Proving Warren Buffett Right – Why Index Investing Works

Warren Buffett recommends low-cost index funds to average investors. In this fable we explain why this works using contemporary research done by Prof. Hendrik Bessembinder.

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Once upon a time, John — an up-and-coming youth with a decent paying job and dreams of secure financial future — decided to put a portion of his money into the stock market to generate greater returns. But where to start? The choices seemed overwhelming. So he reached out to his money guru who, we’ll call, appropriately enough, Guru.

“Guru, I have $1000 to start investing with. I have margin-trading enabled on my account so I can trade with even more money, if I need to. I just read about this great stock that everyone in my company is talking about. I thought I’d start there. What do you think?”

“No. Don’t do individual stocks. They are very risky.”

“Really? I have done my homework on this one. The company has been around for 70 years, has a solid business model, and is doing really well with a new management team over the last five years. 17 out of 18 analysts rate it a ‘Strong Buy’.”

Guru got out of his chair and went to his desk cluttered with papers and books. He searched in there for a bit and handed John an article which looked like it was cut out from the New York Times. “Read this before you get too excited about your hot stock,” he said.

John stared at the well-worn page eyes drawn towards an article titled “The Survivor” by Jenny Anderson dated October 28, 2007.

“Read it when you get a chance,” Guru said. “It’s a glowing article about Lehman Brothers and its CEO Dick Fuld. It’s filled with analysts and name-brand CEOs praising Fuld and the Lehman team, and, and.. get this…,” he said, starting to laugh. “There’s the analyst from Deutsche Bank who praises Lehman for the quality of its comprehensive risk management.” He continued laughing uncontrollably. “That’s like praising Bernie Madoff for running an organization of uncompromising ethics. Wow. Just wow.” He stopped laughing.

Lehman Brothers HQ NYC Sept 15 2008 (Robert Scoble @Wikimedia)

“And, then this company founded in 1850 that weathered the Civil War, two World Wars, a Great Depression is in bankruptcy less than a year later. Poof. The big guys praised Lehman for its risk management — the very thing it lacked. This tells you how much the big guys really know. And if the big guys don’t know the crucial things, how can you possibly know better?”

“Well,” John began to argue, “The investment I am proposing is not like that….” but Guru waved him off. He reached into his pocket pulled out his well-worn wallet and handed John three hundred dollar bills. “Here, John, what’s the difference between these bills?”

John took them puzzled and unsure what Guru was looking for. The bills all looked alike and real enough. “Well,” he stammered, “Their serial numbers, perhaps?”

“Exactly,” he roared. “There’s no difference: Their value or utility to me is the same. I actually got two of those bills this morning at Costco from my cash rebate. The other was from an ATM machine the day prior — so it probably came from my wages. Or, maybe from interest the bank gave me. I don’t know, and frankly I don’t care. As long as the money is lawfully and ethically obtained its provenance has zero value. Now give me my money back.”

John handed the bills back to him, and as he put them back in his wallet, Guru continued, “Look, here’s a three key lessons in investing. First, fall in love with money not with a particular method or instrument of earning it. In other words, do you want to make money or do you want to prove how great your stock is? Don’t confuse your objective.”

Guru then continued on, “Second, every decision you make when you invest has a non-zero probability of going wrong…”

“What decisions?” John interjected.

“What stock to buy or sell? At what price? What quantity? When?” responded Guru. “And since each decision you make has some non-zero probability of going wrong, the more the decisions you make, the more such errors compound. Therefore, second, make as few decisions as possible when it come to investing. And because single stock investing means lots of decisions, it’s a pretty bad way to go.”

“Third, remember that ‘slow and steady wins the race’ as Aesop said. Too many want to get rich quick. There’s nothing wrong in wanting to get ‘rich.’ It’s the ‘quick’ part that is super dangerous. Because to gain wealth quickly, you need to take greater risks. And risks eventually turn against you. Which results in greater loss of wealth. Instead of trying to score a mega-hit with each of your investments, focus on getting sustained steady returns that compound. Remember these three crucial words: Sustained. Steady. And, Compound. Do you know what compound interest is?”

“Yes, I do,” John replied, worried that he’d be quizzed on the math formula he’d long since forgotten.

Compound Interest is the eighth wonder of the world. Those who understand it, earn it. Those who don’t, pay it.
 — Albert Einstein

“Don’t worry,” Guru responded as if reading John’s mind, “I am not gonna give you a quiz. The basic idea is that you plow back any investment gains back into the investment. Don’t take the gains and spend it. The gains then generate additional gains. The additional gains generate still more gains and so on. The point is that with sustained steady returns that compound over any decently long time interval, you are going to do very well. No need to search for risky mega-hits.”

“We are going to have to wrap up now. I am going to give you some reading materials so you can read, reason and convince yourself of these core principles we have discussed.”

So saying, Guru then handed John two printed papers each neatly stapled. The first one was a paper provocatively titled “Do Stocks outperform Treasury Bills?” by Prof. Hendrik Bessembinder. Leafing through it, John found some scary looking mathematics. Yikes! The second was Warren Buffett’s Annual Letter to his shareholders reporting on results for 2017 (released in Feb 2018).

“First, start with the Buffett letter,” Guru advised. “You can read the whole thing — it’s super enjoyable. But for our discussion, it suffices to read pages 9 through 12.” He continued: “On Prof. Bessembinder’s paper, don’t worry about the mathematics. It’s awesome. Read both papers carefully and write down what you learn. Let’s meet back here in two weeks.”

Two Weeks Later

John read the papers given to him by Guru. The Buffett paper was an easy read. He also made a mental note to read the other shareholder letters authored by Buffett. Perhaps, he would be able to get insights into company valuations — the heart of figuring out whether a company was a worthwhile investment or not. The Bessembinder paper was harder, filled as it was with mathematics — not his forte. But he gamely persevered believing that gaining deeper understanding into investing would pay off over the long term.

Two weeks later John returned to Guru who wasted no time in asking him, “OK, so what have you learned? Let’s start with the Buffett paper.”

“Well,” John replied, “that dude can write. It was as you said. Very enjoyable. I liked the ‘If’ quote from Rudyard Kipling on keeping one’s cool when being an investor. Also, I get that Buffett believes that trying to be clever and ‘beating the market’ does not work as he showed in the bet he had. Basically, Buffett recommends that one should invest in a low-cost S&P 500 index fund and simply let it ride. Not to make too many decisions like you said last time.”

“Anything else from the Buffett paper?” Guru asked.

“No,” John responded.

“Really? You missed the bit about not investing with borrowed money?” Guru reminded him.

“I remember it but I kinda thought it was obvious,” replied John.

“So says the guy who last time said he got his account margin-enabled to invest more in his favorite stock, if needed,” Guru admonished.

“But I did not actually do it,” John protested.

“True. But that’s only because you had not started investing yet. Start investing, see yourself doing well, and you suddenly start thinking, ‘Wow. If only I had more capital, I could be doing so much better.’ And then it begins: you borrow a small amount, do well, and you borrow a little more, and so on. So stay away from using margin or borrowed money to invest. Because when the downturn comes — and there will be a next downturn — you will not be in control of your destiny. One of investing’s more famous quotes — perhaps due to Buffett, I am not sure — is to ‘be fearful when others are greedy, and greedy when others are fearful.’ If you are a borrower, you’d be doing the exact opposite. Because when you get hit with a margin call or a panic attack at seeing your investments bleeding red, you’ll liquidate stocks (or, be forced to) at exactly the wrong time — when they are beaten down. That’s when you could be buying!”

“So let’s start our lesson by extending Buffett: ‘First, neither a borrower nor a lender be’ to quote Shakespeare” said Guru emphatically. “OK. What did you pick from the Bessembinder paper?”

“I got lost in the mathematics but here’s the gist of what I picked up: Prof. Bessembinder analyzed more than 25300 stocks that have been publicly listed on the US stock market since 1926 through the end of 2016. Some eye-opening data points: He estimates total wealth created by the stocks at $35 trillion.”

“Let me stop you here. Define ‘wealth creation’ according to Bessembinder. He has, as I recall, a precise definition.”

“I got that quote right here,” John responded. “To quote Prof. Bessembinder: ‘I define wealth creation as the accumulation of market value in excess of the value that would have been obtained if the invested capital had earned one-month Treasury bill interest rates.’”

John continued: “Anyway, total wealth creation is estimated at $35 trillion.

  • But only 5 stocks — Exxon Mobil, Apple, Microsoft, GE, IBM — generated 10% of the total wealth (approx. $3.5 trillion).
  • Just 90 companies generated approx. 50% of the total wealth.
  • And, just 1092 companies (4% of the companies) generated all (100%) of the wealth. This means that the remaining 96% of the companies in aggregate generated no additional wealth beyond that of treasuries.”

“Yeah, we can restate this differently,” said Guru. “If you invest in your favorite company you are likely to be 96% wrong. Individual stock picking is risky endeavor best left to experts. But as Buffett’s paper showed even so-called hedge-fund experts under-perform the S&P 500 index fund.”

John said, “Bessembinder emphasizes diversification. He says ‘…non-diversified stock portfolios are subject to the risk that they will fail to include the relatively few stocks that, ex post, generate large cumulative returns.’”

Guru shuffled through this papers. “Great job, John. You got the essence of the Bessembinder paper. I want to round out what you said. A few more key facts from the Bessembinder paper that are useful to know.

  • Slightly more than 4 out of 7 stocks deliver negative lifetime returns. But this is because of companies that have gone public since 1966. As more capital has become more available, riskier companies are making their way into the public markets. I like to call this the ‘More cap(ital), more crap’ phenomenon. This makes it important that you be more vigilant against bad investments.
  • Too narrow a diversification and you leave wealth on the table. Conversely, overly broad diversification, your precious capital is being wasted.”

Guru continued: “We often think of diversification as a risk-management or loss minimization strategy. We believe we have a winner on our hands but because we are trained to ‘not put our eggs in one basket’ we make other investments as well so that if our winner does turn out to be a dud, we’d still be OK. In actual fact, we need to diversify to pick the winners! Remember, there’s a 96% probability that we are going to just keep pace with Treasury bills, and a 4 in 7 chance that we have picked a wealth destroyer. And, because we cannot know a priori the winners and losers, we need to diversify to actually help us pick the winners. The key take-away is this: ‘To be a winner, buy the winners.’ And, for US investors at least the S&P 500 provides a great list of current winners.”

“Are you convinced why trying to pick individual stocks is a bad idea in general for the average investor?” Guru asked.

“Yes, I am,” John responded. “But I am just worried that the S&P 500 index leaves money on the table. After all, a company has to become pretty successful to be included in the S&P 500. I got a concrete example here. Monster Energy. They make drinks that I consume copious amounts of. They were inducted into the S&P 500 index on June 28, 2012 when it was trading at approx. $23. Today it trades at approx. $64. The gain since S&P 500 induction would have been 178%. But if one had picked up this stock in 2005 for approx. $1, the gains would have been a whopping 6300%!”

Guru — shaking his head — exclaims, “Sure. Heck, why did I not just invest in Microsoft in 1987 and now I’d be sitting on millions? But that’s with the benefit of hindsight. Have you already forgotten the Buffett paper? Did you think those hedge fund managers did not try to beat the S&P 500? Did they not attend conference calls, review analyst reports, buy/sell complex options, and do a whole raft of other things that would make our head spin? For what? They got thoroughly beaten by the S&P 500 fund.”

“OK. I stand corrected,” John said duly chastened. “I believe I understand how the S&P 500 index works but can we walk through it to make sure that my understanding is correct?”

(Source: Overjive @Wikimedia)

“Sure,” Guru replied. “You can actually look this up as well. Here’s the Wikipedia link. Companies included in this index have to meet a defined set of criteria (minimum market capitalization, minimum daily trading volume, etc.). When a new company is inducted into this list, an existing company is dropped from the list. The index value V is simply the sum of stock price times the number of shares publicly available for trading (called the ‘float’ — to be distinguished from the total ‘outstanding’ shares) for all 500 stocks. This sum is then divided by a divisor that is a constant that S&P has defined — currently set to approx. $8.9 billion. The divisor changes when the float values of any of the 500 companies changes (mergers, new stock issued, etc.) or when a new company is added or an old one removed.”

“As a company becomes more valuable (that is, as its price times float value rises), it contributes a greater share towards the final index value. This is the mechanics of the index. What is really good about the index is that it is self-correcting: as new winners are inducted into the index, old losers are ousted (as Lehman was on September 16, 2008). In keeping with the Bessembinder principle that our diversification must include winners, this index will always include the top 500 winning companies in the US market.”

“Its flaws are that it misses the gains that a stock has prior to its inclusion into the index. A point you touched on with your Monster Energy example. Also, it is U.S. centric — so will miss winners in overseas markets.”

“Now I gotta run. Get started with the S&P 500 index fund. Make sure you choose one that has low fees as Buffett advocates. When the urge strikes to do something on your own like buying an individual stock, etc. remember the two papers. When the urge strikes to get in on the “ground floor” of some hot new investment (like Bitcoin, for example), remember that 4 in 7 companies that were once ‘hot’ have crashed and burned destroying shareholder wealth in the process. Good luck.”

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