How Warren Buffett Thinks You Should Invest

Warren Buffett’s latest letter to Berkshire Hathaway shareholders contains a brilliant prescription for managing a personal portfolio. I was prepared to write a post quoting a few good lines from his letter, but his message on individual investing on pages 18 and 19 is so good that I will devote the rest of this article to summarizing it.

The goal of investing is to increase the purchasing power of your savings. Over the past 50 years, S&P 500 stocks, with reinvested dividends, have increased in value by a factor of 113, while the U.S. dollar’s purchasing power has dropped by about a factor of 8.

“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.” This was true in the previous 50 years and “it is almost certain to be repeated during the next century.”

Volatility is not the same as risk. “Stock prices will always be far more volatile than cash-equivalent holdings. 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.”

Over a single year or less, stocks are riskier than cash-equivalents. Anyone who needs money in the short term should “keep appropriate sums in Treasuries or insured bank deposits.” For the great majority of investors who can invest with a multi-decade horizon, short-term volatility is unimportant. “For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities”

Investors who fear price volatility may, “ironically, end up doing some very risky things” like “investing in ‘safe’ Treasury bills or bank certificates of deposit.” U.S. stocks have tripled since 6 years ago. “If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund.”

“Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to ‘time’ market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. Indeed, borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets.” Nobody “can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.”

“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”

Returning to my own voice, I see these words as a validation of my own approach to investing:

– Low-cost stock indexes
– Buy and hold
– No leverage
– For money not needed for 5 years, 100% in stocks
– For money needed in less than 5 years, 100% in cash or GICs

This is one article I may reread myself if I ever start to doubt my approach to investing.