Buffett: The Impossible Expectations of Stock Performance

In his annual Shareholder Letter, Chairman Warren Buffett overviews Berkshire Hathaway's performance in 2007, and also expresses his viewpoint on future investment returns. Buffett asks if it is reasonable to expect equities to repeat their remarkable performance of the last century:

During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.

Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last...

I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about doubledigit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.

[Editor's note: The emphasis is mine]

See the full letter to shareholders [.pdf].

Comments

[NotaComplet...:]

It would appear that you do not recommend equities, without actually saying so. What do you therefore recommend?

2008 Mar 03 09:06 AM

[CM in MA:]

Gary, thanks for posting Warren's thoughts on at least one index return. It helps explain why he's not a passive index investor. It seems Warren is having some fun with us, and I believe he knows it. Putting it kindly, the Dow (DJIA) is a flawed index. At the risk of exaggerating, simply split the prices enough times and have each component go up a buck and the Dow would skyrocket. The DJIA is an artifact that gets reported because everyone is comfortable with it. That said, let's look at a real index, the S&P 500, through the lens of Warren's thoughts. From 1950 to year-end 2000, the S&P 500 (adjusted for splits/dividends) went from 16.66 to 1320.28. This is an annualized return of 8.95% for those 51 years. If the S&P 500 achieved the same record throughout this century, it would finish the year 2100 at roughly 6,972,515. Given the first seven years of the decade, it'll need to turn in a 9.66% annualized rate for the remaining 93 years. Can the 8.95% over time be repeated in the future? There's not one person who knows, including Warren. There's also not one person who knows if it can't do this, but history shows that at least it has. I wonder, though, why he's selling puts on indexes out to the mid-2020s. Could it be that he understands the bias towards upward moves, if only due to inflation? Perhaps he's just an optimist. As for his own holdings, he believes he can consistently find companies that can return an annualized 15% on equity, which if fully reflected in the price of the stock would also be an annualized return of 15% or more. Again, helps to explain why he doesn't want the drag of the rest of the index. I think Warren is great, and I wish I could invest as well as he has, and does. But he knows, as well as we do, that just because a number is large it isn't invalid or impossible to achieve. Want proof, look at the price of Berkshire stock. Back in 1969 who'd have ever thought that was possible.

2008 Mar 03 09:24 AM

[jerry parker:]

these reviews of the last century on the dow 30 stocks are meaningless as it's too narrow and the stocks have changed too much to be able to make any broad statements. it might work a bit better for S&P500, but even then there's been big changes to the composition of changing from industrial co's to an index filled w/ technology and financial svcs co's. btw, the financials are probably responsible for a good chunk of the overall index's weakness recently. therefore, it may not be a good time to be making snapshot analysis of today's performance(subprime fallout) vs. a longer period of time(like a 100 yr period). good luck to all, but i would recommend that people choose real co's rather than the index which is filled w/ dumb money which pushes up larger cap co's due to its size rather than because it's a better stock. after all, were INTC and MSFT better buys when they were $1B mkt cap going to $200B+? or $200B trying to up up 10x? Btw, you saw INTC and MSFT both languish AFTER it became part of the DOW 30 stocks also.

2008 Mar 03 10:00 AM

[mla99:]

Could someone explain why DOW 24M is an unrealistic expectation?

I mean, yes, the number is huge, but anything that compounds shows that growth behavior, right? If we were looking at DOW 66 we'd view DOW 12k as similarly amazing, no?

I'm no Pollyanna and I'm sure Buffett is right, I'm just trying to understand how you can tell when an exponential growth rate is unmaintainable.

2008 Mar 03 06:28 PM

[tkenyon:]

mla99, you re right - just because the number looks big relative to today's level means nothing. It's all a matter of whether the Dow can return 9% on average. I am not sure why Buffett emphasized the enormity of the number, as it is an example of "anchoring" , one of the behavioral mistakes he and Charlie try to avoid. Here he seems to be using our natural tendency to anchor to help make his point.

Regarding the puts, he wrote them because he get $4.5B NOW to play with for 15-20 years. I am sure he believes there is almost NO CHANCE of the indexes being lower in 15-20 years, hence he gets $4.5B almost like he found it on the sidewalk. When you consider the return he should be able to generate on those funds over 15-20 years, the chance of any NET loss is nil. If he can earn 6% on that 4.5B, he'll have 12.5B in 17.5 years. Vintage Buffett. He could care less about the non-cash effect on accounting earnings. I wonder who is on the other side of the trade - can you say sucker...

2008 Mar 04 09:12 AM

[CM in MA:]

tkenyon, you're absolutely right on all counts. I will point out, though, that due to the way the Dow is calculated, talking about returns on that index is a meaningless exercise. Btw, I was being facetious about Buffett selling puts--I guess it did not come across as intended. Sorry. As I wrote, it seems to me that Buffett is having some fun with us. cm

2008 Mar 04 09:47 AM

[hatarakiman:]

people should look at the total returns, not just only on the naked index. btw, use only one instance (20th centry) to pedict another outcome (21th centry), is meaningless.

2008 Mar 05 07:25 AM