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The world of investment involves a huge number of people with high IQs who are trying to outperform others. It is difficult to imagine another field of activity that would attract so much attention. And strange things happened. Years ago, one of our local investment consulting firms, a very large one, was looking for a way to gain an advantage over others.
And they reasoned like this. We have all these brilliant young people from the Wharton School, Harvard, etc. They work so hard trying to understand the business, market trends, and everything else. If we simply asked each of our smartest employees to name their best idea and then created a formula from that collection, we would be significantly ahead of the market .
This seemed plausible to them because they had been falsely taught. This is what happens when you graduate from Harvard or Wharton. They tried it, and of course, it was a complete failure. So they tried again , and it failed completely again . They tried a third time, and that didn't work either. Of course, they were looking for the equivalent of the alchemists of past centuries who wanted to turn lead into gold.
They thought: if you buy a lot of lead, wave a magic wand and turn it into gold, it would be a great way to make money. This consulting firm was looking for a way to turn lead into gold. And, of course , it didn't work. I could have told them, but they didn't ask me . The most interesting thing about this situation is that this is a very intelligent group of people.
They came from all over the world . We have a lot of smart people from China, where people are a little smarter on average. And the problem is very simple. This is a simple question. Why did this plausible idea fail? Think about this for a minute. You all studied at prestigious educational institutions.
I bet there's hardly anyone in the room who understands why it failed. This is a rather pointless demonstration on my part. How can you not know this? But that's something you would have to answer. This shows how difficult it is to be rational about very simple things. How difficult it is, how many crazy ideas people who don't work have.
You don't even know why they don't work. Although this is quite obvious if you have received a proper education. Now, at companies like Berkshire Hathaway or the Daily Journal, we are performing better than average. And now a question arises. Why did this happen? Why did this happen? And the answer is quite simple.
We tried to do less. We never had the illusion that we could just hire a bunch of smart young people and they would know more than anyone else about canned soup, aerospace, utilities, and so on. We never had such a dream. We never thought we would be able to get truly useful information from all subjects, as Jen Kramer pretends.
And we always realized that if we worked hard, we could find a few things we were right about , and that would be enough, and that was a reasonable expectation. This is a completely different approach to the process. And if you asked Warren Buffett the same thing as this investment consulting firm: "give me your best idea this year," and you just followed Warren's best idea, you would see that it works great.
But he would try to know the whole, he would give you one or two shares. He had more limited ambitions. I had a grandfather who was very helpful to me, my mother's grandfather, he was a pioneer and came to Iowa with no money, just youth and health, and took the land from the Indians. He fought in the Black Hawk War, was a captain, stayed there, bought cheap land, was aggressive , smart, and so on.
Eventually, he became the richest man in town, owned a bank, was highly respected, had a large family, and a very happy life. And he had that attitude, coming to Iowa when land was worth little more than a dollar an acre, and staying there until that black soil had created a modern rich civilization and one of the best lands in the world.
His attitude was that in a life as fortunate as his, when you're in the right place, you only have a few opportunities if you live to be 90 . And the secret to success was to take advantage of the few opportunities that came your way when they came . And he told this story over and over to the grandchildren around him throughout the summer.
And my mother, who was not interested in money, remembered this story and told it to me. But I am not a natural imitator of my mother. And I knew that Grandpa was right. So I always knew, from a very early age, that the important opportunities waiting for me would be few and far between, and the whole secret was to prepare myself to take advantage of the few that did come my way.
This is not at all the attitude that prevails in large investment companies. They think that if they study a million things, they will be able to know a million things. And, of course, the result is that almost no one can beat the index. Whereas I sit here with my Daily Journal shares, my Berkshire Hathaway shares, my stake in the Li Lu Asian fund, my Costco shares, and of course, I out-perform everyone, even though I'm 95 years old and I hardly ever make any transactions.
And the answer is: I'm right, and they're wrong. And that's why it worked for me and not for them. Another problem, of course, that has arisen in the world of stock picking, where so much money and effort is invested in trying to be rational, is that something terrible has happened to the investment advisor class.
Namely: these index funds have appeared, and they are essentially beating everyone else. Not only that, the amount they beat everyone by is roughly equal to the cost of managing operations and making changes to investments. So you have an entire profession that is essentially being paid to accomplish next to nothing.
This is very strange. This does not apply to intestinal surgery or even criminal defense or anything like that, where an entire profession cannot do anything in its field . People in this profession used to always have some of this problem, and they justified it like this . We save our clients from insurance agents and stock brokers.
regular stock brokers that serve active traders. And they saved people from insurance agents selling life insurance and from annoying stockbrokers who liked active trading. And I guess the investment class is still saving these people from an even worse fate. But it's very strange when an entire profession that works so hard and is so respected, and whose members we like and are happy to have in our families, simply can't do what the profession really strives for— to produce better than average results.
How is the profession coping with this dire situation as index investing becomes increasingly popular, including at many prestigious institutions? Well, I'll give you a very simple answer. They deal with it through denial. They have a terrible problem that they can't solve. So they just pretend it doesn't exist.
This is a very stupid way to solve the problem. It may be a good thing when you think about your own irreparable death and simply deny it until the very end, but in all practical areas of life, this problem, if deeply understood, is half solved or at least more easily overcome. So it is wrong to keep so many people in denial, doing the same thing year after year, hoping the world will keep paying them for it, even though an unmanaged index would almost certainly show a better result.
And I don't have any solution to this problem. I really believe that index investing won't work if everyone does it. But for a long time to come, index investing will work better than active stock picking, where you try to know a lot .
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