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
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Sorry to post an outside link to my post, but Berkshire Hathaway stock price has increased in the double digits over the past 30 years:
http://www.dividendgrowthinvestor.com/2008/02/warren-buffet-is-one-of-best-investors.html
And imitating Buffett has also proved to be a profitable, market beatin experience..
You left out arguably the two most important items…
1) Buffett Partnership performance
2) Berkshire stock picks (the main ones AXP,WFC,KO)
Alex, I covered Berkshire stock picks directly above in issue one. Buffett himself sat on the board of KO, which isn’t something a normal outside investor has the opportunity to do. Therefore, KO certainly doesn’t count nor do other picks where Buffett exercised direct managerial influence over management such as Washington Post, WFC, etc.
As for the partnership issue, that was over a relatively short period of time and is most likely the result of luck. Why is it so difficult to believe that above-average performance can be the result of luck and luck alone? Do lottery winners possess above-average number-picking skills? No, so why assume stock-pickers do without any supporting evidence?
in addition to luck how about (1) Buffett rode at the back of biggest economic boom in world history, US economic growth! (2) Buffett having a shrewd business acumen?
It was a good read.
Kyle,
You could read the letters to partners at the Buffett Partnership here:
http://www.ticonline.com/buffett.partner.letters.html
I highly doubt that he managed to outperform the S&P 500 and generate a positive return each year just by chance. If you read the letters, you would see that he took calculated risks, worked hard and delivered solid returns.
So how do you explain the success of Edward Thorpe? He has made 1000’s of investments (eg statistical arbitrage) returning approximately 20% per year with relatively low risk. You can read about it at http://edwardothorp.com/id9.html .
Buffet does not have a direct hand in the management of his wholly owned companies.
They are free to run the companies as they like. Not only did buffet purchase the companies for being an excellent business, he also bought them for their superior management.
I agree with you that markets are “generally” efficient, but more so to do with how quickly information is dispersed.
Markets can still do silly things from time to time.
Markets are people, and people never change.
Greed and fear.
I find it mind boggling that you said your retirement portfolio shows that it is pointless to attempt beating the market. Your portfolio consists mainly of various index funds, which will obviously mirror market average. Your portfolio shows that it is your choice to not attempt to beat the market, but offers absolutely no evidence that there is in fact no point in trying to beat the market.
Also we need to define what profiting by pure luck means. Profiting by pure luck means all of the participants were doing the exact same thing, and a few of them emerges with superior return. Buying the lottery is an example of pure luck because every single person chooses the numbers at random but someone is gonna win that multimillion jackpot.
In the case of Warren Buffett, it is obvious that his approach isn’t the same as the majority of the participants. The evidence? Perhaps you could read his letters to shareholder, and compare that to common people’s approach to the market.
Also the difficulty of beating the market also depends on how much money you’re managing. It is not uncommon at all for some amateaur investors to trade frequently in small cap stocks and gain oustanding percentage returns. However amateaur investors manage very little money, and the ones who get a few hundred percent returns a year are likely only managing a few thousands to a few hundred thousand dollars.
Oh the other hand, managers of billion dollar funds have a much tougher job. They can not possibly take advantage of small flunctuations because the sheer size of their fund could in fact move the price and destroy the potential gain in those flunctuations. They can’t go into and out of positions in a matter of minutes like amateaurs. For them , it would take months. Furthermore for mutual fund managers, they are restricted to investing a maximum 5% to each stock. As a result they may be forced to invest in less ideal stocks. Managers of large funds carry systematic risks that makes it hard for them to even meet the market average.
Since beating the market also is determined by how much money is managed and the consequent systematic risk, I really do not understand why people make generalized assertion about the unlikelihood of beating the market average.
There are in fact plenty of evidence against the efficient market theory. The 2000-2001 technology bubble is the easiest example. The publicly available information shows that the newly formed tech companies do not even have revenues, and that their claimed partnership with large companies are not backed by collaborated projects. However blind optimism pushed the price of small newly formed companies hundreds of percent above their IPO price. Such publicaly available information would certainlly show that those companies are not solid investments and consequently in an efficient market there’s no place for those crazy price surges. The bubble would have been self corrected before it even got big enough to burst in 2001. Was there such a self correction? Evidently not.
What proponents of traditional theories often do not consider is that no matter what publicly available information are there, all of those information must be subjectively interpretted. It is not realistic to claim that the subjective interpretation of the market participants will always or almost always confirm rationally with the underlying fundemental, thus creating an efficient market.
I think this argument is well thought-out. Anyone who has studied statistics even in passing will know that outliers are just part of the equation when dealing with massive amounts of data. There is no doubt that Warren Buffet qualifies as an outlier. However, attributing his outlier status to luck is a fallacy. He uses a system, other super-pickers use other systems to varying degrees of success. As far as I know, none of history’s great stock pickers have attributed their success to “guessing” or a “luck” system.
Lots of lotto players have a “system” for picking numbers. Those people win the lotto just as often as those people who guess, so you could say that luck is responsible for winning the lotto.
I agree that the existence of Warren Buffet does not disprove efficient market hypothesis. Buffet himself has agreed that securities’ market performance does reflect the available information IN THE LONG TERM. Buffet and other long-term value investors call this reversion to the mean. In a nutshell, it means day-to-day fluctuations cannot be predicted with any certainty, but long-term performance can be predicted using available factual data.
Thanks for reading my rant, which has no citations and is based completely on my opinions
Bank collapses in the past year were also examples of market inefficiency. At first the banks were able to hold their stock prices by using accounting tricks to exaggerate their intangible assets. The public had a false perception of the bank’s total assets, but hedge fund managers such as John Paulson did not. He examined the bank’s past balance sheets and realized that the bank’s tangible assets were in fact in the negative range, so the bank’s claimed assets must have come from exaggerated intangible assets. The average investors often do not analyze balance sheets, and their false perception were not destroyed until news of bank failures and bail out were all over the place. As a result John Paulson proftted handsomely by short selling bank stocks before the public understood the situation.
I mentioned before that all publically available information must be subjectively interpretted and therefore can’t be consistently rational. From the above example I would like to add that publically available information could well be ignored until they re-surface later in more obvious forms, creating an inefficient market.
Kyle
You state
“Buffett’s superior long-term returns conceivably (and far more likely) originate from three primary sources other than skill.” 1)Management Ability 2)Prestige 3)Random Luck
As an anonymous reader states “Buffet does not have a direct hand in the management of his wholly owned companies”
So you would have to rule the first one out. Prestige yes he gets the deals because e is on everyones radar, but what about in his early years 1956-69 when he ran his partnership fund? He whipped the market then. Luck? maybe that he is Warren Buffett.
I don’t think its random or coincidence that most investors that studied/worked under Buffett’s mentor Ben Graham have outperformed the markets over long periods of time.
Re: Random Luck
Buffett himself responded to this point 25 years ago. Read: The Superinvestors of Graham-and-Doddsville
Anon, I have read The Superinvestors of Graham-and-Doddsville and it represents a complete misunderstanding of statistical inference. Suffice it to say I completely reject Buffett’s argument on logical grounds.