The Curious Case of Warren Buffett and the Efficient Market Hypothesis

in steemleo •  8 months ago  (edited)

Investopedia claims that "the Efficient Market Hypothesis, or EMH, is an investment theory whereby share prices reflect all information and consistent alpha generation is impossible." EMH is an extremely important theory to today's markets because it forms the basis for the majority of money flow in the capital markets. That's because without EMH there would be no way to justify the enormous amounts of inflows into what we call index funds. Sometime over the summer we crossed the Rubicon of having more capital in the stock market invested in index funds than active funds with actual walking, talking, breathing, hamburger eating, happy hour whiskey swillin' Wall Street type managers.

Index funds operate on the belief that "if you can't beat 'em, join 'em." We talk about the basic premise in this post, "On Days Like Today, It Pays to Be a Boglehead," that reviews the life of the Vanguard founder that invented the product. His undergrad research indicated that most active fund managers fail to beat their benchmarks over the long run. After a bit of struggle that you can read about in the post above, passive index investing was born.

But that's not what this post is about. That's just the background needed to assess the following question:

Does Warren Buffett believe in the Efficient Market Hypothesis?

The short answer is that while Buffett does not follow EMH himself, he does believe that, for less talented investors than himself, EMH is a powerful enough concept that most investors need to be putting their money into index funds.

The irony of that stance is that Buffett's consistent investment success is the best example of why efficient market theory is preposterous. His views about the supposed efficiency of the market can be summed up by his repeated references over the years to the parable of Mr. Market, an allegory oft-repeated in Benjamin Graham’s renowned security analysis course at Columbia University where Buffett earned a master of economics in 1951. If you want to read more about the story of Mr. Market check out my blog post on the subject, “Who is Mr. Market?”.

He offers practical advice about the vagaries of Mr. Market in the 1987 Berkshire Hathaway Annual Letter to Shareholders:

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”

Buffett predicates this viewpoint on his verifiable talent in the field of capital allocation. He even goes so far as to say that he won the “ovarian lottery” by being placed in a political and legal system that disproportionately rewards his one particular talent. He often admits that he has few other talents, and is severely lacking elsewhere in many regards.

Robert P. Miles describes Buffett’s oft-repeated story well in his book, Warren Buffett Wealth: Principles and Practical Methods Used by the World's Greatest Investor (available on Google Play):

He was gifted with unique skills to value companies, coupled with being born during the time period that would enjoy the greatest economic expansion and would be capitalism’s finest hour to date. One simply cannot underestimate the luck of being born in the United States, home of 4 percent of the world’s population but one half of the world’s capital and publicly traded companies, with a political and legal system that disproportionately rewards capital allocation talent over most other occupations, and during a century that experienced a sevenfold increase in the standard of living. (24)

Buffett understands that he is incredibly lucky to have these talents. He also understands that not everyone enjoys his occupation or is preternaturally suited to it like himself. In those cases, Buffett believes that EMH serves the majority of “regular” investors in the best way possible. Note the advice he would give to the investment trustee of his own children that he offered in the 2013 Berkshire Hathaway Annual Report:

My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.

But actions speak louder than words. Buffett himself has never invested in an index fund. He thinks you should though. That advice is not even that conflicting either, because Berkshire Hathaway holds no position in BlackRock (BLK), the undisputed champion of passive investing products. So if you think you're a better investor than Warren Buffett, go right ahead and manage those stubs all by yourself!

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Thank you for posting from the interface 🦁

Thanks for the post. I am just recently able to do my own limited investigation into the market. I had retirement plans where I worked and since I retired, and at the encouragement if a good friend who has become a millionaire due to the market, I have had reasonable success on my own and with vanguard type products. I have a brokerage account but don't use the broker's advise. I do believe that in my experience, diversity is more fun and rewarding. I like the idea of price action. I am disinterested generally in other funds choices to "hold".

Thanks for the time and subject matter. Ask an investor, not a trader, I enjoy reading other people's opinions.

I intend to open this up later on my tablet and read the provided links. So, I resteemed it for the purpose of sharing and also to bookmark it for later today, hopefully.

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Thanks for reading. It certainly is more fun to invest in single stocks if you have the time to do the research and proper portfolio management. But it's probably better seen as a potentially rewarding hobby. As always, the more you educate yourself about the investment process, the less risk you will have to endure in your investment portfolio.

I like the potentially rewarding hobby classification you use. I don't need the money for expenses (yet) but I have inflation protection built-in to my standing portfolio. Are you a strong advocate of precious metals? I know that Mr buffet is not. It may not have a yield but in my modest opinion it has distinct value for preservation of wealth.

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This was a very interesting post. I am both educated and entertained by your style of prose. I must confess that I think Warren Buffet is a magnet to investors as they cling to his every word, but I have often been perplexed, by him saying one thing and doing another. Your post reinforced something I secretly suspected, he does things he recommends that others don’t do, because he thinks he can make the action profitable, while he thinks others cannot. 😉
Your reinforcement of this suspicion was gratifying.

I will resteem this post and I hope to have time to read some of the links today m, it’s the weekend, but I am working, so ....

Take Care

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Yeah, gotta give @khaleelkazi some Buffett links for the old SEO for steemleo!

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