When asked his opinion on financial advisers, Warren Buffett (Trades, Portfolio), CEO of Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial), wasn’t too enthused.
“If they told everyone what a simple game it was,” he said, talking of the investment game, “then 90% of the income or more of the people that were speaking would disappear. So, really, it’s a little too much to expect of human nature that people will explain why they aren’t really adding any value to what you can do by yourself. Or, actually, I hate to use the example, but you can have monkeys throwing darts at the page and take away the management fees and everything. I’ll bet on the monkeys.”
Buffett’s sentiments echo those of John Bogle, founder of Vanguard Group. Bogle championed low-cost index fund investing for the average investor, arguing that hedgehogs (index funds) beat foxes (active managers). Let’s explore why these investing legends believe simple index funds outperform both actively managed funds run by supposed experts and the advice given by most financial advisors.
The hedgehog and fox metaphor
John Bogle popularized the metaphor that hedgehogs beat foxes when it comes to investing. In this analogy, hedgehogs represent simple index funds, while foxes symbolize actively managed funds run by smart, resourceful managers.
Foxes are clever animals known for their cunning. Similarly, active fund managers employ numerous tactics in trying to beat the market. They have access to sophisticated research and data to inform their stock picking. Managers build complex, optimized models to try to pick winning stocks.
Active funds hire large teams of analysts to research companies and industries in depth. Some funds utilize armies of Ivy League MBAs, PhDs and CFA charter holders, assuming credentials lead to outperformance. These supposed experts have vast informational and technological resources at their disposal. In Bogle’s view, these are the foxes.
In contrast, hedgehogs represent simple index funds. While not as exotic as foxes, hedgehogs have one extremely effective defense mechanism – rolling into a spiny ball. Index funds take a similarly straightforward approach, simply buying and holding the entire market.
An index fund’s simplicity is its strength. By owning a basket of stocks mirroring a broad market index, it is guaranteed to generate long-run market returns minus minimal fees. According to Bogle, index funds are the hedgehogs.
Why hedgehogs outperform foxes
So why do hedgehogs reliably beat foxes over time? The data clearly shows index funds consistently outperform active funds after fees are taken into account.
While some active managers do beat the market occasionally, few are able to do so consistently. Beating the market requires identifying inefficiencies and having some informational edge over other market participants. The reality is such edges are hard to sustain long term.
Markets evolve rapidly as new information emerges. The stocks and strategies in favor of change. Managers who beat the market one year often underperform the next. Outperformance rotates.
Making matters worse for foxes, active funds charge substantially higher fees than index funds. Expense ratios for active funds often top 1%, whereas index funds are available for 0.03% or less.
These fees provide a significant drag on net returns over time. Legendary investor William Sharpe estimated the average actively managed fund underperformed its benchmark by the amount of fees charged. After fees, the foxes lag behind the hedgehogs.
Given the lack of consistency and high fees, few active managers succeed in beating the market long term. On the other hand, index funds reliably generate market returns minus minimal costs year after year.
Over 10 or 20-year periods, the hedgehog beats the fox thanks to simplicity, diversification and low expenses. Passive investing consistently wins out over active stock picking in the long run.
Buffett's monkey analogy for financial advisors
Buffett took aim at another supposed source of expertise – financial advisors. He famously quipped that he would bet on monkeys throwing darts beating the recommendations of most financial advisors, referring to Princeton University professor Burton Malkiel’s book, "A Random Walk Down Wall Street."
In Buffett’s experiment, a monkey throws 50 darts randomly at a list of stocks. The primate then holds this basket of stocks long term, without any clever trading based on research or market timing.
The monkey knows no analytically sophisticated tricks. It picks stocks and passively sticks with them, regardless of investment trends or headlines.
On the other hand, financial advisors present themselves as experts, possessing wisdom that individual investors lack. Many promote market timing models and claim to identify mispricing.
According to Buffett, however, most advisors are no better at picking winners than random chance. For their expertise, advisors charge sizable fees, eating into long-term returns.
Why monkeys outperform most advisors
So why does Buffett claim monkeys throwing darts would outperform most financial advisors? The logic is straightforward.
While stock prices fluctuate day-to-day, they inexorably rise over decades. Markets have a strong long-term upward bias. Consequently, even a basket of stocks picked randomly is likely to generate good returns given enough time.
The monkey pays no management fees or trading commissions. All gains earned flow directly to the monkey. However, advisor fees drag on performance significantly over long periods.
Rather than trade based on predictions, the monkey remains invested through bull and bear markets alike. Buffett recognizes most advisors cannot time markets effectively. Ultimately, time in the market wins out over vainly attempting to time markets.
The pitfalls of active management
Actively managed mutual funds try to beat the market through savvy stock picking or market timing. However, few can overcome the headwinds of high fees and inconsistent performance over full market cycles.
Trading costs and tax inefficiencies also hinder active managers. Meanwhile, passive index funds simply track the market at a minimal cost. They benefit from decades of academic evidence showing active management fails to outperform long term, after expenses.
Choosing simplicity and discipline over expertise
The bottom line is that simplicity and discipline win in investing. Follow the proven wisdom of Bogle and Buffett – minimize costs by using index funds and stay invested through ups and downs.
Ignore flashy funds run by supposed “experts.” Do not pay for hype and promises from financial advisors. Stick to basic index funds and let your money snowball over your lifetime.
Hedgehogs reliably beat foxes and monkeys beat most advisors. By harnessing time and compounding, ordinary investors can grow their wealth steadily as well.
