As has been widely reported, billionaire investor Warren Buffett made a wager some years ago pitting the US stock market against a group of hedge funds. To be more specific, Buffett took the position that the broad stock market would perform better, over a decade, than a carefully selected group of hedge funds. Buffett chose to bet on the Vanguard S&P 500 Index fund (representing the broad US stock market) while his wagering partner picked a particular group of 5 “fund of funds” that invest in the “best” hedge funds.
Being Warren Buffett, he put his money where his mouth was. The wager is over one million dollars to be donated to charity by the loser. This generated lots of interest and curiosity. Every year, the financial press binges on stories updating us on the bet’s progress. This year’s articles, such as this one in Fortune Magazine inform us that Buffett is way ahead
Warren Buffett is almost sure to win this bet. The question worth answering, though, is why. The reasons Mr. Buffett would make such a wager, and the explanation as to why he will probably win, are extremely valuable to anyone who invests.
Let’s start with knowledge of how investments and markets work. Warren Buffett knows what any good economist knows. And any good economist knows a tremendous amount about how money, markets, investments, indices, and even “hedge funds” behave. (I included the latter only reluctantly since it is challenging just to explain what a “hedge fund” really is – another topic for a day when I am feeling particularly cynical.) Economists have ready access to theoretical understandings published by scholars, the results of empirical experiments, research analysis, and all historical data about the financial markets. They know what can be known, what nobody can ever know, and what they don’t yet know.
As a result, economists are in an extraordinary position to make highly educated guesses about the future. And while they can’t know what the markets will do on your next birthday, they have a pretty good idea of what will happen over a decade or two. [Link to last week’s blog about Meteorologists]
Among the things you can learn from a skilled, honest, and wise economist are the following concepts. Adjusting for random chance, nobody can beat market indices over long periods of time except by overweighing higher returning asset classes. Stocks are expected to be the highest returning asset class over time. Hedge funds are not a “separate asset class” but a bunch of folks making creative use of existing asset classes. And, of course, costs reduce returns.
The previous paragraph may sound like an advanced degree in economics but it amounts to this. An extremely costly method of investing in stocks and other asset classes is very unlikely to do better, over the long haul, than a broad and low-cost stock index fund.
Warren Buffett knows that. Most financial economists know that. And you can know that, too.