Why you won’t become the next Warren Buffett

The stock market is at record highs, everybody is making money, investing is easy — I hate to be the Grinch, but it shouldn’t be this way.

On a total return basis, the Nasdaq-100 is up 39.46% this year, the S&P 500 increased by 17% and the MSCI World index is up by 14.5%. 2020 will go down as an aberration; Covid-19 has accelerated the adoption of digital technology, and governments have unleashed unprecedented levels of monetary and fiscal stimulus to combat the pandemic induced shutdowns. The result of which is to front load future returns to 2020, returns that would that would have normally occurred over many years.

In this environment it is easy to fall prey to delusions of grandeur and overconfidence. Twitter is presently awash with displays of hubris and boasting of abnormally high returns. Here is one example — “If you haven’t made 100% or more in market this year, you’re either a horrible trader or you’re not trading at all.”

As I’m about to explain, these sort of returns are not sustainable and a dose of realism and modesty is warranted before thinking about opening a Robinhood brokerage account.

Reality check

After a year like this it is easy to believe you’ll be able to emulate Buffett’s record, an annual compound return of 20% since 1965 (a 10% outperformance over the S&P 500), after a stellar performance in 2020, that doesn’t seem too difficult? Think again. Larry Swedroe, chief research officer at Buckingham Strategic Wealth wrote a fascinating book called ‘The Quest for Alpha’. It details his search for the holy grail of consistent market outperformance, beyond what can be normally expected by chance. He examines the evidence from numerous academic studies on mutual funds, hedge funds, pension plans, private equity, venture capital and individual investors. His verdict: that consistent market outperformance is just a myth.

Its times like this when even I’m lured into thinking that I can beat the market. However it’s worth remembering why this is so hard to do — imagine the stock market to be a giant supercomputer, incorporating the opinions of all investors around the world. Therefore all known information is already reflected in today’s prices, and to express a view that a particular stock is underpriced or overvalued means to say that you possess more insight than the collective wisdom of the entire market. It’s unlikely that you’ll be right, and even if you are, you have to keep making correct calls to consistently outperform the market, an unlikely outcome.

Against overwhelming odds

The body of evidence against active stock selection is insurmountable; see S&P Dow Jones indices active versus passive scorecard (SPIVA), the study compares active fund managers against their respective benchmarks; it is published twice a year, ever year. The results are always the same, the majority (90%) of actively managed funds underperform their benchmarks over three years, as the time period assessed increases to 10 years and above, the level of underperformance reaches 90%!. They also produce a persistence scorecard, which measures how long an investment manager can sustain market beating performance; the results also make grim reading — The December 2019 persistence scorecard shows that less than 1% of equity funds maintained their top quartile performance at the end of the five-year measurement period.

If professionals fund managers, armed with the brightest analysts and access to the best data can’t beat the market, what chance do you have?

And what insights do you possesses that the collective wisdom of the crowd doesn’t? It doesn’t matter how many investment books, magazines, newspapers or academic studies you read, other people can do this too, and the information is already factored into the market.

The 10,000 hour rule doesn’t apply to investing

Perhaps less known is that investing is one of few fields where effort doesn’t correlate with results. The 10,000 hour rule, the time needed to achieve mastery in a particular field doesn’t apply to investing because the environment in which you operate is constantly evolving. In sport, where the rules are fixed and the system is stable, greater practice will correlate with better outcomes. But in investing, the markets are unstable and the rules are always changing, achieving mastery is hard when the environment you operate in no longer exists, it’s a case of what works in one period doesn’t carry over to the next.

For example, if you’re thinking of picking up a copy of Benjamin Grahams ‘The Intelligent Investor’, think again, most of the formulas in it don’t work anymore. Technology has given access to more and better information, therefore anomalies and discrepancies that once existed are rapidly competed away. Furthermore as economies, businesses and markets are continually evolving, what works in one period doesn’t work in another. Over the last decade, Buffett has underperformed the S&P 500; he and other great investors couldn’t repeat their past successes today.

Pareto Principle

And if you’re still not convinced, remember that a tiny number of stocks account for the lion’s share of market returns, and should you be fortunate to select these companies, few of them remain at the top for long. See Visual Capitalist revealing infographic, highlighting the changes in market capitalization of the largest companies over 15 years. The takeaway is that the top companies are continuously changing hands; this is capitalism 101 at work — whereby winning companies succumb to a combination of creative destruction, feisty competitors taking their business or complacency.

All told, your likelihood of becoming the next Peter Lynch, Buffett etc is infinitesimally small. Instead, focusing on controlling your emotions, costs, diversification and asset allocation is the key to improving investment outcomes.

I agree with the premise of Morgan Housel’s excellent book ‘The Psychology of Money’, that — “doing well with money has little to do with how smart you are and everything to do with how you behave.”

I want to finish with an interesting compromise: Ben Carlson, institutional fund manager of Ritholtz Wealth Management admits that he has a small ‘scratch the itch’ stock portfolio with the Robinhood brokerage App, believing it to prevent you from engaging in risky and reckless investments in the larger part of your portfolio, I think this is a novel idea.