Playing the Efficient Market Theorist for a fool …

I love it when a scientific study – that cost goodness-knows-how-much – produces a result that is, well, kind’a stating the obvious …

Take this paper as an example; it finds that Warren Buffett’s success with stocks is not due to luck or taking higher risks, rather – surprise, surprise (!) – it’s due to superior stock picking skills:

The stock portfolio of Berkshire Hathaway, comprising primarily of stocks of large-cap companies, has beaten the S&P 500 index in 20 out of 24 years for the time period 1980-2003. In addition, the average annual return of Berkshire Hathaway’s stock portfolio exceeds the average annual return of the S&P 500 by 12.24% over this time period.

We examined various potential explanations for Berkshire Hathaway’s investment performance. We first explored the explanation that Berkshire Hathaway’s performance may be due to pure luck. We find that while beating the market in 20 out of 24 years is possible due to luck at a 5% significance level, incorporating the magnitude by which Berkshire beats the market makes the “luck” explanation unlikely.

After employing sophisticated adjustments for risk, we find that Berkshire’s high returns can not be explained by high risk.

Ruling out the major alternate explanations to Berkshire’s investment performance leaves us with the potential explanation that Warren Buffett is an investor with superior stock-picking skills that allows him to identify undervalued securities and thus obtain risk-adjusted positive abnormal returns.

Well, d’ah …

So, let me tell you – and, I’ll accept a $1 Mill. federal government grant to write the obvious up as a paper, if you like – that Warren Buffett makes his money essentially in two ways:

As Businesses

Contrary to popular belief that Warren Buffett is a vulture who swoops in when there is carnage all around to pick up businesses at bargain prices, Warren actually patiently waits to buy sound businesses at fair prices.

These are usually private/family businesses that need to be sold for reasons other than the soundness of the business itself … for example, the largest family business in Australia was split up to avoid squabbling by the ‘next generation’ … succession is usually the major issue facing such private/family businesses. Warren did not buy this Aussie business, but you get my point …

Warren, to the best of my knowledge, rarely bargains on the price of a business and has even been known to overpay; for example, when the Sees family wanted $30 Million for the Sees Candy business, Warren nearly walked away, thinking it was worth only $25 Million …

… Warren is glad that he bought it anyway, as the business returned Warren’s $30 Million in only a few, short years and is worth over $1 billion today.

You see, a business grows and produces continuing cashflows – even if you never sell (and, Warren NEVER sells!), so the price you pay is secondary, IF the business produces outstanding returns. That’s why Warren says:

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

In Defiance

So, Warren Buffett wears two hats, with his first hat (surprisingly) being business owner … but, it’s his second hat as the World’s Greatest Stock Investor seems to be the most fascinating to most people.

Well, I’ll let you in on a ‘secret’ … there is no great secret here, at all: Warren simply makes a ton of money by proving that the so-called Efficient Market Theorists are fools … time and time again!

Given that luck and all the other explanations have been rigorously and scientifically ruled out, what the study has ‘proved’ – at great expense, I might add – is not that Warren Buffett is right …

… but, that Efficient Market Theory is wrong!

Now, THAT is a breakthrough of gargantuan proportions, and tomorrow, I’ll tell you how you can exploit it 😉

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13 thoughts on “Playing the Efficient Market Theorist for a fool …

  1. Not relay efficient market is based on a stock market where you and I can participate. W B makes a lot of money onside of that market. He does this by taking on whole businesses, and of course knowing.

  2. Actually there is some value to doing this kind of analysis – it can differentiate when something is statistically significant. Warren has a long history of performance… however if we were evaluating him at the start of his career luck would be a plausible explanation for his success! What I would really like to see from the study is how many years of data do you need to know which manager has similarly good skills?

    I think we all could have guessed that Warren’s performance was too good to be luck. I’m not sure I believe their estimate that there is still a 5% chance it was luck either… If the analysis is right then if there were 100 Berkshire Hathaway pretenders, 5 would excel just due to luck. If it were that easy shouldn’t there be a few more Berkshire Hathaways around today?

    -Rick Francis

  3. @ Rick – “How many years of data do you need to know which manager has similarly good skills?” is a GREAT question!

    As to WB: I don’t need a study to tell me the world’s richest man (give or take Gates and Slim) has skill – not luck – on his side 🙂

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  5. This reminds me of poker. Thousands join the large tournaments, but many of the same few players make the finals. We all play the some game, just some of us are better at it than others.

  6. I think modern financial theories as they are currently applied to investment portfolios on Main Street are highly flawed. A lot of the theories sort of go like: they work, until they don’t.

    Diversification was kind of like this. The idea of spreading your unsystemic risk with investments in different sectors, geographical regions, different sized businesses seemed almost flawless if you have a low correlation amongst them.

    That was, until a global credit-crisis (at least most of the western hemisphere) hits, manufacturing and trading halts from the east, and a recession of global scale sets in.

    Mass de-leveraging caused almost every investment group to fall (except gold and so far the US currency). So that tested the limits of diversification?

    Short of every individual and institutional investor going off to buy Berkshire Hathaway shares, I’m not sure how this will solve most people’s investing problems.

    PS Funny I wrote an article of almost the exact same idea:

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  8. In my humble opinion, most of the article and its comments are a result of misunderstanding the scientific process and modern financial theory. I am not a scientist and as such, any explanation on my part are likely to be shallow and error ridden. However, I believe that working through and thoroughly understanding a book like “Investment Science” by David G. Luenberger will help greatly in eradicating misunderstandings.

  9. @ Tommy – Having written two great books: “Investment Science” and “Information Science” and being a professor of some note at Stanford where he teaches, I would have to agree by paltry few years studying the scientific process at university is not sufficient …

    … I’ll go back to counting my money and leave the professors of this world to teach us about how to get rich 😉

    BTW: Tommy, did you even read my post?

  10. Adrian : Yes I read your post.

    I am sorry if it sounded like I am trying to compare “who is the better man”. I pointed to that textbook not because I felt that the author is “superior” but rather, that it has sufficient depth regarding financial theory.

    Also, I didn’t want to elaborate on what I felt was misunderstood because I didn’t want to appear as someone who “thinks he knows a lot about finance and is trying to educate those who don’t.” Unfortunately, my previous comment end up reading like “go read a textbook!”, which I agree is rather offensive.

    These are short and totally inadequate elaboration regarding the parts which I felt was misunderstood :

    1) Scientific Process

    Many scientific findings would sound like common sense to someone. This is the result of the myriad beliefs held by each and everyone of us.

    Take for example two groups of people who believed in two different treatment for an illness. If a scientific study rule out one treatment and supported the other, one of the groups is going to claim that the result of that study was “obvious”.

    In simpler terms : there are many “obvious” knowledge in the world but how do we determine which ones are true and which ones are false without science?

    It is easy to make statements like “an object can only be in one place at any one time” and it does sound “obvious” until the research on Quantum Superposition shows that it is possible for the same object to be in two places at the same time.

    2) Diversification

    I feel that the comment regarding financial theory, especially diversification was a result of not really understanding the theory in full rather than a flaw in financial theory.

    Diversification makes use of the proven fact that if you keep half your money in asset X and half of asset Y, the overall variance (“risk” or fluctuation) of the portfolio cannot be higher than putting all your money in either X or Y. This statement is true even for X and Y with strong correlation.

    It is also proven trivially that if both asset X and asset Y decline in value due to for example the current financial crisis, the value of the portfolio will too fall in value. That is, diversification never claimed to protect investors in a situation where every single asset is down.

    Take for example a Bank Account (X) and Bear Stearns Stocks (Y). If you put all your money in Y, you will incur more loss than if you split it between X and Y.

    I believe that people tend to blame the theory rather than check to see if there are any flaws in their understanding when things go awry.

    3) Rich Professors

    *information from wikipedia

    Eugene Fama, creator of the Efficient Market Hypothesis, is research director of a fund that has more than $126 billion under management.

    Burton Malkiel, author of “Random Walk Down Wallstreet”, served 28 years as director of The Vanguard Group, a company which manages more than a trillion dollars of funds.

    David Swensen, PhD Economics from Yale, uses Modern Portfolio Theory to deliver 17.8% annual returns over 10 years while managing Yale’s multi-billion dollar funds.

    4) Warren Buffett

    *information from wikipedia

    Warren Buffett too lost money in the recent crisis. According to wikipedia, his estimated networth plummeted from $62 billion to $37 billion. Even buying only Berkshire Hathaway stocks won’t save me from losses due to the current financial crisis.

    5) Efficient Market Hypothesis

    I feel that there are much misunderstanding regarding the Efficient Market Hypothesis. I think my previous 4 points addressed much of what I think are flaws in the understanding of the theory.

    Additionally, I would like to point out that :

    a. The hypothesis talks about information efficiency and not valuation efficiency. That is, stocks are allowed to be under or over priced in a totally (strong form) efficient market.

    b. We are allowed to outperform the “market” (or benchmark). One of the way to do this is to take on more risk.

    c. The hypothesis do not say that all markets are entirely (strong form) efficient. A person could make a lot of super-normal profits using inside information in semi-strong efficient stock markets of many developed countries.

    d. The scientific process is such that when a scientist propose a theory, much work is done to prove or disprove such a theory. There is nothing wrong when evidence against a theory is presented or when flaws are found.

    Furthermore, scientific reasoning is not about making up theories with no proof behind them but about making informed statements supported by reasoning and justification and then analyzing those statements for flaws.

    e. The research cited in this blog post still claim that there is a 5% chance someone can outperform the market in 20 out of 24 years by pure luck.


    I apologize for the extremely long comment. It is however, in my opinion, still inadequate and is likely to contain many error. I would still recommend reading finance textbooks for a more complete picture but I also understand that such publications tend to be very technical and boring to many people.

  11. @ Tommy – No, you weren’t in the slightest offensive and thanks for a long, well thought out and articulated comment.

    There is a scientific study that I have referred to in a more recent post that ‘proves’ conclusively that Warren Buffett’s sustained investment results (sure, BRK rides the sharemarket sentiment, but over the decades has outperformed the market by a very wide margin) are the result of skill not luck. No scientific theory can be accepted as ‘fact’ until it deals with the exceptions 😉

    Even so, diversification may be right for some; just remember, though, that this blog is about showing people “how I made $7 million in 7 years … and how you can, too!” … diversification just isn’t part of the ‘multimillionaire toolkit’ until, AFTER you have made the $7 Mill. 🙂

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