People point to Warren Buffett as proof for how and why active stock picking works, but they don’t understand that it might just be that he has to exist.
Click here for a little primer on Warren Buffet if you are not familiar with him.
The argument here is that his performance is nothing more than a rare, but statistically explainable, occurrence. In his article “Beware of the 5 sigma“, Matt Koppenheffer explains that 95% of all US males are between 5’5″ and 6’2”. 95% represents two standard deviations, or sigmas. He goes on to point out that Manute Bol at 7’6″ is a 10 sigma event. Clearly he exists, and we all know that it is just a rare occurrence. Warren Buffett’s track record is estimated to be between a 3 sigma and 5 sigma event. So is it that much of a stretch to infer that his record is nothing more than luck?
Maybe
I don’t doubt that there are people who exist with superior stock picking abilities. I know I am not one of them, and I’m pretty sure that Warren Buffett is one of them. So how do I reconcile the statistics and the phenomenon of Warren?
There are a couple of things to consider:
1. Buffett has real and direct influence on the direction of the companies he buys (either in part or in whole). He, or someone close to him, sits on the boards of these companies and imparts his business wisdom. It’s clear he knows what needs to exist for a company to be profitable and sustainable.
2. These days, when Buffett buys a company so do a lot of other investors just because Buffett bought it. It could very well be that Buffett was really lucky in the early part of his career for long enough until he was considered a demi-god. After that point, anything he bought benefited from cult-like loyalty and copy-cat investors – two facts that can help drive a price of a stock up (or keep it from falling as fast). “He’s done so well for so long, that he must know what he is doing!”
The truth is, we will never really know what was behind his stellar record when it eventually comes to an end with his passing. At least, it would be hard to prove it because his track record does not fall outside the bounds of what is possible.
I choose to believe that there is skill there and that there will be future Buffetts, but I also know that I will never be able to identify any of the Buffetts before they establish their track records. And that’s the problem.
What are your thoughts on Buffett? Skill or luck?
Here’s another article (posted on this blog a few months ago) which offers more food for thought.
I doubt that Buffett’s record is luck. My own analysis of his record came up with 10-sigma, but there are so many assumptions built in that you could come up with just about any answer you want. A more compelling argument to my mind against trying to follow Buffett’s lead is Ellis’s argument that the investing world has changed since Buffett started amassing his impressive record. While the investing world is now dominated by professionals with speedy access to information, it used to be dominated by small-time investors who often got information weeks too late. By this argument, an investor with better access to information could have outperformed by skill, but that is no longer possible to any significant degree.
@Michael James – essentially the argument of Benjamin Graham in 1976 who basically said that the advantage he had in the 30’s was by then negated because there were so many more “Grahams” out there.
What everyone forgets about Buffett is that he’s actually a business owner first and investor second. Berkshire Hathaway owns several insurance related businesses and he uses the float from the insurance to invest.
This is what sets him apart from fund managers. He actually understands the business underlying the stock because he runs businesses himself as opposed fund managers who rely on analysts who are well-educated but mostly have never personally experienced day to day cash flow ups and downs of a business.
This is what makes Buffett (and Prem Watsa) an outlier. How many modern day fund managers actually run businesses?
Buffett’s success is skill meets an environment which rarely exists anymore. Most modern fund managers get spit out of b-school, start on a trading desk and then become fund managers. Buffett’s career arch is different explaining his different results.
@Thick – you’ll get no arguments from me on your comments! :)
To truly duplicate Buffett’s performance requires investing in great companies 30+ years ago.
I’m not entirely convinced his track record over the last decade is stellar. He’s a phenomenal investor – much of his wealth comes from a a core group of holdings that he has nurtured over many decades. Granted, I haven’t broken down his assets to see where the majority of his wealth comes from. I’m just speculating on what I understand from his investment style.
You want to talk about purely consistent active managers – I think you’re talking Peter Lynch and to a lesser extent hedge fund manager John Paulson has executed some of the best trades of all time. Bill Miller at Legg Mason was an impressive anomaly who had his streak broken a couple of years ago.
Buffet’s style is so hard to duplicate in this environment. Most investors look at three to five year track records, this guy is an investor/business owner who buys companies with a very long view.
Anyways, Buffett himself said that most Mom and Pop investors are better off buying an index.
I think its fair to say Buffett is good, not lucky. The more important question is whether his investment strategy would work if he was just starting out today as a stock picker?
@Ink – You raise a good point which Lynch wrote about in One Up on Wall Street. For every 5 copmanies he bought, three would be average, one would be a stinker and one would be a multi-bagger. It’s the multi-baggers early on that can make or break a portfolio. Some of them just keep on exploding too. I think he put himself through College on one stock if I’m not mistaken…
Don’t forget that Warren Buffet has a partner, Charlie Munger. As vice chairman I’m sure he has significant control over Berkshire, it’s not all Buffet. So for this to be a random event seems even less likely that they would both be “sigma 5” or whatever.
I believe Buffet/Munger have skill, and I’d say I think it is possible for someone to find a similar great investor. That is if they followed the same long term, slow and steady investment philosophy as Buffet/Munger which seems unlikely these days.
Just think about it, Buffet/Munger have demonstrated their skill for 40 years now! I think after the first 15-20 years of trouncing the market it was a pretty reasonable bet that they aren’t an outlier or simply lucky by random.
So does anyone know of some potentially great fund managers with a good 20 year track record?
I kept reading posts/articles about the Lost Decade.
Apparently it wasn’t for Warren Buffett
http://www.thecynicalinvestor.net/2010/01/lost-decade.html
so I bought ONE BRK-B :) last year in November