this is a great buying opportunity, so hold your stocks and buy more. It will go back up.” people will still freak out and sell.

    I think Buffett is incredible, but I agree that he was in the right place at the right time with the right skills and emotional stability. And as he says about himself, he is a business analyst, not a stock picker. I think that is his true skill, that I certainly don’t know how to acquire. I can read the books and apply formulas, but I won’t ever understand business like he does.

  10. It?s really an interesting allegory. I myself started with my own analysis of stocks for purchase and created an optimal portfolio. By the way, there are many programs for optimal portfolio creating but they are for those who have made up their minds regarding what to invest in. As a result, I had an eligible investment. Why don?t I teach others and get money for that? There are people who are really good in investing, and there are people who want to invest but don?t know how or don?t have time to dig in. This is their choice to pay for such services.
    I just want to say that I do not save on professional services neither in health care nor in investing. Knowledge and experience do cost money.

  11. One of Warren’s classmate recalled that he has an incredible memory: he can remember the balance sheet and income statement of every company traded in NYSE. Can you believe that? He is an unusual business analyst and businessman. If you read the analysis of Coco-cola by Charlie Munger and Buffett, you will find that they have unusual insight about a business, which, ironically, has almost nothing to do with financial statements. Their notion of “great business” is hardly seen in any other investors’ analysis. Business insight is what separate Warren from everyone else.

  12. Gates VP:

    aaactually, there are people who’ve had rates of returns as good as or better than Buffett’s, but a) they didn’t stay in the game as long as he did and b) they didn’t start as young as he did, and thus didn’t have as many years to accumulate returns.

    Peter Lynch and Peter Lynch, George Soros spring to mind.

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