Passive or active? Index funds or individual stocks? This is a choice any would-be investor makes at some point. Option one is to bung all the money into broad-market funds and accept average returns. Option two is to tilt the risk-reward ratio a little by choosing companies to grow the money instead. It’s a wide topic with countless different viewpoints, and one in which Warren Buffett has a rather interesting couple of things to say.
Advantages
The particular quote I’m about to go into is a response to the efficient market hypothesis – the idea that the prices of stocks are more or less always correct. Whenever new information is available? Share prices will near-instantly shift to account for it.
The consequence of the hypothesis, assuming we accept its truth, is that there is no way to gain an advantage from stock picking outside of reliably predicting future events (somewhat difficult) or having access to and acting on insider knowledge (somewhat illegal).
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Buffett does not believe in this hypothesis. In fact, he says efficient markets “only exist in textbooks” and that stocks often trade at “foolish prices, both high and low”.
He ends the piece, from one of his annual letters, by saying, “In truth, marketable stocks and bonds are baffling, their behaviour usually understandable only in retrospect”. And he’s the living embodiment of the proof of his words, having earned above-market returns for decades and decades.
A British stock that might have been trading at a “foolish price” recently is Rolls-Royce (LSE: RR). The engine maker suffered a torrid few years and its share price fell to a low of 39p. The bounceback was sudden and the price today, around four years later, is 525p.
Big target
Was the low price justified? Unlikely, as many were saying on this very website. The firm had yet to see benefits from its cost-cutting exercises and pandemic lockdowns that meant its aeroplane engines weren’t in use were coming to an end. I’d say it’s pretty hard to argue that the stock was trading at a correct price.
The flipside of this is that the shares can be overvalued as well, and a forward price-to-earnings ratio of 25 is on the pricey side compared to other UK stocks. I’m happy to say I bought in on the way up, though I’m not sure I would today.
More broadly, it doesn’t even require picking up 10-baggers like Rolls to benefit from Buffett’s point. Even a small improvement to total returns can make an outsized difference to the cash sum that ends up in a brokerage account.
A £300 a month saving compounded at 10% for 30 years gives about £624k. Tweak the rate of return up to 12% and it is now £924k. Bumping the interest up by what seems like just a couple of percent ends up with a nearly 50% extra after all the maths and compounding has been worked out. And that’s the kind of thing that really helps with a big target like a million pounds.
