It’s been an easy matter for Berkshire and other owners of American equities to prosper over the
years. Between December 31, 1899 and December 31, 1999, to give a really long-term example, the Dow
rose from 66 to 11,497. (Guess what annual growth rate is required to produce this result; the surprising
answer is at the end of this section.) This huge rise came about for a simple reason: Over the century
American businesses did extraordinarily well and investors rode the wave of their prosperity. Businesses
continue to do well. But now shareholders, through a series of self-inflicted wounds, are in a major way
cutting the returns they will realize from their investments.
The explanation of how this is happening begins with a fundamental truth: With unimportant
exceptions, such as bankruptcies in which some of a company’s losses are borne by creditors, the most that
owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn.
True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the
expense of investor B. And, yes, all investors feel richer when stocks soar. But an owner can exit only by
having someone take his place. If one investor sells high, another must buy high. For owners as a whole,
there is simply no magic – no shower of money from outer space – that will enable them to extract wealth
from their companies beyond that created by the companies themselves.
Indeed, owners must earn less than their businesses earn because of “frictional” costs. And that’s
my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than
they historically have.
To understand how this toll has ballooned, 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 “beatmy-
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.
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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 selfconfidence,
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.
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.
(Extracted from 2005 Letter to Shareholders by Warren Buffett)
