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Warren Buffett’s Stellar Record In Defying Economic Gravity

One of the more intriguing observations in Berkshire Hathaway’s new letter to shareholders is Warren Buffett’s reference to what I like to call economic gravity, a.k.a the law of large numbers. There are several ways to keep it at bay (maybe), but in the end it wins no matter what you do. Buffett and company, of course, have an extraordinary history of excelling where so many others have stumbled in this regard. But an unusually long run of success is taking its toll. As Buffett himself recognizes, gravity’s pull is increasing on Berkshire’s prospects. The observation inspires some brief ruminating on how to think about economic gravity generally in the realm of designing and managing investment portfolios. Let’s begin with the salient fact that deserves to precede any discussion of investing that ties in with Buffett, namely: he’s an anomaly in terms of his investment record. That’s something to cheer about if you’ve been a Berkshire shareholder over the last 50 years. But he’s managing expectations down these days: The bad news is that Berkshire’s long-term gains – measured by percentages, not by dollars – cannot be dramatic and will not come close to those achieved in the past 50 years. The numbers have become too big. I think Berkshire will outperform the average American company, but our advantage, if any, won’t be great. Eventually – probably between ten and twenty years from now – Berkshire’s earnings and capital resources will reach a level that will not allow management to intelligently reinvest all of the company’s earnings… Success ultimately plants the seeds of its own destruction… or mediocrity. Buffett, of course, has skirted this curse quite spectacularly through the decades, largely through an uncanny mix of raw talent and steely discipline. A handful of other investors have achieved something similar over long periods of time, but theirs is a tiny club and membership opportunities are limited in the extreme. Accordingly, the overwhelming majority of investment results fall within two standard deviations of the median performance for a relevant benchmark, and that’s not going to change… ever. We’re all fishing in the same pond. The critical differences that separate portfolios (and results) come down to two key factors: asset allocation and rebalancing. Buffett, of course, has opted for a fairly unique asset allocation, as reflected in the companies he’s purchased through the years. The list is a reflection of his talents as an analyst. It’s fair to say that he’s favored a degree of concentration, in large part due to his well-founded confidence in his capabilities to identify value. As for rebalancing, he largely shuns that aspect of portfolio management, which is a direct function of his confidence in security selection. It’s been a winning mix, in large part, due to talent. Concentrated bets with minimal rebalancing has been the basic strategy that’s kept economic gravity to a minimum at Berkshire through time. The results speak for themselves. But gravity- mediocre performance – wins in the end. The best-case scenario is minimizing its bite for a lengthy run, which surely describes Berkshire’s history. For mere mortals in the money game, however, gravity tends to weigh on results much sooner. The reason, of course, is a simple but extraordinarily powerful bit of wisdom attributed to Professor Bill Sharpe a la “The Arithmetic of Active Management” : Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. There is a finite amount of positive alpha (market-beating performance) and it’s financed exclusively by negative alpha. Buffett’s spectacular achievements over the past 50 years have come at the expense of countless losing investment strategies. But having beaten the grim reaper of financial results for so long, the game is getting harder, as it must. The key point is that mediocrity beckons for every investor… eventually. For some of us (very few of us!) the day of reckoning is far off, due to talent and perhaps even some luck. But for the vast majority of investors (professional and amateur) this is one of those rare instances in money management when the future’s quite clear. This outlook suggests that it may be best to embrace mediocrity from the start via index funds and focus on those aspects of portfolio design and management where the odds look a bit more encouraging for enhancing results a bit. Whereas Buffett favored concentration and minimizing rebalancing, the average investor should do the opposite. In short, hold a multi-asset class portfolio, keep the mix from going to extremes (i.e., periodic rebalancing), and use index funds to keep costs low. It’s the anti-Buffett strategy, which is exactly the wrong strategy if you’re Warren Buffett. Then again, if you wait long enough, perhaps this advice becomes relevant even for the Oracle of Omaha.

The Big Lesson From A Bet With Warren Buffett

Seven years ago Ted Seides made a bet with Warren Buffett that a fund of hedge funds could outperform the S&P 500 over a ten-year period. As of today, that bet is looking very bad, with the S&P 500 beating the fund of funds by over 40% (63.5% vs. 19.6%). Seides wrote a piece for CFA Institute explaining why the bet has been wrong and some lessons from it. While Seides makes many good points, there’s one lesson that is particularly important in all of this: Seides explains that half of the underperformance is from fees: Just over half (24.4% ÷ 43.9% = 55.6%) of the underperformance by hedge funds can be attributed to fees. A full 19.5% of cumulative underperformance, or approximately 2.6% per annum, must have been caused by something else. That’s not exactly a glowing endorsement for high fee funds. Why would anyone pay more for less? The fact is, the investment world has become dirt cheap. You can get good financial advice for a fraction of the fee that you once had to pay. The entire hedge fund industry is living in the past, hoping to continue to suck 2&20 out of their unwitting clients for as long as they can. The reality is that you don’t have to pay high fees for smart advice any longer. Heck, I offer my asset management service for a measly 0.35% and I’d say I am a pretty “sophisticated” thinker. That’s what my mother tells me anyhow and I believe everything she says. More importantly, we’re entering a world where future returns are likely to be lower in the future. With bonds generating low yields, a balanced portfolio is either going to produce lower returns in the future or higher volatility returns as more of the gain is made up by stocks. This creates a problem for investors. If you’re paying high fees, you’re either paying more for lower risk adjusted returns OR your fees are eating into your returns by an increasingly large margin. If you’re looking at a real return (after inflation) of 6%-7% in stocks, then we have every reason to be mindful of any other frictions like taxes and fees that might reduce that return even further. But what is the average fee effect? To put things in perspective, consider that the average mutual fund charges 0.9% relative to the average low fee index which charges 0.1%. That’s a 0.8% difference. It doesn’t sound like much, but take a 7% compound annual growth rate on $100,000 and extend that over 30 years. Just how much of an impact does it make? The mutual fund ends up with a balance that is 23% lower than the index. In other words, the mutual fund could just mimic the return of the index and reduce your return by $150,000! Either way, the solution is simple. Stop paying high fees. My general rule of thumb is that you should almost never pay more than 0.5% for portfolio management. If you’re paying more than that, then I highly doubt you’re getting your money’s worth. Are you Bullish or Bearish on ? Bullish Bearish Neutral Results for ( ) Thanks for sharing your thoughts. Submit & View Results Skip to results » Share this article with a colleague

Why The S&P 500 Is A Bad Benchmark

Summary The S&P 500 represents only a portion of the world’s total stock market, whereas a diversified portfolio represents all of the world’s stocks—and can better manage risk over time. Individual parts of a diversified portfolio will always beat the overall portfolio. You just don’t know which part. Are you tall? Your answer to that will likely depend on your own personal context. For example, if you’re a 5’9” American male, and you’re comparing yourself to your American male peers, then you might say no. Why? Many of your friends are likely taller than you are, given that you’re a half-inch shorter than the average American male. ¹ But what happens when you compare your height to all other men in the world? The global average height of men is 5’8 1/2″. So let’s ask again: Are you tall? The lesson here is that we can’t let where we live play an overly important role when we’re trying to provide an objective, evidence-based answer. Applying this concept to investing, let’s examine the importance so many investors attach to the S&P 500 or the Dow Jones Industrial Average. U.S investors tend to heavily measure their portfolio performance against American indices, even though they have been proven not to be the best benchmarks. The S&P 500 is an index of the largest 500 publicly traded U.S. companies, such as Apple, Microsoft, and Ford, weighted by their market capitalization. As such, it’s often used by casual investors as a gauge of stock market performance. In 2014, it did very well—up almost 14%—significantly better than non-U.S. equity markets. Performance Relative to Global Stock Portfolio (click to enlarge) In other years, however, the opposite was true. From 2002 to 2007, the S&P 500 underperformed not only the U.S. stock market as a whole, but also a diversified portfolio and international markets. As American investors, we look to the S&P 500 because it’s familiar and it’s what’s in the headlines. We can’t resist using it as a benchmark for a diversified portfolio. This phenomenon is called home bias. Betterment’s portfolio avoids home bias by reflecting global stock market weights. U.S. stock markets make up roughly half of the world’s investable stock market—the remainder is international developed (43%) and emerging markets (9%). ² It’s important to keep in mind that the S&P 500 represents just over one-third of all the world’s stocks. That means comparing your performance to it is a bit like to comparing your height against only 37% of the world’s people who all come from the same place—say, comparing your height only to the average height of the American male, which is 5’ 9 1/2.” While you might be able to fudge a little with your height, your money is a different story. Using the right evidence—rather than the most convenient context—is the smarter way to invest. Diversification Is a Smarter Investment By using the world’s markets as its baseline, the Betterment portfolio diversifies risk on a number of levels, including currency, interest rates, credit risk, monetary policy, and economic growth country by country. Even as economic circumstances may drag down one nation, global diversification decreases the risk that no one geographic area alone will drag down your portfolio. In short, diversification is a fundamental way to manage risk—it keeps your investment performance more consistent. That’s why we pay so much attention to asset class correlation. ( You can read more about that here .) The result for you, the investor, is that you get the average performance of all the asset classes in which you are invested. If you had only selected one of these asset classes for your portfolio—say, the S&P 500—then you would be at the mercy of that sole index’s performance. By diversifying, you avoid extremes in both gains and losses, and you achieve the same average returns with less uncertainty. Diversification does not guarantee higher returns as compared to each constituent of the portfolio. Rather, diversification is about ensuring average returns—never the best, and never the worst. So, what can you use to compare your performance? The concept of a benchmark basically does not apply to an all-index portfolio. When you’re an index-fund investor—which is what you are when you have a Betterment portfolio—there is no under- or over-performance. You are the average performance. However, it can be useful to have some external yardstick to get a general sense of how you are doing. To do that, you’d need a fund that is similar to your Betterment portfolio with respect to allocation, costs, and diversification. While imperfect, Vanguard’s LifeStrategy Funds could be a point of comparison. If you choose to compare the two, make sure it’s apples-to-apples: Be careful to not equate a 90% stock fund with an 80% stock Betterment account, for instance. But keep in mind that the additional benefits of a Betterment account—general tax efficiency, including tax loss harvesting, free trading, goal-based advice, and more—are likely not included in the performance metrics of a similar non-Betterment diversified portfolio. And next time someone asks you if you are tall, remember that, to be accurate, you need to use the global average before you can say yes or no. Disclosure : Information in this article represents the opinion of the author. No statement in this article should be construed as advice to buy or sell a security. The author does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision.