Warren Buffet explains why you can't beat the market

In 1975, Warren Buffet wrote a memo to the Washington Post's CEO Katharine Graham about how to invest the company's pension fund. His advice -- to ignore pricey fund-managers, be patient and play the long game -- was good enough that the WaPo pension is still in rude health today. Meanwhile, stark assertions like "the rational expectation of assuring above average pension fund management is very close to nil" continue to have relevance today in questions as diverse as whether we need to pay bankers huge bonuses to keep the "best talent" on hand to how you should invest your pension.

For openers, there is one huge, obvious pitfall. I am virtually certain that above-average performance cannot be maintained with large sums of managed money. It is nice to think that $20 billion managed under one roof will produce financial resources which can hire some of the world’s most effective investment talent. After all, doesn’t the big money at Las Vegas attract the most effective entertainers to its stages? Surely $50 million annually of fees on $20 billion of managed assets will allow an array of industry specialists covering minute-by-minute developments affecting companies within their purview; top-flight economists to study the movement of the tides; and nimble, decisive portfolio managers to translate this wealth of information into appropriate market action.

It just doesn’t work that way.

Down the street there is another $20 billion getting the same input. Each such organization has its own group of bridge experts cooperating on identical hands and they all have read the same book and consulted the same computers. Furthermore, you just don’t move $20 billion or any significant fraction around easily or inexpensively—particularly not when all eyes tend to be focused on the same current investment problems and opportunities. An increase in funds managed dramatically reduces the number of investment opportunities, since only companies of very large size can be of any real use in filling portfolios. More money means fewer choices—and the restriction of those choices to exactly the same bill of fare offered to others with ravenous financial appetites.

In short, the rational expectation of assuring above average pension fund management is very close to nil.

The 1975 Buffett memo that saved WaPo's pension

(via Quartz)

(Image: Dow's Damage: 13% in Five Days, a Creative Commons Attribution (2.0) image from yotut's photostream)

Notable Replies

  1. Hmm. Wonder how much the fact that "the WaPo pension is still in rude health today" influenced Jeff Bezos' decision to buy that company. Does control of that pension fund come with the purchase?

  2. skrap says:

    A great (+ short) book in the same vein is by two guys named Goldie and Murray called "The Investment Answer". Murray was a bond salesman at Goldman and a managing director at Lehman, but upon discovering that he had terminal brain cancer, he wanted to write some truth about how to invest in the market. Their advice echos that from this memo, but he goes into a little bit more depth about how to break free from the system. It's a short read - a few hours. I really liked it.

    Here's a NYT article about the book. http://www.nytimes.com/2010/11/27/your-money/27money.html?pagewanted=all

  3. Is "rude health" good or bad?

  4. I suspect that most of them subscribe to a variant of the efficient market hypothesis, which holds that 'consistent market-beating returns are impossible for people less special than me, which is more or less all of them.'

  5. Buffet is not saying that you can't beat the market. He's saying that you can't beat the market over the long term when investing large amounts of money. Simply put, you can't beat the market because you are the market, or you are restricted to the very companies that define the market - very large companies like those that make up the major indexes against which your performance is measured. How can you beat an index made up of IBM, Intel, Johnson & Johnson, etc. when those are the stocks you have to buy because those are the companies where a $50,000,0000 order to buy or sell won't send the market haywire.

    Buffet wouldn't tell you that "you can't beat the market" because he did it for a long time. But at the beginning he was a much smaller fish. And he did it by finding situations like WaPo or Geico that were good businesses that had completely hit the skids for whatever reason and were selling for next to nothing. He had confidence enough in his research to take enormous positions (in comparison to other holdings) and was rewarded when the companies recovered. If you put 20% of your assets in 1 stock and it goes from $2 to $200 over 10 years, it will have a gigantic affect on your long term record. A small hedge fund can make bets like that, but a $20 billion pension or mutual fund can't.

Continue the discussion bbs.boingboing.net

30 more replies