Book of Wise Investors » Warren Buffett Wisdom

Deciding between actively managed mutual funds and passive index funds

wiseinvestor — Sun, 18 Apr 2010 04:21:32 +0000

We have been told by the high priests of finance about the importance of investing of future and not saving only, so as to beat inflation. We are also told that even professionals find it tough to time the market, let alone ordinary people like you and I. Put out any charts for the past 40 years for returns on various assets classes, chances are equities brings the highest return over a 40 years period of all assets classes. The conclusion is that we should invest in some actively managed mutual funds/unit trusts with high transaction fees, high load fees and high expenses ratio etc, and let our money managed by so called professional fund managers for greater returns than the markets.

Warren Buffett’s million dollar charity bet

During the year 2008, Warren Buffett famously made a million-dollar bet with a fund that consisted of hedge funds, net of fees, an S&P500 index fund will beat the expensive hedge fund over the next 10 years. The winner can decide which charity the one million dollars will be donated to.

It is a well known fact that the sage of Omaha once rejected a $2 bet in a golf course when the odds are not in his flavor, what caused him to have such a high conviction that most actively managed mutual funds, not only hedge funds will do worse than the markets in the long run like 10 years?

Bill Sharpe, a Nobel laureate, wrote a very common sense paper in 1991 that the average dollar invested in the stock market from all the investors will equal the market’s return minus expenses. This is a simple mathematical fact, the conclusion that the market must equal itself. Think about it, if MacDonald is still there 10 years later, any exchanges of its shares among investors during these 10 years will not and does not affect the underlying economic profits of its businesses. The price of Macdonald’s stock 10 years later depends on what investors are willing to pay for it 10 years later regardless of how many exchanges done between investors themselves during these 10 years – the market must equal itself.

In almost every marketing message of actively managed mutual funds, there is always this message of “long term investing”, however, this is not always what the fund does in reality. The fact is that if the fund will to do better than the market, the fund managers cannot simply buy and hold, in doing this, the funds will most probably achieve market returns, and then you don’t really need their expensive services. You can buy and hold on your own. As a result, they need to constantly trade securities. However, this will increase transactions costs, though their costs of buy and selling stocks are less than what we paid through brokers. This results in turnover of more than 100% in any one year when they tell you about the benefits of “long term investing.”

But how can your fund manager beat the market when fellow fund managers are also as smart as your guy?

The conclusion is that the reality of the funds contradicts their marketing messages of “long term investing.” And when you trade too much, you are subjecting yourself to Newton’s fourth law of motion, which states that returns decreases as motion increases. (Be it an average person or a fund manger with state of the art software and Bloomberg terminals)

Next look at all the costs associated with an actively managed mutual fund, initial fees, management fees, expense ratios, A much higher return is required to be generated by fund managers given that after paying so much costs, I think one cannot expect just a positive return that is around the same as bank fixed deposits, nor even market returns (as you may as well invest in index funds).

The problem is that actively managed mutual funds need to generate a 50% more return than the market just to give a decent return, as need to deduct all the initial and ongoing costs. For example, if only got 10% return, net of costs, most probably the return is less than market, though still a positive return. Anything less than maybe 6% return of the fund means that you have made a lost investing in it.

Any return less than that means that one will be better of investing in passively managed index funds.

You can look at historical returns of some mutual funds/unit trusts in Singapore and United States to justify what I said.

Of course, this is inconclusive that every active managed and high cost mutual funds will do worse than the market but the odds are there given the causations and what history tells us.

Assume the following for a fair comparison,

1. Using a holding period of 5 years

2. The mutual fund/unit trust has an initial charge of 6% and annual fees of 1.5%.

As you can see, the professional fund manager needs to achieve average return for these 5 years of 7.5% to match market’s return or investor’s return of 5%, which is around 50% better.

What are the odds of that, coupled with all that I mentioned?

In the next post, I will further elaborate on market cycle investing using index funds rather than buy and hold until cash out 40 years later. This will significantly increase returns than just simply buy and hold index funds.

Look for certainty when investing in stocks

wiseinvestor — Sun, 11 Apr 2010 08:44:00 +0000

“I look for businesses in which I think I can predict what they’re going to look like in ten to fifteen years’ time. Take Wrigley’s chewing gum. I don’t think the Internet is going to change how people chew gum.”

People say that investing is risky. When they hear the word – invest, they usually think that it is another synonym for gambling. While there are two words that mean the same thing in English Language, investing and gambling definitely do not mean the same.

There is no certainty in gambling; only increase the odds in your flavor using Kelly Optimization Model and stay in the game long enough to reap its rewards, as in Blackjack and Poker.

While there is not much opportunity to tilt the odds in your favor on casino tables, there are many when it comes to starting own businesses and investing in various asset classes. In other words, the risk in investing is inversely proportional to the amount of research and other types of work performed to reduce uncertainty. If you know what you are doing, there will be discoveries of many high probability events for you to bet high. What happens when you only bet on high probability events and over a long time such as over a lifetime, is that there is a statistical certainty that you will reaped the positive expected return.

There is certainty in investing, properties in some areas certainly go up 10 years later, same for certain stocks also. How do you identify them in the first place?

The Internet may change a lot of things, but it sure do not change the way people have sex, do not change how people smoke, do not change how people drink beer and what brand they drink, do change a need to shave in the morning, do not change the need to wear underwear, do not change the need to have insurance, do not change how people chew gum.

Some products will almost be there 10 years later and so do the businesses producing and selling them. If the same companies will still be selling the same things in 15 years down the road, their earnings will also be there. The good news is, you don’t really need a crystal ball to see the demand that is satisfied by some businesses in 15 years time.

In addition, if the products did not change much, unlike General Motors or even Apple which need to consistently introduce new products, then the companies involved can save all the research and development costs, retooling costs etc.

Remember not only these products become their target markets’ needs already; their brands have also own a piece of their minds. Certainty of revenue is equal to certainty of their loyalty to those brands and needs. There is certainty in change, though someone said that the only constant is change.

Why the stock markets are not efficient 100% of the time

wiseinvestor — Sun, 28 Mar 2010 02:52:24 +0000

“I’d be a bum on the street with a tin cup if the markets were efficient.”

In both academic environment and investment world, there is this efficient market hypothesis which states those stock markets and any other prices on traded assets like bonds and property is also efficiently changes to reflect the true value of the assets. But there are a number of reasons why stock market is always inefficient and why it will remain so in future.

1. 90% of trades, buying and selling is done by institutional investors

These institutional investors include banks, insurance companies, pension funds, mutual funds and sovereign wealth funds.

Depending on the specific institutional investors, for example, actively manage mutual fund especially, as they need to achieve higher than market returns, and higher than other mutual funds returns in order to justify their high commissions and expense charges, they cannot simply buy and hold investment grade blue chips and then do nothing. In fact, by doing so, it will usually only achieve market returns.

As a result, they need to buy when market is going up and sell when market is going down so that annual returns will not look so bad when compared to other mutual funds company. As they controlled billions dollars of assets, a slight change in stock price means that it will either look very good on paper or look very bad.

In addition, when once in a century financial crisis occurs, ordinary small files need to cash out on their mutual fund holdings, but they cannot sell toxic assets because no one wants to buy, so they can only sell investment grades blue chips.

As you can see, this is one reason why stock market will never be efficient, at least some of the time.

2. Short term earnings are used to gauge value of assets, particularly stocks.

Unfortunately for both individuals and institutional investors, what the companies involved expect to earn in one year time, at most five years time, is used to gauge the value of the stocks and not what the businesses are going to earn throughout its lifetime.

The classic example to illustrate this is Warren Buffett purchase of Washington Post Company for $10 millions dollars in 1973 when Wall Street sells it at this price. Wall Street believes that this company will not achieve good earnings for the next year and their analysts are right, Washington Post Company really did badly for the next year but not for the next 30 years.

3. Not every investor is of the same breed

When stock market hits a new high, one can hear students and housewives dabbling in shares. But they most probably were willing to pay $10 millions for a company that is only worth $1 millions simply because they buy when they saw that the price is going up.

Experts in technical investing buy a few lots of shares for a different reason why people like Peter Lynch and Benjamin Graham buy the same shares. What technical investor sees as cheap, Peter Lynch and Benjamin Graham may see the same stock of that price as expensive, simply because based on some candlestick charts, the price is still low.

4. Fire sale of assets when something happen to the owners

If the only son of a billionaire with $1 billions of wealth is kidnapped and kidnappers demand a ransom of $500 millions, then he needs to fire sale his assets to raise money to redeem his son.

Fire sale of assets means cashing out assets like stocks and properties within a short period of time and get substantially less cash than what it is worth.

Or maybe some sovereign wealth fund loses billions by investing in western banks; it needs to sell off national assets to make it look good on paper to its citizens.

“As far as I am concerned, the stock market doesn’t exist. It is only there as a reference to see if anybody is offering to do anything foolish.”

What is investing and what is not investing

wiseinvestor — Thu, 04 Feb 2010 11:21:29 +0000

“We believe that according the name investors to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic.”

Perhaps to some older generations, investing = gambling for them. That’s what you learn from in Hollywood anyway, looking at bickering screens of stock prices and talking to some people on phones at the same time. It is a mistake and a tragedy to assume that investing in stocks or any other things is equated to gambling, especially from both dramas and movies, when stories of people ended up bankrupt by playing with stock market are being told over and over again. But one can only become bankrupt from “investing in stocks” by involving in contra-trading and not using cash to invest.

We are told by mutual funds and unit trusts companies to buy and hold for long term when it seems that the fund managers are involved in trading madness. A common strategy to them is momentum investing – buy and sell shares when it is rapidly rising and falling in prices. Whenever there are changes in interest rates, quarterly earnings and prices, they started to buy and sell. All this is for the purpose of being the fund with the highest returns for that year so that public invests their money with them.

“We do not have, never have had, and never will have an opinion about where the stock market, interest rates, or business activity will be a year from now.”

Investing in stocks is like buying partial ownership in a business and watching it grows in revenue, earnings and profit margins over the years. Definitely not guessing direction of stock’s price based on some variables.

Then how Warren is able to make billions without any indications of stock market and interest rates direction?

The reason is simply because everyone is interested in what the price of the stocks at most one year from now, where interest rates is going to be within the year and how it is going to affect stock prices. When most people sell great businesses with great economics at a low price due to momentum investing, Federal Reserve raising interest rates etc., Buffett is waiting to buy them.

Buffett instead focus on the long term economics of the business underlying the stock, whether it has substantial competitive advantage and most importantly, whether they are undervalued. Stay with this thinking long enough, one day, you may acquire a portfolio of outstanding companies that will make you far richer than shifting in and out of stocks.

Acquisitions of knowledge and asking good questions and innovations for gaining wealth

wiseinvestor — Sat, 10 Oct 2009 15:02:40 +0000

“Someone is sitting in the shade today because someone planted a tree a long time ago.”

This verse is by the Sage of Omaha but is actually similar in words and meanings to an old Chinese saying.

Advances in science and engineering depend very much on concepts and knowledge generated by previous pioneers in the respective fields. Albert Einstein once learned Newtonian Mechanics before coming up with the ideas in General and Special theory of relativity that revolutionizes the whole of Physics.

When an inventor set out to invent a certain thing, he don’t start to go about the process of inventing without searching through the patent office to see whether similar thing has already been invented. Similarly, it is better to learn business and investing lessons from financial legends than to research and develop new principles yourself only to discover that the hard work has already been done by others before you.

Isaac Newton once said that it is only by standing on the shoulder of giant that I can see further. This precisely summarizes why before setting out to achieve a specific goal, it is best and wise to first learn how others have done earlier, even if their thinking and methods are not good enough.

If acquiring previous concepts and knowledge is standing on the shoulder of giant, then asking good questions after having the concepts and knowledge is the binocular that enables you to see even further.

Why is it that Albert Einstein can come up with ideas that revolutionizes Physics while most others don’t?

Because he ask, will the speed of an object with mass exceeds the speed of light, if kept on increasing the force exerted on it, since there seems to be no physical limitations based on the famous F=ma equation.

He also asks, among others similar questions, will I see myself in the mirror if I ride on a beam of light?

As you can see, standing on the shoulder of giant is not good enough to see further, you still need a binoculars to assist you to see further, and that binoculars is asking good questions.

In fact, there is an underlying reason why the mortar boards for bachelor and master degrees are square while that for doctoral degree is round. In the acquisition of knowledge and concepts in any field up to master level, one is learning and to accept what pioneers in that field have created previously. As such, one need to learn and accept whatever is being taught and solves problems using “correct” concepts during examinations, thus becoming square in thinking. For example, if someone uses Einstein’s equations to calculate force instead of Newton’s Second Law before in the years before Einstein came up with General and Special theory of relativity in college entrance examinations, he will most probably never make it to college even though it is more correct in physical reality.

Image Credits: carbonnyc

The interesting thing came after acquisitions of necessary knowledge in a field is complete, when one has to let go of previously accepted notions that lead to square in thinking to continue the mental evolution in that field. To do that, we have to realize that the world is round, that everything is connected to everything else. It’s those who explore completely unrelated areas of life and knowledge who best see that everything is related. Doctoral studies is creating new knowledge and advancing the field, to do that, one must let go what is learned previously, realizes that some things are still not perfect yet. There is a need to let go a bit if concepts regarding that field, become less square in thinking, hence the round shape in mortar board for doctoral degrees. Nobel Prize is not given to first class honors but to someone who come up with some innovations and “conferred the greatest benefit on mankind” at the same time.

It does not matter whether Albert Einstein got an IQ equal of a genius or equal of a retarded, if he cannot let go the commonly accepted notion and common sense notion that time is absolute, he can never come up with Special and General Theories of Relativity.

This post is quite long, before reading, pause and listen to the music below as you go along.

Bruce Lee first learned Wing Chun, but felt that traditional footwork of Wing Chun is not good enough, in which he later burrowed footsteps from Cha Cha dance and fencing to further improves on it. While the classic Wing Chun attack and defense is very useful, powerful and effective for fighting with opponents within 5 meters distance, it lacks techniques for longer range attacks which Bruce Lee later incorporates techniques from other martial arts styles in his Jeet Kune Do. His Jeet Kune Do launched a new discipline known as mixed martial arts.

Buffett do not stop at Benjamin Graham form of value investing, but went on to further the art of investing. Despite Coca-Cola shares are trading at 20 times earnings, he still decides to go ahead and purchase them as it is a fair price for a great company. Benjamin Graham is more of advocating buying stocks that trade at less than their net assets values, without regards to their qualitative analysis. One day, Warren Buffett wakes up and realizes that simply depends on book value is not good enough, then with influence from Charlie Munger, he makes a slight change in his investment philosophy, that is, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Buy a wonderful company at a fair price = buying Coca-Cola at 15 to 20 times earnings

A fair company at a wonderful price = buying a company at less than their net assets values

However, he does kept the concepts of buying below intrinsic value and margin of safety, in a similar sense that Bruce Lee kept the classic Wing Chun moves within 5 meters of opponents when fighting. There is a need to continue progress in field that one pursue, but progress does not mean doing away with what the pioneers had done, neither does it remain stagnant and not improving. Nevertheless, the first thing is still learning previously created knowledge first, that is become square in thinking before learning to let go and become round in thinking.

“All kind of knowledge, eventually becomes self knowledge”

Bruce Lee

One way to interpret this profound statement is almost every piece of knowledge from everywhere applies to you or your specific specialized profession, work and business. It is just that you have not seen the connection yet.

Where you get things from other fields to become self knowledge and applying it to own domain of specialized fields – by reading and other means like communicating with others of course.

Accepting responsibility or rationalize away the mistakes

wiseinvestor — Thu, 30 Jul 2009 03:17:17 +0000

“When ideas fail, words come in very handy.”

This is actually originally by Goethe. You can see very good illustrations of this verse in the words of Lehman Brothers CEO.

The real meanings behind these words are that if your decisions result in not achieving required outcome, then there are many explanations in your head about why things don’t turn out as originally intended and it is not your fault.

When ideas fail, recognize that the ideas are not good enough or not very complete. Recognize that some concepts and data are left off your radar when making decisions regarding investments at that point in time when you make those investments.

Do not use words to justify why you are in no wrong, as it is most probably the ideas/concepts/knowledge/data are not complete and/or does not really apply for those circumstances.

Explanations are faulty, there is always a way to explain why white is black and why black is white.

In business environments, there will always be Lehman Brothers CEO who can justify that they do no wrong and you will be surprised by their creativity. Words can cork up great excuses why one is not incompetent.

Do be on the lookout for signs of such CEOs, when looking over the financial statements of public listed companies and never to touch it until he left the job.

http://www.telegraph.co.uk/finance/financetopics/financialcrisis/3150319/Richard-Fuld-punched-in-face-in-Lehman-Brothers-gym.html

On hiring talent based on IQ and academic qualifications only

wiseinvestor — Mon, 20 Jul 2009 07:15:14 +0000

“You have to think for yourself. It always amazes me how high IQ people mindlessly imitate; I never get good ideas talking to other people. “

One does have to learn and model the success strategies of others successful in your field but beyond that, you still have to think for yourself.

The reason why giants like Lehman Brothers, Merrill Lynch, Citibank, Bear Sterns, Freddie Mac and Fannie Mae, Goldman Sachs, Bank of America and AIG collapsed, (if not of bailouts for some) is simply because the talented people working there are smart not to say something that opposes the view points of their bosses.

It does not take an IQ of above 160 to see that by mentioning and insisting that buying into toxic assets will be detrimental to the company well being in the long run, the first class honors in finance or whatever field from Harvard or MIT is going to get fired from his boss for not sucking up to him.

So what if the company is doing well in the long run if you are already fired?

They are smart enough to know that simply by staying on to the job and be a yes man means that they can get high pay for simply being a graduate of Harvard and MIT. It takes less effort to mindlessly imitate also.

All are high IQ people with excellent academic qualifications from top universities gathering at these banks, as a result, they believe that they are so good that they can do no wrong.

King Solomon does not ask for a high IQ, he asks for wisdom. What is wisdom anyway?

I don’t have a complete answer, but definitely a wise person knows what he knows and don’t know and nobody knows everything. Companies with all “talented” people may end up thinking that they know everything and will not fail.

When to buy a business and then hold on forever

wiseinvestor — Wed, 01 Jul 2009 01:47:23 +0000

“There is a huge difference between the business that grows and requires lots of capital to do so and the business that grows and doesn’t require capital.”

When you hear mutual fund companies advising to buy and hold so that can reap the almost guaranteed returns from stock markets 40 years down the road, what they did not tell you is that their so called professional money managers actively engage in short term trading so that fund A can beat fund B in annual returns.

When should you really buy and hold on for a long time, almost forever?

It is obvious to most that not every stocks (or businesses) can buy and hold on forever, not even well known giants like Lehman Brothers. The key is the nature of the company behind.

The key difference behind whether companies that can hold on forever and one that do not is simply whether it needs significant capital to grow. The logic behind it is very simple. A business that requires huge capital to grow will eventually need to issue new equity, in addition to debt, to finance its operations. And that will unlikely to enable to let the stock grow in value in the long run.

Millions spend in research and development, changing product design and subsequently retooling means millions are unable to spend on expanding business in new markets, buy new and related businesses, or even buy back own stock to undiluted existing shareholders, in the end, unlikely to even declare dividends to shareholders.

Precisely the reason why Warren spend billions on Coca Cola instead of General Motors which by the way, now has filed for bankruptcy. Automobile companies in general have to constantly spend billions designing new models so that consumers will not buy some other better design from others. After introducing a new design, then need to spend some millions more on retooling the factories. This is in addition to earnings heavily affected during recessions, given the fact that a couple of recessions happen during each decade. In contrast, the same formula that produces coke did not change much between now and 100 years ago. People are also unlikely to give up drinking coke and smoking even during severe financial crisis.

It is highly unlikely that stocks will grow in value in the very long run if its business requires massive capital to grow, funds will just tied up somewhere else.

If a business does not require massive capital to grow like Coca Cola, retained earnings will just pile up and make both the management and shareholders rich.

As you can see, not every stock can grow in value if you hold on forever.

I’ll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.

On relations between writing and thinking

wiseinvestor — Wed, 24 Jun 2009 10:18:45 +0000

“There is nothing like writing to force you to think and get your thoughts straight.”

This is by far my favorite quote of Warren Buffett and by far the greatest insight from him.

Buffett has a habit of filling up at least one A4 page of paper with reasons why he wants to invest billions in this company. Thomas Edison has a habit of documenting his thoughts to help him to think, to increase his persistence.

The fact is that if you cannot articulate clearly in own words about something, that means you did not really think about it and just follow other people’s conclusion about the same thing. How can you say you understand about a business when you cannot describe in words how the business operates?

Few people ever know that writing and thinking are intrinsically linked.

Because of the fact that a normal human mind can only hold one conscious thought, when people says that they can make good decisions regarding major issue like dumping more than a few thousands in a single investment in a matter of seconds, the same person usually regret those decisions. This is simply because he usually decides it based on one variable when there are many variables that one needs to consider.

How many thoughts can you hold in your mind right now?

Writing about something literally forces you to think about it rather than blinding accepting opinions of others. It lets you see clearly what concepts, knowledge and data you draw on when analyzing an issue and reaching a conclusion, you can also see clearly if the same mental models are not really applicable in a particular context, you can see the flaws in own logic, you can see unwarranted assumptions, you can also see the flaws in the arguments of others.

As you can see, writing about train of thoughts can very much fine tune own thoughts and leads to better thinking in future.

It has been said that a fool and his money is soon parted.

Let’s fact it, you are going to hear a lot of advices from other people, friends, family and agents. Either well meaning or not really so most of the times, or rather, words by others are more in their best interests but not in yours.

As a result, you need to think for yourself. And to think better, pen down your thoughts on paper.

The world’s greatest investor uses writing to make better investment decisions, perhaps you should too, be it in managing own finances or other issues in life.

“I never buy anything unless I can fill out on a piece of paper my reasons. I may be wrong, but I would know the answer to that. “I’m paying $32 billion today for the Coca Cola Company because…” If you can’t answer that question, you shouldn’t buy it. If you can answer that question, and you do it a few times, you’ll make a lot of money.”

Learning from own and other people’s experience

wiseinvestor — Wed, 17 Jun 2009 02:52:50 +0000

“You want to learn from experience, but you want to learn from other people’s experience when you can.”

Which is wiser?

Screw up everything and then learn from own mistakes or observe both the failure and success stories of business and investments of others and learn from their mistakes.

While experience is a better teacher than books and professors with first class honors, it can get very expensive if you are only learning from own mistakes.

If you learn that people get burnt when buy shares during a bubble period, you don’t do the same thing yourself so as to learn the same lesson from own experience.

Business schools here, there and everywhere only study success stories of businesses around the world. But in real life outside academic environments, one need to learn not to do what, in addition to what is essential for success in business, investing as well as in life.