Monday, March 2, 2015

How Warren Buffett Thinks You Should Invest

Warren Buffett’s latest letter to Berkshire Hathaway shareholders contains a brilliant prescription for managing a personal portfolio. I was prepared to write a post quoting a few good lines from his letter, but his message on individual investing on pages 18 and 19 is so good that I will devote the rest of this article to summarizing it.

The goal of investing is to increase the purchasing power of your savings. Over the past 50 years, S&P 500 stocks, with reinvested dividends, have increased in value by a factor of 113, while the U.S. dollar’s purchasing power has dropped by about a factor of 8.

“The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency.” This was true in the previous 50 years and “it is almost certain to be repeated during the next century.”

Volatility is not the same as risk. “Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions.”

Over a single year or less, stocks are riskier than cash-equivalents. Anyone who needs money in the short term should “keep appropriate sums in Treasuries or insured bank deposits.” For the great majority of investors who can invest with a multi-decade horizon, short-term volatility is unimportant. “For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities”

Investors who fear price volatility may, “ironically, end up doing some very risky things” like “investing in ‘safe’ Treasury bills or bank certificates of deposit.” U.S. stocks have tripled since 6 years ago. “If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund.”

“Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to ‘time’ market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. Indeed, borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets.” Nobody “can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.”

“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”

Returning to my own voice, I see these words as a validation of my own approach to investing:

– Low-cost stock indexes
– Buy and hold
– No leverage
– For money not needed for 5 years, 100% in stocks
– For money needed in less than 5 years, 100% in cash or GICs

This is one article I may reread myself if I ever start to doubt my approach to investing.

12 comments:

  1. Good post and great comments.

    I have posted here before that I currently hold a 70/30 portfolio, but am in my early 30s, and posts like this have repeatedly made me re-evaluate whether that 30% bond allocation belongs. Part of my rationale is that while I intend for my entire portfolio to be for long time use, the fact remains that "you never know", and I do not presently maintain any emergency fund (consider it dead weight given that we have substantial other assets, dual income, and a decent portfolio)

    Maybe I need a new way to look at things? Perhaps I should take the 30% "safe" part of my portfolio, presently invested in bonds, and lock it entirely into cash/GICs as you suggest (effectively create a large emergency fund), then feel justified in investing all future monies 100% into equities?

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    1. @Anonymous: I definitely think it makes sense to have emergency cash savings. I think of it as a certain number of months of essential spending rather than a fixed percentage of my portfolio.

      Something to consider very carefully is whether now is the right time for a switch out of bonds. Stocks have been on a major run for several years. The temptation to jump on the bandwagon is powerful. There are many people who shift their allocation away from stocks after stocks fall and then shift into stocks again after they rise. Don't be one of these people.

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  2. I'm beginning to wonder if my emergency cash wouldn't be better invested in an ETF. I can always get the money in a day or three so why not?

    Any thoughts?
    Ron B

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    1. Sure you can likely sell an ETF when needed, but at what price? What happens if your ETF drops in value? You can't assume the money you invested will still be there at the exact time you need it, prices can and do fall.

      So as was stated in the article, if you need the money quickly it's best to have it in cash. For long term investing, an ETF is definitely a good option.

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    2. @Anonymous: The why not is that you're likely to need the emergency cash when stocks are down. The troubling scenario is the economy tanks, stocks crash, and you lose your job. The bulk of your plans should be anticipating good times, but you also need to be sure you'll be OK if there are bad times.

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  3. "If not for the fear of meaningless price volatility" Therein lies the problem for many people. Many people cannot live with the volatility of an all equity portfolio and will sell when the market crashes, and would therefore be better off with some bonds. So one needs to be careful because of behavioural issues.
    One quibble I do have, cash may have dropped by a factor of 8, but a portfolio of intermediate term bonds has done much better than that, although I don't know what the number is. Interestingly, if you plug in a 100% equity portfolio and a 60/40 stocks/bonds portfolio to portoliovisualizer.com for the last 40 years, although there are periods, like now, when 100% stocks pulls ahead, for much of the time returns are fairly comparable, with, of course, much less volatility.

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    1. @Grant: Yes, people's irrationality can lead to selling low and buying high. We've had an incredible decrease in interest rates that has lasted for 30 years now. This has boosted bond returns. It's not possible to get the same drop in interest rates over the next 30 years.

      To be clear, I don't recommend a 100% stock portfolio to anyone else. I claim it works well for me.

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  4. I wonder if the 5-year rule for stocks is too short? Haven't there been considerable periods throughout history where stocks were down and/or underperformed bonds/cash for periods well in excess of 5yrs? Thinking the 30s, maybe even 70s? Periods in the 1800s for sure? Not arguing with your logic, merely the calibration of the 5yr setting.

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    1. @Anonymous: You're right that there have certainly been bad 5-year periods. But this has to be balanced against the lost returns in most periods that come from investing in cash rather than stocks. I've chosen to balance these concerns at 5 years. I've heard of some who use 3 years and others 10 years.

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    2. Hi MJ;
      As usual different strokes for different folks.
      Cash is good but only to pay bills that don't accept a credit card. Unfortunately you have to pay up some time so some cash is necessary.
      As to no leverage well I have done well with mine. For first two months of 2105 - $3.3K in dividends for $600 in interest. What do I do with the "extra" money (which is taxable by the way but at a lesser rate)? Well it goes straight in to decreasing my leverage (HELOC). I have been doing this for five years now and as you can see it is paying off so to say. Not for everyone and you can lose money just as well as make it. I have lost money on some of my stock picks but overall the game is on the up and up.
      I also believe in buy and hold but you should be prepared to sell as well. As an example I bought JNJ @ $67 and sold at $101 along with the US dollar appreciation. I turned that around and bought KMI (after dumping KMP) and have not regretted it. The stock has apprecaited more than if I had kept JNJ and it pays me more than twice the divs that JNJ was paying me. So "buy and hold" is good but that does not mean you should never sell, even with a good company like JNJ.
      I will probably be retireing this year and am still 100% in equities. About the only time i have cash in my accounts is around now wehn i max out the TFSA and RRSP and obviously when dividends are paid in to those accounts. I try to re-invest them ASAP depending on market values. I have not bought so far this year as i am finding values a bit on the high side
      My only recent purchases have been HSE (DEC/14) and RUS (JAN / 15) and both with the HELOC Starting to pull the divs now. I would buy some more but they have gone up a bit too much for my buying habits.

      So all that to say everyone is different as to their risk tolerance, equities they prefer and obviously funds available to invest.

      RICARDO

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  5. "Market forecasters will fill your ear but will never fill your wallet."

    How true.

    I didn't start reading Buffett's letters until a few years ago. There are a number of gems and words of wisdom in them. I enjoy reading them now. They are stellar really.

    We have some alignment in our approaches although you are way ahead of me in terms of a) progress and b) simplicity:

    I...

    -stick to low-cost stock indexes and about 30 stocks
    -buy and hold only
    -no leverage
    -no bonds; hopefully a pension to use for most of our living expenses in retirement
    -most of our money is invested except for emergency fund

    Thanks for the summary. I want to do the same on my site at some point, my takeaways from this year's letter.

    Mark

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    1. @Mark: There are some other good takeaways in Buffett's latest letter, but this part just seemed so good to me that I wanted to focus on it.

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