Warren Buffett’s annual shareholder letter is probably the most widely read dispatch in the business world. His insights, expressed with his trademark clarity and humour, are a bounty for investors. In December 2007, Buffett made a 10-year bet with hedge fund firm Protégé Partners. Each would choose an investment for a 10-year period and the each would pay $500,000, a total of $1m to the winner’s chosen charity.

Buffett picked a low cost investment in an unmanaged S&P 500 index fund. Protégé Partners picked five “fund-of-funds” which in turn owned interests in more than 200 hedge funds.

In December 2007, the housing crisis in the US had already started and the early signs of stress in the banking sector had begun to appear. The run on Northern Rock in the UK occurred in September. Then, it looked like an active approach was the right call. A static bet on the US stock market that had been on a bull run since October 2002 looked naive. The managers of the five fund-of-funds possessed a further advantage: They could – and did – rearrange their portfolios of hedge funds during the ten years, adding better funds while exiting those hedge funds it deemed unworthy.

In December 2017 the results of the bet showed Buffett’s funds grew +125 and Protégé’s funds +36%.

Buffett’s lessons for investors are:

  • A low cost, low turnover approach wins out. Despite great resources and even greater incentives to perform, the actively managed approach came up well short.
  • Buffett has long been disparaging of the academic view of risk, which equates it to volatility or the dispersion of returns. In his view, investing is an activity in which consumption today is foregone in order to allow greater consumption later. “Risk” is the possibility you fail to meet this objective.
  • We tend to think about money in nominal terms – euros and cents in our bank account. Over the long term, the rational definition of money is purchasing power. If living costs double and your capital remains the same, you lose half your money. So, if money is purchasing power, risk is that which threatens it and safety is what preserves or enhances it.