Warren Buffett isn’t called The Sage of Omaha for nothing. The affable billionaire is undoubtedly one of the best investors in the world. Over the past ten years, his belief that it’s better to invest for the long-haul instead of trying to time the market has proven effective time and time again.
The latest evidence in support of Buffett’s philosophy came in the form of a wager between Buffett and hedge fund managers at Protégé Partners. The 2007 bet was simple: Buffett believed that, over a ten-year period, his S&P 500 index fund would outperform a selection of hedge funds. He put his money where his mouth was – to the tune of $1 million.
While Buffett officially “won” the wager just this year, he repeatedly said during 2017 that he was confident he would prevail. During the ten years of the bet, the S&P 500 index fund returned 7.1% compounded annually. Conversely, the basket of funds selected by an asset manager at Protégé Partners returned only an average of 2.2%.
“My guess is that doubling down on a bet with Warren Buffett for the next 10 years would hold greater-than-even odds of victory,” Ted Seides, a founder of Protégé Partners, wrote in a concession piece on Bloomberg View in May. “The S&P 500 looks overpriced and has a reasonable chance of disappointing passive investors.”
Wow. This is quite the story and one that highlights something I’ve talked about before – the active versus passive investing debate.
What I think is interesting, particularly in Seides’ statement, is that he classifies what Buffett did as “passive.” But is it really? My answer is no.
In investing, there is no such thing as a purely passive approach. Instead, there are just various shades of active investing. Let’s say an investor (like Buffett) chooses to hold the S&P 500 index fund. While widely regarded as a passive strategy, this investor is actively choosing to hold only U.S. stocks. This is an active decision to only invest in about 10% of the world’s more than $240 trillion investable marketplace, which includes U.S. small- and mid-cap stocks, the U.S. bond market, and international markets. Similarly, any approach that uses multiple passive vehicles (such as index funds and ETFs) is, by nature, an active strategy.
So, don’t believe everything that you read in the headlines. The Buffett-Protégé Partners bet was not truly a match of pure passive investing against pure active investing.
Instead, it was more of an illustration of what can happen when you jump in and out of the market, trying to time things just right.
Many investors engage in such “market timing.” That’s understandable. Say our index fund goes down when the market dips due to a poor jobs report. We see ourselves losing money on paper, and our natural reaction is to do something to minimize any additional losses. After all, our money is hard earned, and we don’t want to let any of it slip away. But, selling out too soon could be a costly move.
Empirical data from Dalbar, Inc., an unbiased outfit that analyzes market and investor behavior, shows that the majority of individual investors have little tolerance for dramatic market moves. This point often leads to ill-timed buying and selling, otherwise known as poor “market timing.”
Still, greed can get the best of us. We all want our investments to do well, and it can be frustrating to feel like everyone else is running a faster or better race. If most folks are having a 10% year, and you’re having a 3% year, it’s natural for a sense of frustration to set in. “Why am I not earning 10% as well?”
But investors must ask themselves two questions. Is what everyone else doing realistic for me? Are the risks involved worth it for me?
Rarely have I met an investor who has just ridden out the full ups and downs of owning one index fund through an entire market cycle; the emotional reality of this approach is almost always too much to bear.
Active investing allows investors to have better control over their individual risk tolerance. For instance, most investors are better suited to employ a broad array of low-cost index funds, low-cost active funds, and ETFs that cover several different investment categories, while considering their particular tolerance for risk.
This strategy results in a balanced portfolio somewhere on the passive-active continuum. And when we use any mix of passive funds to accomplish a balanced portfolio, we have entered the realm of active investing. So, as for purely passive investing, I say forget that notion. Focus on your particular needs and risk tolerance, and you’ll be as active as you need to be.