Monday, July 03, 2006

Are you the next Warren Buffett?

In response to my previous post on index funds, some commenters said essentially, “Hey, what about Warren Buffett? He managed to beat the market. Doesn’t that disprove the efficient-market hypothesis?”

Maybe. I have little doubt that Buffett has business, financial, and economic insight that most of us do not have. And this insight helped him amass a huge fortune (which he is now generously giving away). But the existence of a few extraordinary individuals like Buffett does not tell us much about the efficient-market theory as a reasonable approximation to market behavior.

Here is a question to ponder: Suppose you are a young investor. You might be the next investing genius, or you might not. How would you know?

You could try to compile a track record. But doing so would take a long time to produce compelling evidence. Imagine you have produced an excess return over the market with a mean of 2 percent per year and a standard deviation of 10 percent. To confidently conclude that you really are a good stock picker, to reject the hypothesis that you've just been lucky, you would need 100 years of data. (Note to econ geeks: The t-statistic for the mean excess return is 2/[10/sqrt(T)], where T is the number of observations.) Given your life expectancy, testing your ability with statistical methods may not be very useful.

You might try to introspect and ask yourself: Am I really smarter than the market? But that is risky. Most people are overconfident in their own abilities. What makes you think you are any different?

Several decades ago, the young Warren Buffett took a gamble--that he was the real thing, not just a Warren Buffett wannabe. And he lucked out.

Maybe the young Warren Buffett just knew that he had special gift for figuring out businesses. But I bet for every real Warren Buffett, there were hundreds, probably thousands, of would-be Warren Buffetts who also just knew they had special gifts. They tried to beat the market, failed, and ended up with worse returns than they could have gotten in index funds.

Here is my bottom line: The efficient-market hypothesis is not strictly true, but it is close enough to true that most investors are better off believing in it nonetheless.