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Passive or active? Index funds or individual stocks? This is a choice that any potential investor makes at some point. The first option is to invest all the money in broad market funds and accept average returns. The second option is to tilt the risk-reward ratio a bit by choosing companies that grow money. It's a broad topic with countless different points of view, and one where Warren Buffett has a couple of pretty interesting things to say.
Advantages
The particular quote I am about to address is a response to the efficient market hypothesis – the idea that stock prices are more or less always correct. Every time new information becomes available? Stock prices will change almost instantly to take this into account.
The implication of the hypothesis, assuming we accept its truth, is that there is no way to gain an advantage from stock picking other than to reliably predict future events (which is difficult) or to access and act on internal knowledge. (something illegal).
Buffett does not believe in this hypothesis. In fact, he says that efficient markets “they only exist in textbooks” and that shares often trade at “Silly prices, both high and low.”
He ends the article, from one of his annual letters, saying: “The truth is that tradable stocks and bonds are baffling and their behavior can usually only be understood in retrospect.” And he is the living embodiment of proving his words, having outperformed the market for decades and decades.
A British stock that could have been trading at a “dumb price” recently it is Rolls-Royce (LSE: RR). The engine maker suffered a torrid few years and its share price fell to a low of 39p. The recovery was sudden and the price today, some four years later, is 525 pence.
big goal
Was the low price justified? Unlikely, as many on this same website said. The company had not yet seen the benefits of its cost-cutting exercises and the pandemic lockdowns that meant its aircraft engines were not in use were coming to an end. I'd say it's pretty difficult to argue that the stock was trading at the right price.
The flip side of this is that the shares may also be overvalued, and a forward P/E ratio of 25 is expensive compared to other UK stocks. I'm happy to say I bought on the way up, although I'm not sure I would today.
More generally, you don't even need to acquire 10-bagger companies like Rolls to benefit from Buffett's argument. Even a small improvement in total returns can make a huge difference in the amount of cash that ends up in a brokerage account.
A saving of £300 a month compounded at 10% for 30 years works out to around £624,000. Change the rate of return up to 12% and it is now £924,000. Increasing the interest by what seems like just a couple of percent ends up with almost an extra 50% after all the maths and compounding have been worked out. And that's the kind of thing that really helps with a big goal like a million pounds.