That Time Buffett Smashed the Efficient Market Hypothesis | Hacker News Reader

That Time Buffett Smashed the Efficient Market Hypothesis

thereformedbroker.com

69 pointstacon51 comments

Back then Buffett was pure Graham and Dodd. (This refers to the book "Securities Analysis". The more readable version is "The Intelligent Investor", by Graham. Anybody with money should at least read the latter.) The basic concept is to only buy stocks which are priced lower than the value of the company. Value is based on solid assets, an ongoing profitable business, and some degree of protection from competition. Value investors buy very boring companies. This is, historically, quite profitable over a decade or so.

As Buffett got more money, Berkshire Hathaway became a conglomerate, rather than a fund. Berkshire Hathaway owns outright eight insurance companies, including GEICO, which is where Buffett originally got rich. They own the Burlington Northern Santa Fe Railroad, which is most of the railroading west of the Mississippi. Dairy Queen. See's Candies. Fruit of the Loom. A bunch of furniture chains. Acme Brick Company. Boring, important companies that have been around for half a century or more and make useful stuff, and money.

Berkshire Hathaway doesn't trade much. They just study companies, pick carefully, then buy and hold, forever. They do sell occasionally, as the world changes; Berkshire and Hathaway were US-based textile companies, and that industry is dead in the US.

Here are the last few words of the 1934 Securities Analysis:

More satisfactory results are to be obtained, in our opinion, by confining the positive conclusions of the analyst to the following fields of endeavor:

1. The selection of standard senior issues which meet exacting tests of safety.

2. The discovery of senior issues which merit an investment rating but which also have opportunities of an appreciable enhancement in value.

3. The discovery of common stocks, or speculative senior issues, which appear to be selling at far less than their intrinsic value.

4. The determination of definite price discrepancies existing between related securities, which situation may justify making exchanges or initiating hedging or arbitrage operations.

One minor nit. Burlington Northern Santa Fe Railroad is not "most of the railroading west of the Mississippi". The Union Pacific Railroad is larger, including larger west of the Mississippi.

You're right, of course. UP is bigger than BNSF.

A Joke from A Mathematician Plays The Stock Market (I think):

Two Efficient Market theorists were walking down the street and see a $100 bill lying there. They both keep on walking and one says to the other "If that was real, someone would have picked it up by now."

Funny, but if you think about it... if I had followed that exact principle for my entire life and never picked up $100 bills I saw lying on the street, I think I would be exactly as wealthy as I am now. Even if I never picked up street money at all, it would be pretty close. And I expect I have walked in plenty of places where money has been dropped, but the vast majority of the time, it has been picked up before I can get there.

Add in the possibility of dropped money being booby-trapped, and I figure never picking up street money would be a very sensible habit.

That's funny but there are actually several forms of the EMH.

Strong from: There are no $100 bills on the ground. Semi-Strong: By the time you hear about a $100 bill on the ground someone has already taken it. Weak form: You cannot predictably find $100 bills on the ground.

Another useful way to apply EMH to the real world, especially considering that real world markets are not perfectly efficient, is in terms of asymptotic behavior, hyperbolas, mathematical limits. Paradoxically, Warren Buffett's investing performance, far from being a counterexample to EMH, plays an integral part in the drive towards perfect efficiency. But this drive will never be completed.

It's very easy and common to make the leap from EMH, a purely theoretical construct, to asserting that real world markets are perfectly efficient and must therefore behave as EMH entails. This view is mistaken, and the author merely knocks down a straw man with the Buffett counterexample. Instead, in order to use EMH in the real world, one must first judge the efficiency of the market in question.

The broadest, deepest, most active and open markets are the most efficient, which is why "the stock market" (in the US) is a favorite example and testing ground. The idea is not that it's perfectly efficient but that it's the most efficient we can access. The real question is: is it efficient enough for efficiency effects to dominate? A fair view of the evidence (i.e. not hunting for or cherry-picking counterexamples) suggests that efficiency effects do dominate.

EMH is really about the futility of systematic approaches to achieving excess returns. It was conceived (in some part) as a general refutation to systematic investment proposals. Systems could range in sophistication from always bet on black to virtual Warren Buffett. Only where the system sophistication exceeds (in some sense) the current market efficiency is it able to collect. Soon the unsophisticated have no chips, and the efficiency rises accordingly. The bar is raised, over and over, chewing up new challengers and enshrining champions.

That some real world markets are subject to EMH effects also explains the cliché about the highly paid fund manager who performs no better than a dart-throwing monkey. If you find this idea appealing yet EMH is icky, you should check your priors.

Saying that the efficient market hypothesis is false is like saying that the principle of entropy is false because you can heat a pot of water on your stove. The efficient market hypothesis as a long-term, general phenomenon is consistent with short-term, local arbitrage and other examples of information asymmetry in markets.

P.S. The blog from which this submission comes bears the usual signs of hype exceeding performance. The author's firm was established in 2008, which means it

1) doesn't really have a very long-term record,

and

2) what record it does have was established during a recovery from a worldwide financial shock and depression, an atypical period during my lifetime.

In the long term, all stocks become worthless and the heat death of the universe occurs.

If you can't state a particular time period over which a finance model's prediction should be valid, then you haven't actually made any prediction at all.

The main point of the efficient market hypothesis is that the average investor won't consistently beat the market average.

Also note that most of the people beating the efficient market hypothesis aren't doing the kinds of transactions they are being compared to.

Can you really compare moves like bailing out Coca Cola to buying and selling stocks based on market estimates you derive?

If the efficient market hypothesis is confounded by moves like bailing out Coca Cola, what good is it?

The efficient market hypothesis presumes that you can't affect the performance of the market (except possibly the shirt term price action). Bailing out Coca Cola presumably entails gaining enough control to drive the future directin of the company.

The efficient market hypothesis is also equivalent to the problem of whether P=NP, which to me, is more evidence as to it's likely truth value than this blog :)

Here's Buffett betting that the magnitude of the inefficiency is actually quite small. http://longbets.org/362/

That's actually entirely not what he said there. He said "On average, active investors will do just as well as passive investors, but due to fees will actually perform worse."

That doesn't mean that some active investors are not going to do incredibly well. Some of those active investors will be smart and lucky, and some of them will be very good at what they do.

Efficient market hypothesis does not disagree that some active investors will do incredibly well. It does say that those who do will succeed based on luck rather than smarts/skill.

Also, the efficient market hypothesis is of course not completely true. I take it that Buffett is a good counterexample to the strongest possible form of efficient market hypothesis. However, I also take the fact that there are not many Buffetts in the world as evidence that markets are very efficient.

Buffett, I believe, is a genuine counterexample to EMH. Most other people offered as counterexamples are not; i.e., their results are completely consistent with proper statistical understanding of investment results in perfectly efficient markets.

Actually, passive investors should slightly underperform active investors, before fees. The passive investor will have to buy at slightly above market cost, and sell slightly below market cost to avoid tracking error.

This cost is probably dwarfed by the fees of active investing though.

The set of active investors plus the set of passive investors is the set of all market participants.

If the passive investors all earn the market average, then the average earnings of active investors, before fees, must also be equal to the market average. Since passive investors pay less fees and active investors, the average earnings of an active investors, after fees, must always be less than that of the passive investor.

It looks like you missed Buffet's last paragraph, where he says high IQ hedge fund managers can beat the market, but not by much, and not enough to cover their fees. In other words, that is actually entirely what he said there.

The analogy of the coin-flipping game has one crucial flaw: in the securities trading world, the coin-flips are not independent. At any point, a participant may decide not to flip a coin, and instead make the result of someone else's coin their win condition.

Efficient-market theorists would say "Buffett was good at convincing a lot of people to follow his trading strategy instead of flipping their own coins, and he also happened to be lucky." It would actually be more surprising if the 40 people who won weren't in the same lucky group.

Imagine a drug that beat a placebo in 38/46 trials. It would be approved. Everyone on HN would love an A/B test with such clear results.

Call the drug "Berkshire Hathaway performance" and the placebo "S&P 500 performance" and suddenly it's a coincidence.

Yes, it's called a prior, and there's nothing wrong with that.

Those 46 trials weren't anything like independent.

Buffett addressed this criticism in 1984, when he presented the public records of all of the students of Graham and Dodd it was possible to track: <http://www4.gsb.columbia.edu/null?&exclusive=filemgr.downloa...

The relevant bit:

"So these are nine records of “coin-flippers” from Graham-and-Doddsville. I haven’t selected them with hindsight from among thousands. It’s not like I am reciting to you the names of a bunch of lottery winners — people I had never heard of before they won the lottery. I selected these men years ago based upon their framework for investment decision-making. I knew what they had been taught and additionally I had some personal knowledge of their intellect, character, and temperament. ... While they differ greatly in style... all exploit the difference between the market price of a business and its intrinsic value."

First, there was considerably less access to information in 1984 than now, so the market almost certainly was less efficient. Second, thanks to Fama and French, we now know that there is indeed a value premium. However, the majority view is that it is a risk premium: still useful because it exposes one to different risk than pure market beta, but not a free lunch. (Also it is most likely more efficient to capture the premium using low-cost "tilted" (value) funds, rather than by picking individual stocks and unnecessarily taking on unsystematic risk.)

That seems to address hindsight bias, but not independence.

I frequently see articles on the front page of HN discussing publication bias and how positive outcomes for drug trials are often purely coincidence. Your characterization of the community's perceptions seems to be imaginary.

Is the market 100% efficient? No, certainly. But just because it isn't always efficient, doesn't mean that it isn't monumentally better at advancing the human condition than an economy run by a few central planning bureaucrats.

My knowledge of history shows no such correlation.

Russia and China developed through central planning, and free markets do a terrible job helping other countries develop.

The best outcomes seem to rise through some combination of both central coordination and market-base approaches.

Central planning in the USSR and China led to huge famines with millions of deaths.

And you should check what happened in Germany after the WWII: one country, split in two, one with central planning, other with mostly free market. Guess what was the result 40 years later? Same thing for Korea: one country, split in two, one with central planning, other with free market. The free market country gets western standard of living, central planning gets poverty, stagnation and famine.

The divided country examples of west Germany versus east Germany, south Korea versus North Korea, south Vietnam (an especially poorly governed country, but still) versus north Vietnam, and Taiwan (or Hong Kong) versus mainland China all suggest that free market economies in general do better for all their people than centrally planned economies. The recent economic growth in China resulted from basically relaxing central planning in several keys areas of the economy on the examples of Hong Kong and Taiwan.

Those examples seem to me to illustrate the importance of access to foreign trade, which the central planning economies were cut out of for political reasons.

Since when it buying majority shares in companies anything like "putting money in the market"

Exactly.

Buffet is not a passive investor - he takes an active role in how the company is managed.

I read once -- but cannot remember where -- that a market cannot be perfectly efficient if P!=NP. I'm curious if anyone else has ever heard this and where it comes from.

"Markets are efficient if and only if P = NP"[1]

I read it when it was first posted on HN a few years ago.

[1]http://arxiv.org/pdf/1002.2284.pdf

... and HN delivers. :)

""" Friedman, laureate of the Nobel Memorial Prize in Economics, said: "You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that." Friedman did not believe that the trader should be required to make his trade known to the public, because the buying or selling pressure itself is information for the market.

How about: a theory of eventually efficient distributed markets.

Just an FYI, nobody seems to pick up on this. But in 08 when the market crashed. Mr.Buffet had large stakes in BAC and WFC. Mr. Buffet says that he always studies his purchases so forth and so on. Well in the summer of 08, it wasn't difficult to see the banks where in trouble. (I figured it out, and made $$)

However, Mr. Buffett didn't, even know he always says that he does due diligence. Had the banks not been bailed out by the US GOV in Oct 08, (TARP, low interest rates) we would be having a different conversation about Uncle Warren right now, because his stakes in WFC & BAC would be zero.

Josh Brown is a clickbait / SEO / yahoo groups shill for the market. I don't believe this type of article is of interest to Hacker News. If I want this crap, then I can just click over to cnbc or business insider?

Of course, Buffett did also make a fair amount of money on his $5B purchase of Goldman Sachs preferred stock during the crisis – it paid 10% dividend for a few years, got bought back at a 10% premium last year, and he got a couple billion worth of GS stock by exercising the warrants he got given to sweeten the deal.

Josh Brown works with Barry Ritholz, who's one of the more perspicacious commentators on the market around, so lumping him with cnbc and business insider is really a low blow.

You understand that Josh Brown is on CNBC right? That silly little half time report. http://www.cnbc.com/id/100831613, I'm just going to leave that there for you. But don't worry he is reformed!

Are you seeing how easy it is get lumped in with the CNBC crowd?

Not sure where I side in the larger debate, but on this point it's perfectly plausible that Buffett (correctly) guessed that the banks were safer than they might appear. He may have believed a bailout would be inevitable if things went badly for them.

Are you sure he owned Bank of America before the crash? I know he invested another $5 billion in Bank of America in 2011 and the stock jumped 25% overnight: http://dealbook.nytimes.com/2011/08/25/buffett-to-invest-5-b...

And also:

>Buffett’s paper profit on the Bank of America warrants stands at about $5.7 billion.

From: http://www.bloomberg.com/news/2014-05-04/bofa-forgiven-as-bu...

Buffett's investment to BAC was seen as a vote of confidence and definitely helped keep the struggling company from declining further. I'm not sure where you're getting your facts from.

Page 15 --> http://www.berkshirehathaway.com/2008ar/2008ar.pdf

It wasn't BAC, yes you where correct, It was AMEX, WFC and US BANK Corp. It's all listed right here. http://projects.propublica.org/bailout/list

Buffetts investment in BAC is more inline with his buy companies when no one else will philosophy.

Do you suppose Buffett just anticipated a bailout? I mean, I saw it coming in 2005 or so.

There's always a meta game going on at Buffet's scale. Because he is so successful, his act of investing in the banks both before and after the crisis can be seen as a cost of doing business to ensure a healthy US and world economy, upon which his entire empire depends.

This was Buffett's motivation on investing in 2008: http://www.nytimes.com/2008/10/17/opinion/17buffett.html

I think the bottom line seems to be that if you have a day job (e.g. software development, running your own company. whatever) you are highly unlikely to to have the time to come anywhere near beating the market with investing your spare cash. Just stick to what you're good at.

You are almost guaranteed to beat the market using a very simple strategy: just buy the lowest decile ranked by price-to-earnings.

Reply on news.ycombinator.com