The Dumbest Thing I've Heard Warren Buffet Say
gabrielweinberg.com
gabrielweinberg.com
Now that the equity premium is more widely recognized and understood, traders have mostly arbitraged it away. So if present trends continue for the next 92 years then stocks may not return much more than bonds, real estate, commodities, etc. (At least not after you adjust for the actual risk.)
Yes, they are riskier investments. But that is why you buy and hold them for the whole century (or at least as long as you can so the day to day risk smooths out a bit).
Now bonds, on average, grow somewhere near x%, while stocks, on average, grow more than x%. And other things, like most savings accounts grow at less than x%. The reason stocks should grow faster is that they represent money that is being invested in new innovation (often technology), which have generally higher growth prospects than where the bond money is being invested (e.g. infrastructure).
If you look at the economy's growth curve, you can consider it made up of several different curves corresponding to different asset classes, which when summed together in a weighted fashion, yields the overall curve. The stock part makes up more of the growth component than bonds and that is what I meant by makes up a faster part of the growth curve.
This doesn't constitute a trading rule by any means. I'm not talking about any premiums or arbitrage opportunities. In fact, my comment said if the premium is really gone.
All I'm saying is I don't see how the area of study you referenced concludes that bonds as an asset class will grow at the same rate as stocks. And I still don't see it. Please enlighten me.
Note that I am not suggesting stocks outperform bonds on a risk adjusted basis. That's why I ended the comment saying they were riskier, and that, as a result you should buy and hold them.
The overall point here that I suppose I am making is that just because asset classes grow at the same rate when adjusted for risk doesn't mean you should be indifferent to which you invest in. Buying low, selling high aside, if you can smooth out the risk via buy and hold and other strategies, it is wise to invest some in the assets with the higher growth curves.
That's what the grandparent means by "inefficiencies are arbitraged away".
As for equities funding more high-growth areas of the economy - you need to make a distinction between primary and secondary markets for capital. The primary market is where actual, producing firms offer part of their capital structure (either debt or equity) up for sale. This is often associated with entrepreneurs, investment bankers, venture capitalists, and private equity. The secondary market is where financial firms trade securities of existing companies - hedge funds, mutual funds, and retail investors.
In the secondary market, investors always have the option of bidding up the prices of securities that they really, really want. As a result, it doesn't matter how well the economy does, it only matters how well the economy does relative to how people expected it would do. If people expect the economy to shrink 10% but it really shrinks 5%, stocks (in the secondary market) will jump. If they expect it to grow 20% but it really grows 15%, stocks will crash, even though absolute growth rates are significantly higher. That's why only unexpected earnings have an effect on a company's stock price.
The primary market is much less liquid and hence less subject to arbitrage opportunities. If a company is growing very well, it will be able to charge a higher price for its securities, and the proceeds will go directly to its balance sheet.
So, the fact that high-growth industries tend to be financed with equity rather than debt means a lot for entrepreneurs and venture capitals, but very little for investors in the public markets. For that matter, a number of studies have found that "growth" stocks do significantly worse than "value" stocks, because investors consistently overweight their growth prospects.
However, given your comment, would you suggest an investor invest in stocks at all in a buy and hold strategy (as opposed to merely speculation on the price being low at the moment)?
Buying and holding individual stocks is a bad strategy for a long-term investor. Eventually a lot of those stocks will go to zero. In most cases you'll be better off with a passively-managed index fund which periodically rebalances based on market capitalizations.
Also, I never suggested buying and holding individual stocks. I agree that one should only buy and hold that type of index funds.
As for the relevancy of this discussion, I was just responding to your comments. The original post was just about a dumb argument made by Warren Buffett, and not about equity premiums or any other underlying issue at all. In fact the post closed with This is not a discussion about whether we are actually in for similar, higher, or lower returns. Let's leave that for another day. This is just to say that this argument for lower returns is ridiculous!
That being said, with your belief in the equity premium theory, do you believe there is any scenario where investing in stocks long term (say buy and hold for the century) makes sense?
But this is what I was getting at. You say to buy stocks, in a good index mind you, but you also say they are no better as an asset class when you adjust for risk. So why buy them?
Or do you agree with my point from above?:
The overall point here that I suppose I am making is that just because asset classes grow at the same rate when adjusted for risk doesn't mean you should be indifferent to which you invest in. Buying low, selling high aside, if you can smooth out the risk via buy and hold and other strategies, it is wise to invest some in the assets with the higher growth curves.
What I have done is write a small program which can take a set of allocations for portfolio components and then calculate an expected Sharpe ratio for the whole portfolio by using a Monte Carlo simulation run over hundreds of years using historical returns data. It then uses simulated annealing to do a constrained optimization over the solution space. This is only feasible because there are only about 20 available portfolio components. There are also no capital-gains taxes, transaction costs, shorting or borrowing, all of which keeps things reasonably simple.
Of course historical returns are a poor predictor of future performance. But historical correlation coefficients are a reasonably good predictor of future correlations, which is mainly what I am after with trying to find the best diversification.
Actually at the moment I have the majority in a money-market fund just because I'm trying to time the market and play a hunch. But that's usually a poor strategy and I wouldn't recommend it to anyone else.
This is taking the index numbers at face value. Better assessments of returns using good inflation numbers and incorporating tax liabilities make the picture much worse. http://www.itulip.com/realdow.htm
Finally, the real sample size goes back much farther than 1900. We have good equity price data back into the 18th century. 80% market crashes were common. Overall returns were not good.
Stocks were cheap in 1980. Then they soared in price for 20 years. Now people are slow to realize that period was exceptional. Investing is about "buy low, sell high" not "stick your money in stocks." Stocks are high. The smart money bought commodities in the early 70s, changed to bonds in the early 80s, changed to stocks in the early 90s, and changed back to commodities in the early 2000s. That smart investor has absolutely crushed an equity fixated investor. This isn't rocket science, either. It's not that hard to review asset classes once a decade and figure out what's very cheap and what's expensive.
Where will it flow next? Probably wherever it isn't this time.
Right now commodities (a.k.a. "stuff") is getting the attention, as some have predicted for years (someone's always predicting something for years, until it comes true).
Recently: Tech -> Housing -> Stuff -> ?
A problem for people with money to worry about. ;)
I will say that these trends seem to have followed a 17 year period (on average) during the 20th century. If this remains true america has another 9 years of slow economic growth (and commodities have another 9 years of bull). But we must always beware of the induction fallacy :)
I think his point is-- high percentage growth is easy for small things. It gets harder for big things. Growth curves tend to flatten out.
The question that Buffett is addressing is, "Is there as much potential for growth among these companies (and the economy as a whole) as there was 100 years ago?" His answer is no. While I'm not convinced, I don't think it's a "dumb" conclusion.
In particular, I qualified with Now there may be reasons not to expect similar returns in this century as compared to the last, but this is certainly not one of them. and This is not a discussion about whether we are actually in for similar, higher, or lower returns.
That being said, I agree with your underlying point: bigger things are harder to move % wise. However, when you consider the overall economy, it isn't as clear cut as Google (and Google isn't that clear cut!). There are so many factors to consider, including population growth, rate of integration of certain populations into the "developed world," resource constraints, innovation growth %, etc. etc.
The Dow should increasingly roughly move at a small multiple of the growth of the global economy. So if one says you shouldn't expect the same returns, one is essentially saying that the global economy is going to slow down as a whole relative to the past century. I just haven't seen any compelling evidence for this claim. Sure, I have seen wild speculation and isolated scenarios, but I have not seen any well-thought out arguments that really attempt to capture all the factors in a probabilistic fashion.
The best evidence I have seen is that developed countries tend to have slower growth rates after a certain point. But this is a recent trend, not universal, and of course not perpetually written in stone.
Growth for the entire economy is only limited by our abilities to innovate and find resources (both material and human resources). There is no inherent ceiling. The ceiling on a single company (which makes it's growth rate fall off) is imposed when it saturates it's market and can't enter any new markets, the economy as a whole is fueled by the seemingly endless wants of humanity. In essence, there is always a new market for the economy to enter: the next human desire.
In short, the only way there could be a ceiling on the entire economy is if humans stopped wanting new things. Economic growth is supply constrained (supply of resources and innovation), not demand constrained.
Well, you just stated your ceiling. Material and human resources are both finite. Positive thinking cannot just make that go away.
I guess my point is that the reason high percentage growth is easy for small companies is because they can rapidly expand to fill an existing market that is much bigger than the company. The reason it is hard for big companies is because of market saturation.
The economy as a whole doesn't work that way. It just relentlessly grows with our ability to acquire resources and never-ending human desires.
Even if it doesn't, though, everyone knows that the trick to successful investment is to buy low and sell high. There are still plenty of opportunities to buy low - even with limited risk - in large emerging economies. The U.S. may become a low-risk capital preservation stock and China will become the higher-risk investment stock.
1) Emerging markets tend to be riskier, so if you look at it on a risk-adjusted basis the expected returns don't look as good. What happens to your assets if China has another revolution?
2) As a practical matter, an individual US citizen just can't buy equity in many emerging market companies. Either they aren't listed on US exchanges, or are privately held, or national goverments have ownership restrictions in place. There isn't even much in the way of mutual funds to do it indirectly.
3) The few stocks in the BRIC markets available for direct purchase by individual outside investors have already been bid up to ridiculous levels by dumb money who think they can't afford to be left behind. You may be waiting a very long time to see much significant upside.
Inigo Montoya: You keep using that word. I do not think it means, what you think it means.
Timeless WB wisdom.
I'm willing to forgive him the occasional brain fart.