Against all advice from economists he had bought one share of Berkshire Hathaway:
Then I found out that the 76-year-old Mr. Buffett had asked for applications from people wanting to become his successor. Many hundreds applied. So at the annual shareholders’ meeting in Omaha this month, he announced his new search strategy: rather than decide from old-style résumés and interviews, he planned to choose three or four top candidates and then give each $5 billion or so to manage and see how they do. The winner gets the job.
When I heard about this, the romance died. For all of Mr. Buffett’s reputation as the ultimate nonmutual fund, he may have just fallen into one of the biggest mutual fund traps of all — forgetting how incentives affect fund managers’ behavior.
Two of the foremost economists in the country, Glenn Ellison of the Massachusetts Institute of Technology and Judith Chevalier of Yale have shown how important incentives are. In their classic paper “Risk Taking by Mutual Funds as a Response to Incentives,” for example, they showed that investors pour money into mutual funds in a highly skewed way. They chase winners, despite the evidence indicating that mutual funds that win in one year do not necessarily perform better in subsequent years. Funds with the highest annual returns get a huge inflow of money compared with funds that did almost as well but were not at the very top.
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