(MoneyWatch) As discussed in my book, "Think, Act, and Invest Like Warren Buffett," one of the great anomalies, and also tragedies, is that while investors idolize Buffett, not only do they ignore his investment advice, they tend to do the exact opposite of what he recommends. With this in mind, it's interesting to read Fortune's recently published 1975 letter from a 44-year old Buffett to the Washington Post's chairman and chief executive, Katharine Graham.
The letter contains Buffett's advice to how the company should invest its pension accounts. The following are some of the highlights in which Buffett makes a succinct case against traditional stock picking and fund management (otherwise known as active management).
- "If above average performance is to be their yardstick, the vast majority of investment managers must fail." Various studies on the performance of pension fund managers show how right Buffett was. Even Goldman Sachs had this to say in a report on pension fund performance: "Few managers consistently outperform the S&P 500 Index. Thus in the eyes of the plan sponsor, its plan is paying an excessive amount of the upside to the manager while still bearing substantial risk that its investments will achieve sub-par returns." It's also worth noting that Buffett made his observation 16 years before William Sharpe's "The Arithmetic of Active Management" was published.
- "Will a few succeed due either to chance or skill? Of course. For some intermediate period of years a few are bound to look better than average due to chance, just as would be the case if 1,000 "coin managers" engaged in a coin-flipping contest. There would be some "winners" over a 5 or 10-flip measurement cycle." The problem is that because of the lack of persistence of outperformance beyond the randomly expected, it's very difficult to separate the skillful from the lucky.
- "In addition to the ones benefitting from short-term luck, I believe it possible that a few will succeed--in a modest way--because of skill. I do not believe they can be identified solely by a study of their past record." Here Buffett recognized another problem with active management, 20 years before Jonathan Berk wrote his brilliant piece, "Five Myths of Active Portfolio Management." Berk pointed out that in effect, successful active management sows the seeds of its own destruction as the winners attract more and more assets. Buffett put it this way: "I am virtually certain that above-average performance cannot be maintained with large sums of managed money. It is nice to think that $20 billion managed under one roof will produce financial resources which can hire some of the world's most effective investment talent. It just doesn't work that way. Down the street there is another $20 billion getting the same input. Each such organization has its own group of bridge experts cooperating on identical hands and they all have read the same book and consulted the same computers. Furthermore, you just don't move $20 billion or any significant fraction around easily or inexpensively--particularly not when all eyes tend to be focused on the same current investment problems and opportunities. More money means fewer choices--and the restriction of those choices to exactly the same bill of fare offered to others with ravenous financial appetites."
Buffett reached the conclusion that "the rational expectation of assuring above average pension fund management is very close to zero." Yet, in a triumph of hype and hope, each pension plan believes that it will somehow succeed. Buffett offered the analogy of a fellow sitting down to play poker with some friends and announcing, "Well fellows, if we all play carefully tonight we should all be able to win a little." He added: "Clearly the almost universal expectations of above-average performance in pension plans were doomed to disappointment."
The tragedy is that despite Buffett's wisdom and track record, the majority of pension plan sponsors continue to ignore his advice and the evidence. Hopefully, you're making smarter investment decisions.
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