
The 1975 Buffett memo that saved the Washington Post's pension - peter123
http://finance.fortune.cnn.com/2013/08/15/warren-buffett-katharine-graham-letter/
======
robotcookies
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.

~~~
jacques_chester
> _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.

Here's my favourite discussion of the EMH:

[http://skepticlawyer.com.au/2013/05/29/bubble-trouble-all-
in...](http://skepticlawyer.com.au/2013/05/29/bubble-trouble-all-information-
is-not-equal/)

~~~
robotcookies
That's a good point. Many people who don't believe in the strong version do
actually fall into the weak form.

~~~
marvin
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.

~~~
jacques_chester
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.

~~~
marvin
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.

~~~
jacques_chester
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.

~~~
marvin
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.

~~~
jacques_chester
I guess so. Naturally I secretly suspect in my heart of hearts that _I_ am
smart enough to out-perform the market ...

~~~
marvin
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.

------
gvr
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:

Rule #1. Never lose any money

Rule #2. Never break rule #1

------
D9u
I remember reading a quote from a top trading executive which went something
like the following:

"Only a fool plays the stock market without insider information."

------
jmcgough
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).

~~~
aet
Better yet, be the one charging the fees.

------
dredmorbius
Meta: QZ is utterly unreadable to me on both desktop and mobile. Fortunately
there's Readability.

~~~
nether
More meta: the article uses lowercase l to represent the digit 1.

~~~
dredmorbius
Perl can do that in Underwood compatibility mode (obscure Perl Journal cover
reference...).

------
beambot
Quoting from page 13:

 _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?

~~~
ISL
He's been planning for his retirement/demise for a very long time. He's pretty
good at playing the long game, so I wouldn't bet against him.

------
lutusp
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.

More here:
[http://arachnoid.com/equities_myths](http://arachnoid.com/equities_myths)

~~~
mdkess
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.

~~~
conanbatt
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.

~~~
mdkess
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.

------
porter
Warren Buffet also said:

"I’d be a bum on the street with a tin cup if the markets were always
efficient”

~~~
refurb
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.

~~~
jacques_chester
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.

~~~
eli_gottlieb
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.

------
nickff
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]

[1]
[http://faculty.chicagobooth.edu/john.Cochrane/teaching/35150...](http://faculty.chicagobooth.edu/john.Cochrane/teaching/35150_advanced_investments/Luck%20versus%20Skilll%20in%20the%20Cross%20Section%20of%20Mutual%20Fund%20Returns.pdf)

[2] [http://en.wikipedia.org/wiki/Efficient-
market_hypothesis#Str...](http://en.wikipedia.org/wiki/Efficient-
market_hypothesis#Strong-form_efficiency)

~~~
jcnnghm
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.

~~~
nickff
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).

------
d23y
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?

~~~
lutusp
> So what's the catch?

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.

------
Mikeb85
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...

------
rl12345
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.

Good ole Warren nailed it decades ago.

------
jholman
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.

~~~
marvin
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.

------
maerF0x0
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.

~~~
MarkMc
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."

[1]
[http://www.tilsonfunds.com/superinvestors.html](http://www.tilsonfunds.com/superinvestors.html)

~~~
foobarian
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.

------
r0s
The factor I think he missed: All those managers timing trades in their random
way has a randomizing effect on the system overall.

But I'm not an economist, any ideas if or how that influence manifests?

~~~
YokoZar
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.

------
yumraj
It's interesting that this article states "Buffett, then _just_ 44 years old"
while in the tech industry 44 years old is considered...

~~~
jlgreco
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.

------
Pitarou
I love this line:

> Wall Street abhors a commercial vacuum. If the will to believe stirs within
> the customer, the merchandise will be supplied -- without warranty.

------
beefxq
Tell that to the hedge fund billionaires. Oh wait, knowledge networks, I guess
it's all just insider trading.

