Buffet’s Bet Offers Valuable Lessons

Buffet’s Bet Offers Valuable Lessons

For those of you who don’t know him, Warren Buffet is the 87-year-old American billionaire investor and philanthropist referred to by many as the most successful investor of all time. There’s a lot that we can all learn from his life and career but I’m here to tell you about one specific moment. Back in 2007 Buffet offered a bet to the hedge fund industry, a bet which not only did he win, but one that offers a collection of helpful insights investors like you can follow to gain investment success.

“You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.” – Warren Buffet

Buffet has often stated that many investors would see great results if they just employed a simple, low-cost investment strategy. And within his 2005 letter to the shareholders of his own company, Buffet argued that:

Active investment management by professionals, in aggregate, would over a period of years underperform the returns achieved by rank amateurs who simply sat still. That the massive fees levied by a variety of “helpers” would leave their clients, again in aggregate, worse off than if the amateurs simply invested in an unmanaged low-cost index fund”

So, Buffet implied that active managers, and hedge funds in particular who often charge 2% per year plus performance fees, not only increased the chances of making a costly mistake by frequently trading in and out of stocks and assets, but also unnecessarily increased the costs of management due to excessive dealing fees and commissions, reducing the return to below that of someone who just invested simply and then did nothing. The old money adage goes:

Money is like a bar of soap. The more you touch it the less there is.

And in 2007 Buffet put his money where his mouth is and offered to bet $500,000 of his own money against any hedge fund manager willing to put up the same amount. The terms being that over a 10 year investment period starting 1st January 2008, Buffet’s chosen simple S&P 500 index tracking fund would outperform a portfolio of sophisticated hedge funds after all charges had been deducted. In effect, Buffet was betting that the complex hedge fund investment strategies of the rocket scientists and PhDs, would fail to beat the man in the street who invested in a cheap index fund of the 500 largest companies in the US because the hedge fund management costs would negate any performance advantage.

Now, for those of you unsure of what an active, passive or index fund is, you can read one of my earlier pieces here to bring yourself up to date. Go read it and I’ll see you back here in a few minutes.

Now what you have to remember (or learn depending on your age!) is what the investing environment looked like at the time in which the bet was originally made. In the mid-2000’s hedge fund managers were the new so-called ‘masters of the universe’. Hedge funds managed by the brightest minds offered market-beating returns to the wealthy and many of the managers were the toast of the financial industry, the general media and a staple at high society’s calendar events. Not a week went by without seeing celebrities and hedge fund managers mixing at the same black-tie gala’s with photos appearing in the glossy pages of the lifestyle magazines. And everyone wanted (but could not necessarily afford) a piece of that action. Buffet challenged an industry in its prime and suggested that what it was offering had no real value to long-term investors.

So did the hedge fund industry jump at the opportunity to defend itself and put Buffet in his place? I mean a mere $500,000 bet from an industry worth billions. Well, the straight answer is no. Instead of beating down Buffet’s door, only one manager agreed to take on the bet and under the terms of the challenge chose five hedge ‘fund of funds’ whose performance was to be aggregated and compared against Buffet’s index tracking fund. Now I actually remember reading about this bet with some interest at the time that it was made and boy did it start badly for Buffet. The timing couldn’t have been worse if he’d tried and you might remember that something called the ‘Financial Crisis’ hit hard during 2008.

At the end of the first year, Buffet had lost 37% of his investment as the S&P500 index tanked under the strains of the ‘Credit Crunch’, whereas the best hedge fund, although also making a loss, had lost only 16% and the worst 30%. At this point you might forgive an investor for thinking ‘what have I done, I’m never going to win this now?’. But here’s where patience, experience and long-term investing comes into play. The market started a recovery in 2009 and the simple S&P500 index fund went on to post a net of costs cumulative gain of 85.4% up to the end of the year 2016, whereas the best of the 5 hedge funds gained 62.8% over the same period with an average of the five being far less.

Source: Berkshire Hathaway

In fact at the end of 2016 Buffet was so far ahead of the competition that the bet was settled early during September 2017 as the hedge fund manager conceded the difference would be impossible to make up before the end of the year.

So what should investors take from this? Well investing solely in the S&P500 index is not the point of the bet and doing so includes its own specific risks. Instead, the lessons that every investor should take on board are that complicated investment strategies don’t necessarily do better than simple ones. It’s a myth that having more money means a more complicated solution is needed and keeping a lid on the management costs is well known to be a significant determinant of future returns. Having the patience to see things through, even in the face of adversity is a required behavioural trait, that timing the market is next to impossible (even Buffet can’t do it) and that investing for the long term are some of the keys to investment success.

Follow me on Twitter @alexandreriley

(Buffet caricature by DonkeyHotey)

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