Friday, July 11, 2014

Why average isn't average in investing - Warren Buffet explained

The 'average' investor doesn't get the mean return.  The average investor gets substantially less than the mean return because returns are very right tailed.  Because unlike in coin flipping the investment return in each period is entangled with the overall investment return for the entire series.  So a few 'lucky' flips, particularly in early periods compound into significant differences in final returns.  Alex Tabbarok of George Mason University simulated 10,000 investors to get the distribution of returns for a 30 year investment horizon.  Here's what he found:



Mean returns were 7% but the median return was nearer to 5% meaning half of all portfolios returned less than 5% and half returned more.  The right tail of returns is extremely long with one portfolio ending up valued at $25,000.  Looked at another way, the valuation of portfolios diverge over time as those who have had 'lucky' throws (statistically speaking) compound their luck while others don't benefit.
















Another way to put it:  somebody had to be Warren Buffet.  And if it had to be anyone I guess I'm OK with it being a ukelele playing, plain spoken, steak eating man of the people who preaches fundamental value.

But while I am skeptical of Warren's stock picking abilities - particularly over a 60 year career - I am not saying that he's just a 'lucky' investor.  If WB was just a 'lucky investor' he'd have several million dollars in assets and be spending his days playing golf.  But Warren Buffet set out to build an investment management institution that people could trust.  His steady leadership, folksy style, deep integrity and some sweet luck at stock picking resulted in the superb institution that Berkshire Hathaway is today.  You could say that Warren Buffet uniquely positioned himself and his business to take advantage of any good fortune that came along.  And that, my friends, is quite an achievement.




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