PERSPECTIVES Buffett in Foresight and Hindsight Meir Statman and Jonathan Scheid Don’t gamble; take all your savings and buy some good stock and hold it til it goes up, then sell it. If it don’t go up, don’t buy it Will Rogers www.willrogers.org, je know today, with perfect hindsight, that the performance of Warren Buf- fett’s Berkshire Hathaway Inc. was extraordinary. But did we know it with foresight? In this article, we show that, although some investors saw Buffett's performance with foresight, investors asa whole did not. We use this evidence to highlight the pitfalls of hindsight in the assessment of investment foresight. ‘The performance of Berkshice Hathaway's stock has been extraordinary. A share of Berkshire Hathaway stock could have been bought for $180n, May 10, 1965, the day Warren Buffett took control of the company (Lowenstein 1995). That share could have been sold for $71,000 on December 31, 2000. The annualized return of Berkshire Hatha- way’s stock during the period was 26.18 percent, more than double the 11.69 percent of the S&P 500 Index. ‘Samuelson (1989), who called Buffett a genius, also noted the difference between foresight and hindsight: “When Berkshire Hathaway, Buffett's fund, bought into the Washington Post, it was any- thing but clear that this would turn out marvel- ously well” (p. 6). Samuelson did not trust his foresight at the time he wrote this comment any more than he had trusted his foresight before. Although he offered neither a recommendation to buy nor a recommendation to sell shares of Berk- shire Hathaway, he noted: Now that B-H has gone up more than a hun- dredfold, it is at a premium to book value. Buffett himself reports doubts that he can find [for the growing total that he had to invest] ‘opportunities comparable to those in the past. 6 Meir Statman is Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University, Santa Clara, Califoraia. jonathan Scheid is senior research analyst at Assante Asset Management Inc,, San Jose, California. July/August 2002 Buffett understands well the distinction between hindsight and foresight. Lowenstein, writ- ing in his biography of Buffett about the events surrounding the increase in the DJIA beyond 1,000 in early 1966 and its subsequent decline by spring, noted that some of Buffett's partners called to warn him that the market might decline further. Such calls, said Buffett, raised two questions: (1) If they knew in February that the Dow was ‘going to 865 in May, why didn’t they let me in nit then; and (2)ifthey didn’t know what was going to happen during the ensuing three months back in February, how do they know in May? (p. 97) Not everyone distinguishes hindsight from foresight as well as Samuelson or Buffett. Most people fal into the pitfall of hindsight by exagger- ating the quality of their foresight. Fischhoff(1975a, 1975b) described hindsight bias as the belief that whatever happened was bound to happen, as if Uncertainty and chance were banished from the world. So, if an introverted man marries @ shy woman, it must be because (as we have known ail along) “birds of a feather flock together” and if he marries an outgoing woman, it must be because (as we have known all along) “opposites attract.” Sim- ilarly, if stock prices decline after a prolonged rise, it must be (as we have known all along) that “trees don’t grow to the sky” and if stock prices continue to rise, it must be (as we have equally known all along) that “the trend is your friend.” Hindsight, Foresight, and Discounting Some investors saw Buffett's happy investment results and recognized his great abilities many years ago. Loomis extolled his record in the pages of Fortune back in 1970: Buffett's record has been extraordinarily good Invhis thirteen years of operation (all of them, including 1969, profitable) he compounded his investors’ money at a 24 percent annual rate (p19) By 1983, Buffett was famous. Greenbaum (1983) wrote, “Warren Buffett, who has an almost legend- ary reputation as a successful investor. ...” (p. 98). "Financial Analysts Journal But what about investment superstars who were extolled just as they lost their superlative batting averages? “Remember Tsai and Alger?” asks Samuelson (p. 7).! A robust distinction between foresight and hindsight requires that we begin with a series of polls in which investors express their foresight and then follow by comparing what investors “knew” in foresight with what investors know in hindsight. Fortunately, a series of share prices, such as those of Berkshire Hathaway, provides an equivalent of a series of investor polls. In the financial markets, discounting links foresight with hindsight. The value of a share today is the discounted value of future cash flowsas seen by investors, in aggregate, with today’s foresight. Samuelson warned, agnostically, that “knowledge of Buffett's skills may be already fully discounted in the marketplace” (p. 6). What is the value of clear foresight? Imagine that we are transported back to May 10, 1965, the day Buffett took control of Berkshire Hathaway. The $18 price of a share of Berkshire Hathaway on May 10, 1965, is its “value-in-foresight.” That $18 price reflects the foresight of investors, in aggre- gate, about the risk-adjusted future value of Berk- shire Hathaway shares discounted to May 10, 1965. Imagine that investors consider the risk of investing in Berkshire Hathaway shares equal to the risk of investing in the S&P 500 Index and, therefore, consider the return of the SéP 500 to be the proper rate by which to discount the future value of Berkshire Hathaway shares.” If so, the “yalue-in-hindsight" of a Berkshire Hathaway share on May 10, 1965, viewed with hindsight from year-end 2000, is $1,383—almost 77 times its $18 value-in-foresight. The value-inchindsight of a Berkshire Hathaway share on May 10, 1965, is the $71,000 price on December 31, 2000, discounted by the return of the S&P 500 during the period of May 10, 1965, through December 31, 2000. In other words, as Figure 1 illustrates, investors had to buy $1,383 worth of the S&P 500 on May 10, 1965, to accumulate $71,000 by December 31, 2000. Inves- tors accumulated the same $71,000 by buying a single $18 share of Berkshire Hathaway. The value- in-foresight (price) and value-in-hindsight of Berk- shire Hathaway shares along the road from May 1965 to the end of December 2000 are presented in Table 1. In hindsight, anyone, including Samuel- son, would have been wise to buy shares of Berk- shire Hathaway for $8,675 at the end of 1989, when Samuelson wamed that knowledge of Bulfett’s skills might already be fully discounted in the mar ketplace. The share value-in-hindsight on that day was $14,671, almost double its price. Better Than Buffett From the day of Berkshire Hathaway's firstappear- ance in the CRSP database, October 31, 1976, a dollar invested in its shares would have fared much better than a dollar invested in the S&P 500. The Berkshire Hathaway dollar would have grown to $1,044 by the end of 2000; the SéeP 500 dollar would have grown to only $30, Butas Table 2 shows, some of the more than 21,000 stocks on the CRSP list did ‘even better than Berkshire Hathaway's stock.* For example, a dollar invested in Mylan Laboratories shares at the end of October 1976 would have grown to $1,545, and a dollar invested in The Home Depot shares, even though it could have been Figure 1. Price of Berkshire Hathaway Share versus S&P 500 Share, May 10, 1965, to December 31, 2000 Dolls (log normal) 109,000, eet 10,000 — lex _— S&P 500 Index oo : ie al Berkshire Hathaway 100 0 1 8 67 @ 71 73 75 7 7 Bl 83 85 87 89 9 42 ©2002, AIMR®Table 1. Value-in-Foresight and Value-in-Hindsight of Berkshire Hathaway Shares Buffett in Foresight and Hindsight “Annualized Return from Date to 12/31/00 Ratio of Valuein-Foresight Value-in-Hindsight Valuein-Hindsight to Berkshire Date (price) 100 12/31/2000 __Valuein-Foresight Hathaway ‘S&P 500 osfi07es 8 51383 76R 26.18% 116% 03/31/66 2 1a 63.89 2615 193 03/31/67 8 1480 222 2780 ras 03/31/68 Py 1528 6468 1770 148 03/31/69 37 yr 4794 26.88 1232 03/31/70 6 11620 3599 2706 13.08 os/aty7i 4 1880 38.97 278 1298 one a 2072 zat 2695 1308 08/31/73 95 2218 2384 zor 1330 03/31/74 1933 2463 aa 03/31/75 179 3362 1534 03/31/76 2308 4014 1as5 R/AW/76 2487 263 49 pay 2.308 1631 1606 a8 2.460 1567 16st Rau 2913 583 1642 waveo 3857 32 1568 RAVE 3.667 649 1688 1ysi/s2 4.453 1683 RAs 5455 1629 Rises 5797 28.48 1695 RBs 7.662 25.08 1600 12/31/86 9077 2591 1583 nysi/s7 9582 7 16.68 12/31/88 nas? 2539 1667 ya) apr 21.06 141 231/90 14,206 2667 17.45 12/31/91 18585 25.72 16.09 RAY 19958 252i vas 1231/93 16325 21,963, 237 1825 22/31/98 20,400 72250 a0 2134 RAIS 32,100 30579 W721 1835 12/31/96 34,100 37633, 202 W720 2/7 46,000 50,91 1557 1235 2231/98 79.000 64.536 o71 439 1/31/99 56,100 78,108 26.56 9.10 31/00 71,000 Na NA NA ‘Nowe: Prices on May 10,1965, are from Lowenstein, Prices from March 3, 1966, through March 31, 1976, are the midpoint of the bid ‘and ask quotes from the National Monthly stock surumary (National Quotation Bureau). Prices from December 21,1976, on are from CRSP. Prices are rounded tothe nearest dolla Value-in-hindsight isthe 71,00 price of Berkshire Hathaway shares on December 31, 2000, discounted to each date by dhe return of the S&P 300 during the perio. invested only since the end of August 1981 (the day of Home Depot's first appearance in the CRSP data- base), would have grown to $1,347, The shares of companies in the Berkshire Hath- away portfolio did well, better than the S&P 500, but not as well as the shares of Berkshire Hathaway itself. The 2000 annual report of Berkshire Hatha- way lists investments in The Gillette Company, July/August 2002 ‘Wells Fargo, The Coca-Cola Company, and Amer- ican Express Company. Table 2 shows that the Berkshire Hathaway shares grew more than those investments. Was it perfectly clear on October 31, 1976, that an investment in Berkshire Hathaway shares would turn out marvelously well? Was it perfectly clear that an investment in Mylan Labs shares would turn out even better? 13