Do you really think you can beat the market? Warren Buffett thinks you can’t, but don’t need to

Are you a better investor than most people? Do you think that your performance can beat the savviest stock market pros? Warren Buffett might think so; he thinks that if you are an index investor, chances are you are beating most professional investors. He believes that most people would be better off simply investing in index funds.

Warren Buffett’s company, Berkshire Hathaway, released its annual shareholders report this past weekend. There are always several great quotable comments and nuggets of wisdom throughout the document. In this year’s report, Buffett praised John Bogle, calling him a hero.

Bogle, the founder of Vanguard Investing, is considered the father of index investing. Today Vanguard has more than $4 trillion under management, much of which is in the S&P 500 index fund and several other related broad market index funds.

In this year’s Letter to Shareholders, Buffett wrote:

If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of added value.

In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me.

Long-term results in this portfolio will be superior to those attained by most investors

Buffett is a huge proponent of index funds for most people. Upon his demise, he wants his wife to have a very simple portfolio: 90% in an S&P 500 index fund and 10% essentially in cash.

My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.

Buffett believes that very few among us can outperform the S&P 500; not only individual investors, but professional money managers as well. There have been many who have reported that at least 80% of professional money managers under-perform the stock market averages. CNN Money reported that a staggering 86% of active large-cap fund managers failed to beat their benchmarks in 2014.

Can you beat the market?

Clearly, few people seem to be able to consistently beat the overall market returns. Almost a decade ago, Buffett offered up a wager to anyone willing to take him up on this bet. The Oracle of Omaha suggested that the returns for the S&P 500 will beat any five hedge fund managers over a ten-year period. The person willing to take the other side of this bet could pick any five hedge fund managers. Eventually, someone took him up on this bet.

Ted Seides was the only person willing to take this bet. Mr. Seides is the co-manager of Protégé Partners, an asset manager that had raised money from limited partners to form a fund-of-funds – in other words, a fund that invests in multiple hedge funds. Seides selected five fund-of-fund managers; his own firm and four others. Buffett knows who the other four fund managers are, but will not disclose the names.

We are now nine years into this ten-year wage and barring catastrophe, Buffett has declared victory. Here’s how the funds have performed thus far:

The S&P 500 index fund has returned more than 85% from 2008 through 2106. None of the five fund managers have even come close to matching the S&P 500 index fund’s performance; the closest manager was still more than 20% behind the S&P have returned just under 63% thus far.

Reminder, the wager here was that all five managers would have to beat the S&P 500. Three of the five managers are barely making any money at all having returned less than 10% after 9 years. One January 1, 2008, the 10-year U.S. Treasury rate was 3.88%. If you bought a 10-year T-bond and receiving nearly 4% risk-free. Your 4% returns would’ve been fairly competitive as compared to two of the hedge fund managers and would have actually outperformed one of them thus far. (Fund “D” has returned just 2.9% to date; more than one percent less than the risk-free rate you could have received with a 10-year  T-bond.)

Unless something major takes place, it looks as though none of these hedge fund managers’ funds will beat the broad market average. For Buffett to lose the bet, all five would have to beat the S&P. Clearly, that’s not going to happen.

The winner of that wager will receive $500,000. Given that Buffett has been donating the vast majority of his wealth to various charities — back in 2006, he announced plans to donate the bulk of his fortune to the Bill & Melinda Gates Foundation and four other philanthropies — he will likely give this half-million dollars that he wins to some charitable foundation as well.

Warren Buffett’s wager clearly shows that most people are better off putting their money into an S&P 500 index fund. More than four-out-of-five professional managers annually under-perform the market. Hedge fund managers — arguably some of the most brilliant minds — haven’t necessarily showed market-beating returns; at least in this small sampling. Regardless of the size of the sampling, clearly Buffett believes that most people are better off in index funds than having their money anywhere else.

It seems that investors are starting to believe that money is better off in passively managed index funds than in actively managed funds.

 

 

Source: Morningstar

The blue bars show that assets in actively managed funds have been decreasing in recent years, while assets in passively managed funds — the green bars — have seen a significant increase. While there has been a major shift, there is still much more money in actively managed funds than in passively managed funds.

Actively managed funds had $9.525 trillion under their control as of December 2016. Conversely, passively managed funds managed $5.409 trillion. That shows that nearly 64% of fund assets are still in actively managed funds, and 36% are in passive funds.

Investors are duped by slick managed-fund marketing

With all of the evidence indicating that few people are able to outperform the indices, why are people still putting money in managed accounts? A report from the Wharton School back in 2011 offered up this possible rationale:

Investors are duped by slick managed-fund marketing, they don’t know the facts or they believe “you get what you pay for” — that paying higher active-management fees should buy better results. Maybe they are deferential to “professionals,” or believe they are smart enough to pick the active managers who are better than average. All those explanations have one thing in common: They assume investors are not very bright.

Essentially people want to believe that they can beat the market — either they, themselves, or market professional that they engage. It’s human nature to believe that you can do better than average. Buffett suggests that very few people can consistently beat the market:

There are, of course, some skilled individuals who are highly likely to out-perform the S&P over long stretches. In my lifetime, though, I’ve identified – early on – only ten or so professionals that I expected would accomplish this feat.

Both large and small investors should stick with low-cost index funds

Active managers are paid handsomely for managing your money. Whether the fund manager makes money for his or her investors or not, the manager likely is in line to receive a massive compensation package. Given the likelihood that he or she will under-perform, Buffett strongly suggests that you money should be in index funds:

When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.

Win with Warren

As folks at CNBC suggest, for the adventurous (or foolish), you can try your hand at investing in stocks like the master of value investing himself.

You don’t have to go it alone. Plenty of stock screeners, such as those from the American Association of Individual Investors, Morningstar and ValueWalk, strive to identify stocks of companies with positive free cash flows, good returns on capital and strong competitive advantages (what Buffett calls “moats” as in a castle with a moat). Automated investing service Motif lets you buy a basket of Buffett-like stocks for less than $10 per trade. Alternatively, you could just buy shares in Berkshire Hathaway. The “A” class shares closed on Friday at $255,040 per share while the “B” shares closed at $170.22.

If many of the smartest, most savvy professional money managers can’t consistently beat the market, then Buffett is probably right, most people are probably much better off putting their hard-earned cash into an S&P 500 index fund.

 

 

Image source: Flickr/Fortune Live Media

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