If you’re walking along and you see a $20 bill lying on the sidewalk, don’t stop to pick it up. It can’t really be there, because if it were, someone would have picked it up already.
That old economics joke may sound absurd, but it captures the paradoxical thinking at the heart of modern-day investing theory. Academics argue that no one can consistently outperform the broad stock market because any knowledge or any strategy that could produce superior market returns must already be reflected in share prices. Finding true bargains is impossible, unless the companies are so obscure that the cost of analyzing them is greater than whatever extra return they could provide.
The career of Warren Buffett stands as a clear rebuttal to that way of thinking, as shown by a recent study of his investing approach. Over the past 30 years, his company has earned a higher return (adjusted for risk and price volatility) than any competitor or any mutual fund. Some critics point out that Buffett can borrow money at very low effective interest rates from the insurance subsidiaries his company owns, and that he now receives sweetheart deals from some of the businesses he invests in. But the fact remains that for most of his career, Buffett was spectacularly successful investing in just the sort of blue chips that are widely followed and are supposed to be most fairly priced.
Does Warren Buffett really have a secret? Indeed he does. He has found a way to be conservative and aggressive at the same time. In the process, he has been able to crank out extraordinarily good investment returns. Perhaps more important, this success proves that one of the central pillars of modern economic theory is simply wrong. The relationship between risk and return isn’t what the experts have always said it is. And once that is understood, no economic issue looks quite the same.
One key assumption of almost all economic theories is that people are naturally cautious and try to avoid unnecessary risks. It stands to reason, therefore, that bold investments which will likely be volatile or might fail entirely should offer high potential returns to make up for the outsize risk they carry. In theory, all investments should be priced to provide the same return over a long enough period of time. Risky investments would usually return more, but that would be offset by their occasional losses. But it turns out things don’t work so neatly – the returns risky investments offer often aren’t high enough to compensate for the chance of failure.
There are a number of possible explanations for this mispricing. Perhaps returns don’t have to be high enough to offset potential losses because a lot of folks like to gamble or want to be in on whatever is hot. Or perhaps people focus only on the big winners and forget about the losers that disappear. Or maybe fast-growing companies just have a much harder time maintaining their success than anyone allows for. Whatever the explanation, one part of Buffett’s approach is to avoid such companies and favor those whose shares are moderately priced.
Of course, lots of so-called value investors believe that stocks with price/earnings ratios above 20 tend to be overpriced. And some carry this logic to the opposite extreme and conclude that stocks with exceptionally low P/Es will, in the aggregate, outperform the overall market. But Buffett doesn’t share that belief either, recognizing that the cheapest investments are often cheap for good reason. Indeed, they may have serious and irreparable problems. So Buffett looks for companies that have well-managed businesses and strong balance sheets in addition to share prices that are a bit below average.
There’s a name for this kind of investing, too. It’s called GARP, or growth at a reasonable price. But there’s a third step to Buffett’s strategy that differentiates him from other GARP investors. Despite his reputation for prudence and the fact that his specific picks really are fairly conservative, he backs them aggressively, making large investments in a limited number of companies. In addition, he uses leverage to increase his returns. Essentially, this means taking advantage of the cash his insurance subsidiaries have on hand from premium payments to make bigger investments.
So what can we take away from these insights into Buffett’s success? Certainly there are ways to apply such principles when making personal finance decisions. People with IRAs, 401(k)s, and indeed all long-term investors, have to divide their money between stocks, bonds, and other types of securities. Since stocks can suffer in a bad market for up to a decade, people in or near retirement need to balance blue chips with bonds, annuities, or some other non-equity investments.
Younger people are also typically advised, however, to divide their money between stocks and bonds, but to put the stock portion into small growth companies or other more dynamic choices. Buffett’s example, by contrast, suggests that people with time horizons of more than 20 years might be better served by investing in conservative stocks but putting most – or even all – of their money into such choices. That could mean an S&P 500 index fund, or – better yet – a big-cap value-oriented stock fund combined with a utilities fund.
The same principles can be applied to other kinds of economic decisions, too. For example, people should try to minimize their housing costs when they may soon move, but stretch to buy as much house as they can afford once they are fairly sure that they will stay put. And in choosing a career, it makes sense to look for a secure job in a stable field but then seek out entrepreneurial opportunities and take some risks within that framework. The essence of the Buffett approach is looking for predictable payoffs that are high relative to a low level of risk – and then going after them with conviction.
PHOTOS: Warren Buffett: A Life in Photos