Tuesday, March 2, 2010

How Warren Buffett Inadvertently Harms Investors

We admire Warren Buffett and wish he were a friend. He is a national treasure: a true hero, with integrity and abundant humility. According to a recent newspaper article Mr. Buffett ranks near the top of a list of the most trustworthy people in America.

He thinks and writes clearly. His annual letters to shareholders are tours de force. Anticipating his yearly doses of wisdom is like a kid waiting for the holidays. Particularly enjoyable is his irrefutable logic in spotlighting the mischievous ways of the usual Wall Street suspects.

When on occasion he addresses a matter of public policy he is incisively on target. And in terms of capital allocation - and that's how he describes his job, after all - his batting average has created and saved hundreds of thousands of jobs.

And of course his and his partner's results are unprecedented. In. The history. Of the world. In a world of many malevolent economic actors he is a unrivaled force for good.

But Mr. Buffett inadvertently and unintentionally - and totally without fault - harms investors.

How? Because due to his success and name recognition he is the almost-universal example of the preferability of actively investment management over indexing.

The logic of the example is that if there is a Buffett then nothing precludes the current or future existence of more Buffetts. And so then begins the search to find (and pay handsomely) up-and-coming index-beaters. At a cost of hundreds of billions of dollars a year, per Vanguard founder John Bogle, as noted in an earlier post on this blog.

However, citing Warren Buffett as an example of the preferability of active investment management isn't, when one looks closer, a compelling argument that the market can be beat over the long term. One, his company buys other companies typically in their entirety. And so to compare his performance to that of, say, an equity mutual fund manager isn't apples-to-apples. In other words, although he is famously "hands-off" regarding his company's portfolio companies he is still more conglomerate businessman than a stock picker. Two, even if contrary to most academic studies there really are many Warren Buffetts out there -- that is, persons with true risk-adjusted market-beating skill ("alpha") rather than persons who have had an extraordinary run of good luck -- trying to find those few persons among the millions of "financial service industry professionals" is trying to win the lottery.

Mr. Buffett himself has suggested that most people would be far better off investing in index funds. [Source: The Elements of Investing by Burton G. Malkiel and Charles D. Ellis.] Let's take Mr. Buffett's highly trustworthy suggestion.

Please note: in fairness to Mr. Buffett, literally he doesn't harm investors. It's others' references to him that cause the harm. And the harm matters.

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