March 5, 2018: Warren Buffett’s Advices | Better Financial Future -- MyPlanIQ

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Warren Buffett’s Advices

Warren Buffett, considered to be one of the greatest investors in our time, is well liked. When he talks, millions of investors listen and follow. Over time, he has given consistent advices to average investors. For example, in his latest annual report published more than a week ago, Buffett again touted several well known principles. Among them, here are the two most widely quoted:

About stocks: Buffett advises average investors to buy and hold low cost index funds such as Vanguard total stock market index or Vanguard S&P 500 index fund (VFINX) instead of actively managed funds.
About bonds: “If you had to choose between buying long-term bonds or equities, I would choose equities in a minute.”

However, since financial media have always sensationally reported on Buffett’s (Berkshire Hathaway) annual reports or for that matter, anything coming out of Buffett, it’s often more entertaining than scientific to understand his teachings.

In this newsletter, we want to go into more details on the two points in the above. We also want to emphasize that it’s more important to understand our line of reasoning or the reasoning process to gain insights into his claims/teachings than just our conclusions.

Buy and hold an index stock fund

When it comes to invest stocks in a Strategic Asset Allocation (SAA) portfolio, we always advocate to invest in a low cost index fund. For example, in our September 19, 2016: Stock Investing: Actively Managed Funds vs. Index Funds, we presented the following two reasons:

Active stock funds rarely outperform index funds consistently
Risk (stock) funds are heavily influenced by sectors and styles

Obviously, the first reason is also the functional result of the high cost of actively managed funds, a reason cited by Buffett:

“Addressing this question is of enormous importance,” Buffett wrote. “American investors pay staggering sums annually to advisors, often incurring several layers of consequential costs. In the aggregate, do these investors get their money’s worth?”

Of course, the ultimate result of investing is the returns after all fees. In terms of fund selection, it’s the fund expense. In terms of portfolio management, it’s the advisors’ fees. Investors should look at their end result to see whether after all fees, you can simply beat a portfolio consisting of extremely low cost index funds.

Buffett always talks about his ideas in the context of long term investments, not in a short or even intermediate term. As we have repeatedly pointed out, ‘long term’ is a very imprecise phrase. For Buffett, because he mostly manages money that might not be needed in perpetuity, he didn’t bother to give a precise definition on this. Based on the historical return data on stocks and strategic and tactical portfolios, for example, see July 17, 2017: Long Term Stock Holding Periods For Retirement, we have the following rule of thumbs:

For a strategic buy and hold portfolio (the ones Buffett advocates), capital invested in stocks should be held for at least 15 years or longer, preferably more than 20 years.
For a Tactical Asset Allocation(TAA) portfolio, capital invested in stocks should be held for at least 10 years or longer, preferably more than 15 years.

We arrived at the above conclusion by looking at the historical data (since 1871, see May 8, 2017: Holding Period of Long Term Timing Portfolios) and their rolling multiple years’ returns. Unfortunately, for financial media or any so called popular experts, you might get various answers without much data backing. Of course, the media pieces are supposedly to be entertaining and to be understood without much thinking.

So next time when you hear someone mentions ‘long term’, a quest into a more precise or quantitative definition is called for.

Bonds vs. stocks

Buffett’s ‘stocks over bonds in any minute’ advice is widely quoted in a way that many readers might construe that he simply dismissed bonds all together. Well, in a financial article, that’s how things are simplified! But if you read his quote more carefully, he’s actually talking about holding long term stocks for a long term vs. holding a long term bond. In fact, he further elaborated:

“If I were going to own a 30-year government bond or own equities for 30 years, I think equities will considerably outperform that 30-year bond.”

In fact, we can do a simple exercise to estimate the annualized returns for both stocks and bonds. For stocks, we can use Dr. Hussman’s latest estimate:

It’s estimated that for the next 12 years, S&P 500 total return would be negative as stock valuation is historically high. Let’s be generous and just simply assume it returns 0% annually. At the end of 12th year, S&P 500 reaches its normal valuation level and for the remaining 18 years, it would return 10% annually, we can estimate the annualized return for the 30 years as:

(((1+0%)^12)*(1+0.1)^18)^(1/30)-1=5.9%.

Similarly, the annualized return for the next 20 years would be

(((1+0%)^12)*(1+0.1)^8)^(1/20)-1=3.9%.

On the other hand, currently the yield of 30 year US Treasury bond is 3.15%. So even if you can earn over 1% more by investing corporate bonds, you still end up worse than 5.9% from stocks. We can also see that US treasury bonds would probably return about the same as stocks for the next 20 years.

However, for the next 10 years, stocks are likely to underperform 10 year Treasury bond’s 2.8% annualized return.

The point to do the above exercise is to precisely understand the claims made by anyone, even from Warren Buffett, instead of merely catching sound bytes.

Implementation issue

The above exercises also lead us to an important issue: how to actually implement/manage your investments in practice. Though Buffett just simply said that for a long term, buying and holding a stock index fund will probably be the best investment for average investors, in reality, when we are managing our investments, we need to decide

For investments that are long term such as more than 30 years, should we just simply make a lump sum investment in a stock index fund (such as VFINX or SPY)?
What about capital that’s needed before that? For those needed in 20 years? in 10 years? or in 5 years?

For question 1, as we can see through the above analysis, at the current very overvalued level, simply purchasing stocks out right is not the optimal way. In fact, Buffett did qualify this by saying:

“As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.”

Maybe one should wait till valuation drops to a more reasonable level before buying stocks (indexes)? Or maybe one should adopt a more active tactical style (such as MyPlanIQ’s TAA) in order to avoid big loss (thus improve returns, even for the 30 years)? At minimum, one can adopt a Dollar Cost Average (DCA) approach to gradually invest in stocks?

For question 2, Buffett apparently didn’t give any advice at all. Again, MyPlanIQ has outlined the rule of thumbs like:

For capital needed within 2 years, invest in money market, T-bills, brokered CDs with fixed maturity.
For capital needed from 2-10 years (or 2-7 years if you are aggressive), invest in MyPlanIQ’s total return bond portfolios (see those listed on What We Do -> Brokerage Investors page).
For capital needed from 10-15 years (or 7 to 20 years), invest in a tactical stock portfolio (i.e. risk profile 0) such as P Goldman Sachs Global Tactical Include Emerging Market Diversified Bonds
For capital needed for 20 years or longer, just simply buy and hold stock index funds such as VFINX, SPY, VTI, VEA, VWO etc.), i.e. a risk profile 0 SAA portfolio or in combination of both TAA and SAA portfolios.

To summarize, this missive tries to convey that investors should delve into details in a more rigorous manner for those sound bytes or widely reported advices, even given by gurus or sages like Warren Buffett. It’s just not as simple as it seems on surface.

Market Overview

Stocks continued their volatile behavior. Let’s take a look at the percent of stocks in S&P 500 that are above their 200 day moving averages:

Courtesy of stockcharts.com

The number of stocks that are in a downtrend (i.e. below their 200 day moving average) is now greater than its average. At any rate, we are in a state that can transition to the one that shows a more decisive trend change (if it continues to break its recent low) or trend continuation (if it breaks out above its recent all time high). We have no strong opinion on where it will head. However, we do call for caution, considering the extreme stock and bond valuation. As always, staying the course and managing risk to a reasonable level is the best way to deal with such uncertainties.

For more detailed asset trend scores, please refer to 360° Market Overview.

Now that the Trump administration has been in the office for more than a year, the economy and financial markets are in general still in a good shape. Whether the economy will continue to benefit from the supposedly trickle down of the tax cut, the deregulation and the promised infrastructure spending remains to be seen. On the other hand, stocks continued to ascend, regardless of the progress. Looking ahead, however, we remain convinced that markets will experience more volatilities at some point when reality finally sets in.

In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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