Decoding the conflicting investment advice of Warren Buffett

Warren Buffett stands ready to exit stage left from one of the most glittering careers in business history. Over six decades he has turned Berkshire Hathaway from a struggling textiles business into a trillion-dollar company, now often standing alone among the big technology stocks at the top of the S&P 500.

At the end of this year, Warren Buffett will hand over the reins of Berkshire Hathaway to his successor as CEO, Greg Abel. Buffett will remain as Chair, so he won’t be totally out of the picture, but nonetheless the transition will be substantial as well as symbolic.

Why Buffett needs decoding

Over his many years of managing money, Buffett has written plenty about investing, mainly through his annual letter to Berkshire shareholders. These missives are a goldmine for stock market historians, and sometimes Buffett’s lessons are as clear and as memorable as fables.

Invest for the long term, seek out companies with economic moats, and don’t buy crypto because it’s probably “rat poison squared” are pretty unequivocal. But there are other aspects of Buffett’s teachings which might appear inconsistent and require some decoding.

To begin with, there is an enigma at the heart of Buffett’s reputation. He is known as the world’s greatest value investor, largely because of his early association with Benjamin Graham, the granddaddy of the value investing creed. Buffett described his own early work as cigar-butt investing, looking for down and out companies trading at extremely low valuations, but which had one last puff in them. But early on his career, his style shifted, after buddying up with his long-term partner, Charlie Munger, in the mid-1960s.

Is Buffett a growth or value investor?

In 1990 he summarised their approach with characteristic acuity: ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.’ In 1993 he gave his views on growth versus value investing: ‘the two approaches are joined at the hip’. Hardly the sentiments of a die-hard disciple of value investing. Buffett certainly takes valuation into account when investing but would say this is meaningless without some measure of the growth that is expected from a company. It’s not very catchy, but we would now categorise this approach as Growth at a Reasonable Price, or GARP for short. Warren Buffett: the world’s best GARP investor? It’s easy to see why the value label has stuck.

Why is Buffett a fan of passives?

Perhaps one of the most controversial statements made by Buffett is his repeated insistence that ‘large and small investors should stick with low-cost index funds’. This is mind-blowing coming from the most successful active investor of all time, especially one who welcomes thousands of stock market enthusiasts to the Berkshire Hathaway AGM every year, a gathering which has come to be known as ‘Woodstock for capitalists’.

Buffett’s endorsement of tracker funds likely stems from his disdain for Wall Street, with its high fees and propensity to create complex financial products that have a great sales pitch. Retail investors have definitely got the memo, with flows into passive funds far outpacing their active competitors in recent years. Weak active fund performance has helped pour fuel on the fire. Our own Manager versus Machine report shows that in the last 10 years, just 30% of active funds in major equity sectors have outperformed a passive alternative. But Buffett clearly demonstrates it’s possible for an active manager to beat the market. He’s living proof of that. And many of today’s best-known fund managers echo Buffett’s investment philosophy – Terry Smith immediately springs to mind.

Everyone will come to their own view about whether active funds are worth the candle. Arguably there are areas like smaller companies, income investing, and managing volatility where active management comes into its own. And DIY investors have the luxury of being able to blend active and passive strategies in one portfolio, so there’s no need to dogmatically come down on one side of the fence.

What are Buffett’s views on diversification?

Buffett’s advocacy of tracker funds also sits uncomfortably alongside another of his controversial dictums: ‘diversification is protection against ignorance’. This puts him at odds with any investment adviser you might care to meet, and in hot dispute with the adage that diversification is the only free lunch in investing (often attributed to the Nobel laureate economist Harry Markovitz). So, what are we to make of diversification? Is it friend or foe?

There’s no doubt that diversification is a good thing for private investors. But for active fund managers like Buffett, over-diversification is likely to mean performing in line with the market before fees, and below a tracker fund after fees. The UK pension landscape was for many years blighted by closet trackers which invested much like an index fund but charged active fees for doing so.

Remarkably there are still a fair few of these funds kicking around. Where Buffett is coming from on this is that active managers should have conviction in their stock picks, and be willing to back them with big allocations, instead of just pruning around the edges of a portfolio that looks a lot like the market.

Where to find out more

Warren Buffett may be stepping back from the front line of Berkshire Hathaway, but he leaves us with a wealth of opinion and information about markets and investing. And who knows – he may yet add to it. If you’re interested in Buffett you can read his annual letters to shareholders dating back to 1977 on the Berkshire Hathaway website, for free. It’s a tremendous resource, but if you’re willing to shell out a few quid for the highlights you could seek out the Essays of Warren Buffett, edited by Lawrence Cunningham

Whatever your views on active or passive investing, here at AJ Bell we have a range of MPS that covers both passive and active management, alongside a blend of the two, our ‘Pactive’ range. The AJ Bell Funds and MPS also offer a route to keeping costs low, as highlighted by Warren Buffett, ensuring that more of your clients’ assets are invested for the long term and available to compound.

Past performance is not a guide to future performance and some investments need to be held for the long term.