Buffett’s Bequest: Look before you leap

Warren Buffett’s annual shareholder letters, insightful and generous with advice, are a gift to all investors. This year’s letter is no exception, but his asset allocation advice to retirees and those nearing retirement warrants critical scrutiny:

“One bequest provides that cash will be delivered to a trustee for my wife’s benefit. … My advice to the trustee could not be more simple: Put 10 percent of the cash in short-term government bonds and 90 percent in a very low-cost S&P 500 index fund.” — Warren Buffett’s letter to Berkshire Hathaway shareholders, February 28, 2014

Mr. Buffett elaborates further in a CNBC interview (hat tip to Lauren Foster’s Post).

“I laid out what I thought the average person who is not an expert on stocks should do. And my widow will not be an expert on stocks. …the reason for the 10% in short-term governments is that if there’s a terrible period in the market and she’s withdrawing 3% or 4% a year you take it out of that instead of selling stocks at the wrong time. She’ll do fine with that. And anybody will do fine with that. It’s low-cost, it’s in a bunch of wonderful businesses, and it takes care of itself.”

Given Buffett’s legendary track record, is this asset allocation advice on target? Let’s take a closer look…

Unconventionally risky. Conventional advice dictates reduced exposure to the inevitable ups and downs of the market. After all, the older we get, the less time we have to recover from market declines. Target Date Funds apply this notion with stock allocations declining over time as seen in the graph below. At twenty years before retirement, stock allocations near 90% as seen on the far left. At a “target date” retirement, stock allocations decline to around 55% and fall from there. The growing gap, in green, has important implications.

Warren Buffett’s Bequest Allocation versus Target Date Funds

This chart shows a growing difference (in green) between the allocation of Mr. Buffett’s bequest for his wife versus the conventional wisdom of Target Date Funds. (http://granitehillcapital.com/blog/buffetts-asset-allocation/)

Not for the timid. Mr. Buffett’s advice promises to be a wild ride. Its range of annual returns illustrate deep, potentially stomach-losing drops compared to more conventional allocations for those nearing retirement in the middle and deeper into retirement on the right in the graph below.

The expected payoff for Buffett’s riskier portfolio comes in the form of higher expected returns over the long-run. As illustrated below, the 90% stock allocation portfolio had an average return of 11.4% over the past 88 years, as indicated by the red line in the middle of the far-left bar). The same bar also tells us that the same portfolio experienced annual extremes ranging nearly as high as +50% returns and nearly as low as –40%. Compare this to the 7.4% average return for the 30% stock portfolio at the far-right, with annual highs and lows in a smoother range of around +28% to –10%.

Annual Return Ranges and Average Returns

This chart shows the historical range in returns of various stock and bond allocations. As stock allocations rise, the range in returns and the average return also rises. http://granitehillcapital.com/blog/buffetts-asset-allocation/

Wild rides can be trouble. They may translate to selling stocks at low points and then getting back in later, after prices have already climbed and sometimes right before yet another decline. Indicative of such ill-timed entries and exits is the latest Dalbar report, which calculates the average stock investor earned 5.0% over the twenty years ending in 2013 when the S&P 500 returned 9.2%. Over two decades that gap can translate into a large wealth difference.

A low withdrawal rate set. Mr. Buffett’s advice to limit withdrawals to 3% or 4% straps you in tight. On a $1 million portfolio, annual withdrawals equate to $30,000 to $40,000. And don’t forget, taxes will likely be due on the withdrawal as either income or capital gains. Note to those nearing long retirements: You may need to save more than you think to retire in the style you want.

Stress-testing the ride. A stock market plunge at the beginning of retirement is a threat to portfolios with a high allocation to stocks. In four of the worst ten-year periods since 1926, a $1 million portfolio with Mr. Buffett’s allocation and withdrawals would have dwindled to between $400,000 and $800,000 as illustrated below. These back-tests are hypothetical – they assume historical returns and the availability of low cost index funds for implementation. Such bad scenarios may seem improbable but financial history teaches us they are possible.

Buffett's Allocation Back-tested in Bad Markets

This chart shows the simulated performance of a portfolio starting with an allocation similar to the bequest for Warren Buffett’s wife in four bad time periods.

Running out of money. What happens after these ten-year periods may be even more instructive. After the miserable decades of 1929-1938 and 1966-1975 (orange and maroon lines above) these portfolios would have either dwindled to less than $200,000 or completely disappeared over the two ensuing decades if non-essential spending were not reduced. While the 1973-1982 losses (blue line above) were more than restored by the following bull market, increase the initial withdrawal to $40,000 (4%) or reduce each year’s returns by 0.5% to cover higher transactions and/or expenses, and they too would have been depleted within 30 years.

Looking ahead. Stocks are riskier than bonds and expected to compensate investors for that risk with higher expected returns over long time periods. Mr. Buffett’s bequest is a bet on that continuing. With today’s low interest rates, he may be right in the short-term but, by one measure, future expected stock returns may not be as high as they have been in the past over the next ten years. Even if stocks to do not suffer low returns, whether his advice is appropriate for you or not depends on your willingness, capacity, and need to tolerate inevitable declines in your portfolio’s value. More specifically:

  1. Willingness is related to how unnerved you feel by declines. If a decline prompts you to sell stocks, then you may be violating one of Mr. Buffett’s a cardinal rules: “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.” (One hopes Mr. Buffett’s trustee and wife are prepared for results which are likely to fluctuate sharply.)
  2. Capacity is related to your financial resources (salary, pension, social security, and/or other income) relative to your financial goals. With Mr. Buffett’s 90% stock allocation, your portfolio will probably fluctuate more than if it were invested with a more moderate split between stocks and bonds. If a decline of sufficient depth jeopardizes your goals when you are nearing retirement, then it is time to consider a less-volatile portfolio and a “Plan B” which moderates your goals if circumstances warrant a belt-tightening. (We assume Mr. Buffett’s wife’s financial resources are far greater than her goals.)
  3. Need is related to the satisfaction of higher performance. If your financial goals are met by a less risky allocation, why take higher risk? At some point the incremental satisfaction from higher returns declines and you have to ask whether the risk is worth it. Those nearing retirement or in retirement who maintained heavy allocations to stocks prior to the financial crisis in 2008-2009 may well have regretted an overly aggressive stand. (One wonders why Mr. Buffett has chosen such a risky location for his bequest when he could have funded it with more money and reduced the risk. Sure, the risk may pay off in the form of higher returns but will it make his wife happier?)

As you develop your own investment strategy or seek help in creating one anew, it may help to review it from several angles. How would it endure through harsh periods should they occur? What is your willingness, capacity, and need to take risk, and how should you allocate your portfolio accordingly?

Warren Buffett’s Kryptonite? Again, there is a great deal we admire about Mr. Buffett – as an investor, business leader, philanthropist and fine human being. His advice about using a low-cost, passively managed stock fund for his wife’s well-being is on the right track. It’s also possible there are particulars about his estate that have been left unsaid. (This is one reason it’s so important to explore all personal circumstances before determining an appropriate portfolio mix for you and your needs.)

That said, every super man must have his Kryptonite. Perhaps Mr. Buffett’s taste for market risks and expected rewards is his.

Back-test disclosures

Granite Hill Capital Management, LLC back-tested the performance of a strategy similar to Warren Buffett’s bequest as outlined in his shareholder letter and CNBC interview. The performance is provided for informational purposes. To simulate performance, the back-test maintains target weights of 90% US stocks and 10% short-term US government bonds through annual rebalancing; Mr. Buffett did not mention maintaining such target allocation weights. Withdrawals, which started at $35,000 and grew with inflation, were deducted from beginning of year balances. The back-test uses (1) bond index performance (60% one month US T-bills and 40% five year US Treasury notes rebalanced annually) with a .12% expense ratio deducted to approximate a low cost mutual fund expense and (2) S&P 500 index performance with a .05% expense ratio deducted to approximate the Vanguard fund mutual fund Mr. Buffett chose. Mr. Buffett’s strategy calls for the use of short-term US government bonds, not a mutual fund. The back-tested performance does not represent actual performance and should not be interpreted as an indication of such performance. Back-tested performance differs from actual performance in that the simulation: (1) was not available for investment through most of the back-test time period, (2) would have had higher mutual fund expense ratios during most of the back-test time period, and (3) does not reflect transaction costs in an actual account.

This blog entry is distributed for educational purposes and should not be considered investment, financial, or tax advice. Investment decisions should be based on your personal financial situation. Statements of future expectations, estimates or projections, and other forward-looking statements are based on available information believed to be reliable, but the accuracy of such information cannot be guaranteed. These statements are based on assumptions that may involve known and unknown risks and uncertainties. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Copyright © 2014, Granite Hill Capital Management, LLC.

Links to third-party websites are provided as a convenience and do not imply an affiliation, endorsement, approval, verification or monitoring by Granite Hill Capital Management, LLC of any information contained therein. The terms, conditions and privacy policy of linked third-party sites may differ from those of this website.

This blog entry is distributed for educational purposes and should not be considered investment, financial, or tax advice. Investment decisions should be based on your personal financial situation. Statements of future expectations, estimates or projections, and other forward-looking statements are based on available information believed to be reliable, but the accuracy of such information cannot be guaranteed. These statements are based on assumptions that may involve known and unknown risks and uncertainties. Past performance is not indicative of future results and no representation is made that any stated results will be replicated. Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.

Links to third-party websites are provided as a convenience and do not imply an affiliation, endorsement, approval, verification or monitoring by Granite Hill Capital Management, LLC of any information contained therein. The terms, conditions and privacy policy of linked third-party sites may differ from those of this website.