Warren Buffett is known for not only his phenomenal investing prowess, but for his willingness to place big bets outside the stock market. I had heard of his Billion Dollar Bracket Challenge — where he had promised to pay $1 billion to anyone who could correctly predict the winner of every game in a yearly college basketball tournament — but I had not heard of his $1 million investment challenge.
Reading the transcript of the interview with Ted Seides — the person who took the other side of Buffett’s bet — had me rolling on the floor. Here is the set-up, as explained by NPR.org:
Buffett was speaking in front of an audience of thousands of people when the subject of hedge funds came up. Hedge funds are not open to ordinary investors, and they’re often seen as elite. But, Buffett said, most hedge funds just are not worth the fees they charge. In fact, he said, I’m willing to make a bet. I can pick a simple, boring investment that will beat any bunch of big hedge funds.
If his comments about hedge funds sound familiar to you, it may be because you already read my article from earlier this week, Structural Factors: How Good are Hedge Fund Investments?
At the beginning of January 2008, Buffett bet a master of the universe $1 million that hedge funds could not outperform a simple index fund over the subsequent 10 years.
The irony is palpable. Buffett himself has criticized the Efficient Market Hypothesis — the preeminent theory of classical finance which posits that no one should be able to repeatable perform better than a broad-based index — by pointing to his own performance and the performance of other Value Investors. Even still, he selected an index fund as his “boring” vehicle to race against the souped up engines of a portfolio of hedge funds hand picked by Ted Seides. And how is the race — which finishes at the close of 2017 — turning out? According to NPR…
The hedge funds are up 22 percent, but the index fund Buffett bet on is up much more – 66 percent.
There is so much to unpack in this story, I can hardly do it justice in a short posting like this one. Long story short is that the market is very hard to “beat.” It is even harder to beat if you are paying someone 2% of the value of your holdings and 20% of any gains!
Does that mean that we should all simply give up, buy one portfolio’s worth of SPY ETFs and call it a day? In my mind, no — for three reasons.
First is the point made by Sanford Grossman and Joseph Stiglitz in the famous Grossman-Stiglitz Paradox. In short, if everyone assumes the markets are efficient (i.e., that the market price of a stock equals the intrinsic value of the stock) and buys a market portfolio rather than trying to assess the value of individual firms, the market will soon become inefficient. Markets are made more “efficient” by people looking for inefficiencies, in other words.
Second is the fact that over the past 20 years in the investing business, I have seen first-hand the results of the myriad behavioral biases that end up unreasonably inflating stock prices during booms and just as unreasonably depressing them during busts. I know that investors alternately extrapolate their fears and frenzies into the indefinite future, depending on what’s happening on any given day, but I have yet to see a case where these extrapolations are valid.
Last, like Peter Lynch, I believe that principal owners of capital, once trained in the use of a sensible, effective investing framework can make better stock picks than professional agents like hedge fund managers. This observation involves the “structural factors” that I’m so fond of writing and talking about. Certainly, the most obvious structural factor that can make your performance better than a big shot hedge fund manager is that when you manage money yourself, you’re not paying for the big shot to upkeep his summer home in the Hamptons.
All this said, I understand that the market is very hard to beat, so I don’t expect that mispriced stocks will come along once a week, once a month, or even once a year! This idea was expressed brilliantly by University of Chicago Economist Richard Thaler in an editorial in the Financial Times. To paraphrase Thaler’s argument, the part of the Efficient Market Hypothesis that claims the market is hard to beat is true; the part that claims that stocks are always fairly priced is false.
In my opinion, the best policy for an intelligent option investor is to keep it simple by investing mainly in the market portfolio, and allocate the rest in the occasional gem of a mispriced stock. The ability to properly assess the value of a stock and the knowledge of how to use basic tools of modern finance to tilt the balance of risk and reward in your favor are the only things you need to do this successfully.
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