When Warren Buffett Gambles, He's Barely Even Gambling

The NCAA Basketball Tournament is under way again, and as usual, billions of dollars will be wagered on those addictive brackets. But when one of the smartest money men on the planet puts his coin on the line, he's not betting on winning teams -- he's betting against winning gamblers.

In this segment from the episode of Motley Fool Answers, Alison Southwick and Robert Brokamp talk about Buffett's generous offer for an even close to perfect March Madness bracket, as well as a pretty large charity bet he made a decade ago against those perennial big-money gamblers: hedge fund managers. Plus, Bro got a personal response to a request for clarification about the Berkshire Hathaway annual shareholder letter, and he shares it with his podcast listeners.

A full transcript follows the video.

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This video was recorded on March 13, 2018.

Alison Southwick: It's March Madness time and we're all excitedly filling out our brackets in order to win $100 in the office pool. How hard could it be? Do you know what the odds are for getting a perfect bracket?

Robert Brokamp: Incredibly low.

Southwick: The odds are 1 in 128 billion. Now if the games were all 50-50 toss-ups, the odds would closer to 9.2 quintillion, according to a mathematics professor at DePaul University. That's 18 zeros.

Let's say you're the third richest man in the world. How do you play that bet? In previous years, Buffett's offered $1 million a year for life to Berkshire Hathaway employees if they just get the Sweet 16 correct. Not even get a perfect bracket. The conciliatory prize is $100,000 to whoever gets the farthest. Roughly 100,000 Berkshire Hathaway employees participate every year. That's a pretty large pool of people. Still, according to FiveThirtyEight.com, the odds of getting the Sweet 16 right are one in 9 million. So, it's a pretty safe bet for Buffett.

March Madness is interesting and everything, but Bro is actually going to talk about a more interesting bet that Buffett made that you probably heard a little about.

Brokamp: Yes! There's a bet that just closed -- I guess that's the term you could use -- this year. Buffett talked a bit about it in the recent annual letter, and he also talked about it last year as it was closing.

What it came down to is back in December of 2007, Buffett bet that a simple S&P 500 Index fund would beat a collection of hedge funds. The amount on the line was $1 million and both sides of the bet chose their respective charities. Buffett chose Girls, Inc. of Omaha, which runs educational, recreational, and mentorship programs for local girls ages 5 to 18.

His aim, according to the recent annual letter was to "publicize my conviction that my pick, a virtually cost-free investment in an unmanaged S&P 500 Index fund, would over time deliver better results than those achieved by most investment professionals, however well regarded and incentivized those helpers may be."

Now, someone else did take him up on the bet. It was a company called Protege Partners. It's a financial advisory firm. They don't actually manage the money. They pick managers. So, up against the S&P 500 Index fund, they chose five funds of funds, which is basically a hedge fund that then chooses individual hedge funds. All total, it was an S&P Index fund up against 200 hedge funds.

The first year was 2008. That was the year the market crashed, so the S&P 500 went down 37%. In that year the S&P 500 lost to the hedge funds, and to a certain degree that's what you'd expect. That's where the term hedge fund comes from. It's supposed to be a hedge against something like an overall market decline. That said, they didn't make money. They all lost money, too. They just didn't lose as much as the S&P 500.

Then, the next nine years the S&P 500 beat the average return of all five funds of funds. For the total period, which just closed out at the end of 2017, the total return for the S&P 500 was 125% annualized at 8.5%, so keep that in mind. It returned 8.5%. That's lower than that 10% you always hear about. It wasn't a great 10-year period to be invested in stocks. It was below average. Still, the funds of funds -- their average annual return ranged from 0.3% to a high of 6.5%. And all along the way...

Southwick: That's net of fees?

Brokamp: That's net of fees, and that's really one of Buffett's main points, because all along, while these folks are underperforming the market, they are, on average, earning 2.5% a year. So, even though they're losing to the market, they're making tons of money.

And that, in the end, was the main point for Buffett. In fact, he closed it out by saying, "Performance comes. Performance goes. Fees never falter." As you mentioned earlier, the S&P 500 Index fund is what Buffett recommended to LeBron James. It's in his will as what he recommends for his wife if he predeceases her. He thinks most people should have at least some of their money in an index fund.

Southwick: Bro, you're not going to want to talk about this, but you just got an email from Warren Buffett.

Brokamp: I did, actually. It's in response to something he put in his letter relative to this. He talked about how the S&P 500 had an advantage because, just in general, the market goes up. And he had this sentence in his letter. It said, "In 100% of the 43 10-year periods since we took control of Berkshire, years with gains by the S&P 500 exceeded lost years."

For an article I was trying to break up the 10-year periods, and it didn't quite coincide with what he said, so I just emailed Berkshire Hathaway, with, like, at what period Mr. Buffett is starting and that part about years of gains by the S&P 500 exceeding lost years. Some people interpreted it as meaning that the S&P 500 made money over every 10-year period, but that's not true. There are times it didn't. I was just confirming that what he means is that the number of years that it made money exceeded the number of years where it lost money. And I broke it up for an article.

Of those 43 10-year rolling periods, 19 periods had nine up years and only one down year; whereas something like eight had six up years and four down years. Regardless, I just wanted to confirm that I got that right, and I got emailed back from Warren Buffett confirming it. He doesn't do emails, so it had to come from one of his assistants.

The most interesting part about that is he added, "I thought about illustrating my point with the period from my initial stock purchase in the first quarter of 1942, exact date unknown. All 67 of the subsequent 10-year periods have had more plus than minus years. Quite a tailwind for my investing lifetime."

Alison Southwick has no position in any of the stocks mentioned. Robert Brokamp, CFP owns shares of Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.