Friday, May 18, 2007

The Berkshire Hathaway Phenomenon

This post will cause me some trouble, I am sure.

Now don’t jump to conclusions, I generally agree with much of what Warren Buffett says, and specifically, I think that much of his investment advice is good. But I am a little worried that over 20,000 people are willing to shell out good money, and burn fuel, to travel to Omaha to watch Warren and his partner chat on stage for several hours. I also worry a bit about the message that many people seem to hear, even if it is not what Buffett would profess: that stock picking is good, and the lessons of modern investment theory, especially those concerning the value of diversification and indexing, are wrong.

The observations I would put to you are the following. On the one hand, my friends and colleagues who are of a liberal mind (small “l,” not liberal in the political sense but in the “liberal arts” sense) have no problem in seeing only the role of chance, random mutations, and natural selection when they observe the glory of some biological wonder like the human eye. No reason to bring in any role for divine intervention here; chance-based evolution takes care of it all. (Please, bear with me, I do like the theory of evolution!) But these same people, when they observe the glory of Warren Buffett’s investment returns, with the Berkshire Hathaway stock portfolio beating the S&P 500 20 out of 24 years, and an abnormal annual return of 8.6%, have no hesitation in pointing out….well, the equivalent of divine intervention!

We have this thing in auction theory called the winnner’s curse, which means that the winner of an auction needs to think carefully about what it means to be the winner: if there is uncertainty over the value of the item to bidders, then there is a very strong tendency for the person who makes the biggest error in value estimation to be the one who bids the most and wins the auction. Ex ante, all bidders’ estimates are unbiased, but ex post, the WINNER’S estimate is known to be a biased high estimate of the true value. And the more bidders, the more biased is the winner’s estimate. With 2 bidders, the highest value estimate is not too bad an estimate of true value; with 2000 bidders, the highest value estimate will be biased by several standard deviations.

A very similar phenomenon occurs with investment results. Start with 10,000 investors, and let them randomly choose stock portfolios over 24 years – no talent, just random stock picks. After 30 years, what do you think the winner of this contest will look like? I promise you, there is a very good chance that the winner of that contest will have beaten the average return in 20 out of 24 years, and have an abnormal return of at least 8.6% per year. Should we crown that investor queen, and travel thousands of miles to worship at her feet? Or should we say, “Hey, your ideas are great; I will take them into consideration. But what I would really like to borrow is some of your luck.”


Anonymous said...


I agree totally with your thoughts on the impact of luck in some of the winner's performances. In fact you can take your example of portfolio managers and even stipulate that they are bad portfolio managers (55% probability of losing money). If you start with a hoard of 10,000, after 10 years, you will still have 3 that would have produced a positive return each year. No doubt, the three will be crowned the geniuses of the investment community, having never lost money in the past ten years. Eventually, they will be weeded out but before that they will be written up in the front page of the WSJ.

Winning a bid does not necessarily mean paying over true value. The winner of a bid is definitely the one that is willing to pay the highest price compared to the other bidders (all potential bidders if we assume the process was thorough and everyone that would have an interest offered a bid). However, it does not mean that the winner has paid above true value. The estimates of value by bidders are just that estimates, and everyone including the winner could be under-estimating the true value of the property which I would define as the intrinsic value based on perfect knowledge of the future cash flows, interet rates and risk. Time and emotions often distort what people are willing to pay versus true value.

Staying power is a big advantage of Warren Buffet. Staying power allows him to put time aside and because of that maybe control his emotions better so that maybe he can get closer to the true value.

How meaningful are returns without risk measurement? The other issue that seems to be missed when just comparing returns is risk. Achieving the same return while taking less risk is extremely valuable but often ignored by most people as they only see how much a portfolio has increased. This bias in fact rewards higher risk taking.



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Why you don't post more links to read alternative versions of this Phenomenon.