Now you may be asking, how can he be offering advice on something he doesn’t even own?  Well, here is how he can say that.

He is primarily giving this advice to individual investors who aren’t interested in stock picking.  He’s also giving this advice to people who don’t have the resources or expertise to have sophisticated investment strategies.

This is the reason he recommends these.  All index funds track a particular index.  For example, a Dow Jones Index Fund tracks the DJIA.

The Dow has proven itself to grow over time.  That’s huge when many mutual funds are falling prey in the market.  It’s also significant because so many investment strategies that are set to beat the market rarely actually do.  This way, you are not trying to beat the market.  You are trying to grow with the market.  There’s a huge difference.

The financial statistics tell us that this is actually one of the best ways to earn a reasonable return over time.  Many other investments can’t promise you that nor give you reasonable arguments based on hard historical data that it will grow.

The other reason he recommends index funds is because investors then don’t have to go out and do stock picking.  That can be a very arduous, tedious, and time consuming project for most people.  That’s not to mention that most people don’t want to or can’t do it properly.

If you want to check out a good fund, check out the S&P 500 Index Fund.  Well, there are several of them.  The S&P 500 is said to be a more accurate picture of the US economy and stock market because they use more companies in their roster.

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.

1. 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.
2. 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.“
3. 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!

Well what if, like me, you just don’t want to wait that long? Of course, I’m not going to do anything foolish like invest all my savings in penny stocks or the lottery in some desperate effort to strike it rich overnight, but I don’t want to wait 40 years, either. Instead, say my desired time horizon to accumulate $1 million is 15 years (yes, I know $1 million won’t buy as much in 15 years) and I only have $10,000 to start. If I am able to invest an additional $1,000 every month, I would require a 20% annual compound return to reach my goal in 15 years. That’s ambitious, but not impossible. Now, where can I get that 20% per year?

Real Estate

Real estate is down and out right now, but that only serves to make it more attractive as an asset class. Direct ownership of residential and commercial real estate still holds outstanding long-term profit potential, even in this market if you buy correctly and take on a reasonable amount of leverage (70-80% LTV max). Not only do you get modest appreciation (don’t count on it), but you can also get cash-on-cash yields in the 12-14% range, not to mention loads of tax benefits. Nobody knows what the real estate market will do over the next few years, but 15 years from now a properly-bought and maintained piece of property should be worth quite a bit more than it is today. Put it all together and 20-25% annual returns are well within reach. Get lucky, and you could top 30%. All this in an investment you have partial control over.

Your Own Small Business

This is a topic I plan to write on in the near future: everybody ought to start their own home-based small business, if only for the tax benefits. But the benefits go well beyond taxes. Just where do you think you’re going to get that extra $1,000 per month to invest? You’re going to start your own business. It could be an internet business. It could be a homemade arts and crafts business. It could be a lawn-care business or anything else your heart desires. Now this doesn’t have to be something you do full-time, although you may want to eventually make that transition, but it is imperative that you save and reinvest all your earnings from your side business. You aren’t doing this to buy an HD TV, after all, you’re doing it to achieve financial security while you’re still young enough to enjoy it. If your business takes off, 20% per year is actually a very conservative estimate and you will have no trouble reaching $1 million on time. If not, you’ve still got a little extra cash to invest every month. Over time, that seed money will multiply many times over even if you earn much less than 20% on it. And guess what? Even after you reach that $1 million goal, you can continue doing your side business part-time as long as you want, so you won’t even have to rely on your nest egg to support yourself. In fact, hopefully you had so much fun achieving your goal you’ll decide to go for $2 million, $3 million, or more.

Be Warren Buffett

This is where evil scientists have a distinct advantage. If you were to invent some sort of personality-switching ray where you could put your mind in Warren Buffett’s body, that may be the path to go. Kinda like the 74 different versions of that Freaky Friday movie, except with rich people rather than little girls. On second thought, Warren Buffett is getting kinda old so scratch that. Maybe Justin Timberlake is a better bet. At least he can dance.

Just How Much Do The Rich Pay?

Earlier this year, Warren Buffett famously informed a room full of Hillary Clinton supporters that he pays a smaller percentage of his income in tax than his secretary, at only 17.7%.  Is that true?  Highly unlikely.  Buffett is conveniently leaving out some large payments made to the IRS on his behalf, as well as a myriad of phantom “taxes” he and other super-wealthy people pay.  For starters, Buffett claims his 2006 income was $46 million.  Nonsense.  His taxable income was far, far higher than that.  In fact, he paid more than $46 million that year in taxes alone.  Where does this discrepancy come from?  Well, it all depends on what you consider “income”.

Buffett’s 2006 Income And Tax Bill

Obviously, I don’t know the details of Buffett’s personal household income so this will be broad by necessity.  What we do know is that Buffett owns approximately 32% of Berkshire Hathaway (all these filings can be found on EDGAR) and that Berkshire Hathaway earned approximately $16.8 billion in 2006 before paying approximately $5.5 billion in taxes.  “So what,” you ask?  “That’s just his company paying the tax, not Buffett himself.”  I beg to differ.  For decades, Buffett has stressed in his shareholder letters that a stock is not just a piece of paper but rather a real claim on a company’s tangible property and earnings.  If, as Buffett claims (and I share his view fully), stock ownership grants you a share of a company’s earnings, doesn’t it by definition also give you a share of a company’s liabilities, including its tax liability?  Of course it does and Buffett knows it.  It is disingenous to claim that stock ownership grants a share of positive outcomes (earnings) but not of negative outcomes (taxes, lawsuits, etc).  Just ask any Enron shareholder if they shared in Enron’s losses or not.

The Rich Are Taxed Twice

Since Buffett owns 32% of Berkshire Hathaway, he also owns 32% of its earnings and 32% of its tax liability, which works out to be $1.72 billion, which works out to a tax rate of about 33% or almost double what Buffett claimed in his speech.  But that’s not all!  Owning stock doesn’t pay the bills.  In order to pay the bills you must realize income either in the form of stock dividends, which Berkshire Hathaway doesn’t pay, or generating capital gains by selling shares.  Both of these income-realization techniques are taxed by the government, ON TOP of the tax already paid by the corporation (and by extension the shareholder).  This is called double taxation and is a well-known and hated phenomena within the investment community.  Many liberals see that dividends are taxed at 15% and declare the tax rate on that income to be 15% to the investor.  Wrong.  They real tax rate to the investor is about 45% after factoring in the 35% corporate tax rate with the 15% dividend tax.  To those who would argue that corporate income tax shouldn’t count, I say bollocks.  Had the corporation not been required to pay taxes, the shareholder would have been better off by the amount of the taxes paid because either the share price would be higher or the dividend rate would be higher, if not both.  In fact, the very existence of corporate structures such as REITs or MLPs, which allows the company to avoid corporate income tax so long as substantially all of their earnings flow through to shareholders’ personal income tax returns argues very strongly in favor of the fact that the market, congress, and the IRS all agree with my position.  Whatever the true tax rate of dividends and capital gains, it is most certainly not the 15% paid by the end investor to the IRS.  Taxes are paid on behalf of these rich investors all along the way.  Taking all this into account, it’s not at all unusual for a wealthy individual to pay upwards of 50% of their income in taxes every year.  What’s more, their corporate holdings must pay taxes regardless of whether or not any of the income is distributed to shareholders.  To say the rich pay a lower percentage of their income in taxes than the poor is naive at best and downright dishonest at worst.  Buffett, sadly, falls squarely into the dishonest category on this one.

There is also the issue of how the federal tax-exempt status of state and local municipal bonds are a hidden tax on the rich, but I will cover that from a slightly different angle in tomorrow’s post.

The Sequoia Fund has consistently garnered above-average returns with below-average risk at a reasonable price.  While a 1% expense ratio may seem a bit steep to passive investors, it’s rare this caliber of active management is on sale at any price.  This reopening represent an excellent opportunity for active investors to get into a winning mutual fund at a fair price.

Buffett Wishes He Were You

Ok, maybe that’s not entirely accurate.  I’m sure Buffett rather enjoys his billions of dollars and the respect he commands from his peers and rivals alike, but that’s another topic.  Strictly speaking in terms of investing, Buffett is jealous of you.  He’s jealous of your small portfolio (suspend your disbelief, please), of your flexibility, of your ability to take large positions in small companies, and your ability to ignore mundane details such as a stock’s liquidity and treat the market as a black box.  If you want to buy a stock, you buy it.  If you want to sell, you sell.  That’s that.  You don’t have to worry about spacing your activity out over a few days so as to avoid driving up the price of the very stock you’re trying to buy.  You can ply your trade in the less efficient corners of the market, such as small or micro-caps and special situations.  Buffett has none of these advantages.

Warren Buffett is forced by circumstances to invest in large-cap, heavily traded blue-chip companies.  There’s nothing wrong with this, but it’s extremely difficult to generate market-beating returns over the long term when you’re competing with every other institution to buy a stock covered by 40 analysts.  Buffett has been reportedly claimed in the past he could generate returns upwards of 50% per year provided he only had $1 million in order to in micro-cap stocks.  You have a huge advantage over the pros.  Don’t spoil it by copying them.  If you want some Buffett exposure on your portfolio, buy Berkshire Hathaway stock.  But when it comes to your own individual stock selections, you would be better served sticking to areas where you have an advantage.  Buy small companies.  Buy profitable companies with sound fundamentals but that aren’t yet followed by Wall Street.  This is where you’ll make your fortune, not in mega-caps like Coca-Cola or Home Depot.  Don’t try to compete with Buffett because trust me, he’s smarter than you.

“What we are seeing is a huge repricing and evaluation of risk, correcting for problems of the past. I don’t know of good credit propositions that are going unfulfilled. There’s lots of cheap credit for sensible deals, which I don’t define as anything that happened over the last 12, 18 months.”

You can view the full text of the entire discussion over at Underground Value.  As an investor, I can’t think of a better way to learn than listening to the masters.