Sometimes, highly paid experts are just wrong. Or, at least, not worth their lofty pay. Warren Buffett proved that point by winning his 10-year wager with hedge fund manager Ted Seides of Protégé Partners.

In 2008, Buffett bet the investment industry at large that a Vanguard index fund that invested in the S&P 500 would outperform any hedge fund over 10 years. Seides accepted the bet and put up a group of five hedge funds against the index fund. The bet doesn't officially end until December, but with the hedge funds averaging 2.2 percent returns since 2008, compared with more than 7 percent for the index fund, it's been clear for a while that Buffett has won. The prize is $1 million, donated to charity.

Back in May, Seides wrote an opinion piece for Bloomberg, in which he wrote: "For all intents and purposes, the bet is over. I lost." Most expert observers agree that Buffett has indeed won the bet.

Why did he win? In his Bloomberg post, Seides offers several explanations. He notes that in general, the decade from 2008 to 2017 was a particularly good time to invest in the S&P 500--perhaps the next decade won't be so great, he suggests. Besides, the index fund is confined to American companies, whereas the hedge funds also invest abroad, and the bull market in the U.S. has outperformed the rest of the world over the past 10 years. On the other hand, if the U.S. market had tanked during that time, that diversification would have proved good protection. In other words, basically, Buffett got lucky.

Buffett, of course, has a different explanation. It's not that he's so smart, it's that hedge fund managers aren't really smarter than anyone else and that the investments they choose, at best, perform roughly the same as the S&P 500. But hedge fund managers are highly paid for their supposed expertise--perhaps 2 percent per year of invested assets, whereas an index fund might charge as little as .02 percent per year.

If both funds made exactly the same investments with returns of, say, 5 percent, investors in the hedge fund would walk away with a 3 percent gain after fees, compared with 4.98 percent for the index fund investors. In theory, hedge fund managers' wisdom would lead to a better investment strategy and thus better returns, but, over the past decade at least, it didn't. Instead, over time, those high fees ate into profits more and more compared with the index fund, which benefited from compounding its higher return rates.

There's nothing to suggest that this was a 10-year anomaly and everything to suggest that fees really do make a difference. For instance, an S&P study released this spring found that the S&P index fund outperformed more than 92 percent of managed funds over the past 15 years. And Buffett's bet in itself is proof that most managers can't outperform the market and they know it. Otherwise, how do you explain that when Buffett challenged the entire industry to compete against the index fund, Seides was the only one who took him up on it?

Buffett provided an update on the bet in his widely read annual letter to Berkshire Hathaway shareholders with this scathing comment: "When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsize profits, not the clients."

Do "experts" really know best?

It seems a fitting outcome for an age when questioning the wisdom of experts has become the norm. Should we blindly do what doctors tell us when, for example, they for decades provided prostate cancer treatments that turned out to be no more effective than no treatment at all? Increasingly, we turn to data and crowdsourced knowledge, and away from the wisdom of highly trained experts.

In many cases, that approach leads us to make better decisions. That's why, for instance, the first advice most people get when they fall seriously ill is to learn as much as they can about their disease so that they will be able to make their own informed decisions rather than simply follow medical instructions. The same logic should apply to our investments, our businesses, and all the important decisions we make.

There are risks, though, to charting your own course. There's one time, Seides argues, when highly paid managers do earn their keep, and that's when markets are falling. "Hedge funds tend to significantly outperform in bear markets, as demonstrated in 2008 and 2000 to 2002," he writes. Perhaps more important, he argues, by mitigating losses during bad times, hedge fund managers help keep people from making the fundamental mistake Buffett is famous for avoiding--selling when the market is down. In other words, if you're going to stop listening to the experts, you have to be smart enough and levelheaded enough to understand the risks and not let them derail you if things go wrong.

Buffett's bet makes it clear that most investors would be better off making the tradeoff and choosing index funds, or at least an S&P 500 fund, over a managed fund: Stronger returns in the up times more than make up for smaller losses in the down times, and there are more investing options than ever before. It might even mean that an entire industry of highly trained investment professionals aren't worth the hefty salaries they take home.

The lesson here goes way beyond investing. Next time you're faced with a decision and you know what the experts say to do, don't just do it. Stop and do some research and some thinking for yourself and come to your own conclusion about whether to follow the experts' guidance or to take a different approach.

As Steve Jobs once said, "Everything around you that you call life was made up by people that were no smarter than you ... Once you learn that, you'll never be the same again."

Published on: Sep 19, 2017
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