In an earlier post we established that the odds are heavily against you beating stock market benchmarks investing on your own (You Can’t Beat the Market). After accepting this fact most people’s next thought is to hire someone who can. Is this a wise strategy?
Dart Throwing Monkeys
In his classic investing book A Random Walk Down Wall Street, Princeton University professor Burton Malkiel famously stated, “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” The “experts”, understandably, were not amused. However, in numerous experiments over the years the monkeys have held their own. In fact, here is a link to an article at Forbes.com, from December 2012, claiming that the monkeys have more than held their own.
Ironically, the reason the monkeys perform so well is not that the professionals are stupid, but because so many of them are so smart. Famous Wall Street analyst Henry Blodget stated “Everybody thinks they have this supersmart mutual fund manager. He went to Harvard and has been doing it for twenty-five years. How can he not be smart enough to beat the market? The answer is: Because there are nine million of him and they all have a fifty-million-dollar budget and computers co-located in the New York Stock Exchange.”
This intense competition makes the market very efficient, with two related, but paradoxical, consequences:
- The first is that it is very difficult for any one professional investor, over time, to maintain an advantage over the rest as measured by market benchmarks. This has been proven by numerous studies showing that anywhere from 70 percent to 90 percent of professionally managed mutual funds fail to beat market benchmarks. In fact, the number of professional investors who beat the market is about what statisticians would expect considering luck alone.
- The second is that random stock picks, as represented by the dart throwing monkeys, have about as good a chance of being winners as the stocks picked by the experts. The efficiency of the market tends to push everyone towards the average.
Buffett’s Advice
Warren Buffett does not believe in the efficient market theory. And why should he? He has become one of the richest people in the world by exploiting the market’s inefficiencies. Buffett’s experience has also taught him how rare he is, and how difficult it is to consistently beat the market.
So what is Buffett’s advice to the rest of us? He states, “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals. Seriously, costs matter.” Buffett’s advice seems to be that if you are not as smart and talented as him (and who is?) and if you can’t spend all your time investing (and most of us can’t) then index funds are the way to go.
Buffet’s Bold Bet
Buffett doesn’t just dispense advice. He puts his money where his mouth is. In 2008 Buffett made a bold million dollar bet with New York asset manager Protégé Partners that the Vanguard S&P 500 Index Fund, over the next decade, would beat a collection of hedge funds selected by Protégé. The proceeds from the bet will go to charity.
Hedge fund managers are the sexiest, and supposedly smartest, money managers on Wall Street, so most people assumed it would be an easy task for them to beat a simple S&P 500 index fund. With the sixth year of the bet just concluded the contest is, so far, a route in Buffett’s favor. CNN Money reports that the Vanguard index fund is up 43.8% while the hedge funds are up only 12.5%.
Further proof of Buffett’s faith in index funds over professional money managers (excluding himself) is reflected in the instructions in his will for how he wants the money he is leaving his wife invested after he dies. If anyone could pick a money manager to carry on his legacy it would be “The Oracle of Omaha,” but Buffett doesn’t even attempt this. Instead he states, “My advice to the trustee could not be more simple. Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s VFINX).”
Buffett concludes by stating, “When the dumb investor realizes how dumb he is and buys a low-cost index fund, he becomes smarter than the smartest investors.” Since most of us are “dumb” by Buffett’s standards, our best strategy is to quit trying to find the next Warren Buffett and take the advice of the “Oracle” by investing most of our capital in low-cost index funds.
Buffet along with hundreds of others like Phil Town do not invest in stocks. They use stocks as the vehicle to invest in wonderful businesses. This elite group are what Phil Town (a river rafting guide turned investing millionaire) calls rule 1 investors referring to the two rules That Warren Buffet lives by. Rule 1 don’t lose money, Rule 2 remember Rule 1.
The price of the stock is not the value of the business, only the price at which a person can purchase part of the business. If a person takes the time to know the value of the business they want to invest in then they can determine whether they are purchasing the business at a discount or if it is over priced. If the business really is being sold through its stocks at a big discount then you can be confident you will make money eventually.
Don’t guess, Don’t gamble, either use an index fund, spydr, etf if you don’t want to take control of your own investments, or get the pertinent facts on the value of a business you are interested in before you decide to invest a dime. The Books Rule 1 investing or Pay Back Time by Phil Town can help you learn how to do that.
I do not believe in the efficient market theory either except that the price will reflect value at some point.
All the funds managers by their nature are stock buyers and cannot afford to wait for good deals on businesses, as individuals we can and we can get in and out of those stocks much easier. There is an advantage to being small.
If your fund beats the market it may only mean that you did not lose as much money as the market in general. If you always want to make money buy value not price like Warren Buffet does. He always gets to know the business very well before purchasing their stock and will keep his money on the sidelines until he finds a wonderful business on sale. We can do the same thing fund managers can’t or they would lose their jobs.
In other words invest in the business on sale through their stocks, don’t just buy stocks.
Yes, Luke. I am very aware of the principles of value investing and agree with them in theory. I also know that they are much more difficult to implement than to understand. If you have a record of beating the market over a period of time covering at least several years I congratulate you. By all means keep doing what works for you. Just keep in mind the wise words of John Bogle: “Never confuse genius with luck and a bull market.” For most people passive investing through index funds is the better option. Experimenting on the side with a little money, while investing the bulk of your funds in indexes, is a wise plan for those who think they have what it takes to beat the market. Just remember to keep score and be honest with yourself. Good luck.