Saturday, February 26, 2011

Limitations to beating the market

One of my professors (yes I am back to school again, minor detail) is the reason I read a lot of research about the investing process and strategy. Since I have learnt that most academicians who are practitioners too are averse to public profiles, I will stay away from names and stick to the issue.

One of the limitations to generating abnormal returns is the size of portfolio. As your portfolio size increases, your ability to make more profitable bets reduces. One of the reasons is that your individual bets become large enough to affect the price of the asset in consideration due to liquidity demanded and time in which a trade needs to be executed. We recently discussed the tradeoffs between these (the execution costs) and opportunity cost.

Guess who has been feeling the pinch - Warren Buffett (the other explanation is that he is one of those upfront in setting the right expectation). The book value (BV) of Berkshire Hathaway (which considers the right performance measure) rose 13% as compared to 15.1% return on S&P 500. In the letter to shareholders of Berkshire Hathaway he says, "The bountiful years, we want to emphasize, will never return. The huge sums of capital we currently manage eliminate any chance of exceptional performance."

It nice to have immediate validation / application of things you learn in class. Read more at WSJ (needs subscription) and Dealbook at New York Times.

1 comment:

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