In Warren Buffett’s 2013 letter to shareholders, he unveiled that his will outlines a simple investing plan for his beneficiaries:
“My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers."
I decided to backtest this strategy and compare its performance against the S&P 500. I tested the 20-year period between 1996 to 2015 by annually rebalancing the portfolio to have 90% in the S&P 500 and 10% in cash. For the S&P 500, I used total returns including dividends and the effective federal funds rate for cash returns.
During the 20-year period, the S&P 500 had an arithmetic average return of 9.93% compared to an arithmetic average return of 9.21% for the Buffett 90/10 strategy. The time period includes part of the high-flying 90s along with two periods of the market getting cut in half with the crashes of the tech bubble and the financial crisis. It is interesting to see that the strategy has similar returns to the S&P 500, but why not just invest in the S&P 500 since the returns are higher?
The point of using the 90/10 strategy is to reduce risk. It is meant for investors that are in the retirement phase of their lives and depend on the cash within their portfolios. Having 10% in cash is meant to keep investors from selling stock after the market has gone down, which is exactly the wrong time to sell as everyone knows the point is to buy low and sell high. Rebalancing with this strategy will set up a system of systematically buying low and selling high since money will be rotated out of stocks as the market rises and put back into stocks as it falls.
How about the risk-adjusted return? Using average returns of the 90/10 strategy and the S&P 500, I calculated the covariance of the returns and divided it by the variance of the S&P 500 to come up with a resulting beta of 0.85. That means that the 90/10 strategy is 15% less volatile than the overall markets. Using real data from the 20-year period rather than assumptions, I calculated the expected return of the strategy using the capital asset pricing model (CAPM).
Expected Return = Risk Free Rate + Beta x (Market Return - Risk Free Rate)
Risk Free Rate = 4.17% (Average 10-year treasury yield from 1996 to 2015)
Beta = 0.85
Market Return = 9.93% (Average S&P 500 total return from 1996 to 2015)
The expected return calculates to be 9.07%. This compares to the actual return of 9.21% that generates an alpha (excess risk-adjusted return) of 0.14%. Although the alpha is small, it still shows that the 90/10 strategy provides a higher risk-adjusted return. Warren Buffett (Trades, Portfolio) suggests a low-cost Vanguard S&P 500 fund. The fund comes with a low 0.05% expense ratio. Even taking into account the expense ratio, the strategy still generates alpha.
One of the points of the strategy is to have cash available without having to sell stock while still being largely invested in the markets. The backtest used the effective federal funds rate to determine a return on cash. Higher returns can be found using online high-yield savings accounts. Rates of around 1% can easily be found using bankrate.com. The current effective funds rate is 0.4%. This shows that even higher returns can be found on cash and that the 90/10 strategy can provide returns slightly higher than the 9.21% calculated in the backtest. These higher rates were not used in the backtest because the historical rates on these accounts are not available.
If you are discouraged by your stock picks or just do not want to allocate your time towards running a portfolio, Buffett’s 90/10 strategy is a good way to keep you in the game and reap the rewards of the stock market. It is a strategy that has been blessed by one of the top investors of all time, Warren Buffett (Trades, Portfolio). Keep in mind that there are ups and downs with investing in the markets and understand your own risk tolerance. If you have some strategies that you would like to test out, GuruFocus has plenty of economic data readily available to help. I used the Economic Data section listed under the Market menu at the top of the page to find data on the effective federal funds rates and 10-year treasury rates.
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