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Why Warren Buffett Is Wrong About Passive Investing

We all heard it as kids. And we’ve all said it as parents: Do as I say, not as I do.

That seems to be billionaire Warren Buffett’s attitude when it comes to investment advice. For years, the beloved Sage of Omaha has urged investors to take a simple and passive approach; to buy index funds and reap the rewards of the market’s long-term overall upward march.  But that’s not how Buffett invests his money.

Warren Buffett is a famously active investor, which means he regularly buys and sells individuals stock in pursuit of gains that surpass the market’s performance. Specifically, Buffet looks for stocks that are undervalued and poised for growth.

Buffett took this approach from his mentor, Harvard Business School professor Ben Graham. Graham used P/E, Price to Book and dividend yield to ferret out stocks that he believed were undervalued by the market. Holding such equities for at least five years is a powerful way to generate returns, Graham believed. Once a stock has grown to a value reflective of the company’s performance, it’s time to sell it, reap the gains and find another undervalued share.

How has that system worked out for Buffett and like-minded investors? Let’s look at the results of the S&P 500 vs. owning only the bottom 20% of stocks on a P/E basis from 1968 until 2012. We’ll assume that you owned that bottom 20% for five years then switch to the latest batch of under-valued shares.

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In every one of those five-year cycles — 68-72, 73-77, 78-82, 03-07, 08-12 — the basket of the lowest 20% P/E won outperformed the S&P.  During that span, the S&P 500 index averaged a very respectable 9.5% —  $100,000 would have become $5.9 million. But the “value” approach averaged 15.1%. How big a difference does that make in terms of dollars? $100,000 invested using the Graham/Buffett system would have turned into $57 million.

So, why isn’t everyone using this approach? Because it’s demanding. Active investing requires a great deal of time, passion and attention. Not all investors want to make that sort of commitment. But of more significance, active investors must have a certain level of emotional fortitude. You have to be in for the long haul, even when things get rough. In that 1968-2012 timeframe there were several serious downturns -19% -46%, -34%. Investors who grew afraid and bailed during those tough times missed out on the long-term prize.

All of this bolsters my long-held belief that the best way for the average investor to maximize their return is to create a portfolio that holds a mix of both passive and active mutual funds and ETFs. The active funds offer the chance to make hay on under-valued and higher-risk stocks without the investor having to immerse himself in the intricacies of individual companies and equities. Such a portfolio should, of course, reflect its owner’s particular tolerance for risk.

As to why Warren Buffett says one thing and does another. I don’t know. Go ask your mother.

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