Key Points:
- The Power of Passive Investing: Warren Buffett’s bet demonstrated the strength of passive investing over active hedge fund strategies.
- Lessons from the Great Recession: Despite an initial setback during the 2008 recession, the passive strategy proved its resilience and long-term effectiveness.
- Empirical Support: Burton Malkiel’s “A Random Walk Down Wall Street” provides empirical evidence of the unpredictability of stock prices and the inefficiency of active management.
- Insights from Yale’s Success: David Swensen’s “Unconventional Success” endorses low-cost index funds and diversification, backed by Yale’s endowment fund’s impressive returns.
- Purpose Built’s Investment Philosophy: Aligning with these insights, Purpose Built focuses on low-cost passive index funds, annual rebalancing, and a long-term perspective for steady growth.
Introduction
In 2007, Warren Buffett laid down a million-dollar challenge that would reverberate through the financial world, affirming the power of passive investing. He bet that over a decade, a simple S&P 500 index fund would outperform a selection of any five hedge funds selected by anyone willing to accept the bet.
Unfortunately for Ted Seides, a founding partner and hedge fund manager of Protégé Partners, he accepted the bet but delivered a profound lesson in the process. His loss is not just a vindication of passive investment strategies but also resonates deeply with Purpose Built’s investment philosophy.
Buffett’s Bet and Its Decisive Outcome
Buffett chose the Vanguard S&P 500 index fund, a stalwart of passive investment strategies, while Seides selected his five active funds-of-funds.
The bet started very poorly for Buffett since, as we know, the Great Recession decimated the stock market in 2008, with the S&P500 finishing the year down 38.5%. With hedging strategies, the active funds were able to reduce that loss to an average of 23.9% between the five funds.
However, that was the highlight for the active funds. Even with the lead generated in 2008, between 2009 and 2014, the S&P500 outperformed the hand-selected five funds by such a margin that Seides conceded defeat in 2015, two years before the official end of the bet.
The final results were telling. By the end of 2017, the index fund achieved a total gain of 125.8%, significantly outperforming the hedge funds, which showed gains ranging from 2.8% to 87.7%.
Seides paid his $1M, and the proceeds, as Buffet had promised, were donated to charity, emphasizing the benevolent spirit behind the bet.
Supporting Theories and Practical Implications
Empirical Evidence from “A Random Walk Down Wall Street”
Buffett’s triumph in the million-dollar bet finds robust support in empirical research, particularly in Burton Malkiel’s seminal work, “A Random Walk Down Wall Street.” Malkiel argues that stock prices evolve according to a random walk, effectively making it impossible for investors to outperform the market consistently through stock selection or market timing. This unpredictability, coupled with the high costs associated with active management, severely diminishes the net returns available to investors.
Malkiel also discusses various strategies active fund managers use to create the illusion of superior performance. One such tactic is fund merging, where better-performing ones absorb underperforming funds, thus erasing the poor track record and creating an illusion of consistent high returns. He also highlights the problem of survivorship bias, where only successful funds are visible over time while failed ones disappear, skewing performance comparisons.
Insights from “Unconventional Success” by David Swensen
In his book “Unconventional Success,” David Swensen further corroborates the effectiveness of a passive investment strategy. Swensen, the chief investment officer at Yale University, criticizes the mutual fund industry for its inherent structural flaws that disadvantage retail investors. He points out that excessive fees, frequent trading, and overreliance on market timing and stock picking are detrimental to investors’ returns. Instead, he advocates focusing on low-cost index funds and a long-term investment horizon.
Swensen emphasizes the importance of a diversified portfolio and a disciplined rebalancing strategy to maintain the intended asset allocation over time. This approach, he argues, helps investors avoid the pitfalls of market timing and maintain a steady course through the market’s inevitable ups and downs. Swensen’s strategies were more than just academic. They displayed real-world success. Over the 35 years Swensen managed Yale’s endowment fund until his death in 2021, his strategies generated 13.1% per annum returns. The endowment was the best-performing endowment fund in the country, further lending credibility to the passive investment approach.
Purpose Built’s Alignment with Passive Investing
The insights from “A Random Walk Down Wall Street” and “Unconventional Success” converge on several key principles forming the bedrock of Purpose Built’s investment philosophy. First, market predictability is largely a myth, and attempts to outperform the market through active management are often futile and expensive. Second, the active mutual fund industry’s structure often works against the investor’s interest, eroding returns through high fees and frequent trading.
While not exclusively invested in the S&P 500 due to risk tolerance and diversification considerations, Purpose Built’s approach aligns with these insights by emphasizing low-cost passive index funds, annual rebalancing, and a long-term investment perspective. This strategy aims to minimize the costs and risks associated with active management while providing a solid foundation for steady, long-term growth. By adopting this approach, we seek to offer our clients a clear, effective path to achieving their investment goals, free from traditional active management strategies’ unnecessary complexity and costs.
Closing
Warren Buffett’s bet serves as a powerful endorsement of passive investing, a strategy that’s both simple and effective. His victory not only underscores the pitfalls of active management but also aligns perfectly with the core principles of Purpose Built’s investment philosophy. Supported by the research of experts like Burton Malkiel in A Random Walk Down Wall Street and David Swensen in Unconventional Success, the evidence is clear: low-cost index funds, a disciplined rebalancing approach, and a long-term investment strategy consistently outperform more complex, active management approaches.
Malkiel’s work highlights how market predictability is a myth, and efforts to outperform through stock picking and market timing are often futile. Similarly, Swensen emphasizes the structural flaws in the mutual fund industry that make active management costly and ineffective for most investors. Both reinforce the key principles that Purpose Built embraces: minimizing fees, focusing on diversification, and taking a patient, long-term approach to investing.
While Purpose Built does not exclusively invest in S&P 500 index funds due to risk tolerance and diversification considerations, our overall approach mirrors these proven strategies. We emphasize cost-efficient, passive investing, annual rebalancing, and long-term growth—designed to help our clients navigate financial markets with confidence and clarity.
At Purpose Built, we believe that simplifying the investment process and focusing on what truly matters—low fees, disciplined rebalancing, and long-term vision—offers our clients the best opportunity for sustainable financial success.
If you're ready to take the next step toward aligning your investments with these principles and securing your financial future, we invite you to schedule a meeting here to explore how Purpose Built can help you achieve your goals.
Frequently Asked Questions (FAQ)
Q: Why did Warren Buffett choose a passive investment strategy for his bet?
A: Buffett believed in the long-term efficiency and lower costs of passive investment strategies, specifically index funds, over actively managed hedge funds.
Q: How did the S&P 500 index fund perform in Buffett’s bet?
A: The S&P 500 index fund significantly outperformed the selected hedge funds, achieving a total gain of 125.8% by the end of the 10-year period.
Q: What does “A Random Walk Down Wall Street” say about stock price predictability?
A: The book argues that stock prices follow a random walk, making it nearly impossible to consistently outperform the market through active management.
Q: What investment approach does Purpose Built advocate for?
A: Purpose Built advocates for a passive investment strategy focused on low-cost index funds, annual rebalancing, and a long-term view, aligning with the principles shown in Buffett’s bet and supported by academic research.
Q: How did David Swensen’s approach at Yale’s endowment fund support passive investing?
A: David Swensen’s approach, focusing on low-cost index funds and diversification, led to exceptional returns for Yale’s endowment fund, proving the effectiveness of passive investment strategies.
If you have any questions about Buffett’s bet, investing in general, or want to explore how a Flat-Rate Fee-Only structure can help you achieve your goals, set up a time to talk.
Your financial well-being is too important to leave to chance. Choose wisely.
About the Author
Sean Lovison, CPA, CFP®, is a flat fee-only financial planner based in Moorestown, New Jersey, serving clients virtually nationwide. After spending 14 years as a corporate chief financial officer (CFO), receiving and designing compensation plans, he decided to help others navigate their plans.
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