Stop Researching Stocks, Part 2: Why Warren Buffett Agrees

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In a recent article, I made the case for why researching stocks is a waste of investors time. Instead of engaging in the frustrating pursuit of trying to find mispriced stocks, I suggested a simple, and more effective, alternative.

Begin by determining your asset allocation -- the division of your portfolio between stocks and bonds. Then invest the portion allotted to equities in low-management-fee index funds with broad exposure to domestic and international stock markets. Invest the bond portion of your portfolio in index funds providing broad exposure to U.S. investment-grade bonds, primarily U.S. government bonds. Then, other than when you're rebalancing, leave your portfolio alone.

I also referred to the many studies supporting this strategy, appropriately known as "evidence-based investing." I listed a number of Nobel laureates and other famed investors, including Warren Buffett, who advocate this approach.

Buffett Supports Evidence-Based Investing

Some readers responded to my inclusion of Warren Buffett on that list with unconstrained hostility. In their view, Buffett's success validates doing research in an effort to uncover stock "winners." They believe he is the quintessential stock picker and scoff at the notion that they, too, couldn't engage successfully in this activity.

They are wrong for two reasons.

First, Buffett's "secret sauce" isn't stock picking. The well-credentialed authors of an exhaustive study rigorously examined Buffett's record. They compared it to the long-term performance of other stocks and mutual funds. They acknowledged that Buffett's performance has been outstanding, ranking him as "the best among all stocks and mutual funds that have existed for at least 30 years."

However, they found the secret to Buffett's success was a strategy few others could implement. He bought cheap, safe, high-quality stocks and used significant leverage, financed partly using an insurance float, with a low financing rate. The authors of the study concluded: "Leveraging safe stocks can largely explain Buffett's performance."

Leverage Helps That Billionaire

My colleague Larry Swedroe is the author or co-author of 13 highly regarded investing books, including "Think, Act, and Invest Like Warren Buffett." According to Swedroe, Buffett's strategy is responsible for his stellar results, not his stock picking skills. Swedroe notes that once you account for "cheap leverage" and exposure to style factors like market, size, value, momentum, low volatility and quality, Buffett's excess returns were "statistically indifferent from zero."

Second, we don't have to debate Buffett's views about evidence-based investing. In his 2013 annual letter to shareholders, he indicated that he had instructed his trustee to invest his wife's inheritance in low-management-fee index funds. He noted: "I believe the trust's long-term results from this policy will be superior to those attained by most investors -- whether pension funds, institutions or individuals -- who employ high-fee managers."

These views are consistent with his prior, unequivocal support for evidence-based investing. Here's what he wrote in his 1996 annual letter: "Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."

Here's what he stated in an appearance on CNBC in May 2007: "The best way in my view is to just buy a low-cost index fund and keep buying it regularly over time, because you'll be buying into a wonderful industry, which in effect is all of American industry. ... People ought to sit back and relax and keep accumulating over time."

Where's Your Data?

The most vocal advocates of doing research on stocks are brokers and the financial media. Brokers have a strong economic interest in encouraging you to trade because it generates fees. The financial media is incentivized to mislead you into believing that watching an endless parade of market "gurus" making recommendations about which stocks to buy or sell is critical to your investment success. The more viewers they lure, the more revenue they earn.

Conspicuously missing from the argument of stock research advocates is any peer-reviewed data indicating that "doing your homework" is anything other than an exercise in futility.

In fact, there's no shortage of contrary studies. An article to be published in the prestigious Journal of Finance reviewed the recommendations of consultants to 29 institutional investors. They represented 91 percent of the entire investment consulting industry's market share in the U.S. These institutional funds had approximately $3 trillion of assets under management. The authors of the study reviewed 13 years of data.

Study: Consultants Don't Add Value

Here's the stunning conclusion: "We find no evidence that consultants' recommendations add value to plan sponsors."

The study found, on average, that consultants' recommendations caused their clients to underperform their benchmarks by about 1 percent. The funds would have been better off if they had fired the consultants, pocketed the millions in fees paid to them and invested in low-management-fee index funds that tracked appropriate benchmarks.

%VIRTUAL-pullquote-What are your chances of successfully researching stocks and finding mispriced equities on your own?%Howard Jones, one of the authors of the study, was quoted in the New York Times as saying that the recommendations from consultants are a "useless" service.

If the most-skilled, highly paid consultants in the world are unable to make stock recommendations that add value, do you really believe your broker can do any better? What are your chances of successfully researching stocks and finding mispriced equities on your own?

When you objectively view the data, you are likely to conclude that improving your expected returns requires no time spent researching stocks or trying to "beat the market."

Daniel Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."

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Stop Researching Stocks, Part 2: Why Warren Buffett Agrees

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