Warren Buffett’s Record Is Not Evidence The Efficient Market Hypothesis Is Wrong
The Efficient Market Hypothesis is among the most-debated topics in all of finance. Do the prices of securities traded on the major financial exchanges instantly reflect all known information about the prospects of that particular stock? Or is the efficient market hypothesis bunk, as many believe? The answer to this question is extraordinarily important, since modern portfolio theory and most modern financial advice is predicated on market efficiency.
My personal belief is that the market is mostly efficient most of the time, or at least efficient enough that attempting to beat the market isn’t worth the effort, and my retirement portfolio reflects that belief. I will stop short of declaring the market is 100% efficient all of the time and it is impossible to beat the market by skill alone, but I will definitively say there is absolutely no substantiated evidence that the market is not efficient, Warren Buffett included. In short, The existence of Warren Buffett is not evidence that the efficient market hypothesis is wrong.
If Not Investing Skill, Where Do Buffett’s Returns Come From?
First a disclaimer: I am not claiming Buffett’s superior long-term returns aren’t the result of superior investing skill. I am merely saying there is no evidence of said superior investing skills and even if there were, it in no way disproves the efficient market hypothesis.
Buffett’s superior long-term returns conceivably (and far more likely) originate from three primary sources other than skill.
- Management Ability - When people say Buffett has generated 23% annual returns over a 40 year period, what they are really saying is that Berkshire Hathaway’s (BRK) book value has grown at a 23% annual rate over that period of time, which is not even close to the same as saying Buffett’s stock-picking prowess returned 23% per year. Berkhshire Hathaway owns over 70 different companies outright, including such well-known brands as Geico, Dairy Queen, and Fruit Of The Loom. His success generating out-sized returns from these brands is due more to his managerial and leadership ability than investing ability. After all, he’s the CEO of all those companies and has a direct hand in running them. Furthermore, Buffett often takes a seat on the board whenever he buys a large stake in another company, such as Coca-Cola (KO), as an “outside” shareholder. He’s able to get a board seat because he is a well-respected and knowledgeable businessman, allowing him direct control over the strategic direction of the stocks he owns. When you or I are unhappy with the performance of a stock we own, there’s little we can do about it besides sell. Buffett, on the other hand, can directly influence management and sometimes force them to do his bidding (board members control executive pay, after all). That’s hardly the same as the passive form of “investing” most people practice it. Not even most highly-respected and influential mutual fund managers have that sort of pull. Buffett truly is a special case.
- Prestige - Buffett himself has admitted in his biography The Snowball: Warren Buffett and the Business of Life
by Alice Schroeder that his larger-than-life reputation attracts many attractive investment opportunities he would otherwise be locked out of. As Buffett puts it, companies in need of cash often come to Buffett directly and are more than willing to pay him above average returns due to two reasons. First, Buffett’s deep pockets allow him to fund their needs immediately and don’t require them having to jump through any bureaucratic hurdles like they would with a bank or the public markets. Second, being publicly aligned with Warren Buffett is often enough to entice vendors and customers to do business with them. It’s also a clear signal to rivals saying “Beware! Warren Buffett himself has deemed us worthy of his attention. What chance do you think you have competing against us with Buffett on our side? Give up before it’s too late.“
- Random Luck - The most common argument I hear is also the most ridiculous and unfounded one: “It’s simply not possible for Buffett to have done as well as he did for as long as he has purely by luck.” Nonsense, of course it’s possible. Not only is it possible, it is 100% probable that somebody like Warren Buffett must exist and do so purely by chance. Then, the follow-up argument goes something like this: “Well that still doesn’t explain why other investors with similar strategies have also outperformed the market over time, such as Bill Ruane, Bill Miller, etc…“ Nonsense. It explains that phenomenon equally well. To illustrate, try the following experiment. Pretend you have a coin and record on a sheet of paper a series of random flips of the coin (don’t actually flip a coin, just write down what you think a random sequence of coin flips would look like). All done? Now flip a coin for real and record the sequence. Do you notice any differences between the sequence you predicted and the actual sequence you recorded? I bet you will. I can’t give away what that difference will be here without ruining the exercise, but I will reveal it in the comments if anybody is interested. Fully 80-90% of the time you will notice the same inconsistency between somebody’s predicted and actual sequence. In fact, I would be willing to bet I could determine which was which the majority of the time. The moral of the story is that people are horrible at estimating probabilities accurately. Most people think it’s extremely unlikely that Buffett and many with similar investing styles would all outperform the market when in reality, it’s quite probable this will happen purely by chance.
What Does This Mean For The Efficient Market Hypothesis?
In the end, the existence of Warren Buffett neither proves nor disproves the validity of the efficient market hypothesis. It simply has no bearing. Sure, Buffett could be a superior investor, but there’s nothing in his record or the record of managers with similarly-impressive long-term records that suggests the results are anything other than luck. To believe Buffett’s record disproves the efficient market hypothesis is to completely misunderstand the nature of probability and markets. Do I believe Buffett is just lucky? Not really. I personally believe he’s a very skilled investor and that skill has played a large role in his success over the years. But I can’t prove it, and neither can anybody else.
In the end, it really doesn’t matter if Buffett really can beat the market or not. The bottom line is, you’re not Buffett. Just because he can beat the market doesn’t mean you can.
Buy Warren Buffett’s biography The Snowball: Warren Buffett and the Business of Life by Alice Schroeder from Amazon today!

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