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Why There Will Never Be Another Warren Buffett

Summary Increasing numbers of highly intelligent people have been drawn to the stock market over the past several decades. As a result, it has become extremely difficult for individual investors to gain an “edge” over the competition. This explains why it’s so hard to produce the kind of “outlier” returns investing legends like Warren Buffett achieved. In an interview in the late 1990s, Warren Buffett famously said that he could “guarantee” 50% annual returns if he was managing less money. He explained that compounding large sums of money at high rates becomes increasingly difficult over time, because it limits the investable universe to only the largest companies. A smaller portfolio would allow him to invest in smaller companies, which have historically produced slightly better returns than their larger counterparts. He further pointed out that today’s easy access to information makes it easier than ever to find such companies selling cheaply. Unfortunately, Buffett’s argument has a major flaw. It’s certainly possible that his performance would improve (marginally) if he was managing millions, rather than billions, of dollars; but to claim that faster access to more information makes it easier to find attractive investment opportunities is illogical. In reality, this actually makes the stock market more efficient (not less), which makes it harder (not easier) to find and exploit pricing inefficiencies. But there’s another equally important factor driving market efficiency: skill. Today’s investors are much better than those of earlier decades, and the difference between the best and the average investor is less pronounced. This is often called the “paradox of skill.” This phenomenon was famously observed by evolutionary biologist Stephen Jay Gould. He wanted to know why no hitter in Major League Baseball has had a batting average over .400 since Ted Williams hit .406 in 1941. He discovered that, while the league batting average has remained roughly the same throughout baseball’s history, the variation around that average has declined steadily. To put that in plain English, it means that skill of modern baseball players is better than ever, which makes outliers like Ted Williams less likely to occur. The paradox of skill is evident in other competitive sports as well. Today’s elite athletes have superior coaching, training, nutrition, and drugs/supplements. Which is why they’re running faster, jumping higher, throwing farther, and lifting heavier than ever before. But as athletes approach the biological limits of human performance, it makes it harder and harder for individuals to stand out from the competition. A perfect example of this is the men’s Olympic marathon. The winning time has dropped by more than 23 minutes from 1932 to 2012; however, the difference between the time for the winner and the man who came in 20th shrunk from 39 minutes to 7.5 minutes over the same period. In other words, the overall skill of Olympic marathoners is improving on an absolute basis but shrinking on a relative basis. We can see the same thing happening in the game of investing. Growing numbers of today’s investors (both retail and institutional) are far more sophisticated and knowledgeable than their predecessors. As a result, just as we’ve seen the disappearance of .400 hitters in baseball, we’re also seeing the disappearance of superstar investors who were once able to persistently outperform the market by large margins. The table below shows that the standard deviation of excess returns (a proxy for investment skill) has trended lower for U.S. large-cap mutual funds over the past several decades. This means that the variation in stock-picking skill has narrowed as everyone got better and the market became more efficient. Decline in Standard Deviation of Excess Returns (Mutual Funds) Note: The table shows the five-year, rolling standard deviation of excess returns for all U.S. large-cap mutual funds. The benchmark index is the S&P 500 (NYSEARCA: SPY ). Source: A North Investments, Credit Suisse (Dan Callahan, CFA and Michael J. Mauboussin) Now consider Buffett’s track record. What do we see? The same exact story as above! During the early part of his career, when the market was underdeveloped and there was less competition, Buffett was the Ted Williams of investing. He had a huge edge over the less-skilled competition. But as more and more intelligent people were drawn to the market over the years, the variation in skill narrowed, shrinking his margin of outperformance. Ironically, even Buffett’s own teacher and mentor, Benjamin Graham, realized that outperforming the market was becoming increasingly difficult over time. In one of his last interviews before he died, he recommended passive (index fund-style) investing and said that it may no longer be possible to identify individual stocks that will outperform. In recent years, Buffett has also become a fan of index funds – not surprising, considering that he’s underperformed the market four out of the last five years. Decline in Standard Deviation of Excess Returns (Warren Buffett) Note: The table shows the five-year, rolling standard deviation of excess returns for Warren Buffett’s Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ). The benchmark index is the S&P 500. Source: A North Investments, Berkshire Hathaway 2014 Annual Report The bottom line is that beating the market is becoming tougher, even for the best of the best. If Buffett started investing today with a smaller portfolio, it’s highly unlikely that he would come anywhere near the 50% annualized returns he claims he could get. In fact, over the course of his entire professional career, Buffett only accomplished this amazing feat twice (in 1968 and 1976). It should also be pointed out that even Renaissance Technologies’ legendary Medallion Fund, the most successful hedge fund ever, only managed to deliver annualized returns of 35% (that’s after a 5% management fee and a 44% performance fee). Renaissance employs scores of top PhDs who build elaborate algorithms that identify and profit from various market anomalies. If there really was a simple way to consistently earn 50% annualized returns, they would have found it by now. The reality is, as in baseball, the best hitters in money management can no longer bat .400. It’s extremely difficult to outsmart a market in which so many people have become just as smart as you are.

Should We Fear Debt?

Summary Avoiding an indebted investment is short-sighted, because data shows that debt levels and returns aren’t always negatively correlated. By tilting to the segments that are more sensitive to movements in credit spreads, investors must be willing to accept the greater influence of the equity markets. Look at the data before you believe a strategist who encourages you to avoid indebted companies. By Chris Philips Late last year, Josh Barrickman, head of bond indexing at Vanguard, blogged about the smart beta movement in fixed income. Josh challenged the notion that a company or country could flood the market with debt, which would invariably harm market cap-focused investors. You’ve probably heard it before: “Why would anyone want to invest in the most indebted companies or countries? It’s just throwing good money after bad.” While this premise may seem logical and intuitive on the surface, as with many things we see or hear, a bit of logic and perspective can diffuse superficial arguments. First, some perspective from a unique source. I’ve been catching up on some reading, and one piece in particular stuck with me – an article referencing a story about astronomer Carl Sagan. When presented with “evidence” of alien abductions in the form of an individual who was convinced beyond doubt of having been abducted, the astronomer responded: ” To be taken seriously, you need physical evidence… But there’s no [evidence]. All there are, are stories .” So, should we believe the stories and fear debt? The answer is, it depends. But as a general practice, avoiding an investment simply because of its level of debt is short-sighted. For example, see Figure 1, which shows the relationship between a country’s debt-to-GDP level and the returns of that country’s bond market. Included is a mixture of developed and emerging market countries, with a requirement that each country report a debt-to-GDP ratio and 10 years of bond returns. I’ve highlighted two “groups” of countries – those that have seen low returns over the last 10 years and those with higher returns. Notably, there’s no apparent relationship within each group or across groups. Higher debt levels didn’t always lead to lower returns, and low debt levels didn’t always lead to higher returns. So, rather than take intuition at face value, as investors we must ask ourselves: “What causes one country with a low debt-to-GDP ratio to return 1.5% per year, another to return 4% per year, and yet another to return 7.5% per year?” Clearly, market participants are taking many more factors into consideration than just the perception that debt is scary and should therefore be avoided. Figure 1. Another consideration involves the actual portfolio ramifications of focusing on debt levels as a screening metric. The easiest strategy with which to evaluate the impact of debt involves weighting an index according to a country’s GDP instead of to its bond market. And if we compare the Barclays Global Aggregate Bond Index to the GDP-weighted Global Aggregate Bond Index, we see an immediate attraction: Duration is reduced marginally from 6.47 to 6.33, but the yield increases by close to 20% – from 1.72% to 2.06% – by moving to the GDP-weighted index.¹ Less risk and greater return? Free lunch alert! However, if we closely examine Figure 2, we can clearly see what’s going on. By moving away from market cap, you underweight the U.S. and Japan and overweight various emerging market segments. After all, the U.S. and Japan both fit the profile of the most indebted countries. One implication is that while both indexes are considered investment-grade, the GDP-weighted version has a noticeable tilt towards lower-quality bonds. Figure 2. Why is this important? Because as much as we’d like them, free lunches do not exist. Case in point: From January 1, 2008 through February 28, 2009 (the last notable equity bear market), the Aaa segment of the Global Aggregate Bond Index returned 0.2%. The Aa segment returned 5.8%, the A segment returned -17.1% and the Baa segment returned -14.0%.¹ In other words, by tilting to the segments that may be more sensitive to movements in the credit spreads, investors must be willing to accept the greater influence of the equity markets, particularly during really bad times. What’s more – and what’s important – is that a primary motivation for holding fixed income (at least in our opinion) as a consistent and meaningful diversifier for equity market risk may be marginalized (see: Reducing bonds? Proceed with caution ). My advice? Next time you hear a strategist, sales executive, or portfolio manager encouraging you to avoid indebted countries or companies, ask yourself whether you should buy into the hype. Indeed, as Sagan is famous for stating: “Precisely because of human fallibility, extraordinary claims require extraordinary evidence.” So, let’s all take a deep breath and repeat: “I’m not afraid of debt, I’m not afraid of debt.” Source: Barclays Global Aggregate Bond Index. Notes: All investing is subject to risk, including the possible loss of the money you invest. Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. Securities of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years.

The Paradox Of Risk: Central Planning Is Linear, Reality Is Non-Linear

You thought it was safe to drive 90 miles an hour on a rain-slicked narrow road while you were tipsy because the airbag would save you, but it still hurts when you crash. I first discussed the Paradox of Risk in August 2008, just before the stock market melted down : The Unintended (Risky) Consequences of “Backstopping” Risk (August 12, 2008). This is the Paradox of Risk: the more risk is apparently lowered, the higher the risk we are willing to accept. I recently covered a related topic, The Dangerous Illusion That Risk Can Be Offloaded Onto Others (October 2, 2015). The paradox is that believing risk has been eliminated leads us to take on insane levels of risk – levels that we would never have accepted before, levels that essentially guarantee our financial destruction. I recently had the opportunity to discuss these topics with Max Keiser: Keiser Report: Global Paradox of Risk (25:40 – I join Max and Stacy in the 2nd half) 1. The Fed Put, the belief that the Federal Reserve will never let stocks decline by more than a few percentage points before it steps in and saves the market from any further decline. 2. The belief that hedges dependent on counterparties paying off when the market craters have effectively transferred risk to others. 3. The belief in Modern Portfolio Management, i.e. that risk can be hedged or reduced to near-zero by diversifying one’s portfolio, investing in assets with low correlation, etc. All of this is nice, but fatally flawed. Max and I discuss the reality that markets are not linear, they are fractal. Central planning is linear, but reality is non-linear. The net result is the Fed can do whatever it wants, whenever it wants, and markets will still crash from time to time. That markets crash is predictable, but not when they crash. I’ve prepared a chart that depicts the downside of the Paradox of Risk: everyone who believes in the Fed Put, hedges or Modern Portfolio Management will view any decline in stocks as temporary. As a result, they won’t sell as markets plummet. When markets finally hit bottom, believers will assure themselves that the Fed is going to push stocks higher any day now, because they have always done so in the past. When central planning efforts to push stocks back up falter, the believers that risk has been banished grow frustrated; come on, Fed, do whatever it takes! Alas, the Fed has done whatever it takes but it has failed to produce the desired effect. Now the market starts another slide to fresh lows, and the believers finally start recognizing that risk has not been disappeared: counterparties start failing, hedges don’t get paid off, and a sense that events are spiraling beyond the control of central planning is spreading. Sorry, believers that risk has been banished: it’s too late, you’re wiped out. You thought it was safe to drive 90 miles an hour on a rain-slicked narrow road while you were tipsy because the airbag would save you, but it still hurts when you crash: Keiser Report: Global Paradox of Risk (video).