In this Ask The Expert With Larry Swedroe article, Zapp challenges the legitimacy of Modern Portfolio Theory citing Warren Buffett as a rule breaker. So which is it, Modern Portfolio Theory or Warren Buffett? Here’s the question from Zapp:
Other than by taking the self-denigrating stance: “I am not an above average investor”, how can a person justify support of modern portfolio theory when there is a Warren Buffett in this world?
Answer From Larry Swedroe
That is an easy question to deal with. First, with thousands or millions of investors we should expect some to outperform the market every year and some to do so for many years, randomly. The question is: Is there any more persistence of performance than would be randomly expected. The evidence from hundreds of academic studies is there is not.
Warren Buffett Is Not Your Typical Investor
Another answer to the question is that Warren Buffett is not the typical investor. He is not like a mutual fund manager. He often buys companies and then manages them. He provides them with economies of scale, lower cost of capital and the benefits of his managerial wisdom. And when he takes large positions in companies he often gets a board seat. So perhaps his great returns are more a result of his managerial skills than his investment skills, or some combination of both.
Berkshire Hathaway Performance Versus General Market
When I got this question a few years ago I went to do a simple check on the performance of Berkshire Hathaway for the prior ten year period and then compared it to the five major U.S. asset classes of large, small, small value, large value and real estate. During that period BRK had underperformed all but the asset class of large stocks (as represented by the S&P 500) and had underperformed an equally weighted (20% each) portfolio of the five that was rebalanced annually by several percent.
So we know that Buffett had delivered great returns in the past but we don’t know that he will in the future. In fact, during that ten year period BRK underperformed. So now what would you forecast regarding the future?
Who Is The Next Warren Buffett?
The issue is this, we know that there will be some investor who produces “Buffett-like” returns in the future. The problem is we cannot identify them today. Unfortunately we can only buy tomorrow’s returns, not yesterday’s. And finally, what I tell investors is this: If you look in the mirror and you see Warren Buffett, go ahead and try to beat the market by picking stocks. But there is only one person who when he looks in the mirror sees Warren Buffett. The rest of us should simply accept market returns. If you do so you are virtually guaranteed, if you have the discipline to stay the course, to outperform the vast majority of investors, both individual and institutional.
By the way, What Wall Street Doesn’t Want You to Know contains a section called “Buffettology or Mythology” which addresses your question. Also, Wise Investing Made Simple contains the tale “When Even The Best Are Not Likely to Win the Game,” which indirectly addresses you question by looking at the results of large institutional investors who have access to the great money managers.
Disclaimer
- Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.
- Not all questions will be answered
- By submitting a question, you grant us the right to publish your question.
- The answer is given based on the information provided in your question. Please seek professional assistance for more personalized advice.
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Larry Swedroe is a principal and director of research at Buckingham Asset Management, LLC, an SEC Registered Investment Advisor firm in St. Louis, Missouri. He is also principal of BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.
Before joining Buckingham in 1996, Larry served as senior vice president and regional treasurer at Citicorp and vice chairman of Prudential Home Mortgage. Larry is author of The Only Guide to a Winning Investment Strategy You’ll Ever Need (updated and re-released in 2005), as well as six other books. Most recently, he authored The Only Guide to Alternative Investments You’ll Ever Need (2008).
Larry has started his own blog called Wise Investing at CBS Money Watch. Please check it out!
@ Pinyo – Really? You might want to screen the advice from your ‘experts’ a little better … Firstly, Berkshire Hathaway is both an investment company and a management company (taking 100% ownership of 78+ businesses). As an owner of businesses they don’t need to ‘take’ a board seat on any of these companies, they can sit in as many of them as they wish! Secondly, studies of BRK’s ownership of common stock (i.e. where they act as a shareholder) shows that they have returned far greater than the market and that cannot be attributed to ‘randomness’ or ‘luck’: http://7million7years.com/2009/02/09/playing-the-efficient-market-theorist-for-a-fool/… Read more »
@Joe, @Pinyo – Don’t forget about Walter Schloss, Charles Munger, and Bill Ruane. All studied under B. Graham and all significantly beat the market over extended times. There are 17 “Value Investors” from the group that have produced “better than average” results, but not all have been big winners. I think the point is that this is all they do, it is their day job. They spend more time than the rest of us have picking the right companies to invest in.
@James – I respect your opinion and approach; however, I still personally believe broadly diversified investment is still the best choice for me. This is also true many others who do not have time, or do not have the skill to deal with individual stocks. @AJC – I read many of Larry’s book and he is an expert in my opinion. However, I do agree with your point about timeframe that could be used to manipulate numbers and support argument one way or another. As for your final point, very well said, especially about “not common result” @Mark – You… Read more »
few thoughts First, many people have beaten the market in the past. Some did it simply by buying small and value stocks which have outperformed large and growth stocks over the long term, with the simple and logical explanation that the premiums earned were risk premiums, not free lunches. For example, small value stocks have returned about 14% a year vs about 10% for the market. This is certainly an MPT story of risk and expected return being related Second, the criticism of my analysis of BRK is totally off base. I fully acknowledge the long term record of Buffett… Read more »
Interesting discussion. Actually Buffett did write a paper back in 1984 about the SuperInvestors of Graham and Dodd, where he talks about the performance of all of Graham’s students. Even 25 yrs later, I feel as if these value investors have done well, especially Buffett. The thing that he does is that he looks for situations where he has an edge over other investors – picking dollar bills for 40 cents. His recent prefered stock investments in GE,GS, and many others have proven that Buffett knows when to take full advantage of a situation.
few thoughts for you to consider First, remember it has been easy to beat the market simply by being a passive buy and hold investor in value stocks. No stock picking skill required at all. Just a faith that markets reward for risk –at least in terms of expected returns. Second, as I mentioned Buffett has advantages like people who need cash like him as partner and willing to pay more for his money because his cash comes very quickly and with few strings. If you read his book Snowball he even talks about that. The points are really these… Read more »
@ Pinyo – Anybody can buy stocks for 50 cents in the dollar … the trick is KNOWING that they are 50c in the dollar at the time 🙂 @ Larry – You are trying overly hard to make a point that simply cannot be made: that MPT is 100% correct, when I think you SHOULD be saying it’s not wrong often enough for the average (even all but the rare exception, expert) investor to take advantage of. The proof: SOME investors beat the market in large cap; small cap; any cap you care to name, because they know how… Read more »
@AJC, absolutely agree on the many perils of modern finance theory when applied to the individual investor. And Buffett being the prime example that diversification, M&A and such gems from the last few decades do not end up benefiting most investors. But the question is then, given most investors do not have direct access to the management of the businesses they invest in, nor do they have the investment horizon of Buffet, what is the sensible approach? Perhaps that’s when the idea of diversification, and unsystemic risk management comes in. One thing is apparent though, financial advice and planning should… Read more »
@ Dane – Warren Buffett said it best:
“I’d be a bum on the street with a tin cup if the markets were efficient.”
How about you, Larry, has Modern Portfolio Theory made you one of the world’s richest men? Or, have you merely been unlucky? 😉
AJC I fully admit there might be skill that leads to market beating returns. That is not the issue. The issue is that no one can distinguish the skill from the luck–at least until it is too late. The reason is that past performance has proven to be a very poor indicator of future performance–you don’t get persistence beyond the randomly expected. Every study done has found that, at least that I am aware of. I did read the study and as I noted, his long term record looks undeniably like skill. But so did Bill Miller’s. And there was… Read more »
@ Larry – NOW I understand your argument! Thanks for the clarification … Of course, this is a ‘no win’ situation for me: I say that I will back Warren to continue to beat the market because of superior skill and you say that MPT (indirectly, of course) will rush in to fill the ‘gap’ between WB and the rest of the market … if Warren beats the market, it will be because MPT hasn’t quite caught up yet, or randomness, etc. and if WB does NOT beat the market it’s because MPT is correct. Ouch! I can’t win …… Read more »
AJC I think we can agree on two key issues. Buffett’s record is almost certainly the result of skill. But the market’s have become much more efficient over time and the size of his assets under management make the challenge of beating the market now so much greater. Even Buffett himself has made this last point. The other point is this. Likely we will see another Buffett 20 years from now, but there is no way to identify that person TODAY, we will only know who that person is ex post. The evidence is overwhelming that you cannot rely on… Read more »
The big question if MPT is the only way to go is why do we need financial advisors? Basically, all we need is E*Trade or some similar company and Vanguard or some similar company. Or, we could take it one step further and just create a government retirement fund that invests our money in the entire market. This would at least eliminate the need for 90% of the overhead created by financial advisors, traders, etc., as anything that large would just be automated. We wouldn’t be buying houses in the Hamptons with MPT, but at least the people selling us… Read more »
Chad The reason one MIGHT need an advisor –or better very likely needs one–is that the education system has done a miserable job of educating investors about the historical evidence on how capital markets work. Unless one gets an MBA in finance it is unlikely that they have even taken a single course in capital markets theory. And it is not even enough to know to be passive or active and what funds to use, you have to know how to combine them effectively. And you have to know how to build an investment plan that incorporates ones ability, willingness… Read more »
Our education system does do a miserable job of educating people financially. A planner does bring value to tax and estate planning, and for some people I guess they have to pay someone to organize themselves. However, I don’t see the value after that. Essentially you are saying managed funds are worthless…ok, I will go along with that. Now we are down to index funds, which are picked based on cost and sector/country, as there should be minimal differences between indexes in the same sector/country. If the person can read at a high school level they can figure this out… Read more »
One last piece:
MPT is a system devised by looking at historical results. Thus, there is no reason to assume people using MPT won’t look at their portfolios in 10 years and say, “Damn, this didn’t work.”
“The issue is this, we know that there will be some investor who produces “Buffett-like” returns in the future. The problem is we cannot identify them today.”
Just like we can’t say MPT is the correct method for the next 10 years, as the market doesn’t have to perform based on historical data.
Everyone has their system. MPT is just another system.
Chad Unfortunately there are many misconceptions about what MPT is or isn’t. MPT is not a system as you seem to believe. It is a theory about how markets work. It includes the efficient markets hypothesis. And nothing that happened in last year could lead anyone who understands MPT to conclude that it was wrong. Only those that don’t understand what it is make such statements. Second your statements about passive funds like index funds is very much the conventional wisdom and is often the case—is often as wrong as the Earth is flat. There can be very significant differences… Read more »
just for fun I reran some data I did for an article I wrote 4 years ago on this topic about Buffett So here was my hypothesis–want to beat the market, invest in BRK, or invest in DFA small value fund– as it has high loading on size and value risk factors. No stock picking, no market timing, etc. Both live funds if you will with costs. I would argue DFA fund lot less risky since it holds almost 1500 stocks Now this I admit is bit of data mining since I choose the start date, but for some people… Read more »
Theory, strategy, system…it makes no difference what it’s called, as it is guidance for investing. The label doesn’t change that. I understand MPT fine for someone who hasn’t studied it for years. Highest return at lowest risk by using diversification. Return changes as you change your risk level. Obviously, it gets more complicated than that, but this is the basic premise. MPT was created in the 50’s and steadily changed up until today. What makes todays MPT more correct than the 80’s MPT or the 70’s MPT? It’s highly unlikely there won’t be further changes in the future. So why… Read more »
Chad What has changed about MPT is that more research has been done to make it a stronger theory. For example, CAPM was the leading theory to explain returns at the start–we lived in a one factor world where beta (exposure to the market) explained returns. Along come Fama and French and show that three factors do a much better job of explaining returns for equities–the other factors being exposure to value and size. So now models explain about 95-97% of returns instead of about 67%. And there is also a two factor model for fixed income–default and term risk… Read more »
@ Larry – If you’re trying to say that Warren Buffett is now ‘off the boil’ and will never beat the market again (except by luck, etc.) … well, THAT’S speculation 😉
I think the greater lesson here is that unless you are satisfied with ‘market returns’ (perhaps ‘tweaked’ a little/lot for “risks, expected returns, costs, tax efficiency, diversification, revenue generated from securities lending”) then you should NOT be investing in the stock market: start a business; write a book; build some houses; etc; etc.
… who knows, you may even end up BECOMING the next Warren Buffett? 🙂
AJC You seem to misinterpret what I have been saying. I certainly never said that Buffett will no longer beat the market. And I never said it is impossible to beat the market. What I have said is that no one has found a way yet to identify people who WILL outperform the market with any greater odds than randomness. And as Berk points out the more money you have to manage the harder it gets to beat the market because the hurdles get greater. The lessons from the scientific evidence on investing is that while you certainly do have… Read more »
@ Larry – No, I understand the point entirely, which I why I am wondering why you keep bringing up the point of Buffett’s performance over short/recent periods: “a few years ago I went to do a simple check on the performance of Berkshire Hathaway for the prior ten year period” and “I reran some data I did for an article I wrote 4 years ago on this topic about Buffett”? How does that possibly enhance or detract from your theory about MPT?
AJC I give up.The evidence is important as these are NOT short periods. They are fairly long periods and it shows exactly what the literature shows–that even skilled based performance erodes–and you even have the hindsight of knowing how good his performance has been. We could go back and find many other examples of long success followed by miserable failures. Bill Miller is the perfect example–Fortune declared him greatest money manager after beating market 15 years in a row, something Buffett never did. Over and next three years he underperformed by 10, 12 and 18 %. So was he lucky… Read more »
Then how do you explain Benjamin Graham, his mentor, also beating out the market over a significant amount of time?