In his company’s 2006 annual report, Warren Buffett devoted several paragraphs to a scathing criticism of the hedge fund industry. Their fees, Buffett wrote, were so exorbitant and so stacked against investors that they amounted to a “grotesque arrangement.” For that reason, Buffett frequently recommended that individual investors opt for low-cost index funds. To reinforce this point, in 2007 Buffett issued a public challenge: He would bet anyone a million dollars that, over a ten-year period, a simple S&P 500 index fund would beat the performance of a portfolio of hedge funds.
As Buffett put it, “what followed was the sound of silence.” Only one brave soul, a hedge fund managed named Ted Seides, stepped forward. After agreeing to give the proceeds to charity, the two entered into their bet on January 1, 2008.
What happened? The bet’s ten-year span ended on December 31, 2017, but the results were so lopsided that Seides was ready to acknowledge defeat in May of that year. In the end, the S&P 500 delivered an average return of 8.5% per year, while the hedge funds came out just shy of 3.0%.
In the years since, the hedge fund industry has exhibited further weakness. In 2019, for the fifth straight year, more hedge funds shut down than started up. In fact, over the past five years, more than four thousand hedge funds have shut down—about 30% of the industry.
As an individual investor, what lesson can you draw from this?
The obvious conclusion is to avoid hedge funds—and I certainly agree with that. Even Seides himself now supports that view. While select institutions have had notable success with hedge funds, few would argue that this means individuals can achieve the same result.
That is the fairly obvious conclusion, but what else can we learn from the Buffett-Seides wager and its outcome? I see several lessons:
1. Market valuation: In the 1700s, when Isaac Newton lost a fortune in the stock market, he observed that he could, “calculate the motions of the heavenly bodies, but not the madness of the people.” In other words, the stock market doesn’t always behave rationally because it is, after all, just made up of individuals. In Seides’s case, at the inception of the bet in 2007, he was willing to bet against the S&P 500 because he felt it was too expensive. In fact, he might have been right: The stock market did drop at first, but then it bounced back with a vengeance. The lesson: In theory, stock market valuations matter. You should be less enthusiastic investing when the market is booming (as it is today) than when it is bottoming, but don’t fall into the trap of market timing. It’s very difficult to know when the market will decline, how large that decline will be, and when the recovery will begin. Instead, protect yourself through asset allocation.
2. The risk of resulting: Poker champion Annie Duke, writing in Thinking in Bets, describes the concept of “resulting,” which is the risk we run when we conflate a good result with a good decision. “Decisions are bets on the future,” Duke writes. “They aren’t ‘right’ or ‘wrong’ based on whether they turn out well on any particular iteration.” Seides, in fact, says that he would make the same bet again, because he still believes in the logic of his decision. The lesson: You can’t control luck (good or bad), so focus on controlling what you can control by making thoughtful, evidence-based decisions prospectively.
3. Yardstick selection: In his 2017 article, Seides walked through the reasons his bet fell short. One key point: Comparing the S&P 500 to a group of hedge funds, he said, is like comparing the Chicago Bulls to the Chicago Bears and asking which team is better. Just as you can’t compare a basketball and a football team, Seides pointed out, it doesn’t make sense to compare the S&P 500, which is 100% stocks, to a group of hedge funds, which might have just 50% in stocks. The lesson for individual investors: Asset allocation is critical. Whether you are deciding how to allocate your portfolio or assessing its results, it is vitally important to use the right yardstick.
4. The value of diversification: Over the bet’s full ten years, the S&P 500 soundly beat the hedge funds. But in its first year, 2008, the hedge funds held up much better. In that year, the stock market dropped 37%, while the hedge funds lost just 24%. The lesson for investors: Diversification means that you will always have some investments that are lagging while others are shining. It is the rare portfolio in which everything is above average. But that is precisely the value of diversification. I still don’t recommend hedge funds, but I’m sure that in 2008 the diversification value they provided was welcomed by their shareholders. For your portfolio, seek investments with low, or negative, correlations.
5. The other side of returns. This bet was all about performance—about which investment would beat the other. That’s fine as an academic exercise, or for sport between two wealthy investors, but that’s not the only thing that matters in the real world. Equally important is risk. In my view, the best yardstick for success isn’t whether you beat a benchmark (or your neighbor or your brother-in-law). The best measure of success is whether you met your financial goals while also sleeping at night.