I am being assailed by people pointing out that Berkshire Hathaway has done spectacularly, and therefore this EMH stuff is a bunch of hooey. I could point out that if you'd had a million guys flipping coins repeatedly for a year, at least one of them would have come up with a massive streak of heads. Even if you paid him $1mm for each heads flip, this would not actually be attributable to his awesome coin-flipping skill. Indeed, you'd have at least one cluster of guys who'd done well . . . perhaps fellows who'd gone to Harvard together, or people who'd all studied "Value Coin Flipping" under a master. There would be other outliers, and other groups of people who'd studied "Fundamentalist Coin Flipping" or "The Vincenzi Flipping Technique" who would not have done well. But no one would be looking to them for advice, so you would never have heard of them, and it would seem like a minor miracle that this guy, this technique had just produced such amazingly outsized returns.
As even hedge-fund managers will tell you, most of the strategies they explore look terrific in back-testing, and flunk a real time run. And many of the things that pass the real-time runs turn out to be a pretty good way to lose money as soon as the market changes.
The market always changes.
But say you're right. Say Warren Buffett is every bit as good as you say he is. I beg you to consider two questions:
1) What will happen to the price of your Berkshire Hathaway stock when Warren Buffett dies?
2) Do you have any way of predicting when he is going to die?
2) Do you have any way of predicting when he is going to die?
Yes.
Cue sinister laughter.
Your Q's would make some semblence of sense if Buffet was the Only one exhibiting a long-run record of success.. Clue: he isn't
How very craven of you..
http://www.m-w.com/dictionary/craven
Too, Buffett does more than just pick stocks; there's often management changes (or reinforcement) involved. When Berkshire purchases an insurance company, there are generally great efficiencies in financing involved that make the insurance company more profitable. And there's also a bounce from people who follow Berkshire: when Berkshire announces that it has invested in a stock, others do also, raising the price, and creating a self-fulfilling prophecy.
To answer the questions briefly:
1) Warren has devoted a great deal of time to picking a successor (or two successors actually) so I'm not very worried about his demise.
2) I could use actuarial tables, I guess, but actually, because of what I said above, I don't lose a lot of sleep over this.
There is more I could say about this succession issue, but I'm more interested in the debate over EMH. I suggest anyone interested in markets read the following article from the Wall Street Journal. It shows clearly how even Eugene Fama is now starting to back away from the efficient market hypothesis. And all the intellectual momentum is on the side of the behavioral economists. Here is the link:
As Two Economits Debate, the Tide Shifts
After reading it, I think most reasonable people will conclude "No, Virginia, markets aren't efficient (at least not all of the time)."
I've avoided wading into this argument since I vehemently disagree with you but don't have the time to argue. However, you raised the issue of BRK and value investing, and thus deserve a response from none other than Warren Buffett. And the priceless thing is he directly responds to you.
PS. I think you're smart and provocative, but arguing with WB on this one is not going to end well for you.
Here now, from the Superinvestors of Graham-and-Doddsville:
Is the Graham and Dodd "look for values with a significant margin of safety relative to prices" approach to security analysis out of date? Many of the professors who write textbooks today say yes. They argue that the stock market is efficient; that is, that stock prices reflect everything that is known about a company's prospects and about the state of the economy. There are no undervalued stocks, these theorists argue, because there are smart security analysts who utilize all available information to ensure unfailingly appropriate prices. Investors who seem to beat the market year after year are just lucky. "If prices fully reflect available information, this sort of investment adeptness is ruled out," writes one of today's textbook authors.
Well, maybe. But I want to present to you a group of investors who have, year in and year out, beaten the Standard & Poor's 500 stock index. The hypothesis that they do this by pure chance is at least worth examining. Crucial to this examination is the fact that these winners were all well known to me and pre-identified as superior investors, the most recent identification occurring over fifteen years ago. Absent this condition - that is, if I had just recently searched among thousands of records to select a few names for you this morning -- I would advise you to stop reading right here. I should add that all of these records have been audited. And I should further add that I have known many of those who have invested with these managers, and the checks received by those participants over the years have matched the stated records.
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...
I'm convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a "herd" on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.
I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, "I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million." I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.
In conclusion, some of the more commercially minded among you may wonder why I am writing this article. Adding many converts to the value approach will perforce narrow the spreads between price and value. I can only tell you that the secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years that I've practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It's likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.
If superior performance were solely due to luck, wouldn’t we see more “successful” coin-flippers attribute their returns to arbitrary sounding strategies? You know, investing by astrology, the weather or charts patterns. Hey, if it’s all luck so the strategy shouldn’t matter.
But that’s not what we see. If you go down the list of people who have amassed great long-term track records, each one credits Graham and Dodd style value investing. There’s Peter Lynch. There was Bill Ruane who met Buffett decades ago at a Graham conference. There are the guys who Leucadia National who have done even better than Berkshire. They believe the exact same philosophy. The guys at Danaher. The Tisch brothers. Eddie Lampert. The list goes on and on.
As far as I know, no technical analyst is on the Forbes 400 but there are lots of value investors.
I know nothing about this stuff and should probably just shut up. But pretty much all my money, due to a lucky connection, is invested with a Buffett-style value investor whose firm has been in business a long time, and who has been beating the market pretty consistently for a long time. I imagine part of the distinction is that this firm has some of the same advantages Megan noted Harvard and Yale have as investors: the clients are people with deep pockets who don't need immediate returns on their money, so he has an opportunity to try to stay solvent longer than the market can stay irrational, as it were, on a select small group of stocks. Obviously, not all of his picks are winners, but he seems to consistently have, in a mix of perhaps 30 stocks, one or two barn-burners.
On the other hand, for diversification, my wife keeps all her money invested in euros in a white-bread mix of funds and securities, and the climb of the euro over the past 5 years has overwhelmed whatever advantage my dollar investments were getting with this allegedly brilliant value investor. So maybe some wrinkle will always surface to outsmart whatever ingenious strategy you thought you'd concocted.
MEH, there are millions of people playing the market. There's going to be a bell curve of success clustered around the average return, a whole lot of deadweight loss, and several people at both extremes. Efficient markets theory doesn't say that nobody can make money on the market, it says that its random--i.e. by definition, someone will make a killing.
Besides, if you think Buffet solely makes money as a stockpicker, you have no idea how Berkshire Hathaway operates. Buying businesses and running them well is a repeatable skill, and he's the master
I can't see how Warren Buffett beating the market affects your larger point, which is that it is very unlikely that you or I or some B-school whiz kid will beat the market. OK. Lets accept that there are a few investors who can beat the market. There are also a few sprinters who can run 100 meters in less than 9.8 seconds. But there aren't very many, and I am not so deluded as to believe that you or I are among them.
Jim,
If there are a "few" investors who can beat the market, that necessarily means the EMH is false. Those of us who argue against the EMH are simply arguing that while the market is efficient MOST of the time, it is not efficient ALL of the time. And if you, the patient and wise investor, put your capital to work during moment's of inefficiency, it is actually possible to beat the market return. Many people are incapable of doing this, because moments of inefficiency occur precisely because people are either being to greedy or to fearful and it is simply against human behavior to be able to take the other side of the emotional trade. But some can. And they will beat the market. And they will prove, generation after generation, that both the weak and strong form of the EMH argument are false.
Mark my words: the only persistent anomaly in all of financial markets is human emotion. Those who learn to arbitrage this anomaly will over any extended time period beat the market average.
Market prices reflect both information and judgment. In particular, they reflect publicly known information and the central tendency of judgment about the meaning of that information for the value of the securities being traded. So if someone has either non-public information or better than average judgment (that is, better than the weighted average for an investor), that person might expect to "beat" the market (in the long run). Problem for most people is that they tend to overrate their judgment.
Out of all the arguments, you picked the Buffet one to skewer?
The guy hasn't been a money manager in ages, he's the owner of an insurance company with a decent track record on the investing side of the business. Most of his followers tend to do rather poorly.
But putting aside the sainted one, there are far more hedge fund managers who consistently beat the benchmarks, after fees and taxes, than there are people who flip a coin however many times and get all heads.
And frankly, the entire argument from the coin toss analogy has no place in this discussion. Managing a portfolio of stocks for a year is not analogous to one coin toss or a hundred. A professional is going to be making dozens of decisions a day, each one of them based on what the manager knows and whatever method he or she is using to analyze the facts.
When you compare this process to a coin toss you're saying that it's all chance, every single decision. I can't buy that, there are too many other variables in play.
On a related note: you don't need an institutional edge to be better informed than the majority of investors, you just need time. Most amateurs don't read the transcripts of quarterly conference calls or listen to them. Most mutual fund managers don't know their history. Most investors period don't keep track of many relevant items that they should know about before buying or selling a stock. A lot of people just buy and hold and pay attention to nothing. That means someone who listens to the calls, learns their history, runs a few regressions, and keeps track of who owns what, who sponsors what, and why, that person will be better informed than the majority of other investors, giving them a real advantage and making it possible to consistently outperform. Hard work and a little imagination, and yeah luck, that's what it takes.
MM,
I agree with you - EMH is right, holy, and pure. As for Buffett and Berkshire Hathaway, I believe there is a virtuous feedback loop that comes from its long-term success. If you analyzed BH's portfolio, you could divide its positions into three groups:
1. Majority shareholder, BH (or BH-approved) management
2. Minority shareholder, BH on board of directors
3. Minority shareholder, BH not on board
BH does not pick stocks like you or me - they usually take large positions where they have significant influence over the management of the company. Pure stockpicking would be group 3 of the BH portfolio. My guess is that the performance of BH group 3 is not dramatically better than the performance of the market.
BH benefits from getting opportunities that few others do. A not-uncommon phenomenon is for a private, family-owned company to approach BH for succession or liquidity plans instead of going public, selling out, etc. This enables BH to buy at $0.40 on the dollar when that opportunity is not available to anyone else.
Likewise, BH's sustainable advantage appears to be in its management style and training. They are exceptionally disciplined and they often find opportunities where their influence will add value to a company, improving returns.
BH is not a mutual fund, taking small positions in a large basket of stocks. The EMH still applies - BH's success is not attributable to stockpicking but to having access to opportunities not available to the general public.
It's hard to hit a moving target. M. McCardle went from arguing that markets are rational and efficient, to arguing that "markets can stay irrational longer than you can stay solvent" and back to market efficiency...
But the article I linked to above shows that even Eugene Fama, the man who first proposed the efficient market hypothesis, has abandoned it. A few years ago he conceded that markets could indeed become "somewhat irrational," which fatally undermines his orignial theory. Thus Richard Thaler wryly observed, "I guess we're all behaviorists now."
Anyone who was wathcing the markets in the late 90's carefully ought to recognize that markets are not always rational. When Cisco would come out with a positive earnings report, Sysco would jump too. Daytraders were pushing up stocks they knew little or nothing about. Noone but the most Laputan academic could fail to see that was creating irrational prices for some stocks. And equally obviously, some sober investors were able to profit by purchasing neglected securities. As others have pointed out, it wasn't just Warren buffett though he is the most famous and successful. Bill Ruane, and Marty Whitman, and Mason Hawkins and many more also beat the market.
Are they all just "value coin flippers?" I don't think many reasonable people will find that explanation convincing. I doubt that even McCardle fully believes it. But when someone has been indoctrinated into a certain view of the world, it is extremely difficult for her to move away from it completely.
Jack,
nice strawman. past that:
"Efficient markets theory doesn't say that nobody can make money on the market, it says that its random--i.e. by definition, someone will make a killing."
EE's post, prior to yours:
"..If you go down the list of people who have amassed great long-term track records, each one credits Graham and Dodd style value investing. There’s Peter Lynch. There was Bill Ruane who met Buffett decades ago at a Graham conference. There are the guys who built Leucadia National who have done even better than Berkshire. They believe the exact same philosophy. The guys at Danaher. The Tisch brothers. Eddie Lampert. The list goes on and on."
rebuts your contention that: "it's random..", and more fully flowers my original point to MM.
There's one more point in favor of EMH that I think has been missed.
Let's assume that there do indeed exist a class of value investors who consitently beat the market based on merit, not luck (In fact, I do actually believe this). The question is,
1. Can you identify them before the market turns on the 'lucky' ones?
2. Can you replicate their stragegy?
As I remarked above, I do personally believe in the Graham/Buffett value strategies. The problem is that I have never heard a good method of identifying out which managers/advisors actually that good from the ones were just lucky. The idea isn't to invest in Berkshire Hathaway today, it's to find out who's going to be the next Berkshire Hathaway twenty years from now.
A good value manager tends to say the exact same thing as a bad one, but pick different stocks; each will be convinced that he is right. The problem is, an undervalued stock is, by definition, priced lower than its long-term value, so that the 'bad' or 'lucky' manager is likely to outperform his counerpart in the short term. The only way to identify the good managers ahead of time is to evaluate his strategy, not his performance. In that case, the metrics for evaluating managers then becomes exactly the same as the metrics for evaluating an individual stock.
Even when the good managers exist, it's irrelevant if you can't pick them out before they prove themselves to be good managers.
As a Berkshire Hathaway investor, I've given some thought over the years to your questions about the effect of Warren Buffet's health on Berkshire's future. The conclusion I came to was that the issue wasn't nearly serious enough to make me lose the benefit of investing with Berkshire while he's alive. Here are a few points:
1) Berkshire is extremely inexpensive to operate. In fact, its headquarters operating expenses as a fraction of its investments in public companies are less than the 0.08% to 0.20% management fee that well run index funds typically charge [1]. So, if Berkshire’s approach was known to be picking companies at random to invest in, it would be comparable to an index fund (with its tax advantages from not issuing a dividend and lower turnover roughly offsetting its lesser diversification).
2) Berkshire has less turnover in its positions than a typical index fund. [2] Buffet has stated that he views the best holding period as being “forever.” [3] This contributes to its low operating costs, and also means that its value going forward is not primarily a reflection of Buffet’s ability to adapt existing holdings to short run changes in the economy or markets.
3) Berkshire also invests its new cash flow into a variety of investments only some of which are available to the public. Buffet’s main source of value to the company is the extent to which he does a better than random job choosing among these options. In present value terms, though, the ability to make good choices about how to invest future funds (from profits or increases in insurance float) isn’t nearly as important as the quality of existing investments if we assume that those existing investments are unlikely to change (since new funds are only a small fraction of assets). [4] At worst, when Buffet dies, Berkshire stock should give back any premium reflecting advantages here.
4) The opportunities which Berkshire gets to choose among are likely to be fare more related to its other unique properties than to Buffet personally. Berkshire has an AAA credit rating for long term borrowing, but maintains an actively managed investment portfolio consisting primarily of equities. I don’t know of any other institution which can say that. In addition, it has unusually patient shareholders who prefer economic profits to accounting profits. Their patience is evidenced by the very low rate at which Berkshire shares trade on the NYSE. [5]
5) Other posters have already talked about how one of Berkshire’s advantages is its skill in running operating companies (where it owns either all or much of the equity). My impression is that Buffet does not personally get heavily involved in that process beyond initial judgments about which companies to acquire.
-----------------
I'm going to take the lazy route and not look up the underlying numbers and citations, but I'll still put in footnote indicators in square brackets where there is almost certainly public data to confirm (or, if I’ve made a mistake, refute) my point had I looked up data that I vaguely recall.
A link to a Charlie Munger presentation refuting...guess what....
http://gregmankiw.blogspot.com/2007/12/munger-on-economics.html
Let's put this another way. Suppose Warren Buffet were to open a school for asset managers. Lets suppose that, on average, graduates of this school, on average, beat the market indexes by 10% a year. However, the managers fell under a normal distribution - that is, not all the graduates performed the equally.
All of these graduates follow the same strategy, but, based on their individual abilities, performed differently. Some did spectacularly well, some flamed out.
Even if, as a whole, they outperformed the market, you'd still want to pick the best of these graduates. But if you picked the wrong one, your money would underperform the graduates, even if they outperformed the S&P. Since they all follow the same strategy, but execute differently, how can you identify the best from the worst? How can you tell the difference?
Well, you could do your own analysis, and pick the manager who followed what you think the best strategy was. But, if you could do that, you'd be one of those top managers, and wouldn't be in this situation in the first place.
What if, instead, you bought a market-weighted share of all the funds managed by all Buffet Graduates. Call it the Buffett Index. You wouldn't get the best performance, but you could be sure that, in the long run, the Buffett Index would outperform the market.
As soon as Buffett Index starts to grow, though, more people notice it. As more people buy or mimic the Buffett Index, the holdings of the Buffett Index stops being undervalued. Eventually, the Buffett Index starts the look a lot like the market index, and their performance starts to converge. Except... as we said, not all of the Buffet Index managers perform the same. So, the top-half of the Buffet Index managers branch off, and become the Buffet Index v2.0 - which, being in the top half, now beats v 1.0 by 10% a year.
Repeat this a few dozen times, and you wind up with the EMH.
Independent George - All you've done is outlined why it's stupid to follow the herd. Those who buy-and-forget based on popular advice or buy the latest 'hot' stock deserve to be burned by the underperforming segment. Those who understand and can act upon the irrationality of emotions embodied in the market will profit.
It's kind of funny seeing people still clinging to the EMH after even Fama has given up on it. It would be like sticking with Chiristianity, even after Jesus said "uh, never mind" (he didn't of course, so no offense to Christians is intended--indeed beleif in Christianity strikes me as much more sensible than belief in the EMH).
And even the last remaining defenders here are getting tied up in contradictions trying to prop up their collapsing edifice. So McCardle tells us "Yes, Virignia, markets are efficient," and that "markets can stay irrational longer than you can stay solvent." Is there anyone who sees how these two assertions can be reconciled with one another? No wonder she fled from this to the height tax and Gauguin.
And Independent George concedes that intelligent value investors can indeed beat the market over time, but still clings to the EMH, which claims that noone can beat the market over time.
When your opponents start contradicting themselves right and left, you know you've won the debate. So, unless I read a critique of my position (and that of many other insightful commenters here) with more intellectual heft than what I have read thus far, I'll retire from the argument. After all, there's no need to rub it in.
The EMH is nigh impossible to falsify, since it would require finding a class of information that (a) was generally available to market participants, (b) which market participants agreed was germane to the valuation of a security, and (c) which all market participants demonstrably refused to incorporate in their valuation of that security.
Should you find a candidate for this, let me know and, if I agree with your assessment, will prove you wrong by trading on, and making a killing with, this knowledge.
Yet per the EMH, the extent to which a market is efficient simply reflects the extent to which capital and attention has been provided to extract the value from any available information arbitrage. And neither that capital nor the services of those paying attention to it are particularly cheap.
Against Buffett, I'd put up James Simons as the best example of how one can get rich ironing out a market inefficiency. He's been paid to apply a whole lot of math skills and computer power to improve the efficiency of equity market pricing. There's nothing entirely magical in that and others compete with him. They're now in a race to get their computers located as close as possible to the exchange's, in order to cut down the speed-of-light time lag between price observation to order to execution.
So much of the money that has been made in the markets in the last 30 years has been the result of applying computation to improve efficiency. I'd put the whole structured finance market in that category. And, as we're living out, the progress has been a little discontinuous at times.
Of course you can beat the market - arguing otherwise is silly grad school talk. The market reflects CW about the possibilities that a series of future events might occur. But the CW is often OBVIOUSLY wrong when one gets in the weeds and does the research. See, for instance, Iraq.
The only reason to believe otherwise is to believe in economics "magic." Markets - magically transparent! Riiiight.
Cliff Mason should have quit while he was ahead.
He started on one of the other threads by making a fairly convincing argument that the key is understanding the pyschology and behavior of the other investors who control a large portionof the funds invested in the market (I believe he said that 3000-4000 money managers control about 90% of market capitalization). In other words, it's about understanding other investors, not about the fundamentals.
This actually made sense, much like understanding how bookmakers set a betting line not on what they expect the actual point difference of the game to be, but rather on what point difference they believe will lead to equal amounts bet on each on the two teams in the contest. This then allows the bookies to make their money on the vigorish (transaction fee). I can believe that theoretically a very tiny minority of smart bettors with inside information can then on average make money by (1) betting only when they believe that the spread has been skewed by other bettors' folly, and (2) betting only at the last minute so that their bets don''t affect the line.
But now above Cliff argues that anyone who puts some time in to undertstanding the fundamentals can outperform, which contradicts the earlier argument that the key is understanding money managers' investment behavior.
So which is it?
I wonder whether all those commenters who insist that it's relatively easy to beat the market have become rich doing just that. If not, why not? And why do the great majority of professionals fail to do it?
rwe
Thanks for the link to the interesting article. Where does the article state Farma has "given up" on the EMH? On the page 5 the article states
But Mr. Fama says his views haven't changed . He says he's never believed in the pure form of the efficient-market theory.
Also on page 5 the articles says behaviorist Thayer has most of his retirement assets in index funds and is quoted saying:
"it is not easy to beat the market, and most people don't."
rwe, before you declare victory can you define what you think the EFM says and point me towards all of these funds that are beating the market?
"I wonder whether all those commenters who insist that it's relatively easy to beat the market have become rich doing just that. If not, why not? And why do the great majority of professionals fail to do it?"
Exactly. I don't think the market is perfectly efficeint. It can't be. Just that it is pretty damn efficient and if you think you are smarter than the market you are betting against big money that spends every miniute looking for the most tiny advantage.
Look, the up-to-date EFH arguments are much more nuanced then people are making them out to be. But, the bottom line question is can YOU beat the market? The answer to that is almost certainly no. Just because you can point to someone who has managed to beat the market doesn't mean anything: they could be smarter than the market, or just lucky. As someone pointed out above, you have no idea if a money manager is smart or lucky until it's too late--I had a b-school buddy that got rich working at a hedge fund during the tech boom whose "super-secret" strategy was basically to borrow lots of money and invest in tech stocks (a few twists, but that was basically it). He was considered a genius for a while, making returns of hundreds of percent a year for a few years. After lots of law suits, the super-secret strategy came out and he doesn't quite seem like a genius anymore (although he is still loaded, so maybe he is).
If you think you can beat the market, go ahead, and if you're correct, your accounts will show that and you can laugh at all the EMH-types.
Jim Cramer is pretty entertaining and seems like a good guy, but his show is TERRIBLE for investment advice.
Independent George concedes that intelligent value investors can indeed beat the market over time
The key word here is 'intelligent'. As we've both noted, I wholeheartedly concede that there are individuals who can consitently beat the market. Would you concede that these individuals are, by definition, both rare and hard to spot (since, if they were ubiquitous and readily identifiable, they couldn't beat the market because they would be the market)?) The pertinent question isn't whether they exist, but rather:
1. Can you IDENTIFY those individuals (including yourself)?
2. Can you identify those individuals BEFORE everybody else does?
3. Are you confident in your answers to 1 and 2?
In other words, even if you could truthfully answer "Yes" to those questions, my answers are "No, no, and not at all". Therefore, it's far easier to profit off the extent to which it is efficient, than it is off the extent to which it is inefficient.
"I wonder whether all those commenters who insist that it's relatively easy to beat the market have become rich doing just that. If not, why not? And why do the great majority of professionals fail to do it?"-Alan Gunn
I wonder whether this is the Alan Gunn of Natre Dame, or maybe its the guy from LA Guns. Anyway, his questions are interesting, and worth rejoining the argument for, if only breifly.
First, I don't think anyone is arguing that beating the market is "relatively easy." I'm certainly not. All I argue is that a sober and well-informed investor can beat the averages over time with some diligence in researching companies. Peter Lynch gave the exmple of Pebble Beach, which was selling on the market for less than the value of its gravel pits. So all of that valuable real estate including the golf course, was essentially free. Now, was it easy to find that out? No. But someone who was willing to do some work, could have found it out as Lynch did, purchased the stock, and waited patiently for the market to come to its senses.
Second, yes, as a matter of fact I have gotten wealthy from investing. I bought Berkshire and Leucadia (and other investments) some time ago and have trounced the market averages. Of course it's possible that I was just lucky, but I don't think so.
Third, many fund managers are focused on short-term results. Value investing requires patience, and a willingness to choose stocks that might underperform for a time. Lynch made this point in his books. You don't get fired for average performance, so many mutual fund managers essentially mimic the averages, because it is safer to do so. They are closet indexers, so, after fees, they will slightly underperform the market averages.
So, the main point is that it is possible to beat the averages consistently over time with hard work, rationality and patience. The fact that many (or even most) investors do not beat the averages, certainly does not prove that no one can. Indeed, it's fairly clear from behavioral economics that markets soemtimes get out of whack (though, importantly, they are pretty efficient most of the time) and that shrewd investors can capitalize on that.
As Milton Friedman recognized, while free markets are very good at allocating resources efficiently, they are not perfect. And some of the younger generation at Chicago overemphsized the perfection of markets. Of the work of Lucas, Prescott, Fama etc... he said:
Simple proof that those who try to beat the market will on average fail to do so:
By definition, there are two types of investors: 1) Those who "buy the market", ie: own the same x% share of every company in the market, and 2) those who try some other strategy, presumably because they think they can do better than buying the market.
The type 1)'s will get exactly the average market return every day, every year, under every scenario. But given this, as a group, so will the type 2)'s. You can't have one group getting the average return without the other group getting the average return as well, or else the average wouldn't be the average.
So a type 2), someone trying to beat the market, can only do so by beating out other type 2)'s, that is, beating out others who are also trying to beat the market. They can't get their excess returns from those who don't try to beat the market.
Independent George concedes that intelligent value investors can indeed beat the market over time, but still clings to the EMH
The key word here is 'intelligent'. As we've both noted, I wholeheartedly concede that there are individuals who can consitently beat the market. Would you be willing to concede that these individuals are, by nature, both rare and hard to spot (since, if they were ubiquitous and readily identifiable, they couldn't beat the market because they would be the market)?) The pertinent question isn't whether they exist, but rather:
1. Can you IDENTIFY those individuals (including yourself)?
2. Can you identify those individuals BEFORE everybody else does?
3. Are you confident in your answers to 1 and 2?
In other words, even if you could truthfully answer "Yes" to those questions, I can't, and neither can most people. Therefore, it's far easier to profit off the extent to which the market is efficient, than it is to profit off the extent to which it is inefficient.
1. I don't own BH stock.
2. Yes. I'm a life actuary. If you give me enough data, I'll give you the probabilities.
That said, I agree with a particular form of the EMH: =I= can't beat the market.
"Thanks for the link to the interesting article. Where does the article state Farma has "given up" on the EMH? On the page 5 the article states: 'But Mr. Fama says his views haven't changed .' He says he's never believed in the pure form of the efficient-market theory.-bp
bp, you're right that Fama claims he hasn't changed his position. Maybe that's true, but my impression was that he did advocate the EMH in a pretty strict form in previous years. Evidently many of his colleagues had the same impression, since they were "surprised" by his "unexpected concession". Regardless, it's not my intention to skewer a very fine economist.
I only want to point out that now, regardless of his earlier views, even Fama recognizes that markets can sometimes behave irrationally. And that is all that Thaler and Buffett and many commenters here are arguing. There is some irrationality at times, and sober investors can profit from it. Go back and some old editions of Barron's. You'll find John Neff arguing in the 90's that the Nasdaq was too high, and he explained why. He shorted it and made a lot of money.
Megan McCardle started all this off by declaring: "You can't beat the market. YOU can't beat the market. YOU CAN'T BEAT THE MARKET." But some of us can and have. If she had written "most of you won't beat the market, after taxes and fees, so you should consider index funds" then her statment would have been uncontraversial.
MKL,
Go look at the stock chart of MSFT from 2006. On 4/28 they announced that they were increasing their capex budget for the year by ~$1B over the next 12 months. The stock traded down by $3.10 that day, for a lost market value of ~$30B. The stock subsequently bottomed at $21.26 on 6/13, for a loss in market value of ~$60B based on the company spending $1B more in capital. This information was available to all investors. Now, let's see what the behavior was of those of us considered "value" investors.
On 5/23, the manager of Greenlight Capital, David Einhorn, gave a talk at the Tomorrow Children's Fund conference. In that talk, he compared buying MSFT to Alex Rodriguez, saying that paying $23 for MSFT was the equivalent of buying A-Rod in a fantasy baseball auction for the price of an average 3rd baseman. His fund, as well as many many other value funds, bought MSFT stock. Don't believe me, go check the 13-F filings at edgar.com and you'll see how many manager owned the stock at 6/30/06 that didn't own it at 3/31/06.
The stock rallied from $21.50 to $30 by year end, and now trades around $34, for a gain in 18 months of ~60%. And this isn't some small cap stock, that's lightly followed by analysts with low trading volume. This is Mister freakin Softee. The most followed tech stock in the world.
The information was freely available to all market participants. Einhorn and others had no specific knowledge of MSFT that others didn't. They didn't act on the publicly available info any faster than others. All they did was buy when the market was inefficient. And they were rewarded.
That's a specific example of the market being inefficient. It is clear that at $21.50, the market price did not incorporate all known information. It is clear that the BUSINESS value of MSFT did not fall by $60B, nor did it subsequently rise by $120B. Rather the MARKET value wildly fluctuated as market participants adjusted their perceptions of value.
That said, I agree with a particular form of the EMH: =I= can't beat the market.
Ok, Meep wins the thread. That's pretty much my entire thesis, in 1/100th the space.
It's amazing how dogmatic EMH adherents can be. It's also astonishing that Megan would bring up the coin-flipping fallacy that Buffett refuted 23 years ago in the "Superinvestors" lecture I linked to yesterday and Joe quotes from today.
Joe's done a handy job here so far, so I'm just going to respond to Megan's last questions:
If you believe that the market is efficient, wouldn't you also believe that the understanding that Buffett is A) in his late 70's; and B) not immortal would already be priced into the stock? He is, after all, the most famous investor in America. I don't believe the market is entirely efficient, but I do think it's efficient enough to understand the concept of mortality.
Let's assume though that this is one instance where you believe the market is completely inefficient and Berkshire will drop precipitously when Buffett leaves the scene. If you know anything about Berkshire, you know that its stable of wholly-owned operating companies will still be worth a lot, as will its stock portfolio, so you plan on waiting until then to buy Berkshire at what you assume will be a big discount. Two questions for you:
A) What is your opportunity cost for waiting? If you thought that a year ago, you already missed out on a 30%+ move in BRK.
B) What if, while you're waiting, Buffett hires someone like Tom Gayner of Markel to eventually replace him? The stock would start trading at a premium based on that, and you'd never get your hoped-for discount.
Buffett addressed this himself in his last annual shareholder letter. Berkshire is an insurance company, you know, so Buffett is familiar with actuarial tables. He said the tables tell him 12 years, but of course no one knows.
Well said Fred. The argument is pretty much over, I think. The original contention that a shrewd investor like Buffett or Gaynor is no better than a "value coin-flipper" has been totally devastated, by Joe, you, me and many others. No one is really defending it anymore.
Not even M. McCardle, who has fled from the discussion altogether. She's hiding under her desk somewhere, muttering to herself "I can't beat the market, so noone can."
I think one point to be made is that it is impossible to know whether Buffet is good or lucky or both. Or if he will continue to be.
All you can say is that he has made a lot of money.
I work for an company that has made a bunch of money insuring all sorts of risk. While at a cocktail party some of us quants were talking. The general consensus was that while we thought we were good at pricing risk we could never be sure that we were not just lucky. No one knows the true distribution of underlying potential events (earnings,hurricanes,etc). We can only make our best guess given history, but history is often not a great predictor of the future.
Best to not get too cocky with anyone's abilities given that it could in large or small part be luck.
Gene, look again.
I'd give someone doing fundamental analysis and not looking at the guys who control the market an even shot at outperforming the benchmarks, maybe a little less than even.
In my above post I included the idea I mentioned earlier, that you have to know how the people who own stocks evaluate them and what would shake them out or get them to buy more. Here's the quotation:
"That means someone who listens to the calls, learns their history, runs a few regressions, and keeps track of who owns what, who sponsors what, and why, that person will be better informed than the majority of other investors, giving them a real advantage and making it possible to consistently outperform. Hard work and a little imagination, and yeah luck, that's what it takes."
When I said you have to keep track of who owns what and who sponsors what, I meant keeping track of what I wrote about before: what kind of investors own your stocks and how do they tend to behave?
Learning this stuff takes patience, but anyone can do it. Go to stockpickr.com to look up the institutional owners of stocks and check out their filings on edgar to see what they like and how they behave. I also sincerely recommend reading Jim Cramer's latest three books: real money, mad money, and stay mad for life for advice about gaming the pros and some basic investing rules and disciplines that are really helpful.
I'm not exactly an impartial reviewer, but I read Real Money before getting involved with Jim professionally/nepotistically and found it really enlightening. The other two books I helped write, so maybe my judgment is suspect, but Mad Money is where we first articulated the idea that there are only 3000-4000 guys who count and they can be treated as 3 guys because the vast majority of them subscribe to one of three really pervasive methodologies.
WHO CAN OUTPERFORM?
I think a regular person with a full time job can consistent beat the averages if:
1. That person reads up on the books I like (include Ken Fisher's stuff in addition to Jim's and even that silly Phil Towne book)
2. That person spends at least 10 hours a week doing the kind of research I've advocated in previous comments
3. That person sticks to the rules. Here are the ones I endorse:
http://www.thestreet.com/_rmnav/tsc/cramerbook
But any similar set of rules strictly obeyed should do. The point of most of these is to prevent your emotions from taking over and causing you to make bad decisions. The rest are solid pieces of advice that will probably still work a decade from now.
4. That person is interested in the market. No way you devote 10 hours a week if you don't like stocks.
5. That person doesn't try to own more than ten stocks at any given time. Jim's rule is one hour of homework per stock per week, but even if there wasn't a time constraint I think more than ten is too much to reasonably keep track of with the kind of rigor necessary to do well.
I don't think anyone needs to be particularly intelligent to pull this off. You need to be diligent, and you need to be able to admit your mistakes and learn from them, which is not something most people are emotionally prepared to do.
When someone makes a bad investment and then uses that line, "the market can stay irrational longer than you can stay solvent," they are failing to admit a mistake and learn from it. These people will do poorly. That line let's you say, "I was right, but other investors are so dumb and crazy that I lost money even though I was right." The way I see it, you were wrong if you bought or shorted a stock and it went the other way. No investor should want to be "right"about a stock's fair value, you want to be right about where it's going.
"The market isn't as smart as I am," which is the excuse embedded in that quotation, just means you didn't do your homework or think hard enough about why other investors behave the way they do.
Every ignorant know-it-all who shorted Google on the way up used this excuse when they eventually covered at a loss. These people all simply insisted Google was overvalued and would therefore have to come down, but they didn't do the due diligence and learn why so many buyers thought it was cheap. To me that's the height of idiocy and too many people invest this way. They determine what they think a stock is worth and then assume the market will work its magic and take the stock there. Then they become confused and bitter when they can't figure out why the stock doesn't trade up or down to where it "deserves" to be priced.
Earlier in the year many investors were short VMWare, which had a huge run after it came public, and long EMC, the company that spun off VMWare and still owned a huge chunk of it. EMC's stock had moved up a little, but not nearly enough to reflect the new and super-high value of VMWare. So people figured they had an arbitrage opportunity. The prices never actually converged. Both stocks ended up going down eventually, but the big point is that EMC didn't go up as the value of one of its holdings skyrocketed.
This makes no sense to an arbitrageur and a lot of people called it irrational. But when you look at it from the perspective of the mechanics of the market, how stocks get where they do, it makes perfect sense. The arbs expected investors to buy EMC for its undervalued chunk of VMWare. But anyone who wanted to buy VMWare just bought VMWare. The arbs were the only real EMC constituency so the trade didn't work.
the mechanics are everything.
"The EMH is nigh impossible to falsify, since it would require finding a class of information that (a) was generally available to market participants, (b) which market participants agreed was germane to the valuation of a security, and (c) which all market participants demonstrably refused to incorporate in their valuation of that security."
Condition (c) is stated too strongly; the problem is that there is too much information available about any given asset (not just stocks), and thus where many investors can invest in the asset, most won't put in the work to acquire a very large amount of relevant information.
Therefore, the EMH fails on the particular level - an investor who is willing to put an enormous amount of research into a particular asset can, possibly, beat the market. They are adding value to their portfolio by performing the (hard) work of researching and evaluating assets beyond the superficial analysis available from the corner discount broker. However, it is also possible that the researcher has missed something important, or that someone else beat him to it; thus the work has high risks and a significant failure rate. (One could also do lots of research and discover that the asset is pretty much "properly" priced, and not likely to appreciate any faster than the market as a whole, which makes the work effectively worthless.)
As for Buffet and Berkshire Hathaway, it is reasonable to expect that even if Buffett's successor(s) can't do as well as Buffett, that it will take a certain amount of time for their lack of performance to significantly impact the value of the companies that BH runs. Short-term stock-price variations can be expected - there's probably a lot of money to be made by correctly guessing when the panic drop in the BH price reaches bottom, and when the over-correction peaks after Buffett's death.
Well said Fred. The argument is pretty much over, I think. The original contention that a shrewd investor like Buffett or Gaynor is no better than a "value coin-flipper" has been totally devastated, by Joe, you, me and many others. No one is really defending it anymore.
Uh, not quite. Say you had 100,000 people picking stocks randomly, a certain percentage of those people are going to consistently pick winners that beat the market. The point is that you really have no idea if a given "winner" is smart or lucky. If they do it 20 years in a row, the odds certainly are in favor of smart (but those people are unlikely to let me invest their money with them).
I happen to think Buffett is smart, but he isn't just sitting around all day playing the stock market.
"Uh, not quite. Say you had 100,000 people picking stocks randomly, a certain percentage of those people are going to consistently pick winners that beat the market. The point is that you really have no idea if a given "winner" is smart or lucky. If they do it 20 years in a row, the odds certainly are in favor of smart (but those people are unlikely to let me invest their money with them)."
Justin,
Please scroll up and read Joe's excerpt from Buffett's "Superinvestors of Graham-and-Doddsville" lecture. You are at least the third commenter after Megan (I've lost count) who has trotted out a fallacious argument that was refuted by Buffett himself 23 years ago in that lecture.
JAD observed--soundly in my opinion--"Just because you can point to someone who has managed to beat the market doesn't mean anything: they could be smarter than the market, or just lucky." Megan overstated her case by saying "You can't beat the market." Sure you can--sometimes--if you're lucky. I beat it on a slot machine one time. But that's not what I did with my retirement fund. Study after study, year after year, shows the majority of professional money managers doing worse than index funds. I'm willing to believe that Peter Lynch, and maybe Warren Buffet, though there I have my doubts, are rare exceptions. That doesn't mean that anybody can do it. And some of the suggestions for trying are dangerous. Limiting yourself to ten stocks, for instance, will certainly increase your upside potential, but at the cost of leaving you seriously under-diversified.
Buffett's argument doesn't really rebut anything. The question is, what is the likelihood of two or three people using a random strategy to pick winning stocks consistently year after year? Running a simple Monte Carlo simulation will show you that it is LIKELY that a few people can pick winners based on dumb luck.
Maybe these guys beat the market with skill, but the fact that a few people can do it certainly doesn't convince me that anyone else can "beat" the market.
read Joe's excerpt from Buffett's "Superinvestors of Graham-and-Doddsville" lecture. You are at least the third commenter after Megan (I've lost count) who has trotted out a fallacious argument that was refuted by Buffett himself 23 years ago in that lecture.
I've seen this example before, but I don't think it's as ironclad as you think it is. Again - I agree with Graham's ideas on value investing, and I think Buffet's success is more skill than luck. And that, in effect, is precisely the problem with citing Warren Buffet as an example of how value investing can work for individual investors: he's Warren Frakkin' Buffett.
As the name implies, value investing is about finding assets whose underlying value is greater than its market price - sounds easy enough, but damned hard to do. Value is more than just book-to-market ratios; it's also about industry growth, cashflow, leadership, and dozens of other variables which are damned hard to balance or quantify. At the end of the day, deciding whether something is a value or a value trap is a judgement call on the part of the investor; if there were a magic formula, the market really would be efficient.
The fact that Buffett or Lynch or whomever are able to thrive using value analysis tells me nothing about whether I would be able to do so, or which of the dozens of value managers out there will be able to do so in the future. Furthermore, since value-investing is about evaluating long-term value over short-term price inefficiencies, it is necessarily hard to measure success on a shortened time scale.
The interesting thing here is that we both seem to operating on the same assumptions: in order for value investing to work, it has to operate on the assumption that the market will, in the long-term, correct itself, and not continue to irrationally underprice a good asset. At the same time, in order for EMH to work, there has to be inefficiencies in the short-term that allow arbitrageurs to push prices up or down to their true value.
What you're saying has some merit, Independent George. It is difficult to tell which investors are really good and which have been really lucky. I would recommend reading their past reports. Look at what they did and why. See whether they are making good, informed judgments about securities.
One of the problems some people are having here is that they want absolute proof in a world of uncertainty. These are empirical questions, and will never be resolved beyond a shadow of a doubt. And a lot of times what's required are qualitative judgments, not easily verifiable quantitative ones. But you can make reasonable judgments based upon probabilities.
Of course Warren Buffett might just have been lucky, but it isn't bloody likely.
Look at the funds at Dodge & Cox and Longleaf.
"Buffett's argument doesn't really rebut anything."
You still haven't read it, have you?
"The question is, what is the likelihood of two or three people using a random strategy to pick winning stocks consistently year after year? Running a simple Monte Carlo simulation will show you that it is LIKELY that a few people can pick winners based on dumb luck."
That's not the question. Buffett didn't just use hindsight to pick a handful of investors who had beaten the market and use that to justify his claim. He pre-identified a group of investors who would beat the market, based on their Graham-influenced methodology. As Buffett said,
Independent George,
That the market is mostly efficient in the long term doesn't contradict value investing; it's part of what makes it possible. Hence Graham's famous phrase: "In the short term, the market is a voting machine; in the long term, it's a weighing machine".
As for Warren Buffett being Warren "Frakkin" Buffett, you actually have an advantage over him when it comes to stock investing: You can buy smaller stocks (or invest with managers who do). Smaller stocks historically out-perform larger stocks. The reasons I own BRK aren't primarily for Buffett's ability to pick large cap stocks (which he is excellent at) but for access to his special-situation investing and Berkshire's diverse stable of consistently profitable operating companies.
I had a small amount invested in a safe fund in 1999. In early 2000, I noticed that gasoline was cheaper in constant dollars than it had ever been. A bit of research showed oil near its historic low. It seemed obvious that this would not always be the case, so I asked the broker to recommend a well-managed oil company with assets in the ground. Oil companies were cheap then, and the company I chose did well. That was a good decision on my part. I have not continued to make decisions like that because I have not found the opportunity. If oil ever gets cheap again (I think it will, one or two more times at least) I'll buy.
Note that buying underpriced assets doesn't require knowledge of when the market becomes more rational, so it's far safer than shorting.
I have never owned more than two stocks at the same time, and usually own just one. My rate of return has been higher than the index funds. However, my overall performance is dismal. Investment returns are proportional to the amount invested. I couldn't stand the only decent job I've ever had, and my own business ventures usually lose money. If you earn 12 per cent annually on almost nothing, someday you will have a small amount. Big deal.
But, hmmm, I wonder if there might be some kind of tall people exception to EMH?
More seriously, I've always thought that one of the most fascinating things about the EMH is that in order for it to be true, a non-trivial number of participants in the market must believe it to be false. But that's irrational, and well, shouldn't that lead us to getting the sofa stuck in the hallway in some sort of theoretically impossible way? Or lead to some other infinitely improbable Douglas Adams outcome?
To be more precise I should say that there are conditions under which Strong EMH would be true only if some participants believe it to be false (and those conditions are actually plausible). And that would argue for a weaker form of the EMH . Still though, it's extremely unlikely that anyone beats the market consistently, and it's an astonishingly low percentage angle to be playing, no matter how well-educated, smart, insightful, or tall you are.
I am surprised no one has yet mentioned (it may have been mentioned in one of the other EMH threads) Nicholas Taleb's books, especially his "Fooled by Randomness". It is a wake-up for those smug people (I don't exclude myself) who have done well in the markets and in life, and who think it is because they are smarter or faster.
As Ted said in the early comments and a couple of people have referenced since, B-H is not an investment firm in the sense behind Megan's posting. It doesn't buy shares, it buys companies and operates them better than someone else might operate them, thus the fabulous returns to those who invest in B-H. This has as much to do with stock market theories as writing about basketball has with playing or coaching.
It doesn't buy shares, it buys companies and operates them better than someone else might operate them, thus the fabulous returns to those who invest in B-H. This has as much to do with stock market theories as writing about basketball has with playing or coaching.
Rich, as a long time shareholder I know a great deal about Berkshire. It still has huge portfolios of publicly traded securities. If you want to look at the performance of those portfolios over the decades, you'll find that they have outpaced the market.
But if you look back at when Buffett ran a partnership, he was investing chiefly in publicly traded securities and his returns were spectacular. I suggest anyone interested read Roger Lowenstein's book on Buffett to find out more about Buffett's phenomenal record.
Or look at Keynes' record at the Chest fund. That great economist advocated buying:
But that was when economists still had some sense. Anyway, he ran it according to that strategy from 1928 to 1945, getting a 13.2% annual return, compared to -.5% for the UK market as a whole.
But I guess he didn't really know anything either. It was just luck, right?
One thing that everyone should keep in mind when talking about outperformande and the EMH is that the EMH says that you can't make excess RISK ADJUSTED returns.
If I buy one of the many double S&P 500 funds that pay off twice the S&P 500 index I am almost guaranteed to beat the index in the long run assuming that the S&P goes up on average. In fact this is what finace theory says you should do if you want higher returns, buy the market but add leverage to increase risk.
Just for fun I went back and calculated the average annual volatility (a risk measure) for Berkshir Hathaway and the S&P 500 index. Berkshire had a 27% volatility over that period while the S&P had 17% volatility. So what the finace theory would say is that if you want to have a portfolio with 27% volatility you can get it by buying the index with some leverage,
That is the key behind the EMH the index provied better risk adjusted returns than most stock pickers not absolute returns. If you wanted high ablsolute returns over the same perion you don't need Buffet you could have just gon long oil, but you would have taken a bunch of risk.
Eccdog,
Two points:
1) You will find that many value investors don't consider volatility to be a good measure of or definition of risk; they consider risk to be the chance of permanent loss of principal. This is really a more useful definition, if you think about it.
2) Some value managers nevertheless perform well even according to MPT's definition of risk-adjusted returns. Compare, for example, the risk-adjusted returns of the Fairholme Fund (FAIRX) to Vanguard's S&P 500 Index Fund (VFINX). Look at the betas and the Sharpe ratios.
Yeah I know both of those measures as well. The volatity is just one measure and it is not a bad one depending on your time horizion. n general the chance of a permanent loss of capital is related to the volatility. Volatility is a measure of the average daily size of moves up or down. The probability of seeing a loss of capital is just the probability of seeing a number of down moves in a row. So the two measures are almost mathematically related (depending on your assumptions)
FWIW I calculed Berkshire Sharpe it was about .4 compared to the market of about .3 so over the period they had superior risk adjusted returns as well. But the outperformance is far smaller than implied by the gross returns and thus much more likey to be chance than what is impled by the gross returns.
If you were to put a gun to my head and I had to say one way or the other I would probably say that Buffet outperformed the market based in part on skill, but it is not a slam dunk IMO. You could come pretty close to what he did on a risk adjusted basis just by adding some leverage to an S&P index fund. And the S&P is not "The Market" you would need to add more of a total US market index + foreign develped index + emerging market index + REIT Index + Commodities index +
Total bond market index. (my portfolio)
As to the Beta I don't think it is avalid measure when we are talking about investing in a limited number of stocks (10-20) since the underlying premise of the Beta is that every investor owns the market portfolio so risk should be judged against that portfolio. But if people are arguing that you should not own the market then Beta is not a great measure IMO but vol or potential loss of principle is.
But my main point is that to prove how great an investor is and that it is not luck you can't simply trot out how many years they beat the S&P or how great their average returns are. I can acheive both by indexing as well just by adding leverage to increase my return and risk or by overweighting volatile indexes like emerging markets.
It is a wake-up for those smug people (I don't exclude myself) who have done well in the markets and in life, and who think it is because they are smarter or faster.
Not a comment on randomness, but Taleb is perhaps the most annoyingly smug person of all. I mostly agreed with his thesis, but was repulsed by his writing. 'Fooled By Randomness' was a little bit about randomness, and a lot about the magnificence that is Mr. Taleb. He reminds me of an even more arrogant version of Richard Dawkins.
Eccdog,
Buffett doesn't directly control the market price of BRK, which is why he measures his performance by BRK's book value (this isn't the case with Berkowitz's Fairholme Fund, since, as an open-ended mutual fund, FAIRX trades at its net asset value). So if you want to be fair in terms of your comparison, you would compare BRK book value returns to whatever benchmark when doing the sort of risk measurement that most value investors think is pointless.
The reason many think it is pointless is because market volatility per se has no impact on the long-term viability of a company. Buffett and other value investors have seen stocks they purchased drop 50% or more after they bought them, and either held those stocks or invested more. Conventional wisdom about risk and volatility would suggest that those stocks just got a lot riskier. But for value investors who feel they understand the underlying business and the market is over-reacting based on emotion, those stocks are less risky, since there is now more of a discount between the current price and their estimate of the stocks' intrinsic value. A specific example, if you want to look it up, is Buffett's purchase of WaPo in the 1970s.
As far as this claim of yours:
"I can acheive both by indexing as well just by adding leverage to increase my return and risk or by overweighting volatile indexes like emerging markets."
Using leverage you could beat the market in up years, but you'd under-perform the market in down years. It's not a formula for consistent out-performance. It takes skill, not luck, to out perform the market over bull and bear market periods.
Warren Buffett on Beta and Risk:
He's right of course. Beta (or variance) is not a good measure of what investors generally mean by "risk."
I'm really surprised noone has brought up the use of options.
Simple covered call writing strategies can yield significant returns while reducing the risk of holding equities..
Even 401(k) holders/'investors' should understand, at the minimum, that put buying can provide an 'insurance' policy against general market declines.. because, as pointed out above:
"I had a small amount invested in a safe fund in 1999. In early 2000, I noticed that gasoline was cheaper in constant dollars than it had ever been. A bit of research showed oil near its historic low. It seemed obvious that this would not always be the case, so I asked the broker to recommend a well-managed oil company with assets in the ground. Oil companies were cheap then,..."
Seasons change..
Bambi's point, about Oil in specific, was really about Commodities, in general. Uncovered through simple observation, it certainly wasn't broadly proclaimed by outlets like CNBC..
That low point she alludes to, was the start of a new Bull in Things v. paper, one that has much longer to run..
Fred, Buffet does not beat the market every year either. So he does not consistently (whatever that means) outperform either. I wish I had time to compare what a similarly risky portfolio of index investments with leverage would have done over a similar time period. All I have at my fingertips is the S&P which surely isn't "The Market"
But the S&P leveraged to have 27% vol would have beaten the S&P index 9 out of 12 years. Buffet beat it 8 out of 12 years. He did have a higher average return though.
Book value is an accounting entry it equals what you paid for something minus depreciation unless you write the asset down (which is up to management). Saying Buffet measures by book value is essentially Him saying "I think it is still worth what I paid for it" great but in most of the world things are worth what you can sell them for.
Secondly I can't buy BRK at book value. I have to pay market and when I want to get our I have to sell at market as well. So for the investor book value is irrelavent. Now Div Yeild is relavent and I included it in my return calcs. What an investor makes is sell value - buy value + dividends so how much BRK moves in a given day, month, year, decade is very important to me as an investor in edition to what it pays me in dividends to own it.
And taking risk IS a formula for outperformance in the long run. That is why people buy stocks istead of T bills. More risk=more return on average.
Again I want to say that personally I think Buffet does have some skill. My point is that much of what has been said overstates his ability because it does not consider risk and that you can come pretty close to similar returns if you take similar risk. And very very very few of us are Warren Buffet.
My point is that much of what has been said overstates his ability because it does not consider risk and that you can come pretty close to similar returns if you take similar risk.-eccdogg
No, that's not correct eccdogg. Even if Beta were a good measure of risk, Berkshire's beta is (according to yahoo finance) .26 where the beta for the market is, of course, 1.0. This means that Berkshire is much less volatile than the market, and yet has gotten much greater than market returns.
And actually, though we don't generally accept Beta as a good measure of risk, that's precisely the case we are making: that Buffett, and other skilled value investors, can get above market returns for below market risk.
Where did I mention Beta?
The only spot I mentioned it in is where I said it was NOT a good measure to use.
Quoting me
"As to the Beta I don't think it is avalid measure when we are talking about investing in a limited number of stocks (10-20) since the underlying premise of the Beta is that every investor owns the market portfolio so risk should be judged against that portfolio. But if people are arguing that you should not own the market then Beta is not a great measure IMO but vol or potential loss of principle is."
The measure of risk that I used was volatility. I think that is a reasonable measure to use if someone is advocating holding only BRK stock or a basket of stocks/companies that looks a lot like Berkshire.
Okay eccdogg. Your claim is that Berkshire has been more volatile than the market. I don't believe it. I think you've miscalculated. Beta is the most common measure of volatility and indicates that Berkshire is much less volatile than the market.
You are not using beta but your own calculations (of variance, i guess). I don't want to spend the time reproducing the calculation, but as a long-time Berkshire shareholder, I have obeserved over the years that Berkshire tends to swing less than the market.
Of course it depend upon what time period you've used. If you're only looking at the last few months, than Berkshire has jumped up a lot, so its volatility must have increased as well (so then maybe you haven't miscalcualted).
But that just shows why using volatility for risk is silly and results in a tautology. I think your basic contention--that Buffett has gotten higher returns chiefly by taking on more risk, is badly misaken. But it takes a long and deep study of the company and its history to see why. A cursory calculation of volatility and return just isn't an adequate substitute.
Volatility is a pretty common measure in finance.
I looked at the standard deviation of daily returns from 1996-present for the S&P index and BRK-B. That is a typical way to calculate it. Data were from Yahoo finance. In the data se there was one big looser year (1999) and several middling years 04-06. Most of the big years came early in the data set (late 90's). Over the last 5 years BRK and the S&P look to have not been that different.
http://finance.yahoo.com/q/bc?s=BRK-B&t=5y&l=on&z=m&q=l&c=%5EGSPC
It is not that Berkshire is so risky relative to other stocks it is more that due to diversification S&P 500 is much less risky.
By the way the last 5 years is some what arbitrary. I know a different time interval could show something else.
BTW alsmost every individual stock is more risky than the S&P 500. The S&P diversifies over 500 stocks. That is the point of indexing.
Eccdog,
1) Berkshire doesn't pay a dividend.
2) If you want to compare Buffett's stock-picking ability to the market, you need to look at the performance of his publicly-traded stocks over a given period, not the performance of BRK stock. That's why he looks at book value as a measure: it values his publicly traded stocks at their market prices, and it values Berkshire's cash (it actually undervalues its wholly-owned operating companies, but it's still the best proxy of Buffett's capital allocation ability). The 20% decline in 1999 had nothing to do with Buffett's investment management; it had to do with investors ditching BRK for tech stocks. If you don't like looking at book value, because you, as an investor, wouldn't be buying it at book value, than look at the performance of an open-ended mutual fund run by a top value investor (I directed you to FAIRX at least twice), since open-ended funds due trade at Net Asset Value.
3) The S&P 500 Index may indeed have 500 stocks in it, but that doesn't necessarily make it "safe". It's a market cap-weighted index, so the largest mega-stocks dominate its performance. At one point, Enron was its seventh-largest holding because of this. Compare its performance versus The Fairholme Fund in 2002. The Fairholme fund is heavily concentrated keeps about 70% of its portfolio in 10 stocks. It's risk-adjusted returns (using MPT measures like Sharpe ratio) dramatically outperform those of the S&P 500.
4) The MPT is wrong to define risk as volatility and to say that it invariably correlates with higher returns. Look up the numbers on some utility stocks over the last several years, for example. You'll find in some of them lower volatility than the broader market and considerably higher returns. Similar to what you find with the Fairholme fund.
I looked at annual returns over the last 9 years and (using Stata) found a standard deviation of 12.7 for the S&P 500 and 13.06 for Berkshire. It's hard to see how one could say, then, that Berkshire is significantly more volatile than the index (and I note Fred's point that it might be better to use book value, which is probably a little less volatile than the stock price).
And Berkshire returned 9.7% per year while the S&P offered a meager 2.7% per year. Who in the world would rather have held the sluggish index?
Anyway, I don't accept that volatility is the same as risk, but even if I did, there would be little reason to believe, from these data, that Berkshire is getting higher returns chiefly by increasing its risk.
Actually, Mr Bufett runs the company in a fairly risk averse way. he could use a lot more leverage than he does, but he recognizes that many of his shareholders have most of their net worth in the company and is therefore reluctant to make bets that could permanently impair the company's well-being if they didn't pan out... But that's the sort of insight that comes from a careful qualitative analysis. Some things are not easily quantifiable, but are crucial nonetheless.
Regardless, it's been interesting discussing this with you. At least you'll defend your position with elan, unlike the lilly-livered Ms. McCardle, who's still hiding under her desk, I guess.
1) What I meant about including dividends is that I used the "adjusted" price from yahoo. Adjusted prices include dividend yield if the exist so it is in the S&P calcs as it should be. More importantly if Berkshire dose not pay dividend then that makes the market price MORE important, because the only way you get your cash back is to sell the stock AT MARKET which may be temporarily away from "fair" value.
2)I will look at that mutual fund, but his thread is about Buffet. Could you point to all the value funds started between 1996 and today? See that is the problem with many of the market beating funds, survivorship bias. Funds that don't beat the market close shop so you will find that many of the funds in existence "Beat the S&P" One trick that mutual fund companies use is to start a bunch of funds, see which ones have early success just by chance" and then close the loosers and advertise the winners as market beaters.
3)I didn't say it was "safe" that is a relative term, but I did say is is safer in the sense of how much it is likely to change year to year on average than most individual stocks. This is almost a mathematical certainty since stock movements are not 100% correlated and the data bear this out. The top 45 stocks represent 50% of the S&P. Even at 7th in Ranking Enron only represented 3-4% of the S%P index at the time. For instance GE makes up about 3%.
4)Volatilty is not a perfect measure of risk I admit, but it is decent and I have heard few other proposed that are actually measurable. The MPT does not say that risk invariably correlates with higher returns, just that it does on average. You will allways be able to find exceptions. Particularly when you focus on small time scales and individual companies/mutual funds.
I am not a MPT or EMH purist, but I think most of the arguments here pointing to one fund or the other are pretty weak refutations of it. Since they do not look at any measure of risk and typically focus on this guy or this stock or this fund beat the market over this period instead of looking af the full data set and adjusting for risk the way most of the academic literature has. Having read that literature I still think some people can beat the market but I am skeptical of most market beating claims and am very skeptical that the average person can beat the market or identify someone who can.
RWE differences may be between daily and annual returns and time period. I don't know. I used daily which is typical, but annual may make more sense. Did you include div yeild in S&P? 9 years seems a little odd why not 10?
These are the numbers I have for BRK-B
1/4/1999 2330 52%
1/4/2000 1704 -27%
1/2/2001 2411 41%
1/2/2002 2484 3%
1/2/2003 2394 -4%
1/2/2004 2803 17%
1/4/2005 2855 2%
1/4/2006 2967 4%
1/4/2007 3610 22%
12/4/2007 4823 34%
Mean 10%
Stdev 24%
First day of the year to next except for this year
probably back to inception would be best, but I didn't have the time.
I get 9.7 and 2.7 fo the same time periond as well but if you push it back 1 year further it is up to 6% and from 1996 it is 11% Buffets return also goes up to 17%.
I agree it has been interesting. No doubt Buffet has performed well and made a bunch of money.
Value investing works the same way that buying on sale at the store works. Those few that are patient enough to wait for a real, one in a decade sale will beat the impatient ones.
It ain't complicated. EMH is wrong because most market participants are impatient, and impatience is irrational.
The tenth year seemed like an outlier, in which the S&P went up 22% and Berkshire went up 47%. As you noted, that significantly inreases the return and the variance for both, but especially for Berkshire (when results change dramatically with the inclusion of one data point, they become rather suspect, as I'm sure you know).
But this shows what is wrong with using variance, in my opinion. Berkshire is essentially punished for a remarkably good year. It goes up 47%, and is classified as "riskier" even though that stock perfomance might have resulted from dramtically improved results in the underlying business that actually put the company on a sounder financial footing.
Stock prices gyrate according to the ups and downs of human psychology, not just the fundamentals. Coca Cola, for instance, has gone from 100 billion in market value, to 150 billion, in just over one year. I doubt you would fnd a single person who understands Coke's business who would say that it is worth $50 billion more than it was a little over a year ago.
The underlying business is much less volatile than the stock. And therein lies the problem. or so I think.
S&P/ BRK.A
5.6/ 31.3
12.1/ 19.9
6.4/ 7.2
10.9/ -.01
13.0/ 15.2
-17.8/ 4.3
-13.3/ 6.4
-5.3/ 15.4
19.3/ -14.6
21.9/ 47.4
These are the numbers I have, descending from the present (as of today's closing price). For some reason I can't keep the columns separated, so I use the / to demarcate.
It's hard to see how Berkshire is "riskier" given that its worst years were -14.6% and -.01%, while the S&P's worst years were -17.8% and -13.3%. Essentially, using volatility, you end up calling Berkshire riskier because it goes up a lot some years.
But most people are worried about big drops, not big rises.
"But this shows what is wrong with using variance, in my opinion. Berkshire is essentially punished for a remarkably good year. It goes up 47%, and is classified as "riskier" even though that stock perfomance might have resulted from dramtically improved results in the underlying business that actually put the company on a sounder financial footing."
The flip side to this is a point Buffett made: Let's say he (or another value investor) does all his research on a company, and decides it's trading for, say, 50% of its intrinsic value. Now, imagine that the stock goes down 20% with no material change in the underlying business that would change the estimate of intrinsic value. Someone who believes in MPT/EMH would consider this stock riskier because of that volatility. But Buffett (and other similar value investors) would have the exact opposite opinion: all else equal, the stock is now trading at a greater discount to its intrinsic value, so there is less risk. A current example of this is USG, a stock Buffett, Berkowitz, Whitman, and other top value investors are all down on, and I think all have added more to at lower prices.