by Don Gould
Investing legend Warren Buffett issued his ever-colorful annual letter to shareholders in late February. I can only hope to be going as strong at 81.
On pages 17-19, Buffett argues that equities are the least risky asset class because they are most likely to preserve and increase purchasing power in the long run. Volatility, the traditional measure of investment risk, is bunk, according to Buffett. He correctly points out that cash has zero volatility and presently zero return (less than zero when inflation is considered), and therefore is quite a risky thing to hold for the long term. He also rightly notes that gold is a non-productive asset that should not be expected to do as well over time as productive assets like shares in growing companies. So far, so good.
My problem is with Buffett’s conclusion, basically that investors should maximize their investment in stocks. This is one of those cases where the supporting statements are probably true, but the conclusion is false. It’s a very effective form of persuasion – your head keeps nodding yes as he presents one truth after another, and by the time he reaches his conclusion it’s hard not to keep nodding yes. Especially when it’s Warren Buffett who’s telling you this!
Buffett’s viewpoint may be right for Berkshire Hathaway and even for Buffett himself, but it’s most assuredly not right for the average investor.
In Buffett’s Rip Van Winkle world, the average Joe should buy stocks and then take a 30-year snooze. When he awakes, voila! Stocks have beaten bonds and gold. Meanwhile, back in the real world that individual investors inhabit, time horizons are finite and volatility does matter. Show me one investor who bought the Nasdaq in the late 1990s and was still willing to think in terms of 30-year holding periods by late 2002 after an 80% decline. More like 30 minutes. Along the road to the storied long run, stuff happens, some of it so terrifying that the risk-averse will leave the road entirely, making the road’s eventual destination irrelevant. And sometimes, circumstances (e.g., prolonged unemployment) force us to leave the road, at least temporarily.
Buffett’s faulty conclusion stems from a faulty premise, which is that investors buy bonds and gold because they expect these assets to outperform stocks. It may be the case that with a net worth in the tens of billions, Buffett’s only goal is to maximize purchasing power over the long run, in which case Buffett’s objection to bonds and gold could make sense. But the vast majority of investors have mulitiple, often conflicting, objectives. These include not only maximizing long-run purchasing power, but also controlling anxiety during the day and sleeping at night. Warren likes to project an aura of the multi-billionaire next door, just an “aw shucks, down-home” Midwestern kind of guy who eats steak and drives a Ford Taurus (to the airfield where his Citation jet awaits). But I think his misreading of the typical investor’s motivations confirms the obvious, which is that Warren is no average Joe.
So I dispute Buffett’s basic assumption. Investors shouldn’t – and by and large they don’t – expect bonds and gold to beat stocks. His premise falls into the “straw man” category – it’s easy to knock down, but Warren really should pick on someone his own size.
Investors buy bonds not with the expectation of beating stocks over the long run, but rather as a tool to calibrate overall portfolio volatility and hopefully maintain purchasing power, either spending or reinvesting interest income along the way. (I grant that Bernanke’s zero-rate policy, combined with the past 30 years of falling bond yields, makes the purchasing power goal a taller order than usual just now.) And for mature investors, gold is a currency alternative, not a hoped-for stock beater. The finite supply of gold, they reasonably hope, will preserve its purchasing power better than the seemingly infinite supply of government-produced currency.
I note that highly successful people, like Buffett, often and understandably are convinced that their success proves some kind of immutable law. In Buffett’s case, that “law” might be stated as: buy good companies, run by talented managers, and you will be justly rewarded in time. I tend to view these case studies, and the resultant laws, as much more dependent on the time and place in which the success occurred. Buffett’s “law” was accurate in the United States from his mid-1960s start and we hope it’s still the case. However, consider if Buffett had instead started his investing career in Germany in 1905. Subsequent wars and hyperinflation would have yielded a quite different form of Buffet’s law, I’m very sure. Food for thought.