Are you better than Buffett?

Are you better than Buffett?
Be a realistic investor as even Warren Buffett has achieved just 21% annualised return over the years


By WONG SUI JAU

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WHEN presented with or considering any investment scheme, it is always important to ask yourself, 'What are you investing into?' Also, are the risks and returns of this investment reasonable? This leads us to another question, which is 'What makes an investment's returns reasonable?'




In any reasonable kind of investment, one relationship has always held true: High risk = high returns, and Low risk = low returns. However, when markets are doing well, investors sometimes get carried away by greed, and their expectations of their returns can become too high.

This is especially dangerous when unscrupulous people start to use very attractive returns to lure people to place their money into what are probably scams. Let's take a look at how the stock market (S&P 500 Index, which consists of 500 blue chip stocks in the US market) of the largest and most powerful economy in the world has fared over the last 42 years to give us an idea on what makes a 'reasonable' return. From 1965 to 2006, a period of 42 years, the index would have returned an annualised 10.4 per cent (in US dollar terms and with dividends re-invested).

This figure might look rather disappointing, but at that rate of growth, a US$10,000 investment at the start of 1965 would now be worth US$637,800 at the end of 2006. That is how much just US$10,000 would have grown into. Equity markets may go through booms and busts, but returns on average over a long time horizon can turn out to be significant, like in this case.

This is fairly indicative of the type of long term returns that investors can expect to get from just passively investing in the market. Good fund managers will outperform this return. So will good individual investors. But if you believe strongly you can do a lot better, here's another example that might serve to put things in a better perspective.

How good is Buffett?

Let's take one of the most successful investors in the world as an example: Warren Buffett. He is now one of the world's top three richest men with a fortune worth tens of billions of dollars. And he is well known for his investment skills. His primary investment vehicle is his company Berkshire Hathaway. What kind of annualised return do you think Warren Buffet has achieved over the years? It is not 30 per cent, or 50 per cent. In fact, it is just 21 cent.

Based on the annual report of Berkshire Hathaway, from 1965 to 2006, the company's per share book value has increased by an annualised 21.4 per cent. This may not seem much higher than the annualised 10.4 per cent that the S&P 500 Index has achieved. But a difference of just 11 per cent in terms of the annualised return means that the same US$10,000 would now grow to over US$34 million over 42 years.

This brings us back to the issue of what makes an investment's return 'reasonable'. When you do your investing, or are considering any investment vehicle, ask yourself this: 'Are you the best investor in the world? If you admit that you are not, then over the long term, do you expect to achieve a return of 21 per cent per annum?'

When stock markets, or your investments go up, it can sometimes be easy to think that these types of returns are always going to happen every other year. But in truth, they do not. The annualised return of 10.4 per cent that the S&P 500 Index has delivered is made up by good years when the index can grow by more than 20 per cent, as well as bad years where the index may fall by 15 per cent or more. Many investors believe they can skip all the bad times and only participate in the good times.

Trying to time the market to give yourself better investment returns is understandable, but again, we need to be realistic. Even with trying to time the market, what kind of returns would you expect to make over a very long period of time of 20 years or longer?

Even one of the best investors in the world, when measured over decades, has an annualised return of just 21.4 per cent. So, when you try your hand at it, you definitely should be a lot more realistic in your projections of returns. After all, there is only one Warren Buffett in the world! This then leads to some 'investments' which try and promise 50 per cent per annum, on a consistent basis, or even 100 per cent, and higher! I have only one word for such 'investments'. They are scams.

While stock markets can go up 50 per cent or 100 per cent in a very strong bull run year, the key word here is consistency. Stock markets never ever go up 50 per cent or 100 per cent every year for 10 or 20 years. It is impossible. Similarly, if an 'investment' can promise you 50 per cent every year without fail, there is something wrong somewhere. A return of 50 per cent per annum to US$10,000 after 42 years would lead to US$248 billion! And no one today, not even Bill Gates has that kind of money.

If anyone knows of a way to make 50 per cent return every year with no risk, the last thing that person would be trying to do would be to sell that investment to other people. Even by borrowing money and factoring the loan interest, this person can still make a return that would be higher than the most successful investor in the world. So, if he can do that, why would he even need to ask other people to join him?

There are pyramid schemes thought up by scammers who make use of eye-popping returns like 50 per cent per annum to lure people in. Any such high returns, especially if they seem to come with little risk should be treated with extreme suspicion. In fact, it is better not to get involved in these at all. They may paint lots of rosy pictures of how much potential their scheme has, etc. But at the end of the day, ask yourself seriously. If this scheme is so successful and has so much potential, how come they need so many other people to join them?

The answer is because they need your money. And while it may still start off all right initially, eventually, people will find out about their scam, and huge numbers of people at the bottom of the pyramid will lose their money. And you may well be one of these people who will lose their money.

What exactly is a pyramid scheme? A pyramid scheme is a business model that involves mainly enrolling other people into the scheme. There is often little said about the product, or service it is supposed to sell. Far more effort is actually spent trying to get ever more and more people to participate in the scheme. The key thing about a pyramid scheme is that it is unsustainable.

Very often, the product or service itself is very uncompetitive, and under normal circumstances, you would never imagine yourself spending thousands of dollars buying such a product. However, the pyramid scheme promises you very high returns, and on a consistent basis too! You might be getting 50 per cent per year, or even 100 per cent! The thing is, people who join the scheme are actually surprised when they initially do get some money back. This is when their greed starts to really kick in.

Unsustainable scheme

And this is how the pyramid scheme works. It gets an ever increasing number of people to join the scheme. The earlier people who join, and who are experiencing amazing returns, are the biggest proponents of the scheme and insist it is the best thing in the world. These people will then be motivated to try and get their friends into the scheme.

In actual fact, what is happening is that the people joining the scheme later are financing, or paying for the returns that the earlier joiners are getting. And the biggest winners are the people at the very top of this pyramid, who started the scheme in the first place. The whole problem with all this is that a pyramid scheme is unsustainable. That is because the entire scheme isn't really making money. All it is doing is getting more and more people to join it, and pump their money in and then using those monies to pay off the dividends of the earlier people who join. And after a while, when you run out of people to join your scheme, the entire thing collapses.

Suddenly, nobody is getting paid anything anymore. The next thing that happens, people start getting worried and want to withdraw their money. Those who withdraw early might still get their money. But since no profits were ever really made, if a large number of people all start getting worried and want to withdraw, then there is no way the scheme can keep up its deception. At this point, everyone would realise they have been conned and the panic would set in, but by then, it would be too late. All the money would have gone to those few people at the very top of the pyramid, while the rest of the people in the later tiers would be left with nothing.

The table above shows this clearly. See how it looks like a pyramid?

It should be noted that there are valid investment vehicles with a long history, like stocks, unit trusts, bonds and such. Then there are investments which are not well known, and there are outright scams, which are thought up by conmen. By understanding how these investments make their money, and also by understanding the concept behind what is a reasonable type of return versus what is not, you can protect yourself.

Wong Sui Jau (CFP) is the general manager of Fundsupermart.com Pte Ltd, a division of iFAST Financial Pte Ltd