You can’t fully accept Charles Darwin’s Evolution Theory until you explain the Bombardier Beetle; equally, you can’t fully accept Larry Swedroe‘s support of Modern Portfolio Theory [MPT] until you explain Warren Buffett …

… having said that, perhaps I was little harsh when I suggested to my blogging-friend Pinyo that:

You might want to screen the advice from your ‘experts’ a little better …

But …

Larry Swedroe is a guest expert on Pinyo’s Blog, and Larry has published a number of books – including a highly-regarded one on the ‘workings of the stock market’ – so, I read the post with interest; it was a response to a reader question:

How can a person justify support of modern portfolio theory [MPT] when there is a Warren Buffett in this world?

Firstly, you already know my views on MPT and the so-called Efficient Market Hypothesis, which basically says that everybody has access to the same information (illegal trading based upon insider-information, as well as scamsters like Messieurs Ponzi and Madoff, aside) so, stocks must be priced correctly at all times.

Which doesn’t mean that you can’t buy ‘cheap stocks’ from time to time (e.g. now), but more that you can’t beat the market … nobody can, and if someone can, it’s either luck/randomness or can’t be predicted up front.

So, how do you ‘explain’ a Warren Buffett (or, the others)? Or, is this a case of the ‘exception proves the rule’?

First, it was no surprise to see Larry answer the question, in summary, as:

That is an easy question to deal with. First, with thousands or millions of investors we should expect some to outperform the market every year and some to do so for many years, randomly. The question is: Is there any more persistence of performance than would be randomly expected. The evidence from hundreds of academic studies is there is not.

Another answer to the question is that Warren Buffett is not the typical investor. He is not like a mutual fund manager. He often buys companies and then manages them. He provides them with economies of scale, lower cost of capital and the benefits of his managerial wisdom. And when he takes large positions in companies he often gets a board seat. So perhaps his great returns are more a result of his managerial skills than his investment skills, or some combination of both.

When I got this question a few years ago I went to do a simple check on the performance of Berkshire Hathaway for the prior ten year period and then compared it to the five major U.S. asset classes of large, small, small value, large value and real estate. During that period BRK had underperformed all but the asset class of large stocks (as represented by the S&P 500) and had underperformed an equally weighted (20% each) portfolio of the five that was rebalanced annually by several percent.

So we know that Buffett had delivered great returns in the past but we don’t know that he will in the future. In fact, during that ten year period BRK underperformed. So now what would you forecast regarding the future?

So, Larry answered the questions along the following lines:

1. Warren’s performance could be random – but, we already know that’s not the case, and I pointed Larry to the scientific study (http://7million7years.com/2009…..or-a-fool/) proving that Warren’s performance is no fluke, it’s simply only explainable by skill.

2. Warren often buys companies and actively manages them – this is true, for 78 of his investments, but not true for all of his stock holdings (in companies such as Coke, Kraft, etc.); he may – or may not – take board seats, but the reality is that he runs a hundred billion dollar company employing thousands of staff with only 19 people to apply all of his ‘managerial skills’; no, what Warren has is a system to effectively use excess cash from an already well-performing business to buy more (a perpetual money machine on steroids!).

3. Warren underperformed the market for 10 years – Warren agrees! He had too much cash and prices (as ‘perfectly and efficiently and modernly’ priced as surely as they must have been?!) were way too high … cash under-performs stock in a rising market. Let’s rerun that study over the next 20 years and see who wins?

4. We can’t use Warren’s past success to predict his future success – Oh yes we can; if Warren’s success is based upon skill, not luck, and the fundamentals of the market that have allowed that skill to succeed in the past are mostly true in the future, then of course Warren will be more successful in the future.

After some back and forth, Larry changed his ‘story’ somewhat:

I think we can agree on two key issues. Buffett’s record is almost certainly the result of skill. But the market’s have become much more efficient over time and the size of his assets under management make the challenge of beating the market now so much greater. Even Buffett himself has made this last point.

The other point is this. Likely we will see another Buffett 20 years from now, but there is no way to identify that person TODAY, we will only know who that person is ex post.

Now, it seems, Larry agrees that Warren isn’t a random aberration, he is skillful, but that will be less important as time goes on. Well, I agree – and, more importantly, Warren does also agree, to a point: Warren says that the smaller investor (around $1 Mill. to invest) should be able to beat him (hence the market) because Warren’s investments are getting too, d*mn big and he can’t move in/out of positions as quickly as he used to (well, more in than out as he is strictly ‘buy / hold’).

Larry, if Warren’s return via Berkshire Hathaway was 21%+ over the past 40 years, do you really think it will suddenly drop below 11%+ (or whatever the ‘market return’ happens to be) over then next 40? You may say “I don’t know …” (which is your point, I believe) …

… so, here is the kicker: if Warren felt that he could no longer beat the market, he would issue dividends!

Warren wouldn’t risk decreasing his shareholder returns by having them sit in cash or in BRK performing no better than the market – unless, he was expecting to be able to expend this vast ‘war chest’ on future ‘bargains’ – when he could just issue excess cash / profits as dividends and let the shareholders invest in a market-matching Index Fund, presumably at much lower overhead cost than Warren’s BRK can provide.

Therefore, Larry, I can confidently predict that Warren will beat the market (say, over the next 20 or 40 years), simply by ensuring that I invest with him until he changes his mind (on his dividend strategy) 😉

The point that Larry SHOULD be making is that this is not a common result … so, for the ‘average investor’, simply plonking all of the funds that you have earmarked for stock investing (e.g. in your 401k) into a simple, low-cost Index Fund – and, waiting 30+ years for Modern Portfolio Theory to run it’s ‘magic’ – will provide the best ‘bang for buck’ stock market performance that you need.

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