Buffett's lesson in humility
24th April, 2023
Published in The Sunday Times on April 23rd 2023.
Humility is not the first character trait that comes to mind when thinking of the investment profession. Great confidence and strong conviction are the attributes we usually laud in the stewards of our cash.
But Warren Buffett cuts a unique figure in the investment business. Buffett has an awful lot to brag about (see below) and you might pardon if his extreme wealth (estimated to be $112bn by Forbes), had engendered some sense of arrogance, but far from it.
In his recent shareholder letter, Buffett admits how hard it is to consistently pick winning stocks.
“At this point, a report card from me is appropriate: In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so. In some cases, also, bad moves by me have been rescued by very large doses of luck. Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years – and a sometimes-forgotten advantage that favours long-term investors such as Berkshire.”
Buffett’s track record
It’s a stunning 58-year track record. From 1965-2022, Berkshire shares have compounded at an annualised rate of 19.8%, double the 9.9% return for the S&P 500. A $1 investment in the S&P500 would have returned $247 over this period. Buffett’s sprinkling of magic does not give you double the $247. He has doubled the return, every year on average, so through the wonders of compounding, every $1 would now be worth $37,875.
It’s worth delving into Buffett’s comment a little deeper; in nearly sixty years of managing money, only about a dozen decisions have contributed to the vast majority of the returns.
This is very consistent with a recently published academic paper that dissects stock market returns from 1990-2020, the findings of which are nothing short of astounding.
Concentration of index returns
Analysis by Hendrik Bessembinder et al, on 64,000 global companies from 1990-2020 shows that in the US, the total net global stock market wealth creation over the last thirty years was $75.7 trillion. All of that wealth creation is attributable to a hardly credible 2.4% of stocks. That doesn’t mean that all the rest were negative, it just means they netted off – but nonetheless, it’s startling. The majority of U.S. stocks (55.2%) underperform one-month U.S. Treasury bills. This means that the net collective contribution of over 35,000 firms was worse than short-term interest rates, i.e. deposits.
As an investor, you want to engage in an investment activity where the odds are in your favour. Hope springs eternal, but if picking stocks is your thing, the high probability (more than 50%) that any stock you pick today will fail to do even as well as short-term bonds, should put a stop to your gallop.
The good news, of course, is that the average stock market return easily beats bond returns. So, your conclusion should be to want to participate in the stock market. And this can be achieved efficiently and inexpensively through an index fund or Exchange Traded Fund (ETF).
Maybe a concentrated active approach merits consideration
However, there is an alternative interpretation of the data on the concentration in stock market returns. The value lies in the outliers. If you can spot them, it makes no sense to buy an index fund as you’ll significantly dilute the returns with all your other holdings. I’m open to being persuaded on that point and it’s one that some active managers make in justifying a concentrated approach.
An active manager that is trying to capture large outperformance in this way will get far more stocks wrong than right, even in the long term. If they’re successful in identifying the winners, this shouldn’t matter given the asymmetry of returns. But the pattern of returns from this approach will look very different to an index, as short-term deviations will be potentially significant.
I’m a great advocate for long termism, but in over twenty-five years of meeting with clients, I need just one hand to enumerate the number of investors I have met that would have the emotional wherewithal to endure this return pattern.
As I see it, you have three options. You can pick stocks yourself, discharge that responsibility to an active manager or settle for broad stock market returns by buying an index.
Preferences will differ but whichever route you choose, Buffett’s advice is sage. Over an investing lifetime, it's a few big decisions that carry most of the freight. And you need to make those wisely. Money is not made in the buying and selling, but in the waiting.
One final piece of advice - Berkshire’s annual shareholder meeting is next month in Omaha. Put it on your bucket list – but not too far down; Buffett is 92 and Munger turns 100 on New Year’s Day next. The show won’t go on forever.
|Total Return (%)||2018||2019||2020||2021||2022|
Source: Bloomberg. Figures in USD. Total returns.
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