Are High Returns Over Rated? Increased Respect For Buffett

By: ispeculatornew
Date posted: 03.07.2012 (5:00 am) | Write a Comment  (5 Comments)

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Over the past few weeks, I’ve spent a decent amount of time reading a book about hedge funds, which I will discuss later on because it has been very interesting. I am not quite done but there is one thing that has struck me: How high returns can often be very much over rated. Just to be clear, I don’t mean the return of a specific stock but rather returns that are obtained by a hedge fund, a mutual fund, a portfolio manager, etc.

Why is that? The book I’m going through is about some of the best hedge fund managers in the world, the best of the best. They have often been able to generate incredible returns of 30-40% and sometimes much more in a year. As if that was not impressive enough, they seem to be able to do this year after year, sometimes for a decade or more. How? Big, gutsy calls on a few specific trades. I don’t think it matters much if these trades are stock buys, fx, or whatever. The fact remains that if a manager can get such a return, they are generally doing one of 2 things:

-Putting their money on a few select calls
-Using leverage extensively

Since these managers are the best they get such calls right much more than not and they usually consider the downside risk when making such trades meaning that the risk is very limited.

At One Point Things DO Go Wrong

The problem is that no matter how great a manager or strategy is, at some point a bet does go wrong for whatever reason and a fund that is putting too much on the line will end up paying a very costly price. I’m not saying it’s not a good to risk so much but it is just not what I personally believe in. So yes, some such as Mark Cuban say that diversification is useless and almost “stupid” but I’m increasingly thinking that such a mindset can work for some time but eventually, a wrong bet can end up being very expensive.

Increased Respect For Buffett

Warren Buffett is not perfect, far from it as I have discussed often but what I do like about his investment strategy is that it seems fairly “immune” to huge losses. I’m not saying it’s impossible, that would be insane. But his bets are so diversified that it’s difficult to imagine a scenario where a 20-30% of his fund could be wiped out, let alone force the fund to close.

Using Leverage

I’ve been up and down quite a bit about using leverage while investing and have certainly discussed the benefits and downsides of using debt when executing dividend investing. I think the main lesson for me is to always think about the worst case scenarios as a reality rather than a seemingly impossible one. I will continue to use leverage in some aspects (such as the way it’s done in long & short tech stock picks) but I will also continue to VERY careful. Even great returns for 10 or 20 straight years means nothing if it all blows up down the line.

What Are Your Thoughts? Would You Invest In A High Performing Fund?

I would personally need to know how these returns are accomplished as it seems likely that such strategies could eventually mean big losses. Yes, if it seems too good to be true, it usually is…

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  1. Comment by Hans — March 7, 2012 @ 5:48 pm

    IS, if the benchmark is the S&P 500, it is not to difficult to have high returns; since most if not all funds have smaller baskets…

    What really needs to be done, is to compare other funds with similar stocks and positions, then it becomes a matter of timing and execution…

    Hence, a fund with ten holdings, will generally out perform or under perform a fund with twenty or thirty positions…

  2. Comment by IS — March 8, 2012 @ 8:43 pm

    @Hans – Not sure I agree, I would say that it might be more volatile and thus maybe get higher returns but in general for example the S&P500 outperforms the Dow Jones even though it has 15 times more stocks

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  4. Comment by John — March 19, 2012 @ 9:42 am

    IS, you did an piece on selecting dividend stocks where you put a large group thru a selection process and winnowed them down to a small portfolio. Can you show me this article again? I’ve been a vanguard investor for years and am now building a portfoio of currently 18 div stocks. Still have my ETFs at vanguard.
    John in Tacoma WA

  5. Comment by IS — March 19, 2012 @ 7:13 pm

    @John – I guess you are talking abut the USDP portfolio, see the latest update here:

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