In a recent article in The Wall Street Journal titled You’re More Like Warren Buffett Than You Think, financial journalist Spencer Jakab highlighted what I believe to be one of Warren Buffett’s most important, and certainly most overlooked, competitive advantages: Buffett has permanent capital with which to invest.
This is not the case for managers of mutual funds, hedge funds, and individual accounts. These managers must allow their investors to redeem their investments at periodic intervals – daily in the case of mutual funds.
And how do investors in these funds use the redemption feature? Not well. Money tends to flow into and out of funds based on short-term performance. This creates a paradox for money managers: how to invest long-term with (potentially) short-term capital?
Investment managers thus face “career risk” – the prospect of being fired for poor short-term performance. And few professional money managers may admit this, but the reality of career risk influences investment decisions.
One influence that career risk has on investment behavior is diversification. Diversification – the “spreading out” of risk by buying numerous stocks – is a prudent course for a portfolio manager. But the benefits of diversification decline as more stocks are added to a portfolio. In other words, diversification is subject to what economists call “diminishing marginal benefits.” The fifty or more stocks held by the average mutual fund are far beyond what is necessary for prudent risk management. Portfolio managers engage in such wide diversification for a variety of reasons, such as portfolio size and statutory mandates. But the tradeoffs between wide diversification and long-term returns are clear. I’ve heard Buffett say that he has had no more good investment ideas than other money managers. The difference is that other money managers dilute their portfolio with many mediocre or bad ideas.
Buffett’s investment style – few, concentrated bets in competitively advantaged businesses – is likely to underperform the broader stock market in certain years. According to the WSJ article, Buffett trailed the market approximately one-third of the time over his decades at the helm of Berkshire Hathaway’s stock portfolio. In 11 of those years, the Berkshire portfolio lost money. Buffett, however, never had to worry about redemptions. Berkshire Hathaway is a publicly traded holding company. Investors wishing to “redeem” their shares in Berkshire Hathaway must do so by selling their shares on the secondary market. Because secondary market transactions occur between traders, they have no impact on Berkshire’s Hathaway’s investment capital.
Why it Matters
Individual investors have, in theory, the same advantage that Buffett has in being able to invest permanent capital. In my opinion, not all individual investors should go picking their own stocks. For most individual investors, relying on index funds is a perfectly sensible investing strategy. But for those investors who possess the skill set to analyze companies, the time necessary to conduct investment research, and the temperament required to keep calm during excessive market volatility, the advantage of having permanent capital cannot be overstated.
