Value Investing

Warren Buffett And The forever elusive Alpha

Interesting article about Warren Buffett and alpha…

Warren Buffett is probably the most famous investor of his generation, and for good reason: His track record over the long term is a thing of beauty.

He has beaten the market by a wide margin over 49 years, a record so impressive that it’s used in finance classes as a textbook example of “alpha.”

Alpha is an elusive quality. Very simply put, it is the ability to beat an index fund without adding risk to a portfolio. Investment managers are always seeking it. If it exists, Warren Buffett surely has had it.

A new statistical analysis of Mr. Buffett’s long-term record at Berkshire Hathaway has just been done, and it’s come up with some fascinating insights about his abilities, past and present, and about the chances that the rest of us have for beating the market. Using a series of statistical measures, the study suggests that Mr. Buffett has indeed been blessed with an impressively big dose of alpha over a very long career.

But it also reveals something that isn’t impressive at all: For four of the last five years, Mr. Buffett has been doing worse than the typical, no-frills Standard & Poor’s 500-stock index fund — so much worse that it’s unlikely to be a matter of a string of bad luck. Mr. Buffett has begun to behave like an investor with no alpha at all.

Both sobering facts — Mr. Buffett’s long-term outperformance and his recent stretch of mediocrity — appear in high relief in the analysis conducted by Salil Mehta, an independent statistician with deep experience in Washington and on Wall Street. Part of the study appears on his blog,Statistical Ideas, and he shared the rest of it with me, in an elaborate spreadsheet filled with more than 30 pages of data and formulas.

On one hand, Warren Buffett has had incredible career performance of 49 years.  On the other hand, his probabilistic comments concerning performance differences, falls short of expectations.  Is a S&P gain exceeding 15% (>15%) considered “strongly up”?  If Buffett underperformed nearly 1/5 of the time, then we might think a “strongly up” market is a threshold only achieved in about 10 of the past 49 years.  But in fact, a S&P rise >15% is far more commonplace, occurring in 24 of the past 49 years (nearly half the years).  So the quote above has the same absurd utility as a politician stating he or she doesn’t always lie, but when he or she does it mostly happens in the even numbered years (e.g., 2008, 2010, 2012, etc.)  And then you have to fret over which year that politician made the statement…

See the descriptive chart above for the annual frequency count of S&P performance, and the frequency count for Buffett’s underperforming years.  Now some can be thinking, among other things, that underperformance in those 24 years was only 9 times (so just 38% of the time).

The issue with this line of thinking is that it implies there is homogeneity in this underperformance relative to the S&P’s >15% annual performance.  Here too, the underlying statistics fall apart.  Let’s decompose this chart above and isolate Buffett’s performance during the past 5 years.  We see in the chart below that 4 of the 9 years that Buffett has underperformed, during “strongly up” years, were in just the past 5 years.  And there were 4 “strongly up” years in the past 5, so Buffett didn’t underperform 38% of the time then, but 100% of this time (4 of 4).

Full article from NYT here and statistical ideas here.

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