The person who helped inspire the passive-investing boom, the late economist Paul Samuelson, became wealthy from his active investments.
The greatest active investor of our time, Warren Buffett, advocates investing passively.
Their paths crossed, decades ago, in ways that should remind us how rare the lightning bolt of a great investing idea is—but also how huge an edge it can provide.
That’s easy to forget or ignore. Most investors are better off not trying to beat the market, instead buying passive funds that track a market index.
And investors are doing just that. For the year to date through Nov. 30, they have withdrawn $142 billion from active U.S. equity funds and added $184 billion to passive U.S. stock funds, estimates Morningstar.
Index funds have reached 48.1% of total U.S. stock-fund assets at Nov. 30, up from 44.6% one year ago. If present trends continue, says Morningstar analyst Kevin McDevitt, index funds could exceed active funds in total assets by mid-2019.
Prof. Samuelson’s decisions show why investors shouldn’t become so doctrinaire about index funds that they completely cut themselves off from any chance, however rare, of doing better.
In 1970, the same year he became the first American to win the Nobel Prize in economics, Prof. Samuelson began buying stock in Mr. Buffett’s Berkshire Hathaway Inc.(BRK/B) (BRK/A), at a cost that eventually averaged about $44 per share. (Berkshire’s A shares traded this week at approximately $290,000 apiece.)
Prof. Samuelson had been corresponding with Conrad Taff, a private investor, about finance. Mr. Taff had studied at Columbia Business School under Benjamin Graham, the investment analyst who also taught Mr. Buffett.
Visiting the Boston area one day while helping revise Mr. Graham’s classic book, “The Intelligent Investor,” Mr. Taff sat down outside Prof. Samuelson’s office at the Massachusetts Institute of Technology, politely refusing to leave until the great economist saw him.
Prof. Samuelson was already famous, in part, for arguing that investment prices fluctuate randomly, reflecting the latest available information.
That efficient-market theory is often oversimplified into a belief no one can beat the market. Prof. Samuelson thought no such thing; he believed that investment skill does exist.
“There will always be some [investors] quicker and smarter than the others and hence capable of greater capital gains,” he said in 1967. Beating the market is hard; identifying people who can beat the market is even harder.
Mr. Taff waited for about an hour until the door finally opened, recalls Prof. Samuelson’s executive assistant at the time, Joan Thompson.
Mr. Taff, who died in 1988, was persuasive. By the time the door opened, he had already convinced Ms. Thompson to buy some shares of Berkshire. To Prof. Samuelson, he cited Mr. Buffett’s phenomenal track record and pointed out that Berkshire’s gains compounded tax-free for its owners, as the company didn’t pay out dividends.
“The tax treatment was really what motivated him the most,” recalls Prof. Samuelson’s son Paul, chief investment officer at LifeYield LLC, a Boston firm that provides software to financial advisers.
Prof. Samuelson—who for years had been blasting the mediocrity of most fund managers—knew lightning had struck. He soon began buying Berkshire Hathaway shares, adding more over the years.
He ended up bequeathing them to his six children, 15 grandchildren and various charities. If he hadn’t dispersed the Berkshire shares, they would likely be worth more than $100 million today.
His theory notwithstanding, Prof. Samuelson had been an active, but patient, investor. “He did it as a hobby,” says his son William, who teaches finance at Boston University. He recalls his father spreading “tearsheets,” or research summaries of individual stocks, on the dining room table. Prof. Samuelson was also a large charter investor in Commodities Corp., a pioneering futures-and-options trading firm.
In a 1974 essay for the Journal of Portfolio Management, Prof. Samuelson called for the creation of a low-cost mutual fund that would replicate the returns of the S&P 500 index (.SPX).
Inspired by that challenge, Vanguard Group founder John Bogleintroduced the first index mutual fund in 1976. Among its early investors: Prof. Samuelson. From then on, he generally didn’t buy individual stocks, say his sons Paul and William.
In an interview this week, Mr. Buffett says Prof. Samuelson believed the same thing he does: that markets are “generally very efficient but not perfectly efficient.”
Mr. Buffett adds, “I do think if you know something about finance and about people, you may be able to identify someone out there who can overperform. But for every one you identify who can, there’ll be 1,000 others who don’t turn out to be able to.”
Continues Mr. Buffett: “You’re betting enormously on your ability to be a reader of people, even more than your ability—or theirs—to select securities. They’re all promising overperformance and spending a lot of money on selling it very persuasively. Overwhelmingly this is a world of salespeople.”
If a smart analyst materializes out of nowhere, waits outside your office for an hour and then tells you about a great long-term investor who is highly tax-efficient, you are either lucky enough to be encountering a blast of lightning or you are about to be scammed. Do plenty of homework before believing in lightning. It is probably just a flash of marketing glitz.
And if lightning never does strike, you should favor index funds as Prof. Samuelson did and Mr. Buffett does—without fear or shame.
“That’s what I’ve been telling every rich friend of mine for a long time,” Mr. Buffett says. “People who are rich just can’t accept that fact. If you’re rich, you can buy a lot of things, but on average you can’t buy above-average performance.”
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