Why You Can’t Beat Warren Buffett in a Coin-Flipping Contest

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Over the past 50 or so years, Warren Buffett, chairman and CEO of the conglomerate holding company Berkshire Hathaway (NYSE:BRKA)(NYSE:BRKB), has executed what is perhaps the neatest trick in investment history: He managed to beat the market.

We’ll try not to spend too much time gushing, but there are some data that should be put on the table. First, as calculated by Buffett and his team in their 2013 letter to Berkshire shareholders, is the compounded annual growth rate (CAGR) in per-share value of Berkshire stock: 19.7 percent between 1965 and 2013. This compares against a CAGR of 9.8 percent for the S&P 500 over the same period, putting an incredible 9.9 percentage-point gap between Berkshire and the benchmark.

Second, if you measure Buffett’s performance on a risk-adjusted basis — as Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen did in a paper published by Yale University in 2013 called “Buffett’s Alpha” — you’ll find that he not only beat the market but that he did it without making very many risky bets.

After examining the performance of mutual funds that have been around for at least 30 years, the researchers calculated a Sharpe ratio of 0.76 for Buffett, more than double the 0.37 median score of the mutual funds and the 0.39 claimed by the S&P 500. The Sharpe ratio measures risk-adjusted performance and can be used as a way to gain insight into where returns are coming from in a portfolio. A higher Sharpe ratio indicates smarter, or more efficient, investing — that is, more return per unit of risk assumed.