Isaac Newton changed the way we understand the physical universe in the late 1600s with his three laws of motion.
The groundbreaking laws explain the relationship between a given body and the forces acting on it, and changes in the body’s motion in response to those forces.
But Newton’s good old three laws are not enough for Warren Buffett.
Back in his 2005 annual letter to shareholders, Buffett suggested that perhaps, if Newton were a good investor, rather than someone who foolishly speculated in obvious market bubbles, he would have come up with a fourth law of motion to explain the pitfalls of active management.
From Buffett’s letter:
"Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases."
While Newton's unfortunate experience with the stock market is certainly a fun historical nugget, the main point that Buffett is trying to make here is that active management is not always a great strategy for investors.
More specifically, Buffett argued that active management results in a bunch of "frictional" costs that result in shareholders earning much less than they historically did: Shareholders, in aggregate, end up paying out large fees and commissions to managers and consultants, reducing returns, in aggregate.
In the same letter, Buffett also included a neat parable about active management and those frictional side-effects. It's a bit long, but we think it's worth the read:
"... imagine for a moment that all American corporations are, and always will be, owned by a single family. We'll call them the Gotrocks. After paying taxes on dividends, this family - generation after generation - becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually. Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefit. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.
But let's now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers - for a fee, of course - obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family's annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.
After a while, most of the family members realize that they are not doing so well at this new "beat my-brother" game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he'll never outsmart the rest of the family. The suggested cure: "Hire a manager - yes, us - and get the job done professionally." These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.
The family's disappointment grows. Each of its members is now employing professionals. Yet overall, the group's finances have taken a turn for the worse. The solution? More help, of course.
It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don't suggest it to them.
The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group - we'll call them the hyper-Helpers - appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers - brokers, managers, consultants - are not sufficiently motivated and are simply going through the motions. 'What,' the new Helpers ask, 'can you expect from such a bunch of zombies?'
The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments - in addition to stiff fixed fees - are what each family member must fork over in order to really outmaneuver his relatives.
The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.
And that's where we are today: A record portion of the earnings that would go in their entirety to owners - if they all just stayed in their rocking chairs - is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses - and large fixed fees to boot - when the Helpers are dumb or unlucky (or occasionally crooked).
A sufficient number of arrangements like this - heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so - may make it more accurate to call the family the Hadrocks. Today, in fact, the family's frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one."