FrameworkArgumentInvestingIncentives
The Gotrocks family: how helpers take a fifth of what the owners earn
Warren Buffett · Berkshire Hathaway's 2005 letter to shareholders · 2006
The idea
Buffett's parable in the 2005 letter imagines a family that owns all of corporate America. Left alone, they earn what the businesses earn. Then they hire brokers to trade among themselves, managers to pick which brokers, consultants to pick which managers, and finally hedge funds and private equity to do it all with more ambition and higher fees. Each layer of helpers takes a share, and the family as a whole can only earn what the businesses earn minus the helpers. His estimate is that such frictional costs may amount to a fifth of American business earnings. It is the cleanest explanation of why fees and trading reduce what investors as a group can take home.
Investors as a group earn what businesses earn minus what they pay to helpers; every layer of advice is a claim on that pool.
When it works
Asset management economics, the active-passive debate, and any fee discussion.
When it may fail
The parable is about the aggregate; an individual helper can still add value for an individual client. And some frictions pay for liquidity and price discovery that the family also benefits from.
How to use it
Lay out the chain of fees between an end investor and a company's earnings for a real product, and sum them. Then ask what the product would have to outperform by for the investor to break even against owning the businesses directly.
Where it came from
Letter Berkshire Hathaway's 2005 letter to shareholders · Warren Buffett
What the source says. A family that owns all of corporate America grows poorer as it hires broker, manager, consultant and finally hedge fund and private equity helpers, and Buffett estimates such frictional costs may amount to 20 percent of American business earnings.
Connected ideas
Says something similar
Follow the fee before you follow the adviceBefore weighing advice, work out how the adviser is paid and what that pays them to say.
Says something similar
Invert the question, and look at the incentives firstAsk what would make this fail and who is paid for what before asking anything else.
Concepts
Put it to work on L3VLUP
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