Warren Buffett publishes an annual letter to Berkshire Hathaway shareholders. It’s an open letter to shareholders, and it has become a must-read for investors around the world.
The most controversial quote in Warren Buffett’s 2018 annual letter
I’ve previously written about some of the quotes in the 2018 annnual letter relevant to the regular investor, but perhaps one of the most controversial quotes in the letter was when he argues that one should not look exclusively at the stock/bond ratio to assess a portfolio’s risk. A reader sent me a question asking for my take on this quote from Warren Buffett:
“It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment “risk” by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.” – Warren Buffett
What is Buffett exactly trying to say with this quote?
Buffett wrote high-grade, not high-yield, bonds
The first thing about this quote to note is that Buffett wrote high-grade, not high-yield bonds. I had thought that Buffett had said high-yield bonds when I first read the letter. High-yield bonds can also increase the risk of a portfolio, because they often promise high investment returns, but given the significant probability of default, their returns can be risky.
Risk can be defined multiple ways
To fully understand Warren Buffett’s reasoning, you need to understand the context of his quote.
He is not defining risk in this context as volatility. Of course he understands that in the short-term, stocks are more volatile than bonds, as he wrote earlier in the letter:
“I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds.”
When most people think about risk, they are talking about the up and down swings of the market. The volatility of stock returns is incontrovertibly higher than the volatility of bond returns. However, Warren Buffett defines risk in a different way than it is conventionally used in this letter:
“Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. “Risk” is the possibility that this objective won’t be attained.”
So he argues that high-grade bonds, which were offering miniscule yields back in 2012, might make it less likely (or riskier) for an investor to reach their goals. For example, if your goal in 2012 was to grow your money by 25% in the next 5 years, then stocks were far more likely to achieve that goal than high-grade bonds that were yielding < 1%.
This discussion is in the context of his final analysis of his 10-year S&P 500 versus hedge fund bet with Protege Partners. In 2012, approximately halfway through the bet, he and Protege Partners, as part of the hedge fund versus S&P 500 bet, moved the money to be wagered from short-term, high-grade bonds into Berkshire stock. Obviously, Berkshire stock far outperformed short-term bonds over the past 5 years.
What are your goals?
For many, the goal of investing is to maximize the amount of money they have in retirement. But perhaps a better goal would be to maximize the probability that you achieve a good retirement, even if it might mean forgoing a chance for a great retirement.
To use a sports analogy, if you have a big lead in a basketball game, you don’t keep on trying to score baskets as fast as possible, trying to maximize your number of points. Instead, you play slower to run out the clock, which maximizes the chance of winning the game, with the side effect of lowering your total points scored.
Similarly, in investing, there are scenarios where it might make sense to be less aggressive. Physician and personal finance author William Bernstein has famously argued that when you have won the game, stop playing. Many investors take this to heart, lowering their stock/bond allocation as they pass the threshold necessary for a secure retirement.
On the other hand, to continue the sports analogy, when the game is won, why not run up the score? For example, if the probability that you will have a secure retirement is > 99%, there is no reason not to run up the score, so long as you are preserving your high probability of winning the game. Since personal finance is a one-player game, there’s no such thing as poor sportsmanship for scoring more points when you’re winning by a lot.
Conclusion
Warren Buffett’s quote describes the opposite scenario. If you need to make money with your investments to achieve your retirement goals (and most of us cannot reach our retirement goals on savings alone without any investment returns), being too conservative will make it more likely that you will not reach those goals. Some investors are too conservative with their investments, and Warren Buffett advises that too many bonds can be just as risky as too little bonds.
What do you think? What did you think of Warren Buffett’s bond quote in his 2018 annual letter?
I think you see 2 types of errors. Those who are constantly trading looking for the next big idea. These people lose big on trading costs and they are incapable of holding to achieve LTCGs. The second group is the permabear who holds cash and CDs and even gold. To achieve FI you need to stay out of these groups.
Good article WSP. A colleague and I were debating this exact issue (and this exact line from the Buffett letter) last week. I think you are correct that he is really talking about longer-term investors here, with bonds being risky in the same way that keeping all of your money in cash is risky in the long term.
I always struggle with how much of my portfolio to devote to bonds, given the very low current interest-rates. Bonds can also be risky in the shorter term in a rising interest rate environment, if your needs require you to sell the actual bonds (as opposed to holding the bonds to maturity).
I use bonds in my portfolio as “ballast,“ with the understanding that I am essentially foregoing long-term gains.
Bonds are a means of trading some amount of return for a lesser risk premium. But you are giving up a return. The optimal amount is as little as possible to cover your risk tolerance and liquidity needs. Any more then that is a financial loss.
Thought-provoking as usual.
I have a ton of short duration high-quality bonds. I’m sure Buffett would say it is too much. Maybe it is.
I struggle with the “stop playing the game once you won idea.” A significant market decline could wipe out a couple million or more for me. It likely would eventually rebound, but what about in the meantime? Do I need a 10-12% return? No. Further upside won’t increase my QOL, but downside could wreak havoc. We all need some stocks for long-term growth, but how much is too much is a tough nut to crack.
To continue the basketball analogy: in today’s low rate environment, using bonds too heavily means you willl never outscore your opponent Inflation.
Instead, you are likely to see your lead whittled away. And unlike basketball, you don’t know for certain when the game will end.
That leaves you sitting on a lead created by your stocks, and praying that Inflation doesn’t hit a few three pointers.
Part of the problem is distributing portfolios ARE NOT just the negative of accumulating portfolios. As soon as you start pulling money out you become liable to sequence of return risk. What that means is Mr. Market is pulling money out of your nest egg at the same time you are pulling money out of your nest egg making it a double pull. This gives you a frown and may run you out of money before you die. If Mr. Market is adding to your pile while your pulling it gives you a smile. While accumulating you have the luxury to work OMY and therefore adjust your inputs prior to retirement.
Modern portfolio theory and the efficient frontier instructs there are combinations of non correlated assets which when joined together in the proper ratios give you an investment vehicle that yields the same return at a lower risk. Why is this important? Over the very long time the market goes up, the market goes down. If you hold a less risky but equally returning investment vehicle and the market crashes you win. Let’s say Mr Risky looses half his value. Mr safe may only loose 1/3 of his value. Over time Mr Safe only has to make 66% back to break even. Mr Risky needs to make back 100%, and by the time Mr Risky is back to zero, Mr safe is some often considerable percent ahead. Rinse and repeat 5 or 6 times over the course of a portfolio’s life. Mr Safe is less exposed to SORR and so has a better chance of survival.
This is what happened in the lost decade of the early 2000’s. You will clearly see the value of diversity. Make a yahoo finance chart of GSPC (s&p500). In 07/2000 GSPC peaked at 1517 it wasn’t until 02/2013 GSCP regained 1517. Add GLD to the chart. Would you rather have a portfolio of just GSPC or one mixed with GSPC and GLD? The efficient ratio would have been 2/3 GSPC 1/3 GLD and your expected return during that period would have been 9.74%. Buffets argument implies there are only 2 choices, stocks and bonds. In that perspective Buffet is wrong there are many choices. It’s often said “Buffet says: owning gold doesn’t pay you anything”. I’ve owned BRK.B since 2000 and Buffet has owned gold in his portfolio many times during that 18 year period but he doesn’t always own gold. Clearly in this example it paid you to own gold, but what really paid you is the free money associated with non correlated diversity. The correlation between gold and GSPC is .03, highly uncorrelated. The correlation between bonds and GSPC also is .03. During the recent period bonds have been in a 35 year bull market which means the yield has been driven to near zero, BUT that isn’t always the case. In 1975 10 years were yielding 15%. What do you think GSPC would be worth if 10 year bonds were yielding 15%? Buffet likes to be the grand old philosopher, but you can bet if bonds were paying 15% and stocks were returning near or below zero he’d own the bonds.
People forget this, but governments can go bankrupt. So even AAA rated government bonds can be worthless one day if the government defaults because it piled on too much debt.
I think buying a 30 year Treasury bond right now is a terrible idea. Interest rates are still near historic lows, and no one knows how the next 30 years will play out.
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