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Buffett on Frictional Costs

I'm not sure how this escaped my notice for two months, but in Warren Buffet's most recent annual letter to Berkshire Hathaway shareholders he explained the idea of frictional costs with an allegory:

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.

Buffett is trying to explain why he believes stock market returns will be lower in the future than they've been over the past century. Frictional costs brought about by financial managers of various stripes will be to blame:

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 percent of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80 percent or so of what they would earn if they just sat still and listened to no one.

Conspicuously absent is any discussion of the fact that active financial management is a productive activity. The "Helpers" in Buffett's allegory do not simply take a slice of the earnings that would have gone to the investors. Contrary to the facts, Buffett explicitly endorses the zero-sum viewpoint:

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.

He even uses the pie analogy!

This is a Shocking! Outrageous! thing to hear from a professional investor. As I said before:

The overall economic effect of trading in the capital markets is to concentrate assets in the hands of those most capable of directing them toward the most profitable ventures, resulting in greater economic growth.

The "Helpers" do not merely eat the pie. They also make it bigger. Whether they grow it by more than they consume is a debatable (and empirical) issue. My point here is not to declare the answer one way or the other, but to criticize Buffett for propagating economic ignorance. He has a powerful megaphone and he ought to wield it more carefully.

I hope that he knows better than what he wrote. As the world's preeminent investor, I expect him to.

Tiny Island