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Buffett: Why you should ditch active funds and buy passives

03 March 2014

In his annual letter to shareholders, the Berkshire Hathaway chief advises investors to hold a cross-section of businesses that in aggregate are bound to do well, instead of trying to emulate him or other professionals.

By Thomas McMahon,

News Editor, FE Trustnet

Amateur investors would be better off sticking 90 per cent of their money in a low-cost tracker and 10 per cent in cash, according to legendary investor Warren Buffett, chairman and chief executive officer of Berkshire Hathaway.

ALT_TAG Buffett’s (pictured) company has returned 19.7 per cent per annum since 1965 while the S&P 500 has returned 9.8 per cent.

However, the so-called Sage of Omaha says that the vast majority of investors would be better off neither trying to emulate him nor hiring professionals to attempt to do so.

“The goal of the non-professional should not be to pick winners – neither he nor his 'helpers' can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal,” he said.

Buffett says that following this strategy, the average amateur is likely to do better than the average professional.

“The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur,” he said.

“Remember the late Barton Biggs’ observation: 'A bull market is like sex. It feels best just before it ends.'”

“The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never to sell when the news is bad and stocks are well off their highs.”

“Following those rules, the 'know-nothing' investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results.”

“Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.”

Buffett says that he is providing for his family in precisely this way.

“What I advise here is essentially identical to certain instructions I’ve laid out in my will,” he said.

“One bequest provides that cash will be delivered to a trustee for my wife’s benefit.”

“My advice to the trustee could not be more simple: put 10 per cent of the cash in short-term government bonds and 90 per cent 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.”

Buffett’s advice is concentrated on the US market, which is notoriously difficult for active managers to beat.

Data from FE Analytics shows that the average fund in the IMA North American sector has underperformed the S&P 500 by 117 percentage points over the past 20 years.


Performance of sector vs index over 20yrs

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Source: FE Analytics

We can put together Buffett’s suggested portfolio in FE Analytics, and our data shows that it would have almost exactly matched the returns of the average IMA North America fund since September 2010.

Unfortunately we can’t go back further as the Vanguard S&P 500 portfolio was only launched at that time.

The other complication is that the investor would not easily be able to buy short-term US Treasuries. A money market fund could be a reasonable substitute, although these would have fees, albeit low ones.

Performance of portfolio vs sector since Sep 2010

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Source: FE Analytics

Our data suggests that the risk-adjusted returns on Buffett’s suggested passive portfolio are superior, however: the fund has a Sharpe ratio of 0.65 to the 0.55 of the average IMA North America fund.

For anyone who is trying to use active management to do better, Buffett has some advice: they should ignore macro-economic forecasts and focus entirely on the businesses.

“Forming macro opinions or listening to the macro or market predictions of others is a waste of time,” he said.

“Indeed, it is dangerous because it may blur your vision of the facts that are truly important.”

“When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: 'You don’t know how easy this game is until you get into that broadcasting booth.'”

“When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses,” he added.

“We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate.”

“If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people.”

“In fact, these subjects never come up when we make decisions. It’s vital, however, that we recognise the perimeter of our 'circle of competence' and stay well inside of it.”


“Even then, we will make some mistakes, both with stocks and businesses. But they will not be the disasters that occur, for example, when a long-rising market induces purchases that are based on anticipated price behavior and a desire to be where the action is.”

Buffett says that for the patient, rational investor, the hectic nature of the market is a boon.

“It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is.”

“After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behaviour?”

“If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.”

“Owners of stocks, however, too often let the capricious and often irrational behaviour of their fellow owners cause them to behave irrationally as well.”

“Because there is so much chatter about markets, the economy, interest rates, price behaviour of stocks, and so on, some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments.”

“Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of 'don’t just sit there, do something'.”

“For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.”

Continuing the comparison between stocks and the farms in Nebrasksa he owns, Buffett says that investors would do better to imitate farmers than professional money managers.

“If 'investors' frenetically bought and sold farmland to each other, neither the yields nor prices of their crops would be increased.”

“The only consequence of such behaviour would be decreases in the overall earnings realised by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties.”

“Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions.”

“The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.”

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.