Don’t Pay for the Overconfidence of Your Investment Advisors

“Overconfidence is a very serious problem.  If you don’t think it affects you, that’s probably because you are overconfident.”  Carl Richards

In late 2007 legendary investor Warren Buffett made a $1,000,000 bet with Protégé Partners, LLC with the winnings going to charity. The terms of the wager are as follows:

“Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured net of fees, costs and expenses.”

Buffett described his rationale for making the bet, stating “A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors.” 

In other words, hedge fund managers are smart, just not as smart as they think they are.    

Unfortunately investment fees are not based on how smart the managers actually are (as measured by performance) but on their subjective opinions of their own IQs. This is terrible news for investors as fund managers aren’t known as a humble lot.  The result is that investors usually pay dearly for the overconfidence of the latest Wall Street wunderkind.  

As for Buffett’s bet with Protégé, you don’t need to look far for evidence overconfidence. It was apparent right from the start.  When the parties were asked to estimate their chances of winning Buffett put his odds at 60 percent, a conservative estimate based on the record of actively managed funds vs. passive indexes. 

Protégé, on the other hand, predicted their odds of success at 85 percent, a clear case of hope prevailing over experience. At least in this case Protégé, not their investors, will have to pay for their overconfidence.  

2015 Bet Update

2015 put a close on the eighth year of the ten-year bet. At the end of 2015 Buffett maintained a commanding lead with the S&P 500 up 65.67 percent and the hedge funds up only 21.87 percent.  This was in spite of the hedge funds beating Buffett by a slight margin in 2015 (1.36% gain for the S&P 500 vs. 1.70% gain for the hedge funds).  There is very little chance that the hedge funds can make up that big of a deficit in the final two years.      

Lessons for You

The obvious lesson you should learn from Buffett’s bet is that investing in low-cost index funds is the best strategy for almost everyone. This strategy, over time, will likely give you better results than more complicated, exciting, and expensive approaches.

If you are investing in actively managed funds and aren’t convinced that index funds are the way to go, at least ensure that you are not paying for your fund managers’ overconfidence. Do this by comparing the performance of your actively managed funds to appropriate benchmarks.  If your funds are not keeping up with the benchmarks it might be time to reconsider index funds or look for other alternatives. 

Whatever method you choose, ensure that you pay your investment advisors for how smart they actually are and not for how smart they think they are.  Fund managers are certainly entitled to be overconfident but you are not required to pay them for their inflated opinions of themselves. 

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