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.”