Warren Buffett vs Pension Funds

In the vast universe of investing, different strategies cater to different types of investors. This post delves into contrasting investing philosophies, shedding light on the approach of a legendary investor, Warren Buffett, and juxtaposing it with the typical strategies employed by pension funds.

What is Warren Buffett’s approach?

Warren Buffett, the renowned investor and chairperson of Berkshire Hathaway is one of the world’s most successful investors. So, what are the characteristics of his investing philosophy?

He believes in a “buy and hold” strategy, not a “buy and sell” strategy. Once a good investment is made, Warren Buffett holds this investment forever. He never sells.

Warren Buffett promotes simplicity. Rather than rely on some complex formula to determine which investments to make, he only invests in individual businesses and stocks. No bonds, no hedge funds, no private equity funds, no real estate, no gold, no bitcoin, etc.

Here are the main characteristics of Warren Buffett’s investment philosophy:

• Buy and Hold: Buffett believes in purchasing stocks and holding onto them for a long period of time, often indefinitely, to allow their value to compound.
• Invest in Individual Businesses: He emphasizes investing in individual businesses based on their intrinsic economic value, rather than other criteria or opinions.
• Preference for Index Funds: For the average investor, Buffett recommends index funds as they offer broad market exposure, diversification, and low fees.
• Simplicity: Buffett suggests investing in businesses that you understand. He prefers simple, predictable, and stable businesses over complex ones.
• Reduce Emotional Bias: He stresses the importance of separating emotions from investing. Decisions should be based on solid research and business fundamentals, rather than market sentiment or opinion.
• Focus on Long-term Value: Buffett looks at long-term growth prospects rather than short-term fluctuations.
• Reduce Costs: Buffett aims to minimize management fees, transaction costs, and taxes as these expenses can considerably reduce the net returns on investment.

The result of Warren Buffett’s approach to investing is a portfolio focused mostly on stocks and stock index funds. Using his approach, there is little need to pay for investment advice.

What is a typical Pension Fund’s approach?

Alternatively, pension funds don’t invest like Warren Buffett. In fact, they do the opposite.

Most pension funds build their investment portfolio around a portfolio of various assets to match an optimal portfolio along the efficient frontier.

Pension funds use the concept of the Efficient Frontier to create an investment policy and asset allocation that aligns with their risk tolerance and return objectives. The goal is to construct a portfolio that optimizes the trade-off between risk and return.

Most pension funds employ an investment committee to determine the fund’s risk tolerance and return objectives. They would then use these parameters to identify the portfolio on the efficient frontier that aligns with these objectives. The result is a diversified portfolio across asset classes such as equities, bonds, real estate, and potentially alternative investments.

Once this optimal portfolio is identified, it becomes the strategic benchmark for the pension fund. The fund’s actual portfolio is then regularly reviewed and rebalanced to ensure it remains aligned with this strategic benchmark. This forms the basis of the fund’s investment policy and guides its tactical asset allocation decisions.

Warren Buffett vs Pension Funds

Criteria	Warren Buffett	Pension Funds
Asset Allocation	None (all stocks)	Diversified
Re-balancing	None	Periodically
Cost	Low	High
Complexity	Low	High
Expertise Required	None	High

• Asset Allocation: Since Warren Buffett only invests in stocks and individual businesses, there is no need for him to use an Investment Policy or have an asset allocation strategy. Simply buy stocks and hold them for the long-run. Alternatively, pension funds hold diversified portfolios containing different asset classes, not just stocks.
• Re-balancing: Buffett’s “buy and hold” strategy usually involves little to no portfolio rebalancing. Pension funds, however, periodically rebalance their portfolio to maintain their strategic asset allocation and risk level. Pension funds use “tactical re-balancing” to try and time the markets.
• Cost: Buffett’s approach prioritizes minimizing costs, such as management fees and transaction costs. Pension funds, due to their diversified nature and need for regular rebalancing, have higher costs related to management fees, transaction costs, and other administrative expenses.
• Complexity: Buffett’s investment philosophy is simple and straightforward. Pension funds’ investment strategies can be complex due to their diversified asset allocation and the regulatory and fiduciary requirements they must meet.
• Expertise Required: Warren Buffett suggests most investors use low cost index funds. This approach requires no expertise, and anyone from novice to expert can employ this strategy. Pension fund management on the other hand requires understanding of various asset classes, risk management, regulatory compliance, and the ability to develop and maintain an effective investment policy.

So, why don’t Pension Funds follow Warren Buffett’s advice?

To answer this question, we need to consider who benefits the most from the pension fund approach to investing:

• Investment Managers: These professionals often benefit significantly as they are typically paid fees based on the assets they manage. Given the large size of pension funds, even a small percentage fee can translate into substantial earnings. Additionally, regular rebalancing and asset allocation adjustments can lead to more transactions and potentially higher fees.
• Private Equity and Hedge Fund Companies: Pension funds often allocate a portion of their assets to alternative investments such as private equity and hedge funds. Salespeople from these sectors can benefit from selling their funds to pension schemes, which typically make large investments due to their sizable assets under management.
• Pension Fund Employees: Those employed by pension funds can also benefit. These employees have secure jobs managing the extensive and complex assets of the pension fund, which are often associated with competitive compensation and benefits.

How does a Pension Fund approach fail?

Our knowledge of financial markets has grown over time. And, many professionals agree the best way to invest is by holding a diversified portfolio of investments that balance risk & reward. This approach used by pension funds makes perfect sense. And, it’s the approach most professional investment advisors take too.

Even though the pension fund approach is costly and complex. And, it requires many investors to rely on “experts” to guide their decisions. If you invest like a pension fund by holding a diversified portfolio of high-quality investments over the long-run, you’ll reach your financial goals.

What the pension fund approach fails to account for is our emotions.

Most investors rely on their emotions

The pension fund approach to investing assumes that investors are rational decision makers. But, today we know that most investors are plagued by emotional bias that will cloud decision making. It becomes almost impossible for most investors to maintain a disciplined pension fund approach to investing when they’re constantly making emotional decisions.

However, using Warren Buffett’s approach, such emotional bias is virtually eliminated.

Which investing method is best for you? Warren Buffett’s or a Pension Fund approach?

Low cost index fund investing will enable almost everyone to meet their financials goals. If you’re trying to become wealthy, you’ll need to do something entrepreneurial or take on additional risk. But, if you’re already wealthy or if you’re simply saving for retirement, a simple passive investing strategy will enable you to reach your financial goals.

From this perspective, Warren Buffett’s approach to investing works just fine.

The toughest part of following Warren Buffett’s investment advice is that is requires a high degree of discipline. Its hard to resist jumping on the latest investing trend, following a hot stock tip, or trying to time the market. But, if you can hold a high-quality portfolio of investments for the long-run over good times and bad, Warren Buffett’s approach to investing will enable every investor to reach their financial goals.