- All right, folks, you might want to sit down for this one.
One of the most common arguments that I hear
against index investing is Warren Buffett.
He is the centerpiece of many discussions
on stock picking, value investing, and dividend investing.
If stock picking doesn't work,
then why has Warren Buffett been so successful?
Warren Buffett loves dividend paying stocks.
Warren Buffett says that diversification
is protection against ignorance.
Buffett is a wealth of wisdom, knowledge, and experience.
He has also truly been one of the greatest investors
in modern history, based on his track record.
These are facts that cannot be disputed.
However, both Buffett's wisdom and his success
are often taken out of context
to support the idea that stock picking
is a smart investing strategy.
I'm Ben Felix, Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you why Warren Buffett
is not a reason to pick stocks.
(bright music)
Fortunately for us, Warren Buffett documents his thoughts
on many topics in detail
in Berkshire Hathaway's annual letter to shareholders.
Let's start with Buffett's view on index investing.
As much as stock pickers
use Buffett as an argument for stock picking,
Buffett himself has long been a proponent
of investing in index funds.
In the 1996 letter to shareholders,
Buffett offered some investment advice.
Quote,
"Let me add a few thoughts about your own investments.
Most investors, both institutional and individual,
will find that the best way to own common stocks
is through an index fund that charges minimal fees.
Those following this path are sure
to beat the net results, after fees and expenses,
delivered by the great majority
of investment professionals."
In the 2013 letter,
Buffett explained the goal of the non-professional investor
should not be to pick winners.
Neither he nor his helpers,
Buffett is referring to stockbrokers
and high-fee fund managers,
can do that.
But should rather be to own a cross-section of businesses
that in aggregate are bound to do well.
A low cost S&P 500 index fund will achieve this goal.
That's a pretty clear message.
Now, I know what many of you might be thinking.
That only applies to non-professional investors.
If you dedicate enough time to it,
maybe you can be a professional too.
Let me offer some commentary
that Buffett does not mention in his letter.
There have been many academic studies
on professional investor's
ability to generate superior results.
I'll give you two of my favorite
and some quick quotes from their conclusions.
Mark Carhartt's 1997 paper
on persistence in mutual fund performance found, quote,
"The results do not support the existence
of skilled or informed mutual fund portfolio managers."
In their 2010 paper,
luck versus skill
in the cross-section of mutual fund returns,
Eugene Fama and Ken French concluded
through statistical analysis
that few funds produce benchmark-adjusted expected returns
sufficient cover their costs.
Suffice it to say
that even professional investors
have a tremendous amount of trouble
producing consistent risk-adjusted results
in excess of their benchmark.
Also in the 2013 shareholder letter,
Buffett goes on to explain
that investing in index funds is not enough.
You also need to maintain a disciplined approach.
Buffett concludes that with discipline,
the "know-nothing" investor
who both diversifies and keeps his costs minimal
is virtually certain to get satisfactory results.
Indeed, the unsophisticated investor
who is realistic about his shortcomings
is likely to obtain better long-term results
than the knowledgeable professional
who is blind to even a single weakness.
I don't know about you,
but I am far more comfortable managing my own investments
based on the assumption that I'm a know-nothing investor,
rather than assuming that I'm a knowledgeable professional
without blindness to even a single weakness.
Buffett also seems to think
that it is unlikely to find a knowledgeable professional
without blindness to even a single weakness.
Again, in the 2013 letter, Buffett gives us some insight
into how his estate assets
will be managed for the better it have his wife.
Quote,
"My money, I should add, is where my mouth is.
What I advise here is essentially identical
to certain instructions I've laid out in my will.
One bequest provides that cash will be delivered
to a trustee for my wife's benefit.
My advice to the trustee could not be more simple.
Put 10% of the cash in short-term government bonds
and 90% in a very low cost S&P 500 index fund.
I believe that trust's long-term results from this policy
will be superior to those attained by most investors
whether pension funds, institutions, or individuals
who employ high-fee managers."
Buffett similarly put his money where his mouth was
when he made a bet against Ted Seides
who was at the time the co-manager of Protege Partners,
a fund of hedge funds.
The bet was that Ted could not pick
five funds of hedge funds
that would beat Buffett's
Vanguard S&P index fund over 10 years.
The wager was not small either.
It was a $1 million bet.
Buffett won the bet in 2017 by a lot.
In his 2016 letter,
Buffett explained the many reasons that he was confident
that he would win the bet.
This is a quote from Buffett's initial challenge
to hedge fund managers.
"A lot of very smart people
set out to do better than an average in securities markets.
Call them active investors.
Their opposites, passive investors,
will by definition do about average.
In aggregate, their positions will more or less approximate
those of an index fund.
Therefore, the balance of the universe,
the active investors,
must do about average as well.
However, these investors will incur far greater costs.
So, on balance, their aggregate results after these costs
will be worse than those of the passive investors."
Buffett does add though
that some active investors will do well over time.
He explains, quote,
"There are, of course, some skilled individuals
who are highly likely to outperform the S&P
over long stretches.
In my lifetime, though, I've identified early on
only 10 or so professionals
that I expected would accomplish this feat."
Buffett's comment about early on is important.
It's very easy to identify a successful active investor
after they've been successful.
The real challenge is identifying
before they've been successful.
While Buffett believes
that there are some skilled investors out there,
he has only met 10 in his lifetime.
This speaks to the massive odds
that are against any active investor
and what I would call the overconfidence
of anyone who believes themselves to be
one of these extremely rare few.
Buffett concluded this section of the 2016 letter with this.
"The bottom line.
When trillions of dollars are managed
by Wall Streeters charging high fees,
it will usually be the managers who reap outsides profits,
not the clients.
Both large and small investors
should stick with low cost index funds.
Okay, I think you get the message.
Buffett thinks that you should probably invest
in index funds
unless you're one of the extremely rare few
that might have a chance at beating the market.
But I mean, come on,
are you really one of those rare few?
One of the other ones common discussions
that Buffett gets thrown into is dividend investing.
People seem to think
that Buffett is a strong believer in dividend investing
because Berkshire Hathaway owns a lot of companies
that pay dividends.
In Berkshire's 2012 letter,
Buffett explained in detail why he does not care
whether or not a company pays a dividend.
I won't recite the whole thing,
but Buffett walks through the math to explain
why any investor could easily, based on the numbers,
prefer a company that does not pay a dividend.
If you wanna see the math,
it's on page 19 of the 2012 letter.
But my point here is that Buffett clearly understands
that a great business may or may not pay a dividend.
Buffett himself has made the policy decision
for Berkshire Hathaway
to return capital to shareholders
through share repurchases as opposed to dividends.
Finally, I have to touch on one of the discussions
that Buffett is most often thrown into.
If markets are efficient,
how can we Warren Buffett have beaten the market
for such a long period of time?
This is a really good question.
It was answered in a 2018 paper
in The Financial Analyst Journal titled Buffett's Alpha.
In the paper,
the authors set out to explain Buffett's past performance
in terms of exposure to known factors.
A factor is a characteristic of a stock or bond
that consistently explains higher average returns
through exposure to certain types of risk.
For example, value stocks tend to have
higher average returns than growth stocks
because they are generally riskier.
Based on this type of information,
if an investment professional generates higher returns
by maintaining consistent exposure to value stocks,
they are not demonstrating skill.
An index fund can replicate their results.
Value is one factor,
but there have been many others observed in the data.
The authors of Buffett's Alpha
find that accounting for exposure to the market beta,
size, value, momentum, betting against beta,
quality, and leverage factors
explains a large part of Buffett's past performance.
In other words, accounting for the general tendency
of high quality, safe, and cheap stocks to outperform
can explain much of Buffett's performance.
In fact, controlling for these factors
makes Buffett's Alpha,
or his ability as a manager to produce returns
in excess of the risk taken through factor exposure,
statistically insignificant.
This is an important finding.
The authors were able to show that Buffett's success
has not been due to his superior stock picking abilities,
but to his implementation of a factor investing strategy.
I am not saying that Buffett is not a genius.
He is.
He intuitively discovered factor investing
decades before the academic literature caught up.
The reality for an investor today, though,
is that we do know that the factors exist.
It is not by stock picking then,
but by maintaining consistent exposure to the factors
that brought Buffett so much success
that will bring you anywhere near Buffett's track record.
This is a huge argument against stock picking,
which this paper showed
does not explain Buffett's performance,
and in favor of factor investing,
which can be largely accomplished using index funds.
In fact, you are much less likely
to get consistent factor exposure through stock picking
due to the specific risk of each company.
The analysis in this paper shows us
that based on our
current understanding of financial markets,
Buffett's past performance can be recreated systematically
without the Oracle of Omaha at the helm.
This makes it even less likely than previously thought
to recreate Buffett's success
by traditional fundamental analysis and security selection.
If you take Buffett's advice,
you should not be a stock picker
unless you have a tremendous
amount of confidence in your abilities.
And even then, you have to go into it with the understanding
that your confidence is highly likely to be unfounded.
If you do wish to replicate Buffett's results,
you are more likely to do so
by maintaining exposure to the factors
that Buffett intuitively took advantage of,
than by trying to mimic his stock picking process.
Do you think that you can replicate
Warren Buffett's results?
Tell me about it in the comments.
Thanks for watching.
My name is Ben Felix of PWL Capital,
and this is Common Sense Investing.
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