The Frontal Cortex

Buffett

The power of Warren Buffett is impressive. He decides to invest a few billion in Goldman Sachs and panicked investors calm down. And why not? Nobody has an investing record that can even come close to comparing with Buffett’s record: he is the lone outlier of Wall Street. According to most calculations, since 1951 Buffett’s Berkshire Hathaway has generated an average annual return of about 31%. The average return for the Standard & Poor’s 500 over that period is 10% a year. The stock market is a random walk, but Buffett has somehow found a way to consistently beat the randomness.

So what’s his secret? I think this 2005 WSJ article, which describes his work habits and office, is telling. While most investors are obsessed with getting as much information as possible as fast as possible (especially if it’s insider information), Buffett doesn’t have a computer, or even a cell phone. There is no stock-data terminal on his desk, and he doesn’t clutter up his cabinets with newspaper clippings or shareholder reports. Although he keeps a muted television set tuned to CNBC, he rarely glances at the screen. As he told the Journal: “I deplore false precision in math.” According to Buffett, most investment decisions don’t require exact numbers, or extensive statistical spreadsheets, or hundreds of pages of financial information. He is resigned to the inherent mysteriousness of the market.

How, then, does Warren Buffett make investment decisions? Quickly, and without wasting time on too much deliberate analysis. Buffett says he knows he wants to buy something, regardless of whether it’s a company or a stock or a car, as soon as he first sees it. “If I don’t know it in five to 10 minutes,” Buffett says, “then I’m not going to know it in 10 weeks.” For example, in the summer of 2005, as he was quietly working in his office, Buffett received a fax from Forest River Inc., a manufacturer of towable RV’s and cargo trailers. The company abruptly proposed that Buffett buy the company for a cool $800 million. Although he had never heard of the company before, Buffett didn’t hesitate. He quickly glanced through the company’s financials, and saw that the company had a commanding market share, little debt, and a long history of solid profits. The very next day, Buffett offered to purchase Forest River outright. He made his offer without researching Forest River’s competition, or scrutinizing its books, or consulting with financial analysts about the growth prospects of the RV industry. (“I don’t use analysts or fortune tellers,” Buffett is known to say. “If I had to pick one, I don’t know which it would be.” ) The CEO of Forest River told the Journal that “it was easier to sell my business [to Warren Buffett] than to renew my driver’s license.”

Of course, this gut approach only works if you’ve got an immaculately honed set of instincts, your neurons trained by decades of experience. The development of wisdom takes time and practice. (It’s also worth noting that, thanks to his rigorous adherence to “value investing,” Buffett is able to impose an effective decision-making filter on his instincts. Before he even puts his vaunted gut to work, he has excluded the vast majority of potential investments. Unless a company has a high return on equity, a low level of debt, an extended track-record of profit and a unique product, he isn’t interested. He doesn’t waste time even considering it.) If I picked stocks with my gut, I’d perform no better than a chimp throwing darts at the stock tables. Of course, that means I’d still do better than most mutual fund managers, who typically underperform the S&P 500.

There’s some good evidence that Buffett’s approach is the correct one. Consider this experiment: In the late 1980’s, the psychologist Paul Andreassen conducted a simple experiment on MIT business students. First, Andreassen let the students select a portfolio of stock investments. Then he divided the students into two groups. The first group could only see the changes in the prices of their stocks. They had no idea why the share prices rose or fell, and had to make their trading decisions based on an extremely limited amount of data. In contrast, the second group was given access to a steady stream of financial information. They could watch CNBC, read The Wall Street Journal and consult experts for the latest analysis of market trends.

So which group did better? To Andreassen’s surprise, the group with less information ended up earning more than twice as much money as the well-informed group. Being exposed to extra news was distracting, and the “high-information” students quickly became fixated on the latest rumors and insider gossip. (Herbert Simon said it best: “A wealth of information creates a poverty of attention.”) As a result, these students engaged in far more buying and selling than the “low-information” group. They were convinced that all their knowledge allowed them to anticipate the market. But they were wrong.

Note: Portions of this post are cribbed from my forthcoming book, which is now on Amazon.

Comments

  1. #2 dave
    September 24, 2008

    That sounds a lot like what I’ve been saying about math and computer programming for pretty much the entire time I’ve been good at those things: Do the exercises and think hard about them to train your intuition, then when you’re actually trying to accomplish something, let your (hopefully well-trained by now) intuition do most of the work. (Doing post-analysis to create a feedback loop in the “train your intuition” part is also an important part of it, but you shouldn’t be thinking too hard while you’re actually doing the work.) I’ve also done some dabbling in music, where this seems to also apply; I would be unsurprised if it applies to *everything*.
    I think we should start using the phrase “use the force” to describe this, but that might work less well outside the (somewhat nerdy) fields I’m used to.

  2. #3 Anibal
    September 24, 2008

    It´s not a known and established fact that in the process of decision making overated infrormation freeze rather than enrich.
    Maybe neuroeconomists should put in formol Buffet´s brain.

  3. #4 Luci
    September 24, 2008

    Buffett is an amazing guy, but the choicest part of the post was almost hidden at the end: ‘my forthcoming book’
    Something to look forward to in the February bleak days to come, Jonah.

  4. #5 Thinker
    September 24, 2008

    “Warren Buffett is so rich he has to hire Bill Gates to spend his money for him…”

    (Joke circulating after Buffett announced he was going to donate most of his fortune to the Bill and Melinda Gates Foundation. Apparently, Buffett felt that Gates had an efficient philantropy operation already set up, so why create another infrastructure?)

The site is currently under maintenance and will be back shortly. New comments have been disabled during this time, please check back soon.