Diversification according to Warren Buffet (Part 2 of 2)

In the first part, we analyzed Warren Buffett's strong views on diversification. Despite these views, he doesn't recommend most people follow his approach. His will made it clear: his wife's money should be invested 90% in a low-cost index fund that tracks the S&P 500 index and 10% in long-term Treasury bonds. A simple portfolio, without high fees or complex decisions.

Buffett is so confident in this approach that in 2007, he demonstrated with facts why even professional managers can lose against the simplicity of this strategy.

The challenge was clear: an S&P 500-indexed ETF versus five hedge funds selected by Protege Partners. The winner would be determined by net performance (after fees) over a ten-year period (2008-2017). The numbers were overwhelming: the index returned 125.8%, while the hedge funds barely reached 36%. Why? Because their cost structure (2% annual management fee + 20% performance fee) makes them long-term losers. But there's something else: hyperactivity.

Buffett didn't choose the S&P 500 by chance. The index includes the 500 largest-cap US companies, many of them leaders in their sectors and with global operations. Moreover, it is periodically reviewed following a clear methodology that doesn't rely on human emotions.

Their commitment to this passive strategy is simply proof that hedge funds don't lose due to a lack of skill, but rather due to perverse incentives. To justify their high fees, they need to generate constant profits, which leads them to trade frequently, take unnecessary risks, and abandon strategies when results don't come quickly. The S&P 500, on the other hand, has neither emotions nor incentives: it simply continues to grow with the real economy.

But there's a deeper lesson. Buffett didn't just bet on the US economy: he bet on inertia. Numerous studies have shown that the average investor, if they invest in a low-cost index ETF and leave their portfolio alone for a long time horizon (more than 10 years), will outperform 90% of fund managers. Why? Because hedge funds, while flexible in the use of derivatives, short positions, or arbitrage, are locked into producing results over short time horizons to justify their high fees and attract new money. In contrast, passive investors can ignore market noise for decades.

The failure of hedge funds to achieve Buffett's bet isn't due to their lack of seeking maximum returns. On the contrary: that's what they're designed for. The 20% performance fee incentivizes them to beat the S&P 500 Index. But here's the catch: to do so, they must take risks that the index doesn't. Some resort to complex derivatives, others to short-term bets or arbitrage strategies that depend on specific conditions. The problem is that, over a ten-year horizon, these approaches don't hold up. Extreme volatility, the need to justify results each quarter, and the pressure not to lose investors lead them to trade frequently, pay more in fees, and expose themselves to errors in judgment that the S&P 500 avoids. The index doesn't need to "beat" the market: it is the market. And that, in a very low-cost ETF, gives it a structural advantage that's very difficult to overcome in the long term.

Buffett's 2013 annual shareholder letter sums it up well: "You don't need a great brain, a degree in economics, or a command of Wall Street jargon. The crucial thing is to ignore the mass hysteria and focus on the fundamentals."

This approach not only explains why he won his bet, but also why his recommendation for the average investor is so clear: a passive portfolio, without high fees or complex decisions. Or, as I've written many times in this space: a portfolio with a long-term vision, simple, efficient, and very low cost. For him, massive diversification isn't bad in and of itself, but it is inefficient for his own investment methodology.

For the rest of us—most of us—a low-cost index strategy is not just a tool, but a protection that prevents decisions based on emotions, other people's opinions, or short-term movements.