Berkshire Ruminations

Saturday, September 09, 2006

MIZZOU alumni magazine reaction

In the recently published Fall 2006 issue of MIZZOU, the University of Missouri's alumni magazine, there appeared an article about my class, and to some extent, about me. The article was written by Catherine Pernot, and is similar to the article that she wrote for the Columbia Missourian earlier this year.

I anticipated some type of reaction, but beyond phone calls and emails from old friends, the reaction to the article was muted. The editor of the magazine did pass along a letter written to her by an alumnus of the journalism school. I repsonded to the letter only for my own benefit and for this blog, so as far as I can tell, the Reader will never see it. Below, find my summary of the Reader's letter, and then my reaction to it.

Reader writes (paraphrased by me):

Students of MU are ill-served by FIN 8001, the Warren Buffett Class. The material in the course contradicts our best understanding of the markets and even what Mr. Buffett suggests. Mr. Buffett suggests investing in index funds, therefore supporting the efficiency of the markets. I am dismayed that students enjoy "abandoning the academic ideas of efficient markets" and that the author of the article says "Markets are not efficient, financial diversity is for dummies..." Mr. Buffett's recommendation of index funds for individual investors shows that he thinks diversification is better than concentrating on a small number of stocks. Finally, I hope MU's medical school is not as dumb as the business school is to "abandon the academic ideas."

And My Response:

I can appreciate Reader’s reaction, as the article did indeed have a fairly antagonistic tone. And as he is an employee of an “academically-based” investment firm, I can understand his reluctance to embrace the benefits of our course. However, I think his understanding of the course is too superficial to knowledgably rebut it. I would submit the following to him in response.

Our course indeed acknowledges the merits of Efficient Market Theory (EMT), but also its shortcomings. I think Reader misinterprets the word “abandon” in the student quote to which he refers, “It was great to have a class on investing that more or less abandoned the academic ideas of efficient markets....” The course does not disregard EMT, but rather ignores it in favor of alternative explanations for business valuations. Such an approach is crucial to teaching the fundamentals of finding enterprise value – a skill that is highly transferable to a variety of areas in finance and financial services. That is, if EMT held, and firms trade at their intrinsic value, who would concern himself with determining what that intrinsic value is? Instead of dismay, I would hope Reader feels comfort that MU students are working to gain a skill set that many students at other universities graduate without.

I feel the following quote from Mr. Buffett’s 1988 letter to shareholders is very consistent with the perspective of FIN 8001.

"Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day."

Warren Buffett does indeed encourage individual investors to invest through index mutual funds, but not because of the efficiency of the market as this Reader asserts. Rather, he sees diversification as an effective way for an individual, relatively ignorant about business and its valuation, to take part in the economic productivity of business. Diversification is protection against ignorance, he maintains, but those who are not ignorant have no need to diversify. When an individual does diversify, index funds are the best way to do this because they minimize costs that commonly eat away at actively-managed fund returns.

Perhaps the following quote from Mr. Buffett's 1993 Annual Report will help Reader understand Buffett's position as well as the author’s commentary that “financial diversity is for dummies.”

“Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb.

“On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: ‘Too much of a good thing can be wonderful.’”

I would also submit that mutual funds’ general failure to outperform the market is not a result of fear and greed, but rather the often excessive fee structures that they employ. Reader, being a beneficiary of such a fee structure, though, would likely rather ignore this factor.

The academic process is founded in curiosity and is only advanced through a constant questioning of accepted doctrine. If ever there were a place in business education to introduce an alternative explanation, I believe efficient market theory is it given the long history of anomalies and critiques that have been documented and published since Eugene Fama’s original paper in 1970. The recent literature clearly supports this attitude, in my opinion.

I am disappointed that Reader focuses on the course’s “dismissal” of semi-strong form EMT but only makes passing reference to the ideas derived from a different academic theory, behavioral finance, which is discussed in the course and mentioned in the article. It is for this reason that I find his analogy to the medical school “abandoning the academic ideas” not only scurrilous, but unfounded.

Finally, as an academic myself, I wholeheartedly appreciate Reader's objection. However, I think both his perspective on academic finance and on this course is too narrow.


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