Warren Buffett vs. Index Funds

Warren Buffett is the greatest investor of all time. No one disputes this. He has a long track record of beating the markets in investment returns. He has many emulators, but though he is often imitated, he has yet to be duplicated. For some strange reason, the Warren Buffett magic is non-transferrable. Why is this?

I know a lot about Buffett's strategy. Here are the basics:

-Buy stocks when they are cheap.

-Buy stocks only in businesses you understand.

-Hold them forever.

The result of this strategy is pretty straightforward. You reduce costs. You can duplicate Buffett's investing strategy by dollar cost averaging and holding index funds. There is only one part you can't duplicate. This is buying stocks in businesses you understand. This is why Buffett counsels the rest of us to buy index funds. This is good advice because most of the people trying to be the next Warren Buffett fail. So, why does Buffett succeed?

I think stockpicking is a waste of time. People who win at this do so primarily as a consequence of luck. I think Warren Buffett is a lucky coin flipper. Buffett would disagree with me and cite his wealth and track record as evidence. But there have been winners of the lottery that won it more than once. One woman won it five times playing scratch off tickets. These stories abound.

The fact is Warren Buffett has made some horrible investing decisions. The worst one would be not loading up on Wal-Mart stock. How could someone with his investing acumen miss a business that fits everything he loves about a business? Yet, Buffett blew that one by his own admission. Why? The reality is that he can't see the future any better than anyone else. So, why has he done so well?

The biggest aspect of Buffett's strategy isn't his selection of stocks and company's to own but when he buys them. He buys them cheap relative to assets and future earnings. This affords him two advantages. He is automatically going to earn extra because he bought at or near the bottom. The other aspect is that it limits his losses. In a worst case scenario, Buffett will buy a company that must cease operation. It will be bought out by some other company that will break it up or whatnot. It's like buying from a thrift store. If you pay $1 for some pants that end up not fitting, what have you lost? And if you can resell them for 75 cents, it is less of a loss. You can't go wrong with this approach.

Value index funds outperform over the long term. If you had a long term investing horizon, buying shares in these funds would give you a better overall return than either a total sock market fund or a growth oriented fund. The downside is that you will not outperform every year. Neither does Buffett. The reality is that there are years when Buffett does not beat the market. Buffett doesn't care since his overall return trounces the S&P 500.

It is my belief that what has made Buffett so successful as an investor is not his skill at picking stocks but his discipline as an investor which you and I can duplicate. Basically, you should invest in index funds by dollar cost averaging with a weighting towards value and hold for the long term. You don't need to be a genius to do that. As for Buffett, he has made some colossal errors in his picks. They call him the Oracle but to listen to him talk about his picks suggests a nervous gambler. This is why Taleb includes Buffett among those fooled by randomness. For the greatest investor of all time, Buffett exhibits a high degree of self-doubt and humility. This is why he eschews tech and sticks with old economy type businesses. He is afraid of innovative industries because he has no clue about the future. What he does know is that the future does not change as wildly as predicted. Things like furniture and Coca-Cola endure no matter what the internet does. But his stake in the Washington Post may turn out to be a loser because of the internet.

For me, the key to talent or a successful strategy is repeatability. Though Buffett has shown a remarkable track record, few of his disciples have managed to pull off the same trick. The difference between Warren Buffett and some charlatan peddling a get-rich-quick scheme is that Buffett has a proven track record where the charlatan does not. But like the charlatan, the followers of his advice end up nowhere. Compare this to the followers of John Bogle who have done exactly as Bogle has predicted. They have captured the market's return beating a majority of active investors. The best advice Buffett gives is to follow Bogle's advice.

Critics of my criticism will point out that followers of Buffett's philosophy committed errors that can't be blamed on Buffett. Well, I hear the same thing with the charlatans. "You didn't do it right." Basically, the charlatan reaps the credit while everyone else takes the blame. It reminds me of religion. Buffett and his band of disciples are no different. Invest like Buffett and win, and Buffett gets the credit. Invest like Buffett and lose, and you will be shown how you didn't invest like Buffett. That is a neat trick.

Repeatability is the test. Anyone should be able to do it. With indexing, this is repeatable, and Buffett agrees. He even made a famous bet that hedge funds would underperform the S&P 500. We will have to see how this plays out, but it is obvious to me that Buffett believes in indexing even if he derides indexers as "know-nothing investors."

If there is one thing I have learned about randomness, it is to not be fooled by lucky coin flippers. They are bait for the trap regardless if they are aware if they are bait or not. Buffett does not consider himself to be a coin flipper, but what he fails to realize is that his performance is not beyond the realm of possibility. As I have pointed out, people can repeat success in purely random things like the lottery and will. But the fact that most people lose the lottery only shows that it is random. If you want to underperform the market, try to be like Buffett.

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