Does Warren Buffett Not Understand Risk-Adjusted Returns?

In his latest investor letter, Warren Buffett says everyone should be in low-cost S&P 500 index funds -- except for Warren Buffett, of course.

Buffett has handily outperformed the benchmark, with Berkshire Hathaway shares gaining 20.8 percent annually on average since 1965, compared with 9.7 percent for the S&P 500. If you thought this performance was repeatable, you would just give your money to Warren Buffett instead of Vanguard.

But Buffett doesn’t invest in a slice of the S&P 500. He has a very concentrated portfolio. How does he pick the right stocks? Is he some kind of sorcerer? No doubt he’s a great investor, but he also has the advantages of scale, and he can do things normal investors can't, such as provide quasi-bailout financing to Goldman Sachs Group Inc. and Bank of America Corp., which pay humongous preferred dividends. When you get large enough to attain lender-of-last-resort status, benefits accrue.

So, if you really believe in index funds, then why build a firm around trying to beat an index fund? The answer is that you only do that if you believe an index fund really can be beaten. Here's Buffett in his investor letter released Feb. 25 and still being hotly debated on Wall Street:

The Efficient Market Hypothesis doesn’t say nobody can beat the market except for 10 people. It says nobody, absolutely nobody, over time can beat the market on a repeatable basis. But saying you can’t beat the market is a lot different than saying you probably can’t beat the market. You probably can’t beat the market will motivate a lot of people to try. It is like that softball-in-the-basket game at the county fair: you know it can be done, but the darn ball just keeps bouncing out.