In a world where sentiment plays such a decisive role, is it unlikely that sometimes action is worse than inaction? It’s not a view life coaches would share, but one Warren Buffet might.
On the last day of 2017, the Oracle of Omaha officially won the wager first placed in 2007 that an S&P500 index fund would outperform a group of hedge fund managers and their fast computers, and he was right. In the end, the fund, consisting of the 500 largest companies on the New York stock exchange, returned an annualized 7.1% versus the 2.2% of his counterparts.
It was a bet originally for a million dollars, but the pool ballooned to over $2.2M over the course of the ten years. In the end, neither party took any winnings. The real beneficiary was the Girls Inc. of Omaha, a non-profit group which became millions richer overnight.
This story isn’t about how hedge funds have no place in finance. In fact, one of the many sensible explanations of this “defeat” is that hedge funds, as their name may suggest, perform better in sluggish markets, but that’s empirically difficult to prove. Maybe the story would’ve been flipped had we experienced another recession in the last few years. But again, maybe not.
I’ll try to describe my thought process here, but take it with a grain of salt.
To me, the first fundamental understanding is that investing is not about chasing the products with the highest returns. To give you an example – My apartment in Vancouver appreciated by over 30% in 2016, but that doesn’t mean we should all be in real estate because it could go the opposite way next year. Therefore, what we care about is not absolute returns but risk-adjusted ones. In other words, how do we achieve growth without seeing crazy high fluctuations?
There are more details here regarding different types of risks, but we can ignore that for now. The bottom line is that based on historical performance, we know that we can eliminate a lot of risks by investing into about 20 large companies of different sector and space. This is diversifying. It makes things easier for us because we don’t have to put all of our eggs into one basket, but we can go even further.
According to Benjamin Graham (Warren Buffet’s mentor), there are two types of investors. One who spends all their time analyzing stocks and watching the news, and the other who has no interest in the market and looks to invest in passive portfolios that require no supervision.
We may be inclined to think that the former is more successful based on the description, but the key here is that we want to be one or the other, and never in between. Since most of us have jobs and obligations that take up our free time, I would argue that we should err on the passive side.
Knowing that, what investment vehicle do we have that is well-diversified (20+ companies) and could free us from any decision making? The S&P500 index fund that Warren Buffet loves is a great place to start. By siphoning a set % of our income into a fund every paycheck when we’re in our 20s, we would be well on our way to leverage the benefits of exponential growth.
Passively managed index funds like the S&P500 are a newer class of investment option that holds an advantage over traditional mutual funds. Not only are we free of the usual 2-3% management fees, index funds have also just outright outperformed against actively managed ones. It’s not that fund managers are stupid, it’s just very difficult to beat the market by the margin of your fees.
For those who want more control of their portfolios, ETFs (exchange-traded funds) are also worth looking into. They are a subset of index funds that trade on the market like any other stock. ETFs represent a basket of stocks/bonds that could track something as high-level as the entire S&P, or something more specific like ‘North American Large Cap Resources’. This way, investors can play around with their macro ideas without having to pick individual stocks.
To sum it up, I think investing (and budgeting by extension) is a skill for everyone. With even a few hundred dollars, anyone can open an online brokerage account and start investing. By buying and holding index funds and not giving a damn about what Trump tweets next, we are already well ahead of many peers earning abysmal returns in their savings accounts.
Nothing is certain and some years will be worse than others, but as long as our investment horizon is long enough, historical performance will skew heavily into our favor.