Introduction to Warren Buffett’s Beliefs on Diversification
In the first part, we analyzed Warren Buffett’s strong opinions on diversification. Despite these views, he does not recommend that most people follow his approach. His will clearly outlines this: the money for his wife must be invested 90% in a low-cost S&P 500 index fund and 10% in long-term Treasury bonds. A simple portfolio, free of high fees and complex decisions.
Buffett’s Confidence in His Approach
Buffett is so confident in this strategy that, in 2007, he demonstrated with facts why even professional fund managers can lose against the simplicity of this approach.
The Challenge: S&P 500 Index ETF vs. Five Hedge Funds
The challenge was clear: a low-cost S&P 500 index ETF versus five hedge funds selected by Protege Partners. The winner would be determined by net returns (after fees) over a ten-year period (2008-2017). The numbers were conclusive: the index returned 125.8%, while the hedge funds barely reached 36%. Why? Because their cost structure (2% annual management fee + 20% performance) makes them long-term losers.
The Role of Overactivity
Buffett did not choose the S&P 500 by chance. The index includes the 500 largest U.S. companies by market capitalization, many of which are industry leaders with global operations. Moreover, it undergoes periodic reviews following a clear methodology, independent of human emotions.
His bet on this passive strategy is simply a testament that hedge funds don’t lose due to lack of skill but rather perverse incentives. To justify their high fees, they need consistent returns, leading to excessive trading, unnecessary risks, and abandoning strategies when quick results don’t materialize.
The Profound Lesson
Beyond this, there’s a deeper lesson. Buffett didn’t just bet on the U.S. economy; he bet on inertia. Numerous studies have shown that an average investor, if they invest in a low-cost index ETF and leave their portfolio unchanged for a long period (over 10 years), will outperform 90% of fund managers.
Why? Because hedge funds, despite their flexibility to use derivatives, short positions, or arbitrage, are bound to produce results within short timeframes to justify their high fees and attract new money. In contrast, the passive investor can ignore market noise for decades.
The Hedge Funds’ Failure
The hedge funds’ failure in Buffett’s bet isn’t due to not seeking maximum returns. Instead, their 20% performance fee on gains incentivizes them to outperform the S&P 500. However, the trap lies in assuming they need to take on risks that the index avoids to achieve this. Some resort to complex derivatives, short-term bets, or arbitrage strategies dependent on specific conditions.
These approaches don’t withstand a decade-long horizon. Extreme volatility, the need to justify results quarterly, and pressure to avoid losing investors lead them to overtrade, pay more in fees, and make judgment errors the S&P 500 avoids.
The S&P 500 doesn’t need to “win” against the market; it is the market. This structural advantage, in a very low-cost ETF, is hard to overcome long-term.
Key Takeaways
- Simple Approach: Buffett’s strategy emphasizes a simple, low-cost index fund approach rather than complex strategies.
- Inertia and Long-term Focus: The prolonged success of passive investing, ignoring short-term market noise, highlights the importance of a long-term perspective.
- Perverse Incentives: Hedge funds’ high fees and short-term focus lead to excessive risk-taking, ultimately underperforming a passive index strategy.
Buffett’s recommendation for the average investor is clear: a passive, low-cost portfolio with a long-term vision. While he doesn’t deem massive diversification inherently bad, it’s inefficient for his investment methodology.
For most of us, a low-cost index fund strategy isn’t just a tool but a safeguard against emotional decisions, others’ opinions, or short-term market movements.
