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Knowing when to shut up is an under-appreciated attribute. The more you talk, the more you diminish what you’ve said, no matter how profound the initial observations. Talk enough and you’ll either bore or you’ll contradict.
Warren Buffett has done a lot of talking this past week. A lot of the talking is unavoidable when you’re forced to hold court to entertain 30,000 acolytes. The demand to relentlessly talk is Buffett’s cross to bear at the annual Berkshire Hathaway (NYSE: BRK.b) shareholders meeting.
A swamped email in-box is my cross to bear. I’ve been deluged by a relentless stream of Buffett-centric articles over the past week, most in list form: Buffett’s “top 5 this” or “top 10 that” from a nondescript writer who pinched the list from secondary and tertiary sources.
I’ve long ago ceased to care about these annual pearls of wisdom. Most are restatements of axioms long repeated. What market insights offered are offered by a formerly dynamic investor who today is as staid and as risk-averse as any mutual-fund manager.
These thoughts invaded my mind when I heard Buffett extol the virtues of index investing. An S&P 500 index appears virtuous in Buffett’s eyes these days. “My regular recommendation has been a low-cost S&P 500 index fund,” Buffett said to the rabble. “To their credit, my friends who possess only modest means have usually followed my suggestion.”
This is an odd recommendation, and a contradiction to boot, from previous pronouncements about the Buffett approach: “Keep all your eggs in one basket, but watch that basket closely” being a previous pronouncement. Run a concentrated portfolio, in other words. (This sentiment actually originated with Andrew Carnegie.)
The Buffett Approach
Contrary to previous beliefs that investors should invest based on company fundamentals and outlook, Buffett embraces the passive approach that indexing imbues. The market knows best, even if Buffett made his bones ̶ long before he had been elevated to a deity ̶ concentrating his investments in a few companies when the market didn’t know better.
Indeed, Buffett generated his most impressive returns for Berkshire Hathaway (NYSE: BRK.b) when he ran a concentrated stock portfolio. Through most of the 1980s, Berkshire’s common stock portfolio rarely exceeded 10 issues. In one year, 1987, Berkshire closed the year owning just three issues. Six to eight was the norm.
Over the decade of the 1980s, Berkshire shares appreciated at an eye-popping 42% average annual rate. As for the S&P 500, it appreciated at an 11% rate.
But running a concentrated portfolio is so risky, you might think. Please think again. Research (most notably a 1968 Journal of Finance article with the dull, scholarly title, “Diversification and the Reduction of Dispersion: An Empirical Analysis”) shows as few as 10 to 15 stocks can serve as a properly diversified portfolio, though one that still offers the opportunity to outperform.
So, you won’t generate superior returns investing in a broad-based index, though you’ll surely generate less volatility, you also might think. Maybe, maybe not. Depending on the time frame, you can spend a lot of time getting nowhere in a broad-based index, and experience a lot of volatility getting there.
S&P 500: Price Performance From 2000-to-2017
Buffett’s attitude toward passive index investing suggests that he’s succumbed to the popular views presented by Modern Portfolio Theory (MPT): The theory states that financial securities always reflect all available information, thus rendering individual out-performance impossible.
If it were true, why do we have active investors? Even with a “passive” investment strategy, someone calls the shots. Investors (including Buffett) analyze and buy individual securities, and they buy and sell those securities. You might be passive, but someone is active. You’re simply investing according to someone else’s objectives.
Following the Herd
Following the herd is not without risk. Because fewer investors are active, investment objectives coalesce. The top 10 stocks by market cap account for 20% of the value of the S&P 500; the top five stocks in the NASDAQ 100 account for 42% of the value. A lot of investors are piled into the same stocks. What do you think will happen when many of these same investors wish to pile out at the same time?
Focus on what Buffett does (or used to do), not what he says, if you must focus. As for me, I focus on quality individual income-producing securities and buy what I perceive as the best values ̶ the top 10 to 15 values ̶ from the group. Such a strategy is within the capabilities of any intelligent layperson. Over time, the strategy works, as the Buffett approach of yesteryear has proven.