A Crypto Degen Meets Warren Buffett

Most of my writing has been about crypto, and although we have a deep passion for the space, the scope of the investing universe doesn't begin and end with it. For anyone aspiring to become an investor from their early forays into crypto, you'd be a fool to think that this is where the game ends.

Instead, one should embrace diversification and risk management to build generational wealth, and that's what we aim to help aspiring investors achieve in this post.

Suppose you've only ever been investing in crypto. In that case, we aim to change your perspective and start diversifying you away from it, hoping you'll continue generating exceptional returns without the downside risk.

Let's get down to it. We'll introduce you to several investment strategies, primarily within equities. But instead of writing a laundry list, we wrote a short story. Kind of…

So the scene is set - after losing millions in Dogecoin, Chad realises he needs to diversify away from crypto. Equities are an easy alternative he’s heard of - but how does he approach them?

Active vs Passive

Chad must learn the difference between "Active" and "Passive" investing, contrasting strategies for putting your money to work in markets.

Active investing is like being that hyperactive kid on a sugar rush, hopping from one trade to another. It's all about picking and trading individual stocks to outsmart the market. On the flip side, passive investing is being the chill, laid-back dude who's content to kick back and let the market do its thing. They usually buy into index funds that mirror the broader market’s performance and ride the wave for the long haul.

One can use a purely passive, purely active or hybrid approach to go a layer deeper. For example, Chad may decide to invest actively in passive funds, such as the S&P 500 or any other market index, which means that Chad frequently trades in and out of these funds to take advantage of market movements.

Or, Chad may decide to invest passively in an active fund, such as the Orbis Global Equity Fund. Chad may invest, say, $10,000 a month without fail, with the active manager who seeks to beat the market.

With new-found clarity on the main investing styles, Chad approaches the stock market as his first beast to tackle.

Buffett’s Secret Sauce

However, Chad faces another set of questions:

• Where should he put his money?

• Should he be actively investing in passive index funds?

• Or passively invest with an active manager?

Becoming overwhelmed, he consults the vast wisdom of Warren Buffett - arguably the most terrific value investor of the last century.

While Buffett effectively runs his own actively-managed equity fund through his company Berkshire Hathaway (more on that in a bit), he has some counterintuitive advice that keeps popping up in what Chad is reading.

Buffett's simple advice is that investors would be better off over the long term by putting their money into the S&P 500 index instead of with any active manager. That’s because passively investing in the index has generated more consistent returns than the average active manager at a lower cost to the investor.

The Power of the S&P 500

The S&P 500 index tracks the 500 largest companies in the US and has been the global benchmark for investment returns for as long as anyone can remember.

Since its inception in 1957 to the end of 2021, it has returned an annualised average return of around 11.88% every year.

While these are rubbish returns compared to the 100x's we regularly hear about in crypto, they come with much less downside risk. No one needs reminding of how funds in crypto can evaporate overnight, mainly Chad.

Let's do a simple numbers exercise to showcase the power of slow and steady compound interest to Chad. Say he initially invests $10,000 into the S&P 500 with follow-up monthly contributions of $1,000. He does this for the next 40 years. At the historic annualised average rate of return of the S&P, Chad will come away with nearly $10 million after 40 years.

That's a crazy amount of cash, considering we started on $10,000. Beginning on a more realistic base for someone like Chad, say $1 million, jacks the end value up to $175 million.

And remember, this is all from sitting tight, being disciplined and investing in the index each month.

Now, that's not to say returns like these are guaranteed - investing is not a straight line. That's why Chad is considering investing with an active manager.

While active managers' selling point is that they will return above the benchmark, their track records have been poor.

From 2008 to 2017, Warren Buffett ran a bet against Protege Partners, a New York City money management firm that invests in hedge funds, that the S&P 500 would outperform a portfolio of five hedge funds. Buffett won this bet by a landslide, with the hedge funds returning 36.3% over this period against the S&P's return of 125.8%.

Additionally, S&P has been tracking active managers' performance for more than 20 years. Their 2022 report indicates that, over the 20-year reporting period, ~97% of large-cap actively managed fund managers underperform their benchmark. Frankly, their track record is “abysmal”.

Why have active managers had such poor performance?

Well, fees are too high, so any outperformance gets eroded. In addition, fund managers tend to over-trade, which compounds mistakes. Finally, increased trading competition with access to the same technology between active managers has resulted in a lack of information asymmetry.

While the active vs passive decision may seem obvious, the debate about which is better has been ongoing for ages and will continue to evolve. Interestingly, many top investors think the next decade could be defined by great active managers able to identify value rather than index trackers. 

So the real question for Chad is, how does he find a great active manager?

Berkshire’s Blueprint 

Well, Chad doesn’t actually need to look further than Warren Buffet himself.

As we mentioned, he allocates capital through his company, Berkshire Hathaway, which used to be a defunct textile business before its takeover in 1965. Since then, it has become one of the world's largest conglomerates, worth nearly $700bn today.

Buffett invests with one goal - to obtain control of the company he invests in. This has paid off well - Berkshire's success over such a long period has made Buffett a celebrity among investors and business people.

He earned this reputation for a simple reason: The long-term track record of Berkshire is unparalleled. For example, from 1965 to 2021, Berkshire Hathaway stock grew at a ~21% compound annualised rate, compared with the 11.88% rate for the S&P 500. Back to compounding interest, that amounted to a 3.6 million % return for Berkshire shareholders compared to 30k% from the S&P 500. Outrageous.

For every $10,000 invested in Berkshire in 1965, investors would have nearly $365 million by the end of 2021. S&P 500 investors would have just $3 million.

Returns like that aren't generated through pure luck.

And the excellent news for Chad is that he can invest in Berkshire Hathaway as quickly as an S&P 500 index fund. All he needs to do is open a stock brokerage account and buy the share.

However, it's worth noting that Warren Buffett is at the tender age of 92, and his eventual succession could impact the future performance of Berkshire. 

Nonetheless, Berkshire will be a fascinating watch for the next decade. Buffett's investing style thrives in these market environments - where everything trades at a discount, and the future is even more uncertain.

Diversify to Dominate 

Before we go, let’s drive home a critical takeaway from our AI-crafted tale of Chad:

It's almost surreal that I'm emphasising these vital investing principles from a story about a crypto enthusiast generated by an AI.

But seriously, diversification and risk management are crucial, and they're nearly impossible to achieve if you're solely focused on crypto.

So, let's strive to create true generational wealth by learning from Chad's investing saga. At the same time, we can sidestep the pitfalls of putting all our eggs in the meme-coin basket.

That’s all for today. If you found this post insightful, share it with a friend or anyone who might appreciate it.

Thanks for reading,

— Luca