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."
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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!
"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.