Would I Make a Buffett Bet 2.0?

Here’s the first question in the Abnormal Returns blogger wisdom series:

Question: Let’s say Warren Buffett re-ups his famous decade-long bet. (He’s not.) He takes the S&P 500. What would you take (and why)?

My answer:

This is a more interesting bet now. In the 5 years prior to the 2008 bet the US markets had only compounded at about 9% vs the 13% rate of the last five years. But I’d throw in a caveat. Comparing the nominal returns of the S&P 500 to a hedge fund index over 10 years is stupid. The Protege team should have known better than to take that bet. Given how stable the equity market has been in the last 8 years I’d require that we split the bet into two separate bets. Half the pot goes to the nominal return winner and the other half goes to the risk adjusted return winner based on Sharpe ratio. That way we’re creating a bit more balance with the bet since hedge funds are judged in large part not by how much return they generate but by how they generate it. Interestingly, with low yields, stretched stock valuations and excessive fees in hedge funds I have to admit that neither the hedge fund nor the 100% S&P 500 portfolio looks all that great to me if you’re putting your money where your mouth is….

So, if I were making this bet with Buffett – well, over a ten year time horizon I’d feel pretty comfortable taking the S&P 500 with 10% leverage. Over any 10 year period the high probability bet is that the stock market will rise so if you want to beat Buffett then just beat him with a higher beta bet than he has going on. Lame, yes? Smart, Yes.

This is just a classic risk/reward model with the assumption that 10 years is a long enough time horizon over which to bear the stock market’s risk with the assumption of a profitable outcome. That’s a pretty good bet in the vast majority of scenarios. Of course, you have to be willing to bear the potential for huge swings within that 10 years so on a risk adjusted basis this doesn’t look like a great scenario to be entering into an overly aggressive portfolio, but it’s fun to theorize.

NB – My favorite thing about this whole Buffett bet is the fact that Buffett actually lost his own bet. That is, his own stock, which is essentially a congolmerate of actively picked public and private stocks, has generated a worse return than the S&P 500 since 2008. But perhaps even better than that is the fact that the relatively conservative zero coupon bonds that they invested the proceeds into at the beginning of the bet performed so well by 2012 that they actually sold that piece. In other words, not only did Buffett’s company lose the bet to an index fund, but a relatively conservative bond instrument beat them both so early on into the bet that they took that money off the table!