[Editor’s Note: This post was  originally a Pro/Con post. Anytime someone participates in a Pro/Con post, I always offer the option to not run it if they’re not satisfied with how it turned out in the end. In this case, the writer for the Pro position decided he didn’t want it run. Frankly, I’m surprised that anyone ever agrees to one of these since most of the time I’m arguing from a much stronger position. At any rate, I’d spent way too much time writing my portion of it to not use it at all, so I’ve modified it into a Q & A post. Hopefully it still works.]

Q.

Why can’t I just buy the same stocks that Warren Buffett buys and then enjoy his outsized returns? I mean, there are a few talented managers out there, most of them value stock pickers a la Buffett and he basically gives the instructions in all of his letters to shareholders.

A.

Buying individual stocks is still dumb even if you buy the same ones as Warren Buffett. I love reading Warren Buffett’s letters. I also enjoyed reading The Intelligent Investor by Benjamin Graham. I think both are worth reading even if you never buy an individual stock. Let me begin my discussion of purchasing individual stocks with a quotation from each of these fine investors.

Warren_Buffett_KU_Visit

“Warren Buffett KU Visit” by Mark Hirschey

What Does Buffett Say You Should Do?

First, Warren Buffett:

A low-cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth.

Then, Benjamin Graham:

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors…

If we could assume that the price of each of the leading issues already reflects the expectable developments of the next year or two, then a random selection should work out as well as one confined to those with the best near-term outlook.

There’s point # 1. Both Warren Buffett and Benjamin Graham don’t think buying individual stocks is a very good idea. When asked how an investor should invest, they essentially recommend index funds.

Just Buy Berkshire Hathaway

Besides, if you’re just going to buy the same stocks as Warren Buffett, there is a far easier way to do so- just buy shares of Berkshire Hathaway (the insurance company shell Warren uses to buy and sell stocks.) Not only does this have the advantage of not having to pick and choose and analyze individual stocks yourself, but you don’t even have to wait for his letter to come out at the end of the year. When you own Berkshire Hathaway, you essentially purchase stocks at the same time Warren Buffett does, BECAUSE HE’S BUYING THEM FOR YOU! Plus, don’t discount the value of your time. Analyzing stocks, even if you’re just reading the annual reports of 5 or 10 gurus and placing a few trades, takes time. You know what your time is worth, so be sure to subtract that from your investment returns! That’s point # 2.

Berkshire Hathaway Owns More Than 5 Stocks

Some people think that buying just 5 stocks is somehow a good idea. If it was such a good idea, you would think Warren Buffett, the great investor, would do that with his Berkshire Hathaway money. How money stocks does Berkshire Hathaway own anyway? As of the time of this writing, the total is 45 stocks. Why would you own only 5 if Buffett thinks holding 45 is a good idea? Point # 3.

Uncompensated Risk

I’ve written before about the concept of uncompensated risk. That’s risk for which you aren’t paid. If you can diversify away a risk, the market isn’t going to pay you to take it. Single stock risk is very diversifiable. So the market isn’t going to pay you, on average, to take it. You’re not investing. You’re gambling. Single stocks can and do go out of business all the time. Remember Enron? What about Worldcom? Delorean? Eastern Airlines? RCA? Pets.com? Compaq? General Foods? Standard Oil? PanAm? Montgomery Ward? American Motors? Woolworth?

Even entire industries go out of business from time to time. How many buggy whip manufacturers do you know of? How many of the original Dow 12 companies still exist in its original form? Only 1. (Although to be fair, the successors of many of the others still exist.) 414 of the original S&P 500 are no longer in that index either. Where’d they go? What happens to your portfolio returns when you only have 5 companies and due to simple bad luck 1 or 2 of them disappear? Single stock risk is real. Point # 4.

Has Buffett Lost His Touch?

Warren Buffett’s goal is to beat the S&P 500. Well, he’s losing over the last 5 years. He’s still got a great record, of course, but it’s not perfect by any means. A significant percentage of the great returns he has enjoyed came before many investors were ever born, much less started investing. At any rate, even if he hasn’t lost his touch, the dude is 84 years old. How long is your investing horizon? I bet it’s longer than Warren Buffett’s life expectancy. Then you’ll need a new guru. I have met lots of 84 year olds and looked at a lot of 84 year old brains on CT. Even if Warren hasn’t yet lost his touch, I’m confident he will soon. When you’re 90, your brain just doesn’t work the same as when you were 40. Experience can only take you so far. But he failed to mention Point # 5.

It Doesn’t Matter What You Do With 2% Of Your Portfolio

If you want to go pick individual stocks, or buy whole life insurance, or dink around with peer to peer loans, or simply put it in a jar and bury it in the backyard, it just doesn’t matter what you do with tiny portions of your portfolio. If you think this concentrated portfolio is an awesome idea, then do it with the big money- the 90-98% of your portfolio that is actually going to determine whether you eat Alpo or Caviar in retirement. Nobody cares what you do with your fun money. But the fact is that even proponents of concentrated portfolios still diversify. Why? To protect themselves against the fact that their crystal ball is just as cloudy as the rest of ours. Point # 6.

Picking Talented Managers is a Fool’s Errand

Some people suggest that there are a number of Warren Buffetts out there. However, statistically, by the time you are sure that a manager is skillful, and not lucky, he’s retired and its too late to jump on the bandwagon. So that leaves you with two options- follow a guru when you’re not sure if he’s lucky or good, or ignore the guru completely and just buy all the stocks. I know what Warren Buffett would recommend you do. Point # 7.

What About Buffett’s Anti-Diversification Advice and Practices?

Some might argue that Warren Buffett has told people to avoid real diversification, such as in this quote from the 1993 letter:

 

“If you are able to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices.”

 

They might also argue that 70 percent of Berkshire’s money is in just 4 stocks, which is true. However, it is important to note that there are far worse ways to invest than this particular method.  In fact, if there were no low-cost index mutual funds available, or if the data on the folly of trying to best the “know-nothing” technique of just buying everything were not so robust, I would also likely use a Warren Buffett-like value investing technique to try to select great companies with a wide moat trading at reasonable prices. But there are low-cost index funds, and the data is quite clear about the likelihood of you (or Warren Buffett, or any of his favorite managers) picking winning stocks well enough to overcome the costs, fees, taxes, and time required to do so, especially over the long run.

However, I absolutely agree with Warren that if you’re going to be a believer in active management, concentrating your bets in your best ideas is your best chance at beating the market. Hope your best idea isn’t Enron.

Warren Buffett Is Not Just A Stockpicker

One other point that ought to be made, is that Warren Buffett isn’t just a stockpicker. The old mantra is put all your eggs in one basket AND WATCH THAT BASKET CLOSELY. Warren does that by putting himself onto the boards of the companies he buys. In effect, he’s not just buying the stock, he’s running the company. He’s adding value using his business and managerial skill. While you can buy the stocks Warren buys, when you buy a handful of individual stocks, you’re not being put on the boards of the companies yourself. And Warren isn’t going to be on those boards for long. Better hope his replacement is as good as he is. Point # 8.

 

Warren vs The World

While there is no doubt Warren is a savvy businessman and perhaps the world’s greatest investor, I prefer to cast my lot with the rest of the world when it comes down to the question of Warren vs the world. How do I side with the world? I simply take the world’s estimate of what companies are worth and buy them all at that price while minimizing my transaction and tax costs and eliminating manager risk, stock timing risk etc. When those companies make money, so do I. Warren Buffett owns no publicly traded companies that I don’t own myself. If Warren’s selected companies do great, that’s wonderful. I own them too.

What do you think? Do you think buying a handful of stocks similar to those picked by a guru such as Warren Buffett is appropriate for all or part of your portfolio? Why or why not? Comment below!