Mr. Graham taught an investment class at Columbia’s business school and also ran a successful partnership, in spite of the economic turmoil of the Great Depression as a backdrop. His most-famous protege, Warren Buffett, once taught a class on investing at the University of Nebraska at Omaha before eventually taking over the helm of Berkshire Hathaway (BRK.A)(BRK.B) and growing book value by 19.8% annualized over the last 46 years. As we’re big fans of both gentlemen (read: copycats), we decided to follow in their footsteps and teach classes on investing as a way to hone our craft. Little did we know that we’d find the process so enjoyable.
We come into contact with more than our share of bright and thoughtful students in the MBA program where we teach. One question that keeps coming up (enough that we thought we should formalize our response): “My parents are nearing retirement — what should they be invested in?”
There’s no doubt, knowing what to invest in as you approach retirement can be a daunting puzzle. Stocks, bonds, cash, commodities, options, gold, annuities... there’s such a wide range of opinions — how can so many experts have such contradictory recommendations?
At the 2012 Berkshire Shareholders’ Meeting, Warren Buffett delivered a great quote to the audience: “Never risk what you have and need, for what you don’t have and don’t need.” Basically, always be mindful of the risks each investment entails.
The conventional finance rule of thumb is to start with 100 and subtract your age to determine the percentage you should allocate between stocks vs bonds. Based on that “wisdom,” at 81 years old, Mr. Buffett should have 19% of his portfolio in stocks and 81% in bonds. Is he following that conventional wisdom and should we? The short answer is a less-than-surprising “no.”
On Feb. 9, 2012, Mr. Buffett released an article in Fortune magazine detailing how he thinks about current investment opportunities. A peek into the mind of one of the best investors of all time is rare treat, and we encourage anyone who cares about their finances to read it when they have time.
Cash and Bonds
The first class of investments Mr. Buffett examines are “currency-based,” meaning cash and bonds. Mr. Buffett doesn’t find either cash or bonds currently attractive for two reasons:
1. The low interest-rate environment (how much has your savings account been paying you lately? All LIBOR-manipulation aside.)
2. Potential inflation (have you been to the grocery store or gas pump lately? Ouch!)
According to the Senior Citizens’ League, “Since 2000, the Social Security Cost of Living Adjustment (COLA) has increased benefits just 36 percent while typical senior expenses have jumped 82 percent, more than twice as fast.”
As a recent MSN article highlighted, “The American Institute for Economic Research recently unveiled a new inflation gauge that better measures the actual day-to-day experiences of most people. We rarely buy a new house or a car, yet we are very sensitive to prices of ordinary purchases like food, fuel, phone services and personal care products. This new measure, dubbed the "Everyday Price Index," is running at 7.2%.” On a fixed income, a 7.2% inflation rate will cut your living standard in half in 10 years time! You don’t want to be in supposedly “conservative” investments like cash and bonds during inflationary times, lest you find yourself clipping Alpo coupons.
The second class of investments Mr. Buffett covers are what could be termed “unproductive assets.” They’ve also been classified as “greater fool” investments — they are bought with the hope that a greater fool will come along and pay more for them than you just paid. Mr. Buffett singles out gold today, housing in the 2000s, Internet stocks in the 1990s, and tulips in the 17th century. Buffett’s concern with these type of investments are two-fold:
1. They produce no cash flow, in fact often incurring storage and insurance costs.
2. They are “sterile” — they don’t replicate themselves or compound themselves with time.
It can be very difficult to determine an intrinsic value for these type of assets, making it nearly impossible to find the all-important margin of safety.
That leaves us with the third class of investments; what Mr. Buffett recommends and also buys with the majority of his wealth. This third class is the equity of world-class businesses, especially when they’re bought at attractive prices. These businesses have the pricing strength to keep up with inflation and protect their owners’ purchasing power (never forget that stocks aren’t just pieces of paper-- they represent partial ownership of a business). Companies like Coca-Cola (KO) and Walmart (WMT) will be able to raise their prices in-step with inflation and protect the owners of the business. Great businesses provide real, useful goods and services to people. No matter what happens with currencies, that value will pass through to the owners (hyperinflationary disaster excluded). Granted, even the most remarkable company isn’t worth an infinite price though, so be mindful of over-paying.
Mr. Buffett concludes:
“Berkshire's goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety -- but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we've examined. More important, it will be by far the safest.”
Based on Mr. Buffett’s logical insights, our recommendations for those approaching retirement are:
1. Hold a certain amount of cash for liquidity, living expenses, and the ability to buy more businesses should the market present abnormally great prices.
2. Own the equity of first-class businesses, purchased at attractive, or at worst, reasonable prices in order to utilize the company’s pricing power to shield your own purchasing power. (If you’re not sure what’s a great business or an attractive price, it may be worthwhile to hire someone who does.)
3. Rebalance whenever relative equity or cash percentages get too far away from your comfort zone, eg. 70% equity and 30% cash or 90% equity and 10% cash.
Note: At some point, interest rate changes will make bonds attractive again, but we’re a long way from there right now.