In Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial)’s 2014 shareholders letter, Warren Buffett (Trades, Portfolio) gave to investors a profound piece of investment advice while looking back at the journey of the last 50 years.
Warren's 50-year experience
Buffett said:
“During the 1964-2014 period, the S&P rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196% ... Concurrently, the purchasing power of the dollar declined a staggering 87%. That decrease means that it now takes $1 to buy what could be bought for 13¢ in 1965 (as measured by the Consumer Price Index)."
“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.”
It has been far safer to invest in stocks! Now that’s a statement that goes against common sense.
It does not mean that stocks are not more volatile than cash. They are, especially in the short term. But “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.”
Investing for the long term
Francisco Garcia Paramés took this argument a little further in his recently published book, “Investing for the Long Term.”
He started by dividing investments into two categories: real and monetary.
Real investments include stocks, real estate, commodities and so forth. These are the investments that give the direct property of an underlying asset. That asset generates an income for the service it provides. The consequence of this is that generally these assets hold their buying power pretty well over the long term, if their demand subsists.
Of course, we have to distinguish between real assets that have a durable competitive advantage from those that are easily replicable. The first ones, like a very well-located shopping center or that local bakery where everyone goes, should provide their investors a higher-growing stream of income. The second ones, like a poorly located mining company or a certain commodity, like gold, should have a more difficult task in raising their prices over time. Competition and technological advancements limit their appreciation.
Monetary investments are those that grant the investor the promise to have their money back in some date in the future plus interests, in a denominated currency. Here we include bank deposits, sovereign and company bonds, and so forth.
Stocks for the long term
Professor Jeremy Siegel has explained to investors that stocks are the best investment over the long term. In the U.S., for the last 200 years, they have provided an annual real return of 6.6%, compared with 3.6% for bonds and 2.7% for Treasury bills. In the same period the dollar has devalued 95%.
That 2-3% real difference compounds into almost 400x more net worth in stocks than in bonds. The result is the same if we extend the study to 20 other developed markets, as professors Dimson, Marsh and Staunton did in their acclaimed book, “Triumph of the Optimists,” whose results are updated every year in collaboration with Credit Suisse.
Source: Credit Suisse Global Investment Returns Yearbook 2018, by Elroy Dimson, Paul Marsh, Mike Staunton.
Professor Siegel also stated that in the short term, stocks are effectively more volatile than bonds, but over the long term that differential is substantially reduced.
Why do stocks provide better returns with less risk?
Paramés explained that over the long term each asset class has to fight currency devaluation. Of course, each individual investment has its own specific risks, but considering assets classes has a whole, currency devaluation should be the first concern of any investor.
In history there have been multiples episodes of hyperinflation and consequent severe currency devaluation. These events can impair the value of an asset class and cause permanent capital risk. That is risk. In these situations, bonds can get devaluations of 70%, 80% or 100%, which are very hard to recover. Look at the examples of Germany, France and Japan, which suffered such devaluation crises in the aftermath of the two worlds wars, in the graph above. Their real annual return, over the last 117 years, is still negative today!
Stocks also go through these events. But they always come back. Stocks are real assets, managed by people with the same interests has investors (ideally): to produce the best return possible. The currency in which they are denominated can devalue, but companies adjust to that. They correct costs, they convert prices and raise them according to inflation. And if their goods are still in demand, their profits come back.
Despite going through periods of significant currency devaluation, German, French and Japanese stocks still manage to produce a 3-4% real annual return over the same period. Stocks are a safer investment.
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