Warren Buffett

(The contents of this page are provided by the Finance and Economics Experimental Laboratory at the University of Exeter.)

Stand-alone demonstration - Try out this single-player experiment. 

Example subject instructions - View subject instructions.

• Level: Year ?1 undergraduate
• Pre-requisite knowledge: ?
• Suitable modules: ?

Abstract

Students play individually and have a choice of 3 funds in which to invest money. The first fund mimics the long term behaviour of the stock market and exhibits steady growth with occasional downturns. The second fund has by far the highest mean gross return, trebling in value half of the time, but it also has the highest variance and is a risky investment. The third fund mimics the inflation-adjusted behaviour of treasury bonds and stays virtually constant.

The game consists of a number of repeated rounds and the growth in each fund during a given round is determined by making a random selection from among 6 possible outcomes. In the basic game, students must invest 100% in one of the 3 funds, although they may switch funds between rounds. Alternatively, the instructor may allow investments to be split across more than one fund.

Intended Learning Outcomes

1. Variance as a measure of the risk of an investment; volatility drag.

2. Role of a diversified portfolio in reducing risk.

Discussion of Likely Results

The Green 'stock market' fund is the best of the original investments, when adjusted for volatility.

The Red fund is superficially attractive because of its high mean return and one or two students who invest in it over 20 rounds can be expected to do spectacularly well. However the majority will be ruined and overall it represents a poor investment.

The Blue 'treasury bond' fund is a safe investment but with very uninspiring growth.

Outcome	Green	Red	Blue	Purple
1	0.8	0.05	0.95
2	0.9	0.2	1
3	1.1	1	1
4	1.1	3	1
5	1.2	3	1
6	1.4	3	1.1
Mean return	1.0833	1.7083	1.0083	1.3583
Variance of return	0.0381	1.7554	0.0020	0.4393
Volatility adjusted	1.0643	0.8307	1.0073	1.1387

Purple is a portfolio investment of 50% in the risky Red fund and 50% in the safe Blue fund. Critically, the portfolio is re-balanced between rounds to retain 50% of the total value in each fund. Since Red and Blue are independent random variables, and the variance of Blue is negligible, the variance of Purple is pretty much one quarter that of Red.

mean(Purple) = mean((Red + Blue) / 2) = (mean(Red) + mean(Blue)) / 2

var(Purple) = var((Red + Blue) / 2) = (var(Red) + var(Blue)) / 4

So, paradoxically, Purple is a better investment than Green, despite being a mixture of two funds that are worse performers individually.

Acknowledgements

Being Warren Buffett: A Classroom Simulation of Risk and Wealth when Investing in the Stock Market