One of the most common arguments that I hear

against index investing is Warren Buffett.

He is the centerpiece of many discussions

on stock picking, value investing, and dividend investing.

If stock picking doesn't work,

then why has Warren Buffett been so successful?

Warren Buffett loves dividend paying stocks.

Warren Buffett says that diversification

is protection against ignorance.

Buffett is a wealth of wisdom, knowledge, and experience.

He has also truly been one of the greatest investors

in modern history, based on his track record.

These are facts that cannot be disputed.

However, both Buffett's wisdom and his success

are often taken out of context

to support the idea that stock picking

is a smart investing strategy.

I'm Ben Felix, Portfolio Manager at PWL Capital.

In this episode of Common Sense Investing,

I'm going to tell you why Warren Buffett

is not a reason to pick stocks.

(bright music)

Fortunately for us, Warren Buffett documents his thoughts

on many topics in detail

in Berkshire Hathaway's annual letter to shareholders.

Let's start with Buffett's view on index investing.

As much as stock pickers

use Buffett as an argument for stock picking,

Buffett himself has long been a proponent

of investing in index funds.

In the 1996 letter to shareholders,

Buffett offered some investment advice.

Quote,

"Let me add a few thoughts about your own investments.

Most investors, both institutional and individual,

will find that the best way to own common stocks

is through an index fund that charges minimal fees.

Those following this path are sure

to beat the net results, after fees and expenses,

delivered by the great majority

of investment professionals."

In the 2013 letter,

Buffett explained the goal of the non-professional investor

should not be to pick winners.

Neither he nor his helpers,

Buffett is referring to stockbrokers

and high-fee fund managers,

can do that.

But should rather be to own a cross-section of businesses

that in aggregate are bound to do well.

A low cost S&P 500 index fund will achieve this goal.

That's a pretty clear message.

Now, I know what many of you might be thinking.

That only applies to non-professional investors.

If you dedicate enough time to it,

maybe you can be a professional too.

Let me offer some commentary

that Buffett does not mention in his letter.

There have been many academic studies

on professional investor's

ability to generate superior results.

I'll give you two of my favorite

and some quick quotes from their conclusions.

Mark Carhartt's 1997 paper

on persistence in mutual fund performance found, quote,

"The results do not support the existence

of skilled or informed mutual fund portfolio managers."

In their 2010 paper,

luck versus skill

in the cross-section of mutual fund returns,

Eugene Fama and Ken French concluded

through statistical analysis

that few funds produce benchmark-adjusted expected returns

sufficient cover their costs.

Suffice it to say

that even professional investors

have a tremendous amount of trouble

producing consistent risk-adjusted results

in excess of their benchmark.

Also in the 2013 shareholder letter,

Buffett goes on to explain

that investing in index funds is not enough.

You also need to maintain a disciplined approach.

Buffett concludes that with discipline,

the "know-nothing" investor

who both diversifies and keeps his costs minimal

is virtually certain to get satisfactory results.

Indeed, the unsophisticated investor

who is realistic about his shortcomings

is likely to obtain better long-term results

than the knowledgeable professional

who is blind to even a single weakness.

I don't know about you,

but I am far more comfortable managing my own investments

based on the assumption that I'm a know-nothing investor,

rather than assuming that I'm a knowledgeable professional

without blindness to even a single weakness.

Buffett also seems to think

that it is unlikely to find a knowledgeable professional

without blindness to even a single weakness.

Again, in the 2013 letter, Buffett gives us some insight

into how his estate assets

will be managed for the better it have his wife.

Quote,

"My money, I should add, is where my mouth is.

What I advise here is essentially identical

to certain instructions I've laid out in my will.

One bequest provides that cash will be delivered

to a trustee for my wife's benefit.

My advice to the trustee could not be more simple.

Put 10% of the cash in short-term government bonds

and 90% in a very low cost S&P 500 index fund.

I believe that trust's long-term results from this policy

will be superior to those attained by most investors

whether pension funds, institutions, or individuals

who employ high-fee managers."

Buffett similarly put his money where his mouth was

when he made a bet against Ted Seides

who was at the time the co-manager of Protege Partners,

a fund of hedge funds.

The bet was that Ted could not pick

five funds of hedge funds

that would beat Buffett's

Vanguard S&P index fund over 10 years.

The wager was not small either.

It was a $1 million bet.

Buffett won the bet in 2017 by a lot.

In his 2016 letter,

Buffett explained the many reasons that he was confident

that he would win the bet.

This is a quote from Buffett's initial challenge

to hedge fund managers.

"A lot of very smart people

set out to do better than an average in securities markets.

Call them active investors.

Their opposites, passive investors,

will by definition do about average.

In aggregate, their positions will more or less approximate

those of an index fund.

Therefore, the balance of the universe,

the active investors,

must do about average as well.

However, these investors will incur far greater costs.

So, on balance, their aggregate results after these costs

will be worse than those of the passive investors."

Buffett does add though

that some active investors will do well over time.

He explains, quote,

"There are, of course, some skilled individuals

who are highly likely to outperform the S&P

over long stretches.

In my lifetime, though, I've identified early on

only 10 or so professionals

that I expected would accomplish this feat."

Buffett's comment about early on is important.

It's very easy to identify a successful active investor

after they've been successful.

The real challenge is identifying

before they've been successful.

While Buffett believes

that there are some skilled investors out there,

he has only met 10 in his lifetime.

This speaks to the massive odds

that are against any active investor

and what I would call the overconfidence

of anyone who believes themselves to be

one of these extremely rare few.

Buffett concluded this section of the 2016 letter with this.

"The bottom line.

When trillions of dollars are managed

by Wall Streeters charging high fees,

it will usually be the managers who reap outsides profits,

not the clients.

Both large and small investors

should stick with low cost index funds.

Okay, I think you get the message.

Buffett thinks that you should probably invest

in index funds

unless you're one of the extremely rare few

that might have a chance at beating the market.

But I mean, come on,

are you really one of those rare few?

One of the other ones common discussions

that Buffett gets thrown into is dividend investing.

People seem to think

that Buffett is a strong believer in dividend investing

because Berkshire Hathaway owns a lot of companies

that pay dividends.

In Berkshire's 2012 letter,

Buffett explained in detail why he does not care

whether or not a company pays a dividend.

I won't recite the whole thing,

but Buffett walks through the math to explain

why any investor could easily, based on the numbers,

prefer a company that does not pay a dividend.

If you wanna see the math,

it's on page 19 of the 2012 letter.

But my point here is that Buffett clearly understands

that a great business may or may not pay a dividend.

Buffett himself has made the policy decision

for Berkshire Hathaway

to return capital to shareholders

through share repurchases as opposed to dividends.

Finally, I have to touch on one of the discussions

that Buffett is most often thrown into.

If markets are efficient,

how can we Warren Buffett have beaten the market

for such a long period of time?

This is a really good question.

It was answered in a 2018 paper

in The Financial Analyst Journal titled Buffett's Alpha.

In the paper,

the authors set out to explain Buffett's past performance

in terms of exposure to known factors.

A factor is a characteristic of a stock or bond

that consistently explains higher average returns

through exposure to certain types of risk.

For example, value stocks tend to have

higher average returns than growth stocks

because they are generally riskier.

Based on this type of information,

if an investment professional generates higher returns

by maintaining consistent exposure to value stocks,

they are not demonstrating skill.

An index fund can replicate their results.

Value is one factor,

but there have been many others observed in the data.

The authors of Buffett's Alpha

find that accounting for exposure to the market beta,

size, value, momentum, betting against beta,

quality, and leverage factors

explains a large part of Buffett's past performance.

In other words, accounting for the general tendency

of high quality, safe, and cheap stocks to outperform

can explain much of Buffett's performance.

In fact, controlling for these factors

makes Buffett's Alpha,

or his ability as a manager to produce returns

in excess of the risk taken through factor exposure,

statistically insignificant.

This is an important finding.

The authors were able to show that Buffett's success

has not been due to his superior stock picking abilities,

but to his implementation of a factor investing strategy.

I am not saying that Buffett is not a genius.

He is.

He intuitively discovered factor investing

decades before the academic literature caught up.

The reality for an investor today, though,

is that we do know that the factors exist.

It is not by stock picking then,

but by maintaining consistent exposure to the factors

that brought Buffett so much success

that will bring you anywhere near Buffett's track record.

This is a huge argument against stock picking,

which this paper showed

does not explain Buffett's performance,

and in favor of factor investing,

which can be largely accomplished using index funds.

In fact, you are much less likely

to get consistent factor exposure through stock picking