The Evidence-Based Investor

Buffett: The simple math that means indexing MUST win

Posted by Robin Powell on February 28, 2017

I don’t know about you, but I’ve read just about enough articles about Warren Buffett for one week.

As happens every year, there’s been a huge response to his latest letter to Berkshire Hathaway shareholders — much of it from money managers, brokers and consultants who pretty much worship Buffett most of the time, but get very uptight when their poster boy’s public pronouncements start to threaten their business models.

But please allow me one more post on Buffett, because it was interesting him, in an interview on CNBC, boiling down the whole active versus passive investing issue to simple arithmetic.

Asked by presenter Becky Quick to explain why he has instructed that, on his death, 90% of his wealth should simply be invested in an S&P 500 index fund, Buffett said this:

“Professionals, after fees, don’t know how to get a better result. If you take half the people.. and they don’t do anything, they just own the average, they are going to get average results, right? The other (half) are going to incur all kinds of fees and they are going to do.. way worse than the people.. who do nothing. The difference is incredible.”

In saying what he did, Buffett was more or less paraphrasing the Nobel Prize-winning economist William Sharpe, whose 1991 paper, The Arithmetic of Active Management, made the same point.

In a nutshell, Sharpe said this:

— The investing community is divided into active and passive investors.

Before costs, the return on the average actively managed pound/ euro/ dollar will equal the return on the average passively managed dollar.

— After costs, the return on the average actively managed pound/ euro/ dollar will be less than the return on the average passively managed dollar.

Therefore, the average active investor must — yes, must — underperform the average passive investor.

To quote Professor Sharpe: “These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”

Jack Bogle, whom Buffett described in his latest letter as a hero, likes to refer to “the relentless rules of humble arithmetic” — a phrase he used for the title of a 2005 paper for The Financial Analysts Journal. In it Bogle said: “The overarching reality is simple. Gross returns in the financial markets minus the costs of financial intermediation equal the net returns actually delivered to investors.”

OK, that’s positively the last word from me on Buffett for a while. But next time you read about the active versus passive “debate”, remember that it’s not really a debate at all. The average investor the average active investor must underperform the average passive investor after costs.

Buffet’s right — it’s simple arithmetic. And yes, “the difference is incredible.”

 

You can read the full transcript of Buffett’s interview on CNBC here:

Warren Buffett’s interview on CNBC, February 27, 2012

 

Related post:

The basic arithmetic the fund industry won’t acknowledge

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Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector. Regis Media.

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