Successful stock pickers such as Warren Buffett deserve their success even though the Efficient Market Theory claims they’re just lucky “coin flippers.”
The Efficient Market or Random Walk Theory of Finance states that nobody can successfully predict which stocks will rise in the future, because all known information about stocks is already reflected in the (ever-changing) market price. A stock’s price is random — that is, unpredictable.
A lot of people working on Wall Street dispute these claims. After all, a lot of people on Wall Street are paid a lot of money to analyze, buy, sell, recommend and otherwise work with stocks on the assumption that their efforts do make a difference in portfolio returns.
And is that so wrong? Well, it’s a well-known statistic, proven by innumerable studies, that the vast majority of active mutual fund and stock portfolio managers do NOT beat the market on a long term basis.
The truth is, most people would do just as well buying stocks by throwing darts at the stock listings. The editors of THE WALL STREET JOURNAL did just that years ago, and the stocks they bought on that basis did just as well as most mutual funds, without having to pay any mutual fund expenses.
So how do Efficient Market advocates explain the long term, market beating success of such investors as Warren Buffett?
Easy — by pointing out that if you have thousands of people flipping coins, somebody will flip Heads many more times than average. Most coin flippers will be average, but somebody will always be way above average.
So does that explain Warren Buffett and others, such as Peter Lynch? They’re just lucky coin flippers?
I recently read a biography of Warren Buffett, BUFFETT: The Making of an American Capitalist by Roger Lowenstein. He was a business person as a child, buying 6 bottles of soda for 25 cents and selling them for a nickel each, to make 5 cents profit per six-pack. He delivered newspapers. He leveraged his own efforts by paying other boys to do most of the labor of his businesses.
Not only that, but he was fascinated by numbers. He loved to count, and learned how to perform math in his head at high speed. Unfortunately, the biography was not clear about whether he learned techniques for this (you can learn many from books by “The Human Calculator” Scott Flansburg) or whether he developed the speed through simple determination and repetition.
As he got a little older he studied accounting and finance and how businesses worked. In college, he studied under the great guru of value investing, Benjamin Graham. According to a fellow student, the class periods were entirely a conversation between Professor Graham and student Buffett. Buffett was given the only A grade Graham ever handed out.
He learned to read and understand balance sheets and income statements by reading hundreds and eventually thousands of them — that is still most of his daily routine . . . reading annual reports.
When he was young, people would make stock recommendations to him, and Buffett could quote the company’s annual report back to the person.
So I had to ask myself — if Buffett’s success is due to simple good luck, how is it that everything in his post-babyhood life has seemed to prepare him for it? He learned how businesses work by running his own businesses. He could perform complicated financial calculations in his head faster than other people could solve the equations using a calculator. He knew the financial statements of almost every publicly listed company in the United States better than almost anybody except their own Chief Financial Officers.
What are the odds that a man with such skills and experience also just happened — as a matter of pure random chance, mind you — to be the supreme stock picker “coin flipper” champion of the 20th century?
If stock picking success is simply a matter of random chance, then why didn’t the best record go to Dr. Joe Dufus of Birmingham, Alabama? Or why not to some mutual fund manager who Fidelity hired right out of college?
But if Warren Buffett’s success is not due to random chance, then why can’t more hard-working and dedicated mutual fund managers beat the market in the long term?
Simple — Warren Buffett’s success IS due to random chance in the sense that he possesses and developed a lot of qualities that are rare in the population as a whole, including the vast majority of investors and even mutual fund and portfolio managers.
But he deserves his success as much as Michael Jordan deserves his. Basketball talent is random distributed through the population, but nobody claims that athletes who work hard to develop that talent are just “lucky.”
Intelligence is randomly distributed through the population, but we don’t claim that Albert Einstein was just “flipping coins” when he developed the Theory of Relativity.
Acting talent is randomly distributed through the population, but we don’t claim that a movie producer should fill in movie roles by randomly selecting every actor who shows up to try out for a part. We don’t say that Oscar winners are just lucky.
So I believe that successful stock picking is a talent that is randomly distributed through the population. Actually, it evidently requires a combination of talents. Since they’re all randomly distributed through the population, it’s rare for people to possess large amount of all the necessary talents. Plus the motivation to develop his talents that has driven Warren Buffett since he was in grade school.
All talents are randomly distributed, and must be developed, and those who do so deserve their success, including Warren Buffett.
Yet, paradoxically, the Random Walk theorists still have a good point. If it takes a rare genius such as Warren Buffett to beat the market long term, the only way to find such people is to examine their long term records, and then join them.
But by that time, many years will have passed. You can’t wait. You need to invest your funds now, not after the new fund manager has proven their own genius 20 years from now. But until they has proven themself the next Warren Buffett, you have to assume that in the long run they’ll do no better than the market.
So you’re still stuck with:
1. Buying Berkshire Hathaway if you can afford a share of it.
2. Putting your money into an index fund so that your portfolio goes up with the market, which is better than 98% of long term mutual fund managers.
3. Putting your money into dividend or interest paying investments so you get cash into your pocket, and don’t have to worry about market prices.
Warren Buffett deserves his success, and it’s certainly possible that some other fund or portfolio manager out there is going to match his long term record of success . . . in 20 or 30 years.
Who that person is, is NOT random — but it is unpredictable. Don’t waste your money.
Copyright 2007 by Richard Stooker
Learn more about how to beat the stock market odds against you, and Warren Buffett http://www.incomeinvesthome.com/books/buffett.htm