Should You Keep Idle Funds in Cash, an Index Fund or Berkshire Hathaway?

Take your time filling your portfolio with new stock ideas; until you have enough, you'll need to keep money somewhere else

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Nov 30, 2016
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Someone who reads my blog emailed me this question:

“Does it make sense to use index funds (when appropriate, based on multiyear historical trailing P/E for example) as part of the portfolio allocation when picking stocks (assuming the stock picker is above average)? Or does this stock picker have no business looking at index funds at all?”

I honestly don’t think it makes sense to use index funds if you are an above-average stock picker. Also, it’s not just a matter of skill. It’s a matter of focus. If you are spending time buying index funds, you are spending time thinking about the overall market instead of specific stocks. There are some situations where I could imagine someone who is a stock picker also owning an index fund. But they aren’t in the situations of which you are probably thinking.

Let’s start with how I’ve used index funds. I started investing when I was 14. When I started, I used index funds. Instead of just having a bunch of savings in cash and then picking stocks in which to invest a certain portion, I put everything in stocks initially. I just put all my savings in an index fund. Whenever I found a stock I liked, I would sell about 20% of the index fund and put the proceeds into a stock. In this way, I would end up with no more than one-fifth of my account in any one stock even though I didn’t have five stock ideas yet. Once I had two stock ideas, I was 20% Stock A, 20% Stock B and 60% index fund. Eventually, I got to the point where I was 100% stocks I had picked and 0% index funds.

This is a terrific way to use index funds. And I suggest that every new investor start out this way. Figure out how diversified you’d like to be. I suggest picking from one of three options: low diversification (five stocks), medium diversification (10 stocks) and high diversification (20 stocks). Very few investors hold fewer than five stocks. And there is little benefit to holding more than 20 stocks. It just doesn’t reduce risk. You’d be better off splitting a 20-stock portfolio into different pockets of portfolios with a different focus.

Instead of going from a 20-stock portfolio to a 40-stock portfolio in an effort to add to diversification – you should just split your 20 slots into 10 U.S. stock slots and 10 foreign stock slots. Or you could split your portfolio up into five slots of U.S. micro-caps, five slots of well-known U.S. stocks, five foreign micro-caps and five well-known foreign stocks.

That kind of diversification will do more to diversify away the specific risk you are still seeing in a 20-stock portfolio. If you are interested in index funds, I suggest you use a 20-stock portfolio instead. You may want to be diversified by size of the stocks you are looking at – micro-cap versus mid-cap, big-cap, etc. And you may want to be diversified by the country those stocks are in – U.S. versus foreign.

I would start by putting everything in an index fund. If you are planning to always own 10 U.S. stocks and always own 10 foreign stocks – I’d suggest instead buying two index funds. One is a U.S. index fund. The other is some index fund that does not include the U.S. And then you can sell 10% of one of these two funds whenever you find a specific stock belonging to that category. Let’s say you start out with a portfolio that is 50% U.S. index fund, 50% foreign index fund and then you buy Luxottica. Luxottica (LUX, Financial) is an Italian stock. You’d sell 10% of your foreign stock index fund, you’d put that 10% into Luxottica. The resulting account would be: 50% U.S. index fund, 40% foreign index fund, and 10% Luxottica. This is how I think investors should use an index fund. You can use it to increase selectivity. One problem I notice with investors – especially new investors – is that they want to be diversified, but they don’t have enough good ideas yet. They make the mistake of picking too many stocks too quickly in their first few years as investors. The same thing happens if they change strategies. If they shift from more of a Ben Graham investor to more of a Warren Buffett (Trades, Portfolio) investor or more of a Phil Fisher investor or something like that they are too active in buying and selling stocks for that one year. Instead, they could sell whichever stocks they no longer believe in and put that money in an index fund as a holding cell. An index fund can be a staging area.

You could also do something else. And this is the thing I’d recommend a lot of value investors do. You can just buy Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). Berkshire Hathaway is diversified. It’s a lot like an index fund. Berkshire is cheaper than the Standard & Poor's 500 right now. And it has a better capital allocator (Buffett) at the top than the average S&P 500 stock. This is a matter of personal preference. In your gut, would you feel safer owning an S&P 500 index fund or Berkshire Hathaway? Or would you feel equally comfortable with both?

If you’re starting a new portfolio, and you’d feel more comfortable with Berkshire than with the S&P 500 – put 100% of your portfolio into Berkshire and then sell Berkshire piece by piece (at a rate of 5%, 10%, or 20% of your portfolio – depending on how concentrated you want to be) as you replace Berkshire with a stock you like better than Berkshire. I think that’s a good exercise for most investors. Then you are comparing the stock you have found yourself with what Buffett has built. If you don’t like the stock you’ve found better than Berkshire – then why not just own Berkshire? Berkshire can be your staging area. It can be where you keep your money until you find someplace to put it to work for yourself. And that someplace has to be better than Berkshire to make the switch worthwhile.

That makes a lot of sense. Starting with a 100% Berkshire portfolio and then shifting it as you find stocks is a good approach. Starting 100% in an index fund also makes some sense. To me, it makes less sense than owning Berkshire. As of today, the S&P 500 is clearly inferior to Berkshire Hathaway. I’m not sure why anyone would prefer owning an S&P 500 index to owning Berkshire. But some people may feel there are risks at Berkshire (Buffett dies, an insurance subsidiary makes some terrible mistakes, etc.) that can’t be diversified away by the structure of that company. The S&P 500 is more diverse than Berkshire.

My suggestion would be to imagine a 50% decline in the S&P 500 and a 50% decline in Berkshire Hathaway. All your money is in the S&P 500; it drops 50%. How do you feel now? What do you do? Buy? Sell? Hold? Now, imagine all your money is in Berkshire Hathaway. It drops 50%. How do you feel now? What do you do? Buy? Sell? Hold? Compare the two gut feelings you are imagining. In which scenario did you feel sicker to your stomach? Put your idle money in the one that made you feel less sick.

You can also split the difference. You can start with an account that is 50% Berkshire Hathaway and 50% S&P 500 index fund and then you can sell – for a 10-stock portfolio – one-tenth of each position to fund the latest stock you’ve found.

For a stock picker, the only advantage I see to an index fund is that it reduces the number of decisions you have to make. There’s a danger of complete loss if you make a mistake picking a single stock. That danger doesn’t exist in an index fund. The S&P 500 is never going to go to zero. It may drop 50%. Berkshire may also drop 50%. But the S&P 500 will always – eventually – recover from a 50% drop. A specific stock may not. I’ve owned Barnes & Noble (BKS, Financial) and Weight Watchers (WTW, Financial). If they dropped 50%, I’m not sure they’d ever make that money back.

That’s the risk with an individual stock pick. It’s the risk with an individual business. Buffett bought into the original Berkshire Hathaway textile company. It closed 20 years later. It was eventually a complete loss. He bought Dexter Shoe. It was a complete loss. He bought Bank of Ireland common stock. It was a complete loss. If Buffett manages to find one total wipeout of an investment at least once a decade (and he’s come pretty close to that) then so will you. You can expect that one of your stocks will go to zero at least once a decade. For that reason, you may want some diversification.

Let’s say you are comfortable with a 20-stock portfolio. That’s great. I own far fewer stocks. But I think 20 is a great number for the average investor. How quickly can you fill up this portfolio? I don’t think you can do it in less than five years. I think it’s totally unreasonable to expect to find a good enough – safe enough – stock idea more than once a quarter. Set a goal of finding the best stock idea you can each quarter and then – at the end of the quarter – buying that stock. Let’s look at how this would work for a totally new investor with the goal of owning 20 stocks.

The investor would put 100% of his money in an index fund. He could start looking at stocks now. But, he won’t buy any until the end of the first full quarter he’s devoted himself to investing. We’ll say the first purchase will be made at the end of March 2017. You spend the months of January, February and March looking for the best stock you can find. You rank them. Whatever is No. 1 at the end of March is what you buy. On the last day of March you sell 5% of the S&P 500 index fund you own and put that 5% into whatever stock you’ve decided is the best one out there. You repeat this process every quarter. At the end of 2017, you’ll be 5% Stock A, 5% Stock B, 5% Stock C, 5% Stock D and 80% S&P 500 index fund. At the end of 2018, you’ll be 40% hand-picked stocks and 60% S&P 500 index fund. Then it’s 40% index fund in 2019, 20% index fund in 2020 and finally 100% hand-picked stocks in 2021.

This is an approximation. The reality is that you’ll have less in hand-picked stocks than I suggested here. In my experience, the “takeout” rate for stocks I pick is pretty high. You may lose 10% to 20% of your portfolio to mergers, going private transactions, etc. Things that create turnover in your portfolio without any action on your part. That means that you’re not going to have much more than 60% of your portfolio in handpicked stocks at the end of 2021. It’s hard to come up with an exact number. I don’t know how many stocks you pick will be taken over. But I’ve never had a portfolio that lost less than 10% a year to various takeovers. It’s usually been a going private transaction with my stocks. There haven’t been many takeovers at all. But I’ve always lost more than 10% of my portfolio to going private transactions. So, I wouldn’t be able to reach 100% handpicked stocks within five years.

Nevertheless, this is the right “slow and steady” approach to take to stock picking. I try to limit myself to buying just one stock per year. I’ve never been disciplined enough to stick with that idea for long. But it’s a goal I am always reaching for. For most investors, I’d suggest a quota of one stock purchase every quarter. It should take you three months times the number of stocks you want in your portfolio to fill up a portfolio. It’s not a good idea to go from owning no stocks to having all hand-picked stocks in just one year. It’s a better plan to take three to five years to build your own hand-picked portfolio.

An index fund can be the green room where you keep cash before moving it into your own ideas. Berkshire Hathaway can better serve that purpose for many value investors.

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