Warren Buffett said in an interview with Germany’s Der Spiegel, published last Saturday, that the US is “already in recession”, even though “perhaps not in the sense that economists would define it”, and “it will be deeper and last longer than many think”.

How does an economist define a recession? This is associated with a decline in the country’s GDP (gross domestic product) or negative real economic growth for two or more consecutive quarters.

Buffett says “people are already feeling the effect” of recession, and how true he is! If you do regular chores, like buying grocery or gas for your car, you know this is mighty tough time we are going through. But well, if there is one thing we learned from economic history, tough times never last.

In the recent annual meeting of the Berkshire Hathaway shareholders held last Saturday, CEO Warren Buffett was asked about the best investment idea he would recommend to an investor in his 30’s. In his own words:

I would just have it all in a very low-cost index fund from a reputable firm, maybe Vanguard. Unless I bought during a strong bull market, I would feel confident that I would outperform…and I could just go back and get on with my work.

Coming from the most famous “stock picker” in the world, such drumrolling for index investing may come as a surprise to some. But as I said in this post, he has been advising this for many years, because with index funds you “would feel confident that (you) would outperform” and “get on with (your) work”.

An estimated 30,000+ strong crowd assembled in this meeting to hear from the Sage of Omaha in these troubling financial times. His main message was that it is impractical to expect an earning of 7 to 10% with publicly traded stocks today. Contrast that with past returns: between 1985 and 2004 a simple portfolio of S&P 500 Index fund would have earned 13.2%!.

You can read the meeting excerpt here and here.

In Part I, I discussed the two main and opposing theories of investing - efficient market theory (EMT) and fundamental analysis (FA). Here I talk about which one of these two can be thought as “correct”.

EMT or FA - which one is “correct”?

Interestingly, even though Buffett began his session with the Wharton students by criticizing the “misguided” EMT, he later advised average “non-professional” investors to buy-and-hold index funds (the strategy based on EMT), instead of trying to pick value stocks (the motto of FA) because “they are not going to be able to pick the right price and the right time”.

Coming from the Oracle of Omaha, this seeming contradiction can throw you. But, what he is really saying is that both these investing strategies are in fact correct, but they apply to two quite different types of investors. Value investing is the correct approach for professional investors, whereas portfolio diversification (with index funds) is correct for the armchair kinds.

A savvy investor, after finding a potentially undervalued stock, must do extensive study of the company (financial statements, annual reports, latest news etc.) before he can be confident enough to buy the stock. A value investor must execute frequent trading to replace old overvalued stocks in his portfolio with new undervalued ones.

By contrast, an average investor buys and holds a bunch of index funds from different industry sectors to diversify his portfolio (against market risks), and rebalances the porfolio once a year to restore the original proportion of funds. This investing method demands very little time and effort from the investor.

If both are correct, who gets more?

A simple portfolio, made up of a single index fund that tracks a broad market index such as the S&P 500 Index, experiences the usual market fluctuations over short times. Over long time, though, the portfolio guarantees the market return (minus the small operating cost of managing the fund), which was more than 10% over several past decades.

A value investor’s portfolio, on the other hand, is expected to grow (despite short-term fluctuations driven by market events) until the undervalued stocks are priced “right”. The probability of a higher-than-market return increases with the expertise of the investor, and with the time and effort spent in researching the stock’s prospect.

Simply put, an average investor with a portfolio of index funds will certainly get at least the market return over long term, whereas a professional investor with his value stocks has only a chance of achieving a higher-than-market return. (And unless the difference is substantial, high costs and taxes incurred from frequent trading can eat into the return, often pulling it down below the market return.)

There is overwhelming evidence available that achieving such higher-than-market returns on a consistent basis is an extremely rare phenomenon indeed, because no one can “pick the right price and the right time” year after year after year (if you want proof, I suggest reading Burton Malkiel’s classic A Random Walk Down Wall Street). As for me, I prefer certainty over chance, and I am very happy with index funds.

(This post is a part of the series Basics of Finance and Investing.)

It did not surprise anyone when Warren Buffett, while recently hosting a group of business students from the University of Pennsylvania’s Wharton School (his alma mater) for a two-hour question-answer session, began by pointing out the folly of the efficient market theory (EMT). After all, his objection to EMT is as legendary as his support for fundamental analysis (FA), as the foundation for smart investing.

But first thing first: what is EMT, and what indeed is FA? (These are my short-hands, by the way.)

Efficient Market Theory (EMT)

EMT holds that the (stock) market is so efficient in absorbing the latest developments in the industry (company merger, major product launch, corporate scandal etc.) that the stock prices almost instantly reflect these developments. Thus, there is very little time available to an average investor to act on such “inside information”, before it becomes common knowledge so everyone does the same (thereby quickly driving stock prices up or down). In other words, because such developments are unpredictable, stock prices in turn cannot be predicted and they execute a random walk down Wall Street.

The investing strategy based on EMT is known as portfolio diversification, where the investors buy and hold a range of stock (and bond) funds indexed to broad segments of the financial market (also called index mutual funds). Because the prices of individual securities in a fund do not move in lockstep with each other, the portfolio achieves “diversification” by spreading the risk of asset downturns (dip in one security is compensated by rise in another).

Fundamental Analysis (FA)

FA holds the contrasting view that although unpredictable market events drive the stock prices over short times (as in EMT), there is a fundamental (or intrinsic) value of every stock that can be determined by analyzing the company papers (financial statements, annual reports etc.) and other available information on its management policy, competitive edge and so on. The stock price eventually catches up with its value (which is predictable), and the investor can benefit by trading the mispriced stock and waiting till it is “corrected” by the market.

The investing strategy based on FA is known as value investing, where the investor looks to buy undervalued stocks of otherwise healthy companies. Such a portfolio is expected to grow with time despite short-term fluctuations (so no need for diversification). But, because a company does not generally stay healthy forever (management changes, economy takes a hit, and so on), a value investor must tune his portfolio time to time by selling old overvalued stocks and buying new undervalued ones.

Go on to “Part II - Which one of them is correct?”

A scientist colleague of mine, a quiet 52-year old fellow with mind sharp as a tack in most earthly matters, has become caught up in the same affliction that many of us get in these uncertain financial times. He wanted to time the market, to make most of the up-down-up cycles of the ongoing fluctuations.

He tried to buy $5000 worth of stocks just before the end of Monday, when the stock market was showing a noticeable slide. Fed was making noises of giving it a boost the next day, so he was correct in thinking that stocks will take off Tuesday on this positive news, thereby netting him a tidy gain.

S&P500 index dropped 20 points by the end of Monday, a 1.55% loss. Fed announced a $200 billion loan to the banks the following day, and the index soared 47 points by closing time Tuesday, a whopping 3.7% gain. If my friend were to buy a mutual fund that tracks S&P500 index, he could have made 3.7% in a single day!

So, what went wrong? He failed to time his buying. He did send the money before the end of Monday, but the transaction could not be completed before Tuesday, when stocks were already near their peak. And by closing Wednesday (today), the index is again down 12 points, and so he actually ended up losing money.

If I were him, I would have spread $5000 into several small transactions over the entire month, which increases the odds of riding at least one wave from the bottom to the top - the standard advantage of dollar-cost averaging. What is more, you can automate the process, and do not have to spend any time trying to track the market.