Tag Archives: career

Summary Increasing numbers of highly intelligent people have been drawn to the stock market over the past several decades. As a result, it has become extremely difficult for individual investors to gain an “edge” over the competition. This explains why it’s so hard to produce the kind of “outlier” returns investing legends like Warren Buffett achieved. In an interview in the late 1990s, Warren Buffett famously said that he could “guarantee” 50% annual returns if he was managing less money. He explained that compounding large sums of money at high rates becomes increasingly difficult over time, because it limits the investable universe to only the largest companies. A smaller portfolio would allow him to invest in smaller companies, which have historically produced slightly better returns than their larger counterparts. He further pointed out that today’s easy access to information makes it easier than ever to find such companies selling cheaply. Unfortunately, Buffett’s argument has a major flaw. It’s certainly possible that his performance would improve (marginally) if he was managing millions, rather than billions, of dollars; but to claim that faster access to more information makes it easier to find attractive investment opportunities is illogical. In reality, this actually makes the stock market more efficient (not less), which makes it harder (not easier) to find and exploit pricing inefficiencies. But there’s another equally important factor driving market efficiency: skill. Today’s investors are much better than those of earlier decades, and the difference between the best and the average investor is less pronounced. This is often called the “paradox of skill.” This phenomenon was famously observed by evolutionary biologist Stephen Jay Gould. He wanted to know why no hitter in Major League Baseball has had a batting average over .400 since Ted Williams hit .406 in 1941. He discovered that, while the league batting average has remained roughly the same throughout baseball’s history, the variation around that average has declined steadily. To put that in plain English, it means that skill of modern baseball players is better than ever, which makes outliers like Ted Williams less likely to occur. The paradox of skill is evident in other competitive sports as well. Today’s elite athletes have superior coaching, training, nutrition, and drugs/supplements. Which is why they’re running faster, jumping higher, throwing farther, and lifting heavier than ever before. But as athletes approach the biological limits of human performance, it makes it harder and harder for individuals to stand out from the competition. A perfect example of this is the men’s Olympic marathon. The winning time has dropped by more than 23 minutes from 1932 to 2012; however, the difference between the time for the winner and the man who came in 20th shrunk from 39 minutes to 7.5 minutes over the same period. In other words, the overall skill of Olympic marathoners is improving on an absolute basis but shrinking on a relative basis. We can see the same thing happening in the game of investing. Growing numbers of today’s investors (both retail and institutional) are far more sophisticated and knowledgeable than their predecessors. As a result, just as we’ve seen the disappearance of .400 hitters in baseball, we’re also seeing the disappearance of superstar investors who were once able to persistently outperform the market by large margins. The table below shows that the standard deviation of excess returns (a proxy for investment skill) has trended lower for U.S. large-cap mutual funds over the past several decades. This means that the variation in stock-picking skill has narrowed as everyone got better and the market became more efficient. Decline in Standard Deviation of Excess Returns (Mutual Funds) Note: The table shows the five-year, rolling standard deviation of excess returns for all U.S. large-cap mutual funds. The benchmark index is the S&P 500 (NYSEARCA: SPY ). Source: A North Investments, Credit Suisse (Dan Callahan, CFA and Michael J. Mauboussin) Now consider Buffett’s track record. What do we see? The same exact story as above! During the early part of his career, when the market was underdeveloped and there was less competition, Buffett was the Ted Williams of investing. He had a huge edge over the less-skilled competition. But as more and more intelligent people were drawn to the market over the years, the variation in skill narrowed, shrinking his margin of outperformance. Ironically, even Buffett’s own teacher and mentor, Benjamin Graham, realized that outperforming the market was becoming increasingly difficult over time. In one of his last interviews before he died, he recommended passive (index fund-style) investing and said that it may no longer be possible to identify individual stocks that will outperform. In recent years, Buffett has also become a fan of index funds – not surprising, considering that he’s underperformed the market four out of the last five years. Decline in Standard Deviation of Excess Returns (Warren Buffett) Note: The table shows the five-year, rolling standard deviation of excess returns for Warren Buffett’s Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ). The benchmark index is the S&P 500. Source: A North Investments, Berkshire Hathaway 2014 Annual Report The bottom line is that beating the market is becoming tougher, even for the best of the best. If Buffett started investing today with a smaller portfolio, it’s highly unlikely that he would come anywhere near the 50% annualized returns he claims he could get. In fact, over the course of his entire professional career, Buffett only accomplished this amazing feat twice (in 1968 and 1976). It should also be pointed out that even Renaissance Technologies’ legendary Medallion Fund, the most successful hedge fund ever, only managed to deliver annualized returns of 35% (that’s after a 5% management fee and a 44% performance fee). Renaissance employs scores of top PhDs who build elaborate algorithms that identify and profit from various market anomalies. If there really was a simple way to consistently earn 50% annualized returns, they would have found it by now. The reality is, as in baseball, the best hitters in money management can no longer bat .400. It’s extremely difficult to outsmart a market in which so many people have become just as smart as you are.