Wednesday, December 17, 2008

Buffett’s Market Timing

Alice Schroeder’s fascinating biography The Snowball: Warren Buffet and the Business of Life makes it clear that Buffett engages in market timing in the sense that he varies his allocation to stocks over time. If he does it, why shouldn’t we?

Of course, Buffett’s market timing is different from the investor who makes short-term bets on whether stocks will go up or down. Buffett looks for attractively-priced stocks, and during some time periods he finds them and sometimes he doesn’t. This is still a form of market timing, though.

It’s easy to show that market timers as a whole must make less money than buy-and-hold investors, on average. It’s simple mathematics that the extra trading costs along with investing in inferior asset classes like cash and bonds must hurt the average market timer’s returns. This doesn’t mean that all of them lose to the market averages, though. Buffett is a remarkable example of someone who has beaten the odds so convincingly that he must have talent that almost all of the rest of us lack.

In some ways the situation is similar to playing poker. Because the house takes a slice of every pot, it is simple mathematics that the average poker player must lose money. But, this doesn’t mean that all poker players lose money. The big poker stars seem to win reliably enough that they have skills that most of us don’t have.

So, if you’re going to play poker or try to beat the stock market averages through some form of market timing, you should convince yourself that you’re not just above average, but well above average. But be warned that the majority of people who convince themselves that they are well above average will be wrong.

2 comments:

  1. Good article.

    I recall reading somewhere about a thought experiment where everyone in the U.S. tries to flip heads continually. On the first try only half, or 150 million, of say 300 million people flip heads. Those who flipped heads try again and the winners move on to the next round.

    After 26 or 27 rounds, you are likely left with a couple of people who flipped heads 26 or 27 times. They will also probably think they are either lucky or above average coin flippers. They might even write books or give lectures on how to flip heads continually. Maybe they will start their own service for a fee to flip coins for those who aren't comfortable flipping their own coins.

    Replace coin flipping with stock picking.

    Is Buffet above average or just lucky?

    I dunno...

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  2. Blitzer68: The coin-flipping analogy nicely illustrates the important question of whether Buffett was just lucky. My sense after looking at his record is that (in terms of the analogy) after Buffett was one of the few who had flipped 26 or 27 heads in a row, he continued to flip heads another 100 times in a row demonstating that he could control the flip or had a biased coin.

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