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.
By Jonathan Ping | Investing | 10/24/07, 4:13am