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The Track Record
One of the greatest practicing scholars of investing, Warren Buffett made his first investment at 11 years old and is legendary for building Berkshire Hathaway into the business equivalent of a Wonder of the World over half a century, just by investing in other businesses.
Berkshire Hathaway recently crossed the $1 trillion mark in market capitalization and is the only non-tech U.S. company to do so. He is the oldest CEO of a Fortune 500 company (and the 7th largest, currently) at the age of 94 . His investing partner, Charlie Munger, notable for such quotes as "the money is not in the buying and selling, but in the waiting," passed away recently at the age of 99 and was memorialized as the "architect" of Berkshire Hathaway by Warren in his 2023 shareholder letter. Warren was the inspiration for switching me from unprofitable speculating to profitable long-term investing. His investing record is roughly double the performance of the S&P 500 Index since 1965 - an unmatched long-term accomplishment.
Where Should I Invest?
What does the world's most successful investor recommend? His principal advice in a global sense is to "never bet against America." An excerpt from his 2020 letter:
"In its brief 232 years of existence, however, there has been no incubator for unleashing human potential like America. Despite some severe interruptions, our country’s economic progress has been breathtaking. Beyond that, we retain our constitutional aspiration of becoming “a more perfect union.” Progress on that front has been slow, uneven and often discouraging. We have, however, moved forward and will continue to do so. Our unwavering conclusion: Never bet against America." Warren has often joked that he won the ovarian lottery by being born in America.
If America has such a competitive advantage for the average investor, how should we take advantage of it? It seems like wealthy people have all the advantages because they can invest in hedge funds and other "high net worth" paywalled structures, correct? In fact, it's quite the opposite.
What Should I Invest In?
Warren is a proponent of low-cost, passive investing in the form of index funds pioneered at Vanguard by investing democratists such as Jack Bogle. Warren's wager is that these simple, low-cost index funds will outperform expensive, risky hedge funds over 10 years. In Buffet's own words in his famous 2016 shareholder letter (italics are all Buffett's):
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Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion.
I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helper called a consultant.
That professional, however, faces a problem. Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S&P 500? That would be career suicide. Large fees flow to these hyper-helpers, however, if they recommend small managerial shifts every year or so. That advice is often delivered in esoteric gibberish that explains why fashionable investment “styles” or current economic trends make the shift appropriate.
The wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket, you name it. Their money, they feel, should buy them something superior compared to what the masses receive.
In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial “elites” – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars. This reluctance of the rich normally prevails even though the product at issue is –on an expectancy basis – clearly the best choice. My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Figure it out: Even a 1% fee on a few trillion dollars adds up. Of course, not every investor who put money in hedge funds ten years ago lagged S&P returns. But I believe my calculation of the aggregate shortfall is conservative.
Much of the financial damage befell pension funds for public employees. Many of these funds are woefully underfunded, in part because they have suffered a double whammy: poor investment performance accompanied by huge fees. The resulting shortfalls in their assets will for decades have to be made up by local taxpayers.
Human behavior won’t change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something “extra” in investment advice. Those advisors who cleverly play to this expectation will get very rich. This year the magic potion may be hedge funds, next year something else. The likely result from this parade of promises is predicted in an adage: “When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.”
Long ago, a brother-in-law of mine, Homer Rogers, was a commission agent working in the Omaha stockyards. I asked him how he induced a farmer or rancher to hire him to handle the sale of their hogs or cattle to the buyers from the big four packers (Swift, Cudahy, Wilson and Armour). After all, hogs were hogs and the buyers were experts who knew to the penny how much any animal was worth. How then, I asked Homer, could any sales agent get a better result than any other? Homer gave me a pitying look and said: “Warren, it’s not how you sell ‘em, it’s how you tell ‘em.” What worked in the stockyards continues to work in Wall Street.
Buffett's Wager
Now, to my bet and its history. In Berkshire’s 2005 annual report, I argued that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still. I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund.
Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?
What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge. Ted was a co-manager of Protégé Partners, an asset manager that had raised money from limited partners to form a fund-of-funds – in other words, a fund that invests in multiple hedge funds.
The results? "The compounded annual increase to date for the index fund is 7.1%, which is a return that could easily prove typical for the stock market over time...the five funds-of-funds delivered, through 2016, an average of only 2.2%, compounded annually. That means $1 million invested in those funds would have gained $220,000. The index fund would meanwhile have gained $854,000."
Buffett's Conclusion
Bear in mind that every one of the 100-plus managers of the underlying hedge funds had a huge financial incentive to do his or her best. Moreover, the five funds-of-funds managers that Ted selected were similarly incentivized to select the best hedge-fund managers possible because the five were entitled to performance fees based on the results of the underlying funds.
I’m certain that in almost all cases the managers at both levels were honest and intelligent people. But the results for their investors were dismal – really dismal. And, alas, the huge fixed fees charged by all of the funds and funds-of-funds involved – fees that were totally unwarranted by performance – were such that their managers were showered with compensation over the nine years that have passed. As Gordon Gekko might have put it: “Fees never sleep.”
The underlying hedge-fund managers in our bet received payments from their limited partners that likely averaged a bit under the prevailing hedge-fund standard of “2 and 20,” meaning a 2% annual fixed fee, payable even when losses are huge, and 20% of profits with no clawback (if good years were followed by bad ones). Under this lopsided arrangement, a hedge fund operator’s ability to simply pile up assets under management has made many of these managers extraordinarily rich, even as their investments have performed poorly.
Still, we’re not through with fees. Remember, there were the fund-of-funds managers to be fed as well. These managers received an additional fixed amount that was usually set at 1% of assets. Then, despite the terrible overall record of the five funds-of-funds, some experienced a few good years and collected “performance” fees. Consequently, I estimate that over the nine-year period roughly 60% – gulp! – of all gains achieved by the five funds-of-funds were diverted to the two levels of managers. That was their misbegotten reward for accomplishing something far short of what their many hundreds of limited partners could have effortlessly – and with virtually no cost – achieved on their own. In my opinion, the disappointing results for hedge-fund investors that this bet exposed are almost certain to recur in the future.
So that was my argument – and now let me put it into a simple equation. If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average results before costs, so, too, must A. Whichever group has the lower costs will win. (The academic in me requires me to mention that there is a very minor point – not worth detailing – that slightly modifies this formulation.) And if Group A has exorbitant costs, its shortfall will be substantial.
There are, of course, some skilled individuals who are highly likely to out-perform the S&P over long stretches. In my lifetime, though, I’ve identified – early on – only ten or so professionals that I expected would accomplish this feat.
There are no doubt many hundreds of people – perhaps thousands – whom I have never met and whose abilities would equal those of the people I’ve identified. The job, after all, is not impossible. The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well. Bill Ruane – a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul – said it well: “In investment management, the progression is from the innovators to the imitators to the swarming incompetents.”
Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods. If 1,000 managers make a market prediction at the beginning of a year, it’s very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him.
Finally, there are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions (sob!). Third, most managers will nevertheless seek new money because of their personal equation – namely, the more funds they have under management, the more their fees.
These three points are hardly new ground for me: In January 1966, when I was managing $44 million, I wrote my limited partners: “I feel substantially greater size is more likely to harm future results than to help them. This might not be true for my own personal results, but it is likely to be true for your results. Therefore, . . . I intend to admit no additional partners to BPL. I have notified Susie that if we have any more children, it is up to her to find some other partnership for them.”
The Bottom Line
The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.
If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of added value.
In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me.
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This wager is proof that hedge fund investors, with all their wealthy elitism, do not triumph over financial literacy which is accessible to all, thanks to index fund pioneers like Jack Bogle.
As visual confirmation of the power of compound interest through ultra-low-fee index investing which Bogle and Buffett recommend for the average investor to triumph over so-called "smart money", consider the following 50-year investment of $10,000 in the S&P 500, and in the NASDAQ. This is simply letting $10,000 sit invested and never adding to it (notice for context that 10K invested 50 years ago is the same as approximately $53K invested today due to inflation).
As an aside to technological progress which drives returns like this, I created the above chart using a generative AI large-language model in about 30 minutes using Llama 3.1 (405b) and Python's Matplotlib library. This is why I'm also a big proponent of investing in technology, which you get by virtue of technology members of the S&P 500, but also with low-cost index funds targeting the technology sector or NASDAQ.
As a bonus, I’ve collected fifteen of my favorite Warren quotes which best capture the spirit of Golden Goose Guide:
1) Rule Number One: Never lose money. Rule Number 2: Never forget Rule Number 1.
2) The most important investment you can make is in yourself.
3) Someone is sitting in the shade today because someone planted a tree a long time ago.
4) It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.
5) Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
6) Never ask a barber if you need a haircut.
7) What the wise do in the beginning, fools do in the end.
8) In the world of business, the people who are most successful are those who are doing what they love.
9) You’ve got to keep control of your time, and you can’t unless you say no. You can’t let people set your agenda in life.
10) Tell me who your heroes are and I’ll tell you how you’ll turn out to be.
11) Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.
12) Do not save what is left after spending; instead spend what is left after saving.
13) If you don’t find a way to make money while you sleep, you will work until you die.
14) Risk comes from not knowing what you’re doing.
15) It’s better to hang out with people better than you. Pick out associates whose behavior is better than yours and you’ll drift in that direction.
See more of Warren’s quotes at Wikiquote. For a free master class in operating an investment business, read Warren’s letters to shareholders at Berkshire Hathaway. The definitive source on Buffett's investing wisdom is The Essays of Warren Buffett: Lessons for Investors and Managers, which curates and modernatizes excerpts from his shareholder letters. I highly recommend it.
-Golden Goose Guy
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