If you’re going to bet against Warren Buffett, you better have the odds tilted in your favor.

Back in January 2008, Buffett wagered $318,250 that an S&P 500 index fund would beat a hedge fund portfolio (five fund-of-funds chosen by Protégé Partners which invested in over 200 hedge funds) over the next ten years.

The results were not even close.

The S&P 500 gained 125.8% (8.5% annualized) over the 10-year period versus a 36.3% gain for the basket of hedge funds (3.1% annualized).

Source: Berkshire Hathaway 2017 Investor Letter

After suffering a 37% decline in 2008 and trailing all the hedge funds that year, the S&P 500 would come roaring back, posting a 15% annualized return over the next 9 years. Meanwhile, none of the five fund-of-funds chosen would end up besting the S&P 500’s return.

The bet, of course, was an apples-to-oranges comparison from the start. The goal of most hedge funds and alternative investments is not to beat an equity index like S&P 500, but instead to generate alpha or superior risk-adjusted returns that are not entirely dependent on the direction of the stock market.

That said, a bet is a bet, and on Buffet’s terms (where the ending net return is all that mattered) the hedge funds failed miserably.

Was it simply a result of bad timing?

It would be hard to argue that given the unremarkable 8.5% annualized return for the S&P 500, which is slightly below the long-term average of 10% (since 1928).

If the bet had been postponed and made instead in January 2009, January 2010, or January 2011, it would have been even harder to beat Buffett as the S&P 500 would return 13.1%, 13.6%, and 13.9% annualized over the subsequent ten years periods.

Which begs the question: is there any possible way to tilt the odds in your favor while making a similar bet against Buffett?

I can think of just one: make the bet only when investors in stocks are so exuberant that valuations have been driven to historic extremes, and future market returns are likely to suffer as a result.

Has that ever happened before?

Two times in recent history come to mind.

January the first 2000, when the S&P 500 was trading at a CAPE Ratio (P/E Ratio smoothed with 10 years of earnings and adjusted for inflation) of 43.

Over the subsequent 10 years, the S&P 500 would decline 9.1%, or -0.9% annualized.

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How did hedge funds do over the same period?

There’s no S&P 500 equivalent for hedge funds, making the comparison difficult. But one well-known broad hedge fund index that has been around since 1990 (HFRI Fund Weighted Composite Index) gained 86% (6.4% annualized) over those same 10 years. And importantly, it did so with significantly lower volatility (6.9% vs. 16.1% for the S&P 500).

What was the second time?

That would be today, with the CAPE Ratio having risen to 40, its highest level since 2000.

How did valuations get back to these extremes?

The last 10 years have been incredibly good for U.S. equities, with the S&P 500 rising 347% (16.2% annualized). By comparison, the 73% increase (7.2% annualized) in the hedge fund composite seems downright lousy.

But investing is about the future, not the past. The fact that alternative investments have lagged the S&P 500 by such large amount is precisely what makes them a more valuable diversifier in a portfolio today.

If the next 10 years are indeed more difficult for U.S. equities as Vanguard and others are estimating, they should in theory be easier to beat.¹ That’s true on an absolute basis (simply comparing the ending net returns) but even more likely to be true after adjusting for risk levels (equities tend to exhibit higher volatility/drawdowns than a composite of hedge funds). The ride matters and the odds of a tougher road ahead for U.S. equities increases the importance of diversification and finding ways to mitigate volatility.

While I wouldn’t advise betting against Buffett, if you’re going to do it, now would seem to be a better time than most. But given the record pile of cash Berkshire Hathaway currently is holding due to a lack of compelling investment opportunities ($149 billion), I’m not so sure he would take the bet anyway.

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1. Vanguard is projecting a 2.4%-4.4% annualized return for U.S. equities over the next 10 years. Source: Vanguard