Warren Buffett's investing lesson

Run, not walk, the other way
March 2, 2011, 12:01 a.m. EST
By Mark Hulbert

CHAPEL HILL, N.C. (MarketWatch) — Warren Buffett’s annual letter to Berkshire Hathaway shareholders is probably the most widely read commentary on Wall Street of the entire year.

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Strangely, though, in all the ink that has already been spilled since Buffett released this year’s letter this past Saturday, I’ve seen no mention of what I think is perhaps its most profound investment lesson: Long-term returns in excess of around 20% annualized are next to impossible to achieve.
Overlooked as this investment lesson is, though, it jumps out from the very first page of Buffett’s letter, where he reports the growth in book value of Berkshire Hathaway /quotes/comstock/13*!brk.b/quotes/nls/brk.b (BRK.B 85.84, +0.82, +0.97%)   since he took over the company in the mid 1960s. Though Buffett is widely recognized to be the most successful long-term investor alive today, that growth rate from 1965 through the end of 2010 was “just” 20.2% annualized.
That’s most definitely nothing to sneeze at, of course. The S&P 500 index /quotes/comstock/21z!i1:in\x (SPX 1,328, +19.82, +1.52%)   over the same period produced a dividend-adjusted return of not even quite half as much — 9.4% annualized. Cumulatively (on an un-annualized basis), these two rates of return work out to gains of 490,409% and 6,262%, respectively.
Yet, even though Buffett’s return has produced riches beyond the dreams of avarice, far too many investors won’t leave well enough alone. And who can blame them? There is no shortage of advisers and unscrupulous marketers who regularly promise returns several orders of magnitude higher than 20% per year. Claims of 100% per year, and more, are commonplace.
My advice: You should run, not walk, the other way from any adviser making performance claims of that magnitude.
Think about it this way: Whenever you come across an adviser making performance claims this high, you know one of three things is going on:

1. The adviser in question is a far better investor than Warren Buffett
   
2. The adviser in question is lying
   
3. The adviser is accurately reporting his historical performance, but it was produced over such a short period of time that regression to the mean will quickly cause his return to come back to Earth.
   

As for Possibility #1, I’ll leave it to you decide the likelihood that the ad you’ve received in your email inbox is from a superstar adviser who is genuinely better than Buffett. If your answer is “yes,” I have a bridge I want to sell you.
As for Possibility #2, I know you’ll be shocked to learn that lots of advisers regularly lie about their performance. If you don’t believe it, I want to sell another bridge to you too.
Possibility #3 is more insidious, since it enables an adviser to imply a falsehood while nevertheless telling the truth. To appreciate the role that regression to the mean plays, consider the evidence in the accompanying table.

Length of period	Annualized return of top investment newsletter over this period	Annualized return of top mutual fund over this period
Last 1 year	85.2%	76.4%
Last 10 years	21.7%	29.7%
Last 20 years	19.3%	15.6%
Last 30 years	15.3%	14.5%

The data in the table for investment newsletters, of course, comes from my Hulbert Financial Digest monitoring service. The mutual fund data comes from Morningstar and Lipper.
Notice the remarkable similarity in the pattern in both columns. The degradation in both series of returns, as the time period lengthens, is almost identical.
Luckily, you don’t need to determine which of these three possible factors is at work when you receive a performance claim well in excess of 20% annualized, since your proper course of action is the same regardless.
To do anything else would be a triumph of hope over experience.

Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.