How can the market be efficient if warren buffet is getting above average returns?

they say “many economists and academics state that because of the efficient-market hypothesis it is unlikely that any amount of analysis can help an investor make any gains above the stock market itself”

How can the market be efficient if warren buffet is getting above average returns?

I don’t have an answer, but I’ll add a corollary question: could Buffet’s above-average returns simply be luck? Are they really statistically significant?

The obvious answer would be that somebody else is getting below average returns, but I don’t actually have any education in finance.

I’ve wondered about this and will be interested to read other responses. But I think the following factors, listed roughly by decreasing importance, are relevant.

  1. Suppose that some company, e.g. Coca Cola, has an intrinsic and more-or-less permanent advantage over other companies. Stock market pricing, however “efficient” cannot negate the fact (if it is a fact) that Coke will yield above-market returns in the long term. It can price the stock higher, but if that premium remains constant in percentage terms, Coke will continue to grow faster than Pepsi. This is relevant to Buffet as he specializes in long-term investment in companies with high consistent profits.

(Market theory suggests that competitors will eventually arise and steal share from Coke. I don’t have an answer to this except … in the long run you’re dead anyway. :D)

  1. Efficient market hypothesis is, after all, just a hypothesis. That the hypothesis is flawed is shown by the 1990’s Internet bubble. Avoiding the over-exuberant stocks at that time was a winning idea, and Buffet did avoid them.

  2. The efficient market depends on successful traders and speculaters. If the market became so efficient that such traders were no longer successful, they’d stop trading … (and the market would no longer be efficent :smack: )

  3. Buffet gets some sweetheart deals. For example, he got a great deal on GE convertible bonds, or some such, about 3 years ago that I’d have been happy to buy.

Certainly a possibility. Statistics will tell you that if you took a hundred identically talented investors, random variation will give you a bell curve on their results. Buffett could just be the lucky guy in the group who always rolled sixes.

The efficient-market hypothesis assumes perfect information available to everyone in the market. If Warren Buffet has better information, then it’s not surprising that he does better.

The concept of an efficient market means the price of a given equity reflects all available information. For example, the price of BP right now reflects a real, summed opinion of BP’s prospects by investors trading BP. There isn’t a secret treasure trove of information on BP that should cause it to be priced differently.

That’s not the same as saying BP is a good stock to buy right now for a longer-term hold. Maybe alternate energy is going to render BP’s petroleum production obsolete. Maybe anthropogenic climate change is going to turn out to be hysterical hoopla and the oil business is the right place to be…an efficient market pools ignorance, poor prognostication and herd behaviour just fine. All of those things are what drive today’s price, even if they are wildly wrong.

The efficient market hypothesis is really saying you can’t time the market for short-term investment horizons.

Warren Buffet gets above average returns because he is an above average mind with a longer timeline and a more disciplined approach to investing. He doesn’t get those returns by buying stocks on sale because an inefficient market accidentally underpriced a stock for short-term investors. For a glimpse into how he thinks, look over some of his annual letters to Berkshire Hathaway shareholders. They are good for a laugh, good for an investing education, and good for a contrast from the usual letter.

My favorite one was back during the dot-com boom when everyone was making a fortune investing in dot com startups and Warren said something to the effect of getting in on this very exciting trend by investing in carpets and railroads…

There are weak, semi-strong and strong efficiencies. Only the strong efficient market hypothesis predicts all information, even hidden or private information, is priced instantly in the market. As you pointed out, there’s already a lot of evidence against strong market efficiency being true.

I am not an economist, but it seems entirely reasonable that Mr. Buffet gets above average returns for the same reason that some people get rich in Las Vegas. Timing. Over a long period, no one will make above average returns in an efficient market. But over the short term, luck and good judgement happens. Mr. Buffet seems to be unusually skilled at buying low and selling high. He avoids the averaging by not staying in any trading situation long enough to get averaged.
Plus, his reputation and resources are such that he is in a special class of investor. So for his population, perhaps he is getting an average return.
There aren’t too many people to which major international banks turn to for investment just to be able to say they are strong enough to be worthy of investment from Mr. Buffet. That kind of reputation is worth an above average return (compared to what you and I get).

This is probably a better analysis than my guess that he is in the market for a term shorter than the averaging period. :slight_smile:

But actually we are saying the same thing. Buying tech stocks during the bubble was a bad investment because they were high compared to their long-term worth. Buying carpets and railroads then was a good investment because they were low compared to their history. But if an investor stayed in either market long enough, then they would get average returns. Mr. Buffet is smart enough to identify high markets and avoid them, identify low markets and join them, and trade on his well-deserved reputation as a successful and ethical investor.

First, it’s Warren Buffett (two Ts in his last name). Second, I second the recommendation to read the Berkshire Hathaway letters to the shareholders (and that’s the actual Berkshire Hathaway website; about as unflashy and plain as you can get). I remember the letter in which he described buying a company called Scott Fetzer for $100 million (although Wikipedia says it was $315 million) because it produced $25 million in free cash annually. That’s the sort of boring but profitable business he likes. During the financial crisis, he bought preferred shares in Goldman Sachs and General Electric that gave him 10% dividends. The most profitable part of his company is the insurance business, particularly GEICO, in which he can make money on the “float” and he explains that really well in the letters. As for jokes, I liked the 2000 Annual Report, in which he said, “I will detail our purchases in the next section of the report. But I will tell you now that we have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint. Try to control your excitement.” I’m not a shareholder, but I admire him. I’d love to own a Class A share, partly so I could go to those annual meetings, but I’m not sure if his successor can match his performance so I’ve held back on buying in.

Hey, I was gathering data on the herd instinct. I was counting how many posters were going to follow the misspelling in the OP.

Because a good gambler gambles as little as possible. Buffett is smart enough to resist the temptation to join the swingers and high rollers and make long-term investments in solid, non-sexy businesses that tend to make a steady if unspectacular return year after year. Not “get-rich-quick”, but “get-steadily-richer”.

Buffett’s professor, mentor and later partner was Benjamin Graham, who wrote a famous book on security analysis. The idea is to analyze the financial statements of companies and identify those that are undervalued by the market. But even Graham later agreed with the efficient market idea, that most companies are fairly valued by the overall market. In 1976, he told a financial publication, “In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.”

Let me correct my own fallacy, before someone else does.

Even if some company (e.g. Coke) has a permanent profit advantage, it can’t reinvest its profits and grow with the same high return forever. (For example, its market share, once 100%, isn’t going to grow anymore! :smack: ) This negates the point I tried to make.

Coke may be a good example of this. Those who follow Buffett: Did he carefully cash out his Coca Cola shares near the top?

Coca Cola is still Berkshire Hathaway’s biggest stock holding.

The success of Buffet seems to invalidate EMH, but no one really thinks EMH is true. It is just close enough to being true that there is almost no practicable difference between it and truth. In other words just because Buffet can beat the market does not mean that anyone else can.

Again, I’d like to reiterate that the concept of “an efficient market” does not mean an investor cannot “beat the market.” It means that there is an efficient exchange of information such that the market price for an equity at a given moment reasonably reflects the net sum of information and opinion about that equity. The thing that is “efficient” is the ubiquity of information. Thus, you can’t “beat the market” by getting a stock on sale because you know something someone else does not. (Obviously, that’s not perfectly true all the time, but that is the idea of an efficient market.)

The market can be beaten by folks who do not agree with that pooled opinion. The fact that an opinion of what a stock price should be is an efficiently-pooled opinion does not mean that the pooled opinion is correct. It means you can’t beat the market by thinking you know something “the market” does not. Simply knowing data points is not the same as analyzing an investment. The herd is frequently wrong.

The other way to look at it is to understand that information is always information about the present (and the past). We have no information about the future. We can use the information we have about the present to make extrapolations. In fact we do. These are stock prices, which reflect the monetary values that people put on these extrapolations. However, these values will change moment by moment as new information arrives and new extrapolations made.

Any theory about information fails in the future. It must. Nobody has any information about the future. (Even contracts for future goods, services, or values can’t tell you if a catastrophic failure will negate them.)

Nor can the idealized perfect information about the present be used by itself. It must be put into a model so it can be extrapolated into the future. All models differ. Some will be better than others. No such thing a perfect model exists, even in theory.

If you believe in EMT you can say that the market is priced right at this moment, given the small differences between idealized perfect information and actualized imperfect information. You can also say that’s a tautology - that the market must be priced excactly what it is or else it would be priced something different.

Whichever side you take, you can’t make EMT or anything else a commentary on the future. We don’t have any information on the future. We have only our models. Models fail, as they do in every bubble. Buffett lost billions too. It’s just that for him, that was a minor loss and could be corrected by the strength of the rest of his positions. That can’t work for everybody.

Buffett also gets involved with companies, get’s his people on the board, etc.