Buffett on Sex, Hedge Funds, and the Efficient Market Hypothesis

Once again, in his annual letter, Warren Buffett demonstrates why he is so revered.  Always a pleasure to read, this year's letter even included two sex jokes: “Once you’ve flown NetJets, returning to commercial flights is like holding hands,” and the suggestion that Buffett and Charlie Munger are seeking the acquisition equivalent of "a gorgeous blond with a body that would cause a bishop to go through a stained glass window."  More importantly, Buffett again blasted CEO pay and ridiculed the “2 and 20” compensation structure of hedge funds:  “The inexorable math of this grotesque arrangement is certain to make [all investors in aggregate] poorer over time than [they] would have been had [they] never heard of [hedge funds]."  Someday, perhaps, intelligent commentators will recognize that this observation is not sour grapes.

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Buffett also takes a moment to praise “one of the good guys of Wall Street,” his friend Walter Schloss, who recently turned 90.  Schloss, you may remember, was a lead character in Buffett’s essay, The Super-Investors of Graham-and-Doddsville, recently republished in a new edition of The Intelligent Investor.  In this essay, Buffett invoked the performance of Schloss and other Ben Graham adherents to suggest that the Efficient Market Hypothesis was a crock.

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In this year’s letter, Buffett once again takes aim at the EMH—and especially at the academics who continue to promote it.  And in so doing, for the only time in the 20-page letter, he sounds as though he hasn’t kept up with the times.

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Thanks to the work of professors Fama, French, and others, the prevailing wisdom in academia is no longer that security analysis is worthless and "market averages" can’t be beaten.  Rather, it is that different classes of stocks (value/growth, big/small) usually produce different returns—and, therefore, by buying the classes priced to yield higher-than-average returns, investors can beat a “total market” index.  One of the most successful fund firms in the world, Dimensional Fund Advisors, employs this investment strategy, and its returns have blown away those of almost all traditional stock-pickers (if not the Oracle himself).

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Today's academics debate whether the different returns of value/growth and large/small are the result of different risk profiles (which would be in keeping with the EMH) or of repeated mistakes by investors (who over-estimate the opportunities for large growth stocks and underestimate them for small value stocks).  For the average investor, however, the correct answer is not particularly relevant.

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The point is that today’s smartest academics do not think that market averages can't be beaten, or that it is impossible to pick superior stocks except by pure luck.  Rather, they think that beating the market through stock-picking is extremely difficult and that, over the long term, small value stocks will likely continue to deliver higher returns than large growth stocks.  The academics would probably suggest, moreover, that Walter Schloss's screening system, in which he tried to buy "cheap stocks", is very much in keeping with this philosophy.

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All of which is to say, the most talented proponents of both major schools of investing--active and passive--have more of a meeting-of-the-minds than most people think.

Comments

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For your hedge fund comment: Do you think that the ordinary 'Joe' either can, or will, get into a hedge fund?

If I can throw $1 million to make much more I'm not really thinking about how much I could throw away.

It's not my rent money.

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If I can throw $1 million to make much more I'm not really thinking about how much I could throw away.

It's not my rent money.

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