Warren Buffett - Bonds / Risk / Portfolio Ratio

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escape_velocity
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Warren Buffett - Bonds / Risk / Portfolio Ratio

Post by escape_velocity » Fri Mar 09, 2018 10:57 am

I usually love Warren's advice, but I need some help with this one:
"It is a terrible mistake for investors with long-term horizons -- among them, pension funds, college endowments and savings-minded individuals -- to measure their investment 'risk' by their portfolio's ratio of bonds to stocks," Mr Buffett wrote. "Often, high-grade bonds in an investment portfolio increase its risk."

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Can someone explain it to me like I'm 5 years old? Everyone on this site measures their portfolios on a 60/40 (or whatever) ratio and I think it's safe to say that most people believe that a dose of bonds "smooths" the bumps which translates to (in my mind) reducing risk.

Help me understand what Warren is trying to explain, please!

dbr
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Re: Warren Buffett - Bonds / Risk / Portfolio Ration

Post by dbr » Fri Mar 09, 2018 11:10 am

escape_velocity wrote:
Fri Mar 09, 2018 10:57 am
I usually love Warren's advice, but I need some help with this one:
"It is a terrible mistake for investors with long-term horizons -- among them, pension funds, college endowments and savings-minded individuals -- to measure their investment 'risk' by their portfolio's ratio of bonds to stocks," Mr Buffett wrote. "Often, high-grade bonds in an investment portfolio increase its risk."

Read more: http://www.afr.com/markets/warren-buffe ... z59Gdz3NIG
Follow us: @FinancialReview on Twitter | financialreview on Facebook
Can someone explain it to me like I'm 5 years old? Everyone on this site measures their portfolios on a 60/40 (or whatever) ratio and I think it's safe to say that most people believe that a dose of bonds "smooths" the bumps which translates to (in my mind) reducing risk.

Help me understand what Warren is trying to explain, please!
There are already a jillion threads on this question. The gist of Mr. Bogle's advice is that bonds do not offer enough return to meet objectives and that stocks do. Especially, bonds, meaning long bonds, are at great risk to inflation. Mr. Bogle has great and enduring confidence in the future of American enterprise and industry and believes that the safest financial policy is to be an owner of that enterprise. That is why when asked what one should invest in he says the stocks of the American S&P 500 index. As an alternative he might suggest shares in his company, Berkshire. Buffett believes that one invests by holding enterprises rather than by holding assets.

Bogleheads don't like all stock advice because we are convinced that no one is able to hold an all stock portfolio without panicking and doing something really stupid during a stock downturn. We also believe that most investors don't understand what it means to live with high volatility in investments and will not be able to live with that for the long run. Mr. Bogle can live with it and he thinks any professional investor can too. Bogleheads believe inherently that diversification of every kind is an obviously correct strategy, which means not just stocks vs bonds, but US vs international stocks, maybe diversification over risk factors (Bogle himself rejects both international and factor investing), but includes diversified income streams by holding pensions, annuities, and Social Security. We have not been able to shout down those who hold real estate, but other alternative investments such as gold fare less well here.

Also, don't invest by listening to soundbites from anyone, including Mr. Buffett and Mr.Bogle.

Valuethinker
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Re: Warren Buffett - Bonds / Risk / Portfolio Ration

Post by Valuethinker » Fri Mar 09, 2018 11:14 am

escape_velocity wrote:
Fri Mar 09, 2018 10:57 am
I usually love Warren's advice, but I need some help with this one:
"It is a terrible mistake for investors with long-term horizons -- among them, pension funds, college endowments and savings-minded individuals -- to measure their investment 'risk' by their portfolio's ratio of bonds to stocks," Mr Buffett wrote. "Often, high-grade bonds in an investment portfolio increase its risk."

Read more: http://www.afr.com/markets/warren-buffe ... z59Gdz3NIG
Follow us: @FinancialReview on Twitter | financialreview on Facebook
Can someone explain it to me like I'm 5 years old? Everyone on this site measures their portfolios on a 60/40 (or whatever) ratio and I think it's safe to say that most people believe that a dose of bonds "smooths" the bumps which translates to (in my mind) reducing risk.

Help me understand what Warren is trying to explain, please!
"Risk" is usually measured in finance as annual portfolio volatility in returns. So bonds in a portfolio damp down the volatility of stocks (which can rise or drop by 50% in a year, and the long run average is something like 15%).

"Risk" in the sense Buffett means it is a failure to have enough money for your goals in the long run.

Bonds pay low fixed returns (very low right now). Not even enough to keep up with inflation some years. Thus in the long run a portfolio with more bond will be much smaller than one with fewer or no bonds due to the impact of compounding.

What he's really saying is that if you take a long enough view, and a university endowment should be practically forever, stocks are less risky (despite much higher annual volatility) because you will have more money.

This works fine, as long as you don't have a specific need for cash in the meantime. If you are Warren Buffett, you have more money than you could ever spend (and he's famously frugal, to boot). A bad year in the stock market world gives him opportunities to buy businesses on the cheap-- as he did with GE and with Goldman Sachs during the financial crisis: lent them money at 10% p.a. plus the ability to buy their shares at a discounted price. Note also through his insurance and other operations he sits on a $100bn pile of cash, as well as one of the world's lowest interest rates to borrow. If he needs cash, he has it or can borrow it fairly easily.

If you are retired and dependent upon your portfolio to live, then you are in a different position. Markets go down, maybe you can forgo travel that year, but you cannot forgo healthcare and housing expenses.

dbr
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Re: Warren Buffett - Bonds / Risk / Portfolio Ration

Post by dbr » Fri Mar 09, 2018 11:24 am

Valuethinker wrote:
Fri Mar 09, 2018 11:14 am

If you are retired and dependent upon your portfolio to live, then you are in a different position. Markets go down, maybe you can forgo travel that year, but you cannot forgo healthcare and housing expenses.
Actually retirement withdrawal models do not generally support the idea that more in stocks is risky in retirement, at least not to the degree they show that not enough in stocks is risky in retirement. It will still be true that a retiree who is still concerned with how wealthy he might get rather than just whether or not he will run out money needs to have a lot in stocks. A better argument for the retiree is that if he doesn't need the risk taken in stocks he should not take that risk, and few retirees need to take that risk. Mr. Buffett, as you point out, has an entirely different situation and an entirely different set of incentives, which include practicing his trade as a businessman and might extend to a new found interest in philanthropy which would be benefited by maximum growth of wealth. The ordinary retiree interested in philanthropy might make similar decisions.

itstoomuch
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Re: Warren Buffett - Bonds / Risk / Portfolio Ration

Post by itstoomuch » Fri Mar 09, 2018 11:31 am

+1
In my Discretionary trading accounts, I buy a company, NOT its stock. A stock is a manifestation of the company.
No bonds in our portfolio.
Rev012718; 4 Incm stream buckets: SS+pension; dfr'd GLWB VA & FI anntys, by time & $$ laddered; Discretionary; Rentals. LTCi. Own, not asset. Tax TBT%. Early SS. FundRatio (FR) >1.1 67/70yo

pascalwager
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Re: Warren Buffett - Bonds / Risk / Portfolio Ration

Post by pascalwager » Fri Mar 09, 2018 12:12 pm

Buffett stipulates that his comments refer to investors with "long-term horizons", so there's not really much to argue about.

NPT
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Re: Warren Buffett - Bonds / Risk / Portfolio Ration

Post by NPT » Fri Mar 09, 2018 1:37 pm

escape_velocity wrote:
Fri Mar 09, 2018 10:57 am
Can someone explain it to me like I'm 5 years old? Everyone on this site measures their portfolios on a 60/40 (or whatever) ratio and I think it's safe to say that most people believe that a dose of bonds "smooths" the bumps which translates to (in my mind) reducing risk.

dbr wrote:
Fri Mar 09, 2018 11:10 am
(...) The gist of Mr. Bogle's advice is that bonds do not offer enough return to meet objectives and that stocks do. Especially, bonds, meaning long bonds, are at great risk to inflation. (...) Buffett believes that one invests by holding enterprises rather than by holding assets. (...)


The most insightful thing Buffett said about this topic in my opinion is that volatility is a really bad measure of risk. Bad here does not mean that it is less than optimal but still the best we have, as some assume; instead, bad means it is actually misleading. Buffett explains this very clearly in his 2014 letter, for example. Once one no longer sees lower volatility as an especially important feature, bonds start to look much less attractive.

This is what I would say to a 5-year-old (to be clear, this is just my personal opinion, inspired by Buffett's advice):
  • Smoothing the bumps only reduces some types of risk, but does not by itself reduce overall risk. Financial literature is wrong: Bumps have relatively little to do with risk.
  • Bonds are safer in the short term and diversified stocks are safer in the long term.
    (This is sometimes disputed on the basis that the likely dispersion of outcomes with stocks is much wider, but it is a mistake to consider the upside uncertainty to be risk. It may be mathematically elegant but it does not make sense in the real world.)
  • You will always need both stocks and bonds because on the one hand you can never rule out the possibility of unexpected but necessary expenditures in the short term, and on the other hand you can never be certain that you will not beat the odds and survive much longer than predicted.
    Also, there is a small chance that even these very general assumptions about stocks and bonds could be wrong.
  • Be careful about how much you allocate to each asset class. Popular wisdom is wrong: There is rarely any situation in which having more in stocks than in bonds is not a better and safer bet.
  • You may decide to put a large portion of your wealth into fixed income if you are very fearful and easily driven by emotions. It could be a wise choice but keep in mind that doing so is risky and expensive in the long term, so try to balance your emotional and financial needs.

magneto
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Re: Warren Buffett - Bonds / Risk / Portfolio Ration

Post by magneto » Fri Mar 09, 2018 1:59 pm

deleted - must read posts more carefully
'There is a tide in the affairs of men ...', Brutus (Market Timer)

itstoomuch
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Re: Warren Buffett - Bonds / Risk / Portfolio Ration

Post by itstoomuch » Fri Mar 09, 2018 3:10 pm

JMO
Everyone must remember that BH is essentially a Vanguard/Index/MF site.
Vanguard makes money on selling and manages Indexes and MF of stocks and bonds. It does not purposely sell cash instruments or will they sell cash instruments which will make them a depository bank.
Eleven years ago, the investment environment is very different than today.
Bogle and other BHers who wrote books and articles did so years ago when the investing climate was different (climate change cycles) :annoyed .
YMMV
Rev012718; 4 Incm stream buckets: SS+pension; dfr'd GLWB VA & FI anntys, by time & $$ laddered; Discretionary; Rentals. LTCi. Own, not asset. Tax TBT%. Early SS. FundRatio (FR) >1.1 67/70yo

Valuethinker
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Re: Warren Buffett - Bonds / Risk / Portfolio Ration

Post by Valuethinker » Sun Mar 11, 2018 7:10 am

dbr wrote:
Fri Mar 09, 2018 11:24 am
Valuethinker wrote:
Fri Mar 09, 2018 11:14 am

If you are retired and dependent upon your portfolio to live, then you are in a different position. Markets go down, maybe you can forgo travel that year, but you cannot forgo healthcare and housing expenses.
Actually retirement withdrawal models do not generally support the idea that more in stocks is risky in retirement, at least not to the degree they show that not enough in stocks is risky in retirement.
On the basis of what pattern of returns?

The whole point of stocks is that any return is possible from minus 82% (UK 1972-74, in real terms) to no doubt +100% (some market, somewhere).

This is the point. Buffett can afford that nightmare year. He's got $100bn of cash, and he would simply buy more of what he already owns + businesses on the cheap. But a retiree needs to have cash to spend to meet expenses.
It will still be true that a retiree who is still concerned with how wealthy he might get rather than just whether or not he will run out money needs to have a lot in stocks. A better argument for the retiree is that if he doesn't need the risk taken in stocks he should not take that risk, and few retirees need to take that risk. Mr. Buffett, as you point out, has an entirely different situation and an entirely different set of incentives, which include practicing his trade as a businessman and might extend to a new found interest in philanthropy which would be benefited by maximum growth of wealth. The ordinary retiree interested in philanthropy might make similar decisions.
He's actually always been philanthropic. It's just his quantum of money is now so much greater, and he is looking to his legacy. Along came his bridge partner, Bill Gates, with a plan & infrastructure to do it (the Gates Foundation). The Gates endowment itself presumably holds a lot of stocks.

https://www.gatesfoundation.org/Who-We- ... tion-Trust

https://fintel.io/i13d/cascade-investment is what I could find in terms of latest filings for Bill Gates' fund manager.

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