Why You Can’t Beat Warren Buffett in a Coin-Flipping Contest

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Over the past 50 or so years, Warren Buffett, chairman and CEO of the conglomerate holding company Berkshire Hathaway (NYSE:BRKA)(NYSE:BRKB), has executed what is perhaps the neatest trick in investment history: He managed to beat the market.

We’ll try not to spend too much time gushing, but there are some data that should be put on the table. First, as calculated by Buffett and his team in their 2013 letter to Berkshire shareholders, is the compounded annual growth rate (CAGR) in per-share value of Berkshire stock: 19.7 percent between 1965 and 2013. This compares against a CAGR of 9.8 percent for the S&P 500 over the same period, putting an incredible 9.9 percentage-point gap between Berkshire and the benchmark.

Second, if you measure Buffett’s performance on a risk-adjusted basis — as Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen did in a paper published by Yale University in 2013 called “Buffett’s Alpha” — you’ll find that he not only beat the market but that he did it without making very many risky bets.

After examining the performance of mutual funds that have been around for at least 30 years, the researchers calculated a Sharpe ratio of 0.76 for Buffett, more than double the 0.37 median score of the mutual funds and the 0.39 claimed by the S&P 500. The Sharpe ratio measures risk-adjusted performance and can be used as a way to gain insight into where returns are coming from in a portfolio. A higher Sharpe ratio indicates smarter, or more efficient, investing — that is, more return per unit of risk assumed.

That the Sharpe ratio of the typical mutual fund would lag the S&P 500 isn’t surprising. Fees, taxes, human error, and the fog of war make reliably beating the market an incredibly difficult task, and money managers too often accept too much risk in their search for yield. This reasoning has helped increase the popularity of lightly managed index funds. If the data show that fees et al. erode the would-be superior returns of a managed fund, why bother? Just sit back and enjoy the ebb and flow — or the inexorable rise, depending on perspective — of equity valuations. This strategy is the one that Buffett himself suggests is correct for the vast majority of investors.

That Buffett could actually beat the market over the long term, however, is surprising. Even by Buffett’s own sound reasoning, it’s preposterous.

One of the most endearing things about Buffett is how candid his investment philosophy is and how willingly he shares his thoughts. Case in point: A 1984 issue of the Columbia Business School Magazine, in which Buffett put forward a now-famous coin-tossing conceit and offered a perspective on how “superinvestors” like him managed to execute the trick of reliably beating the market.

The article, titled “The Superinvestors of Graham-and-Doddsville,” was adapted from a speech Buffett gave marking the 50th anniversary of the publication of Security Analysis, a book by Ben Graham and David Dodd that became the value investor’s bible. The theory of value investing was adopted by Buffett and the other superinvestors at the Columbia Business School, where Graham and Dodd taught.

In the article, Buffett draws an analogy between money managers and stock pickers (like him) and participants in a national coin-flipping contest. Buffett said it best, so we highly recommend you read the article yourself, but the analogy breaks down this way:

Imagine you get 225 million people (the approximate population of the U.S. at the time) to participate in a coin-flipping contest. Each person bets $1 and flips a coin. “If they call correctly, they win a dollar from those who called wrong. Each day the losers drop out, and on the subsequent day the stakes build as all previous winnings are put on the line,” Buffett wrote.

With the rules and players in place, we can start to play the game. On day one, 225 million people flip a coin and approximately half of the players fall out of the game. On day two, the same thing happens. Ten flips in and you’ll have approximately 220,000 people with $1,000.

“Now this group will probably start getting a little puffed up about this, human nature being what it is,” wrote Buffett. “They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.”

Ten more flips will reduce the pool of contestants down to just a lucky 215, each with more than $1 million. America has produced enough eccentric millionaires to know that sometimes, it’s the money that comes first and not the crazy.

“By then,” Buffett writes, “this group will really lose their heads. They will probably write books on ‘How I Turned a Dollar into a Million in Twenty Days Working Twenty Seconds a Morning.’ Worse yet, they’ll probably start jetting around the country attending seminars on efficient coin-flipping and tackling skeptical professors with, ‘If it can’t be done, why are there 215 of us?’”

The punch line here is, of course, that “if 225 million orangutans had engaged in a similar exercise, the results would be much the same — 215 egotistical orangutans with 20 straight winning flips.” The analogy isn’t perfect, but it is illustrative and describes a random-walk theory of the market and investing that many prescribe to. If the conceit ends here, then Buffett and the superinvestors of Graham-and-Doddsville simply had the good fortune to be one of those 215.

But if this were true, then (to extend the metaphor) an observer would not expect to find a concentration of winners who all came from the same town. But this is exactly what happened. “I think you will find,” Buffett wrote, “that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village,” that being Graham-and-Doddsville. “A concentration of winners that simply cannot be explained by chance can be traced to this particular intellectual village.”

Buffett is often critical of “stock pickers,” but there are some general policies that he has put forth over the years that can help guide any investment decision. We took a look at some of these policies a few weeks ago — here they are.

1. Invest within your circle of competence

Investors think that they can outsmart the market by finding the next big thing. Whether it’s social media, 3-D printing, or rare earth metals, it is incredible how a few news stories and stock price increases can create an entire group of people devoted to a particular sector of the economy. But at the same time, these people probably don’t know much about these sectors. Do retail investors honestly know how a 3-D printer work, or how a computer chip works? Probably not. But that doesn’t stop them from buying 3D Systems (NYSE:DDD) or Intel (NASDAQ:INTC). While they may make money, they won’t do so because they understand their investments.

Buffett’s response to these investing frenzies is to invest in what you know. While you probably don’t know how a computer chip works or why Intel makes computer chips that people want to buy, you probably know, for instance, why Coca-Cola (NYSE:KO) is such a popular drink: It tastes good and the company has exceptional marketing. Thus, Coca-Cola falls within your circle of competence even if you don’t know the company’s secret formula. All you need to know is why the company is successful, and you can postulate with relative certainty that this success will continue into the future.

Investing in companies that make simple products that you understand may be boring, but it is a winning approach that can generate a lot of value over time.

2. Buy wonderful companies at a fair price

The full saying is that it is better to buy a wonderful company at a fair price than a fair company at a wonderful price. When you are investing, you find value not just by looking at the numbers but by looking at intangible features as well such as management. A company that is well managed and that has a reputation for providing a quality product is worth more than a company lacking these qualities. The former company is positioned to take market share from the latter, and it is better positioned to withstand economic weakness. As a result, from a long-term perspective, it is better to pay a higher price-to-earnings ratio for the shares of a high-quality company than to pay a low price-to-earnings ratio for a low-quality company.

3. Be greedy when others are fearful, and be fearful when others are greedy

Once you have decided which companies to buy using the first two pieces of advice, you need to know when to buy them. As with anything else you buy, you want to get a good price. However, the market fluctuates wildly and frequently, and this adds an emotional element to investing that this piece of advice helps you avoid. When stocks go down, people often assume it is for a reason (i.e., the downturn is justified). Similarly, when a stock rises, people often assume that it is because the company is improving. But market price fluctuations do not have any necessary correlation to a company’s fundamentals. As a result, you want to pick out companies to buy and then wait for the hit prices that you feel make them worthwhile investments.

This piece of advice depends on the first two mentioned. You cannot be confident in buying a falling stock, especially if it goes down even more after you’ve first bought it, unless you are confident in the company’s underlying business. For this to take place, you need to understand how and why the company makes money, how and why it will continue to make money, and what makes it such a great company. If you can figure this out, then you can have the confidence to buy when there is proverbial blood in the streets.