Back in February, Warren Buffett released his 54th annual letter to the shareholders of Berkshire Hathaway.
Warren’s letters garner a lot of attention – not only because of their author, but because they are intelligent, humorous, down-to-earth, understandable, informative and, quite often, excellent. They are more than a recap of his company’s performance. He shares insights into important investment and business related concepts interwoven with jokes, anecdotes and important life lessons. There’s a take-away for almost any individual that reads his letters – either on an investment level, a business level or a personal level.
Since reading this year’s letter, however, I have been meaning to capture my thoughts on an aspect of Warren’s note that, while accurate, misses the point for most investors and perhaps shows that, understandably, Warren has a somewhat different perspective to the rest of us.
In 1942 at the age of 11, Warren made his first investment – a total of $US114.75 (or about $US1,500 in today’s dollars).
Warren calculates that if he had simply invested this $114.75 in a ‘simple’ diversified index fund over the entire time (77 years), it would have grown more than 5,000 times to $606,811 (before taxes and assuming all dividends were reinvested). This outcome is the result of an annual compound rate of nearly 12%.
He then says, again correctly, that an investment of $1 million by a tax-free institution of that time (e.g. pension fund or college endowment) would have grown to roughly $5.3 billion and compares this to the actual long-term average performance of 6 or 7% per annum.
While the raw numbers are correct – equities have a stronger growth result over the long-term than endowment and pension funds – this message read in isolation could easily result in an invalid conclusion.
Let’s dial it back to what purpose endowment and pension funds serve. An endowment fund supports institutions, such as universities, not-for-profits, hospitals or churches, by making periodic withdrawals from its invested capital for the use of the institution. Pension funds work in a similar way except to support individuals by generating an income throughout retirement.
Both endowment and pension funds exist to support and meet periodic payment obligations to institutions or individuals. The key words here are periodic payment obligations – i.e. they can’t afford to play a 77-year waiting game for returns.
There is a very specific risk that exists for those who are planning to retire or those who are recently retired. It’s called Sequencing Risk and it relates to the (very real and currently elevated) risk that the path or sequence of returns leaves a retiree with significantly less money due to portfolio losses occurring close to the commencement of retirement – a time when they generally stop contributing to their superannuation and instead start drawing from it.
Consider a portfolio of stocks alone. Now consider the stock market suffers a downturn. Someone like Warren can afford this hit. Most can’t. That’s why no institution with an annual payout obligation would invest only in stocks. That’s why retirees shouldn’t construct a retirement portfolio of only stocks.
So, what can investors do?
A good starting point is to know why you’re investing, understand what you’re investing in, be aware of the risks and reassess your strategy. What’s important to you? Maximising returns is very unlikely to be your objective. Rather, funding future expenses and meeting your future cash flow requirements will be. Keeping this front of mind is key.
My colleague Richard wrote an article a few months ago that talks to Sequencing Risk and strategies for retiring in uncertain times. It looks at how retirees (or soon-to-be retirees) can structure investment portfolios to reduce the risk of loss in the lead up to and in the early years of retirement. He talks about goal-setting, employing a goals-based investment framework, the importance of averaging and funding for liquidity as well as how to avoid behavioural mistakes we are all prone to making. A worthwhile read for those that are starting to think about funding retirement.
Disclaimer: This article contains general information only and is not intended to constitute financial product advice. Any information provided or conclusions made, whether express or implied, do not take into account the investment objectives, financial situation and particular needs of an investor. It should not be relied upon as a substitute for professional advice.