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.
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.