Over the past 50 years, Warren Buffett’s annual letters have attracted fans far beyond the shareholders of his company, Berkshire Hathaway.
Proto-Buffetts have long devoured the master’s words for insights into how he achieved an average return of around 20% a year for half a century – and perhaps to pick up a few stock tips, too.
But recently passive investors have also got in on the action.
Warren Buffett has repeatedly recommended index funds as the best solution for the average investor – whom he defines as nearly everybody, incidentally – but lately he’s become more strident.
Just last year Buffett revealed that when he passes away, the bulk of his wife’s estate would be placed into a single Vanguard index tracking fund, with the rest in government bonds.
And here on Monevator we covered how a UK investor can copy Buffett’s simple portfolio when it comes to index investing.
Buffett’s long-term case for investing in shares
In this year’s letter Buffett was more explicit still.
He didn’t just say you could buy via an index fund if you want to invest in equities 1.
He said you should invest in equities via those index funds.
True, Buffett is explicitly talking about US equities.
But I think global equities amount to the same thing as far as his argument is concerned. (Besides, as I said the other day it’s important to beware of home bias robbing your returns as a UK investor).
Compared to cash or bonds, equities are clearly the place for long-term investors to be, says Buffett:
“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.
That was also true in the preceding half-century, a period including the Great Depression and two world wars.
Investors should heed this history.
To one degree or another it is almost certain to be repeated during the next century.”
Of course most people have seen those long-term charts that show stock markets going up over the decades.
So why then do so many of us still horde our money in cash or bonds?
The answer is volatility – both the day-to-day fluctuations in share prices, and the ever-present risk of a stock market crash.
Buffett says:
“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.”
Of course, you should always have some cash in an emergency fund.
You also shouldn’t be risking money that’s needed in the next 3-5 years in the stock market, given it’s propensity to crash when it’s least convenient.
But beyond that, says Buffett, the key is to distinguish between short-term risk caused by market fluctuations, and the long-term risk of inflation eroding the purchasing power of seemingly safer assets like cash or bonds – as well as the opportunity cost of missing out on the superior returns from shares.
Ignore the market noise
When investing in a pension over 30-40 years, for instance, I think it’s best to invest into an equity-heavy portfolio automatically year in, year out, and to try to ignore the news about the stock market – as opposed to holding a huge slug of safer assets to help you sleep at night while you obsessively track its value.
Buffett again:
“For the great majority of investors who can – and should – invest with a multi-decade horizon, quotational declines are unimportant.
Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime.
For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.”
Fearful investors in 2008 and 2009 missed out on the buying opportunity of a lifetime, Buffett points out (assuming they didn’t do the only thing worse, which was to sell out of shares altogether and never get back in).
“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 whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).”
Easier said than done – but that’s exactly why you get a better return from shares than from sitting snug in cash.
Here’s what you shouldn’t do
Buffett’s laundry list of bad investing behaviour should be familiar to Monevator readers.
Investors are often their own worse enemies, he says, and they make putting money into the market riskier than it needs to be by turning short-term volatility into longer-term capital reduction through their antics.
Buffett highlights the following investing sins:
- Active trading
- Attempts to “time” market movements
- Inadequate diversification
- The payment of high and unnecessary fees to managers and advisors
- The use of borrowed money
All of these can “destroy the decent returns that a life-long owner of equities would otherwise enjoy” says Buffett, who adds that borrowing to invest is particularly risky given that “anything can happen anytime in markets”.
Obviously I agree with all this, but I don’t suppose Buffett will be any more successful than the rest of us in trying to make people understand that the fact that “anything can happen anytime in markets” is not a reason to avoid equities, but rather a reason to invest in a way that reflects this reality.
In other words, buy steadily and automatically over multiple decades to take advantage of the various dips and to enjoy long-term compounded returns.
Some friends who’ve been asking me about investing since our 20s – and getting the same advice on getting started from me – still begin these conversations with: “Is now a good time to invest?”
Nearly all would do far better never to think about it.
The trouble with active management
Similarly, here on Monevator I forever field questions from newcomers who think it is “obvious” that investing via the more skillful active managers is the way to better returns.
And indeed it would be if (a) the active managers did it for free, or very nearly so, and (b) you could pick those who outperformed in advance.
High fees crush the returns from active managers as a group, turning it into a worse-than zero sum game for active investors as a whole.
As for picking winners in advance, let’s just say many billions of pounds has been spent over the past 50 years trying to do exactly that.
Obviously some do succeed in some particular period, either through luck or judgement. But in terms of a demonstrable, repeatable process that we can use to reliably pick active funds that can overcome their fees and beat the market in advance – sorry, no bananas.
Hence passive investing – wrong as it feels – beats the majority of active investors. So why bother trying, when you don’t need to beat the market to achieve your goals?
But don’t take my word for it when we have one of greatest active investors of all-time on hand to say the same thing:
“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.
There are a few investment managers, of course, who are very good – though in the short run, it’s difficult to determine whether a great record is due to luck or talent.
Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship.”
Instead of listening to their siren songs, says Buffett, investors – large and small – should instead read Jack Bogle’s The Little Book of Common Sense Investing
Quoting Shakespeare:
“The fault, dear Brutus, is not in our stars, but in ourselves.”
- Reminder: Equities is just a fancy word for ‘shares’.[↩]
Good reads from around the Web.
I read at least 100 investing articles every week, probably twice as many company news stories and 30-40 RNS updates from companies reporting to the stock market.
Like every week, some of the better ones are collated below.
But let’s face it, you’re not going to enjoy any of them as much as a cartoon from Dilbert creator Scott Adams!
Adams has begun a new investing advice series:
He has actually written quite a bit over the years about investing – I’ve previously featured one of his old cartoons – and all his work
Adams advocates index funds and passive investing, obviously.
I don’t agree with every word uttered by Jack Bogle, the founder of indexing behemoth Vanguard.
Of course, I have no problem with Bogle’s touting of index funds – in contrast to the active investing salesmen who try to exploit people’s natural suspicion of passive funds (“Cheap and dumb can’t really be smart and profitable, can it?”)
No, the thing I find disagreeable is Bogle’s claim that US investors needn’t bother investing overseas.
Bogle recently told Bloomberg:
“When you look at global market capitalization it’s true that the U.S. accounts for about 48 percent and other countries 52 percent.
But the top three markets outside the U.S. are the U.K., Japan and France.
What’s the excitement about there?
Emerging markets have great potential, but have fragile sovereigns and fragile institutions.
I wouldn’t invest outside the U.S. If someone wants to invest 20 percent or less of their portfolio outside the U.S., that’s fine. I wouldn’t do it, but if you want to, that’s fine.”
All the other passive investing gurus point to the diversification benefit of investing overseas.
But Jack Bogle doesn’t just suffer from unthinking home bias – he presents it as an optimal strategy!
Team America
Bogle has been right about so much in his 85 years that I don’t dismiss his view out of hand. The man is a legend.
Also, the most important thing to appreciate from a UK perspective is that if you’re going to do Bogle-style home bias anywhere, you want to be a US investor.
It’s not just that the US has well-established regulatory institutions – compared to say China – or a sophisticated and liquid market – compared to say Peru.
We in the UK also have a good legal system and a liquid market (far better than China and Peru, anyway).
We also have a market where our top 100 companies earn more than 70% of their money overseas. That’s a superior global reach to the US multinationals, albeit I’d argue in part through lower quality sectors such as materials and energy.
However the pound is no longer a reserve currency, unlike the dollar, which is one big advantage enjoyed by US investors.
Also, the US market’s share of the global whole has only grown since Bogle opined on the subject.
- The US market now makes up over 50% of the world’s market capitalisation.
- The UK is good for just 7.4%!
This means a US-only investor is more than halfway towards the weighting of Vanguard’s Total World Stock Market ETF without putting a cent overseas.
In contrast, a UK-only investor is under-weight some 92% of total world index.
In light of all that, you can see why a US investor might seek to sidestep currency risk and the other complications of overseas investing (such as withholding taxes). They are in a unique position.
As I say, I don’t think it’s the right decision even for them strategically, and as it happens (and sacrilegiously when writing on Passive Investing Tuesday, I know) I suspect it’s not a good idea tactically, either.
Why?
Because the growth of the US market to an even greater portion of the global pie may well suggest it’s due for a thwack with the old leveling stick (you know, the one labelled ‘reversion to the mean’).
But anyway, if you’re a passive investor who doesn’t want to invest overseas, best you live in the US.
Techno-mericans
There’s another thing stay-at-home US investors have in their favour which I’ve not mentioned yet, which is that their market is host to the world’s most innovative and vibrant tech sector, by a supersonic mile.
In the US, technology is the largest single sector of the market, making up 17% of the total US market (and nearly 20% of the S&P 500 index).
And if you think about the companies that are driving humanity’s move towards the robot-powered, cloud-based, artificially intelligent utopia/dystopia of tomorrow – where there’s nothing for us humans to do but eat and swap pictures on Instagram – then you probably don’t want to hear about the UK’s puny share of the high-tech spoils.
Okay, you asked for it.
It’s roughly 1%.
Yes: The UK tech sector is about one percent of the total UK market.
I’ve seen tracker funds with higher fees than that!
Dotcom again
Being so underweight technology matters because while it’s a very volatile sector, it’s also been a huge driver of global returns in recent decades.
The following graph from Credit Suisse is an eye-opener:
Yes, barely 15 years since the Dotcom boom and bust, the US technology has regained almost all the ground it lost, and it’s racing ahead of the World Market.
It’s the most surprising comeback since John Travolta appeared 15 years after Grease to dance with Uma Thurman in Quentin Tarintino’s Pulp Fiction.
Of course, things are very different today.
For a start, another 15 years have passed and now Mr Travolta is really too old to be bothering young women.
More importantly, the US tech sector is a different beast, too.
According to CapitalIQ, the tech-focused Nasdaq index’s P/E ratio is about 28.
That might seem high, but the Nasdaq’s P/E ratio was around 200 at the end of December 2000!
(Yes, young ‘un, you heard me right. 200. Go read this prescient Chicago Tribune article for more on the crazy time that by good fortune I witnessed only as a wallflower. Crazy times.)
Not only are tech companies much more profitable than in 2000 – they’re far more economically embedded, too, in my view.
Apple is the largest company in the world, for example, and the smartphone revolution it spawned has enabled companies that didn’t even exist 15 years ago such as Facebook, Google, and Uber to reach hundreds of millions if not billions of customers around the world.
A lot of the recent growth of the Nasdaq has also been driven by a surge in biotech shares.
There’s perhaps a faint echo there of 2000 (the likes of GlaxoSmithKline and AstraZeneca were formed around then) but biotechs are really a different story (and very possibly will end up in their own bubble).
The bottom line is technology is a perennial growth engine, and the UK has very little of it – ARM Holdings, and, um, a few small caps.
Don’t let the sun set on your investment empire
Now this isn’t a post to say you should rush out and load up on technology stocks – although I think we will hear plenty of that over the next few weeks if the Nasdaq index does break through its old Dotcom peak.
It’s just to highlight one of the dangers of sticking too closely to home when investing your money in shares.
Remember, risk can be transformed but risk cannot destroyed in investing.
Any passive investor seeking to avoid currency risk and overseas volatility by sticking to the UK market in recent years has paid for it with underperformance, partly due to that technology deficit.
The best way for passive investors to avoid this fate is by investing in diversified portfolios that pay their respects to global market weightings.
Our collection of simple ETF portfolio ideas is a good place to start.
Bolt-on technology upgrades
Alternatively, if you’re not persuaded to properly diversify overseas but you have decided you want to up your tech weighting, adding a cheap Nasdaq tracker is a simple solution.
There are also long-standing tech-focused investment trusts for those who are so inclined, such as the Herald Investment Trust and the Polar Capital Technology Trust. (Disclosure: I own the latter).
As a nefarious active investor, I’m more exposed to the UK than other regions of the world. That’s because while I’m deluded enough to think I can pick market-beating stocks in the relatively small market I know best, I’m not so arrogant to think I can also do it in Argentina or Indonesia or even Germany.
So I get my overseas exposure via index funds, ETFs, and investment trusts, with a smattering of US shares added to the mix.
And where do the majority of my US companies do their business?
You guessed it – in the tech sector!
The bottom line is while I make no short-term predictions, over the long-term I think the UK’s puny weighting in technology is a 1% club you do not want to be part of.
Note: In case you’re wondering, The Accumulator will be away quite a bit over the next few months as he’s writing the first Monevator book! So I’m afraid you’ll have to put up with me running a little more off-piste most Tuesdays, though I’ll try to keep it under control. Also T.A. will be popping in now and then with a fresh post when he’s had enough of his writer’s garret. We’ll also be taking the chance to update and re-run a few of his golden oldies, too.
Good reads from around the Web.
A couple of weeks ago Weekend Reading featured an inspiring story about a janitor who died at 92 to leave an estate worth $8 million.
His secret? Regular saving and investment into a range of blue chip US stocks (and living until 92 to work that compound interest!)
But could a janitor achieve the same thing today?
The Philosophical Economics blog thinks not.
In a deep and nerdy-in-a-good way post that unpicks returns over the past 65 years, the author concludes that it would not be feasible for the average janitor to sock away sufficient cash to get to the $8 million mark, given today’s starting valuations and the low US minimum wage.
There are wrinkles though, so do read the whole post.
I especially liked the conclusion, which was that anyone who would become rich via the stock market needs to pray for a few crashes on the way:
If you’re an investor with a short time horizon, you should want valuations to stay high, or even better, go higher, into a bubble, so that you can get the most out of your holdings when you cash them out. But if you’re a disciplined investor that is in this for the long term, particularly a 20-something, 30-something, or even early 40-something, with a lot of income yet to be earned, you should not want valuations to stay where they are.
You definitely should not want them to go higher, into a bubble. Instead, you should want the opposite of a bubble, a period of depressed valuations–the lower the better.
Granted, a rapid downward move in the markets, towards valuations that are genuinely cheap, would entail the pain and regret of mark-to-market losses on present holdings. But that pain and regret will only be short-term.
In 20 or 30 or 50 or 65 years, the paper losses, by then evaporated, will have been long since forgotten, having proven themselves to have been nothing more than opportunities to compound wealth–monthly contributions, reinvested dividends, and share buybacks–at high rates of return.
The very thing that keeps many people out of equities is what we’re banking on for our long-term returns.
As I’ve explained before, it’s why I buy in bear markets.
Good reads from around the Web.
I really enjoyed today’s spirited column by Ken Fisher in the FT [Search result] on the doomster-ism implied by the negative bond yields we’re seeing across Europe.
Monevator started life a year before the financial crisis, and its early articles were often trying to help people understand that the case for buying shares hadn’t changed just because they’d crashed – quite the opposite – and that the elevation of gold and the likes of Zero Hedge to cult status were typical over-reactions to a severe market dislocation.
A couple of years later, and the fight had turned to making the case for developed market shares – US and European companies.
Many out there, including some readers and Monevator commentators, were convinced that everyone should sell out of supposedly sclerotic mature markets in the West because the emerging markets were going to overrun us.
(A few of these Monevator commentators seem to have forgone their previous certainty, as we may well see again in comments on this post… 🙂 )
Of course, emerging markets have underperformed since then and the US has shot the lights out.
I didn’t know that was going to happen, but I was pretty convinced the doom-and-gloom theory was bogus.
A decade ago I was having arguments with people who thought peak oil was about to cripple us (never even slightly likely in our lifetimes, even back at higher prices) and a couple of years ago The Accumulator was arguing that most investors should still have money in bonds.
He was called irresponsible and reckless or worse; bonds went on to deliver excellent returns (which was unexpected and wasn’t his point, but it goes to show…)
You usually sound like a happy-clappy idiot if you take the opposite side in these arguments.
The bear case always sounds smarter.
A balanced mind and a balanced portfolio
None of this is about being particularly clever, or being seen to be clever.
It’s just a reminder that betting on extremely bad and unusual outcomes is very rarely a winning strategy.
The flipside is true, too.
For instance, those believing dotcom valuations in 2000 were justifiable because the world had changed forever were making a similar mistake.
But to stick with the doomsters, Fisher writes:
If it’s Armageddon or total societal collapse you fear, you don’t want any securities. Not stocks. Not bonds. They’ll just be worthless paper, no use for anything except lighting fires. Gold? You can’t eat gold bars.
If you really fear the total collapse of western civilization, then invest in canned food, bottled water, armour, guns, bullets, bows, arrows, knives and a bunker. Do you need a cave? Can I sell you a rock to crawl under? A shovel to dig your moat?
Does that all sound crazy? If so, go back to question one: why buy a negative-yielding long-term bond
If you do, you’re betting on a scenario you don’t remotely believe in.
Markets move on probabilities, not possibilities. If you don’t think economic doom has a snowball’s chance, don’t invest like it is inevitable.
Put your money on what’s likeliest — the world keeps turning, advancing and growing.
The unpalatable fact for the perma-bearish is that it pays to be optimistic as an investor.
Also, the most sensible hedge to that optimism being misplaced is a diversified portfolio – not a theory that everything is rigged / about to crash / unsustainable / different this time.
