The title is incorrect because Buffett doesn't say playing the market is futile. In fact, he clearly states he believes a few will outperform due to skill (but that you can't distinguish which outperformers did so on skill versus luck).
What he does say in the quoted part is that a large fund of say 20 billion likely can't outperform due to it's size. That is a big difference from saying that it's futile to play the market (since not everyone is trying to invest 20 billion). It's also similar to what other investors like Peter Lynch believed.. that smaller investors have an advantage over the large funds.
This isn't made clear at all in the linked page. As far as I know, Buffett has always felt efficient market theory is wrong and that a few could beat the market on skill. There's also nothing in the linked quote that contradicts this (just the title that suggests it).
So the title is clearly deceptive. It suggests that Buffett did not believe in investing skill at a younger age and only changed his stated beliefs after becoming a very successful investor.
> Buffett has always felt efficient market theory is wrong
People often refute the EMH without understand that it is a family of hypotheses, from the Strong to the Weak form, with a great deal of subtlety in their concept and meaning.
Buffet's argument in the linked excerpts is actually pretty close to a weak form of the EMH: all participants start with broadly similar information and capabilities, so performance naturally regresses to the mean.
I should correct myself, because I've made an incorrect statement of the facts. Strong to weak in Fama's major paper identifying strong, semi-strong and weak variants[1] refers to the distribution of knowledge available to participants. The strong form assumes some participants monopolise inside information; the weak form assumes that all participants start with identical information of historical stock prices. The semi-strong looks at changes based on changes in publicly available information -- like Icahn's tweet the other day.
However there are variations in the construction of the models of EMH. I guess you might generally divide them into calculus models, which resolve instantly, and agent models, which introduce time. For example, in the linked paper, there's a discussion first of the "frictionless" market and then a discussion of more realistic models which include transaction costs, different opinions of agents etc.
The general idea that a market can be efficient in the long run and bubbly in the short run isn't easily refuted. Not least because at any point in time there's just no way to know what future prices will be and so no yardstick by which we can say "this is rational" and "that is bonkers".
But there is a very significant difference between the two. The strong form leads you to believe that it is impossible to expect to do better than the average even with a Herculean effort. The weak form allows that it is possible to beat the market, even by a lot, if you have insight or capabilities that most of the market lacks.
This leads to wholely different conclusions. In (1), a cheap index fund is the only investment option that isn't equivalent to gambling. This is comforting to believe, because you could feel completely comfortable in not spending any effort on researching your investments. In (2), it is okay to buy a modest position in Google in 2004 because your knowledge of the untapped potential of the Internet hints that Google could be much more important than the (median) skeptic believes.
Perhaps most importantly, if you are in camp (2) you will consistently have your investment choices denounced by those in camp (1), which gets very annoying.
It's important to note that the EMH doesn't suppose that all actors agree on the price. It just means that the price represents the summed outlook of participants.
Those who think a stock is underpriced will bid it up to get more; those who think it is overpriced will sell out at progressively lowering prices.
Because the movement in prices creates an opportunity to profit for those who have information that is not yet revealed, those people will enter the market and create pressure on the price.
In some mathematical forms, this is assumed to happen instantaneously and universally. Thus: all available information is factored into the price. Essentially, you can't arbitrage because you have instantaneously driven up the price already by arbitraging. (It's weird, yay calculus).
The looser forms basically say that this is what happens in the long run, on the average, even without instantaneous adjustment of prices. And when you compare market time series to pure randomness, they have similar characteristics. So in a sufficiently large group of agents, some will profit and some will lose merely by chance. Then you're back to taking an average and being unable to beat it in the long run, because in a game of chance outcomes converge to the long-run probabilities of the game.
Okay, so would I be correct to assume that you claim it is in the long run impossible to beat the market except by dumb luck?
I don't see how this follows from your reasoning. You've allowed the possibility of beating the market if an individual trader has some knowledge or insight which the average of the rest of the market does not. So presumably an investor which only acts when he has such knowledge would beat the market also in the long run.
The EMH grew out of the empirical observation that prices wiggle around randomly (and the different forms look at different ways available information could be responsible for that).
Buffet himself, in the letter, has already said that most investors start with comparable amounts of information and capability. So speculating by buying and selling according to predictions of future values of stocks will eventually cause a regression to the mean.
Buffet disagrees with the EMH but he agrees with the conclusion that you can't beat the market by speculating on the movement of prices. He basically lets the random wiggle happen, and when a price dips to what he thinks is a bargain, he buys.
The problem is that we struggle to test the null hypothesis. We can't create 1,000 parallel 20th centuries with 1,000 Warren Buffets to see if he comes out significantly ahead a statistically meaningful number of times. We can only compare him to chance. In a sufficiently large sample, long streaks of perfect performance can emerge purely by chance.
So what you're saying is that it may (or may not) be possible for an individual inevstor to consistently beat the market through skill, but that it is impossible to verify whether an investor who beat the market is in fact skilled or just lucky.
If you believe Buffett's thesis that skilled value investors who do their homework consistently beat the market, it stands to reason that there should also be other strategies that consistently beat the market (let's say over 20 years or so). It also stands to reason that value investing, since it is such a heavily publicized strategy, probably does not beat the market today, since it is such a widely published and acknowledged strategy.
I think if people just chill out and accept that the strong form is a model that allows us to sketch out a lower bound of possible outcomes, everyone will be better off.
Throwing a model away because it isn't perfect is a case of nirvana fallacy. All models are wrong. We build them because they're mentally tractable. So long as the value of the model exceeds the costs of mismatch, they're a boon.
To paraphrase Buffett it's quite nice to have your "opponents" be taught the efficient market hypothesis is a fact, you can't beat the market, etc since its essentially stacking the deck even more in the favor of skilled individual investors.
I mostly agree. But "playing the market" as its normally understood involves trying to make money on the market within a fairly short time frame, by buying low and selling high. I believe Buffett has many times said that the market is a casino in the short run (playing the market) but becomes an accurate "weighing machine" over the long run (buying and holding for five, ten years or more). E.g., http://www.youtube.com/watch?v=-aYEOsZgRm8 So in that sense Buffett does think "playing the market" is a loser's game (that's played by "speculators", not "investors"), though I don't think that's specifically addressed in the linked letter.
His point is that playing the market is "speculation", not investing. He differentiates this with "investing", where you simply try to assess the intrinsic value of a stock, and if the stock is trading at a significant discount to it, then you buy it.
Further, once you've bought it, you keep it. You don't try to time the ups and downs of the market, buying moving and out of the position quickly. Since this is how Buffett likes to invest, one of his key principles is investing in owner-operators or people that are behaving as such. You want the executives of the company to treat it as if they owned all the stock and could never sell it. Because when you have the people running the company worrying about next quarter, you're not worrying about next decade.
Also related, Buffett's two key rules to investing:
This is why investing in an index fund is a great decision. When you rely on more active management, you pay higher fees, and your returns are likely to be about average (or worse). With an index fund you can take a healthy return, mitigate risk by diversifying well, and pay a fraction of the fee (which equates to hundreds of thousands of dollars over 30-40 years from the added growth).
A further problem is that in no case were the superior records (returns) I have observed based upon institutional skills which could be maintained despite changes in the faces. Rather, the good results have been accomplished by a single individual or, at most, a few, working in fairly specialized areas in which the great bulk of investment money simply had no interest.
So... he seems to predict a bleak future for Berkshire's returns after his departure as well?
A quote from Warren Buffet: "In addition to the ones benefitting from short-term luck, I believe it possible that a few [stock portfolio managers] will succeed—in a modest way—because of skill."
Yes, but with an appropriate degree of scientific skepticism, the "skill" assumption could actually be chance. And Occam's razor argues that chance is the more likely cause, not skill.
For 100 stock fund managers buying and selling stocks, statistics tells us that 50 of them will do better than the market averages (and 50 will do worse). And a few of the managers will do very well indeed, but not because of skill. In fact, one can design a blind computer model that buys and sells stocks randomly, using pseudorandom numbers to make the decisions, and half the accounts will come out ahead of the averages, and a small number will do much better than the averages, just as in real life -- all because of chance.
> For 100 stock fund managers buying and selling stocks, statistics tells us that 50 of them will do better than the market averages (and 50 will do worse).
If you're going to simplify things, take out the numbers because the numbers are wrong.
For example, let's suppose that there are six companies you can invest in, and six managers who each invest in one company. One company grows 600%, and the other five declare bankruptcy. Average growth is 16%, but only 1 in 6 managers beat the average.
The other thing that's wrong is that you use the term "statistics" where you mean "probability theory". Probability theory describes how many managers you'd expect to beat the average. Statistics describes how you'd test this.
> If you're going to simplify things, take out the numbers because the numbers are wrong.
The numbers are exactly right. The problem lies with your example in which businesses either grow without bound or go bankrupt. In the real world, and typically, half of investors do better, and half do worse, than the market average.
> The other thing that's wrong is that you use the term "statistics" where you mean "probability theory".
Since one forms the foundation of the other, that's a distinction without a difference, especially when conversing with people who think there are secrets of the winners. The ideas are very simple, and specifying which aspect of statistics gives the most detail is hardly worth specifying.
Quote: "As a mathematical foundation for statistics, probability theory is essential to many human activities that involve quantitative analysis of large sets of data."
You're mistaken on both counts, even though your top-level point is essentially correct.
On the first count, you're mistaken because there's no reason to assume that the distribution is symmetric. This doesn't damage your point, but as klodoph says, your actual example numbers are not necessarily representative. You'll note that this minor mistake in your comment has attracted a legion of minor corrections, all of them correct, all of them missing (or at least ignoring) your most-important point.
On the second count, that's like saying that math is the foundation of computing, and so the two are indistinguishable. klodolph is correct that the two are different, and it doesn't affect your point at all, so you should acknowledge the minor correction and stick to the relevant point.
More generally, did you notice that your top-level comment was basically saying "Warren Buffet is wrong about this aspect of investing"? You could be right, but it's not likely. I believe the reason for this mistake is that you may have have misread this sample of Buffet's thinking (and your overall claims as I understand them may actually agree with and Buffet as I understand him).
(In my humble understanding) Buffet claims that there may or may not exist investors who have superior (or inferior) skill, but that in MOST cases the results are due to luck, and "skilled" investors are mostly indistinguishable from lucky investors. Although I have not seen you agree or disagree with this claim, I note that all of your arguments are consistent with this. Your arguments revolve around being unable to determine which are which, after the fact; so do Buffet's! I further note that it seems ludicrous to claim that there do not exist anti-skilled investors, and thus all other investors will be more skilled than the mean skill level, and that this probably won't matter, because luck will drown it all out.
My overall points here are:
* I agree with your high-level claims (as I understand them) about money-managers
* I believe Warren Buffet, in this letter to Katherine Graham, agrees with
your high-level claims
* nearly every commenter in these threads agrees with your high-level claims
* the comment by wheaties is a counter-example
* some of the minor details of your points are technically wrong or confusing,
in ways that invite nit-picking, but do not impact your actual argument
On the other hand, starting on page 15 (of 19), Buffet suggests (and advocates) an alternative (his #5) that is NOT fully respectful of the efficient market hypothesis. So your position is not Buffet's entire position (though I see from your Equities Myths page that you have noticed this, and you suggest that perhaps Buffet is nothing except lucky).
> On the first count, you're mistaken because there's no reason to assume that the distribution is symmetric.
First, I never said that, and second, that assumption isn't necessary -- the location of the mean won't change, and the mean is the thing you would need to beat, not the median. The reason is that market indices measure the mean (the sum of all the values divided by the count of values), not the median (the midpoint between the highest and lowest value).
> On the second count, that's like saying that math is the foundation of computing, and so the two are indistinguishable.
And? I invite you to argue that it's not so. Computers do what they do solely on mathematical and logical principles. Some would argue that that represents a drawback, hence experiments with things like fuzzy logic. But even fuzzy logic is deterministic and logical, it's just sometimes closer to messy reality. But all of computer science, and computer operations, are strictly logical.
> ... klodolph is correct that the two are different ...
Computer science and mathematics? Only someone unfamiliar with computer science would make that claim. Computer science is applied mathematics.
> ... so you should acknowledge the minor correction ...
Are you familiar with the idea that, if you make an argument, the burden is yours to produce evidence for it? Computer science is applied mathematics.
> Buffet suggests (and advocates) an alternative (his #5) that is NOT fully respectful of the efficient market hypothesis.
But that's not the topic. Whether the EMH is reflected in the real market or not, the issue is whether someone can consistently beat the market averages for reasons other than chance. These are separate, independent topics.
> Buffet claims that there may or may not exist investors who have superior (or inferior) skill, but that in MOST cases the results are due to luck, and "skilled" investors are mostly indistinguishable from lucky investors. Although I have not seen you agree or disagree with this claim ...
The reason I haven't either agreed or disagreed is because there's no way to establish it scientifically, with evidence. So I disagree that Buffett can make the case, and for the same reason, I can't make the case either. That leaves us with the null hypothesis -- without evidence, the thesis is assumed to be false.
> More generally, did you notice that your top-level comment was basically saying "Warren Buffet is wrong about this aspect of investing"?
If you invent quotes for people, we won't get anywhere. I can only say that Buffett can't make his case, and I have said that. That leaves us with the default scientific position -- the null hypothesis. Without evidence, an assumption that a thesis is false.
> ... some of the minor details of your points are technically wrong or confusing ...
Your simplification ruins the example because in the real world, as in lutusp's example, managers are investing in a portfolio of stocks, not 1 in 6 with a 1/6 chance of a 600% return.
There is a reason for market theory and the saying that you can't outperform the market in the long term: everything will average out.
Lutusp's example is perfectly adequate and theoretically sound
This comment deserves more votes. Buffett's argument in favour of skill is very persuasive, not to mention genuinely funny. Here's an extract:
--------------------------------------
I would like you to imagine a national coin-flipping contest. Let's assume we get 225 million Americans up tomorrow morning and we ask them all to wager a dollar. They go out in the morning at sunrise, and they all call the flip of a coin. If they call correctly, they win a dollar from those who called wrong. Each day the losers drop out, and on the subsequent day the stakes build as all previous winnings are put on the line. After ten flips on ten mornings, there will be approximately 220,000 people in the United States who have correctly called ten flips in a row. They each will have won a little over $1,000.
Now this group will probably start getting a little puffed up about this, human nature being what it is. They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.
Assuming that the winners are getting the appropriate rewards from the losers, in another ten days we will have 215 people who have successfully called their coin flips 20 times in a row and who, by this exercise, each have turned one dollar into a little over $1 million. $225 million would have been lost, $225 million would have been won.
By then, this group will really lose their heads. They will probably write books on "How I turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning." Worse yet, they'll probably start jetting around the country attending seminars on efficient coin-flipping and tackling skeptical professors with, "If it can't be done, why are there 215 of us?"
Thanks. I am commenting on this just so I can refer to the full text whenever someone claims that Warren Buffett believes in the Efficient Market Hypothesis (something which appears to be the case from this extract, and which numerous commenters on this story seem to vehemently argue ;) )
For posterity, the key quote for those looking to intuit Buffett's view comes on page 13: "I'm convinced that there is much inefficiency in the market."
Well, the excerpt corresponds to your view, but not the full article. I'd be curious to know what you make of the arguments Buffett presents against this view.
> I'd be curious to know what you make of the arguments Buffett presents against this view.
I read the entire article, and the problem is that it cannot distinguish between an effect and chance, and many have an incentive to call chance an effect. Also there's the announcement effect to consider -- once a player has a track record, people start reacting to his moves by buying the same stocks, after which the track record is no longer meaningful data.
The WSJ Dartboard Contest was a terrific test that could have shown a real effect, if there is one, and anyone who produced reliable returns would get a lot of free publicity. So there was a big incentive, but no one could show an effect. It was the closest thing to science I've seen, and it supported the null hypothesis.
> For 100 stock fund managers buying and selling stocks, statistics tells us that 50 of them will do better than the market averages (and 50 will do worse).
50 will do better/worse than the MEDIAN of that GROUP OF 100 fund managers, not the market averages.
> 50 will do better/worse than the MEDIAN of that GROUP OF 100 fund managers, not the market averages.
Oh, the managers will do worse than the market averages, because even if they avoid dumb moves, they will charge you for the privilege of managing your portfolio.
My original remark was meant to measure their performance before fees, as the WSJ Dartboard Contest did it (a contest in which the managers weren't able to keep up with market averages).
EDIT: for a symmetrical distribution, a distribution for which a classic Gaussian curve is appropriate, the median and the mean are the same.
Indeed, 50 may do worse than the market... but it's not because of a faulty appeal to "statistics."
haliax is pointing out that 100 fund managers may not be an unbiased sample. It's perfectly possible to find a biased sample of 100 individuals capable of beating the market (eg. a group of 100 insiders trading illegally).
EDIT: The "correct" thing to say is... "Based on evidence, fund managers do not outperform the market. Therefore, in a random sampling of 100 fund managers, we would expect 50 to underperform the market." This assumes (1) there is such evidence (likely?) and (2) that 100 is a sufficiently large sample to overcome the error bounds.
> haliax is pointing out that 100 fund managers may not be an unbiased sample.
My point is that, of 100 typical managers, 50 will beat the averages. Not any specific set of 100 managers, just typical ones.
> ... and (2) that 100 is a sufficiently large sample to overcome the error bounds.
You're completely missing the point that it's not about any particular set of 100 managers -- they're just a representative sample meant to turn the results into convenient percentages.
A: "Take a random selection of 100 typical fund managers. Now ..."
B: "Wait! Which specific managers are you thinking of?"
A: "No, the 100 managers are meant to represent perfectly typical, average managers, and only to be able to use the number 100, in order to discuss the outcome in terms of percentages."
B: "Oh, umm, okay."
A: "How about I say 'Take a typical set of 1024 managers. Given that, 512 of them will beat the averages.'"
B: "Wait, where's my calculator? Is 512 half of 1024? Why are you trying to trip me up with oddball numbers?"
Arg... Assume the entire population of fund managers, which is smaller than the population of the entire "market", has a mean return of 15%. Further, assume the market as a whole (superset including fund managers) has a mean return of 10%.
Under those conditions... in a sampling of 100 "typical fund managers", more than half would still produce higher returns than the market.
You made an implicit assumption, which I believe is probably correct, that fund managers as a population are an unbiased sampling of the entire market -- ie. that their returns are the same as the market (or worse) -- but provided no evidence to back it up.
> Further, assume the market as a whole (superset including fund managers) has a mean return of 10%. Under those conditions... in a sampling of 100 "typical fund managers", more than half would still produce higher returns than the market.
No, because we're comparing manager performance with market indices, like the DJIA, both of which include overall market growth.
The "average market" is measured by market indices, each of which tries to characterize a typical buy & hold portfolio. Thus, market indices ascend with overall market growth. That's what an average manager has to beat.
And the WSJ Dartboard Contest, which compares market indices with submitted manager performances, proves that managers cannot beat the market, even if their fees aren't included in the tallies.
> Under those conditions... in a sampling of 100 "typical fund managers", more than half would still produce higher returns than the market.
No, just half. not more, not less. Both the market indices and the managers would ride the ascending average value of the market as a whole. The only difference would be the theory being tested -- that some managers have special abilities that would give them an edge.
> You made an implicit assumption, which I believe is probably correct, that fund managers as a population are an unbiased sampling of the entire market -- ie. that their returns are the same as the market (or worse) -- but provided no evidence to back it up.
I keep proving my point with examples like the Dartboard Contest, and people keep ignoring the evidence. Don't you understand that submitters to the Dartboard Contest had every incentive to display their best performance -- a success would assure them of fame and wealth. But none of them could do it, over a period of years.
To expand on this point, Benjamin Graham gives an excellent layman's breakdown of why pursuing an index almost always prevails against trying to "beat the market" in The Intelligent Investor.
If you're looking to make money with the market, and you're not looking for a particularly high amount, and time is not an issue, an index fund is the way to go.
>statistics tells us that 50 of them will do better than the market averages (and 50 will do worse)
This is a common misunderstanding, but actually 50% will do better than the median not the average. Averages can be dominated by extreme events, so more than 50% can do better (or worse) depending on the skew.
Median is an average, as is mean and mode. Saying median not the average makes no sense. You mean median not the mean. All three are different kinds of averages.
> This is a common misunderstanding, but actually 50% will do better than the median not the average.
If the market were skewed to the degree that a symmetrical normal distribution wasn't a realistic model, then (assuming a particular skew) beating the median would be child's play, but it also wouldn't produce returns different than the average portfolio -- that average portfolio that sits at or near the mean, not the median.
Another way to say this is that, if a skewed distribution peaked at some mean value M (the value on the curve that has a zero first derivative), and if there was a pathological, nonsymmetrical tail at the right or left that shifted the median value, the majority of portfolios would remain at the mean value in spite of the asymmetry.
What is the market? A bunch of fund managers. So your critique about not beating the median like saying half of all hockey players are worse than the median and so hockey is just a game of chance. You have to fix your prior. Track performance for some period of time. Then track the winners. This will show whether it's a game of skill or chance.
This is like saying all personal relationships are limited to prostitutes. One can buy stocks directly, or invest in index mutual funds that don't have managers, for the reason that no management is required.
> Then track the winners. This will show whether it's a game of skill or chance.
But that's been done -- the WSJ Dartboard Contest showed that the experts don't do better than throwing darts at a list of stocks.
My point is that buying and holding an index fund, and relying on long-term market growth instead of phony expertise, is a much better approach to equity investment.
The market is NOT a bunch of fund managers. Its a representation of the state of assets being debt/credit or company shareholding.
The market does not do better because there are fund managers, it does better if the underlying assets increase in value. All the other fluctuations are based on expectancies of those assets and arbitration.
It is entirely possible for 100% of fund managers to do below the market average, as fund managers dont own 100% of the market.
It is also likely they have a losing bet against a market, as active fund managers employ resources in their operations, by trading and actively managing a portfolio, usually in the form of fees, and potential downsides on extra taxation as well.
Tracking "the winners" is the most fallacious and common attempt at gauging how good a fund manager or a stock is doing.
Bernie Madoff was one of the winners for decades. Past results give no expectation to the future, which is so misleading given that the most common tool to show the value of a stock is a chart of how it did before, as opposed to how the company is doing (which require reading the statement).
I suggest reading "The Intelligent Investor". It is by far the best book on this topic out there , and it has enough layman terms and concepts that are very easy to understand once you expose yourself to them.
While I think The Intelligent Investor is a worthwhile book, I think it got it wrong for the very reasons I mentioned above.
Anyway, I'm not making any argument here for how the market works, other than pointing out that saying that half of fund managers do worse than the median does not imply that they are unskilled or not providing value. Nor am I saying that they do provide value, but rather the original theory is both flawed and insufficient to make a conclusion.
In games of skill, past results certainly give expectations of future results. Going back to the hockey analogy, I would expect the top 10% of performers over five years (determined by some metric) would as a whole outperform a random sample of 10% of the league in a sixth year. Madoff is a bad example here - he was breaking the law, but nobody knew. If you catch a top sports player doping, it doesn't suddenly mean that the game is a game of chance, or that all of the top performers are cheaters (although repeatedly catching cheaters may indicate systematic problems) - rather it means that someone cheated to fake performance. They were playing a different game, but nobody knew.
Going back to the original point, if you want to determine whether something is a game of chance or skill, you have to fix the prior.
Let's say we had coin flipping tournaments, and people were claiming that it's a game of skill. Looking at past statistics, some people seemed to perform far better than the expected 50-50 split. You however claim that coin flipping is just a game of chance. How do you prove it? You look at results for some period of time, say five years. Take the "winners" from that group - say the top 20% of performers. Under the hypothesis that it's a game of skill, these should be a selection of the most skilled people.
Now track their results for a sixth year. If it was a game of skill, the expectation would be that as a whole, these individuals would continue to perform at a high level. However, as a game of chance, you would expect performance to be completely random among these high performers - and by doing this, you can determine whether coin flipping is a game of chance or skill.
The hockey analog doesn't hold if you can replace any given player with a stochastic robot, which is what stock picker programs (and dart-throwing monkeys) have demonstrated.
You have to adjust your evaluation with the volume. If you're heading for the winning team, then alright, good intelligence on performance will be rewarded. But if you are three investors on the entire competition, it is very likely that skills advantage fades, since all your competitors have strong (if not mandatory) incentive to get top intelligence on the investment. In the end, your performance will be average, and your value earnings volumes will be your share of the entire market value creation for the invested period.
The problem is fundamentally that fund managers consume a large portion of the returns, after you factor the cost of the fund manager the result is negative.
To put it succinctly: On average fund managers reduce ROI.
As an alternative measurement, if you take the funds managed by most managers and look at the portfolio 1 year ago the fund would be better off with the previous year's portfolio. (This time mostly because of transaction costs)
> The problem is fundamentally that fund managers consume a large portion of the returns, after you factor the cost of the fund manager the result is negative.
Yes, a point I make in my article, but didn't make in my post. Fund managers are very difficult to justify.
No. For 100 stock fund managers buying and selling stocks, statistics tell us that 50 of them will do better than the average of them (than the lower 50). To assume half will do better than the market is a failure of logic, assuming non stock fund managers are allowed to buy and sell too. Please qualify and clarify what you actually mean.
There are managers who excel at investing money and unlocking value. Just because most managers in assets and investment vehicles afforded by those whose worth is not of a sufficient level does not mean they do not exist. People who can, do. They happen to charge 2 and 20 for the privilege of working your money.
> There are managers who excel at investing money and unlocking value.
From a scientific standpoint, that is false. You need to realize that it's not possible to show (prove, demonstrate) that such stories arise from anything but chance. A certain number of people are going to do very well because of chance, and some of those people are going to try to pose as experts.
But don't take my word for it -- instead, think. If there really was a surefire way to beat market averages, it wouldn't remain a secret for long, then everyone would practice it, then that "system" would become the norm -- the market average performance.
And if there really was a way to beat the market averages, if it was possible to make a huge sum of money systematically without risk or uncertainty, using a scheme other than chance, businesspeople (who are not fools) would refuse to raise capital using equities.
If you think hard enough, you will realize why there cannot be a deterministic, legal system to beat the market. There's always insider trading, but that's illegal for a reason.
> Just because most managers in assets and investment vehicles afforded by those whose worth is not of a sufficient level does not mean they do not exist.
They do not exist. I just proved it. If you didn't understand the above proof, read it again.
And yet Ed Thorpe, from 1969-88, had 227 months where he made money, and 3 where he lost. Over that time frame, he had a mean return of well north of 15%, with a standard deviation of 4%.
What precisely did you prove? Edit - your arguments are incoherent - I, or most others who claim that some people can consistently beat the market, are not relying upon some mythical, eternal method. You're correct in that any such method will become public and therefore worthless. I imagine consistently winning takes constant work and innovation.
Furthermore, no is claiming that [i]anyone[/i] can "make huge sums of money systematically without risk," or that successful hedge funds that can turn 1 dollar into 1+r dollars can always turn 1e9 dollars into (1+r)e9 dollars, or even that there exists a single financial genius that can entirely eliminate risk.
What a collection of straw men you have succeeded in knocking down!
> And yet Ed Thorpe, from 1969-88, had 227 months where he made money, and 3 where he lost.
First, he didn't beat the market average 227 times in a row -- for most of those periods, he didn't lose money, but then a buy & hold investor also didn't lose money. A meaningful comparison would have to compare his outcomes with that for a buy & hold investor riding the ascending market value by holding a boring, geriatric index fund.
Second, I wish people would study probability theory and statistics before trying to have conversation like this one. A totally random computer-generated market, with random trades, produces a handful of very spectacular outcomes, by chance alone. The larger the investor pool, the greater the chance for a spectacular chance performance.
In the above market model, which is a computer market driven by random trades, no intelligence, essentially flipping coins, out of 100 investors, the best performance over 30 years is $233,000 from an initial stake of $10,000 (an average performance would be $51,800). And if you increase the investor pool to millions like in real life, you greatly increase the size of the most spectacular performances.
Now imagine that the best performer is a human being instead of a computer model. What are the chances that he will say, "Oh, I was just lucky." For one thing, he might not understand enough probability theory to even grasp that chance could explain the outcome. For another, he might want to set himself up as a financial expert and make more money exploiting other people's stupidity than he ever made in equities.
> I imagine consistently winning takes constant work and innovation.
Imagine anything you like. There are no secrets of the winners. Prove this false using scientific evidence. Prove that spectacular performances cannot result from the workings of chance, as my computer model proves.
> ... your arguments are incoherent ...
Only to someone who has his mind made up and who cannot evaluate evidence. Imagine a group of people flipping coins -- how many people need there be, flipping fair coins, for one of them to have a 50% chance to flip heads 20 times in a row? And what is the chance for the lucky winner to say, "Oh well, it was probably a chance outcome"?
It is difficult to imagine what sort of evidence will convince you. All sorts of behavior is possible under all sorts of unrealistic models.
I'd also like to note the irony of your snarky comment about wishing that those who disagree with you ought to study some math, given the background of managers like Jim Simons.
Edit:
> First, he didn't beat the market average 227 times in a row -- for most of those periods, he didn't lose money, but then a buy & hold investor also didn't lose money. A meaningful comparison would have to compare his outcomes with that for a buy & hold investor riding the ascending market value by holding a boring, geriatric index fund
The stock market rose by about 8 or 9% annually during that time. Dismissing his 227 positive months requires absurd contortions, like positing that his firm would invest in the stock market or t-bills for 11 months out of the year, and then make a series of large bets in the remaining month. Given that he made, I believe, 10k bets a year, the disparity in bet size must be massive to even come close to supporting your hypothesis.
> It is difficult to imagine what sort of evidence will convince you.
What are you talking about? There is no evidence for the assumption, and the only reliable evidence stands against it, like the WSJ Dartboard Contest.
If a particular institution does better than the averages, the most likely explanation is chance, and no other explanation has anything resembling scientific evidence. And the Dartboard Contest demonstrates that, when called on to put up or shut up, the professionals weren't able to put up.
> The stock market rose by about 8 or 9% annually during that time. Dismissing his 227 positive months requires absurd contortions ...
No, it requires acknowledging that the market rose by 8 or 9% per annum, as you just pointed out. His performance needs to be compared to the market averages, not to a hypothetical flat market. I can see you're not getting this -- someone says, "I must be a stock genius, because I never saw zero or negative growth in my portfolio." Someone then deflatingly points out, "Neither did the average market, the holdings of retired, risk-averse investors in Ohio."
> ... to even come close to supporting your hypothesis.
It is not my hypothesis, it is the default assumption of people with scientific training -- if there is no evidence, there is no effect. And there is no evidence.
In a pool of ten million investors, a handful will show spectacular performance by chance alone -- this is a mathematical fact -- and those individuals would have to be saints to avoid assuming and claiming they're stock picking geniuses.
Occam's razor is a precept that says the simplest explanation tends to be the right one. The simplest explanation is that some investors come out ahead because of chance. This means the burden of evidence rests with those who would like to claim that stock market performances arise from "secrets of the winners".
>But don't take my word for it -- instead, think. If there really was a surefire way to beat market averages, it wouldn't remain a secret for long, then everyone would practice it.
Not if it's costly. By that I mean what if there is a market oracle that can pick tomorrows winners, but you have to pay X dollars to pull the crank and get the info.
In that case, it could be possible to "beat the market" in the sense that your stocks overperform, but you do not actually beat the market if you factor in the cost of the oracle.
>A closely watched consumer confidence number that routinely moves markets upon release is accessed by an elite group of traders, for a fee, a full two seconds before its official release, according to a document obtained by CNBC.
Another situation would be that you could overperform the market if you hired thousands of employees that analysed the markets, but not so much that you could pay their wages and still win.
It could also be the case that some people have a comparative advantage. Maybe they have certain skills that enable them to win were other people cannot.
That's an announcement effect, not a method for beating the market. It exploits people's stupidity, not their intelligence. For a classic announcement effect, there are an equal number of winners and losers, and the average return is zero. In this specific example, some people get to buy the stocks in advance of the public announcement, then the public investors stupidly and dutifully buy stocks whose price has already peaked and is about to fall. It transfers money from uneducated investors to educated ones. If the uneducated investors realized what was being done to them, they would not invest and the system would collapse.
A typical announcement effect scam are online penny stock touters, who:
1. Buy a worthless stock.
2. Tout the stock online: "I just heard from my cousin that this stock is about to move!"
3. Wait for some idiots to invest in the stock.
4. Sell.
> It could also be the case that some people have a comparative advantage. Maybe they have certain skills that enable them to win were other people cannot.
You're on the money in both this post and the grandparent. However, I'd urge you to examine your style. There's no need to condescend. In particular:
> I just proved it. If you didn't understand the above proof, read it again.
> I can't believe you aren't getting this.
Plenty of otherwise rationally minded people have a hard time reasoning about this stuff. If I had a dollar for every time someone suggested that you can beat the house by playing a Martingale... gosh! You'll have a much easier time persuading people if you don't insult them.
I agree with your point, but in the 21st century, I have a hard time accepting that many people ignore basic scientific principles -- in particular, the null hypothesis, which in essence says that a given proposition is assumed to be false until there's evidence for it.
> Plenty of otherwise rationally minded people have a hard time reasoning about this stuff.
Rationality is what rationality does. There's a devious investment scam that, once explained, seems obvious, but most people fall for it unless forewarned. I call it the "Miracle Man" scam. Here it is:
I would like to live in a world where a scam like "Miracle Man" couldn't work, because people would say "It seems too good to be true, therefore chances are it's not true."
I think the point of the article is that is difficult to distinguish between luck and skill. (Or even a combination) But skill is still involved. Not doubt some people are smart and knowledgeable and some are not.
Following your example I can imagine that there is a mechanism (I wouldn't call it surefire) that can improve your odds. But that mechanism is difficult to acquire, difficult to transfer and not very scaleable. Therefore it is difficult for everybody to practice it. In fact some do it so badly that they end up loosing more than the average.
> If you think hard enough, you will realize why there cannot be a deterministic, legal system to beat the market.
I don't think anyone is arguing that there is a deterministic legal system to beat the market. Only that some people may be skilled enough to beat the market.
edit:punctuation
> I think the point of the article is that is difficult to distinguish between luck and skill.
Not difficult, impossible. It cannot be established scientifically. No control group, no meaningful controls.
> Following your example I can imagine that there is a mechanism (I wouldn't call it surefire) that can improve your odds.
And people who write worthless "secrets of the winners" books rely on this very assumption (and on the stupidity of the average investor). If such a thing existed, one of two things would happen:
1. It wouldn't remain secret for long, therefore everyone would practice it, therefore it would become the new average market performance. End result: no secret.
2. It would remain secret in perpetuity, the owner(s) of the secret would use it to either drain the market of its capital or foment public doubt about market fairness, as a result of which businesses would stop using the equities market to raise capital. End result: no market.
So the "secret" would either destroy the market, or the market would adjust to its existence in a way that everyone would have the same opportunity. Therefore there is no secret.
> I don't think anyone is arguing that there is a deterministic legal system to beat the market. Only that some people may be skilled enough to beat the market.
> It would remain secret in perpetuity, the owner(s) of the secret would use it to either drain the market of its capital or foment public doubt about market fairness...
If this 'secret' could only be applied in small amounts, then the owner couldn't drain the market. Why do you think Buffett believes large funds can't outperform?
You assume any such 'secret' is infinitely scaleable. That's an incorrect assumption.
Insider trading is an advantage that exists but doesn't fall into your #1. Has it 'drained the market' or stopped businesses from using the stock market?
> You assume any such 'secret' is infinitely scaleable.
First, I never said or assumed that. Second, Human greed is, in fact, infinitely scaleable. But this is a silly debate -- obviously the most likely explanation for a spectacular market performance is chance.
> Insider trading is an advantage that exists but doesn't fall into your #1. Has it 'drained the market' or stopped businesses from using the stock market?
In a word, yes -- in a number of cases, companies try to buy themselves out of the stock market, for that and other reasons (like the tyranny of quarterly earnings reports and shortsighted boards of directors).
We're off on a tangent now. We've left the original topic. And the original topic was resolved by noting the WSJ Dartboard Contest, where managers had every incentive to show what they could accomplish, but instead they failed, spectacularly, in public, for years.
If there really was a surefire way to beat market averages, it wouldn't remain a secret for long, then everyone would practice it, then that "system" would become the norm -- the market average performance
But this applies to any human endeavour! What's the secret to being successful in any field? Or rather, why aren't we all world-class concert pianists or martial artists or ballet dancers or whatever takes your fancy? Because knowing "the system" and practicing the system are very different things...
It doesn't have to be a 'system' that's replicable. It might just be on a case-by-case basis. Maybe a few people just have a knack at seeing something most others tend to miss and that this varies from stock to stock.
> It doesn't have to be a 'system' that's replicable. It might just be on a case-by-case basis.
Sure, no problem with that. Case by case -- half the time it works, the other half the time it doesn't. Sum the outcomes and you have average performance, and you might as well have invested in an index fund and caught up on your reading.
For some things, a real scientific experiment isn't possible, because there's isn't enough control. Equities is one of those things. For equities, when you see a performance that beats the market averages, it wise to assume it's because of chance, not genius.
Also, there are any number of convincing scams meant to distort one's thinking. My favorite is one I call "Miracle Man", in which a manager mails you six perfectly correct monthly predictions, all in advance of the real market they predict, then asks to take over your portfolio. Hard to believe, but it's a scam, it isn't real:
I think one particular problem with the strong-form efficient market hypotheses is this:
A stock should already be priced for all of the publicly available information. However, that information has to be analyzed and interpreted. That's the catch.
"Today company XYZ announced their purchase of Chinese company ABC."
There are probably many different ways to interpret that information. Maybe the purchase will result in increased profit, maybe it will bankrupt the company. Nobody knows.
If all public information were easily interpreted, i.e. if X happens the stock will drop by 5%, then the markets probably would be efficient.
The EMH doesn't propose that participants have future knowledge. It says that current prices reflect current information and that in the long run, all participants regress to the mean.
Well yes, but he's still correct. Not all participants accurately gauge what the available information means for their positions, and even for those who do, figuring it out takes time.
There is no evidence that mutual funds (or any other active managers) can outperform the stock market.[1] This can be explained by the strong form of the efficient markets hypothesis; "In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns." [2]
The market is definitely not strong-form efficient. If it were, you wouldn't have any price movement attributable to earnings surprises, because the private information would already be priced in. More importantly, markets are only efficient because some people are researching and trading to the true underlying value. The whole reason markets are supposed to be efficient is because if they are not, there is an opportunity to make riskless arbitrage profit, which someone will exploit.
Strong form efficiency does not imply perfectly predictive of all future events. Such a claim would imply that no durable good could increase in price at a rate higher than the federal funds rate plus some risk premium (haircut).
If what he says here is true, the parents of every kid on the planet should test their child for some aptitude in this area--at least a little--because learning your kid was preternaturally adept at, basically, "Making a Lot Of Money" would be the most important thing that ever happened to the kid. Also wouldn't it have been one of the most sensational "news events" of all time, if nothing else, when someone honestly reported Someone Has Found the One Weird Trick To Becoming Really Rich, And It Always Works If You Do It Right. The rise in billionaires I surely would have heard about, at least.
So what's the catch? Why can't I just go and study this book and make a lot money if I think I'm smart, now that I've read this article?
The catch is that testing people for an unexplained adeptness at making money in equities is essentially certain to produce a handful of "successes" that arise from chance, not talent.
Given a pool of ten million investors, all playing the market, and all making random picks, it is certain that a handful will succeed spectacularly because of chance. I know because I have modeled this sort of thing with computer programs, each of which produce "winners" simply by making random picks.
With a large enough population, some will "succeed" spectacularly, through chance. Those successes will find it hard to accept that their success arose from chance rather than genius, just as happens in real life.
> Why can't I just go and study this book and make a lot money if I think I'm smart, now that I've read this article?
If there really was a book that contained secrets to beat the market, secrets that worked, that were reliable, that anyone could put into practice, businesses would abandon equities as a way to raise operating capital. After all, why should they line the pockets of a bunch of non-productive speculators? What possible incentive would they have?
The only reason the equities market works is because investors get a fair return on their investment, consistent with the risks they take, and businesses get operating capital at a reasonable rate as well. Both parties to the transaction get a fair deal. All this talk about making a killing in stocks using "secrets of the winners" overlooks the fact that, if it were possible, if someone could really make a fortune by something other than blind luck, reliably, deterministically, the market would collapse.
And for the life of me, I can't understand why people find this so hard to understand.
The title is misleading, but Warren Buffett is right.
The more money you manage, the harder it is to beat the market as a trader. However, if you're playing with a modest amount of money, you can play the market, since moving small amounts of money around is much easier than say, 20 billion...
I read all this 1975 dated letter and while I enjoyed every piece of it, this phrase contained in the very last page is what caught my attention the most:
"Conventional approaches to money management should not be expected to produce above average results."
It basically means that if you want to perform better than your competitors you logically should act differently from them. As in distancing yourself from the status quo.
I can see this advice being spot on for startups as well, it has everything to do with thinking outside of the box and redefining the rules of the game.
I had a funny thought reading the letter (the actual letter at Forbes, not the vacuous qz.com summary).
The letter is type-written, with nice tables and footnotes. That probably means that it was either hand-written by Buffet or by a secretary (or stenographed or whatever), and then given to a typist to format.
In turn that means that some random lowly typist got to snoop on all this premium investment advice, that 20 years later would be becoming common wisdom. I wonder if she (I assume a typist in the 70s would be female) noticed and appreciated it, perhaps acted on it.
Probably not. It's a sad fact that women are on average disinclined towards risk-taking, and investment is a classical risk-taking activity. This effect must have been even more pronounced in the 70s.
and yet he himself is an example of exactly the opposite mentality. He has been an outlier manager for decades and would have been a great choice of manager for anyone he would take money from. He effectively takes new money whenever his holdings pay dividends and reinvests it successfully. Roughly speaking he's returned 100% (vs 50% for the Sp500) in 10yrs giving about a 7.2% return rate. He consistently beats the market and then claims that "managers" cannot.
Not quite - I think his point was that money managers with very large sums to invest cannot beat the market. He made that claim almost 40 years ago, and more recently his own record clearly contradicts it. So perhaps he no longer holds such a view...
Edit: It looks like Buffett had changed his view by 1984 [1]: "Size is the anchor of performance. There is no question about it. It doesn't mean you can't do better than average when you get larger, but the margin shrinks."
It's simple math. A money manager controlling 100% of the market by definition can't beat the average ;) So the potential for good performance must increase along that spectrum.
Buffett is an interesting character. From this article, it would appear that he sees himself as some kind of entrepreneur/investor/manager hybrid than as a pure money manager.
If you go on to read anything about activist investors, like Carl Icahn, you get the feeling that the only way to beat the market is to tamper with it.
> He consistently beats the market and then claims that "managers" cannot.
But he isn't beating the market -- he's beating the pants off his followers, people who dutifully buy the same stocks he does. It's the announcement effect -- Buffett buys a given stock, Buffett is a winner, so everyone responds by buying the same stock: self-fulfilling prophecy.
The irony is that the timing of the groupie-purchases assures that money flows from them into Buffett's accounts, because the followers buy too late to benefit.
Another effect is that, if Buffett buys stock in a particular company, he is betting that company will grow. Potential customers notice this, prospective employees notice this, the public notices this: it's another self-fulfilling prophecy.
Is this a mere hypothesis? Yes, it is. Can it be proven? Only in principle, not in fact. Is Buffett actually a genius? Chances are no one will ever know, and it's certainly not science.
The insult here--"groupie-purchases"--suggests you understand Buffett's existence is a serious blow to your case. As you implicitly acknowledge with your hypothesis of the "announcement effect", the null hypothesis is that Buffett beat the market. It's time you hold yourself to the same standard you demand elsewhere in this thread and prove that "groupies" from 40 years ago maintaining their positions all these years account for Buffett's long term rate of return.
My case? The fact that investment managers cannot produce results has been proven over and over again. It's not my case, it is a simple fact about reality. All you need to do is review the WSJ Dartboard Contest.
In the Dartboard Contest, managers had every incentive to prove what they could do -- a success would have made them simultaneously rich and famous. They failed. Any questions?
> As you implicitly acknowledge with your hypothesis of the "announcement effect" ...
"My hypothesis?" You need to learn something about equities. The announcement effect is very well-known.
Do you suppose I wrote all these articles, and talked a bunch of economists into believing in it? For God's sake.
> ... the null hypothesis is that Buffett beat the market.
The null hypothesis is that Buffett did not beat the market based on special skills. The null hypothesis is that Buffett's performance has a pedestrian explanation -- chance. That's what the null hypothesis means.
Quote: "In statistical inference of observed data of a scientific experiment, the null hypothesis refers to a general or default position: that there is no relationship between two measured phenomena, or that a potential medical treatment has no effect."
I can't repair the defects in your education in a series of forum posts -- you will just have to go out and get an education on your own, like a grown-up.
In aggregate, it wouldn't much matter since randomness would cancel itself out. So broad index funds wouldn't see that volatility.
At shorter scales, however, randomness like that would add volatility to individual stocks, so you'd see more random results for returns among small portfolios -- thus creating quite a few genuinely lucky fund managers.
I would expect similar language to be used if this were instead an article about something Donald Knuth said when he was 44. The "just" reflects the public familiarity with the 82 year old Buffett.
What he does say in the quoted part is that a large fund of say 20 billion likely can't outperform due to it's size. That is a big difference from saying that it's futile to play the market (since not everyone is trying to invest 20 billion). It's also similar to what other investors like Peter Lynch believed.. that smaller investors have an advantage over the large funds.
This isn't made clear at all in the linked page. As far as I know, Buffett has always felt efficient market theory is wrong and that a few could beat the market on skill. There's also nothing in the linked quote that contradicts this (just the title that suggests it).
So the title is clearly deceptive. It suggests that Buffett did not believe in investing skill at a younger age and only changed his stated beliefs after becoming a very successful investor.