How Does Warren Buffett make money? Warren Buffett is one of the greatest investors of our time, with a significant impact on the U.S. and worldwide markets. He and his holding company, Berkshire Hathaway, are always on the minds of investors, and Buffett’s moves in and out of particularly stocks are tracked constantly.
In a research paper recently uploaded to Yale’s website, Andrea Frazzini, David Kabiller and Lasse H. Pedersen from AQR Capital Management attempt to understand how Buffett has become such a noteworthy investor. The study, simply titled “Buffett’s Alpha,” finds that Berkshire has “a higher Sharpe ratio than any stock or mutual fund with a history of more than 30 years” with “significant alpha.”
The Sharpe ratio, or as it also called, the Sharpe index, is used to calculate the risk premium per unit of deviation in an investment or trading strategy. In other words, it measures performance after it’s adjusted for risk factors.
According to Frazzini, Kabiller and Pedersen, the Sharpe ratio of Berkshire Hathaway was about 0.76 between 1976 and 2011–double the Sharpe ratio of the overall stock market during this time frame. The study also finds that Buffett managed to gain a subset of his wealth by boosting Berkshire’s returns via leverage, which amounted to an average of 1.6-to-1 over the same period.
One other interesting point the study brings up is how Buffett is able to grasp this leverage. “Buffett has developed a unique access to leverage that he has invested in safe, high-quality, cheap stocks and that these key characteristics can largely explain his impressive performance,” the paper states, adding that Buffett sometimes uses private companies to provide stable financing for his publicly-traded investments.